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revenue of $54,000 (12% 3 1⁄2 3 $900,000) at December 31, 2014. The journal entry to record SEK’s sale to Grant Company is as follows (ignoring the cost of goods sold entry). July 1, 2014 Notes Receivable 1,416,163 Sales Revenue 900,000 Discount on Notes Receivable 516,163 SEK makes the following entry to record interest revenue. December 31, 2014 Discount on Notes Receivable 54,000 Interest Revenue (12% 3 ½ 3 $900,000) 54,000 Sales with Right of Return Whether cash or credit sales are involved, a special problem arises with claims for returns and allowances. In Chapter 7, we presented the accounting treatment for normal returns and allowances. However, certain companies experience such a high rate of returns—a high ratio of returned merchandise to sales—that they find it necessary to postpone reporting sales until the return privilege has substantially expired. For example, in the publishing industry, the rate of return approaches 25 percent for hardcover books and 65 percent for some magazines. Other types of companies that experience high return rates are perishable food dealers, distributors who sell to retail outlets, recording-industry companies, and some toy and sporting goods manufactur- ers. Returns in these industries are frequently made either through a right of contract or as a matter of practice involving “guaranteed sales” agreements or consignments. Three alternative revenue recognition methods are available when the right of return exposes the seller to continued risks of ownership. These are (1) not recording a sale until all return privileges have expired; (2) recording the sale, but reducing sales by an estimate of future returns; and (3) recording the sale and accounting for the returns as they occur. The FASB concluded that if a company sells its product but gives the buyer the right to return it, the company should recognize revenue from the sales trans- actions at the time of sale only if all of the following six conditions have been met. [3] 1. The seller’s price to the buyer is substantially fi xed or determinable at the date of sale. 2. The buyer has paid the seller, or the buyer is obligated to pay the seller, and the obligation is not contingent on resale of the product. 1048 Chapter 18 Revenue Recognition 3. The buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product. 4. The buyer acquiring the product for resale has economic substance apart from that provided by the seller. 5. The seller does not have signifi cant obligations for future performance to directly bring about resale of the product by the buyer. 6. The seller can reasonably estimate the amount of future returns. What if the six conditions are not met? In that case, the company must recognize sales revenue and cost of sales either when the return privilege has substantially expired or when those six conditions subsequently are met, whichever occurs first. In the income statement, the company must reduce sales revenue and cost of sales by the amount of the estimated returns.11 An example of a return situation is presented in Illustration 18-5. ILLUSTRATION 18-5 SALES WITH RETURNS Recognition—Returns Facts: Pesido Company is in the beta-testing stage for new laser equipment that will help patients who have acid reflux problems. The product that Pesido is selling has been very successful in trials to date. As a result, Pesido has received regulatory authority to sell this equipment to various hospitals. Because of the uncertainty surrounding this product, Pesido has granted to the participating hospitals the right to return the device and receive full reimbursement for a period of 9 months. Question: When should Pesido recognize the revenue for the sale of the new laser equipment? Solution: Given that the hospital has the right to rescind the purchase for a reason specified in the sales contract and Pesido is uncertain about the probability of return, Pesido should not record revenue at the time of delivery. If there is uncertainty about the possibility of return, revenue is recognized when the
goods have been delivered and the time period for rejection has elapsed. Only at that time have the risks and rewards of ownership transferred and its performance obligation satisfied. Companies may retain only an insignificant risk of ownership when a refund or right of return is provided. For example, revenue is recognized at the time of sale (even though a right of return exists or refund is permitted), provided the seller can reliably estimate future returns. In this case, the seller recognizes an allowance for returns based on previous experience and other relevant factors. Returning to the Pesido example, assume that Pesido sold $300,000 of laser equip- ment on August 1, 2014, and retains only an insignificant risk of ownership. On October 15, 2014, $10,000 in equipment was returned. In this case, Pesido makes the following entries. August 1, 2014 Accounts Receivable 300,000 Sales Revenue 300,000 October 15, 2014 Sales Returns and Allowances 10,000 Accounts Receivable 10,000 At December 31, 2014, based on prior experience, Pesido estimates that returns on the remaining balance will be 4 percent. Pesido makes the following entry to record the expected returns. 11Here is an example where GAAP provides detailed guidelines beyond the general revenue recognition principle. Revenue Recognition at Point of Sale (Delivery) 1049 December 31, 2014 Sales Returns and Allowances [($300,000 2 $10,000) 3 4%] 11,600 Allowance for Sales Returns and Allowances 11,600 The Sales Returns and Allowances account is reported as contra revenue in the income statement, and Allowance for Sales Returns and Allowances is reported as a contra account to Accounts Receivable in the balance sheet. As a result, the net revenue and net accounts receivable recognized are adjusted for the amount of the expected returns. Sales with Buybacks If a company sells a product in one period and agrees to buy it back in the next period, has the company sold the product? As indicated in Chapter 8, legal title has transferred in this situation. However, the economic substance of this transaction is that the seller retains the risks of ownership. Illustration 18-6 provides an example of a sale with a buyback provision. ILLUSTRATION 18-6 SALE WITH BUYBACK Recognition—Sale with Facts: Morgan Inc., an equipment dealer, sells equipment to Lane Company for $135,000. The equipment Buyback has a cost of $115,000. Morgan agrees to repurchase the equipment at the end of 2 years at its fair value. Lane Company pays full price at the sales date, and there are no restrictions on the use of the equipment over the 2 years. Question: How should Morgan record this transaction? Solution: For a sale and repurchase agreement, the terms of the agreement need to be analyzed to ascertain whether, in substance, the seller has transferred the risks and rewards of ownership to the buyer. In this case, it appears that the risks and rewards of ownership are transferred to Lane Company and therefore a sale should be recorded. That is, Lane will receive fair value at the date of repurchase, which indicates Morgan has transferred risks of ownership and satisfied its performance obligation. Furthermore, Lane has no restrictions on use of the equipment, which indicates that Morgan has transferred the rewards of ownership. Morgan records the sale and related cost of goods sold as follows. Cash 135,000 Sales Revenue 135,000 Cost of Goods Sold 115,000 Inventory 115,000 Now assume that Morgan requires Lane to sign a note with repayment to be made in 24 monthly payments. Lane is also required to maintain the equipment at a certain level. Morgan sets the payment schedule such that it receives a normal lender’s rate of return on the transaction. In addition, Morgan agrees to repurchase the equipment after two years for $95,000. In this case, this arrangement appears to be a financing transaction rather than a sale. That is, Lane is required to maintain the equipment at a certain level and Morgan agrees to repurchase at a set price, resulting in a lender’s return. Thus, the risks and
rewards of ownership are to a great extent still with Morgan. When the seller has retained the risks and rewards of ownership, even though legal title has been trans- ferred, the transaction is a financing arrangement and does not give rise to revenue.12 In other words, Morgan has not satisfied its performance obligation. 12In essence, Lane is renting the equipment from Morgan for two years. We discuss the accounting for such rental or lease arrangements in Chapter 21. 1050 Chapter 18 Revenue Recognition Bill and Hold Sales Bill and hold sales result when the buyer is not yet ready to take delivery but does take title and accept billing. For example, a customer may request a company to enter into such an arrangement because of (1) lack of available space for the product, (2) delays in its production schedule, or (3) more than sufficient inventory in its distribution channel.13 Illustration 18-7 provides an example of a bill and hold arrangement. ILLUSTRATION 18-7 BILL AND HOLD Recognition—Bill and Hold Facts: Butler Company sells $450,000 of fireplaces to a local coffee shop, Baristo, which is planning to expand its locations around the city. Under the agreement, Baristo asks Butler to retain these fireplaces in its warehouses until the new coffee shops that will house the fireplaces are ready. Title passes to Baristo at the time the agreement is signed. Question: Should Butler report the revenue from this bill and hold arrangement when the agreement is signed, or should revenue be deferred and reported when the fireplaces are delivered? Solution: When to recognize revenue in a bill and hold situation depends on the circumstances. Butler should record the revenue at the time title passes, provided (1) the risks of ownership have passed to Baristo, that is, Butler does not have specific performance obligations other than storage; (2) Baristo makes a fixed commitment to purchase the goods, requests that the transaction be on a bill and hold basis, and sets a fixed delivery date; and (3) goods must be segregated, complete, and ready for shipment. Otherwise, if these conditions are not met, it is assumed that the risks and rewards of ownership remain with the seller even though title has passed. In this case, it appears that these conditions were probably met and therefore revenue recognition should be permitted at the time the agreement is signed. Butler makes the following entry to record the bill and hold sale. Accounts Receivable 450,000 Sales Revenue 450,000 If a significant period of time elapses before payment, the accounts receivable is discounted. In addition, it is likely that one of the conditions above is violated (such as the normal payment terms). In this case, the most appropriate approach for bill and hold sales is to defer revenue recognition until the goods are delivered because the risks and rewards of ownership usually do not transfer until that point. [4] Principal–Agent Relationships In a principal–agent relationship, amounts collected on behalf of the principal are not revenue of the agent. Instead, revenue for the agent is the amount of the commission it receives (usually a percentage of the total revenue). Classic Example An example of principal-agent relationships is an airline that sells tickets through a travel agent. For example, assume that Fly-Away Travels sells airplane tickets for British Airways (BA) to various customers. In this case, the principal is BA and the agent is Fly-Away Travels. BA is acting as a principal because it has exposure to the significant risks and rewards associated with the sale of its services. Fly-Away is acting as an agent because it does not have exposure to significant risks and rewards related to the tickets. Although Fly-Away collects the full airfare from the client, it then remits this amount to BA less a commission. Fly-Away therefore should not record the full amount of the fare as revenue on its books—to do so overstates its revenue. Its revenue is the commission— not the full fare price. The risks and rewards of ownership are not transferred to
Fly-Away because it does not bear any inventory risk as it sells tickets to customers. 13Proposed Accounting Standards Update, “Revenue from Contracts with Customers” (Stamford, Conn.: FASB, June 24, 2010), p. 54. Revenue Recognition at Point of Sale (Delivery) 1051 This distinction is very important for revenue recognition purposes. Some might argue that there is no harm in letting Fly-Away record revenue for the full price of the ticket and then charging the cost of the ticket against the revenue (often referred to as the gross method of recognizing revenue). Others note that this approach overstates the agent’s revenue and is misleading. The revenue received is the commission for providing the travel services, not the full fare price (often referred to as the net approach). The profession believes the net approach is the correct method for recognizing revenue in a principal- agent relationship. As a result, the FASB has developed specific criteria to determine when a principal-agent relationship exists.14 An important feature in deciding whether Fly-Away is acting as an agent is whether the amount it earns is predetermined, being either a fixed fee per transaction or a stated percentage of the amount billed to the customer. What do the numbers mean? GROSSED OUT As you learned in Chapter 4, many corporate executives ob- your own price” for airline tickets and hotel rooms. In one sess over the bottom line. However, analysts on the outside quarter, Priceline reported that it earned $152 million in look at the big picture, which includes examination of both the revenues. But, that included the full amount customers paid top line and the important subtotals in the income statement, for tickets, hotel rooms, and rental cars. Traditional travel such as gross profi t. Recently, the top line is causing some agencies call that amount “gross bookings,” not revenues. concern, with nearly all companies in the S&P 500 reporting a And, much like regular travel agencies, Priceline keeps only 2 percent decline in the bottom line while the top line saw rev- a small portion of gross bookings—namely, the spread be- enue decline by 1 percent. This is troubling because it is the fi rst tween the customers’ accepted bids and the price it paid for decline in revenues since we crawled out of the recession the merchandise. The rest, which Priceline calls “product following the fi nancial crisis. McDonald’s gave an ominous costs,” it pays to the airlines and hotels that supply the preview—it saw its fi rst monthly sales decline in nine years. tickets and rooms. And the United States, rather than foreign markets, led the drop. However, Priceline’s product costs came to $134 million, What about income subtotals like gross margin? These leaving Priceline just $18 million of what it calls “gross metrics too have been under pressure. There is concern that profi t” and what most other companies would call revenues. struggling companies may employ a number of manipula- And that’s before all of Priceline’s other costs—like advertis- tions to mask the impact of gross margin declines on the bottom ing and salaries—which netted out to a loss of $102 million. line. In fact, Rite Aid prepares an income statement that omits The difference isn’t academic. Priceline shares traded at the gross margin subtotal. That is not surprising when you about 23 times its reported revenues but at a mind-boggling consider that Rite Aid’s gross margin has steadily declined 214 times its “gross profi t.” This and other aggressive recog- from 28 percent in 2010 to 26 percent in 2012. Rite Aid has used nition practices explains the stricter revenue recognition a number of suspect accounting adjustments related to tax guidance, indicating that if a company performs as an agent allowances and inventory gains to offset its weak gross margin. or broker without assuming the risks and rewards of owner- Or, consider the classic case of Priceline.com, the com- ship of the goods, the company should report sales on a net pany made famous by William Shatner’s ads about “naming (fee) basis.
Sources: Jeremy Kahn, “Presto Chango! Sales Are Huge,” Fortune (March 20, 2000), p. 44; A. Catanach and E. Ketz, “RITE AID: Is Management Selling Drugs or Using Them?” Grumpy Old Accountants (August 22, 2011); and S. Jakab, “Weak Revenue Is New Worry for Investors,” Wall Street Journal (November 25, 2012). Consignments Another common principal-agent relationship involves consignments. In these cases, manufacturers (or wholesalers) deliver goods but retain title to the goods until they are sold. This specialized method of marketing certain types of products makes use of a device 14Common principal-agent arrangements include (but are not limited to) (1) arrangements with third-party suppliers to drop-ship merchandise on behalf of the entity, (2) services offered by a company that will be provided by a third-party service provider, (3) shipping and handling fees and costs billed to customers, and (4) reimbursements for out-of-pocket expenses (expenses often include, but are not limited to, expenses related to airfare, mileage, hotel stays, out-of-town meals, photocopies, and telecommunications and facsimile charges). Principal-agent accounting guidance is not limited to entities that sell products or services over the Internet but also to transactions related to advertisements, mailing lists, event tickets, travel tickets, auctions (and reverse auctions), magazine subscription brokers, and catalog, consignment, or special-order retail sales. [5] 1052 Chapter 18 Revenue Recognition known as a consignment. Under this arrangement, the consignor (manufacturer or whole- saler) ships merchandise to the consignee (dealer), who is to act as an agent for the con- signor in selling the merchandise. Both consignor and consignee are interested in selling— the former to make a profit or develop a market, the latter to make a commission on the sale. The consignee accepts the merchandise and agrees to exercise due diligence in caring for and selling it. The consignee remits to the consignor cash received from customers, after deducting a sales commission and any chargeable expenses. In consignment sales, the consignor uses a modified version of the sale basis of revenue recognition. That is, the consignor recognizes revenue only after receiving notification of sale and the cash remittance from the consignee. The consignor carries the merchandise as inventory throughout the consignment, separately classified as Inventory (consign- ments). The consignee does not record the merchandise as an asset on its books. Upon sale of the merchandise, the consignee has a liability for the net amount due the con- signor. The consignor periodically receives from the consignee a report called account sales that shows the merchandise received, merchandise sold, expenses chargeable to the consignment, and the cash remitted. Revenue is then recognized by the consignor. Analysis of a consignment arrangement is provided in Illustration 18-8. ILLUSTRATION 18-8 SALES ON CONSIGNMENT Entries for Consignment Sales Facts: Nelba Manufacturing Co. ships merchandise costing $36,000 on consignment to Best Value Stores. Nelba pays $3,750 of freight costs, and Best Value pays $2,250 for local advertising costs that are reimbursable from Nelba. By the end of the period, Best Value has sold two-thirds of the consigned merchandise for $40,000 cash. Best Value notifies Nelba of the sales, retains a 10% commission, and remits the cash due Nelba. Question: What are the journal entries that the consignor (Nelba) and the consignee (Best Value) make to record this transaction? Solution: NELBA MFG. CO. BEST VALUE STORES (CONSIGNOR) (CONSIGNEE) Shipment of consigned merchandise Inventory (consignments) 36,000 No entry (record memo of merchandise Finished Goods Inventory 36,000 received). Payment of freight costs by consignor Inventory (consignments) 3,750 No entry. Cash 3,750 Payment of advertising by consignee No entry until notified. Receivable from Consignor 2,250 Cash 2,250 Sales of consigned merchandise No entry until notified. Cash 40,000
Payable to Consignor 40,000 Notification of sales and expenses and remittance of amount due Cash 33,750 Payable to Consignor 40,000 Advertising Expense 2,250 Receivable from Commission Expense 4,000 Consignor 2,250 Revenue from Commission Revenue 4,000 Consignment Sales 40,000 Cash 33,750 Adjustment of inventory on consignment for cost of sales Cost of Goods Sold 26,500 No entry. Inventory (consignments) 26,500 [2/3 ($36,000 1 $3,750) 5 $26,500] Revenue Recognition at Point of Sale (Delivery) 1053 Under the consignment arrangement, the consignor accepts the risk that the merchandise might not sell and relieves the consignee of the need to commit part of its working capital to inventory. Companies use a variety of different systems and account titles to record consignments, but they all share the common goal of post- poning the recognition of revenue until it is known that a sale to a third party has occurred. Trade Loading and Channel Stuffi ng One commentator describes trade loading this way: “Trade loading is a crazy, uneco- nomic, insidious practice through which manufacturers—trying to show sales, profits, and market share they don’t actually have—induce their wholesale customers, known as the trade, to buy more product than they can promptly resell.” For example, the ciga- rette industry appears to have exaggerated a couple years’ operating profits by as much as $600 million by taking the profits from future years. In the computer software industry, a similar practice is referred to as channel stuff- ing. When a software maker needed to make its financial results look good, it offered deep discounts to its distributors to overbuy and then recorded revenue when the soft- ware left the loading dock. Of course, the distributors’ inventories become bloated and the marketing channel gets too filled with product, but the software maker’s current- period financials are improved. However, financial results in future periods will suffer, unless the company repeats the process. Trade loading and channel stuffing distort operating results and “window dress” financial statements. In addition, similar to consignment transactions or sales with buy- back agreements, these arrangements generally do not transfer the risks and rewards of ownership. If used without an appropriate allowance for sales returns, channel stuffing is a classic example of booking tomorrow’s revenue today. Business managers need to be aware of the ethical dangers of misleading the financial community by engaging in such practices to improve their financial statements. What do the numbers mean? NO TAKE-BACKS Investors in Lucent Technologies were negatively affected declined $1.31 per share, or 8.5 percent. Lucent is not alone when Lucent violated one of the fundamental criteria for in this practice. Sunbeam got caught stuffi ng the sales revenue recognition—the “no take-back” rule. This rule channel with barbeque grills and other outdoor items, holds that revenue should not be booked on inventory that is which contributed to its troubles when it was forced to shipped if the customer can return it at some point in the restate its earnings. future. In this particular case, Lucent agreed to take back Investors can be tipped off to potential channel stuffi ng shipped inventory from its distributors if the distributors by carefully reviewing a company’s revenue recognition were unable to sell the items to their customers. policy for generous return policies or use of cash incentives In essence, Lucent was “stuffi ng the channel.” By book- to encourage distributors to buy products (as was done at ing sales when goods were shipped, even though they most Monsanto) and by watching inventory and receivables levels. likely would get them back, Lucent was able to report con- When sales increase along with receivables, that’s one sign tinued sales growth. However, Lucent investors got a nasty that customers are not paying for goods shipped on credit. surprise when distributors returned those goods and Lucent And growing inventory levels are an indicator that custom-
had to restate its fi nancial results. The restatement erased ers have all the goods they need. Both scenarios suggest a $679 million in revenues, turning an operating profi t into a higher likelihood of goods being returned and revenues and loss. In response to this bad news, Lucent’s share price income being restated. So remember, no take-backs! Sources: Adapted from S. Young, “Lucent Slashes First Quarter Outlook, Erases Revenue from Latest Quarter,” Wall Street Journal Online (December 22, 2000); Tracey Byrnes, “Too Many Thin Mints: Spotting the Practice of Channel Stuffi ng,” Wall Street Journal Online (February 7, 2002); and H. Weitzman, “Monsanto to Restate Results After SEC Probe,” Financial Times (October 5, 2011). 1054 Chapter 18 Revenue Recognition Multiple-Deliverable Arrangements One of the most difficult issues related to revenue recognition involves multiple- deliverable arrangements (MDAs). MDAs provide multiple products or services to customers as part of a single arrangement. The major accounting issues related to this type of arrangement are how to allocate the revenue to the various products and ser- vices and how to allocate the revenue to the proper period. These issues are particularly complex in the technology area. Many devices have contracts that typically include such multiple deliverables as hardware, software, pro- fessional services, maintenance, and support—all of which are valued and accounted for differently. A classic example relates to the Apple iPhone and its AppleTV product. Basically, until a recent rule change, revenues and related costs were accounted for on a subscription basis over a period of years. The reason was that Apple provides future unspecified software upgrades and other features without charge. It was argued that Apple should defer a significant portion of the cash received for the iPhone and recog- nize it over future periods. At the same time, engineering, marketing, and warranty costs were expensed as incurred. As a result, Apple reported conservative numbers related to its iPhone revenue. However, as a result of efforts to more clearly define the various services related to an item such as the iPhone, Apple is now able to report more revenue at the point of sale. In general, all units in a multiple-deliverable arrangement are considered separate units of accounting, provided that: 1. A delivered item has value to the customer on a standalone basis; and 2. The arrangement includes a general right of return relative to the delivered item; and 3. Delivery or performance of the undelivered item is considered probable and substantially in the control of the seller. Once the separate units of accounting are determined, the amount paid for the ar- rangement is allocated among the separate units based on relative fair value. A company determines fair value based on what the vendor could sell the component for on a standalone basis. If this information is not available, the seller may rely on third-party evidence or if not available, the seller may use its best estimate of what the item might sell for as a standalone unit. [6] Illustration 18-9 identifies the steps in the evaluation process. ILLUSTRATION 18-9 Multiple-Deliverable Evaluation Process Multiple-Deliverable Arrangements • Includes general right of return Value to Customer Account for as Yes • Delivery of undelivered items Yes on Standalone Basis Separate Unit probable and substantially controlled by seller Do Not Account for Allocate Based on No Separate Unit No Fair Values Revenue Recognition at Point of Sale (Delivery) 1055 Presented in Illustrations 18-10 and 18-11 are two examples of the accounting for MDAs. ILLUSTRATION 18-10 MULTIPLE DELIVERABLES MDA—Equipment and Facts: Lopez Company enters into a contract to build, run, and maintain a highly complex piece of Maintenance electronic equipment for a period of 5 years, commencing upon delivery of the equipment. There is a fixed fee for each of the build, run, and maintenance deliverables, and any progress payments made are not
refundable. In addition, there is a right of return in the arrangement. All the deliverables have a standalone value, and there is verifiable evidence of the selling price for the building and maintenance but not for running the equipment. Question: Should Lopez separate and then measure and allocate the amounts paid for the MDA? Solution: Assuming delivery (performance) is probable and Lopez controls any undelivered items, Lopez determines whether the components have standalone value. The components of the MDA are the equipment, maintenance of the equipment, and running the equipment; each component has a standalone value. Lopez can determine standalone values of equipment and the maintenance agreement by third-party evidence of fair values. The company then makes its best estimate of the selling price for running of the equipment. Lopez next applies the relative fair value method at the inception of the MDA to determine the proper allocation to each component. Once the a llocation is performed, the company recognizes revenue independently for each component u sing regular revenue recognition criteria. ILLUSTRATION 18-11 PRODUCT, INSTALLATION, AND SERVICE MDA—Product, Facts: Handler Company is an experienced manufacturer of equipment used in the construction industry. Installation, and Service Handler’s products range from small to large individual pieces of automated machinery to complex systems containing numerous components. Unit selling prices range from $600,000 to $4,000,000 and are quoted inclusive of installation and training. The installation process does not involve changes to the features of the equipment and does not require proprietary information about the equipment in order for the installed equipment to perform to specifications. Handler has the following arrangement with Chai Company. • Chai purchases equipment from Handler for a price of $2,000,000 and chooses Handler to do the installation. Handler charges the same price for the equipment irrespective of whether it does the installation or not. (Some companies do the installation themselves because they either prefer their own employees to do the work or because of relationships with other customers.) The price of the installation service is estimated to have a fair value of $20,000. • The fair value of the training sessions is estimated at $50,000. • Chai is obligated to pay Handler the $2,000,000 upon the delivery and installation of the equipment. Handler delivers the equipment on September 1, 2014, and completes the installation of the equipment on November 1, 2014. Training related to the equipment starts once the installation is completed and lasts for 1 year. The equipment has a useful life of 10 years. Questions: (a) What are the standalone units for purposes of accounting for the sale of the equipment? (b) If there is more than one standalone unit, how should the fee of $2,000,000 be allocated to various components? Solution: (a) The first condition for separation into a standalone unit for the equipment is met. That is, the equipment, installation, and training are three separate components. (b) The total revenue of $2,000,000 should be allocated to the three components based on their relative fair values. In this case, the fair value of the equipment should be considered $2,000,000, the installation fee is $20,000, and the training is $50,000. The total fair value to consider is $2,070,000 ($2,000,000 1 $20,000 1 $50,000). The allocation is as follows. Equipment $1,932,367 ($2,000,000 4 $2,070,000) 3 $2,000,000 Installation 19,324 ($20,000 4 $2,070,000) 3 $2,000,000 Training 48,309 ($50,000 4 $2,070,000) 3 $2,000,000 1056 Chapter 18 Revenue Recognition Handler makes the following entries on November 1, 2014. November 1, 2014 Cash 2,000,000 Service Revenue (installation) 19,324 Unearned Service Revenue 48,309 Sales Revenue 1,932,367 The sale of the equipment should be recognized once the installation is completed on November 1, 2014, and the installation fee also should be recognized because these services have been provided. The training revenues should be allocated on a straight-
line basis starting on November 1, 2014, or $4,026 ($48,309 4 12) per month for one year (unless a more appropriate method such as the percentage-of-completion method is warranted). The journal entry to recognize the training revenue for two months in 2014 is as follows. December 31, 2014 Unearned Service Revenue 8,052 Service Revenue (training) ($4,026 3 2) 8,052 Therefore, the total revenue recognized at December 31, 2014, is $1,959,743 ($1,932,367 1 $19,324 1 $8,052). Handler makes the following journal entry to recognize the training revenue in 2015, assuming adjusting entries are made at year-end. December 31, 2015 Unearned Service Revenue 40,257 Service Revenue (training) ($48,309 2 $8,052) 40,257 Summary ILLUSTRATION 18-12 Illustration 18-12 provides a summary of revenue recognition methods and related Revenue Recognition at accounting guidance. the Point of Sale General Principles Recognize revenue (1) when it is realized or realizable, and (2) when it is earned. In numerous cases, GAAP provides additional specific guidance to help determine proper revenue recognition. Specific Transactions Accounting Guidance Sales with discounts Trade, volume, and cash discounts reduce sales revenue. Sales with extended payment The fair value measurement of revenue is determined by using the fair value of the consideration terms received or by discounting the future payments using an imputed interest rate. Sales with right of return If there is uncertainty about the possibility of return, recognize revenue when the goods are delivered and the return period has lapsed. If the company can reliably estimate future returns, revenue (less estimated returns) is recognized at the point of sale. Sales with buyback Terms of the buyback agreement must be analyzed to determine if, in substance, the seller has transferred the risks and rewards of ownership. Bill and hold sales Recognition depends on the circumstances. Recognize revenue when title passes if (1) the risks of ownership have passed to the customer, and the seller does not have specific obligations other than storage; (2) the customer makes a fixed commitment to purchase the goods, requests that the transaction be on a bill and hold basis, and sets a fixed delivery date; and (3) goods must be segregated, complete, and ready for shipment. Sales involving principal-agent Amounts collected by the agent on behalf of the principal are not revenue of the agent. Instead, relationship (general) revenue to the agent is the amount of commission it receives. Sales involving principal-agent Consignor recognizes revenue (sales and cost of goods sold) when goods are sold by consignee. relationship (consignments) Consignee recognizes revenue for commissions received. Trade loading and channel Unless returns can be reliably measured, revenue should not be recognized until the goods are stuffing sold (by the distributor) to third parties. Multiple-deliverable Apply general revenue recognition principles to each element of the arrangement that has stand- arrangements a lone value. Once the separate units of accounting are determined, the amount paid for the arrangement is allocated among the separate units based on relative fair value. Revenue Recognition before Delivery 1057 REVENUE RECOGNITION BEFORE DELIVERY For the most part, companies recognize revenue at the point of sale (delivery) 3 LEARNING OBJECTIVE because at point of sale most of the uncertainties in the earning process are Apply the percentage-of-completion removed and the exchange price is known. Under certain circumstances, however, method for long-term contracts companies recognize revenue prior to completion and delivery. The most notable example is long-term construction contract accounting, which uses the percentage- of-completion method. Long-term contracts frequently provide that the seller (builder) may bill the purchaser at intervals, as it reaches various points in the project. Examples of long-term contracts are construction-type contracts, development of military and commercial aircraft,
weapons-delivery systems, and space exploration hardware. When the project consists of separable units, such as a group of buildings or miles of roadway, contract provisions may provide for delivery in installments. In that case, the seller would bill the buyer and transfer title at stated stages of completion, such as the completion of each building unit or every 10 miles of road. The accounting records should record sales when installments are “delivered.”15 Two distinctly different methods of accounting for long-term construction contracts are recognized.16 They are: • Percentage-of-completion method. Companies recognize revenues and gross prof- its each period based upon the progress of the construction—that is, the percentage of completion. The company accumulates construction costs plus gross profit earned to date in an inventory account (Construction in Process), and it accumu- lates progress billings in a contra inventory account (Billings on Construction in Process). • Completed-contract method. Companies recognize revenues and gross profit only when the contract is completed. The company accumulates construction costs in an inventory account (Construction in Process), and it accumulates progress billings in a contra inventory account (Billings on Construction in Process). The rationale for using percentage-of-completion accounting is that under most of these contracts the buyer and seller have enforceable rights. The buyer has the legal right to require specific performance on the contract. The seller has the right to require progress payments that provide evidence of the buyer’s ownership interest. Underlying Concepts As a result, a continuous sale occurs as the work progresses. Companies should recognize revenue according to that progression. The percentage-of-completion Companies must use the percentage-of-completion method when estimates method recognizes revenue of progress toward completion, revenues, and costs are reasonably dependable from long-term contracts in the and all of the following conditions exist. [7] periods in which the revenue is earned. The fi rm contract fi xes 1. The contract clearly specifi es the enforceable rights regarding goods or the selling price. And, if costs services to be provided and received by the parties, the consideration to be are estimable and collection exchanged, and the manner and terms of settlement. reasonably assured, the revenue recognition concept is not 2. The buyer can be expected to satisfy all obligations under the contract. violated. 3. The contractor can be expected to perform the contractual obligations. 15Statement of Financial Accounting Concepts No. 5, par. 84, item c. 16Accounting Trends and Techniques—2012 reports that of the 83 of its 500 sample companies that referred to long-term construction contracts, 75 used the percentage-of-completion method and 8 used the completed-contract method. 1058 Chapter 18 Revenue Recognition Companies should use the completed-contract method when one of the following conditions applies: • When a company has primarily short-term contracts, or • When a company cannot meet the conditions for using the percentage-of-completion method, or • When there are inherent hazards in the contract beyond the normal, recurring busi- ness risks. The presumption is that percentage-of-completion is the better method. Therefore, companies should use the completed-contract method only when the percentage-of- completion method is inappropriate. We discuss the two methods in more detail in the following sections. Percentage-of-Completion Method The percentage-of-completion method recognizes revenues, costs, and gross profit as a company makes progress toward completion on a long-term contract. To defer recogni- tion of these items until completion of the entire contract is to misrepresent the efforts (costs) and accomplishments (revenues) of the accounting periods during the contract. In order to apply the percentage-of-completion method, a company must have some basis or standard for measuring the progress toward completion at particular interim dates.
Measuring the Progress toward Completion As one practicing accountant wrote, “The big problem in applying the percentage-of- completion method . . . has to do with the ability to make reasonably accurate estimates of completion and the final gross profit.”17 Companies use various methods to deter- mine the extent of progress toward completion. The most common are the cost-to-cost and units-of-delivery methods.18 The objective of all these methods is to measure the extent of progress in terms of costs, units, or value added. Companies identify the various measures (costs incurred, labor hours worked, tons produced, floors completed, etc.) and classify them as input or output measures. Input measures (costs incurred, labor hours worked) are efforts de- voted to a contract. Output measures (with units of delivery measured as tons pro- duced, floors of a building completed, miles of a highway completed) track results. Neither are universally applicable to all long-term projects. Their use requires the exer- cise of judgment and careful tailoring to the circumstances. Both input and output measures have certain disadvantages. The input measure is based on an established relationship between a unit of input and productivity. If ineffi- ciencies cause the productivity relationship to change, inaccurate measurements result. Another potential problem is front-end loading, in which significant up-front costs re- sult in higher estimates of completion. To avoid this problem, companies should disre- gard some early-stage construction costs—for example, costs of uninstalled materials or costs of subcontracts not yet performed—if they do not relate to contract performance. Similarly, output measures can produce inaccurate results if the units used are not com- parable in time, effort, or cost to complete. For example, using floors (stories) completed can be deceiving. Completing the first floor of an eight-story building may require more than one-eighth the total cost because of the substructure and foundation construction. 17Richard S. Hickok, “New Guidance for Construction Contractors: ‘A Credit Plus,’” The Journal of Accountancy (March 1982), p. 46. 18R. K. Larson and K. L. Brown, “Where Are We with Long-Term Contract Accounting?” Accounting Horizons (September 2004), pp. 207–219. Revenue Recognition before Delivery 1059 The most popular input measure used to determine the progress toward completion is the cost-to-cost basis. Under this basis, a company like EDS measures the percentage of completion by comparing costs incurred to date with the most recent estimate of the total costs required to complete the contract. Illustration 18-13 shows the formula for the cost-to-cost basis. ILLUSTRATION 18-13 Costs incurred to date 5Percent complete Formula for Percentage- Most recent estimate of total costs of-Completion, Cost-to- Cost Basis Once EDS knows the percentage that costs incurred bear to total estimated costs, it applies that percentage to the total revenue or the estimated total gross profit on the contract. The resulting amount is the revenue or the gross profit to be recognized to date. Illustration 18-14 shows this computation. ILLUSTRATION 18-14 Estimated Revenue (or gross Percent Formula for Total 3 total revenue 5 profit) to be complete Revenue to Be (or gross profit) recognized to date Recognized to Date To find the amounts of revenue and gross profit recognized each period, EDS subtracts total revenue or gross profit recognized in prior periods, as shown in Illustration 18-15. ILLUSTRATION 18-15 Revenue (or gross Revenue (or gross Current-period Formula for Amount of profit) to be 2 profit) recognized 5 revenue Current-Period Revenue, recognized to date in prior periods (or gross profit) Cost-to-Cost Basis Because the cost-to-cost method is widely used (without excluding other bases for measuring progress toward completion), we have adopted it for use in our examples. [8] Example of Percentage-of-Completion Method—Cost-to-Cost Basis To illustrate the percentage-of-completion method, assume that Hardhat Construction
Company has a contract to construct a $4,500,000 bridge at an estimated cost of $4,000,000. The contract is to start in July 2014, and the bridge is to be completed in October 2016. The following data pertain to the construction period. (Note that by the end of 2015, Hardhat has revised the estimated total cost from $4,000,000 to $4,050,000.) 2014 2015 2016 Costs to date $1,000,000 $2,916,000 $4,050,000 Estimated costs to complete 3,000,000 1,134,000 — Progress billings during the year 900,000 2,400,000 1,200,000 Cash collected during the year 750,000 1,750,000 2,000,000 Hardhat would compute the percentage complete as shown in Illustration 18-16. ILLUSTRATION 18-16 2014 2015 2016 Application of Percentage- Contract price $4,500,000 $4,500,000 $ 4,500,000 of-Completion Method, Less estimated cost: Cost-to-Cost Basis Costs to date 1,000,000 2,916,000 4,050,000 Estimated costs to complete 3,000,000 1,134,000 — Estimated total costs 4,000,000 4,050,000 4,050,000 Estimated total gross profit $ 500,000 $ 450,000 $ 450,000 Percent complete 25% 72% 100% $1,000,000 $2,916,000 $4,050,000 $4,000,000 $4,050,000 $4,050,000 a b a b a b 1060 Chapter 18 Revenue Recognition On the basis of the data above, Hardhat would make the following entries to record (1) the costs of construction, (2) progress billings, and (3) collections. These entries appear as summaries of the many transactions that would be entered individually as they occur during the year. ILLUSTRATION 18-17 2014 2015 2016 Journal Entries— To record cost of construction: Percentage-of- Construction in Process 1,000,000 1,916,000 1,134,000 Completion Method, Materials, Cash, Cost-to-Cost Basis Payables, etc. 1,000,000 1,916,000 1,134,000 To record progress billings: Accounts Receivable 900,000 2,400,000 1,200,000 Billings on Construction in Process 900,000 2,400,000 1,200,000 To record collections: Cash 750,000 1,750,000 2,000,000 Accounts Receivable 750,000 1,750,000 2,000,000 In this example, the costs incurred to date are a measure of the extent of progress toward completion. To determine this, Hardhat evaluates the costs incurred to date as a proportion of the estimated total costs to be incurred on the project. The estimated revenue and gross profit that Hardhat will recognize for each year are calculated as shown in Illustration 18-18. ILLUSTRATION 18-18 Recognized in Recognized in Percentage-of- To Date Prior Years Current Year Completion Revenue, 2014 Costs, and Gross Profi t by Year Revenues ($4,500,000 3 25%) $1,125,000 $1,125,000 Costs 1,000,000 1,000,000 Gross profit $ 125,000 $ 125,000 2015 Revenues ($4,500,000 3 72%) $3,240,000 $1,125,000 $2,115,000 Costs 2,916,000 1,000,000 1,916,000 Gross profit $ 324,000 $ 125,000 $ 199,000 2016 Revenues ($4,500,000 3 100%) $4,500,000 $3,240,000 $1,260,000 Costs 4,050,000 2,916,000 1,134,000 Gross profit $ 450,000 $ 324,000 $ 126,000 Illustration 18-19 shows Hardhat’s entries to recognize revenue and gross profit each year and to record completion and final approval of the contract. ILLUSTRATION 18-19 2014 2015 2016 Journal Entries to To recognize revenue and Recognize Revenue and gross profit: Gross Profi t and to Construction in Process Record Contract (gross profit) 125,000 199,000 126,000 Completion—Percentage- Construction Expenses 1,000,000 1,916,000 1,134,000 of-Completion Method, Revenue from Long-Term Cost-to-Cost Basis Contracts 1,125,000 2,115,000 1,260,000 To record completion of the contract: Billings on Construction in Process 4,500,000 Construction in Process 4,500,000 Revenue Recognition before Delivery 1061 Note that Hardhat debits gross profit (as computed in Illustration 18-18) to C onstruction in Process. Similarly, it credits Revenue from Long-Term Contracts for the amounts computed in Illustration 18-18. Hardhat then debits the difference between the amounts recognized each year for revenue and gross profit to a nominal account, Construction Expenses (similar to Cost of Goods Sold in a manufacturing company). It reports that amount in the income statement as the actual cost of construction incurred in that period. For example, Hardhat uses the actual costs of $1,000,000 to compute both
the gross profit of $125,000 and the percent complete (25 percent). Hardhat continues to accumulate costs in the Construction in Process account, in order to maintain a record of total costs incurred (plus recognized gross profit) to date. Although theoretically a series of “sales” takes place using the percentage-of-completion method, the selling company cannot remove the inventory cost until the construction is completed and transferred to the new owner. Hardhat’s Construction in Process account for the bridge would include the following summarized entries over the term of the construction project. ILLUSTRATION 18-20 Construction in Process Content of Construction 2014 construction costs $1,000,000 12/31/16 to close in Process Account— 2014 recognized gross profit 125,000 completed Percentage-of- 2015 construction costs 1,916,000 project $4,500,000 Completion Method 2015 recognized gross profit 199,000 2016 construction costs 1,134,000 2016 recognized gross profit 126,000 Total $4,500,000 Total $4,500,000 Recall that the Hardhat Construction Company example contained a change in estimate: In the second year, 2015, it increased the estimated total costs from $4,000,000 to $4,050,000. The change in estimate is accounted for in a cumulative catch-up manner. This is done by first adjusting the percent completed to the new estimate of total costs. Next, Hardhat deducts the amount of revenues and gross profit recognized in prior periods from revenues and gross profit computed for progress to date. That is, it ac- counts for the change in estimate in the period of change. That way, the balance sheet at the end of the period of change and the accounting in subsequent periods are as they would have been if the revised estimate had been the original estimate. Financial Statement Presentation—Percentage-of-Completion Generally, when a company records a receivable from a sale, it reduces the Inventory account. Under the percentage-of-completion method, however, the company continues to carry both the receivable and the inventory. Subtracting the balance in the Billings account from Construction in Process avoids double-counting the inventory. During the life of the contract, Hardhat reports in the balance sheet the difference between the Con- struction in Process and the Billings on Construction in Process accounts. If that amount is a debit, Hardhat reports it as a current asset; if it is a credit, it reports it as a current liability. At times, the costs incurred plus the gross profit recognized to date (the balance in Construction in Process) exceed the billings. In that case, Hardhat reports this excess as a current asset entitled “Cost and recognized profit in excess of billings.” Hardhat can at any time calculate the unbilled portion of revenue recognized to date by subtracting the billings to date from the revenue recognized to date, as illustrated for 2014 for Hardhat Construction in Illustration 18-21. ILLUSTRATION 18-21 $1,000,000 Contract revenue recognized to date: $4,500,0003 $1,125,000 Computation of Unbilled $4,000,000 Contract Price at Billings to date (900,000) 12/31/14 Unbilled revenue $ 225,000 1062 Chapter 18 Revenue Recognition At other times, the billings exceed costs incurred and gross profit to date. In that case, Hardhat reports this excess as a current liability entitled “Billings in excess of costs and recognized profit.” It probably has occurred to you that companies often have more than one project going at a time. When a company has a number of projects, costs exceed billings on some contracts and billings exceed costs on others. In such a case, the company segre- gates the contracts. The asset side includes only those contracts on which costs and recognized profit exceed billings. The liability side includes only those on which billings exceed costs and recognized profit. Separate disclosures of the dollar volume of billings and costs are preferable to a summary presentation of the net difference. Using data from the bridge example, Hardhat Construction Company would report
the status and results of its long-term construction activities under the percentage-of- completion method as shown in Illustration 18-22. ILLUSTRATION 18-22 HARDHAT CONSTRUCTION COMPANY Financial Statement Income Statement (from Illustration 18-18) 2014 Presentation— Percentage-of-Completion Revenue from long-term contracts $1,125,000 Method (2014) Costs of construction 1,000,000 Gross profit $ 125,000 Balance Sheet (12/31) 2014 Current assets Accounts receivable ($900,000 2 $750,000) $ 150,000 Inventory Construction in process $1,125,000 Less: Billings 900,000 Costs and recognized profit in excess of billings 225,000 In 2015, its financial statement presentation is as follows. ILLUSTRATION 18-23 HARDHAT CONSTRUCTION COMPANY Financial Statement Income Statement (from Illustration 18-18) 2015 Presentation— Percentage-of- Revenue from long-term contracts $2,115,000 Completion Method Costs of construction 1,916,000 (2015) Gross profit $ 199,000 Balance Sheet (12/31) Current assets Accounts receivable ($150,000 1 $2,400,000 2 $1,750,000) $ 800,000 Current liabilities Billings $3,300,000 Less: Construction in process 3,240,000 Billings in excess of costs and recognized profits 60,000 In 2016, Hardhat’s financial statements only include an income statement because the bridge project was completed and settled. Revenue Recognition before Delivery 1063 ILLUSTRATION 18-24 HARDHAT CONSTRUCTION COMPANY Financial Statement Income Statement (from Illustration 18-18) 2016 Presentation— Revenue from long-term contracts $1,260,000 Percentage-of-Completion Costs of construction 1,134,000 Method (2016) Gross profit $ 126,000 In addition, Hardhat should disclose the following information in each year. ILLUSTRATION 18-25 Note 1. Summary of significant accounting policies. Percentage-of- Long-Term Construction Contracts. The company recognizes revenues and reports profits from long- Completion Method term construction contracts, its principal business, under the percentage-of-completion method of accounting. These contracts generally extend for periods in excess of one year. The amounts of revenues Note Disclosure and profits recognized each year are based on the ratio of costs incurred to the total estimated costs. Costs included in construction in process include direct materials, direct labor, and project-related overhead. Corporate general and administrative expenses are charged to the periods as incurred and are not allocated to construction contracts. Completed-Contract Method Under the completed-contract method, companies recognize revenue and gross 4 LEARNING OBJECTIVE profit only at point of sale—that is, when the contract is completed. Under this Apply the completed-contract method method, companies accumulate costs of long-term contracts in process, but they for long-term contracts. make no interim charges or credits to income statement accounts for revenues, costs, or gross profit. The principal advantage of the completed-contract method is that reported International Perspective revenue reflects final results rather than estimates of unperformed work. Its major disadvantage is that it does not reflect current performance when the period of a IFRS prohibits the use of the contract extends into more than one accounting period. Although operations completed-contract method of may be fairly uniform during the period of the contract, the company will not accounting for long-term con- report revenue until the year of completion, creating a distortion of earnings. struction contracts. Companies Under the completed-contract method, the company would make the same must use the percentage-of- annual entries to record costs of construction, progress billings, and collections completion method. If revenues and costs are diffi cult to from customers as those illustrated under the percentage-of-completion estimate, then companies method. The significant difference is that the company would not make entries recognize revenue only to the to recognize revenue and gross profit. extent of the cost incurred—a For example, under the completed-contract method for the bridge project
zero-profi t approach. illustrated on the preceding pages, Hardhat Construction Company would make the following entries in 2016 to recognize revenue and costs and to close out the inventory and billing accounts. Billings on Construction in Process 4,500,000 Revenue from Long-Term Contracts 4,500,000 Costs of Construction 4,050,000 Construction in Process 4,050,000 Illustration 18-26 compares the amount of gross profit that Hardhat Construction Company would recognize for the bridge project under the two revenue recognition methods. ILLUSTRATION 18-26 Percentage-of-Completion Completed-Contract Comparison of Gross 2014 $125,000 $ 0 Profi t Recognized under 2015 199,000 0 Different Methods 2016 126,000 450,000 1064 Chapter 18 Revenue Recognition Under the completed-contract method, Hardhat Construction would report its long-term construction activities as follows. ILLUSTRATION 18-27 HARDHAT CONSTRUCTION COMPANY Financial Statement 2014 2015 2016 Presentation— Completed-Contract Income Statement Method Revenue from long-term contracts — — $4,500,000 Costs of construction — — 4,050,000 Gross profit — — $ 450,000 Balance Sheet (12/31) Current assets Accounts receivable $150,000 $800,000 $ –0– Inventory Construction in process $1,000,000 Less: Billings 900,000 Costs in excess of billings 100,000 –0– Current liabilities Billings ($3,300,000) in excess of costs ($2,916,000) 384,000 –0– Note 1. Summary of significant accounting policies. Long-Term Construction Contracts. The company recognizes revenues and reports profits from long- term construction contracts, its principal business, under the completed-contract method. These contracts generally extend for periods in excess of one year. Contract costs and billings are accumulated during the periods of construction, but no revenues or profits are recognized until completion of the contract. Costs included in construction in process include direct material, direct labor, and project- related overhead. Corporate general and administrative expenses are charged to the periods as incurred. Long-Term Contract Losses Two types of losses can become evident under long-term contracts:19 LEARNING OBJECTIVE 5 Identify the proper accounting for 1. Loss in the current period on a profi table contract. This condition arises when, losses on long-term contracts. during construction, there is a signifi cant increase in the estimated total con- tract costs but the increase does not eliminate all profi t on the contract. Under the percentage-of-completion method only, the estimated cost increase requires a current-period adjustment of excess gross profi t recognized on the project in prior periods. The company records this adjustment as a loss in the current period because it is a change in accounting estimate (discussed in Chapter 22). 2. Loss on an unprofi table contract. Cost estimates at the end of the current period may indicate that a loss will result on completion of the entire contract. Under both the percentage-of-completion and the completed-contract methods, the company must recognize in the current period the entire expected contract loss. The treatment described for unprofitable contracts is consistent with the accounting custom of anticipating foreseeable losses to avoid overstatement of current and future income (conservatism). Loss in Current Period To illustrate a loss in the current period on a contract expected to be profitable upon completion, we’ll continue with the Hardhat Construction Company bridge project. 19Sak Bhamornsiri, “Losses from Construction Contracts,” The Journal of Accountancy (April 1982), p. 26. Revenue Recognition before Delivery 1065 Assume that on December 31, 2015, Hardhat estimates the costs to complete the bridge contract at $1,468,962 instead of $1,134,000 (refer to page 1059). Assuming all other data are the same as before, Hardhat would compute the percentage complete and recognize the loss as shown in Illustration 18-28. Compare these computations with those for 2015 in Illustration 18-16 (page 1059). The “percent complete” has dropped, from 72 percent
to 661⁄ percent, due to the increase in estimated future costs to complete the contract. 2 ILLUSTRATION 18-28 Cost to date (12/31/15) $2,916,000 Computation of Estimated costs to complete (revised) 1,468,962 Recognizable Loss, Estimated total costs $4,384,962 2015—Loss in Current Percent complete ($2,916,000 4 $4,384,962) 661⁄% Period 2 Revenue recognized in 2015 ($4,500,000 3 661⁄%) 2 $1,125,000 $1,867,500 2 Costs incurred in 2015 1,916,000 Loss recognized in 2015 $ (48,500) The 2015 loss of $48,500 is a cumulative adjustment of the “excessive” gross profit recognized on the contract in 2014. Instead of restating the prior period, the company absorbs the prior period misstatement entirely in the current period. In this illustration, the adjustment was large enough to result in recognition of a loss. Hardhat Construction would record the loss in 2015 as follows. Construction Expenses 1,916,000 Construction in Process (loss) 48,500 Revenue from Long-Term Contracts 1,867,500 Hardhat will report the loss of $48,500 on the 2015 income statement as the differ- ence between the reported revenues of $1,867,500 and the costs of $1,916,000.20 Under the completed-contract method, the company does not recognize a loss in 2015. Why not? Because the company still expects the contract to result in a profit, to be recognized in the year of completion. Loss on an Unprofi table Contract To illustrate the accounting for an overall loss on a long-term contract, assume that at December 31, 2015, Hardhat Construction Company estimates the costs to complete the bridge contract at $1,640,250 instead of $1,134,000. Revised estimates for the bridge con- tract are as follows. 2014 2015 Original Revised Estimates Estimates Contract price $4,500,000 $4,500,000 Estimated total cost 4,000,000 4,556,250* Estimated gross profit $ 500,000 Estimated loss $ (56,250) *($2,916,000 1 $1,640,250) 20In 2016, Hardhat Construction will recognize the remaining 33½ percent of the revenue ($1,507,500), with costs of $1,468,962 as expected, and will report a gross profit of $38,538. The total gross profit over the three years of the contract would be $115,038 [$125,000 (2014) 2 $48,500 (2015) 1 $38,538 (2016)]. This amount is the difference between the total contract revenue of $4,500,000 and the total contract costs of $4,384,962. 1066 Chapter 18 Revenue Recognition Under the percentage-of-completion method, Hardhat recognized $125,000 of gross profit in 2014 (see Illustration 18-18 on page 1060). This amount must be offset in 2015 because it is no longer expected to be realized. In addition, since losses must be recognized as soon as estimable, the company must recognize the total estimated loss of $56,250 in 2015. Therefore, Hardhat must recognize a total loss of $181,250 ($125,000 1 $56,250) in 2015. Illustration 18-29 shows Hardhat’s computation of the revenue to be recognized in 2015. ILLUSTRATION 18-29 Revenue recognized in 2015: Computation of Revenue Contract price $4,500,000 Recognizable, 2015— Percent complete 3 64%* Unprofi table Contract Revenue recognizable to date 2,880,000 Less: Revenue recognized prior to 2015 1,125,000 Revenue recognized in 2015 $1,755,000 *Cost to date (12/31/15) $2,916,000 Estimated cost to complete 1,640,250 Estimated total costs $4,556,250 Percent complete: $2,916,000 4 $4,556,250 5 64% To compute the construction costs to be expensed in 2015, Hardhat adds the total loss to be recognized in 2015 ($125,000 1 $56,250) to the revenue to be recognized in 2015. Illustration 18-30 shows this computation. ILLUSTRATION 18-30 Revenue recognized in 2015 (computed above) $1,755,000 Computation of Total loss recognized in 2015: Construction Expense, Reversal of 2014 gross profit $125,000 2015—Unprofi table Total estimated loss on the contract 56,250 181,250 Contract Construction cost expensed in 2015 $1,936,250 Hardhat Construction would record the long-term contract revenues, expenses, and loss in 2015 as follows. Construction Expenses 1,936,250 Construction in Process (loss) 181,250 Revenue from Long-Term Contracts 1,755,000 At the end of 2015, Construction in Process has a balance of $2,859,750 as shown below.21
ILLUSTRATION 18-31 Construction in Process Content of Construction 2014 Construction costs 1,000,000 in Process Account at 2014 Recognized gross profit 125,000 End of 2015— 2015 Construction costs 1,916,000 2015 Recognized loss 181,250 Unprofi table Contract Balance 2,859,750 21If the costs in 2016 are $1,640,250 as projected, at the end of 2016 the Construction in Process account will have a balance of $1,640,250 1 $2,859,750, or $4,500,000, equal to the contract price. When the company matches the revenue remaining to be recognized in 2016 of $1,620,000 [$4,500,000 (total contract price) 2 $1,125,000 (2014) 2 $1,755,000 (2015)] with the construction expense to be recognized in 2016 of $1,620,000 [total costs of $4,556,250 less the total costs recognized in prior years of $2,936,250 (2014, $1,000,000; 2015, $1,936,250)], a zero profit results. Thus, the total loss has been recognized in 2015, the year in which it first became evident. Revenue Recognition before Delivery 1067 Under the completed-contract method, Hardhat also would recognize the contract loss of $56,250 through the following entry in 2015 (the year in which the loss first became evident). Loss from Long-Term Contracts 56,250 Construction in Process (loss) 56,250 Just as the Billings account balance cannot exceed the contract price, neither can the balance in Construction in Process exceed the contract price. In circumstances where the Construction in Process balance exceeds the billings, the company can deduct the recog- nized loss from such accumulated costs on the balance sheet. That is, under both the percentage-of-completion and the completed-contract methods, the provision for the loss (the credit) may be combined with Construction in Process, thereby reducing the inventory balance. In those circumstances, however (as in the 2015 example above), where the billings exceed the accumulated costs, Hardhat must report separately on the balance sheet, as a current liability, the amount of the estimated loss. That is, under both the percentage-of-completion and the completed-contract methods, Hardhat would take the $56,250 loss, as estimated in 2015, from the Construction in Process account and report it separately as a current liability titled “Estimated liability from long-term contracts.” [9] What do the numbers mean? LESS CONSERVATIVE Halliburton provides engineering- and construction-related The accounting method put in place in 1998 is more services in jobs around the world. Much of the company’s a ggressive than the company’s former policy, but it is still work is completed under contract over long periods of time. within the boundaries of generally accepted accounting The company uses percentage-of-completion accounting. principles. However, the SEC noted that over six quarters, The SEC started enforcement proceedings against the com- Halliburton failed to disclose its change in accounting practice. pany related to its accounting for contract claims and dis- In the absence of any disclosure, the SEC believed the investing agreements with customers, including those arising from public was misled about the precise nature of Halliburton’s change orders and disputes about billable amounts and costs income in comparison to prior periods. associated with a construction delay. Similar issues have arisen in how Boeing accounts for Prior to 1998, Halliburton took a very conservative losses on its Dreamliner aircraft long-term contracts. While approach to its accounting for disputed claims. As stated in costs for producing the fi rst group of airplanes more than the company’s 1997 annual report, “Claims for additional doubled in a recent year, the losses did not show up in compensation are recognized during the period such claims Boeing’s bottom line. The reason? Boeing is spreading the are resolved.” That is, the company waited until all disputes higher cost over future years when it expects costs to decline were resolved before recognizing associated revenues. In and profi t margins to increase. Boeing recently increased the
contrast, in 1998 the company recognized revenue for dis- number of planes over which future cost will be spread from puted claims before their resolution, using estimates of 400 to 1,100 due to increased demand for the planes, which amounts expected to be recovered. Such revenue and its further reduces the impact on profi tability. The Halliburton related profi t are more tentative and are subject to possible and Boeing situations illustrate the diffi culty of using esti- later adjustment than revenue and profi t recognized when mates in percentage-of-completion accounting and the impact all claims have been resolved. As a case in point, the com- of those estimates on the fi nancial statements. pany noted that it incurred losses of $99 million in 1998 related to customer claims. Sources: “Failure to Disclose a 1998 Change in Accounting Practice,” SEC (August 3, 2004), www.sec.gov/news/press/2004-104.htm. See also “Accounting Ace Charles Mulford Answers Accounting Questions,” Wall Street Journal Online (June 7, 2002); and J. Ostrower, “Dreamliner Hits a Milestone,” Wall Street Journal (June 8, 2012). 1068 Chapter 18 Revenue Recognition Disclosures in Financial Statements Construction contractors usually make some unique financial statement disclosures in addition to those required of all businesses. Generally, these additional disclosures are made in the notes to the financial statements. For example, a construction contractor should disclose the following: the method of recognizing revenue, [10] the basis used to classify assets and liabilities as current (the nature and length of the operating cycle), the basis for recording inventory, the effects of any revision of estimates, the amount of backlog on uncompleted contracts, and the details about receivables (billed and un- billed, maturity, interest rates, retainage provisions, and significant individual or group concentrations of credit risk). Completion-of-Production Basis Underlying Concepts In certain cases, companies recognize revenue at the completion of production even though no sale has been made. Examples of such situations involve pre- This is not an exception to the cious metals or agricultural products with assured prices. Under the completion- revenue recognition principle. At of-production basis, companies recognize revenue when these metals are the completion of production, mined or agricultural crops harvested because the sales price is reasonably as- realization is virtually assured sured, the units are interchangeable, and no significant costs are involved in and the earning process is substantially completed. distributing the product.22 (See discussion in Chapter 9, page 481, “Valuation at Net Realizable Value.”) Likewise, when sale or cash receipt precedes production and delivery, as in the case of magazine subscriptions, companies recognize revenues as earned by production and delivery.23 REVENUE RECOGNITION AFTER DELIVERY In some cases, the collection of the sales price is not reasonably assured and reve- LEARNING OBJECTIVE 6 nue recognition is deferred. One of two methods is generally employed to defer Describe the installment-sales method revenue recognition until the company receives cash: the installment-sales of accounting. method or the cost-recovery method. A third method, the deposit method, applies in situations in which a company receives cash prior to delivery or transfer of the property; the company records that receipt as a deposit because the sales transaction is incomplete. This section examines these three methods. Installment-Sales Method The installment-sales method recognizes income in the periods of collection rather than in the period of sale. The logic underlying this method is that when there is no reasonable approach for estimating the degree of collectibility, companies should not recognize revenue until cash is collected. The expression “installment sales” generally describes any type of sale for which payment is required in periodic installments over an extended period of time. All types
of farm and home equipment as well as home furnishings are sold on an installment basis. The heavy equipment industry also sometimes uses the method for machine in- stallations paid for over a long period. Another application of the method is in land- development sales. 22Such revenue satisfies the criteria of Concepts Statement No. 5 since the assets are readily realizable and the earning process is virtually complete (see par. 84, item c). 23Statement of Financial Accounting Concepts No. 5, par. 84, item b. Revenue Recognition after Delivery 1069 Because payment is spread over a relatively long period, the risk of loss re- Underlying Concepts sulting from uncollectible accounts is greater in installment-sales transactions than in ordinary sales. Consequently, selling companies use various devices to Realization is a critical part of protect themselves. Two common devices are (1) the use of a conditional sales revenue recognition. Thus, if a contract, which specifies that title to the item sold does not pass to the purchaser high degree of uncertainty exists until all payments are made, and (2) use of notes secured by a chattel (personal about collectibility, a company property) mortgage on the article sold. Either of these permits the seller to must defer revenue recognition. “repossess” the goods sold if the purchaser defaults on one or more payments. The seller can then resell the repossessed merchandise at whatever price it will bring to compensate for the uncollected installments and the expense of repossession. Under the installment-sales method of accounting, companies defer income recog- nition until the period of cash collection. They recognize both revenues and costs of sales in the period of sale, but defer the related gross profit to those periods in which they collect the cash. Thus, instead of deferring the sale, along with related costs and expenses, to the future periods of anticipated collection, the company defers only the proportional gross profit. This approach is equivalent to deferring both sales and cost of sales. Other expenses—that is, selling expense, administrative expense, and so on— are not deferred. Thus, the installment-sales method matches cost and expenses against sales through the gross profit figure, but no further. Companies using the installment-sales method generally record operating expenses without regard to the fact that they will defer some portion of the year’s gross profit. This practice is often justified on the basis that (1) these expenses do not follow sales as closely as does the cost of goods sold, and (2) accurate apportionment among periods would be so difficult that it could not be justi- fied by the benefits gained.24 Acceptability of the Installment-Sales Method The use of the installment-sales method for revenue recognition has fluctuated widely. At one time, it was widely accepted for installment-sales transactions. Somewhat para- doxically, as installment-sales transactions increased in popularity, acceptance and use of the installment-sales method decreased. Finally, the profession concluded that except in special circumstances, “the installment method of recognizing revenue is not accept- able.” [11] The rationale for this position is simple. Because the installment method recognizes no income until cash is collected, it is not in accordance with the accrual- accounting concept. Use of the installment-sales method was often justified on the grounds that the risk of not collecting an account receivable may be so great that the sale itself is not sufficient evidence that recognition should occur. In some cases, this reasoning is valid but not in a majority of cases. The general approach is that a company should recognize a com- pleted sale. If the company expects bad debts, it should record this possibility as sepa- rate estimates of uncollectibles. Although collection expenses, repossession expenses, and bad debts are an unavoidable part of installment-sales activities, the incurrence of these costs and the collectibility of the receivables are reasonably predictable.
We study this topic in intermediate accounting because the method is acceptable in cases where a company believes there to be no reasonable basis of estimating the degree of collectibility. In addition, the sales method of revenue recognition has certain weak- nesses when used for franchise and land-development operations. Application of the sales method to franchise and license operations has resulted in the abuse described 24In addition, other theoretical deficiencies of the installment-sales method could be cited. For example, see Richard A. Scott and Rita K. Scott, “Installment Accounting: Is It Inconsistent?” The Journal of Accountancy (November 1979). 1070 Chapter 18 Revenue Recognition earlier as “front-end loading.” In some cases, franchisors recognized revenue prema- turely, when they granted a franchise or issued a license, rather than when revenue was earned or the cash is received. Many land-development ventures were susceptible to the same abuses. As a result, the FASB prescribes application of the installment-sales method of accounting for sales of real estate under certain circumstances. [12]25 Procedure for Deferring Revenue and Cost of Sales of Merchandise One could work out a procedure that deferred both the uncollected portion of the sales price and the proportionate part of the cost of the goods sold. Instead of apportioning both sales price and cost over the period of collection, however, the installment-sales method defers only the gross profit. This procedure has exactly the same effect as deferring both sales and cost of sales, but it requires only one deferred account rather than two. For the sales in any one year, the steps companies use to defer gross profit are as follows. 1. During the year, record both sales and cost of sales in the regular way, using the special accounts described later, and compute the rate of gross profi t on installment- sales transactions. 2. At the end of the year, apply the rate of gross profi t to the cash collections of the current year’s installment sales, to arrive at the realized gross profi t. 3. Defer to future years the gross profi t not realized. For sales made in prior years, companies apply the gross profit rate of each year’s sales against cash collections of accounts receivable resulting from that year’s sales, to arrive at the realized gross profit. Special accounts must be used in the installment-sales method. These accounts pro- vide certain information required to determine the realized and unrealized gross profit in each year of operations. In computing net income under the installment-sales method as generally applied, the only peculiarity is the deferral of gross profit until realized by accounts receivable collection. We will use the following data to illustrate the installment-sales method in accounting for the sales of merchandise. 2014 2015 2016 Installment sales $200,000 $250,000 $240,000 Cost of installment sales 150,000 190,000 168,000 Gross profit $ 50,000 $ 60,000 $ 72,000 Rate of gross profit on sales 25%a 24%b 30%c Cash receipts 2014 sales $ 60,000 $100,000 $ 40,000 2015 sales 100,000 125,000 2016 sales 80,000 a $50,000 b $60,000 c $72,000 $200,000 $250,000 $240,000 To simplify this example, we have excluded interest charges. Summary entries in general journal form for the year 2014 are as follows. 25The installment-sales method of accounting must be applied to a retail land sale that meets all of the following criteria: (1) the period of cancellation of the sale with refund of the down payment and any subsequent payments has expired; (2) cumulative cash payments equal or exceed 10 percent of the sales value; and (3) the seller is financially capable of providing all promised contract representations (e.g., land improvements, off-site facilities). Revenue Recognition after Delivery 1071 2014 Installment Accounts Receivable, 2014 200,000 Installment Sales 200,000 (To record sales made on installment in 2014) Cash 60,000 Installment Accounts Receivable, 2014 60,000 (To record cash collected on installment receivables)
Cost of Installment Sales 150,000 Inventory (or Purchases) 150,000 (To record cost of goods sold on installment in 2014 on either a perpetual or a periodic inventory basis) Installment Sales 200,000 Cost of Installment Sales 150,000 Deferred Gross Profit, 2014 50,000 (To close installment sales and cost of installment sales for the year) Deferred Gross Profit, 2014 15,000 Realized Gross Profit 15,000 (To remove from deferred gross profit the profit realized through cash collections; $60,000 3 25%) Realized Gross Profit 15,000 Income Summary 15,000 (To close profits realized by collections) Illustration 18-32 shows computation of the realized and deferred gross profit for the year 2014. ILLUSTRATION 18-32 2014 Computation of Realized Rate of gross profit current year 25% and Deferred Gross Cash collected on current year’s sales $60,000 Realized gross profit (25% of $60,000) 15,000 Profi t, 2014 Gross profit to be deferred ($50,000 2 $15,000) 35,000 Summary entries in journal form for year 2 (2015) are as follows. 2015 Installment Accounts Receivable, 2015 250,000 Installment Sales 250,000 (To record sales made on installment in 2015) Cash 200,000 Installment Accounts Receivable, 2014 100,000 Installment Accounts Receivable, 2015 100,000 (To record cash collected on installment receivables) Cost of Installment Sales 190,000 Inventory (or Purchases) 190,000 (To record cost of goods sold on installment in 2015) Installment Sales 250,000 Cost of Installment Sales 190,000 Deferred Gross Profit, 2015 60,000 (To close installment sales and cost of installment sales for the year) Deferred Gross Profit, 2014 ($100,000 3 25%) 25,000 Deferred Gross Profit, 2015 ($100,000 3 24%) 24,000 Realized Gross Profit 49,000 (To remove from deferred gross profit the profit realized through cash collections) Realized Gross Profit 49,000 Income Summary 49,000 (To close profits realized by collections) 1072 Chapter 18 Revenue Recognition Illustration 18-33 shows computation of the realized and deferred gross profit for the year 2015. ILLUSTRATION 18-33 2015 Computation of Realized Current year’s sales and Deferred Gross Rate of gross profit 24% Profi t, 2015 Cash collected on current year’s sales $100,000 Realized gross profit (24% of $100,000) 24,000 Gross profit to be deferred ($60,000 2 $24,000) 36,000 Prior year’s sales Rate of gross profit—2014 25% Cash collected on 2014 sales $100,000 Gross profit realized in 2015 on 2014 sales (25% of $100,000) 25,000 Total gross profit realized in 2015 Realized on collections of 2014 sales $ 25,000 Realized on collections of 2015 sales 24,000 Total $ 49,000 The entries in 2016 would be similar to those of 2015, and the total gross profit taken up or realized would be $64,000, as shown by the computations in Illustra- tion 18-34. ILLUSTRATION 18-34 2016 Computation of Realized Current year’s sales and Deferred Gross Rate of gross profit 30% Profi t, 2016 Cash collected on current year’s sales $ 80,000 Gross profit realized on 2016 sales (30% of $80,000) 24,000 Gross profit to be deferred ($72,000 2 $24,000) 48,000 Prior years’ sales 2014 sales Rate of gross profit 25% Cash collected $ 40,000 Gross profit realized in 2016 on 2014 sales (25% of $40,000) 10,000 2015 sales Rate of gross profit 24% Cash collected $125,000 Gross profit realized in 2016 on 2015 sales (24% of $125,000) 30,000 Total gross profit realized in 2016 Realized on collections of 2014 sales $ 10,000 Realized on collections of 2015 sales 30,000 Realized on collections of 2016 sales 24,000 Total $ 64,000 In summary, here are the basic concepts you should understand about accounting for installment sales: 1. How to compute a proper gross profi t percentage. 2. How to record installment sales, cost of installment sales, and deferred gross profi t. 3. How to compute realized gross profi t on installment receivables. 4. How the deferred gross profi t balance at the end of the year results from applying the gross profi t rate to the installment accounts receivable. Revenue Recognition after Delivery 1073 Additional Problems of Installment-Sales Accounting In addition to computing realized and deferred gross profit currently, other problems
are involved in accounting for installment-sales transactions. These problems are re- lated to: 1. Interest on installment contracts. 2. Uncollectible accounts. 3. Defaults and repossessions. Interest on Installment Contracts. Because the collection of installment receivables is spread over a long period, it is customary to charge the buyer interest on the unpaid balance. The seller and buyer set up a schedule of equal payments consisting of interest and principal. Each successive payment is attributable to a smaller amount of interest and a correspondingly larger amount of principal, as shown in Illustration 18-35. This illustration assumes that a company sells for $3,000 an asset costing $2,400 (rate of gross profit 5 20%), with interest of 8 percent included in the three installments of $1,164.10. ILLUSTRATION 18-35 Interest Installment Installment Realized Installment Payment Cash Earned Receivables Unpaid Gross Schedule Date (Debit) (Credit) (Credit) Balance Profit (20%) 1/2/14 — — — $3,000.00 — 1/2/15 $1,164.10a $240.00b $ 924.10c 2,075.90d $184.82e 1/2/16 1,164.10 166.07 998.03 1,077.87 199.61 1/2/17 1,164.10 86.23 1,077.87 –0– 215.57 $600.00 aPeriodic payment 5 Original unpaid balance 4 PV of an annuity of $1.00 for three periods at 8%; $1,164.10 5 $3,000 4 2.57710. b$3,000.00 3 .08 5 $240. c$1,164.10 2 $240.00 5 $924.10. d$3,000.00 2 $924.10 5 $2,075.90. e$924.10 3 .20 5 $184.82. The company accounts for interest separate from the gross profit recognized on the installment-sales collections during the period, by recognizing interest revenue at the time of its cash receipt. Uncollectible Accounts. The problem of bad debts or uncollectible accounts receivable is somewhat different for concerns selling on an installment basis because of a reposses- sion feature commonly incorporated in the sales agreement. This feature gives the sell- ing company an opportunity to recoup an uncollectible account through repossession and resale of repossessed merchandise. If the experience of the company indicates that repossessions do not, as a rule, compensate for uncollectible balances, it may be advis- able to provide for such losses through charges to a special bad debt expense account, just as is done for other credit sales. Defaults and Repossessions. Depending on the terms of the sales contract and the policy of the credit department, the seller can repossess merchandise sold under an installment arrangement if the purchaser fails to meet payment requirements. The seller may then recondition repossessed merchandise before offering it for resale, for either cash or installment payments. The accounting for repossessions recognizes that the company is not likely to col- lect the related installment receivable and should write it off. Along with the installment 1074 Chapter 18 Revenue Recognition account receivable, the company must remove the applicable deferred gross profit using the following entry. Repossessed Merchandise (an inventory account) xxx Deferred Gross Profit xxx Installment Accounts Receivable xxx This entry assumes that the company will record the repossessed merchandise at exactly the amount of the uncollected account less the deferred gross profit applicable. This assumption may or may not be proper. To determine the correct amount, the com- pany should consider the condition of the repossessed merchandise, the cost of recondi- tioning, and the market for secondhand merchandise of that particular type. The objec- tive should be to put any asset acquired on the books at its fair value, or at the best possible approximation of fair value when fair value is not determinable. A loss can occur if the fair value of the repossessed merchandise is less than the uncollected balance less the deferred gross profit. In that case, the company should record a “loss on repos- session” at the date of repossession.26 To illustrate the required entry, assume that Klein Brothers sells a refrigerator to Marilyn Hunt for $1,500 on September 1, 2014. Terms require a down payment of $600 and $60 on the first of every month for 15 months, starting October 1, 2014. It is further
assumed that the refrigerator cost $900 and that Klein Brothers priced it to provide a 40 percent rate of gross profit on selling price. At the year-end, December 31, 2014, Klein Brothers should have collected a total of $180 in addition to the original down payment. If Hunt makes her January and February payments in 2015 and then defaults, the account balances applicable to Hunt at time of default are as shown in Illustration 18-36. ILLUSTRATION 18-36 Installment accounts receivable (September 1, 2014) $1,500 Computation of Less: Down payment: $600 Installment Receivable Payments to date ($60 3 5) 300 900 Balances Installment accounts receivable (March 1, 2015) $ 600 Installment accounts receivable (March 1, 2015) $ 600 Gross profit rate 3 40% Deferred gross profit $ 240 As indicated, Klein Brothers compute the balance of deferred gross profit appli- cable to Hunt’s account by applying the gross profit rate for the year of sale to the balance of Hunt’s account receivable: 40 percent of $600, or $240. The account balances are therefore: Installment Account Receivable, 2014 600 (Dr.) Deferred Gross Profit, 2014 240 (Cr.) 26Some contend that a company should record repossessed merchandise at a valuation that will permit the company to make its regular rate of gross profit on resale. If the company enters the value at its approximated cost to purchase, the regular rate of gross profit could be provided for upon its ultimate sale, but that is completely a secondary consideration. It is more important that the company record the repossessed asset at fair value. This accounting would be in accordance with the general practice of carrying assets at acquisition price, as represented by the fair value at the date of acquisition. Revenue Recognition after Delivery 1075 Klein repossesses the refrigerator following Hunt’s default. If Klein sets the esti- mated fair value of the repossessed article at $150, it would make the following entry to record the repossession. Deferred Gross Profit, 2014 240 Repossessed Merchandise 150 Loss on Repossession 210 Installment Accounts Receivable, 2014 600 Klein determines the amount of the loss in two steps. (1) It subtracts the deferred gross profit from the amount of the account receivable, to determine the unrecovered cost (or book value) of the merchandise repossessed. (2) It then subtracts the estimated fair value of the merchandise repossessed from the unrecovered cost, to get the amount of the loss on repossession. Klein Brothers computes the loss on the refrigerator as shown in Illustration 18-37. ILLUSTRATION 18-37 Balance of account receivable (representing uncollected selling price) $600 Computation of Loss on Less: Deferred gross profit 240 Repossession Unrecovered cost 360 Less: Estimated fair value of merchandise repossessed 150 Loss (Gain) on repossession $210 As pointed out earlier, the loss on repossession may be charged to Allowance for Doubtful Accounts if a company carries such an account. Financial Statement Presentation of Installment-Sales Transactions If installment-sales transactions represent a significant part of total sales, it is desirable to make full disclosure of installment sales, the cost of installment sales, and any ex- penses allocable to installment sales. However, if installment-sales transactions consti- tute an insignificant part of total sales, it may be satisfactory to include only the realized gross profit in the income statement as a special item following the gross profit on sales. Illustration 18-38 shows this simpler presentation. ILLUSTRATION 18-38 HEALTH MACHINE COMPANY Disclosure of Installment- INCOME STATEMENT Sales Transactions— FOR THE YEAR ENDED DECEMBER 31, 2015 Insignifi cant Amount Sales $620,000 Cost of goods sold 490,000 Gross profit 130,000 Gross profit realized on installment sales 51,000 Total gross profit $181,000 If a company wants more complete disclosure of installment-sales transactions, it would use a presentation similar to that shown in Illustration 18-39 (page 1076). The presentation in Illustration 18-39 is awkward. Yet the awkwardness of this
method is difficult to avoid if a company wants to provide full disclosure of installment- sales transactions in the income statement. One solution, of course, is to prepare a sepa- rate schedule showing installment-sales transactions, with only the final figure carried into the income statement. 1076 Chapter 18 Revenue Recognition ILLUSTRATION 18-39 HEALTH MACHINE COMPANY Disclosure of Installment- INCOME STATEMENT Sales Transactions— FOR THE YEAR ENDED DECEMBER 31, 2015 Signifi cant Amount Installment Other Sales Sales Total Sales $248,000 $620,000 $868,000 Cost of goods sold 182,000 490,000 672,000 Gross profit 66,000 130,000 196,000 Less: Deferred gross profit on installment sales of this year 47,000 47,000 Realized gross profit on this year’s sales 19,000 130,000 149,000 Add: Gross profit realized on installment sales of prior years 32,000 32,000 Gross profit realized this year $ 51,000 $130,000 $181,000 In the balance sheet, it is generally considered desirable to classify installment accounts receivable by year of collectibility. There is some question as to whether com- panies should include in current assets installment accounts that are not collectible for two or more years. Yet if installment sales are part of normal operations, companies may consider them as current assets because they are collectible within the operating cycle of the business. Little confusion should result from this practice if the company fully discloses maturity dates, as illustrated in the following example. ILLUSTRATION 18-40 Current assets Disclosure of Installment Notes and accounts receivable Accounts Receivable, Trade customers $78,800 by Year Less: Allowance for doubtful accounts 3,700 75,100 Installment accounts collectible in 2015 22,600 Installment accounts collectible in 2016 47,200 $144,900 On the other hand, a company may have receivables from an installment contract, resulting from a transaction not related to normal operations. In that case, the company should report such receivables in the “Other assets” section if due beyond one year. Repossessed merchandise is a part of inventory, and companies should report it as such in the “Current assets” section of the balance sheet. They should include any gain or loss on repossession in the income statement in the “Other revenues and gains” or “Other expenses and losses” section. If a company has deferred gross profit on installment sales, it generally treats it as unearned revenue and classifies it as a current liability. Theoretically, deferred gross profit consists of three elements: (1) income tax liability to be paid when the sales are reported as realized revenue (current liability); (2) allowance for collection expense, bad debts, and repossession losses (deduction from installment accounts receivable); and (3) net income (retained earnings, restricted as to dividend availability). Because of the difficulty in allocating deferred gross profit among these three elements, however, com- panies frequently report the whole amount as unearned revenue. In contrast, the FASB in SFAC No. 6 states that “no matter how it is displayed in fi- nancial statements, deferred gross profit on installment sales is conceptually an asset valuation—that is, a reduction of an asset.”27 We support the FASB position, but we 27See Statement of Financial Accounting Concepts No. 6, paras. 232–234. Revenue Recognition after Delivery 1077 recognize that until an official standard on this topic is issued, financial statements will probably continue to report such deferred gross profit as a current liability. Cost-Recovery Method Under the cost-recovery method, a company recognizes no profit until cash 7 LEARNING OBJECTIVE payments by the buyer exceed the cost of the merchandise sold. After the seller Explain the cost-recovery method has recovered all costs, it includes in income any additional cash collections. The of accounting. seller’s income statement for the period reports sales revenue, the cost of goods sold, and the gross profit—both the amount (if any) that is recognized during the
period and the amount that is deferred. The deferred gross profit is offset against the related receivable—reduced by collections—on the balance sheet. Subsequent income statements report the gross profit as a separate item of revenue when the company recognizes it as earned. A seller is permitted to use the cost-recovery method to account for sales in which “there is no reasonable basis for estimating collectibility.” In addition, use of this method is required where a high degree of uncertainty exists related to the collection of receiv- ables. [13], [14], [15] To illustrate the cost-recovery method, assume that early in 2014, Fesmire Manufac- turing sells inventory with a cost of $25,000 to Higley Company for $36,000. Higley will make payments of $18,000 in 2014, $12,000 in 2015, and $6,000 in 2016. If the cost-recovery method applies to this transaction and Higley makes the payments as scheduled, Fesmire recognizes cash collections, revenue, cost, and gross profit as follows.28 ILLUSTRATION 18-41 2014 2015 2016 Computation of Gross Cash collected $18,000 $12,000 $6,000 Profi t—Cost-Recovery Revenue $36,000 –0– –0– Method Cost of goods sold 25,000 –0– –0– Deferred gross profit 11,000 11,000 6,000 Less: Recognized gross profit –0– 5,000* 6,000 Deferred gross profit balance (end of period) $11,000 $ 6,000 $ –0– *$25,000 2 $18,000 5 $7,000 of unrecovered cost at the end of 2014; $12,000 2 $7,000 5 $5,000, the excess of cash received in 2015 over unrecovered cost. Under the cost-recovery method, Fesmire reports total revenue and cost of goods sold in the period of sale, similar to the installment-sales method. However, unlike the installment-sales method, which recognizes income as cash is collected, Fesmire recog- nizes profit under the cost-recovery method only when cash collections exceed the total cost of the goods sold. 28An alternative format for computing the amount of gross profit recognized annually is shown below. Original Balance of Gross Cash Cost Unrecovered Profit Year Received Recovered Cost Realized Beginning balance — — $25,000 — 12/31/14 $18,000 $18,000 7,000 $ –0– 12/31/15 12,000 7,000 –0– 5,000 12/31/16 6,000 –0– –0– 6,000 1078 Chapter 18 Revenue Recognition Therefore, Fesmire’s journal entry to record the deferred gross profit on the Higley sales transaction (after recording the sale and the cost of sales in the normal manner) at the end of 2014 is as follows. 2014 Sales Revenue 36,000 Cost of Sales 25,000 Deferred Gross Profit 11,000 (To close sales and cost of sales and to record deferred gross profit on sales accounted for under the cost-recovery method) In 2015 and 2016, the deferred gross profit becomes realized gross profit as the cumulative cash collections exceed the total costs, by recording the following entries. 2015 Deferred Gross Profit 5,000 Realized Gross Profit 5,000 (To recognize gross profit to the extent that cash collections in 2015 exceed costs) 2016 Deferred Gross Profit 6,000 Realized Gross Profit 6,000 (To recognize gross profit to the extent that cash collections in 2016 exceed costs) Deposit Method In some cases, a company receives cash from the buyer before it transfers the goods or property. In such cases, the seller has not performed under the contract and has no claim against the purchaser. There is not sufficient transfer of the risks and rewards of owner- ship for a sale to be recorded. The method of accounting for these incomplete transac- tions is the deposit method. Under the deposit method, the seller reports the cash received from the buyer as a deposit on the contract and classifies it on the balance sheet as a liability (refundable deposit or customer advance). The seller continues to report the property as an asset on its balance sheet, along with any related existing debt. Also, the seller continues to charge depreciation expense as a period cost for the property. The seller does not recognize revenue or income until the sale is complete. [16] At that time, it closes the deposit account and applies one of the revenue recognition methods discussed in this
chapter to the sale. The major difference between the installment-sales and cost-recovery methods and the deposit method relates to contract performance. In the installment-sales and cost-recovery methods, it is assumed that the seller has performed on the contract but cash collection is highly uncertain. In the deposit method, the seller has not performed and no legitimate claim exists. The deposit method postpones recognizing a sale until the company determines that a sale has occurred for accounting purposes. If there has not been sufficient transfer of risks and rewards of ownership, even if the selling com- pany has received a deposit, the company postpones recognition of the sale until sufficient transfer has occurred. In that sense, the deposit method is not a revenue recognition method as are the installment-sales and cost-recovery methods. Revenue Recognition after Delivery 1079 Summary and Concluding Remarks Illustration 18-42 summarizes the revenue recognition bases or methods, the criteria for their use, and the reasons for departing from the sale basis. ILLUSTRATION 18-42 Specific Transactions Accounting Guidance Revenue Recognition Point of sale See Illustration 18–12 (page 1056). Bases Long-term contracts (construction) (a) Percentage-of- Long-term construction of property; dependable estimates of extent of completion method progress and cost to complete; reasonable assurance of collectibility of contract price; expectation that both contractor and buyer can meet obligations; and absence of inherent hazards that make estimates doubtful. (b) Completed-contract Use on short-term contracts and whenever percentage-of-completion method cannot be used on long-term contracts. Existence of inherent hazards in the contract beyond the normal, recurring business risks; conditions for using the percentage-of-completion method are absent. Completion-of- Immediate marketability at quoted prices; unit interchangeability; and no production basis significant distribution costs. Installment-sales method Absence of reasonable basis for estimating degree of collectibility and and cost-recovery method costs of collection. Collectibility of the receivable is so uncertain that gross profit (or income) is not recognized until cash is actually received. Deposit method Cash received before the sales transaction is completed. No recognition of revenue and income because there is not sufficient transfer of the risks and rewards of ownership. As indicated, revenue recognition principles are sometimes difficult to apply International and often vary by industry. Recently, the SEC has attempted to provide Perspective more guidance in this area because of concern that the revenue recognition There is no international principle is sometimes being incorrectly applied. Many cases of intentional enforcement body comparable misstatement of revenue to achieve better financial results have recently come to the U.S. SEC. to light. Such practices are fraudulent, and the SEC is vigorously prosecuting these situations. For our capital markets to be efficient, investors must have confidence that the financial information provided is both relevant and reliable. As a result, it is imperative that the accounting profession, regulators, and companies eliminate aggressive revenue recognition practices. It is our hope that recent efforts by the SEC and the accounting profession will lead to higher-quality reporting in this area. You will want to read the IFRS INSIGHTS on pages 1109–1113 for discussion of IFRS related to revenue recognition. 1080 Chapter 18 Revenue Recognition KEY TERMS SUMMARY OF LEARNING OBJECTIVES Billings account, 1061 completed-contract method, 1057, 1063 1 Describe and apply the revenue recognition principle. Companies should completion-of-production recognize revenue (1) when revenue is realized or realizable and (2) when it is earned. basis, 1068 Revenues are realized when goods or services are exchanged for cash or claims to cash. consignee, 1052 Revenues are realizable when assets received in exchanges are readily convertible to
consignment, 1052 known amounts of cash or claims to cash. Revenues are earned when a company has consignor, 1052 substantially accomplished what it must do to be entitled to the benefits represented by cost-recovery the revenues—that is, when the earnings process is complete or virtually complete. method, 1077 cost-to-cost basis, 1059 2 Describe accounting issues for revenue recognition at point of sale. deposit method, 1078 The two conditions for recognizing revenue are usually met by the time a company earned revenues, 1043 d elivers products or merchandise or provides services to customers. Companies c ommonly recognize revenue from manufacturing and selling activities at time of sale. high rate of returns, 1047 Problems of implementation can arise because of (1) sales with discounts, (2) sales with input measures, 1058 extended payment terms, (3) sales with right of return, (4) sales with buyback, (5) bill installment-sales and hold sales, (6) principal-agent relationships, (7) trade loading and channel stuffing, method, 1068 and (8) multiple-deliverable arrangements. Illustration 18-12 (page 1056) summarizes multiple-deliverable accounting guidance in these areas. arrangements, 1054 output measures, 1058 3 Apply the percentage-of-completion method for long-term contracts. percentage-of-completion To apply the percentage-of-completion method to long-term contracts, a company must method, 1057, 1058 have some basis for measuring the progress toward completion at particular interim point of sale dates. One of the most popular input measures used to determine the progress toward (delivery), 1046 completion is the cost-to-cost basis. Using this basis, a company measures the percent- principal-agent age of completion by comparing costs incurred to date with the most recent estimate of relationship, 1050 the total costs to complete the contract. The company applies that percentage to the total realizable revenues, 1043 revenue or the estimated total gross profit on the contract, to arrive at the amount of realized revenues, 1043 revenue or gross profit to be recognized to date. repossessions, 1073 4 Apply the completed-contract method for long-term contracts. Under revenue recognition this method, companies recognize revenue and gross profit only at point of sale—that principle, 1043 is, when the company completes the contract. The company accumulates costs of long- term contracts in process and current billings. It makes no interim charges or credits to income statement accounts for revenues, costs, and gross profit. The annual entries to record costs of construction, progress billings, and collections from customers would be identical to those for the percentage-of-completion method—with the significant exclu- sion of the recognition of revenue and gross profit. 5 Identify the proper accounting for losses on long-term contracts. Two types of losses can become evident under long-term contracts. (1) Loss in current period on a profitable contract: Under the percentage-of-completion method only, the estimated cost increase requires a current-period adjustment of excess gross profit recognized on the project in prior periods. The company records this adjustment as a loss in the current period because it is a change in accounting estimate. (2) Loss on an unprofitable contract: Under both the percentage-of-completion and the completed-contract methods, the company must recognize the entire expected contract loss in the current period. 6 Describe the installment-sales method of accounting. The installment- sales method recognizes income in the periods of collection rather than in the period of sale. The installment-sales method of accounting is justified on the basis that when there is no reasonable approach for estimating the degree of collectibility, a company should not recognize revenue until it has collected cash. 7 Explain the cost-recovery method of accounting. Under the cost-recovery method, companies do not recognize profit until cash payments by the buyer exceed the Appendix 18A: Revenue Recognition for Franchises 1081
seller’s cost of the merchandise sold. After the seller has recovered all costs, it includes in income any additional cash collections. The income statement for the period of sale reports sales revenue, the cost of goods sold, and the gross profit—both the amount recognized during the period and the amount deferred. The deferred gross profit is off- set against the related receivable on the balance sheet. Subsequent income statements report the gross profit as a separate item of revenue when revenue is recognized as earned. APPENDIX 18A REVENUE RECOGNITION FOR FRANCHISES In this appendix, we cover a common yet unique type of business transaction— 8 LEARNING OBJECTIVE franchises. As indicated throughout this chapter, companies recognize revenue Explain revenue recognition for on the basis of two criteria: (1) when it is realized or realizable (occurrence of an franchises. exchange for cash or claims to cash), and (2) when it is earned (completion or virtual completion of the earnings process). These criteria are appropriate for most business activities. For some sales transactions, though, they do not adequately define when a company should recognize revenue. The fast-growing franchise industry is of special concern and challenge. In accounting for franchise sales, a company must analyze the transaction and, con- sidering all the circumstances, use judgment in selecting one or more of the revenue rec- ognition bases, and then possibly must monitor the situation over a long period of time. Four types of franchising arrangements have evolved: (1) manufacturer-retailer, (2) manufacturer-wholesaler, (3) service sponsor-retailer, and (4) wholesaler-retailer. The fastest-growing category of franchising, and the one that caused a reexamination of appropriate accounting, has been the third category, service sponsor-retailer. Included in this category are such industries and businesses as: • Soft ice cream/frozen yogurt stores (Tastee Freez, TCBY, Dairy Queen) • Food drive-ins (McDonald’s, KFC, Burger King) • Restaurants (TGI Friday’s, Pizza Hut, Denny’s) • Motels (Holiday Inn, Marriott, Best Western) • Auto rentals (Avis, Hertz, National) • Others (H & R Block, Meineke Mufflers, 7-Eleven Stores, Kelly Services) Franchise companies derive their revenue from one or both of two sources: (1) from the sale of initial franchises and related assets or services, and (2) from continuing fees based on the operations of franchises. The franchisor (the party who grants business rights under the franchise) normally provides the franchisee (the party who operates the franchised business) with the following services. 1. Assistance in site selection: (a) analyzing location and (b) negotiating lease. 2. Evaluation of potential income. 3. Supervision of construction activity: (a) obtaining fi nancing, (b) designing building, and (c) supervising contractor while building. 4. Assistance in the acquisition of signs, fi xtures, and equipment. 5. Bookkeeping and advisory services: (a) setting up franchisee’s records; (b) advising on income, real estate, and other taxes; and (c) advising on local regulations of the franchisee’s business. 6. Employee and management training. 1082 Chapter 18 Revenue Recognition 7. Quality control. 8. Advertising and promotion.29 In the past, it was standard practice for franchisors to recognize the entire franchise fee at the date of sale, whether the fee was received then or was collectible over a long period of time. Frequently, franchisors recorded the entire amount as revenue in the year of sale, even though many of the services were yet to be performed and uncertainty existed regarding the collection of the entire fee.30 (In effect, the franchisors were count- ing their fried chickens before they were hatched.) However, a franchise agreement may provide for refunds to the franchisee if certain conditions are not met, and fran- chise fee profit can be reduced sharply by future costs of obligations and services to be rendered by the franchisor. To curb the abuses in revenue recognition that existed and
to standardize the accounting and reporting practices in the franchise industry, the FASB issued rules which form the basis for the accounting discussed below. INITIAL FRANCHISE FEES The initial franchise fee is payment for establishing the franchise relationship and pro- viding some initial services. Franchisors record initial franchise fees as revenue only when and as they make “substantial performance” of the services they are obligated to perform and when collection of the fee is reasonably assured. Substantial performance occurs when the franchisor has no remaining obligation to refund any cash received or excuse any nonpayment of a note and has performed all the initial services required under the contract. Commencement of operations by the franchisee shall be presumed to be the earliest point at which substantial performance has occurred, unless it can be demonstrated that substantial performance of all obligations, including services rendered voluntarily, has occurred before that time. [17] Example of Entries for Initial Franchise Fee To illustrate, assume that Tum’s Pizza Inc. charges an initial franchise fee of $50,000 for the right to operate as a franchisee of Tum’s Pizza. Of this amount, $10,000 is payable when the franchisee signs the agreement, and the balance is payable in five annual payments of $8,000 each. In return for the initial franchise fee, Tum’s will help locate the site, negotiate the lease or purchase of the site, supervise the construction activity, and provide the book- keeping services. The credit rating of the franchisee indicates that money can be borrowed at 8 percent. The present value of an ordinary annuity of five annual receipts of $8,000 each discounted at 8 percent is $31,941.68. The discount of $8,058.32 represents the interest revenue to be accrued by the franchisor over the payment period. The following examples show the entries that Tum’s Pizza Inc. would make under various conditions. 1. If there is reasonable expectation that Tum’s Pizza Inc. may refund the down pay- ment and if substantial future services remain to be performed by Tum’s Pizza Inc., the entry should be: Cash 10,000.00 Notes Receivable 40,000.00 Discount on Notes Receivable 8,058.32 Unearned Franchise Fees 41,941.68 29Archibald E. MacKay, “Accounting for Initial Franchise Fee Revenue,” The Journal of Accountancy (January 1970), pp. 66–67. 30At one time, the SEC ordered a half-dozen fast-growing startup franchisors, including Jiffy Lube International, Moto Photo, Inc., Swensen’s, Inc., and LePeep Restaurants, Inc., to defer their initial franchise fee recognition until earned. See “Claiming Tomorrow’s Profits Today,” Forbes (October 17, 1988), p. 78. Appendix 18A: Revenue Recognition for Franchises 1083 2. If the probability of refunding the initial franchise fee is extremely low, the amount of future services to be provided to the franchisee is minimal, collectibility of the note is reasonably assured, and substantial performance has occurred, the entry should be: Cash 10,000.00 Notes Receivable 40,000.00 Discount on Notes Receivable 8,058.32 Revenue from Franchise Fees 41,941.68 3. If the initial down payment is not refundable, represents a fair measure of the ser- vices already provided, with a signifi cant amount of services still to be performed by Tum’s Pizza in future periods, and collectibility of the note is reasonably assured, the entry should be: Cash 10,000.00 Notes Receivable 40,000.00 Discount on Notes Receivable 8,058.32 Revenue from Franchise Fees 10,000.00 Unearned Franchise Fees 31,941.68 4. If the initial down payment is not refundable and no future services are required by the franchisor, but collection of the note is so uncertain that recognition of the note as an asset is unwarranted, the entry should be: Cash 10,000.00 Revenue from Franchise Fees 10,000.00 5. Under the same conditions as those listed in case 4 above, except that the down pay- ment is refundable or substantial services are yet to be performed, the entry should be: Cash 10,000.00 Unearned Franchise Fees 10,000.00
In cases 4 and 5—where collection of the note is extremely uncertain—franchisors may recognize cash collections using the installment-sales method or the cost-recovery method.31 CONTINUING FRANCHISE FEES Continuing franchise fees are received in return for the continuing rights granted by the franchise agreement and for providing such services as management training, advertising and promotion, legal assistance, and other support. Franchisors report con- tinuing fees as revenue when they are earned and receivable from the franchisee, unless a portion of them has been designated for a particular purpose, such as providing a specified amount for building maintenance or local advertising. In that case, the portion deferred shall be an amount sufficient to cover the estimated cost in excess of continuing franchise fees and provide a reasonable profit on the continuing services. BARGAIN PURCHASES In addition to paying continuing franchise fees, franchisees frequently purchase some or all of their equipment and supplies from the franchisor. The franchisor would account for these sales as it would for any other product sales. 31A study that compared four revenue recognition procedures—installment-sales basis, spreading recognition over the contract life, percentage-of-completion basis, and substantial performance— for franchise sales concluded that the percentage-of-completion method is the most acceptable revenue recognition method; the substantial-performance method was found sometimes to yield ultra-conservative results. See Charles H. Calhoun III, “Accounting for Initial Franchise Fees: Is It a Dead Issue?” The Journal of Accountancy (February 1975), pp. 60–67. 1084 Chapter 18 Revenue Recognition Sometimes, however, the franchise agreement grants the franchisee the right to make bargain purchases of equipment or supplies after the franchisee has paid the ini- tial franchise fee. If the bargain price is lower than the normal selling price of the same product, or if it does not provide the franchisor a reasonable profit, then the franchisor should defer a portion of the initial franchise fee. The franchisor would account for the deferred portion as an adjustment of the selling price when the franchisee subsequently purchases the equipment or supplies. OPTIONS TO PURCHASE A franchise agreement may give the franchisor an option to purchase the franchisee’s business. As a matter of management policy, the franchisor may reserve the right to purchase a profitable franchise outlet, or to purchase one that is in financial difficulty. If it is probable at the time the option is given that the franchisor will ultimately purchase the outlet, then the franchisor should not recognize the initial franchise fee as revenue but should instead record it as a liability. When the franchisor exercises the option, the liability would reduce the franchisor’s investment in the outlet. FRANCHISOR’S COST Franchise accounting also involves proper accounting for the franchisor’s cost. The objective is to match related costs and revenues by reporting them as components of income in the same accounting period. Franchisors should ordinarily defer direct costs (usually incremental costs) relating to specific franchise sales for which revenue has not yet been recognized. They should not, however, defer costs without reference to antici- pated revenue and its realizability. [18] Indirect costs of a regular and recurring nature, such as selling and administrative expenses that are incurred irrespective of the level of franchise sales, should be expensed as incurred. DISCLOSURES OF FRANCHISORS Franchisors must disclose all significant commitments and obligations resulting from franchise agreements, including a description of services that have not yet been substan- tially performed. They also should disclose any resolution of uncertainties regarding the collectibility of franchise fees. Franchisors segregate initial franchise fees from other franchise fee revenue if they are significant. Where possible, revenues and costs related
to franchisor-owned outlets should be distinguished from those related to franchised outlets. KEY TERMS SUMMARY OF LEARNING OBJECTIVE continuing franchise fees, 1083 FOR APPENDIX 18A franchisee, 1081 franchisor, 1081 initial franchise fee, 1082 8 Explain revenue recognition for franchises. In a franchise arrangement, substantial the franchisor records as revenue the initial franchise fee as it makes substantial perfor- performance, 1082 mance of the services it is obligated to perform and collection of the fee is reasonably assured. Franchisors recognize continuing franchise fees as revenue when they are earned and receivable from the franchisee. Demonstration Problem 1085 DEMONSTRATION PROBLEM Outback Industries manufactures power-distribution equipment, builds power plants, and develops real estate. While the company recognizes the majority of its revenues at point of sale, Outback appropriately recognizes revenue on long-term construction projects using the percentage-of-completion method. It rec- ognizes sales of some properties using the installment-sales approach. Income data for 2014 from opera- tions other than construction and real estate are as follows. Revenues $6,500,000 Expenses 4,350,000 Other information: 1. Outback started a construction project during 2013. The total contract price is $1,000,000, and $100,000 in costs were incurred in 2014. Estimated costs to complete the project in 2015 are $400,000. In 2013, Outback incurred $200,000 of costs and recognized $50,000 gross profit on this project. 2. During this year, Outback sold real estate parcels at a price of $400,000. It recognizes gross profit at a 35% rate when cash is received. Outback collected $200,000 during the year on these sales. 3. The reported revenues include an order for power relays valued at $150,000. At year-end, this new customer is not ready to take delivery. Outback billed the customer and moved the relays to an Outback warehouse close to the customer for quick delivery when needed. Instructions (a) Determine net income for Outback Industries for 2014. (Ignore taxes.) (b) Some year-end audit work discovered that in 2014 Outback made installment sales in the amount of $80,000 (cost of sales $52,000) to customers with very questionable credit backgrounds. The com- pany accounted for these sales using the cost-recovery method. Outback collected $20,000 from these customers in 2014. Determine the effect of this change in accounting on the income computed in part (a). Solution (a) Revenues $6,350,000* Expenses 4,350,000 2,000,000 Gross profi t on construction contract** 78,571 Gross profi t on installment sales*** 70,000 Net income $2,148,571 * $6,500,000 2 $150,000. Outback should not recognize this revenue until the customer takes delivery. $200,0001$100,000 ** 542.857%3($1,000,0002$700,000)5$128,571 $200,0001$100,0001$400,000 Less gross profi t recognized in 2013 (50,000) $ 78,571 ***$200,000 3 35% 5 $ 70,000 (b) Cash received on these sales was $20,000 3 35% 5 7,000, which Outback recognized in (a) under the installment method. Income would be $7,000 lower under cost-recovery; the company would recog- nize no gross profit until collections exceed cost. Thus, Outback will not recognize any gross profit on these sales until it collects another $32,000 ($52,000 2 $20,000). 1086 Chapter 18 Revenue Recognition FASB CODIFICATION FASB Codification References [1] FASB ASC 605-10-S99-1. [Predecessor literature: “Revenue Recognition in Financial Statements,” SEC Staff Accounting B ulletin No. 101 December 3, 1999), and “Revenue Recognition,” SEC Staff Accounting Bulletin No. 104 (December 17, 2003).] [2] FASB ASC 470-40-25. [Predecessor literature: “Accounting for Product Financing Arrangements,” Statement of Financial Accounting Standards No. 49 (Stamford, Conn.: FASB, 1981).] [3] FASB ASC 605-15-25-1. [Predecessor literature: “Revenue Recognition When Right of Return Exists,” Statement of Financial Accounting Standards No. 48 (Stamford, Conn.: FASB, 1981), par. 6.] [4] FASB ASC 605-10-S99-1. [Predecessor literature: “Revenue Recognition in Financial Statements,” SEC Staff Accounting
Bulletin No. 101 (December 3, 1999), and “Revenue Recognition,” SEC Staff Accounting Bulletin No. 104 (December 17, 2003).] [5] FASB ASC 605-45-15. [Predecessor literature: “Revenue Recognition in Financial Statements,” SEC Staff Accounting Bulletin No. 101 (December 3, 1999), and “Revenue Recognition,” SEC Staff Accounting Bulletin No. 104 (December 17, 2003).] [6] FASB ASC 605-25-05. [Predecessor literature: “EITF 00-21 Revenue Arrangements with Multiple Deliverables” (May 15, 2003).] [7] FASB ASC 605-35-25-57. [Predecessor literature: “Accounting for Performance of Construction-Type and Certain Production- Type Contracts,” Statement of Position 81-1 (New York: AICPA, 1981), par. 23.] [8] FASB ASC 605-35-05-7. [Predecessor literature: Committee on Accounting Procedure, “Long-Term Construction-Type Contracts,” Accounting Research Bulletin No. 45 (New York: AICPA, 1955), p. 7.] [9] FASB ASC 910-405. [Predecessor literature: Construction Contractors, Audit and Accounting Guide (New York: AICPA, 1981), pp. 148–149.] [10] FASB ASC 910-605-50-1. [Predecessor literature: Construction Contractors, Audit and Accounting Guide (New York: AICPA, 1981), p. 30.] [11] FASB ASC 605-10-25-3. [Predecessor literature: “Omnibus Opinion,” Opinions of the Accounting Principles Board No. 10 (New York: AICPA, 1966), par. 12.] [12] FASB ASC 976-605-25. [Predecessor literature: “Accounting for Sales of Real Estate,” Statement of Financial Accounting Standards No. 66 (Norwalk, Conn.: FASB, 1982), paras. 45–47.] [13] FASB ASC 605-10-25-4. [Predecessor literature: “Omnibus Opinion,” Opinions of the Accounting Principles Board No. 10 (New York: AICPA, 1966), footnote 8, p. 149.] [14] FASB ASC 952-605-25-7. [Predecessor literature: “Accounting for Franchise Fee Revenue,” Statement of Financial Accounting Standards No. 45 (Stamford, Conn.: FASB, 1981), par. 6.] [15] FASB ASC 360-20-55-13. [Predecessor literature: “Accounting for Sales of Real Estate,” Statement of Financial Accounting Standards No. 66, paras. 62 and 63.] [16] FASB ASC 360-20-55-17. [Predecessor literature: “Accounting for Sales of Real Estate,” Statement of Financial Accounting Standards No. 66, par. 65.] [17] FASB ASC 952-605-25-3. [Predecessor literature: “Accounting for Franchise Fee Revenue,” Statement of Financial Accounting Standards No. 45 (Stamford, Conn.: FASB, 1981), par. 5.] [18] FASB ASC 952-340-25. [Predecessor literature: “Accounting for Franchise Fee Revenue,” Statement of Financial Accounting Standards No. 45 (Stamford, Conn.: FASB, 1981), p. 17.] Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE18-1 Access the glossary (“Master Glossary”) to answer the following. (a) What is the cost-recovery method? (b) What is the percentage-of-completion method? (c) What is the deposit method? (d) What is the installment method? CE18-2 Is the installment-sales method of recognizing revenue generally acceptable? Why or why not? CE18-3 When would a construction company be allowed to use the completed-contract method? CE18-4 When is it appropriate to use the cost-recovery method? An additional Codification case can be found in the Using Your Judgment section, on page 1108. Questions 1087 Be sure to check the book’s companion website for a Review and Analysis Exercise, with solution. Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS. Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter. QUESTIONS 1. Explain the current environment regarding revenue Construction Co. appropriately uses the percentage- recognition. of-completion method. How much revenue and gross profit should Hawkins recognize in the first year of the 2. What is viewed as a major criticism of GAAP as regards project? revenue recognition? 16. For what reasons should the percentage-of-completion
3. What are the criteria to recognize revenue? method be used over the completed-contract method 4. When is revenue recognized in the following situations: whenever possible? (a) Revenue from selling products? (b) Revenue from 17. What methods are used in practice to determine the extent s ervices performed? (c) Revenue from permitting others of progress toward completion? Identify some “input to use enterprise assets? (d) Revenue from disposing of measures” and some “output measures” that might be assets other than products? used to determine the extent of progress. 5. What is the proper accounting for volume discounts on 18. What are the two types of losses that can become evident sales of products? in accounting for long-term contracts? What is the nature 6. What are the three alternative accounting methods avail- of each type of loss? How is each type accounted for? able to a seller that is exposed to continued risks of owner- 19. Under the percentage-of-completion method, how are the ship through return of the product? Construction in Process and the Billings on Construction 7. Under what conditions may a seller who is exposed to in Process accounts reported in the balance sheet? continued risks of a high rate of return of the product sold 20. Explain the differences between the installment-sales recognize sales transactions as current revenue? method and the cost-recovery method. 8. Explain a bill and hold sale. When is revenue recognized 21. Identify and briefly describe the two methods generally in these situations? employed to account for the cash received in situations 9. What are the reporting issues in a sale and buyback where the collection of the sales price is not reasonably agreement? assured. 10. Explain a principal-agent relationship and its significance 22. What is the deposit method and when might it be to revenue recognition. applied? 11. What is the nature of a sale on consignment? 23. What is the nature of an installment sale? How do install- 12. Explain a multiple-deliverable arrangement. What is the ment sales differ from ordinary credit sales? major accounting issue related to these arrangements? 24. Describe the installment-sales method of accounting. 13. Explain how multiple-deliverable arrangements are mea- 25. How are operating expenses (not included in cost of goods sured and reported. sold) handled under the installment-sales method of 14. What are the two basic methods of accounting for long- accounting? What is the justification for such treatment? term construction contracts? Indicate the circumstances 26. Marjorie sold her condominium for $500,000 on Septem- that determine when one or the other of these methods ber 14, 2014; she had paid $330,000 for it in 2006. Marjorie should be used. collected the selling price as follows: 2014, $80,000; 2015, 15. Hawkins Construction Co. has a $60 million contract to $320,000; and 2016, $100,000. Marjorie appropriately uses construct a highway overpass and cloverleaf. The total the installment-sales method. Prepare a schedule to deter- estimated cost for the project is $50 million. Costs incurred mine the gross profit for 2014, 2015, and 2016 from the in the first year of the project are $8 million. Hawkins installment sale. 1088 Chapter 18 Revenue Recognition 27. When interest is involved in installment-sales transac- * 32. Why in franchise arrangements may it not be proper to tions, how should it be treated for accounting purposes? recognize the entire franchise fee as revenue at the date of 28. How should the results of installment sales be reported on sale? the income statement? * 33. How does the concept of “substantial performance” apply to accounting for franchise sales? 29. At what time is it proper to recognize income in the following cases: (a) Installment sales with no reasonable * 34. How should a franchisor account for continuing franchise basis for estimating the degree of collectibility? (b) Sales fees and routine sales of equipment and supplies to for future delivery? (c) Merchandise shipped on consign- franchisees?
ment? (d) Profit on incomplete construction contracts? * 35. What changes are made in the franchisor’s recording of (e) Subscriptions to publications? the initial franchise fee when the franchise agreement: 30. When is revenue recognized under the cost-recovery (a) Contains an option allowing the franchisor to pur- method? chase the franchised outlet, and it is likely that the 31. When is revenue recognized under the deposit method? option will be exercised? How does the deposit method differ from the installment- (b) Allows the franchisee to purchase equipment and sales and cost-recovery methods? supplies from the franchisor at bargain prices? BRIEF EXERCISES 2 BE18-1 Manual Company sells goods to Nolan Company during 2014. It offers Nolan the following rebates based on total sales to Nolan. If total sales to Nolan are 10,000 units, it will grant a rebate of 2%. If it sells up to 20,000 units, it will grant a rebate of 4%. If it sells up to 30,000 units, it will grant a rebate of 6%. In the first quarter of the year, Manual sells 11,000 units to Nolan at a sales price of $110,000. Manual, based on past experience, has sold over 40,000 units to Nolan and these sales normally take place in the third quarter of the year. Prepare the journal entry to record the sale of the 11,000 units in the first quarter of the year. 2 BE18-2 Adani Inc. sells goods to Geo Company for $11,000 on January 2, 2014, with payment due in 12 months. The fair value of the goods at the date of sale is $10,000. Prepare the journal entry to record this transaction on January 2, 2014. How much total revenue should be recognized on this sale in 2014? 2 BE18-3 Travel Inc. sells tickets for a Caribbean cruise to Carmel Company employees. The total cruise package costs Carmel $70,000 from ShipAway cruise liner. Travel Inc. receives a commission of 6% of the total price. Travel Inc. therefore remits $65,800 to ShipAway. Prepare the entry to record the revenue recog- nized by Travel Inc. on this transaction. 2 BE18-4 Aamodt Music sold CDs to retailers and recorded sales revenue of $700,000. During 2014, retailers returned CDs to Aamodt and were granted credit of $78,000. Past experience indicates that the normal return rate is 15%. Prepare Aamodt’s entries to record (a) the $78,000 of returns and (b) estimated returns at December 31, 2014. 2 BE18-5 Jansen Corporation shipped $20,000 of merchandise on consignment to Gooch Company. Jansen paid freight costs of $2,000. Gooch Company paid $500 for local advertising, which is reimbursable from Jansen. By year-end, 60% of the merchandise had been sold for $21,500. Gooch notified Jansen, retained a 10% commission, and remitted the cash due to Jansen. Prepare Jansen’s entry when the cash is received. 2 BE18-6 Telephone Sellers Inc. sells prepaid telephone cards to customers. Telephone Sellers then pays the telecommunications company, TeleExpress, for the actual use of its telephone lines. Assume that Telephone Sellers sells $4,000 of prepaid cards in January 2014. It then pays TeleExpress based on usage, which turns out to be 50% in February, 30% in March, and 20% in April. The total payment by Telephone Sellers for TeleExpress lines over the 3 months is $3,000. Indicate how much income Telephone Sellers should recog- nize in January, February, March, and April. 3 BE18-7 Turner, Inc. began work on a $7,000,000 contract in 2014 to construct an office building. During 2014, Turner, Inc. incurred costs of $1,700,000, billed its customers for $1,200,000, and collected $960,000. At December 31, 2014, the estimated future costs to complete the project total $3,300,000. Prepare Turner’s 2014 journal entries using the percentage-of-completion method. 3 BE18-8 O’Neil, Inc. began work on a $7,000,000 contract in 2014 to construct an office building. O’Neil uses the percentage-of-completion method. At December 31, 2014, the balances in certain accounts were Exercises 1089 Construction in Process $2,450,000; Accounts Receivable $240,000; and Billings on Construction in Process
$1,400,000. Indicate how these accounts would be reported in O’Neil’s December 31, 2014, balance sheet. 4 BE18-9 Use the information from BE18-7, but assume Turner uses the completed-contract method. Prepare the company’s 2014 journal entries. 4 BE18-10 Guillen, Inc. began work on a $7,000,000 contract in 2014 to construct an office building. Guillen uses the completed-contract method. At December 31, 2014, the balances in certain accounts were Con- struction in Process $1,715,000; Accounts Receivable $240,000; and Billings on Construction in Process $1,000,000. Indicate how these accounts would be reported in Guillen’s December 31, 2014, balance sheet. 5 BE18-11 Archer Construction Company began work on a $420,000 construction contract in 2014. During 2014, Archer incurred costs of $278,000, billed its customer for $215,000, and collected $175,000. At Decem- ber 31, 2014, the estimated future costs to complete the project total $162,000. Prepare Archer’s journal entry to record profit or loss using (a) the percentage-of-completion method and (b) the completed-contract method, if any. 6 BE18-12 Gordeeva Corporation began selling goods on the installment basis on January 1, 2014. During 2014, Gordeeva had installment sales of $150,000; cash collections of $54,000; cost of installment sales of $102,000. Prepare the company’s entries to record installment sales, cash collected, cost of installment sales, deferral of gross profit, and gross profit recognized, using the installment-sales method. 6 BE18-13 Lazaro Inc. sells goods on the installment basis and uses the installment-sales method. Due to a customer default, Lazaro repossessed merchandise that was originally sold for $800, resulting in a gross profit rate of 40%. At the time of repossession, the uncollected balance is $520, and the fair value of the repossessed merchandise is $275. Prepare Lazaro’s entry to record the repossession. 6 BE18-14 At December 31, 2014, Grinkov Corporation had the following account balances. Installment Accounts Receivable, 2013 $ 65,000 Installment Accounts Receivable, 2014 110,000 Deferred Gross Profi t, 2013 23,400 Deferred Gross Profi t, 2014 41,800 Most of Grinkov’s sales are made on a 2-year installment basis. Indicate how these accounts would be r eported in Grinkov’s December 31, 2014, balance sheet. The 2013 accounts are collectible in 2015, and the 2014 accounts are collectible in 2016. 7 BE18-15 Schuss Corporation sold equipment to Potsdam Company for $20,000. The equipment is on Schuss’s books at a net amount of $13,000. Schuss collected $10,000 in 2014, $5,000 in 2015, and $5,000 in 2016. If Schuss uses the cost-recovery method, what amount of gross profit will be recognized in each year? 8 * BE18-16 Frozen Delight, Inc. charges an initial franchise fee of $75,000 for the right to operate as a fran- chisee of Frozen Delight. Of this amount, $25,000 is collected immediately. The remainder is collected in 4 equal annual installments of $12,500 each. These installments have a present value of $41,402. There is reasonable expectation that the down payment may be refunded and substantial future services be performed by F rozen Delight, Inc. Prepare the journal entry required by Frozen Delight to record the franchise fee. EXERCISES 2 E18-1 (Revenue Recognition—Point of Sale) Jupiter Company sells goods on January 1 that have a cost of $500,000 to Danone Inc. for $700,000, with payment due in 1 year. The cash price for these goods is $610,000, with payment due in 30 days. If Danone paid immediately upon delivery, it would receive a cash discount of $10,000. Instructions (a) Prepare the journal entry to record this transaction at the date of sale. (b) How much revenue should Jupiter report for the entire year? 2 E18-2 (Revenue Recognition—Point of Sale) Shaw Company sells goods that cost $300,000 to Ricard Company for $410,000 on January 2, 2014. The sales price includes an installation fee, which is valued at $40,000. The fair value of the goods is $370,000. The installation is expected to take 6 months.
1090 Chapter 18 Revenue Recognition Instructions (a) Prepare the journal entry (if any) to record the sale on January 2, 2014. (b) Shaw prepares an income statement for the first quarter of 2014, ending on March 31, 2014. How much revenue should Shaw recognize related to its sale to Ricard? 2 E18-3 (Revenue Recognition—Point of Sale) Presented below are three revenue recognition situations. (a) Grupo sells goods to MTN for $1,000,000, payment due at delivery. (b) Grupo sells goods on account to Grifols for $800,000, payment due in 30 days. (c) Grupo sells goods to Magnus for $500,000, payment due in two installments: the first installment payable in 6 months and the second payment due 3 months later. Instructions Indicate how each of these transactions is reported. 2 E18-4 (Revenue Recognition—Point of Sale) Wood-Mode Company is involved in the design, manufac- ture, and installation of various types of wood products for large construction projects. Wood-Mode recently completed a large contract for Stadium Inc., which consisted of building 35 different types of con- cession counters for a new soccer arena under construction. The terms of the contract are that upon completion of the counters, Stadium would pay $2,000,000. Unfortunately, due to the depressed economy, the comple- tion of the new soccer arena is now delayed. Stadium has therefore asked Wood-Mode to hold the counters at its manufacturing plant until the arena is completed. Stadium acknowledges in writing that it ordered the counters and that they now have ownership. The time that Wood-Mode Company must hold the coun- ters is totally dependent on when the arena is completed. Because Wood-Mode has not received additional progress payments for the arena due to the delay, Stadium has provided a deposit of $300,000. Instructions (a) Explain this type of revenue recognition transaction. (b) What factors should be considered in determining when to recognize revenue in this transaction? (c) Prepare the journal entry(ies) that Wood-Mode should make, assuming it signed a valid sales con- tract to sell the counters and received at the time of sale the $300,000 payment. 2 E18-5 (Right of Return) Organic Growth Company is presently testing a number of new agricultural seeds that it has recently harvested. To stimulate interest, it has decided to grant to five of its largest cus- tomers the unconditional right of return to these products if not fully satisfied. The right of return extends for 4 months. Organic Growth sells these seeds on account for $1,500,000 on January 2, 2014. Companies are required to pay the full amount due by March 15, 2014. Instructions (a) Prepare the journal entry for Organic Growth at January 2, 2014, assuming Organic Growth esti- mates returns of 20% based on prior experience. (Ignore cost of goods sold.) (b) Assume that one customer returns the seeds on March 1, 2014, due to unsatisfactory performance. Prepare the journal entry to record this transaction, assuming this customer purchased $100,000 of seeds from Organic Growth. (c) Briefly describe the accounting for these sales, if Organic Growth is unable to reliably estimate returns. 1 2 E18-6 (Revenue Recognition on Book Sales with High Returns) Uddin Publishing Co. publishes college textbooks that are sold to bookstores on the following terms. Each title has a fixed wholesale price, terms f.o.b. shipping point, and payment is due 60 days after shipment. The retailer may return a maximum of 30% of an order at the retailer’s expense. Sales are made only to retailers who have good credit ratings. Past experience indicates that the normal return rate is 12%, and the average collection period is 72 days. Instructions (a) Identify alternative revenue recognition criteria that Uddin could employ concerning textbook sales. (b) Briefly discuss the reasoning for your answers in (a) above. (c) In late July, Uddin shipped books invoiced at $15,000,000. Prepare the journal entry to record this event that best conforms to GAAP and your answer to part (b). (d) In October, $2 million of the invoiced July sales were returned according to the return policy, and the
remaining $13 million was paid. Prepare the entries for the return and payment. 1 2 E18-7 (Sales Recorded Both Gross and Net) On June 3, Hunt Company sold to Ann Mount merchandise having a sales price of $8,000 with terms of 2/10, n/60, f.o.b. shipping point. An invoice totaling $120, terms n/30, was received by Mount on June 8 from the Olympic Transport Service for the freight cost. Upon receipt of the goods, June 5, Mount notified Hunt Company that merchandise costing $600 contained Exercises 1091 flaws that rendered it worthless. The same day, Hunt Company issued a credit memo covering the worth- less merchandise and asked that it be returned at company expense. The freight on the returned merchan- dise was $24, paid by Hunt Company on June 7. On June 12, the company received a check for the balance due from Mount. Instructions (a) Prepare journal entries for Hunt Company to record all the events noted above under each of the following bases. (1) Sales and receivables are entered at gross selling price. (2) Sales and receivables are entered net of cash discounts. (b) Prepare the journal entry under basis (2), assuming that Ann Mount did not remit payment until August 5. 1 2 E18-8 (Revenue Recognition on Marina Sales with Discounts) Taylor Marina has 300 available slips that rent for $800 per season. Payments must be made in full at the start of the boating season, April 1, 2015. Slips for the next season may be reserved if paid for by December 31, 2014. Under a new policy, if payment is made by December 31, 2014, a 5% discount is allowed. The boating season ends October 31, and the marina has a December 31 year-end. To provide cash flow for major dock repairs, the marina operator is also offering a 20% discount to slip renters who pay for the 2016 season. For the fiscal year ended December 31, 2014, all 300 slips were rented at full price. Two hundred slips were reserved and paid for the 2015 boating season, and 60 slips for the 2016 boating season were reserved and paid for. Instructions (a) Prepare the appropriate journal entries for fiscal 2014. (b) Assume the marina operator is unsophisticated in business. Explain the managerial significance of the accounting above to this person. 1 2 E18-9 (Consignment Computations) On May 3, 2014, Eisler Company consigned 80 freezers, costing $500 each, to Remmers Company. The cost of shipping the freezers amounted to $840 and was paid by Eisler Company. On December 30, 2014, a report was received from the consignee, indicating that 40 freezers had been sold for $750 each. Remittance was made by the consignee for the amount due, after deducting a com- mission of 6%, advertising of $200, and total installation costs of $320 on the freezers sold. Instructions (a) Compute the inventory value of the units unsold in the hands of the consignee. (b) Compute the profit for the consignor for the units sold. (c) Compute the amount of cash that will be remitted by the consignee. 2 E18-10 (Multiple-Deliverable Arrangement) Appliance Center is an experienced home appliance dealer. Appliance Center also offers a number of services together with the home appliances that it sells. Assume that Appliance Center sells ovens on a standalone basis. Appliance Center also sells installation services and maintenance services for ovens. However, Appliance Center does not offer installation or maintenance services to customers who buy ovens from other vendors. Pricing for ovens is as follows. Oven only $ 800 Oven with installation service 850 Oven with maintenance services 975 Oven with installation and maintenance services 1,000 In each instance in which maintenance services are provided, the maintenance service is separately priced within the arrangement at $175. Additionally, the incremental amount charged by Appliance Center for installation approximates the amount charged by independent third parties. Ovens are sold subject to a general right of return. If a customer purchases an oven with installation and/or maintenance services, in the event Appliance Center does not complete the service satisfactorily, the customer is only entitled to a
refund of the portion of the fee that exceeds $800. Instructions (a) Assume that a customer purchases an oven with both installation and maintenance services for $1,000. Based on its experience, Appliance Center believes that it is probable that the installation of the equipment will be performed satisfactorily to the customer. Assume that the maintenance ser- vices are priced separately. Explain whether the conditions for a multiple-deliverable arrangement exist in this situation. (b) Indicate the amount of revenues that should be allocated to the oven, the installation, and to the maintenance contract. 1092 Chapter 18 Revenue Recognition 2 E18-11 (Multiple-Deliverable Arrangement) On December 31, 2014, Grando Company sells production equipment to Fargo Inc. for $50,000. Grando includes a 1-year warranty service with the sale of all its equipment. The customer receives and pays for the equipment on December 31, 2014. Grando estimates the prices to be $48,800 for the equipment and $1,200 for the warranty. Instructions (a) Prepare the journal entry to record this transaction on December 31, 2014. (b) Indicate how much (if any) revenue should be recognized on January 31, 2015, and for the year 2015. 3 4 E18-12 (Recognition of Profit on Long-Term Contracts) During 2014, Nilsen Company started a con- struction job with a contract price of $1,600,000. The job was completed in 2016. The following information is available. 2014 2015 2016 Costs incurred to date $400,000 $825,000 $1,070,000 Estimated costs to complete 600,000 275,000 –0– Billings to date 300,000 900,000 1,600,000 Collections to date 270,000 810,000 1,425,000 Instructions (a) Compute the amount of gross profit to be recognized each year, assuming the percentage-of- completion method is used. (b) Prepare all necessary journal entries for 2015. (c) Compute the amount of gross profit to be recognized each year, assuming the completed-contract method is used. 3 E18-13 (Analysis of Percentage-of-Completion Financial Statements) In 2014, Steinrotter Construction Corp. began construction work under a 3-year contract. The contract price was $1,000,000. Steinrotter uses the percentage-of-completion method for financial accounting purposes. The income to be recognized each year is based on the proportion of cost incurred to total estimated costs for completing the contract. The financial statement presentations relating to this contract at December 31, 2014, are shown below. Balance Sheet Accounts receivable $18,000 Construction in process $65,000 Less: Billings 61,500 Costs and recognized profi t in excess of billings 3,500 Income Statement Income (before tax) on the contract recognized in 2014 $19,500 Instructions (a) How much cash was collected in 2014 on this contract? (b) What was the initial estimated total income before tax on this contract? (AICPA adapted) 3 E18-14 (Gross Profit on Uncompleted Contract) On April 1, 2014, Dougherty Inc. entered into a cost- plus-fixed-fee contract to construct an electric generator for Altom Corporation. At the contract date, Dougherty estimated that it would take 2 years to complete the project at a cost of $2,000,000. The fixed fee stipulated in the contract is $450,000. Dougherty appropriately accounts for this contract under the percentage-of-completion method. During 2014, Dougherty incurred costs of $800,000 related to the project. The estimated cost at December 31, 2014, to complete the contract is $1,200,000. Altom was billed $600,000 under the contract. Instructions Prepare a schedule to compute the amount of gross profit to be recognized by Dougherty under the con- tract for the year ended December 31, 2014. Show supporting computations in good form. (AICPA adapted) 3 E18-15 (Recognition of Profit, Percentage-of-Completion) In 2014, Gurney Construction Company agreed to construct an apartment building at a price of $1,200,000. The information relating to the costs and billings for this contract is shown below. 2014 2015 2016 Costs incurred to date $280,000 $600,000 $ 785,000 Estimated costs yet to be incurred 520,000 200,000 –0–
Customer billings to date 150,000 500,000 1,200,000 Collection of billings to date 120,000 320,000 940,000 Exercises 1093 Instructions (a) Assuming that the percentage-of-completion method is used, (1) compute the amount of gross profit to be recognized in 2014 and 2015, and (2) prepare journal entries for 2015. (b) For 2015, show how the details related to this construction contract would be disclosed on the balance sheet and on the income statement. 3 4 E18-16 (Recognition of Revenue on Long-Term Contract and Entries) Hamilton Construction Company uses the percentage-of-completion method of accounting. In 2014, Hamilton began work under contract #E2-D2, which provided for a contract price of $2,200,000. Other details follow: 2014 2015 Costs incurred during the year $640,000 $1,425,000 Estimated costs to complete, as of December 31 960,000 –0– Billings during the year 420,000 1,680,000 Collections during the year 350,000 1,500,000 Instructions (a) What portion of the total contract price would be recognized as revenue in 2014? In 2015? (b) Assuming the same facts as those above except that Hamilton uses the completed-contract method of accounting, what portion of the total contract price would be recognized as revenue in 2015? (c) Prepare a complete set of journal entries for 2014 (using the percentage-of-completion method). 3 4 E18-17 (Recognition of Profit and Balance Sheet Amounts for Long-Term Contracts) Yanmei Construc- tion Company began operations January 1, 2014. During the year, Yanmei Construction entered into a contract with Lundquist Corp. to construct a manufacturing facility. At that time, Yanmei estimated that it would take 5 years to complete the facility at a total cost of $4,500,000. The total contract price for construc- tion of the facility is $6,000,000. During the year, Yanmei incurred $1,185,800 in construction costs related to the construction project. The estimated cost to complete the contract is $4,204,200. Lundquist Corp. was billed and paid 25% of the contract price. Instructions Prepare schedules to compute the amount of gross profit to be recognized for the year ended December 31, 2014, and the amount to be shown as “costs and recognized profit in excess of billings” or “billings in excess of costs and recognized profit” at December 31, 2014, under each of the following methods. (a) Completed-contract method. (b) Percentage-of-completion method. Show supporting computations in good form. (AICPA adapted) 4 5 E18-18 (Long-Term Contract Reporting) Berstler Construction Company began operations in 2014. Con- struction activity for the first year is shown below. All contracts are with different customers, and any work remaining at December 31, 2014, is expected to be completed in 2015. Cash Contract Estimated Total Billings Collections Costs Incurred Additional Contract through through through Costs to Project Price 12/31/14 12/31/14 12/31/14 Complete 1 $ 560,000 $ 360,000 $340,000 $450,000 $130,000 2 670,000 220,000 210,000 126,000 504,000 3 520,000 500,000 440,000 330,000 –0– $1,750,000 $1,080,000 $990,000 $906,000 $634,000 Instructions Prepare a partial income statement and balance sheet to indicate how the above information would be reported for financial statement purposes. Berstler Construction Company uses the completed-contract method. 6 E 18-19 (Installment-Sales Method Calculations, Entries) Coffin Corporation appropriately uses the installment-sales method of accounting to recognize income in its financial statements. The following information is available for 2014 and 2015. 2014 2015 Installment sales $900,000 $1,000,000 Cost of installment sales 594,000 680,000 Cash collections on 2014 sales 370,000 350,000 Cash collections on 2015 sales –0– 450,000 1094 Chapter 18 Revenue Recognition Instructions (a) Compute the amount of realized gross profit recognized in each year. (b) Prepare all journal entries required in 2015. 6 E18-20 (Analysis of Installment-Sales Accounts) Samuels Co. appropriately uses the installment-sales method of accounting. On December 31, 2016, the books show balances as follows.
Installment Receivables Deferred Gross Profit Gross Profit on Sales 2014 $12,000 2014 $ 7,000 2014 35% 2015 40,000 2015 26,000 2015 33% 2016 80,000 2016 95,000 2016 32% Instructions (a) Prepare the adjusting entry or entries required on December 31, 2016 to recognize 2016 real- ized gross profit. (Installment receivables have already been credited for cash receipts during 2016.) (b) Compute the amount of cash collected in 2016 on accounts receivable from each year. 6 E18-21 (Gross Profit Calculations and Repossessed Merchandise) Basler Corporation, which began business on January 1, 2014, appropriately uses the installment-sales method of accounting. The following data were obtained for the years 2014 and 2015. 2014 2015 Installment sales $750,000 $840,000 Cost of installment sales 510,000 588,000 General & administrative expenses 70,000 84,000 Cash collections on sales of 2014 310,000 300,000 Cash collections on sales of 2015 –0– 400,000 Instructions (a) Compute the balance in the deferred gross profit accounts on December 31, 2014, and on December 31, 2015. (b) A 2014 sale resulted in default in 2016. At the date of default, the balance on the installment receiv- able was $12,000, and the repossessed merchandise had a fair value of $8,000. Prepare the entry to record the repossession. (AICPA adapted) 6 E18-22 (Interest Revenue from Installment Sale) Becker Corporation sells farm machinery on the install- ment plan. On July 1, 2014, Becker entered into an installment-sales contract with Valente Inc. for an 8-year period. Equal annual payments under the installment sale are $100,000 and are due on July 1. The first pay- ment was made on July 1, 2014. Additional information: 1. The amount that would be realized on an outright sale of similar farm machinery is $586,842. 2. The cost of the farm machinery sold to Valente Inc. is $425,000. 3. The finance charges relating to the installment period are based on a stated interest rate of 10%, which is appropriate. 4. Circumstances are such that the collection of the installments due under the contract is reasonably assured. Instructions What income or loss before income taxes should Becker record for the year ended December 31, 2014, as a result of the transaction above? (AICPA adapted) 6 7 E18-23 (Installment-Sales Method and Cost-Recovery Method) Swift Corp., a capital goods manufactur- ing business that started on January 4, 2014, and operates on a calendar-year basis, uses the installment- sales method of profit recognition in accounting for all its sales. The following data were taken from the 2014 and 2015 records. 2014 2015 Installment sales $480,000 $620,000 Gross profi t as a percent of costs 25% 28% Cash collections on sales of 2014 $130,000 $240,000 Cash collections on sales of 2015 –0– $160,000 The amounts given for cash collections exclude amounts collected for interest charges. Exercises 1095 Instructions (a) Compute the amount of realized gross profit to be recognized on the 2015 income statement, pre- pared using the installment-sales method. (Round percentages to three decimal places.) (b) State where the balance of Deferred Gross Profit would be reported on the financial statements for 2015. (c) Compute the amount of realized gross profit to be recognized on the income statement, prepared using the cost-recovery method. (CIA adapted) 6 7 E18-24 (Installment-Sales Method and Cost-Recovery Method) On January 1, 2014, Wetzel Company sold property for $250,000. The note will be collected as follows: $120,000 in 2014, $90,000 in 2015, and $40,000 in 2016. The property had cost Wetzel $150,000 when it was purchased in 2012. Instructions (a) Compute the amount of gross profit realized each year, assuming Wetzel uses the cost-recovery method. (b) Compute the amount of gross profit realized each year, assuming Wetzel uses the installment-sales method. 6 E18-25 (Installment-Sales—Default and Repossession) Crawford Imports Inc. was involved in two default and repossession cases during the year: 1. A refrigerator was sold to Cindy McClary for $1,800, including a 30% markup on selling price. McClary
made a down payment of 20%, four of the remaining 16 equal payments, and then defaulted on further payments. The refrigerator was repossessed, at which time the fair value was determined to be $800. 2. An oven that cost $1,200 was sold to Travis Longman for $1,500 on the installment basis. Longman made a down payment of $240 and paid $80 a month for six months, after which he defaulted. The oven was repossessed and the estimated fair value at time of repossession was determined to be $750. Instructions Prepare journal entries to record each of these repossessions using a fair value approach. (Ignore interest charges.) 6 E18-26 (Installment-Sales—Default and Repossession) Seaver Company uses the installment-sales method in accounting for its installment sales. On January 1, 2014, Seaver Company had an installment account receivable from Jan Noble with a balance of $1,800. During 2014, $500 was collected from Noble. When no further collection could be made, the merchandise sold to Noble was repossessed. The merchan- dise had a fair value of $650 after the company spent $60 for reconditioning of the merchandise. The mer- chandise was originally sold with a gross profit rate of 30%. Instructions Prepare the entries on the books of Seaver Company to record all transactions related to Noble during 2014. (Ignore interest charges.) 8 * E18-27 (Franchise Entries) Pacific Crossburgers Inc. charges an initial franchise fee of $70,000. Upon the signing of the agreement, a payment of $28,000 is due. Thereafter, three annual payments of $14,000 are required. The credit rating of the franchisee is such that it would have to pay interest at 10% to borrow money. Instructions Prepare the entries to record the initial franchise fee on the books of the franchisor under the following assumptions. (Round to the nearest dollar.) (a) The down payment is not refundable, no future services are required by the franchisor, and collec- tion of the note is reasonably assured. (b) The franchisor has substantial services to perform, the down payment is refundable, and the collec- tion of the note is very uncertain. (c) The down payment is not refundable, collection of the note is reasonably certain, the franchisor has yet to perform a substantial amount of services, and the down payment represents a fair measure of the services already performed. 8 *E 18-28 (Franchise Fee, Initial Down Payment) On January 1, 2014, Lesley Benjamin signed an agreement to operate as a franchisee of Campbell Inc. for an initial franchise fee of $50,000. The amount of $10,000 was paid when the agreement was signed, and the balance is payable in five annual payments of $8,000 each, 1096 Chapter 18 Revenue Recognition beginning January 1, 2015. The agreement provides that the down payment is not refundable and that no future services are required of the franchisor. Lesley Benjamin’s credit rating indicates that she can borrow money at 11% for a loan of this type. Instructions (a) How much should Campbell record as revenue from franchise fees on January 1, 2014? At what amount should Benjamin record the acquisition cost of the franchise on January 1, 2014? (b) What entry would be made by Campbell on January 1, 2014, if the down payment is refundable and substantial future services remain to be performed by Campbell? (c) How much revenue from franchise fees would be recorded by Campbell on January 1, 2014, if: (1) The initial down payment is not refundable, it represents a fair measure of the services already provided, a significant amount of services is still to be performed by Campbell in future periods, and collectibility of the note is reasonably assured? (2) The initial down payment is not refundable and no future services are required by the fran- chisor, but collection of the note is so uncertain that recognition of the note as an asset is unwarranted? (3) T he initial down payment has not been earned and collection of the note is so uncertain that recognition of the note as an asset is unwarranted? EXERCISES SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional
set of exercises. PROBLEMS 2 3 P18-1 (Comprehensive Three-Part Revenue Recognition) Van Hatten Industries has three operating 4 6 d ivisions—Depp Construction Division, DeMent Publishing Division, and Ankiel Securities Division. Each division maintains its own accounting system and method of revenue recognition. Depp Construction Division During the fiscal year ended November 30, 2014, Depp Construction Division had one construction project in process. A $30,000,000 contract for construction of a civic center was granted on June 19, 2014, and con- struction began on August 1, 2014. Estimated costs of completion at the contract date were $25,000,000 over a 2-year time period from the date of the contract. On November 30, 2014, construction costs of $7,200,000 had been incurred and progress billings of $9,500,000 had been made. The construction costs to complete the remainder of the project were reviewed on November 30, 2014, and were estimated to amount to only $16,800,000 because of an expected decline in raw materials costs. Revenue recognition is based upon a percentage-of-completion method. DeMent Publishing Division The DeMent Publishing Division sells large volumes of novels to a few book distributors, which in turn sell to several national chains of bookstores. DeMent allows distributors to return up to 30% of sales, and dis- tributors give the same terms to bookstores. While returns from individual titles fluctuate greatly, the returns from distributors have averaged 20% in each of the past 5 years. A total of $7,000,000 of paperback novel sales were made to distributors during fiscal 2014. On November 30, 2014 (the end of the fiscal year), $1,500,000 of fiscal 2014 sales were still subject to return privileges over the next 6 months. The remaining $5,500,000 of fiscal 2014 sales had actual returns of 21%. Sales from fiscal 2013 totaling $2,000,000 were col- lected in fiscal 2014 less 18% returns. This division records revenue according to the method referred to as revenue recognition when the right of return exists. Ankiel Securities Division Ankiel Securities Division works through manufacturers’ agents in various cities. Orders for alarm systems and down payments are forwarded from agents, and the division ships the goods f.o.b. factory directly to customers (usually police departments and security guard companies). Customers are billed directly for the balance due plus actual shipping costs. The company received orders for $6,000,000 of goods during the fiscal year ended November 30, 2014. Down payments of $600,000 were received, and $5,200,000 of goods Problems 1097 were billed and shipped. Actual freight costs of $100,000 were also billed. Commissions of 10% on product price are paid to manufacturing agents after goods are shipped to customers. Such goods are warranted for 90 days after shipment, and warranty returns have been about 1% of sales. Revenue is recognized at the point of sale by this division. Instructions (a) There are a variety of methods of revenue recognition. Define and describe each of the following methods of revenue recognition, and indicate whether each is in accordance with generally a ccepted accounting principles. (1) Point of sale. (2) Completion-of-production. (3) Percentage-of-completion. (4) Installment-sales. (b) Compute the revenue to be recognized in fiscal year 2014 for each of the three operating divisions of Van Hatten Industries in accordance with generally accepted accounting principles. 3 4 P18-2 (Recognition of Profit on Long-Term Contract) Shanahan Construction Company has entered into a contract beginning January 1, 2014, to build a parking complex. It has been estimated that the complex will cost $600,000 and will take 3 years to construct. The complex will be billed to the purchasing company at $900,000. The following data pertain to the construction period. 2014 2015 2016 Costs to date $270,000 $450,000 $610,000 Estimated costs to complete 330,000 150,000 –0– Progress billings to date 270,000 550,000 900,000 Cash collected to date 240,000 500,000 900,000
Instructions (a) Using the percentage-of-completion method, compute the estimated gross profit that would be rec- ognized during each year of the construction period. (b) Using the completed-contract method, compute the estimated gross profit that would be recognized during each year of the construction period. 3 4 P18-3 (Recognition of Profit and Entries on Long-Term Contract) On March 1, 2014, Chance Company entered into a contract to build an apartment building. It is estimated that the building will cost $2,000,000 and will take 3 years to complete. The contract price was $3,000,000. The following information pertains to the construction period. 2014 2015 2016 Costs to date $ 600,000 $1,560,000 $2,100,000 Estimated costs to complete 1,400,000 520,000 –0– Progress billings to date 1,050,000 2,000,000 3,000,000 Cash collected to date 950,000 1,950,000 2,850,000 Instructions (a) Compute the amount of gross profit to be recognized each year, assuming the percentage-of- completion method is used. (b) Prepare all necessary journal entries for 2016. (c) Prepare a partial balance sheet for December 31, 2015, showing the balances in the receivables and inventory accounts. 3 P18-4 (Recognition of Profit and Balance Sheet Presentation, Percentage-of-Completion) On February 1, 2014, Hewitt Construction Company obtained a contract to build an athletic stadium. The stadium (for a local high school) was to be built at a total cost of $5,400,000 and was scheduled for completion by September 1, 2016. One clause of the contract stated that Hewitt was to deduct $15,000 from the $6,600,000 billing price for each week that completion was delayed. Completion was delayed 6 weeks, which resulted in a $90,000 penalty. Below are the data pertaining to the construction period. 2014 2015 2016 Costs to date $1,620,000 $3,850,000 $5,500,000 Estimated costs to complete 3,780,000 1,650,000 –0– Progress billings to date 1,200,000 3,300,000 6,510,000 Cash collected to date 1,000,000 2,800,000 6,510,000 1098 Chapter 18 Revenue Recognition Instructions (a) Using the percentage-of-completion method, compute the estimated gross profit recognized in the years 2014–2016. (b) Prepare a partial balance sheet for December 31, 2015, showing the balances in the receivables and inventory accounts. 3 4 P18-5 (Completed-Contract and Percentage-of-Completion with Interim Loss) Reynolds Custom 5 Builders (RCB) was established in 1987 by Avery Conway and initially built high-quality customized homes under contract with specific buyers. In 2002, Conway’s two sons joined the company and expanded RCB’s activities into the high-rise apartment and industrial plant markets. Upon the retire- ment of RCB’s long-time financial manager, Conway’s sons recently hired Ed Borke as controller for RCB. Borke, a former college friend of Conway’s sons, has been associated with a public accounting firm for the last 6 years. Upon reviewing RCB’s accounting practices, Borke observed that RCB followed the completed- contract method of revenue recognition, a carryover from the years when individual home building was the majority of RCB’s operations. Several years ago, the predominant portion of RCB’s activities shifted to the high-rise and industrial building areas. From land acquisition to the completion of construction, most building contracts cover several years. Under the circumstances, Borke believes that RCB should follow the percentage-of-completion method of accounting. From a typical building contract, Borke developed the following data. BLUESTEM TRACTOR PLANT Contract price: $8,000,000 2014 2015 2016 Estimated costs $1,600,000 $2,880,000 $1,920,000 Progress billings 1,000,000 2,500,000 4,500,000 Cash collections 800,000 2,300,000 4,900,000 Instructions (a) Explain the difference between completed-contract revenue recognition and percentage-of-completion revenue recognition. (b) Using the data provided for the Bluestem Tractor Plant and assuming the percentage-of-completion method of revenue recognition is used, calculate RCB’s revenue and gross profit for 2014, 2015, and
2016, under each of the following circumstances. (1) A ssume that all costs are incurred, all billings to customers are made, and all collections from customers are received within 30 days of billing, as planned. (2) F urther assume that, as a result of unforeseen local ordinances and the fact that the build- ing site was in a wetlands area, RCB experienced cost overruns of $800,000 in 2014 to bring the site into compliance with the ordinances and to overcome wetlands barriers to construction. (3) F urther assume that, in addition to the cost overruns of $800,000 for this contract incurred under part (b)(2), inflationary factors over and above those anticipated in the development of the original contract cost have caused an additional cost overrun of $850,000 in 2015. It is not anticipated that any cost overruns will occur in 2016. (CMA adapted) 3 4 P18-6 (Long-Term Contract with Interim Loss) On March 1, 2014, Pechstein Construction Company 5 contracted to construct a factory building for Fabrik Manufacturing Inc. for a total contract price of $8,400,000. The building was completed by October 31, 2016. The annual contract costs incurred, esti- mated costs to complete the contract, and accumulated billings to Fabrik for 2014, 2015, and 2016 are given below. 2014 2015 2016 Contract costs incurred during the year $2,880,000 $2,230,000 $2,190,000 Estimated costs to complete the contract at 12/31 3,520,000 2,190,000 –0– Billings to Fabrik during the year 3,200,000 3,500,000 1,700,000 Instructions (a) Using the percentage-of-completion method, prepare schedules to compute the profit or loss to be recognized as a result of this contract for the years ended December 31, 2014, 2015, and 2016. (Ignore income taxes.) Problems 1099 (b) Using the completed-contract method, prepare schedules to compute the profit or loss to be recog- nized as a result of this contract for the years ended December 31, 2014, 2015, and 2016. (Ignore incomes taxes.) 3 4 P18-7 (Long-Term Contract with an Overall Loss) On July 1, 2014, Torvill Construction Company Inc. 5 contracted to build an office building for Gumbel Corp. for a total contract price of $1,900,000. On July 1, Torvill estimated that it would take between 2 and 3 years to complete the building. On December 31, 2016, the building was deemed substantially completed. Following are accumulated contract costs incurred, e stimated costs to complete the contract, and accumulated billings to Gumbel for 2014, 2015, and 2016. At At At 12/31/14 12/31/15 12/31/16 Contract costs incurred to date $ 300,000 $1,200,000 $2,100,000 Estimated costs to complete the contract 1,200,000 800,000 –0– Billings to Gumbel 300,000 1,100,000 1,850,000 Instructions (a) Using the percentage-of-completion method, prepare schedules to compute the profit or loss to be recognized as a result of this contract for the years ended December 31, 2014, 2015, and 2016. (Ignore income taxes.) (b) Using the completed-contract method, prepare schedules to compute the profit or loss to be recog- nized as a result of this contract for the years ended December 31, 2014, 2015, and 2016. (Ignore income taxes.) 6 P18-8 (Installment-Sales Computations and Entries) Presented below is summarized information for Johnston Co., which sells merchandise on the installment basis. 2014 2015 2016 Sales (on installment plan) $250,000 $260,000 $280,000 Cost of sales 155,000 163,800 182,000 Gross profi t $ 95,000 $ 96,200 $ 98,000 Collections from customers on: 2014 installment sales $ 75,000 $100,000 $ 50,000 2015 installment sales 100,000 120,000 2016 installment sales 100,000 Instructions (a) Compute the realized gross profit for each of the years 2014, 2015, and 2016. (b) Prepare all entries required in 2016, applying the installment-sales method of accounting. (Ignore interest charges.) 6 P18-9 (Installment-Sales Income Statements) Chantal Stores sells merchandise on open account as well as on installment terms. 2014 2015 2016 Sales on account $385,000 $426,000 $525,000 Installment sales 320,000 275,000 380,000 Collections on installment sales
Made in 2014 100,000 90,000 40,000 Made in 2015 110,000 140,000 Made in 2016 125,000 Cost of sales Sold on account 270,000 277,000 341,000 Sold on installment 214,400 176,000 228,000 Selling expenses 77,000 87,000 92,000 Administrative expenses 50,000 51,000 52,000 Instructions From the data above, which cover the 3 years since Chantal Stores commenced operations, determine the net income for each year, applying the installment-sales method of accounting. (Ignore interest charges.) 1100 Chapter 18 Revenue Recognition 6 P18-10 (Installment-Sales Computations and Entries) Paul Dobson Stores sell appliances for cash and also on the installment plan. Entries to record cost of sales are made monthly. PAUL DOBSON STORES TRIAL BALANCE DECEMBER 31, 2015 Dr. Cr. Cash $153,000 Installment Accounts Receivable, 2014 56,000 Installment Accounts Receivable, 2015 91,000 Inventory—New Merchandise 123,200 Inventory—Repossessed Merchandise 24,000 Accounts Payable $ 98,500 Deferred Gross Profi t, 2014 45,600 Capital Stock 170,000 Retained Earnings 93,900 Sales Revenue 343,000 Installment Sales 200,000 Cost of Goods Sold 255,000 Cost of Installment Sales 120,000 Loss on Repossession 800 Operating Expenses 128,000 $951,000 $951,000 The accounting department has prepared the following analysis of cash receipts for the year. Cash sales (including repossessed merchandise) $424,000 Installment accounts receivable, 2014 96,000 Installment accounts receivable, 2015 109,000 Other 36,000 Total $665,000 Repossessions recorded during the year are summarized as follows. 2014 Uncollected balance $8,000 Loss on repossession 800 Repossessed merchandise 4,800 Instructions From the trial balance and accompanying information: (a) Compute the rate of gross profit on installment sales for 2014 and 2015. (b) Prepare closing entries as of December 31, 2015, under the installment-sales method of accounting. (c) Prepare an income statement for the year ended December 31, 2015. Include only the realized gross profit in the income statement. 6 P18-11 (Installment-Sales Entries) The following summarized information relates to the installment- sales activity of Phillips Stores, Inc. for the year 2014. Installment sales during 2014 $500,000 Cost of goods sold on installment basis 350,000 Collections from customers 180,000 Unpaid balances on merchandise repossessed 24,000 Estimated value of merchandise repossessed 11,200 Instructions (a) Prepare journal entries at the end of 2014 to record on the books of Phillips Stores, Inc. the summa- rized data above. (b) Prepare the entry to record the gross profit realized during 2014. 6 P18-12 (Installment-Sales Computation and Entries—Periodic Inventory) Mantle Inc. sells merchandise for cash and also on the installment plan. Entries to record cost of goods sold are made at the end of each year. Problems 1101 Repossessions of merchandise (sold in 2014) were made in 2015 and were recorded correctly as follows. Deferred Gross Profi t, 2014 7,200 Repossessed Merchandise 8,000 Loss on Repossession 2,800 Installment Accounts Receivable, 2014 18,000 Part of this repossessed merchandise was sold for cash during 2015, and the sale was recorded by a debit to Cash and a credit to Sales Revenue. The inventory of repossessed merchandise on hand December 31, 2015, is $4,000; of new merchandise, $127,400. There was no repossessed merchandise on hand January 1, 2015. Collections on accounts receivable during 2015 were: Installment Accounts Receivable, 2014 $80,000 Installment Accounts Receivable, 2015 50,000 The cost of the merchandise sold under the installment plan during 2015 was $111,600. The rate of gross profit on 2014 and on 2015 installment sales can be computed from the information given. MANTLE INC. TRIAL BALANCE DECEMBER 31, 2015 Dr. Cr. Cash $118,400 Installment Accounts Receivable, 2014 80,000 Installment Accounts Receivable, 2015 130,000 Inventory, Jan. 1, 2015 120,000 Repossessed Merchandise 8,000 Accounts Payable $ 47,200 Deferred Gross Profi t, 2014 64,000 Common Stock 200,000 Retained Earnings 40,000 Sales Revenue 400,000 Installment Sales 180,000
Purchases 360,000 Loss on Repossession 2,800 Operating Expenses 112,000 $931,200 $931,200 Instructions (a) From the trial balance and other information given above, prepare adjusting and closing entries as of December 31, 2015. (b) Prepare an income statement for the year ended December 31, 2015. Include only the realized gross profit in the income statement. 6 P18-13 (Installment Repossession Entries) Selected transactions of TV Land Company are presented below. 1. A television set costing $540 is sold to Jack Matre on November 1, 2014, for $900. Matre makes a down payment of $300 and agrees to pay $30 on the first of each month for 20 months thereafter. 2. Matre pays the $30 installment due December 1, 2014. 3. On December 31, 2014, the appropriate entries are made to record profit realized on the installment sales. 4. The first seven 2015 installments of $30 each are paid by Matre. (Make one entry.) 5. In August 2015, the set is repossessed after Matre fails to pay the August 1 installment and indicates that he will be unable to continue the payments. The estimated fair value of the repossessed set is $100. Instructions Prepare journal entries to record the transactions above on the books of TV Land Company. Closing entries should not be made. 6 P18-14 (Installment-Sales Computations and Schedules) Saprano Company, on January 2, 2014, entered into a contract with a manufacturing company to purchase room-size air conditioners and to sell the units on an installment plan with collections over approximately 30 months with no carrying charge. 1102 Chapter 18 Revenue Recognition For income tax purposes, Saprano Company elected to report income from its sales of air conditioners according to the installment-sales method. Purchases and sales of new units were as follows. Units Purchased Units Sold Year Quantity Price Each Quantity Price Each 2014 1,400 $130 1,100 $200 2015 1,200 112 1,500 170 2016 900 136 800 205 Collections on installment sales were as follows. Collections Received 2014 2015 2016 2014 sales $42,000 $88,000 $ 80,000 2015 sales 51,000 110,000 2016 sales 34,600 In 2016, 50 units from the 2015 sales were repossessed and sold for $120 each on the installment plan. At the time of repossession, $2,000 had been collected from the original purchasers, and the units had a fair value of $3,000. General and administrative expenses for 2016 were $60,000. No charge has been made against current income for the applicable insurance expense from a 3-year policy expiring June 30, 2017, costing $7,200, and for an advance payment of $12,000 on a new contract to purchase air conditioners beginning January 2, 2017. Instructions Assuming that the weighted-average method is used for determining the inventory cost, including repos- sessed merchandise, prepare schedules computing for 2014, 2015, and 2016: (a) (1) The cost of goods sold on installments. (2) The average unit cost of goods sold on installments for each year. (b) The gross profit percentages for 2014, 2015, and 2016. (c) The gain or loss on repossessions in 2016. (d) The net income from installment sales for 2016. (Ignore income taxes.) (AICPA adapted) 4 5 P18-15 (Completed-Contract Method) Monat Construction Company, Inc., entered into a firm fixed-price contract with Hyatt Clinic on July 1, 2014, to construct a four-story office building. At that time, Monat es- timated that it would take between 2 and 3 years to complete the project. The total contract price for con- struction of the building is $4,400,000. Monat appropriately accounts for this contract under the completed- contract method in its financial statements and for income tax reporting. The building was deemed substantially completed on December 31, 2016. Estimated percentage of completion, accumulated contract costs incurred, estimated costs to complete the contract, and accumulated billings to the Hyatt Clinic under the contract are shown below. At At At December December December 31, 2014 31, 2015 31, 2016 Percentage of completion 30% 70% 100% Contract costs incurred $1,140,000 $3,290,000 $4,800,000
Estimated costs to complete the contract $2,660,000 $1,410,000 –0– Billings to Hyatt Clinic $1,400,000 $2,500,000 $4,300,000 Instructions (a) Prepare schedules to compute the amount to be shown as “Cost in excess of billings” or “Billings in excess of costs” at December 31, 2014, 2015, and 2016. (Ignore income taxes.) Show supporting computations in good form. (b) Prepare schedules to compute the profit or loss to be recognized as a result of this contract for the years ended December 31, 2014, 2015, and 2016. (Ignore income taxes.) Show supporting computa- tions in good form. (AICPA adapted) Problems Set B 1103 3 4 P18-16 (Revenue Recognition Methods—Comparison) Sue’s Construction is in its fourth year of busi- ness. Sue performs long-term construction projects and accounts for them using the completed-contract method. Sue built an apartment building at a price of $1,100,000. The costs and billings for this contract for the first three years are as follows. 2014 2015 2016 Costs incurred to date $240,000 $600,000 $ 790,000 Estimated costs yet to be incurred 560,000 200,000 –0– Customer billings to date 150,000 410,000 1,100,000 Collection of billings to date 120,000 340,000 950,000 Sue has contacted you, a certified public accountant, about the following concern. She would like to a ttract some investors, but she believes that in order to recognize revenue she must first “deliver” the product. Therefore, on her balance sheet, she did not recognize any gross profits from the above contract until 2016, when she recognized the entire $310,000. That looked good for 2016, but the preceding years looked grim by comparison. She wants to know about an alternative to this completed-contract revenue recognition. Instructions Draft a letter to Sue, telling her about the percentage-of-completion method of recognizing revenue. Com- pare it to the completed-contract method. Explain the idea behind the percentage-of-completion method. In addition, illustrate how much revenue she could have recognized in 2014, 2015, and 2016 if she had used this method. 3 4 P18-17 (Comprehensive Problem—Long-Term Contracts) You have been engaged by Buhl Construction Company to advise it concerning the proper accounting for a series of long-term contracts. Buhl com- menced doing business on January 1, 2014. Construction activities for the first year of operations are shown below. All contract costs are with different customers, and any work remaining at December 31, 2014, is expected to be completed in 2015. Cash Contract Estimated Total Billings Collections Costs Incurred Additional Contract Through Through Through Costs to Project Price 12/31/14 12/31/14 12/31/14 Complete A $ 300,000 $200,000 $180,000 $248,000 $ 72,000 B 350,000 110,000 105,000 67,800 271,200 C 280,000 280,000 255,000 186,000 –0– D 200,000 35,000 25,000 118,000 87,000 E 240,000 205,000 200,000 190,000 10,000 $1,370,000 $830,000 $765,000 $809,800 $440,200 Instructions (a) Prepare a schedule to compute gross profit (loss) to be reported, unbilled contract costs and recog- nized profit, and billings in excess of costs and recognized profit using the percentage-of-completion method. (b) Prepare a partial income statement and balance sheet to indicate how the information would be reported for financial statement purposes. (c) Repeat the requirements for part (a), assuming Buhl uses the completed-contract method. (d) Using the responses above for illustrative purposes, prepare a brief report comparing the concep- tual merits (both positive and negative) of the two revenue recognition approaches. PROBLEMS SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of problems. 1104 Chapter 18 Revenue Recognition CONCEPTS FOR ANALYSIS CA18-1 (Revenue Recognition—Alternative Methods) Peterson Industries has three operating divi- sions—Farber Mining, Enyart Paperbacks, and Glesen Protection Devices. Each division maintains its own accounting system and method of revenue recognition. Farber Mining Farber Mining specializes in the extraction of precious metals such as silver, gold, and platinum. During
the fiscal year ended November 30, 2014, Farber entered into contracts worth $2,250,000 and shipped metals worth $2,000,000. A quarter of the shipments were made from inventories on hand at the beginning of the fiscal year, and the remainder were made from metals that were mined during the year. Mining totals for the year, valued at market prices, were silver at $750,000, gold at $1,400,000, and platinum at $490,000. Farber uses the completion-of-production method to recognize revenue because its operations meet the specified criteria, i.e., reasonably assured sales prices, interchangeable units, and insignificant distribution costs. Enyart Paperbacks Enyart Paperbacks sells large quantities of novels to a few book distributors that in turn sell to several national chains of bookstores. Enyart allows distributors to return up to 30% of sales, and distributors give the same terms to bookstores. While returns from individual titles fluctuate greatly, the returns from dis- tributors have averaged 20% in each of the past 5 years. A total of $7,000,000 of paperback novel sales were made to distributors during the fiscal year. On November 30, 2014, $2,200,000 of fiscal 2014 sales were still subject to return privileges over the next 6 months. The remaining $4,800,000 of fiscal 2014 sales had actual returns of 21%. Sales from fiscal 2013 totaling $2,500,000 were collected in fiscal 2014, with less than 18% of sales returned. Enyart records revenue according to the method referred to as revenue recognition when the right of return exits, because all applicable criteria for use of this method are met by Enyart’s operations. Glesen Protection Devices Glesen Protection Devices works through manufacturers’ agents in various cities. Orders for alarm systems and down payments are forwarded from agents, and Glesen ships the goods f.o.b. shipping point. Custom- ers are billed for the balance due plus actual shipping costs. The firm received orders for $6,000,000 of goods during the fiscal year ended November 30, 2014. Down payments of $600,000 were received, and $5,000,000 of goods were billed and shipped. Actual freight costs of $100,000 were also billed. Commissions of 10% on product price were paid to manufacturers’ agents after the goods were shipped to customers. Such goods are warranted for 90 days after shipment, and warranty returns have been about 1% of sales. Revenue is recognized at the point of sale by Glesen. Instructions (a) There are a variety of methods for revenue recognition. Define and describe each of the following methods of revenue recognition, and indicate whether each is in accordance with generally ac- cepted accounting principles. (1) Completion-of-production method. (2) Percentage-of-completion method. (3) Installment-sales method. (b) Compute the revenue to be recognized in the fiscal year ended November 30, 2014, for (1) Farber Mining. (2) Enyart Paperbacks. (3) Glesen Protection Devices. (CMA adapted) CA18-2 (Recognition of Revenue—Theory) Revenue is usually recognized at the point of sale. Under special circumstances, however, bases other than the point of sale are used for the timing of revenue recognition. Instructions (a) Why is the point of sale usually used as the basis for the timing of revenue recognition? (b) Disregarding the special circumstances when bases other than the point of sale are used, discuss the merits of each of the following objections to the sale basis of revenue recognition: (1) It is too conservative because revenue is earned throughout the entire process of production. (2) It is not conservative enough because accounts receivable do not represent disposable funds, sales returns and allowances may be made, and collection and bad debt expenses may be incurred in a later period. Concepts for Analysis 1105 (c) Revenue may also be recognized (1) during production and (2) when cash is received. For each of these two bases of timing revenue recognition, give an example of the circumstances in which it is properly used and discuss the accounting merits of its use in lieu of the sale basis.
(AICPA adapted) CA18-3 (Recognition of Revenue—Theory) The earning of revenue by a business enterprise is recog- nized for accounting purposes when the transaction is recorded. In some situations, revenue is recognized approximately as it is earned in the economic sense. In other situations, however, accountants have devel- oped guidelines for recognizing revenue by other criteria, such as at the point of sale. Instructions (Ignore income taxes.) (a) Explain and justify why revenue is often recognized as earned at time of sale. (b) Explain in what situations it would be appropriate to recognize revenue as the productive activity takes place. (c) At what times, other than those included in (a) and (b) above, may it be appropriate to recognize revenue? Explain. CA18-4 (Recognition of Revenue—Bonus Dollars) Griseta & Dubel Inc. was formed early this year to sell merchandise credits to merchants who distribute the credits free to their customers. For example, cus- tomers can earn additional credits based on the dollars they spend with a merchant (e.g., airlines and hotels). Accounts for accumulating the credits and catalogs illustrating the merchandise for which the credits may be exchanged are maintained online. Centers with inventories of merchandise premiums have been established for redemption of the credits. Merchants may not return unused credits to Griseta & Dubel. The following schedule expresses Griseta & Dubel’s expectations as to percentages of a normal month’s activity that will be attained. For this purpose, a “normal month’s activity” is defined as the level of operations expected when expansion of activities ceases or tapers off to a stable rate. The company expects that this level will be attained in the third year and that sales of credits will average $6,000,000 per month throughout the third year. Actual Merchandise Credit Credit Sales Premium Purchases Redemptions Month Percent Percent Percent 6th 30% 40% 10% 12th 60 60 45 18th 80 80 70 24th 90 90 80 30th 100 100 95 Griseta & Dubel plans to adopt an annual closing date at the end of each 12 months of operation. Instructions (a) Discuss the factors to be considered in determining when revenue should be recognized in measur- ing the income of a business enterprise. (b) Discuss the accounting alternatives that should be considered by Griseta & Dubel Inc. for the recog- nition of its revenues and related expenses. (c) For each accounting alternative discussed in (b), give balance sheet accounts that should be used and indicate how each should be classified. (AICPA adapted) CA18-5 (Recognition of Revenue from Subscriptions) Cutting Edge is a monthly magazine that has been on the market for 18 months. It currently has a circulation of 1.4 million copies. Negotiations are underway to obtain a bank loan in order to update the magazine’s facilities. They are producing close to capacity and expect to grow at an average of 20% per year over the next 3 years. After reviewing the financial statements of Cutting Edge, Andy Rich, the bank loan officer, had indi- cated that a loan could be offered to Cutting Edge only if it could increase its current ratio and decrease its debt to equity ratio to a specified level. Jonathan Embry, the marketing manager of Cutting Edge, has devised a plan to meet these require- ments. Embry indicates that an advertising campaign can be initiated to immediately increase circulation. The potential customers would be contacted after the purchase of another magazine’s mailing list. The campaign would include: 1. An offer to subscribe to Cutting Edge at 3/4 the normal price. 2. A special offer to all new subscribers to receive the most current world atlas whenever requested at a guaranteed price of $2. 1106 Chapter 18 Revenue Recognition 3. An unconditional guarantee that any subscriber will receive a full refund if dissatisfied with the magazine. Although the offer of a full refund is risky, Embry claims that few people will ask for a refund after receiving half of their subscription issues. Embry notes that other magazine companies have tried this sales
promotion technique and experienced great success. Their average cancellation rate was 25%. On average, each company increased its initial circulation threefold and in the long run increased circulation to twice that which existed before the promotion. In addition, 60% of the new subscribers are expected to take ad- vantage of the atlas premium. Embry feels confident that the increased subscriptions from the advertising campaign will increase the current ratio and decrease the debt to equity ratio. You are the controller of Cutting Edge and must give your opinion of the proposed plan. Instructions (a) When should revenue from the new subscriptions be recognized? (b) How would you classify the estimated sales returns stemming from the unconditional guarantee? (c) How should the atlas premium be recorded? Is the estimated premium claims a liability? Explain. (d) Does the proposed plan achieve the goals of increasing the current ratio and decreasing the debt to equity ratio? CA18-6 (Long-Term Contract—Percentage-of-Completion) Widjaja Company is accounting for a long- term construction contract using the percentage-of-completion method. It is a 4-year contract that is currently in its second year. The latest estimates of total contract costs indicate that the contract will be completed at a profit to Widjaja Company. Instructions (a) What theoretical justification is there for Widjaja Company’s use of the percentage-of-completion method? (b) How would progress billings be accounted for? Include in your discussion the classification of progress billings in Widjaja Company financial statements. (c) How would the income recognized in the second year of the 4-year contract be determined using the cost-to-cost method of determining percentage of completion? (d) What would be the effect on earnings per share in the second year of the 4-year contract of using the percentage-of-completion method instead of the completed-contract method? Discuss. (AICPA adapted) CA18-7 (Revenue Recognition—Membership Fees) Midwest Health Club (MHC) offers one-year mem- berships. Membership fees are due in full at the beginning of the individual membership period. As an incentive to new customers, MHC advertised that any customers not satisfied for any reason could receive a refund of the remaining portion of unused membership fees. As a result of this policy, Richard Nies, corporate controller, recognized revenue ratably over the life of the membership. MHC is in the process of preparing its year-end financial statements. Rachel Avery, MHC’s treasurer, is concerned about the company’s lackluster performance this year. She reviews the financial statements Nies prepared and tells Nies to recognize membership revenue when the fees are received. Instructions Answer the following questions. (a) What are the ethical issues involved? (b) What should Nies do? *C A18-8 (Franchise Revenue) Amigos Burrito Inc. sells franchises to independent operators throughout the northwestern part of the United States. The contract with the franchisee includes the following provisions. 1. The franchisee is charged an initial fee of $120,000. Of this amount, $20,000 is payable when the agreement is signed, and a $20,000 non-interest-bearing note is payable at the end of each of the 5 subsequent years. 2. All of the initial franchise fee collected by Amigos is to be refunded and the remaining obligation canceled if, for any reason, the franchisee fails to open his or her franchise. 3. In return for the initial franchise fee, Amigos agrees to (a) assist the franchisee in selecting the loca- tion for the business, (b) negotiate the lease for the land, (c) obtain financing and assist with build- ing design, (d) supervise construction, (e) establish accounting and tax records, and (f) provide e xpert advice over a 5-year period relating to such matters as employee and management training, quality control, and promotion. 4. In addition to the initial franchise fee, the franchisee is required to pay to Amigos a monthly fee of 2% of sales for menu planning, receipt innovations, and the privilege of purchasing ingredients
from Amigos at or below prevailing market prices. Using Your Judgment 1107 Management of Amigos Burrito estimates that the value of the services rendered to the franchisee at the time the contract is signed amounts to at least $20,000. All franchisees to date have opened their locations at the scheduled time, and none have defaulted on any of the notes receivable. The credit ratings of all franchisees would entitle them to borrow at the current interest rate of 10%. The present value of an ordinary annuity of five annual receipts of $20,000 each discounted at 10% is $75,816. Instructions (a) Discuss the alternatives that Amigos Burrito Inc. might use to account for the initial franchise fees, evaluate each by applying generally accepted accounting principles, and give illustrative entries for each alternative. (b) Given the nature of Amigos Burrito’s agreement with its franchisees, when should revenue be r ecognized? Discuss the question of revenue recognition for both the initial franchise fee and the additional monthly fee of 2% of sales, and give illustrative entries for both types of revenue. (c) Assume that Amigos Burrito sells some franchises for $100,000, which includes a charge of $20,000 for the rental of equipment for its useful life of 10 years; that $50,000 of the fee is payable immedi- ately and the balance on non-interest-bearing notes at $10,000 per year; that no portion of the $20,000 rental payment is refundable in case the franchisee goes out of business; and that title to the equip- ment remains with the franchisor. Under those assumptions, what would be the preferable method of accounting for the rental portion of the initial franchise fee? Explain. (AICPA adapted) USING YOUR JUDGMENT FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website, www. wiley.com/college/kieso. Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions. (a) What were P&G’s net sales for 2011? (b) What was the percentage of increase or decrease in P&G’s net sales from 2010 to 2011? From 2009 to 2010? From 2009 to 2011? (c) In its notes to the financial statements, what criteria does P&G use to recognize revenue? (d) How does P&G account for trade promotions? Does the accounting conform to accrual accounting concepts? Explain. Comparative Analysis Case The Coca-Cola Company and PepsiCo, Inc. Instructions Go to the book’s companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) What were Coca-Cola’s and PepsiCo’s net revenues (sales) for the year 2011? Which company in- creased its revenues more (dollars and percentage) from 2010 to 2011? (b) Are the revenue recognition policies of Coca-Cola and PepsiCo similar? Explain. (c) In which foreign countries (geographic areas) did Coca-Cola and PepsiCo experience significant revenues in 2011? Compare the amounts of foreign revenues to U.S. revenues for both Coca-Cola and PepsiCo. Financial Statement Analysis Case Westinghouse Electric Corporation The following note appears in the “Summary of Significant Accounting Policies” section of the Annual Report of Westinghouse Electric Corporation. 1108 Chapter 18 Revenue Recognition Note 1 (in part): Revenue Recognition. Sales are primarily recorded as products are shipped and services are rendered. The percentage-of-completion method of accounting is used for nuclear steam supply system orders with delivery schedules generally in excess of five years and for certain construction projects where this method of accounting is consistent with industry practice. WFSI revenues are generally recognized on the accrual method. When accounts become delinquent for more than two payment periods, usually 60 days, income is recognized only as payments are received. Such delinquent
accounts for which no payments are received in the current month, and other accounts on which income is not being recognized because the receipt of either principal or interest is questionable, are classified as nonearning receivables. Instructions (a) Identify the revenue recognition methods used by Westinghouse Electric as discussed in its note on significant accounting policies. (b) Under what conditions are the revenue recognition methods identified in the first paragraph of Westinghouse’s note above acceptable? (c) From the information provided in the second paragraph of Westinghouse’s note, identify the type of operation being described and defend the acceptability of the revenue recognition method. Accounting, Analysis, and Principles Diversified Products, Inc. operates in several lines of business, including the construction and real estate industries. While the majority of its revenues are recognized at point of sale, Diversified appropriately recognizes revenue on long-term construction contracts using the percentage-of-completion method. It recognizes sales of some properties using the installment-sales approach. Income data for 2014 from operations other than construction and real estate are as follows. Revenues $9,500,000 Expenses 7,750,000 1. Diversified started a construction project during 2013. The total contract price is $1,000,000, and $200,000 in costs were incurred in both 2013 and 2014. In 2013, Diversified recognized $50,000 gross profit on the project. Estimated costs to complete the project in 2015 were $400,000. 2. During 2014, Diversified sold real-estate parcels at a price of $630,000. Gross profit at a 25% rate is recognized when cash is received. Diversified collected $500,000 during the year on these sales. Accounting Determine Diversified Products’ 2014 net income. (Ignore taxes.) Analysis Determine free cash flow (see Chapter 5) for Diversified Products for 2014. In 2014, Diversified had depre- ciation expense of $175,000 and a net increase in working capital (changes in accounts receivable and accounts payable) of $250,000. In 2014, capital expenditures were $500,000; Diversified paid dividends of $120,000. Principles “Application of the percentage-of-completion and installment-sales method revenue recognition ap- proaches illustrates the trade-off between relevance and faithful representation of accounting informa- tion.” Explain. BRIDGE TO THE PROFESSION Professional Research: FASB Codifi cation Employees at your company disagree about the accounting for sales returns. The sales manager believes that granting more generous return provisions can give the company a competitive edge and increase sales revenue. The controller cautions that, depending on the terms granted, loose return provisions might lead to non-GAAP revenue recognition. The company CFO would like you to research the issue to provide an authoritative answer. IFRS Insights 1109 Instructions If your school has a subscription to the FASB Codification, go to http://aaa.hq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. (a) What is the authoritative literature addressing revenue recognition when right of return exists? (b) What is meant by “right of return”? (c) When there is a right of return, what conditions must the company meet to recognize the revenue at the time of sale? (d) What factors may impair the ability to make a reasonable estimate of future returns? Additional Professional Resources See the book’s companion website, at www.wiley.com/college/kieso, for professional simulations as well as other study resources. IFRS INSIGHTS The general concepts and principles used for revenue recognition are similar 9 LEARNING OBJECTIVE between IFRS and GAAP. Where they differ is in the details. As indicated in the Compare the accounting procedures chapter, GAAP provides specific guidance related to revenue recognition for many related to revenue recognition under different industries. That is not the case for IFRS. GAAP and IFRS.
RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to revenue recognition. Similarities • Revenue recognition fraud is a major issue in U.S. fi nancial reporting. The same situation occurs overseas as evidenced by revenue recognition breakdowns at Dutch software company Baan NV, Japanese electronics giant NEC, and Dutch grocer AHold NV. • In general, the accounting at point of sale is similar between IFRS and GAAP. As indi- cated earlier, GAAP often provides detailed guidance, such as in the accounting for right of return and multiple-deliverable arrangements. • In long-term construction contracts, IFRS requires recognition of a loss immediately if the overall contract is going to be unprofi table. In other words, GAAP and IFRS are the same regarding this issue. Differences • The IASB defi nes revenue to include both revenues and gains. GAAP provides sepa- rate defi nitions for revenues and gains. • IFRS has one basic standard on revenue recognition—IAS 18. GAAP has numerous standards related to revenue recognition (by some counts over 100). • Accounting for revenue provides a most fi tting contrast of the principles-based (IFRS) and rules-based (GAAP) approaches. While both sides have their advocates, the IASB and the FASB have identifi ed a number of areas for improvement in this area. • In general, the IFRS revenue recognition principle is based on the probability that the economic benefi ts associated with the transaction will fl ow to the company selling the 1110 Chapter 18 Revenue Recognition goods, rendering the service, or receiving investment income. In addition, the reve- nues and costs must be capable of being measured reliably. GAAP uses concepts such as realized, realizable, and earned as a basis for revenue recognition. • Under IFRS, revenue should be measured at fair value of the consideration received or receivable. GAAP measures revenue based on the fair value of what is given up (goods or services) or the fair value of what is received—whichever is more clearly evident. • IFRS prohibits the use of the completed-contract method of accounting for long-term construction contracts (IAS 13). Companies must use the percentage-of-completion method. If revenues and costs are diffi cult to estimate, then companies recognize rev- enue only to the extent of the cost incurred—a cost-recovery (zero-profi t) approach. ABOUT THE NUMBERS Long-Term Contracts (Construction) Under IFRS, two distinctly different methods of accounting for long-term construction contracts are recognized. They are: • Percentage-of-completion method. Companies recognize revenues and gross profi ts each period based on the progress of the construction—that is, the percentage of com- pletion. The company accumulates construction costs plus gross profi t earned to date in an inventory account (Construction in Process), and it accumulates progress bill- ings in a contra inventory account (Billings on Construction in Process). This approach is the same as GAAP. • Cost-recovery (zero-profi t) method. In some cases, contract revenue is recognized only to the extent of costs incurred that are expected to be recoverable. Once all costs are recognized, profi t is recognized. The company accumulates construction costs in an inventory account (Construction in Process), and it accumulates progress billings in a contra inventory account (Billings on Construction in Process). The rationale for using percentage-of-completion accounting is that under most of these contracts, the buyer and seller have enforceable rights. The buyer has the legal right to require specific performance on the contract. The seller has the right to require progress payments that provide evidence of the buyer’s ownership interest. As a result, a continuous sale occurs as the work progresses. Companies should recognize revenue according to that progression. Companies must use the percentage-of-completion method when estimates of progress toward completion, revenues, and costs can be estimated reliably and all of the following conditions exist.
1. Total contract revenue can be measured reliably; 2. It is probable that the economic benefi ts associated with the contract will fl ow to the company; 3. Both the contract costs to complete the contract and the stage of contract completion at the end of the reporting period can be measured reliably; and 4. The contract costs attributable to the contract can be clearly identifi ed and measured reliably so the actual contract costs incurred can be compared with prior estimates. Companies should use the cost-recovery method when one of the following condi- tions applies: • When a company cannot meet the conditions for using the percentage-of-completion method, or • When there are inherent hazards in the contract beyond the normal, recurring busi- ness risks. IFRS Insights 1111 The presumption is that percentage-of-completion is the better method. Therefore, com- panies should use the cost-recovery method only when the percentage-of-completion method is inappropriate. Cost-Recovery (Zero-Profi t) Method During the early stages of a contract, a company like Alcatel-Lucent may not be able to estimate reliably the outcome of a long-term construction contract. Nevertheless, Alcatel-Lucent is confident that it will recover the contract costs incurred. In this case, Alcatel-Lucent uses the cost-recovery method (sometimes referred to as the zero-profit method). This method recognizes revenue only to the extent of costs incurred that are expected to be recoverable. Only after all costs are incurred is gross profit recognized. To illustrate the cost-recovery method for a bridge project, recall the Hardhat Construction example on pages 1059–1067. Under the cost-recovery method, Hardhat would report the following revenues and costs for 2014–2016, as shown in Illustration IFRS18-1. ILLUSTRATION Recognized in Recognized IFRS18-1 To Date Prior Years in Current Year 2014 Cost-Recovery Method Revenue, Costs, and Revenues (costs incurred) $1,000,000 $1,000,000 Gross Profi t by Year Costs 1,000,000 1,000,000 Gross profit $ 0 $ 0 2015 Revenues (costs incurred) $2,916,000 $1,000,000 $1,916,000 Costs 2,916,000 1,000,000 1,916,000 Gross profit $ 0 $ 0 $ 0 2016 Revenues ($4,500,000 3 100%) $4,500,000 $2,916,000 $1,584,000 Costs 4,050,000 2,916,000 1,134,000 Gross profit $ 450,000 $ 0 $ 450,000 Illustration IFRS18-2 shows Hardhat’s entries to recognize revenue and gross profit each year and to record completion and final approval of the contract. 2014 2015 2016 Construction Expenses 1,000,000 1,916,000 Revenue from Long-Term Contracts 1,000,000 1,916,000 (To recognize costs and related expenses) Construction in Process (Gross Profit) 450,000 Construction Expenses 1,134,000 Revenue from Long-Term Contracts 1,584,000 (To recognize costs and related expenses) Billings on Construction in Process 4,500,000 Construction in Process 4,500,000 (To record completion of the contract) ILLUSTRATION As indicated, no gross profit is recognized in 2014 and 2015. In 2016, Hardhat then rec- IFRS18-2 ognizes gross profit and closes the Billings and Construction in Process accounts. Journal Entries— Cost-Recovery Method Illustration IFRS18-3 (page 1112) compares the amount of gross profit that Hardhat Construction Company would recognize for the bridge project under the two revenue recognition methods. 1112 Chapter 18 Revenue Recognition ILLUSTRATION Percentage-of-Completion Cost-Recovery IFRS18-3 2014 $125,000 $ 0 Comparison of Gross 2015 199,000 0 Profi t Recognized under 2016 126,000 450,000 Different Methods Under the cost-recovery method, Hardhat Construction would report its long-term construction activities as shown in Illustration IFRS18-4. ILLUSTRATION HARDHAT CONSTRUCTION COMPANY IFRS18-4 Income Statement 2014 2015 2016 Financial Statement Presentation—Cost- Revenue from long-term contracts $1,000,000 $1,916,000 $1,584,000 Costs of construction 1,000,000 1,916,000 1,134,000 Recovery Method Gross profit $ 0 $ 0 $ 450,000 Statement of Financial Position (12/31) 2014 2015 2016 Current assets Inventories Construction in process $1,000,000 Less: Billings 900,000
Costs in excess of billings $ 100,000 $ –0– Accounts receivable 150,000 $ 800,000 –0– Current liabilities Billings 3,300,000 Less: Construction in process 2,916,000 Billings in excess of costs and recognized profits 384,000 –0– Note 1. Summary of significant accounting policies. Long-Term Construction Contracts. The company recognizes revenues and reports profits from long- term construction contracts, its principal business, under the cost-recovery method. These contracts generally extend for periods in excess of one year. Contract costs and billings are accumulated during the periods of construction, and revenues are recognized only to the extent of costs incurred that are expected to be recoverable. Only after all costs are incurred is net income recognized. Costs included in construction in process include direct material, direct labor, and project-related overhead. Corporate general and administrative expenses are charged to the periods as incurred. ON THE HORIZON The FASB and IASB are now involved in a joint project on revenue recognition. The objective of the project is to develop coherent conceptual guidance for revenue recogni- tion and a comprehensive statement on revenue recognition based on those concepts. In particular, the project is intended to improve financial reporting by (1) converging U.S. and international standards on revenue recognition, (2) eliminating inconsistencies in the existing conceptual guidance on revenue recognition, (3) providing conceptual guidance that would be useful in addressing future revenue recognition issues, (4) elim- inating inconsistencies in existing standards-level authoritative literature and accepted practices, (5) filling voids in revenue recognition guidance that have developed over time, and (6) establishing a single, comprehensive standard on revenue recognition. Presently, the Boards proposed a “customer-consideration” model; under this model, revenue is recognized when a performance obligation is satisfied. It is hoped that IFRS Insights 1113 this approach (rather than using the earned and realized criteria) will lead to a better basis for revenue recognition. For more on this topic, see http://www.fasb.org/project/revenue_recognition. shtml. IFRS SELF-TEST QUESTIONS 1. The IASB: (a) has issued over 100 standards related to revenue recognition. (b) has issued one standard related to revenue recognition. (c) indicates that the present state of reporting for revenue is satisfactory. (d) All of the above. 2. Under IFRS, the revenue recognition principle indicates that revenue is recognized when: I. the benefits can be measured reliably. II. the sales transaction is initiated and completed. III. it is probable the benefits will flow to the company. IV. the date of sale, date of delivery, and billing have all occurred. (a) I, II, and III. (b) II and III. (c) I and III. (d) I, II, III and IV. 3. Lark Corp. has a contract to construct a $5,000,000 cruise ship at an estimated cost of $4,000,000. The company will begin construction of the cruise ship in early January 2013 and expects to com- plete the project sometime in late 2014. Lark Corp. has never constructed a cruise ship before, and the customer has never operated a cruise ship. Due to this and other circumstances, Lark Corp. believes there are inherent hazards in the contract beyond the normal, recurring business risks. Lark Corp. expects to recover all its costs under the contract. Under these circumstances, Lark Corp. should: (a) wait until the completion of construction before it recognizes revenue. (b) use the percentage-of-completion method and measure progress toward completion using the units-of-delivery method. (c) use the percentage-of-completion method and measure progress toward completion using the cost-to-cost method. (d) use the cost-recovery (zero-profit) method. 4. Swallow Corp. has a contract to construct a $5,000,000 cruise ship at an estimated cost of $4,000,000. The company will begin construction of the cruise ship in early January 2013 and expects to com- plete the project sometime in late 2016. Swallow Corp. has never constructed a cruise ship before,
and the customer has never operated a cruise ship. Due to this and other circumstances, Swallow Corp. believes there are inherent hazards in the contract beyond the normal, recurring business risks. Swallow Corp. expects to recover all its costs under the contract. During 2013 and 2014, the company has the following activity: 2013 2014 Costs to date $ 980,000 $2,040,000 Estimated costs to complete 3,020,000 1,960,000 Progress billings during the year 1,000,000 1,000,000 Cash collected during the year 648,000 1,280,000 For the year ended December 31, 2014, how much revenue should Swallow Corp. recognize on its income statement? (a) $980,000. (c) $1,300,000. (b) $2,040,000. (d) $1,060,000. 5. Given the information in question 4 above, on its statement of financial position at December 31, 2014, what amount is reported in the cost of construction and billings presentation by Swallow? (a) $40,000 costs in excess of billings. (b) $1,020,000 costs in excess of billings. (c) $40,000 billings in excess of costs. (d) $20,000 billings in excess of costs. 1114 Chapter 18 Revenue Recognition IFRS CONCEPTS AND APPLICATION IFRS18-1 What is a major difference between IFRS and GAAP as regards revenue recognition practices? IFRS18-2 IFRS prohibits the use of the completed-contract method in accounting for long-term contracts. If revenues and costs are difficult to estimate, how must companies account for long-term contracts? IFRS18-3 Livesey Company has signed a long-term contract to build a new basketball arena. The total revenue related to the contract is $120 million. Estimated costs for building the arena are $40 million in the first year and $30 million in both the second and third years. The costs cannot be reliably estimated. How much revenue should Livesey Company report in the first year under IFRS? IFRS18-4 What are the two basic methods of accounting for long-term construction contracts? Indicate the circumstances that determine when one or the other of these methods should be used. IFRS18-5 When is revenue recognized under the cost-recovery method? IFRS18-6 Turner, Inc. began work on a $7,000,000 contract in 2014 to construct an office building. During 2014, Turner, Inc. incurred costs of $1,700,000, billed its customers for $1,200,000, and collected $960,000. At December 31, 2014, the estimated future costs to complete the project total $3,300,000. Prepare Turner’s 2014 journal entries using the percentage-of-completion method. IFRS18-7 Use the information from IFRS18-6, but assume Turner uses the cost-recovery method. Prepare the company’s 2014 journal entries. IFRS18-8 Hamilton Construction Company uses the percentage-of-completion method of accounting. In 2014, Hamilton began work under contract #E2-D2, which provided for a contract price of $2,200,000. Other details are as follows. 2014 2015 Costs incurred during the year $640,000 $1,425,000 Estimated costs to complete, as of December 31 960,000 –0– Billings during the year 420,000 1,680,000 Collections during the year 350,000 1,500,000 Instructions (a) What portion of the total contract price would be recognized as revenue in 2014? In 2015? (b) Assuming the same facts as those shown above except that Hamilton uses the cost-recovery method of accounting, what portion of the total contract price would be recognized as revenue in 2015? Professional Research IFRS18-9 Employees at your company disagree about the accounting for sales returns. The sales manager believes that granting more generous return provisions and allowing customers to order items on a bill and hold basis can give the company a competitive edge and increase sales revenue. The controller cautions that, depending on the terms granted, loose return or bill and hold provisions might lead to non-IFRS r evenue recognition. The company CFO would like you to research the issue to provide an authoritative answer. Instructions Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use
the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.) (a) What is the authoritative literature addressing revenue recognition when right of return exists? (b) What is meant by “right of return”? “Bill and hold”? (c) When there is a right of return, what conditions must the company meet to recognize the revenue at the time of sale? (d) What factors may impair the ability to make a reasonable estimate of future returns? (e) When goods are sold on a bill and hold basis, what conditions must be met to recognize revenue upon receipt of the order? IFRS Insights 1115 International Financial Reporting Problem Marks and Spencer plc IFRS18-10 The financial statements of Marks and Spencer plc (M&S) are available at the book’s com- panion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/Marks-and- Spencer-Annual-report-and-financial-statements-2012.pdf. Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions. (a) What were M&S’s sales for 2012? (b) What was the percentage of increase or decrease in M&S’s sales from 2011 to 2012? From 2010 to 2011? From 2010 to 2012? (c) In its notes to the financial statements, what criteria does M&S use to recognize revenue? (d) How does M&S account for discounts and loyalty schemes? Does the accounting conform to accrual-accounting concepts? Explain. ANSWERS TO IFRS SELF-TEST QUESTIONS 1. b 2. c 3. d 4. d 5. a Remember to check the book’s companion website to fi nd additional resources for this chapter. 1 Identify differences between pretax financial 6 Describe various temporary and permanent income and taxable income. differences. 2 Describe a temporary difference that results 7 Explain the effect of various tax rates and tax in future taxable amounts. rate changes on deferred income taxes. 3 Describe a temporary difference that results 8 Apply accounting procedures for a loss carryback in future deductible amounts. and a loss carryforward. 4 Explain the purpose of a deferred tax asset 9 Describe the presentation of deferred income valuation allowance. taxes in financial statements. 5 Describe the presentation of income tax expense 10 Indicate the basic principles of the asset- in the income statement. liability method. How Much Is Enough? In the wake of the economic downturn due to the financial crisis, a number of companies and numerous banks reported operating losses. As you will learn in this chapter, the tax code allows companies that report operating losses to claim a tax credit related to these losses for taxes paid in the past (referred to as “carrybacks”) and to offset taxable income in periods following the operating loss (referred to as “carryforwards”). When companies use these offsets, they reduce income tax expense, which increases net income. For tax carryforwards, companies also record a deferred tax asset, which measures the expected future net cash inflows from lower taxable income in future periods. Citigroup is a good example of a company that has used operating loss credits to reduce its tax bill. In 2008, it had deferred tax assets (DTAs) of $28.5 billion, which represented 80 percent of stockholders’ equity and nearly eclipsed the bank’s market value of equity. Some analysts have raised concerns about Citi’s DTAs and whether these assets will ever be realized by Citi. Why the concerns? Well, in order to receive the tax deductions in future years, a company like Citigroup needs to be reasonably sure it will have taxable income in the future. In Citi’s case, analysts predict that the struggling bank will need to earn $99 billion in taxable income over the next 20 years. Given that Citigroup recorded operating losses of $60 billion in 2008 and 2009, some are skeptical that the DTAs will be realized. As a result, market watchers are debating whether Citi should set up an allowance to reduce its deferred tax assets due to the possibility that the assets will not be realized. Not surprisingly, Citigroup has resisted
setting up an allowance as it would reduce its DTAs and increase its income tax expense. This accounting does not sit well with some market observers. As one critic noted, “Why should auditors, investors, regulators and others rely on Citigroup’s projections . . . to justify the use (realizability) of their DTAs?” Former SEC chief accountant, Lynn Turner, agrees: “Citi’s position defies imagination and logic. Instead of talking about making money, what Citi ought to do is to reserve for at least part of the deferred tax assets and reap the benefit of reducing the reserves once it actually makes money.” RETPAHC 19 Accounting for Income Taxes LEARNING OBJECTIVES After studying this chapter, you should be able to: CONCEPTUAL FOCUS > Read the Evolving Issue on page 1143 for a discussion of uncertain tax positions. INTERNATIONAL FOCUS In response, Citigroup, which accumulated deferred tax as- sets partly because of its huge losses during the financial crisis, > See the International Perspectives on said it was “very comfortable with the recording of our deferred pages 1119, 1128, 1137, 1140, and 1145. tax assets.” And some market analysts sided with the bank, > Read the IFRS Insights on pages 1175–1181 remarking that Citi’s accounts were not out of order due to a for a discussion of: misstatement of its DTAs. The Citigroup debate has arisen —Deferred tax asset (non-recognition) because accounting standards on DTAs are vague, stating that — Statement of financial position an allowance is not needed if management believes it is “more classification likely than not” the company will earn enough taxable income in the future. This debate over Citigroup’s accounting highlights the extent to which management judgment plays an important role in the accounting for taxes. After studying this chapter, you should be better able to evaluate Citigroup’s accounting as well as the other judgments inherent in the accounting for income taxes. Sources: Adapted from J. Weil, “Citigroup’s Capital Was All Casing, No Meat,” www.bloomberg.net (November 24, 2008); and F. Guerra and J. Eaglesham, “Citi Under Fire Over Deferred Tax Assets,” Financial Times (September 6, 2010). As our opening story indicates, the accounting for income taxes PREVIEW OF CHAPTER 19 involves significant judgment. Investors need to be knowledgeable of the accounting provisions related to taxes to be able to evaluate these judgments. Thus, companies must present financial information to the investment community that provides a clear picture of present and potential tax obligations and tax benefits. In this chapter, we discuss the basic guidelines that companies must follow in reporting income taxes. The content and organization of the chapter are as follows. Accounting for Income Taxes Fundamentals of Accounting for Net Financial Statement Review of the Asset- Accounting for Operating Losses Presentation Liability Method Income Taxes • Future taxable amounts • Loss carryback • Balance sheet and deferred taxes • Loss carryforward • Income statement • Future deductible amounts • Loss carryback example and deferred taxes • Loss carryforward example • Valuation allowance • Income statement presentation • Specific differences • Rate considerations 1117 1118 Chapter 19 Accounting for Income Taxes FUNDAMENTALS OF ACCOUNTING FOR INCOME TAXES Up to this point, you have learned the basic guidelines that corporations use to LEARNING OBJECTIVE 1 report information to investors and creditors. Corporations also must file income Identify differences between pretax tax returns following the guidelines developed by the Internal Revenue Service financial income and taxable income. (IRS). Because GAAP and tax regulations differ in a number of ways, so frequently do pretax financial income and taxable income. Consequently, the amount that a com- pany reports as tax expense will differ from the amount of taxes payable to the IRS. Illustration 19-1 highlights these differences. ILLUSTRATION 19-1 Financial Statements Tax Return Fundamental Differences b Tae xtw Re ee pn o F rti in na gncial and STOCK BOND Exchanges
Investors and Creditors IRS “We’ll use “We’ll use GAAP.” the tax code.” GAAP Tax Code Pretax Financial Income Taxable Income Income Tax Expense Income Taxes Payable Pretax financial income is a financial reporting term. It also is often referred to as income before taxes, income for financial reporting purposes, or income for book pur- poses. Companies determine pretax financial income according to GAAP. They measure it with the objective of providing useful information to investors and creditors. Taxable income (income for tax purposes) is a tax accounting term. It indicates the amount used to compute income taxes payable. Companies determine taxable income according to the Internal Revenue Code (the tax code). Income taxes provide money to support government operations. To illustrate how differences in GAAP and IRS rules affect financial reporting and taxable income, assume that Chelsea Inc. reported revenues of $130,000 and expenses of $60,000 in each of its first three years of operations. Illustration 19-2 shows the (partial) income statement over these three years. ILLUSTRATION 19-2 CHELSEA INC. Financial Reporting GAAP REPORTING Income 2014 2015 2016 Total Revenues $130,000 $130,000 $130,000 Expenses 60,000 60,000 60,000 Pretax financial income $ 70,000 $ 70,000 $ 70,000 $210,000 Income tax expense (40%) $ 28,000 $ 28,000 $ 28,000 $ 84,000 Fundamentals of Accounting for Income Taxes 1119 For tax purposes (following the tax code), Chelsea reported the same expenses to the IRS in each of the years. But, as Illustration 19-3 shows, Chelsea reported taxable revenues of $100,000 in 2014, $150,000 in 2015, and $140,000 in 2016. ILLUSTRATION 19-3 CHELSEA INC. Tax Reporting Income TAX REPORTING 2014 2015 2016 Total Revenues $100,000 $150,000 $140,000 Expenses 60,000 60,000 60,000 Taxable income $ 40,000 $ 90,000 $ 80,000 $210,000 Income taxes payable (40%) $ 16,000 $ 36,000 $ 32,000 $ 84,000 Income tax expense and income taxes payable differed over the three years but were equal in total, as Illustration 19-4 shows. ILLUSTRATION 19-4 CHELSEA INC. Comparison of Income INCOME TAX EXPENSE AND INCOME TAXES PAYABLE Tax Expense to Income Taxes Payable 2014 2015 2016 Total Income tax expense $28,000 $28,000 $28,000 $84,000 Income taxes payable 16,000 36,000 32,000 84,000 Difference $12,000 $ (8,000) $ (4,000) $ 0 The differences between income tax expense and income taxes payable in International this example arise for a simple reason. For financial reporting, companies use Perspective the full accrual method to report revenues. For tax purposes, they use a modi- In some countries, taxable fied cash basis. As a result, Chelsea reports pretax financial income of $70,000 income equals pretax fi nancial and income tax expense of $28,000 for each of the three years. However, taxable income. As a consequence, income fluctuates. For example, in 2014 taxable income is only $40,000, so accounting for differences Chelsea owes just $16,000 to the IRS that year. Chelsea classifies the income between tax and book income taxes payable as a current liability on the balance sheet. is insignifi cant. As Illustration 19-4 indicates, for Chelsea the $12,000 ($28,000 2 $16,000) difference between income tax expense and income taxes payable in 2014 reflects taxes that it will pay in future periods. This $12,000 difference is often referred to as a deferred tax amount. In this case, it is a deferred tax liability. In cases where taxes will be lower in the future, Chelsea records a deferred tax asset. We explain the measurement and accounting for deferred tax liabilities and assets in the following two sections.1 Future Taxable Amounts and Deferred Taxes The example summarized in Illustration 19-4 shows how income taxes payable 2 LEARNING OBJECTIVE can differ from income tax expense. This can happen when there are temporary Describe a temporary difference that differences between the amounts reported for tax purposes and those reported for results in future taxable amounts. 1Determining the amount of tax to pay the IRS is a costly exercise for both individuals and
companies. Individuals and businesses must pay not only the taxes owed but also the costs of their own time spent filing and complying with the tax code, including (1) the tax collection costs of the IRS, and (2) the tax compliance outlays that individuals and businesses pay to help them file their taxes. One study estimated this cost to be 30 cents on every dollar sent to the government. Another study noted how big the tax compliance industry has become. According to the research, the tax compliance industry employs more people than all the workers at Wal-Mart, UPS, McDonald’s, IBM, and Citigroup combined. Source: A. Laffer, “The 30-Cent Tax Premium,” Wall Street Journal (April 18, 2011). 1120 Chapter 19 Accounting for Income Taxes book purposes. A temporary difference is the difference between the tax basis of an asset or liability and its reported (carrying or book) amount in the financial statements, which will result in taxable amounts or deductible amounts in future years. Taxable amounts increase taxable income in future years. Deductible amounts decrease taxable income in future years. In Chelsea’s situation, the only difference between the book basis and tax basis of the assets and liabilities relates to accounts receivable that arose from revenue recog- nized for book purposes. Illustration 19-5 indicates that Chelsea reports accounts receiv- able at $30,000 in the December 31, 2014, GAAP-basis balance sheet. However, the receivables have a zero tax basis. ILLUSTRATION 19-5 Per Books 12/31/14 Per Tax Return 12/31/14 Temporary Difference, Accounts receivable $30,000 Accounts receivable $–0– Sales Revenue What will happen to the $30,000 temporary difference that originated in 2014 for Chelsea? Assuming that Chelsea expects to collect $20,000 of the receivables in 2015 and $10,000 in 2016, this collection results in future taxable amounts of $20,000 in 2015 and $10,000 in 2016. These future taxable amounts will cause taxable income to exceed pretax financial income in both 2015 and 2016. An assumption inherent in a company’s GAAP balance sheet is that companies recover and settle the assets and liabilities at their reported amounts (carrying amounts). This assumption creates a requirement under accrual accounting to recognize currently the deferred tax consequences of temporary differences. That is, companies recognize the amount of income taxes that are payable (or refundable) when they recover and settle the reported amounts of the assets and liabilities, respectively. Illustration 19-6 shows the reversal of the temporary difference described in Illustration 19-5 and the resulting taxable amounts in future periods. ILLUSTRATION 19-6 Reversal of Temporary Cumulative Temporary Difference Future Taxable Amounts Difference, Chelsea Inc. (Taxable income lower than (Taxable income higher than pretax financial income) pretax financial income) 2014 2015 2016 $30,000 $20,000 $10,000 Chelsea assumes that it will collect the accounts receivable and report the $30,000 collection as taxable revenues in future tax returns. A payment of income tax in both 2015 and 2016 will occur. Chelsea should therefore record in its books in 2014 the deferred tax consequences of the revenue and related receivables reflected in the 2014 financial statements. Chelsea does this by recording a deferred tax liability. Deferred Tax Liability A deferred tax liability is the deferred tax consequences attributable to taxable tempo- rary differences. In other words, a deferred tax liability represents the increase in taxes payable in future years as a result of taxable temporary differences existing at the end of the current year. Recall from the Chelsea example that income taxes payable is $16,000 ($40,000 3 40%) in 2014 (Illustration 19-4 on page 1119). In addition, a temporary difference exists Fundamentals of Accounting for Income Taxes 1121 at year-end because Chelsea reports the revenue and related accounts receivable differ- ently for book and tax purposes. The book basis of accounts receivable is $30,000, and
the tax basis is zero. Thus, the total deferred tax liability at the end of 2014 is $12,000, computed as shown in Illustration 19-7. ILLUSTRATION 19-7 Book basis of accounts receivable $30,000 Computation of Deferred Tax basis of accounts receivable –0– Tax Liability, End of 2014 Cumulative temporary difference at the end of 2014 30,000 Tax rate 40% Deferred tax liability at the end of 2014 $12,000 Companies may also compute the deferred tax liability by preparing a schedule that indicates the future taxable amounts due to existing temporary differences. Such a schedule, as shown in Illustration 19-8, is particularly useful when the computations become more complex. ILLUSTRATION 19-8 Future Years Schedule of Future 2015 2016 Total Taxable Amounts Future taxable amounts $20,000 $10,000 $30,000 Tax rate 40% 40% Deferred tax liability at the end of 2014 $ 8,000 $ 4,000 $12,000 Because it is the first year of operations for Chelsea, there is no deferred tax liability at the beginning of the year. Chelsea computes the income tax expense for 2014 as shown in Illustration 19-9. ILLUSTRATION 19-9 Deferred tax liability at end of 2014 $12,000 Computation of Income Deferred tax liability at beginning of 2014 –0– Tax Expense, 2014 Deferred tax expense for 2014 12,000 Current tax expense for 2014 (income taxes payable) 16,000 Income tax expense (total) for 2014 $28,000 This computation indicates that income tax expense has two components—current tax expense (the amount of income taxes payable for the period) and deferred tax expense. Deferred tax expense is the increase in the deferred tax liability balance from the beginning to the end of the accounting period. Companies credit taxes due and payable to Income Taxes Payable, and credit the increase in deferred taxes to Deferred Tax Liability. They then debit the sum of those two items to Income Tax Expense. For Chelsea, it makes the following entry at the end of 2014. Income Tax Expense 28,000 Income Taxes Payable 16,000 Deferred Tax Liability 12,000 At the end of 2015 (the second year), the difference between the book basis and the tax basis of the accounts receivable is $10,000. Chelsea multiplies this difference by the applicable tax rate to arrive at the deferred tax liability of $4,000 ($10,000 3 40%), which it reports at the end of 2015. Income taxes payable for 2015 is $36,000 (Illustration 19-3 on page 1119), and the income tax expense for 2015 is as shown in Illustration 19-10 (page 1122). 1122 Chapter 19 Accounting for Income Taxes ILLUSTRATION 19-10 Deferred tax liability at end of 2015 $ 4,000 Computation of Income Deferred tax liability at beginning of 2015 12,000 Tax Expense, 2015 Deferred tax expense (benefit) for 2015 (8,000) Current tax expense for 2015 (income taxes payable) 36,000 Income tax expense (total) for 2015 $28,000 Chelsea records income tax expense, the change in the deferred tax liability, and income taxes payable for 2015 as follows. Income Tax Expense 28,000 Deferred Tax Liability 8,000 Income Taxes Payable 36,000 The entry to record income taxes at the end of 2016 reduces the Deferred Tax Liability by $4,000. The Deferred Tax Liability account appears as follows at the end of 2016. ILLUSTRATION 19-11 Deferred Tax Liability Deferred Tax Liability 2015 8,000 2014 12,000 Account after Reversals 2016 4,000 The Deferred Tax Liability account has a zero balance at the end of 2016. What do the numbers mean? “REAL LIABILITIES” Some analysts dismiss deferred tax liabilities when assessing 3. It represents a future sacrifi ce. Taxable income and taxes the fi nancial strength of a company. But the FASB indicates due in future periods will result from past events. The that the deferred tax liability meets the defi nition of a liabil- payment of these taxes when they come due is the future ity established in Statement of Financial Accounting Concepts sacrifi ce. No. 6, “Elements of Financial Statements” because: A study by B. Ayers indicates that the market views deferred 1. It results from a past transaction. In the Chelsea example, tax assets and liabilities similarly to other assets and liabili-
the company performed services for customers and rec- ties. Further, the study concludes that the FASB rules in this ognized revenue in 2014 for fi nancial reporting purposes area increased the usefulness of deferred tax amounts in but deferred it for tax purposes. fi nancial statements. 2. It is a present obligation. Taxable income in future periods will exceed pretax fi nancial income as a result of this temporary difference. Thus, a present obligation exists. Source: B. Ayers, “Deferred Tax Accounting Under SFAS No. 109: An Empirical Investigation of Its Incremental Value-Relevance Relative to APB No. 11,” The Accounting Review (April 1998). Summary of Income Tax Accounting Objectives One objective of accounting for income taxes is to recognize the amount of taxes payable or refundable for the current year. In Chelsea’s case, income taxes payable is $16,000 for 2014. A second objective is to recognize deferred tax liabilities and assets for the future tax consequences of events already recognized in the financial statements or tax returns. For example, Chelsea sold services to customers that resulted in accounts receivable of $30,000 in 2014. It reported that amount on the 2014 income statement, but not on the tax return as income. That amount will appear on future tax returns as income for the period when collected. As a result, a $30,000 temporary difference exists at the end of 2014, which will cause future taxable amounts. Chelsea reports a deferred tax liability of $12,000 on the balance sheet at the end of 2014, which represents the increase in taxes payable in future years ($8,000 in 2015 and $4,000 in 2016) as a result of a temporary difference existing at the end of the current year. The related deferred tax liability is reduced by $8,000 at the end of 2015 and by another $4,000 at the end of 2016. Fundamentals of Accounting for Income Taxes 1123 In addition to affecting the balance sheet, deferred taxes impact income tax expense in each of the three years affected. In 2014, taxable income ($40,000) is less than pretax financial income ($70,000). Income taxes payable for 2014 is therefore $16,000 (based on taxable income). Deferred tax expense of $12,000 results from the increase in the Deferred Tax Liability account on the balance sheet. Income tax expense is then $28,000 for 2014. In 2015 and 2016, however, taxable income will exceed pretax financial income, due to the reversal of the temporary difference ($20,000 in 2015 and $10,000 in 2016). Income taxes payable will therefore exceed income tax expense in 2015 and 2016. Chelsea will debit the Deferred Tax Liability account for $8,000 in 2015 and $4,000 in 2016. It records credits for these amounts in Income Tax Expense. These credits are often referred to as a deferred tax benefit (which we discuss again later on). Future Deductible Amounts and Deferred Taxes Assume that during 2014, Cunningham Inc. estimated its warranty costs related to 3 LEARNING OBJECTIVE the sale of microwave ovens to be $500,000, paid evenly over the next two years. Describe a temporary difference that For book purposes, in 2014 Cunningham reported warranty expense and a related results in future deductible amounts. estimated liability for warranties of $500,000 in its financial statements. For tax purposes, the warranty tax deduction is not allowed until paid. Therefore, Cunning- ham recognizes no warranty liability on a tax-basis balance sheet. Illustration 19-12 shows the balance sheet difference at the end of 2014. ILLUSTRATION 19-12 Per Books 12/31/14 Per Tax Return 12/31/14 Temporary Difference, Estimated liability for Estimated liability for Warranty Liability warranties $500,000 warranties $–0– When Cunningham pays the warranty liability, it reports an expense (deductible amount) for tax purposes. Because of this temporary difference, Cunningham should recognize in 2014 the tax benefits (positive tax consequences) for the tax deductions that will result from the future settlement of the liability. Cunningham reports this future tax benefit in the December 31, 2014, balance sheet as a deferred tax asset.
We can think about this situation another way. Deductible amounts occur in future tax returns. These future deductible amounts cause taxable income to be less than pretax financial income in the future as a result of an existing temporary difference. Cunningham’s temporary difference originates (arises) in one period (2014) and reverses over two periods (2015 and 2016). Illustration 19-13 diagrams this situation. ILLUSTRATION 19-13 Cumulative Temporary Difference Future Deductible Amounts Reversal of Temporary (Taxable income higher than (Taxable income lower than Difference, Cunningham pretax financial income) pretax financial income) Inc. 2014 2015 2016 $500,000 $250,000 $250,000 Deferred Tax Asset A deferred tax asset is the deferred tax consequence attributable to deductible tempo- rary differences. In other words, a deferred tax asset represents the increase in taxes refundable (or saved) in future years as a result of deductible temporary differences existing at the end of the current year. 1124 Chapter 19 Accounting for Income Taxes To illustrate, assume that Hunt Co. accrues a loss and a related liability of $50,000 in 2014 for financial reporting purposes because of pending litigation. Hunt cannot deduct this amount for tax purposes until the period it pays the liability, expected in 2015. As a result, a deductible amount will occur in 2015 when Hunt settles the liability (Estimated Litigation Liability), causing taxable income to be lower than pretax financial income. Illustration 19-14 shows the computation of the deferred tax asset at the end of 2014 (assuming a 40 percent tax rate). ILLUSTRATION 19-14 Book basis of litigation liability $50,000 Computation of Deferred Tax basis of litigation liability –0– Tax Asset, End of 2014 Cumulative temporary difference at the end of 2014 50,000 Tax rate 40% Deferred tax asset at the end of 2014 $20,000 Hunt can also compute the deferred tax asset by preparing a schedule that indicates the future deductible amounts due to deductible temporary differences. Illustration 19-15 shows this schedule. ILLUSTRATION 19-15 Future Years Schedule of Future Future deductible amounts $50,000 Deductible Amounts Tax rate 40% Deferred tax asset at the end of 2014 $20,000 Assuming that 2014 is Hunt’s first year of operations and income taxes payable is $100,000, Hunt computes its income tax expense as follows. ILLUSTRATION 19-16 Deferred tax asset at end of 2014 $ 20,000 Computation of Income Deferred tax asset at beginning of 2014 –0– Tax Expense, 2014 Deferred tax expense (benefit) for 2014 (20,000) Current tax expense for 2014 (income taxes payable) 100,000 Income tax expense (total) for 2014 $ 80,000 The deferred tax benefit results from the increase in the deferred tax asset from the beginning to the end of the accounting period (similar to the Chelsea example earlier). The deferred tax benefit is a negative component of income tax expense. The total income tax expense of $80,000 on the income statement for 2014 thus consists of two elements—current tax expense of $100,000 and a deferred tax benefit of $20,000. For Hunt, it makes the following journal entry at the end of 2014 to record income tax expense, deferred income taxes, and income taxes payable. Income Tax Expense 80,000 Deferred Tax Asset 20,000 Income Taxes Payable 100,000 At the end of 2015 (the second year), the difference between the book value and the tax basis of the litigation liability is zero. Therefore, there is no deferred tax asset at this date. Assuming that income taxes payable for 2015 is $140,000, Hunt computes income tax expense for 2015 as shown in Illustration 19-17. ILLUSTRATION 19-17 Deferred tax asset at the end of 2015 $ –0– Computation of Income Deferred tax asset at the beginning of 2015 20,000 Tax Expense, 2015 Deferred tax expense (benefit) for 2015 20,000 Current tax expense for 2015 (income taxes payable) 140,000 Income tax expense (total) for 2015 $160,000 Fundamentals of Accounting for Income Taxes 1125 The company records income taxes for 2015 as follows. Income Tax Expense 160,000
Deferred Tax Asset 20,000 Income Taxes Payable 140,000 The total income tax expense of $160,000 on the income statement for 2015 thus consists of two elements—current tax expense of $140,000 and deferred tax expense of $20,000. Illustration 19-18 shows the Deferred Tax Asset account at the end of 2015. ILLUSTRATION 19-18 Deferred Tax Asset Deferred Tax Asset 2014 20,000 2015 20,000 Account after Reversals What do the numbers mean? “REAL ASSETS” A key issue in accounting for income taxes is whether a com- probable future benefi t exists at the end of the current pany should recognize a deferred tax asset in the fi nancial period. records. Based on the conceptual defi nition of an asset, a de- 3. The entity controls access to the benefi ts. Hunt can ferred tax asset meets the three main conditions for an item obtain the benefi t of existing deductible temporary dif- to be recognized as an asset: ferences by reducing its taxes payable in the future. 1. It results from a past transaction. In the Hunt example, Hunt has the exclusive right to that benefi t and can control others’ access to it. the accrual of the loss contingency is the past event that gives rise to a future deductible temporary difference. Market analysts’ reactions to the write-off of deferred tax 2. It gives rise to a probable benefi t in the future. Taxable assets also supports their treatment as assets. When Bethlehem income exceeds pretax fi nancial income in the current Steel reported a $1 billion charge to write off a deferred tax year (2014). However, in the next year the exact oppo- asset, analysts believed that Bethlehem was s ignaling that it site occurs. That is, taxable income is lower than pretax would not realize the future benefi ts of the tax deductions. fi nancial income. Because this deductible temporary Thus, Bethlehem should write down the asset like other difference reduces taxes payable in the future, a assets. Source: J. Weil and S. Liesman, “Stock Gurus Disregard Most Big Write-Offs but They Often Hold Vital Clues to Outlook,” Wall Street Journal Online (December 31, 2001). Deferred Tax Asset—Valuation Allowance Companies recognize a deferred tax asset for all deductible temporary differences. 4 LEARNING OBJECTIVE However, a company should reduce a deferred tax asset by a valuation allowance Explain the purpose of a deferred tax if, based on available evidence, it is more likely than not that it will not realize asset valuation allowance. some portion or all of the deferred tax asset. “More likely than not” means a level of likelihood of at least slightly more than 50 percent. Assume that Jensen Co. has a deductible temporary difference of $1,000,000 at the end of its first year of operations. Its tax rate is 40 percent, which means it records a deferred tax asset of $400,000 ($1,000,000 3 40%). Assuming $900,000 of income taxes payable, Jensen records income tax expense, the deferred tax asset, and income taxes payable as follows. Income Tax Expense 500,000 Deferred Tax Asset 400,000 Income Taxes Payable 900,000 After careful review of all available evidence, Jensen determines that it is more likely than not that it will not realize $100,000 of this deferred tax asset. Jensen records this reduction in asset value as follows. Income Tax Expense 100,000 Allowance to Reduce Deferred Tax Asset to Expected Realizable Value 100,000 1126 Chapter 19 Accounting for Income Taxes This journal entry increases income tax expense in the current period because Jensen does not expect to realize a favorable tax benefit for a portion of the deductible tempo- rary difference. Jensen simultaneously establishes a valuation allowance to recognize the reduction in the carrying amount of the deferred tax asset. This valuation account is a contra account. Jensen reports it on the financial statements in the following manner. ILLUSTRATION 19-19 Deferred tax asset $400,000 Balance Sheet Less: Allowance to reduce deferred tax Presentation of Valuation asset to expected realizable value 100,000 Allowance Account Deferred tax asset (net) $300,000
Jensen then evaluates this allowance account at the end of each accounting period. If, at the end of the next period, the deferred tax asset is still $400,000 but now the company expects to realize $350,000 of this asset, Jensen makes the following entry to adjust the valuation account. Allowance to Reduce Deferred Tax Asset to Expected Realizable Value 50,000 Income Tax Expense 50,000 Jensen should consider all available evidence, both positive and negative, to determine whether, based on the weight of available evidence, it needs a valuation allowance. For example, if Jensen has been experiencing a series of loss years, it reasonably assumes that these losses will continue. Therefore, Jensen will lose the benefit of the future deductible amounts. We discuss the use of a valuation account under other conditions later in the chapter. Income Statement Presentation Circumstances dictate whether a company should add or subtract the change in LEARNING OBJECTIVE 5 deferred income taxes to or from income taxes payable in computing income tax Describe the presentation of income expense. For example, a company adds an increase in a deferred tax liability to income tax expense in the income statement. taxes payable. On the other hand, it subtracts an increase in a deferred tax asset from income taxes payable. The formula in Illustration 19-20 is used to compute income tax expense (benefit). ILLUSTRATION 19-20 Total Formula to Compute Income Taxes Change in Income Tax Income Tax Expense Payable or 6 Deferred Inc ome 5 Expense or Refundable Taxes Benefit In the income statement or in the notes to the financial statements, a company should disclose the significant components of income tax expense attributable to continuing operations. Given the information related to Chelsea on page 1121, Chelsea reports its income statement as follows. ILLUSTRATION 19-21 CHELSEA INC. Income Statement INCOME STATEMENT Presentation of Income FOR THE YEAR ENDING DECEMBER 31, 2014 Tax Expense Revenues $130,000 Expenses 60,000 Income before income taxes 70,000 Income tax expense Current $16,000 Deferred 12,000 28,000 Net income $ 42,000 Fundamentals of Accounting for Income Taxes 1127 As illustrated, Chelsea reports both the current portion (amount of income taxes payable for the period) and the deferred portion of income tax expense. Another option is to simply report the total income tax expense on the income statement and then indi- cate in the notes to the financial statements the current and deferred portions. Income tax expense is often referred to as “Provision for income taxes.” Using this terminology, the current provision is $16,000, and the provision for deferred taxes is $12,000. Specifi c Differences Numerous items create differences between pretax financial income and taxable 6 LEARNING OBJECTIVE income. For purposes of accounting recognition, these differences are of two types: Describe various temporary and (1) temporary, and (2) permanent. permanent differences. Temporary Differences Taxable temporary differences are temporary differences that will result in taxable amounts in future years when the related assets are recovered. Deductible temporary differences are temporary differences that will result in deductible amounts in future years, when the related book liabilities are settled. As discussed earlier, taxable temporary differences give rise to recording deferred tax liabilities. Deductible temporary differences give rise to recording deferred tax assets. Illustration 19-22 ILLUSTRATION 19-22 provides examples of temporary differences. Examples of Temporary Differences Revenues or gains are taxable after they are recognized in financial income. An asset (e.g., accounts receivable or investment) may be recognized for revenues or gains that will result in taxable amounts in future years when the asset is recovered. Examples: 1. Sales accounted for on the accrual basis for financial reporting purposes and on the installment (cash) basis for tax purposes. 2. Contracts accounted for under the percentage-of-completion method for financial reporting purposes and a portion of related gross
profit deferred for tax purposes. 3. Investments accounted for under the equity method for financial reporting purposes and under the cost method for tax purposes. 4. Gain on involuntary conversion of nonmonetary asset which is recognized for financial reporting purposes but deferred for tax purposes. 5. Unrealized holding gains for financial reporting purposes (including use of the fair value option), but deferred for tax purposes. Expenses or losses are deductible after they are recognized in financial income. A liability (or contra asset) may be recognized for expenses or losses that will result in deductible amounts in future years when the liability is settled. Examples: 1. Product warranty liabilities. 2. Estimated liabilities related to discontinued operations or restructurings. 3. Litigation accruals. 4. Bad debt expense recognized using the allowance method for financial reporting purposes; direct write-off method used for tax purposes. 5. Stock-based compensation expense. 6. Unrealized holding losses for financial reporting purposes (including use of the fair value option), but deferred for tax purposes. Revenues or gains are taxable before they are recognized in financial income. A liability may be recognized for an advance payment for goods or services to be provided in future years. For tax purposes, the advance payment is included in taxable income upon the receipt of cash. Future sacrifices to provide goods or services (or future refunds to those who cancel their orders) that settle the liability will result in deductible amounts in future years. Examples: 1. Subscriptions received in advance. 2. Advance rental receipts. 3. Sales and leasebacks for financial reporting purposes (income deferral) but reported as sales for tax purposes. 4. Prepaid contracts and royalties received in advance. Expenses or losses are deductible before they are recognized in financial income. The cost of an asset may have been deducted for tax purposes faster than it was expensed for financial reporting purposes. Amounts received upon future recovery of the amount of the asset for financial reporting (through use or sale) will exceed the remaining tax basis of the asset and thereby result in taxable amounts in future years. Examples: 1. Depreciable property, depletable resources, and intangibles. 2. Deductible pension funding exceeding expense. 3. Prepaid expenses that are deducted on the tax return in the period paid. 1128 Chapter 19 Accounting for Income Taxes Determining a company’s temporary differences may prove difficult. A company should prepare a balance sheet for tax purposes that it can compare with its GAAP balance sheet. Many of the differences between the two balance sheets are temporary differences. Originating and Reversing Aspects of Temporary Differences. An originating temporary difference is the initial difference between the book basis and the tax basis of an asset or liability, regardless of whether the tax basis of the asset or liability exceeds or is exceeded by the book basis of the asset or liability. A reversing difference, on the other hand, occurs when eliminating a temporary difference that originated in prior periods and then removing the related tax effect from the deferred tax account. For example, assume that Sharp Co. has tax depreciation in excess of book depre- ciation of $2,000 in 2012, 2013, and 2014. Further, it has an excess of book depreciation over tax depreciation of $3,000 in 2015 and 2016 for the same asset. Assuming a tax rate of 30 percent for all years involved, the Deferred Tax Liability account reflects the following. ILLUSTRATION 19-23 Deferred Tax Liability Tax Effects of Originating Tax Effects 2015 900 2012 600 Tax Effects and Reversing of 2016 900 2013 600 of Differences Reversing Differences e 2014 600 Originating Differences ¶ The originating differences for Sharp in each of the first three years are $2,000. The related tax effect of each originating difference is $600. The reversing differences in 2015 and 2016 are each $3,000. The related tax effect of each is $900.
Permanent Differences International Some differences between taxable income and pretax financial income are Perspective permanent. Permanent differences result from items that (1) enter into pretax financial income but never into taxable income, or (2) enter into taxable income If companies switch to IFRS, but never into pretax financial income. the impact on tax accounting Congress has enacted a variety of tax law provisions to attain certain political, methods will require consider- ation. For example, in cases in economic, and social objectives. Some of these provisions exclude certain reve- which GAAP and tax rules are nues from taxation, limit the deductibility of certain expenses, and permit the the same, what happens if IFRS deduction of certain other expenses in excess of costs incurred. A corporation that is different from GAAP? Should has tax-free income, nondeductible expenses, or allowable deductions in excess of the tax method change to IFRS? cost has an effective tax rate that differs from its statutory (regular) tax rate. And what might happen at the Since permanent differences affect only the period in which they occur, they state level, due to changes in do not give rise to future taxable or deductible amounts. As a result, companies the fi nancial reporting rules? recognize no deferred tax consequences. Illustration 19-24 shows examples of permanent differences. ILLUSTRATION 19-24 Examples of Permanent Items are recognized for financial reporting purposes but not for tax purposes. Differences Examples: 1. Interest received on state and municipal obligations. 2. Expenses incurred in obtaining tax-exempt income. 3. Proceeds from life insurance carried by the company on key officers or employees. 4. Premiums paid for life insurance carried by the company on key officers or employees (company is beneficiary). 5. Fines and expenses resulting from a violation of law. Items are recognized for tax purposes but not for financial reporting purposes. Examples: 1. “Percentage depletion” of natural resources in excess of their cost. 2. The deduction for dividends received from U.S. corporations, generally 70% or 80%. Fundamentals of Accounting for Income Taxes 1129 Examples of Temporary and Permanent Differences To illustrate the computations used when both temporary and permanent differences exist, assume that Bio-Tech Company reports pretax financial income of $200,000 in each of the years 2012, 2013, and 2014. The company is subject to a 30 percent tax rate and has the following differences between pretax financial income and taxable income. 1. Bio-Tech reports gross profi t of $18,000 from an installment sale in 2012 for tax pur- poses over an 18-month period at a constant amount per month beginning January 1, 2013. It recognizes the entire amount for book purposes in 2012. 2. It pays life insurance premiums for its key offi cers of $5,000 in 2013 and 2014. Although not tax-deductible, Bio-Tech expenses the premiums for book purposes. The installment sale is a temporary difference, whereas the life insurance premium is a permanent difference. Illustration 19-25 shows the reconciliation of Bio-Tech’s pretax financial income to taxable income and the computation of income taxes payable. ILLUSTRATION 19-25 2012 2013 2014 Reconciliation and Pretax financial income $200,000 $200,000 $200,000 Computation of Income Permanent difference Taxes Payable Nondeductible expense 5,000 5,000 Temporary difference Installment sale (18,000) 12,000 6,000 Taxable income 182,000 217,000 211,000 Tax rate 30% 30% 30% Income taxes payable $ 54,600 $ 65,100 $ 63,300 Note that Bio-Tech deducts the installment-sales gross profit from pretax financial income to arrive at taxable income. The reason: Pretax financial income includes the installment-sales gross profit; taxable income does not. Conversely, it adds the $5,000 insurance premium to pretax financial income to arrive at taxable income. The reason: Pretax financial income records an expense for this premium, but for tax purposes the premium is not deductible. As a result, pretax financial income is lower than taxable
income. Therefore, the life insurance premium must be added back to pretax financial income to reconcile to taxable income. Bio-Tech records income taxes for 2012, 2013, and 2014 as follows. December 31, 2012 Income Tax Expense ($54,600 1 $5,400) 60,000 Deferred Tax Liability ($18,000 3 30%) 5,400 Income Taxes Payable ($182,000 3 30%) 54,600 December 31, 2013 Income Tax Expense ($65,100 2 $3,600) 61,500 Deferred Tax Liability ($12,000 3 30%) 3,600 Income Taxes Payable ($217,000 3 30%) 65,100 December 31, 2014 Income Tax Expense ($63,300 2 $1,800) 61,500 Deferred Tax Liability ($6,000 3 30%) 1,800 Income Taxes Payable ($211,000 3 30%) 63,300 Bio-Tech has one temporary difference, which originates in 2012 and reverses in 2013 and 2014. It recognizes a deferred tax liability at the end of 2012 because the tem- porary difference causes future taxable amounts. As the temporary difference reverses, 1130 Chapter 19 Accounting for Income Taxes Bio-Tech reduces the deferred tax liability. There is no deferred tax amount associated with the difference caused by the nondeductible insurance expense because it is a permanent difference. Although an enacted tax rate of 30 percent applies for all three years, the effective rate differs from the enacted rate in 2013 and 2014. Bio-Tech computes the effective tax rate by dividing total income tax expense for the period by pretax financial income. The effective rate is 30 percent for 2012 ($60,000 4 $200,000 5 30%) and 30.75 percent for 2013 and 2014 ($61,500 4 $200,000 5 30.75%). Tax Rate Considerations In our previous illustrations, the enacted tax rate did not change from one year LEARNING OBJECTIVE 7 to the next. Thus, to compute the deferred income tax amount to report on the Explain the effect of various tax rates balance sheet, a company simply multiplies the cumulative temporary difference and tax rate changes on deferred by the current tax rate. Using Bio-Tech as an example, it multiplies the cumulative income taxes. temporary difference of $18,000 by the enacted tax rate, 30 percent in this case, to arrive at a deferred tax liability of $5,400 ($18,000 3 30%) at the end of 2012. Future Tax Rates What happens if tax rates are expected to change in the future? In this case, a company should use the enacted tax rate expected to apply. Therefore, a company must consider presently enacted changes in the tax rate that become effective for a particular future year(s) when determining the tax rate to apply to existing temporary differences. For example, assume that Warlen Co. at the end of 2011 has the following cumulative tem- porary difference of $300,000, computed as shown in Illustration 19-26. ILLUSTRATION 19-26 Book basis of depreciable assets $1,000,000 Computation of Tax basis of depreciable assets 700,000 Cumulative Temporary Cumulative temporary difference $ 300,000 Difference Furthermore, assume that the $300,000 will reverse and result in taxable amounts in the future, with the enacted tax rates shown in Illustration 19-27. ILLUSTRATION 19-27 2012 2013 2014 2015 2016 Total Deferred Tax Liability Future taxable amounts $80,000 $70,000 $60,000 $50,000 $40,000 $300,000 Based on Future Rates Tax rate 40% 40% 35% 30% 30% Deferred tax liability $32,000 $28,000 $21,000 $15,000 $12,000 $108,000 The total deferred tax liability at the end of 2011 is $108,000. Warlen may only use tax rates other than the current rate when the future tax rates have been enacted, as is the case in this example. If new rates are not yet enacted for future years, Warlen should use the current rate. In determining the appropriate enacted tax rate for a given year, companies must use the average tax rate. The Internal Revenue Service and other taxing jurisdictions tax income on a graduated tax basis. For a U.S. corporation, the IRS taxes the first $50,000 of taxable income at 15 percent, the next $25,000 at 25 percent, with higher incremental levels of income at rates as high as 39 percent. In computing deferred income taxes, companies for which graduated tax rates are a significant factor must therefore deter-
mine the average tax rate and use that rate. Fundamentals of Accounting for Income Taxes 1131 What do the numbers mean? GLOBAL TAX RATES If you are concerned about your tax rate and the taxes you United States 40.0% Germany 29.5% pay, you might want to consider moving to Switzerland, Japan 38.0 Luxembourg 28.8 Belgium 33.9 New Zealand 28.0 which has a personal tax rate of anywhere from zero percent France 33.3 Spain 28.0 to 13.2 percent. You don’t want to move to Denmark though. Australia 30.0 Canada 26.0 Yes, the people of Denmark are regularly voted to be the hap- On the low end of the tax rate spectrum are Iceland and I reland, piest people on Earth but it’s uncertain how many of these with tax rates of 15 percent and 12.5 percent, respectively. In- polls take place at tax time. The government in Denmark deed, corporate tax rates have been dropping around the world charges income tax rates ranging from 38 percent to 59 per- as countries attempt to spur capital investment, which in turn cent. So, taxes are a major item to many individuals, wherever spurs international tax competition. However, with stagnant they reside. global economic growth, there is concern that governments Taxes are also a big deal to corporations. For example, the will target increases in corporate tax rates as a source of reve- Organisation for Economic Co-operation and Development nues to address budget shortfalls. In addition, further expan- (OECD) is an international organization of 30 countries that sion of value-added taxes (VAT) is being considered. Indirect accepts the principles of a free-market economy. Most OECD taxes such as VAT are charged on consumption of goods and members are high-income economies and are regarded as services, which is much more stable than the corporate tax. developed countries. However, companies in the OECD can If these tax proposals result in changes in the tax rates be subject to signifi cant tax levies, as indicated in the follow- applied to future deductible and taxable amounts, be pre- ing list of the ten highest corporate income tax rates for the pared for signifi cant remeasurement of deferred tax assets OECD countries. and liabilities. Source: The rates reported refl ect the base corporate rate in effect in 2012. Effective rates paid may vary depending on country-specifi c addi- tional levies for such items as unemployment and local taxes, and, in the case of Japan, earthquake damage assessments. Effective rates may be lower due to credits for investments and capital gains. See http://www.kpmg.com/global/en/services/tax/tax-tools-and-resources/pages/tax-rates- online.aspx. See also P. Toscano, “The World’s Highest Tax Rates,” http://www.cnbc.com/id/30727913 (May 13, 2009). Revision of Future Tax Rates When a change in the tax rate is enacted, companies should record its effect on the existing deferred income tax accounts immediately. A company reports the effect as an adjustment to income tax expense in the period of the change. Assume that on December 10, 2011, a new income tax act is signed into law that lowers the corporate tax rate from 40 percent to 35 percent, effective January 1, 2013. If Hostel Co. has one temporary difference at the beginning of 2011 related to $3 million of excess tax depreciation, then it has a Deferred Tax Liability account with a balance of $1,200,000 ($3,000,000 3 40%) at January 1, 2011. If taxable amounts related to this dif- ference are scheduled to occur equally in 2012, 2013, and 2014, the deferred tax liability at the end of 2011 is $1,100,000, computed as follows. ILLUSTRATION 19-28 2012 2013 2014 Total Schedule of Future Future taxable amounts $1,000,000 $1,000,000 $1,000,000 $3,000,000 Taxable Amounts and Tax rate 40% 35% 35% Related Tax Rates Deferred tax liability $ 400,000 $ 350,000 $ 350,000 $1,100,000 Hostel, therefore, recognizes the decrease of $100,000 ($1,200,000 2 $1,100,000) at the end of 2011 in the deferred tax liability as follows. Deferred Tax Liability 100,000 Income Tax Expense 100,000 1132 Chapter 19 Accounting for Income Taxes
Corporate tax rates do not change often. Therefore, companies usually employ the current rate. However, state and foreign tax rates change more frequently, and they require adjustments in deferred income taxes accordingly.2 ACCOUNTING FOR NET OPERATING LOSSES Every management hopes its company will be profitable. But hopes and profits LEARNING OBJECTIVE 8 may not materialize. For a start-up company, it is common to accumulate operating Apply accounting procedures for a loss losses while expanding its customer base but before realizing economies of scale. carryback and a loss carryforward. For an established company, a major event such as a labor strike, rapidly changing regulatory and competitive forces, a disaster such as 9/11, or a general economic reces- sion can cause expenses to exceed revenues—a net operating loss. A net operating loss (NOL) occurs for tax purposes in a year when tax-deductible expenses exceed taxable revenues. An inequitable tax burden would result if companies were taxed during profitable periods without receiving any tax relief during periods of net operating losses. Under certain circumstances, therefore, the federal tax laws permit taxpayers to use the losses of one year to offset the profits of other years. Companies accomplish this income-averaging provision through the carryback and carryforward of net operating losses. Under this provision, a company pays no income taxes for a year in which it incurs a net operating loss. In addition, it may select one of the two options discussed below and on the following pages. Loss Carryback Through use of a loss carryback, a company may carry the net operating loss back two years and receive refunds for income taxes paid in those years. The company must apply the loss to the earlier year first and then to the second year. It may carry forward any loss remaining after the two-year carryback up to 20 years to offset future taxable income. Illustration 19-29 diagrams the loss carryback procedure, assuming a loss in 2014. ILLUSTRATION 19-29 Loss Carryback Net Operating Loss Procedure (Loss Carryback) 2014 2012 2013 2015 2016 2034 (Loss) Loss Carryback Loss Carryforward 2 Years Back 20 Years Forward Loss Carryforward A company may forgo the loss carryback and use only the loss carryforward option, offsetting future taxable income for up to 20 years. Illustration 19-30 shows this approach. 2Tax rate changes nearly always will substantially impact income numbers and the reporting of deferred income taxes on the balance sheet. As a result, you can expect to hear an economic consequences argument every time that Congress decides to change the tax rates. For example, when Congress raised the corporate rate from 34 percent to 35 percent in 1993, companies took an additional “hit” to earnings if they were in a deferred tax liability position. Thus, corporate America is following closely the recent budget and deficit-reduction negotiations. Some proposals will eliminate certain corporate deductions (or loopholes) in order to “broaden the tax base” and therefore allow for lower tax rates. Depending on a company’s deferred tax position, a change in tax rates can have a positive or negative effect on net income. Accounting for Net Operating Losses 1133 ILLUSTRATION 19-30 Net Operating Loss Loss Carryforward (Loss Carryforward) Procedure 2014 2012 2013 2015 2016 2034 (Loss) Loss Carryforward 20 Years Forward Operating losses can be substantial. For example, Yahoo! at one time had net operat- ing losses of approximately $5.4 billion. That amount translates into tax savings of $1.4 billion if Yahoo! is able to generate taxable income before the NOLs expire. Loss Carryback Example To illustrate the accounting procedures for a net operating loss carryback, assume that Groh Inc. has no temporary or permanent differences. Groh experiences the following. Taxable Income Year or Loss Tax Rate Tax Paid 2011 $ 50,000 35% $17,500 2012 100,000 30% 30,000 2013 200,000 40% 80,000 2014 (500,000) — –0– In 2014, Groh incurs a net operating loss that it decides to carry back. Under the law,
Groh must apply the carryback first to the second year preceding the loss year. There- fore, it carries the loss back first to 2012. Then, Groh carries back any unused loss to 2013. Accordingly, Groh files amended tax returns for 2012 and 2013, receiving refunds for the $110,000 ($30,000 1 $80,000) of taxes paid in those years. For accounting as well as tax purposes, the $110,000 represents the tax effect (tax benefit) of the loss carryback. Groh should recognize this tax effect in 2014, the loss year. Since the tax loss gives rise to a refund that is both measurable and currently realizable, Groh should recognize the associated tax benefit in this loss period. Groh makes the following journal entry for 2014. Income Tax Refund Receivable 110,000 Benefit Due to Loss Carryback (Income Tax Expense) 110,000 Groh reports the account debited, Income Tax Refund Receivable, on the balance sheet as a current asset at December 31, 2014. It reports the account credited on the income statement for 2014 as shown in Illustration 19-31. ILLUSTRATION 19-31 GROH INC. Recognition of Benefi t of INCOME STATEMENT (PARTIAL) FOR 2014 the Loss Carryback in the Operating loss before income taxes $(500,000) Loss Year Income tax benefit Benefit due to loss carryback 110,000 Net loss $(390,000) Since the $500,000 net operating loss for 2014 exceeds the $300,000 total taxable income from the 2 preceding years, Groh carries forward the remaining $200,000 loss. 1134 Chapter 19 Accounting for Income Taxes Loss Carryforward Example If a carryback fails to fully absorb a net operating loss, or if the company decides not to carry the loss back, then it can carry forward the loss for up to 20 years.3 Because com- panies use carryforwards to offset future taxable income, the tax effect of a loss carry- forward represents future tax savings. Realization of the future tax benefit depends on future earnings, an uncertain prospect. The key accounting issue is whether there should be different requirements for rec- ognition of a deferred tax asset for (a) deductible temporary differences, and (b) operat- ing loss carryforwards. The FASB’s position is that in substance these items are the same—both are tax-deductible amounts in future years. As a result, the Board concluded that there should not be different requirements for recognition of a deferred tax asset from deductible temporary differences and operating loss carryforwards.4 Carryforward without Valuation Allowance To illustrate the accounting for an operating loss carryforward, return to the Groh e xample from the preceding section. In 2014, the company records the tax effect of the $200,000 loss carryforward as a deferred tax asset of $80,000 ($200,000 3 40%), assuming that the enacted future tax rate is 40 percent. Groh records the benefits of the carryback and the carryforward in 2014 as follows. To recognize benefit of loss carryback Income Tax Refund Receivable 110,000 Benefit Due to Loss Carryback (Income Tax Expense) 110,000 To recognize benefit of loss carryforward Deferred Tax Asset 80,000 Benefit Due to Loss Carryforward (Income Tax Expense) 80,000 Groh realizes the income tax refund receivable of $110,000 immediately as a refund of taxes paid in the past. It establishes a Deferred Tax Asset account for the benefits of future tax savings. The two accounts credited are contra income tax expense items, which Groh presents on the 2014 income statement shown in Illustration 19-32. ILLUSTRATION 19-32 GROH INC. Recognition of the INCOME STATEMENT (PARTIAL) FOR 2014 Benefi t of the Loss Carryback and Operating loss before income taxes $(500,000) Carryforward in the Income tax benefit Benefit due to loss carryback $110,000 Loss Year Benefit due to loss carryforward 80,000 190,000 Net loss $(310,000) The current tax benefit of $110,000 is the income tax refundable for the year. Groh determines this amount by applying the carryback provisions of the tax law to the tax- able loss for 2014. The $80,000 is the deferred tax benefit for the year, which results from an increase in the deferred tax asset.
3The length of the carryforward and carryback periods has varied. The carryforward period has increased from 7 years to 20 years over a period of time. As part of the Economic Recovery Act of 2009, Congress enacted a temporary extension of the carryback period from 2 to 5 years for operating losses incurred in 2008 and 2009. It is estimated that the companies in the S&P 500 will reap a refund of $5 billion due to this change. See D. Zion, A. Varshney, and C. Cornett, “Spinning Losses into Gold,” Equity Research—Accounting and Tax, Credit Suisse (November 12, 2009). 4This requirement is controversial because many believe it is inappropriate to recognize deferred tax assets except when assured beyond a reasonable doubt. Others argue that companies should never recognize deferred tax assets for loss carryforwards until realizing the income in the future. Accounting for Net Operating Losses 1135 For 2015, assume that Groh returns to profitable operations and has taxable income of $250,000 (prior to adjustment for the NOL carryforward), subject to a 40 percent tax rate. Groh then realizes the benefits of the carryforward for tax purposes in 2015, which it recognized for accounting purposes in 2014. Groh computes the income taxes payable for 2015 as shown in Illustration 19-33. ILLUSTRATION 19-33 Taxable income prior to loss carryforward $ 250,000 Computation of Income Loss carryforward deduction (200,000) Taxes Payable with Taxable income for 2015 50,000 Realized Loss Tax rate 40% Carryforward Income taxes payable for 2015 $ 20,000 Groh records income taxes in 2015 as follows. Income Tax Expense 100,000 Deferred Tax Asset 80,000 Income Taxes Payable 20,000 The benefits of the NOL carryforward, realized in 2015, reduce the Deferred Tax Asset account to zero. The 2015 income statement that appears in Illustration 19-34 does not report the tax effects of either the loss carryback or the loss carryforward because Groh had reported both previously. ILLUSTRATION 19-34 GROH INC. Presentation of the INCOME STATEMENT (PARTIAL) FOR 2015 Benefi t of Loss Income before income taxes $250,000 Carryforward Realized in Income tax expense 2015, Recognized in 2014 Current $20,000 Deferred 80,000 100,000 Net income $150,000 Carryforward with Valuation Allowance Let us return to the Groh example. Assume that it is more likely than not that Groh will not realize the entire NOL carryforward in future years. In this situation, Groh records the tax benefits of $110,000 associated with the $300,000 NOL carryback, as we previously described. In addition, it records Deferred Tax Asset of $80,000 ($200,000 3 40%) for the potential benefits related to the loss carryforward, and an allowance to reduce the deferred tax asset by the same amount. Groh makes the following journal entries in 2014. To recognize benefit of loss carryback Income Tax Refund Receivable 110,000 Benefit Due to Loss Carryback (Income Tax Expense) 110,000 To recognize benefit of loss carryforward Deferred Tax Asset 80,000 Benefit Due to Loss Carryforward (Income Tax Expense) 80,000 To record allowance amount Benefit Due to Loss Carryforward (Income Tax Expense) 80,000 Allowance to Reduce Deferred Tax Asset to Expected Realizable Value 80,000 The latter entry indicates that because positive evidence of sufficient quality and quantity is unavailable to counteract the negative evidence, Groh needs a valuation allowance. 1136 Chapter 19 Accounting for Income Taxes Illustration 19-35 shows Groh’s 2014 income statement presentation. ILLUSTRATION 19-35 GROH INC. Recognition of Benefi t of INCOME STATEMENT (PARTIAL) FOR 2014 Loss Carryback Only Operating loss before income taxes $(500,000) Income tax benefit Benefit due to loss carryback 110,000 Net loss $(390,000) In 2015, assuming that Groh has taxable income of $250,000 (before considering the carryforward) subject to a tax rate of 40 percent, it realizes the deferred tax asset. It thus no longer needs the allowance. Groh records the following entries. To record current and deferred income taxes Income Tax Expense 100,000 Deferred Tax Asset 80,000
Income Taxes Payable 20,000 To eliminate allowance and recognize loss carryforward Allowance to Reduce Deferred Tax Asset to Expected Realizable Value 80,000 Benefit Due to Loss Carryforward (Income Tax Expense) 80,000 Groh reports the $80,000 Benefit Due to the Loss Carryforward on the 2015 income statement. The company did not recognize it in 2014 because it was more likely than not that it would not be realized. Assuming that Groh derives the income for 2015 from continuing operations, it prepares the income statement as shown in Illustration 19-36. ILLUSTRATION 19-36 GROH INC. Recognition of Benefi t of INCOME STATEMENT (PARTIAL) FOR 2015 Loss Carryforward When Realized Income before income taxes $250,000 Income tax expense Current $ 20,000 Deferred 80,000 Benefit due to loss carryforward (80,000) 20,000 Net income $230,000 Another method is to report only one line for total income tax expense of $20,000 on the face of the income statement and disclose the components of income tax expense in the notes to the financial statements. Valuation Allowance Revisited A company should consider all positive and negative information in determining whether it needs a valuation allowance. Whether the company will realize a deferred tax asset depends on whether sufficient taxable income exists or will exist within the carryforward period available under tax law. Illustration 19-37 shows possible sources of taxable income that may be available under the tax law to realize a tax benefit for deductible temporary differences and carryforwards.5 5Companies implement a tax-planning strategy to realize a tax benefit for an operating loss or tax credit carryforward before it expires. Companies consider tax-planning strategies when assessing the need for and amount of a valuation allowance for deferred tax assets. Accounting for Net Operating Losses 1137 ILLUSTRATION 19-37 Taxable Income Sources Possible Sources of Taxable Income a. Future reversals of existing taxable temporary differences. b. Future taxable income exclusive of reversing temporary differences and carryforwards. c. Taxable income in prior carryback year(s) if carryback is permitted under the tax law. d. Tax-planning strategies that would, if necessary, be implemented to: (1) Accelerate taxable amounts to utilize expiring carryforwards. (2) C hange the character of taxable or deductible amounts from ordinary income or loss to capital gain See the FASB or loss. Codification section (3) Switch from tax-exempt to taxable investments. [1] (page 1156). If any one of these sources is sufficient to support a conclusion that a valuation allowance is unnecessary, a company need not consider other sources. Forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years. Companies may also cite positive evidence indicating that a valuation allowance is not needed. Illustra- tion 19-38 presents examples (not prerequisites) of evidence to consider when determin- ing the need for a valuation allowance.6 ILLUSTRATION 19-38 Negative Evidence Evidence to Consider in Evaluating the Need for a. A history of operating loss or tax credit carryforwards expiring unused. a Valuation Account b. Losses expected in early future years (by a presently profitable entity). c. Unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years. d. A carryback, carryforward period that is so brief that it would limit realization of tax benefits if (1) a significant deductible temporary difference is expected to reverse in a single year or (2) the enterprise operates in a traditionally cyclical business. Positive Evidence a. Existing contracts or firm sales backlog that will produce more than enough taxable income to realize the deferred tax asset based on existing sale prices and cost structures. b. An excess of appreciated asset value over the tax basis of the entity’s net assets in an amount sufficient to realize the deferred tax asset.
c. A strong earnings history exclusive of the loss that created the future deductible amount (tax loss carryforward or deductible temporary difference) coupled with evidence indicating that the loss is an aberration rather than a continuing condition (for example, the result of an unusual, infrequent, or extraordinary item). [2] The use of a valuation allowance provides a company with an opportunity International to manage its earnings. As one accounting expert notes, “The ‘more likely than Perspective not’ provision is perhaps the most judgmental clause in accounting.” Some Under IFRS (IAS 12), a company companies may set up a valuation account and then use it to increase income as may not recognize a deferred needed. Others may take the income immediately to increase capital or to offset tax asset unless realization is large negative charges to income. “probable.” However, “probable” is not defi ned in the standard, 6In contrast to the valuation allowance issue for Citigroup in the opening story, Sony leading to diversity in the recog- Corp. announced a $3.2 billion net loss, blaming a $4.4 billion write-off on a certain nition of deferred tax assets. portion of deferred tax assets in Japan, in what would be the company’s third straight year of red ink. The write-off is an admission that the March 2011 earthquake and tsunami have shattered its expectations for a robust current fiscal year. In the wake of the disaster, Sony temporarily shut 10 plants in and around the quake-hit region. Like other Japanese auto and electronics makers, Sony faced uncertainties because its recovery prospects are partially dependent on parts and materials suppliers, many of which have also been affected by the quake. Thus, the post-quake outlook put Sony in a position where it had to set aside reserves of ¥360 billion on certain deferred tax assets in its fiscal fourth quarter. See J. Osawa, “Sony Expects Hefty Loss: Electronics Giant Reverses Prediction for Full-Year Profit, Blaming Earthquake,” Wall Street Journal (May 24, 2011). 1138 Chapter 19 Accounting for Income Taxes What do the numbers mean? NOLs: GOOD NEWS OR BAD? Here are some net operating loss numbers reported by several notable companies. NOLs ($ in millions) Operating Loss Tax Benefit Company Income (Loss) Carryforward (Deferred Tax Asset) Comment Delta Air Lines, Inc. $(5,198.00) $7,500.00 $2,848.00 Begins to expire in 2022. Valuation allowance recorded. Goodyear 114.80 1,306.60 457.30 Begins to expire in next year. Full valuation allowance. Kodak 556.00 509.00 234.00 Begins to expire in next year. Valuation allowance on foreign credits only. Yahoo! 42.82 5,400.00 1,443.50 State and federal carryforwards. Begins to expire in next year. Valuation allowance recorded. All of these companies are using the carryforward provi- carryforwards, a company must have future taxable income sions of the tax code for their NOLs. For many of them, the in the carryforward period in order to claim the NOL deduc- NOL is an amount far exceeding their reported profi ts. Why tions. As we learned, if it is more likely than not that a com- carry forward the loss to get the tax deduction? First, the pany will not have taxable income, it must record a valuation company may have already used up the carryback provision, allowance (and increased tax expense). As the data above in- which allows only a two-year carryback period. (Carryfor- dicate, recording a valuation allowance to refl ect the uncer- wards can be claimed up to 20 years in the future.) In some tainty of realizing the tax benefi ts has merit. But for some, the cases, management expects the tax rates in the future to be NOL benefi ts begin to expire in the following year, which higher. This difference in expected rates provides a bigger tax may be not enough time to generate suffi cient taxable in- benefi t if the losses are carried forward and matched against come in order to claim the NOL deduction. future income. Is there a downside? To realize the benefi ts of Source: Company annual reports. FINANCIAL STATEMENT PRESENTATION
Balance Sheet Deferred tax accounts are reported on the balance sheet as assets and liabilities. LEARNING OBJECTIVE 9 Companies should classify these accounts as a net current amount and a net non- Describe the presentation of deferred current amount. An individual deferred tax liability or asset is classified as cur- income taxes in financial statements. rent or noncurrent based on the classification of the related asset or liability for financial reporting purposes. A company considers a deferred tax asset or liability to be related to an asset or l iability if reduction of the asset or liability causes the temporary difference to reverse or turn around. A company should classify a deferred tax liability or asset that is unrelated to an asset or liability for financial reporting, including a deferred tax asset related to a loss carryforward, according to the expected reversal date of the temporary difference. To illustrate, assume that Morgan Inc. records bad debt expense using the allowance method for accounting purposes and the direct write-off method for tax purposes. It currently has Accounts Receivable and Allowance for Doubtful Accounts balances of $2 million and $100,000, respectively. In addition, given a 40 percent tax rate, Morgan has a debit balance in the Deferred Tax Asset account of $40,000 (40% 3 $100,000). It considers the $40,000 debit balance in the Deferred Tax Asset account to be related to the Accounts Receivable and the Allowance for Doubtful Accounts balances because collection or write-off of the receivables will cause the temporary difference to reverse. Therefore, Financial Statement Presentation 1139 Morgan classifies the Deferred Tax Asset account as current, the same as the Accounts Receivable and Allowance for Doubtful Accounts balances. In practice, most companies engage in a large number of transactions that give rise to deferred taxes. Companies should classify the balances in the deferred tax accounts on the balance sheet in two categories: one for the net current amount, and one for the net noncurrent amount. We summarize this procedure as follows. 1. Classify the amounts as current or non-current. If related to a specifi c asset or liabil- ity, classify the amounts in the same manner as the related asset or liability. If not related, classify them on the basis of the expected reversal date of the temporary difference. 2. Determine the net current amount by summing the various deferred tax assets and liabilities classifi ed as current. If the net result is an asset, report it on the balance sheet as a current asset; if a liability, report it as a current liability. 3. Determine the net non-current amount by summing the various deferred tax assets and liabilities classifi ed as noncurrent. If the net result is an asset, report it on the balance sheet as a noncurrent asset; if a liability, report it as a long-term liability. To illustrate, assume that K. Scott Company has four deferred tax items at December 31, 2014. Illustration 19-39 shows an analysis of these four temporary differences as current or noncurrent. ILLUSTRATION 19-39 Related Classifi cation of Resulting Balance Deferred Tax Sheet Temporary Differences as Temporary Difference (Asset) Liability Account Classification Current or Noncurrent 1. Rent collected in advance: recognized when earned for accounting purposes and when Unearned received for tax purposes. $(42,000) Rent Current 2. Use of straight-line depreciation for accounting purposes and accelerated depreciation for tax purposes. $214,000 Equipment Noncurrent 3. Recognition of profits on installment sales during period of sale for accounting purposes Installment and during period of collection Accounts for tax purposes. 45,000 Receivable Current 4. Warranty liabilities: recognized Estimated for accounting purposes at time Liability of sale; for tax purpose at time under paid. (12,000) Warranties Current Totals $(54,000) $259,000 K. Scott classifies as current a deferred tax asset of $9,000 ($42,000 1 $12,000 2 $45,000). It also reports as noncurrent a deferred tax liability of $214,000. Consequently,
K. Scott’s December 31, 2014, balance sheet reports deferred income taxes as shown in Illustration 19-40. ILLUSTRATION 19-40 Current assets Balance Sheet Deferred tax asset $ 9,000 Presentation of Deferred Long-term liabilities Income Taxes Deferred tax liability $214,000 1140 Chapter 19 Accounting for Income Taxes As we indicated earlier, a deferred tax asset or liability may not be related to an asset or liability for financial reporting purposes. One example is an operating loss carry- forward. In this case, a company records a deferred tax asset, but there is no related, identifiable asset or liability for financial reporting purposes. In these limited situations, deferred income taxes are classified according to the expected reversal date of the tem- porary difference. That is, a company should report the tax effect of any temporary dif- ference reversing next year as current, and the remainder as noncurrent. If a deferred tax asset is noncurrent, a company should classify it in the “Other assets” section. The total of all deferred tax liabilities, the total of all deferred tax assets, and the total valuation allowance should be disclosed. In addition, companies should disclose the following: (1) any net change during the year in the total valuation allowance, and (2) the types of temporary differences, carryforwards, or carrybacks that give rise to International significant portions of deferred tax liabilities and assets. Perspective Income taxes payable is reported as a current liability on the balance sheet. IFRS requires that deferred tax Corporations make estimated tax payments to the Internal Revenue Service assets and liabilities be quarterly. They record these estimated payments by a debit to Prepaid Income classifi ed as noncurrent, regard- Taxes. As a result, the balance of the Income Taxes Payable offsets the balance of less of the classifi cation of the the Prepaid Income Taxes account when reporting income taxes on the balance underlying asset or liability. sheet. What do the numbers mean? IMAGINATION AT WORK Here’s one thing you can say that’s true about U.S. corporate fi rm. Indeed, the company’s slogan, “Imagination at Work,” taxes: The statutory rate (35 percent at the federal level, fi ts this department well. The team includes former offi cials 39.2 percent when you average in state rates) is the highest not just from the Treasury, but also from the IRS and virtually on earth (see the “What Do the Numbers Mean?” box on all the tax-writing committees in Congress. The strategies page 1131). Here’s another thing you can say that’s true employed by Apple, Google, and GE, as well as changes in about U.S. corporate taxes: The average effective tax rate is tax laws that encouraged some businesses and professionals more like 25 percent, and many corporations generally pay to fi le as individuals, have pushed down the corporate share much less than that. How do they do it? Take Apple, for ex- of the nation’s tax receipts from 30 percent of all federal rev- ample. It uses a tax structure known as the “Double Irish enue in the mid-1950s to 6.6 percent in 2009. with a Dutch Sandwich,” which reduces taxes by routing One IRS provision designed to curb excessive tax avoid- profi ts through Irish subsidiaries and the Netherlands and ance is the alternative minimum tax (AMT). Companies then to the Caribbean. As a result of using this tactic, Apple compute their potential tax liability under the AMT, adjust- paid cash taxes of $3.3 billion around the world on its re- ing for various preference items that reduce their tax bills ported profi ts of $34.2 billion in a recent year, a tax rate of just under the regular tax code. (Examples of such preference 9.8 percent. Google uses the same strategy to reduce its over- items are accelerated depreciation methods and the install- seas tax rate to 2.4 percent, the lowest of the top fi ve U.S. ment method for revenue recognition.) Companies must pay technology companies by market capitalization, according to the higher of the two tax obligations computed under the
regulatory fi lings in six countries. AMT and the regular tax code. But, as indicated by the cases General Electric (GE) is generally viewed as the most above, some profi table companies avoid high tax bills, even skilled at reducing its tax burden. GE uses a maze of shelters, in the presence of the AMT. Indeed, a recent study by the tax credits, and subsidiaries to pay far less than the stated Government Accounting Offi ce found that roughly two- tax rate. In a recent year, it reported worldwide profi ts of thirds of U.S. and foreign corporations paid no federal $14.2 billion, and said $5.1 billion of the total came from its income taxes from 1998–2005. Many citizens and public- operations in the United States. Its American tax bill? Zero. interest groups cite corporate avoidance of income taxes as a In fact, GE claimed a tax benefi t of $3.2 billion. GE’s giant tax reason for more tax reform. department is viewed by some as the world’s best tax law Sources: D. Kocieniewski, “G.E.’s Strategies Let It Avoid Taxes Altogether,” The New York Times (March 24, 2011); and J. Fox, “Why Some Multinationals Pay Such Low Taxes,” HBR Blog Network (March 27, 2012). Financial Statement Presentation 1141 Income Statement Gateway to the Profession Companies should allocate income tax expense (or benefit) to continuing operations, Expanded Discussion discontinued operations, extraordinary items, and prior period adjustments. This approach of Intraperiod Tax is referred to as intraperiod tax allocation. Allocation In addition, companies should disclose the significant components of income tax expense attributable to continuing operations: 1. Current tax expense or benefi t. 2. Deferred tax expense or benefi t, exclusive of other components listed below. 3. Investment tax credits. 4. Government grants (if recognized as a reduction of income tax expense). 5. The benefi ts of operating loss carryforwards (resulting in a reduction of income tax expense). 6. Tax expense that results from allocating tax benefi ts either directly to paid-in capital or to reduce goodwill or other noncurrent intangible assets of an acquired entity. 7. Adjustments of a deferred tax liability or asset for enacted changes in tax laws or rates or a change in the tax status of a company. 8. Adjustments of the beginning-of-the-year balance of a valuation allowance because of a change in circumstances that causes a change in judgment about the realizabil- ity of the related deferred tax asset in future years. In the notes, companies must also reconcile (using percentages or dollar amounts) income tax expense attributable to continuing operations with the amount that results from applying domestic federal statutory tax rates to pretax income from continuing significant reconciling items. Illustration 19-41 (page 1142) presents an example from the 2011 annual report of PepsiCo, Inc. These income tax disclosures are required for several reasons: 1. Assessing quality of earnings. Many investors seeking to assess the quality of a company’s earnings are interested in the reconciliation of pretax fi nancial income to taxable income. Analysts carefully examine earnings that are enhanced by a favor- able tax effect, particularly if the tax effect is nonrecurring. For example, the tax disclosure in Illustration 19-41 indicates that PepsiCo’s effective tax rate increased from 23 percent in 2010 to 26.8 percent in 2011 (due to acquisitions of PBG and PAS and “other”). This decrease in the effective tax rate increased income for 2011. 2. Making better predictions of future cash fl ows. Examination of the deferred portion of income tax expense provides information as to whether taxes payable are likely to be higher or lower in the future. In PepsiCo’s case, analysts expect future taxable amounts and higher tax payments, primarily from lower depreciation and amorti- zation in the future. PepsiCo expects future deductible amounts and lower tax payments due to deductions for carryforwards, employee benefi ts, and state taxes. These deferred tax items indicate that actual tax payments for PepsiCo will be higher
than the tax expense reported on the income statement in the future.7 7An article by R. P. Weber and J. E. Wheeler, “Using Income Tax Disclosures to Explore Significant Economic Transactions,” Accounting Horizons (September 1992), discusses how analysts use deferred tax disclosures to assess the quality of earnings and to predict future cash flows. 1142 Chapter 19 Accounting for Income Taxes ILLUSTRATION 19-41 PepsiCo, Inc. Disclosure of Income (in millions) Taxes—PepsiCo, Inc. Note 5—Income Taxes (in part) 2011 2010 Income before income taxes U.S. $3,964 $4,008 Foreign 4,870 4,224 $8,834 $8,232 Provision for income taxes Current: U.S. Federal 611 932 Foreign 882 728 State 124 137 Current and deferred tax 1,617 1,797 expense Deferred: U.S. Federal 789 78 Foreign (88) 18 State 54 1 755 97 $2,372 $1,894 Tax rate reconciliation U.S. Federal statutory tax rate 35.0% 35.0% State income tax, net of U.S. Federal tax benefit 1.3 1.1 Lower taxes on foreign results (8.7) (9.4) Tax rate reconciliation Acquisitions of PBG and PAS 0 (3.1) Other, net (0.8) (0.6) Annual tax rate 26.8% 23.0% Deferred tax liabilities Investments in noncontrolled affiliates $ 41 $ 74 Debt guarantee of wholly owned subsidiary 828 828 Property, plant and equipment 2,466 1,984 Intangible assets other than nondeductible goodwill 4,297 3,726 Other 184 647 Gross deferred tax liabilities 7,816 7,259 Deferred tax assets Net carryforwards 1,373 1,264 Stock-based compensation 429 455 Retiree medical benefits 504 579 Other employee-related benefits 695 527 Deferred tax liabilities and Pension benefits 545 291 Deductible state tax and interest benefits 339 320 deferred tax assets Long-term debt obligations acquired 223 291 Other 822 904 Gross deferred tax assets 4,930 4,631 Valuation allowances (1,264) (875) Deferred tax assets, net 3,666 3,756 Net deferred tax liabilities (assets) $4,150 $3,503 Deferred taxes included within: Assets: Prepaid expenses and other current assets $ 845 $ 554 Liabilities: Deferred income taxes $4,995 $4,057 Analysis of valuation allowances Valuation allowance Balance, beginning of year $ 875 $ 586 adjustments (Benefit/provision) 464 75 Other additions/(deductions) (75) 214 Balance, end of year $1,264 $ 875 Carryforwards and allowances Operating loss carryforwards totaling $10.0 billion at year-end 2011 are being carried forward in a number of foreign and state jurisdictions where we are permitted to use tax operating losses from prior periods to reduce future taxable income. These operating losses will expire as follows: $0.1 billion in 2012, $8.2 billion between 2013 and 2031 and $1.7 billion may be carried forward indefinitely. We establish valuation allowances for our deferred tax assets if, based on the available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Financial Statement Presentation 1143 3. Predicting future cash fl ows for operating loss carryforwards. Companies should disclose the amounts and expiration dates of any operating loss carryforwards for tax purposes. From this disclosure, analysts determine the amount of income that the company may recognize in the future on which it will pay no income tax. For example, the PepsiCo disclosure in Illustration 19-41 indicates that PepsiCo has $10.0 billion in net operating loss carryforwards that it can use to reduce future taxes. However, the valuation allowance indicates that $1.264 million of deferred tax assets may not be realized in the future. Loss carryforwards can be valuable to a potential acquirer. For example, as men- tioned earlier, Yahoo! has a substantial net operating loss carryforward. A potential ac- quirer would find Yahoo! more valuable as a result of these carryforwards. That is, the acquirer may be able to use these carryforwards to shield future income. However the acquiring company has to be careful because the structure of the deal may lead to a situ- ation where the deductions will be severely limited. Much the same issue arises in companies emerging from bankruptcy. In many cases, these companies have large NOLs but the value of the losses may be limited. This is
because any gains related to the cancellation of liabilities in bankruptcy must be offset against the NOLs. For example, when Kmart Holding Corp. emerged from bankruptcy in early 2004, it disclosed NOL carryforwards approximating $3.8 billion. At the same time, Kmart disclosed cancellation of debt gains that reduced the value of the NOL c arryforward. These reductions soured the merger between Kmart and Sears Roebuck because the cancellation of the indebtedness gains reduced the value of the Kmart carryforwards to the merged company by $3.74 billion.8 Evolving Issue UNCERTAIN TAX POSITIONS Whenever there is a contingency, companies determine if the used a lower threshold, such as that found in the existing contingency is probable and can be reasonably estimated. If authoritative literature. As we have learned, the lower both of these criteria are met, the company records the con- threshold—described as “more likely than not”—means tingency in the financial statements. These guidelines also that the company believes it has at least a 51 percent chance apply to uncertain tax positions. Uncertain tax positions are that the uncertain tax position will pass muster with the tax positions for which the tax authorities may disallow a t axing authorities. Thus, there has been diversity in practice deduction in whole or in part. Uncertain tax positions often concerning the accounting and reporting of uncertain tax arise when a company takes an aggressive approach in its tax positions. planning. Examples are instances in which the tax law is un- As a result, the FASB has issued rules for companies to clear or the company may believe that the risk of audit is low. follow to determine whether it is “more likely than not” that Uncertain tax positions give rise to tax benefits either by re- tax positions will be sustained upon audit. [3] If the probabil- ducing income tax expense or related payables or by increas- ity is more than 50 percent, companies may reduce their lia- ing an income tax refund receivable or deferred tax asset. bility or increase their assets. If the probability is less than 50 Unfortunately, companies have not applied these provi- percent, companies may not record the tax benefit. In deter- sions consistently in accounting and reporting of uncertain mining “more likely than not,” companies must assume that tax positions. Some companies have not recognized a tax they will be audited by the tax authorities. If the recognition benefit unless it is probable that the benefit will be realized threshold is passed, companies must then estimate the and can be reasonably estimated. Other companies have amount to record as an adjustment to their tax assets and 8P. McConnell, J. Pegg, C. Senyak, and D. Mott, “The ABCs of NOLs,” Accounting Issues, Bear Stearns Equity Research (June 2005). In addition, some U.S. banks hope to cash in tax credits by acquiring weaker banks with operating losses and housing credits, arising from the credit crisis. See D. Palletta, “Goldman Looks to Buy Fannie Tax Credits,” Wall Street Journal (November 2, 2009). The IRS frowns on acquisitions done solely to obtain operating loss carryforwards. If it determines that the merger is solely tax-motivated, the IRS disallows the deductions. But because it is very difficult to determine whether a merger is or is not tax-motivated, the “purchase of operating loss carryforwards” continues. 1144 Chapter 19 Accounting for Income Taxes liabilities. (This estimation process is complex and is beyond or their tax assets increase. For example, PepsiCo recorded a the scope of this textbook.) $7 million increase to retained earnings upon adoption of the Companies will experience varying financial statement guidelines. Others that followed more aggressive tax plan- effects upon adoption of these rules. Those with a history of ning may have to increase their liabilities or reduce their conservative tax strategies may have their tax liabilities decrease assets, with a resulting negative effect on net income. REVIEW OF THE ASSET-LIABILITY METHOD
The FASB believes that the asset-liability method (sometimes referred to as the LEARNING OBJECTIVE 10 liability approach) is the most consistent method for accounting for income taxes. Indicate the basic principles of the One objective of this approach is to recognize the amount of taxes payable or asset-liability method. refundable for the current year. A second objective is to recognize deferred tax liabilities and assets for the future tax consequences of events that have been recog- nized in the financial statements or tax returns. To implement the objectives, companies apply some basic principles in accounting for income taxes at the date of the financial statements, as listed in Illustration 19-42. [4] ILLUSTRATION 19-42 Basic Principles of the Basic Principles Asset-Liability Method a. A current tax liability or asset is recognized for the estimated taxes payable or refundable on the tax return for the current year. b. A deferred tax liability or asset is recognized for the estimated future tax effects attributable to temporary differences and carryforwards. c. The measurement of current and deferred tax liabilities and assets is based on provisions of the enacted tax law; the effects of future changes in tax laws or rates are not anticipated. d. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not expected to be realized. Illustration 19-43 diagrams the procedures for implementing the asset-liability method. ILLUSTRATION 19-43 Procedures for Computing and Identify types and amounts of existing temporary differences and carryforwards. Reporting Deferred Income Taxes Measure deferred tax asset Measure deferred tax for deductible temporary differences liability for taxable and loss carryforwards (use enacted temporary differences (use tax rate). enacted tax rate). Gateway to Establish valuation allowance the Profession account if more likely than not that some portion or all of the deferred Discussion of Conceptual tax asset will not be realized. Approaches to Interperiod Tax Allocation On the balance sheet Classify deferred taxes as current or noncurrent based on asset or liability to which they relate. Report a net current and a net noncurrent amount. On the income statement Report current tax expense (benefit) and deferred tax expense (benefit) and total income tax expense (benefit). Review of the Asset-Liability Method 1145 As an aid to understanding deferred income taxes, we provide the following glossary. KEY DEFERRED INCOME TAX TERMS International Perspective CARRYBACKS. Deductions or credits that cannot be utilized on the tax return during a year IFRS on income taxes and that may be carried back to reduce taxable income or taxes paid in a prior year. An operat- is based on the same ing loss carryback is an excess of tax deductions over gross income in a year. A tax credit car- principles as GAAP— ryback is the amount by which tax credits available for utilization exceed statutory limitations. comprehensive CARRYFORWARDS. Deductions or credits that cannot be utilized on the tax return during recognition of deferred a year and that may be carried forward to reduce taxable income or taxes payable in a future tax assets and year. An operating loss carryforward is an excess of tax deductions over gross income in a liabilities. year. A tax credit carryforward is the amount by which tax credits available for utilization exceed statutory limitations. CURRENT TAX EXPENSE (BENEFIT). The amount of income taxes paid or payable (or refundable) for a year as determined by applying the provisions of the enacted tax law to the taxable income or excess of deductions over revenues for that year. DEDUCTIBLE TEMPORARY DIFFERENCE. Temporary differences that result in deductible amounts in future years when recovering or settling the related asset or liability, respectively. DEFERRED TAX ASSET. The deferred tax consequences attributable to deductible tempo- rary differences and carryforwards. DEFERRED TAX CONSEQUENCES. The future effects on income taxes as measured by
the enacted tax rate and provisions of the enacted tax law resulting from temporary differ- ences and carryforwards at the end of the current year. DEFERRED TAX EXPENSE (BENEFIT). The change during the year in a company’s deferred tax liabilities and assets. DEFERRED TAX LIABILITY. The deferred tax consequences attributable to taxable tem- porary differences. INCOME TAXES. Domestic and foreign federal (national), state, and local (including fran- chise) taxes based on income. INCOME TAXES CURRENTLY PAYABLE (REFUNDABLE). Refer to current tax expense (benefi t). INCOME TAX EXPENSE (BENEFIT). The sum of current tax expense (benefi t) and deferred tax expense (benefi t). TAXABLE INCOME. The excess of taxable revenues over tax-deductible expenses and exemptions for the year as defi ned by the governmental taxing authority. TAXABLE TEMPORARY DIFFERENCE. Temporary differences that result in taxable amounts in future years when recovering or settling the related asset or liability, respectively. TAX-PLANNING STRATEGY. An action that meets certain criteria and that a company implements to realize a tax benefi t for an operating loss or tax credit carryforward before it expires. Companies consider tax-planning strategies when assessing the need for and You will amount of a valuation allowance for deferred tax assets. want to TEMPORARY DIFFERENCE. A difference between the tax basis of an asset or liability and its read the IFRS INSIGHTS reported amount in the fi nancial statements that will result in taxable or deductible amounts in on pages 1175–1181 future years when recovering or settling the reported amount of the asset or liability, respectively. for discussion of VALUATION ALLOWANCE. The portion of a deferred tax asset for which it is more likely IFRS related to than not that a company will not realize a tax benefi t. income taxes. 1146 Chapter 19 Accounting for Income Taxes KEY TERMS SUMMARY OF LEARNING OBJECTIVES alternative minimum tax (AMT), 1140 asset-liability 1 Identify differences between pretax financial income and taxable method, 1144 income. Companies compute pretax financial income (or income for book purposes) average tax rate, 1130 in accordance with generally accepted accounting principles. They compute taxable current tax expense income (or income for tax purposes) in accordance with prescribed tax regulations. (benefit), 1121, 1134 Because tax regulations and GAAP differ in many ways, so frequently do pretax finan- deductible amounts, 1120 cial income and taxable income. Differences may exist, for example, in the timing of deductible temporary revenue recognition and the timing of expense recognition. difference, 1127 deferred tax asset, 1123 2 Describe a temporary difference that results in future taxable amounts. deferred tax expense Revenue recognized for book purposes in the period earned but deferred and reported (benefit), 1121, 1124 as revenue for tax purposes when collected results in future taxable amounts. The future deferred tax liability, 1120 taxable amounts will occur in the periods the company recovers the receivable and effective tax rate, 1130 reports the collections as revenue for tax purposes. This results in a deferred tax liability. enacted tax rate, 1130 3 Describe a temporary difference that results in future deductible Income Tax Refund amounts. An accrued warranty expense that a company pays for and deducts for tax Receivable, 1133 purposes, in a period later than the period in which it incurs and recognizes it for book loss carryback, 1132 purposes, results in future deductible amounts. The future deductible amounts will loss carryforward, 1132 occur in the periods during which the company settles the related liability for book more likely than not, 1125 purposes. This results in a deferred tax asset. net current amount, 1139 net noncurrent 4 Explain the purpose of a deferred tax asset valuation allowance. A de- amount, 1139 ferred tax asset should be reduced by a valuation allowance if, based on all available net operating loss evidence, it is more likely than not (a level of likelihood that is at least slightly more than
(NOL), 1132 50 percent) that it will not realize some portion or all of the deferred tax asset. The com- originating temporary pany should carefully consider all available evidence, both positive and negative, to de- difference, 1128 termine whether, based on the weight of available evidence, it needs a valuation allowance. permanent 5 Describe the presentation of income tax expense in the income state- difference, 1128 ment. Significant components of income tax expense should be disclosed in the income pretax financial statement or in the notes to the financial statements. The most commonly encountered income, 1118 components are the current expense (or benefit) and the deferred expense (or benefit). reversing difference, 1128 taxable amounts, 1120 6 Describe various temporary and permanent differences. Examples of taxable income, 1118 temporary differences are (1) revenues or gains that are taxable after recognition in taxable temporary financial income; (2) expenses or losses that are deductible after recognition in financial difference, 1127 income; (3) revenues or gains that are taxable before recognition in financial income; tax effect (tax benefit), 1133 and (4) expenses or losses that are deductible before recognition in financial income. temporary Examples of permanent differences are (1) items recognized for financial reporting difference, 1120 purposes but not for tax purposes, and (2) items recognized for tax purposes but not for uncertain tax financial reporting purposes. positions, 1143 7 Explain the effect of various tax rates and tax rate changes on deferred valuation allowance, 1125 income taxes. Companies may use tax rates other than the current rate only after enact- ment of the future tax rates. When a change in the tax rate is enacted, a company should immediately recognize its effect on the deferred income tax accounts. The company reports the effects as an adjustment to income tax expense in the period of the change. 8 Apply accounting procedures for a loss carryback and a loss carryfor- ward. A company may carry a net operating loss back two years and receive refunds for income taxes paid in those years. The loss is applied to the earlier year first and then to the second year. Any loss remaining after the two-year carryback may be carried forward up to 20 years to offset future taxable income. A company may forgo the loss carryback and use the loss carryforward, offsetting future taxable income for up to 20 years. Appendix 19A: Comprehensive Example of Interperiod Tax Allocation 1147 9 Describe the presentation of deferred income taxes in financial state- ments. Companies report deferred tax accounts on the balance sheet as assets and lia- bilities. These deferred tax accounts are classified as a net current and a net noncurrent amount. Companies classify an individual deferred tax liability or asset as current or noncurrent based on the classification of the related asset or liability for financial report- ing. A deferred tax liability or asset that is not related to an asset or liability for financial reporting, including a deferred tax asset related to a loss carryforward, is classified ac- cording to the expected reversal date of the temporary difference. 10 Indicate the basic principles of the asset-liability method. Companies apply the following basic principles in accounting for income taxes at the date of the financial statements. (1) Recognize a current tax liability or asset for the estimated taxes payable or refundable on the tax return for the current year. (2) Recognize a deferred tax liability or asset for the estimated future tax effects attributable to temporary differences and carryforwards using the enacted tax rate. (3) Base the measurement of current and deferred tax liabilities and assets on provisions of the enacted tax law. (4) Reduce the measurement of deferred tax assets, if necessary, by the amount of any tax benefits that, based on available evidence, companies do not expect to realize. APPENDIX 19A COMPREHENSIVE EXAMPLE OF INTERPERIOD TAX ALLOCATION
This appendix presents a comprehensive illustration of a deferred income tax 11 LEARNING OBJECTIVE problem with several temporary and permanent differences. The example follows Understand and apply the concepts and one company through two complete years (2013 and 2014). Study it carefully. It procedures of interperiod tax allocation. should help you understand the concepts and procedures presented in the chapter. FIRST YEAR—2013 Allman Company, which began operations at the beginning of 2013, produces various products on a contract basis. Each contract generates a gross profit of $80,000. Some of Allman’s contracts provide for the customer to pay on an installment basis. Under these contracts, Allman collects one-fifth of the contract revenue in each of the following four years. For financial reporting purposes, the company recognizes gross profit in the year of completion (accrual basis); for tax purposes, Allman recognizes gross profit in the year cash is collected (installment basis). Presented below is information related to Allman’s operations for 2013. 1. In 2013, the company completed seven contracts that allow for the customer to pay on an installment basis. Allman recognized the related gross profi t of $560,000 for fi nancial reporting purposes. It reported only $112,000 of gross profi t on installment sales on the 2013 tax return. The company expects future collections on the related installment receivables to result in taxable amounts of $112,000 in each of the next four years. 2. At the beginning of 2013, Allman Company purchased depreciable assets with a cost of $540,000. For fi nancial reporting purposes, Allman depreciates these assets using the straight-line method over a six-year service life. For tax purposes, the assets fall in the fi ve-year recovery class, and Allman uses the MACRS system. The depreciation schedules for both fi nancial reporting and tax purposes are shown on page 1148. 1148 Chapter 19 Accounting for Income Taxes Depreciation for Depreciation for Year Financial Reporting Purposes Tax Purposes Difference 2013 $ 90,000 $108,000 $(18,000) 2014 90,000 172,800 (82,800) 2015 90,000 103,680 (13,680) 2016 90,000 62,208 27,792 2017 90,000 62,208 27,792 2018 90,000 31,104 58,896 $540,000 $540,000 $ –0– 3. The company warrants its product for two years from the date of completion of a contract. During 2013, the product warranty liability accrued for fi nancial reporting purposes was $200,000, and the amount paid for the satisfaction of warranty liability was $44,000. Allman expects to settle the remaining $156,000 by expenditures of $56,000 in 2014 and $100,000 in 2015. 4. In 2013, nontaxable municipal bond interest revenue was $28,000. 5. During 2013, nondeductible fi nes and penalties of $26,000 were paid. 6. Pretax fi nancial income for 2013 amounts to $412,000. 7. Tax rates enacted before the end of 2013 were: 2013 50% 2014 and later years 40% 8. The accounting period is the calendar year. 9. The company is expected to have taxable income in all future years. Taxable Income and Income Taxes Payable—2013 The first step is to determine Allman Company’s income taxes payable for 2013 by calculating its taxable income. Illustration 19A-1 shows this computation. ILLUSTRATION 19A-1 Pretax financial income for 2013 $412,000 Computation of Taxable Permanent differences: Income, 2013 Nontaxable revenue—municipal bond interest (28,000) Nondeductible expenses—fines and penalties 26,000 Temporary differences: Excess gross profit per books ($560,000 2 $112,000) (448,000) Excess depreciation per tax ($108,000 2 $90,000) (18,000) Excess warranty expense per books ($200,000 2 $44,000) 156,000 Taxable income for 2013 $100,000 Allman computes income taxes payable on taxable income for $100,000 as follows. ILLUSTRATION 19A-2 Taxable income for 2013 $100,000 Computation of Income Tax rate 50% Taxes Payable, End of Income taxes payable (current tax expense) for 2013 $ 50,000 2013 Computing Deferred Income Taxes—End of 2013 The schedule in Illustration 19A-3 summarizes the temporary differences and the resulting
future taxable and deductible amounts. Appendix 19A: Comprehensive Example of Interperiod Tax Allocation 1149 ILLUSTRATION 19A-3 Future Years Schedule of Future 2014 2015 2016 2017 2018 Total Taxable and Deductible Future taxable Amounts, End of 2013 (deductible) amounts: Installment sales $112,000 $112,000 $112,000 $112,000 $448,000 Depreciation (82,800) (13,680) 27,792 27,792 $58,896 18,000 Warranty costs (56,000) (100,000) (156,000) Allman computes the amounts of deferred income taxes to be reported at the end of 2013 as shown in Illustration 19A-4. ILLUSTRATION 19A-4 Future Computation of Deferred Taxable (Deductible) Tax Deferred Tax Income Taxes, End of Temporary Difference Amounts Rate (Asset) Liability 2013 Installment sales $448,000 40% $179,200 Depreciation 18,000 40% 7,200 Warranty costs (156,000) 40% $(62,400) Totals $310,000 $(62,400) $186,400* *Because only a single tax rate is involved in all relevant years, these totals can be reconciled: $310,000 3 40% 5 ($62,400) 1 $186,400. A temporary difference is caused by the use of the accrual basis for financial report- ing purposes and the installment method for tax purposes. This temporary difference will result in future taxable amounts and hence a deferred tax liability. Because of the installment contracts completed in 2013, a temporary difference of $448,000 originates that will reverse in equal amounts over the next four years. The company expects to have taxable income in all future years, and there is only one enacted tax rate applicable to all future years. Allman uses that rate (40 percent) to compute the entire deferred tax liability resulting from this temporary difference. The temporary difference caused by different depreciation policies for books and for tax purposes originates over three years and then reverses over three years. This dif- ference will cause deductible amounts in 2014 and 2015 and taxable amounts in 2016, 2017, and 2018. These amounts sum to a net future taxable amount of $18,000 (which is the cumulative temporary difference at the end of 2013). Because the company expects to have taxable income in all future years and because there is only one tax rate enacted for all of the relevant future years, Allman applies that rate to the net future taxable amount to determine the related net deferred tax liability. The third temporary difference is caused by different methods of accounting for warranties. This difference will result in deductible amounts in each of the two future years it takes to reverse. Because the company expects to report a positive income on all future tax returns and because there is only one tax rate enacted for each of the relevant future years, Allman uses that 40 percent rate to calculate the resulting deferred tax asset. Deferred Tax Expense (Benefi t) and the Journal Entry to Record Income Taxes—2013 To determine the deferred tax expense (benefit), we need to compare the beginning and ending balances of the deferred income tax accounts. Illustration 19A-5 (on page 1150) shows that computation. 1150 Chapter 19 Accounting for Income Taxes ILLUSTRATION 19A-5 Deferred tax asset at the end of 2013 $ 62,400 Computation of Deferred Deferred tax asset at the beginning of 2013 –0– Tax Expense (Benefi t), Deferred tax expense (benefit) $ (62,400) 2013 Deferred tax liability at the end of 2013 $186,400 Deferred tax liability at the beginning of 2013 –0– Deferred tax expense (benefit) $186,400 The $62,400 increase in the deferred tax asset causes a deferred tax benefit to be reported in the income statement. The $186,400 increase in the deferred tax liability during 2013 results in a deferred tax expense. These two amounts net to a deferred tax expense of $124,000 for 2013. ILLUSTRATION 19A-6 Deferred tax expense (benefit) $ (62,400) Computation of Net Deferred tax expense (benefit) 186,400 Deferred Tax Expense, Net deferred tax expense for 2013 $124,000 2013 Allman then computes the total income tax expense as follows. ILLUSTRATION 19A-7 Current tax expense for 2013 $ 50,000 Computation of Total Deferred tax expense for 2013 124,000
Income Tax Expense, Income tax expense (total) for 2013 $174,000 2013 Allman records income taxes payable, deferred income taxes, and income tax expense as follows. Income Tax Expense 174,000 Deferred Tax Asset 62,400 Income Taxes Payable 50,000 Deferred Tax Liability 186,400 Financial Statement Presentation—2013 Companies should classify deferred tax assets and liabilities as current and noncurrent on the balance sheet based on the classifications of related assets and liabilities. Multiple categories of deferred taxes are classified into a net current amount and a net noncurrent amount. Illustration 19A-8 shows the classification of Allman’s deferred tax accounts at the end of 2013. ILLUSTRATION 19A-8 Resulting Classifi cation of Deferred Deferred Tax Related Balance Tax Accounts, End of Temporary Difference (Asset) Liability Sheet Account Classification 2013 Installment sales $179,200 Installment Receivable Current Depreciation 7,200 Plant Assets Noncurrent Warranty costs $(62,400) Warranty Obligation Current Totals $(62,400) $186,400 For the first temporary difference, there is a related asset on the balance sheet, in- stallment accounts receivable. Allman classifies that asset as current because it has a trade practice of selling to customers on an installment basis. Allman therefore classifies the resulting deferred tax liability as a current liability. Appendix 19A: Comprehensive Example of Interperiod Tax Allocation 1151 Certain assets on the balance sheet are related to the depreciation difference—the property, plant, and equipment being depreciated. Allman would classify the plant assets as noncurrent. Therefore, it also classifies the resulting deferred tax liability as noncurrent. Since the company’s operating cycle is at least four years in length, Allman classifies the entire $156,000 warranty obligation as a current liability. Thus, it also classifies the related deferred tax asset of $62,400 as current.9 The balance sheet at the end of 2013 reports the following amounts. ILLUSTRATION 19A-9 Current liabilities Balance Sheet Income taxes payable $ 50,000 Presentation of Deferred Deferred tax liability ($179,200 2 $62,400) 116,800 Taxes, 2013 Long-term liabilities Deferred tax liability $ 7,200 Allman’s income statement for 2013 reports the following. ILLUSTRATION 19A-10 Income before income taxes $412,000 Income Statement Income tax expense Current $ 50,000 Presentation of Income Deferred 124,000 174,000 Tax Expense, 2013 Net income $238,000 SECOND YEAR—2014 1. During 2014, Allman collected $112,000 from customers for the receivables arising from contracts completed in 2013. The company expects recovery of the remaining receivables to result in taxable amounts of $112,000 in each of the following three years. 2. In 2014, the company completed four new contracts that allow for the customer to pay on an installment basis. These installment sales created new installment receiv- ables. Future collections of these receivables will result in reporting gross profi t of $64,000 for tax purposes in each of the next four years. 3. During 2014, Allman continued to depreciate the assets acquired in 2013 according to the depreciation schedules appearing on page 1148. Thus, depreciation amount- ed to $90,000 for fi nancial reporting purposes and $172,800 for tax purposes. 4. An analysis at the end of 2014, of the product warranty liability account, showed the following details. Balance of liability at beginning of 2014 $156,000 Expense for 2014 income statement purposes 180,000 Amount paid for contracts completed in 2013 (56,000) Amount paid for contracts completed in 2014 (50,000) Balance of liability at end of 2014 $230,000 9If Allman’s operating cycle were less than one year in length, the company would expect to settle $56,000 of the warranty obligation within one year of the December 31, 2013, balance sheet and would use current assets to do so. Thus, $56,000 of the warranty obligation would be a current liability and the remaining $100,000 warranty obligation would be a long-term (noncurrent) liability. This would mean that Allman would classify $22,400 ($56,000 3 40%) of
the related deferred tax asset as a current asset, and $40,000 ($100,000 3 40%) of the deferred tax asset as a noncurrent asset. In doing homework problems, unless it is evident otherwise, assume a company’s operating cycle is not longer than one year. 1152 Chapter 19 Accounting for Income Taxes The balance of the liability is expected to require expenditures in the future as follows. $100,000 in 2015 due to 2013 contracts $ 50,000 in 2015 due to 2014 contracts $ 80,000 in 2016 due to 2014 contracts $230,000 5. During 2014, nontaxable municipal bond interest revenue was $24,000. 6. Allman accrued a loss of $172,000 for fi nancial reporting purposes because of pend- ing litigation. This amount is not tax-deductible until the period the loss is realized, which the company estimates to be 2022. 7. Pretax fi nancial income for 2014 amounts to $504,800. 8. The enacted tax rates still in effect are: 2013 50% 2014 and later years 40% Taxable Income and Income Taxes Payable—2014 Allman computes taxable income for 2014 as follows. ILLUSTRATION 19A-11 Pretax financial income for 2014 $504,800 Computation of Taxable Permanent difference: Income, 2014 Nontaxable revenue—municipal bond interest (24,000) Reversing temporary differences: Collection on 2013 installment sales 112,000 Payments on warranties from 2013 contracts (56,000) Originating temporary differences: Excess gross profit per books—2014 contracts (256,000) Excess depreciation per tax (82,800) Excess warranty expense per books—2014 contracts 130,000 Loss accrual per books 172,000 Taxable income for 2014 $500,000 Income taxes payable for 2014 are as follows. ILLUSTRATION 19A-12 Taxable income for 2014 $500,000 Computation of Income Tax rate 40% Taxes Payable, End of Income taxes payable (current tax expense) for 2014 $200,000 2014 Computing Deferred Income Taxes—End of 2014 ILLUSTRATION 19A-13 Schedule of Future The schedule in Illustration 19A-13 summarizes the temporary differences existing at Taxable and Deductible the end of 2014 and the resulting future taxable and deductible amounts. Amounts, End of 2014 Future Years 2015 2016 2017 2018 2022 Total Future taxable (deductible) amounts: Installment sales—2013 $112,000 $112,000 $112,000 $336,000 Installment sales—2014 64,000 64,000 64,000 $64,000 256,000 Depreciation (13,680) 27,792 27,792 58,896 100,800 Warranty costs (150,000) (80,000) (230,000) Loss accrual $(172,000) (172,000) Appendix 19A: Comprehensive Example of Interperiod Tax Allocation 1153 Allman computes the amounts of deferred income taxes to be reported at the end of 2014 as follows. ILLUSTRATION 19A-14 Future Computation of Deferred Taxable (Deductible) Tax Deferred Tax Income Taxes, End of Temporary Difference Amounts Rate (Asset) Liability 2014 Installment sales $592,000* 40% $236,800 Depreciation 100,800 40% 40,320 Warranty costs (230,000) 40% $ (92,000) Loss accrual (172,000) 40% (68,800) Totals $290,800 $(160,800) $277,120** *Cumulative temporary difference 5 $336,000 1 $256,000 **Because of a flat tax rate, these totals can be reconciled: $290,800 3 40% 5 $(160,800) 1 $277,120 Deferred Tax Expense (Benefi t) and the Journal Entry to Record Income Taxes—2014 To determine the deferred tax expense (benefit), Allman must compare the beginning and ending balances of the deferred income tax accounts, as shown in Illustration 19A-15. ILLUSTRATION 19A-15 Deferred tax asset at the end of 2014 $160,800 Computation of Deferred Deferred tax asset at the beginning of 2014 62,400 Tax Expense (Benefi t), Deferred tax expense (benefit) $ (98,400) 2014 Deferred tax liability at the end of 2014 $277,120 Deferred tax liability at the beginning of 2014 186,400 Deferred tax expense (benefit) $ 90,720 The deferred tax expense (benefit) and the total income tax expense for 2014 are, therefore, as follows. ILLUSTRATION 19A-16 Deferred tax expense (benefit) $ (98,400) Computation of Total Deferred tax expense (benefit) 90,720 Income Tax Expense, Deferred tax benefit for 2014 (7,680) 2014 Current tax expense for 2014 200,000 Income tax expense (total) for 2014 $192,320 The deferred tax expense of $90,720 and the deferred tax benefit of $98,400 net to a
deferred tax benefit of $7,680 for 2014. Allman records income taxes for 2014 with the following journal entry. Income Tax Expense 192,320 Deferred Tax Asset 98,400 Income Taxes Payable 200,000 Deferred Tax Liability 90,720 Financial Statement Presentation—2014 Illustration 19A-17 (on page 1154) shows the classification of Allman’s deferred tax accounts at the end of 2014. 1154 Chapter 19 Accounting for Income Taxes ILLUSTRATION 19A-17 Resulting Classifi cation of Deferred Deferred Tax Related Balance Tax Accounts, End of Temporary Difference (Asset) Liability Sheet Account Classification 2014 Installment sales $236,800 Installment Receivables Current Depreciation 40,320 Plant Assets Noncurrent Warranty costs $ (92,000) Warranty Obligation Current Loss accrual (68,800) Litigation Obligation Noncurrent Totals $(160,800) $277,120 The new temporary difference introduced in 2014 (due to the litigation loss accrual) results in a litigation obligation that is classified as a long-term liability. Thus, the related deferred tax asset is noncurrent. Allman’s balance sheet at the end of 2014 reports the following amounts. ILLUSTRATION 19A-18 Other assets (noncurrent) Balance Sheet Deferred tax asset ($68,800 2 $40,320) $ 28,480 Presentation of Deferred Taxes, End of 2014 Current liabilities Income taxes payable $200,000 Deferred tax liability ($236,800 2 $92,000) 144,800 The income statement for 2014 reports the following. ILLUSTRATION 19A-19 Income before income taxes $504,800 Income Statement Income tax expense Presentation of Income Current $200,000 Tax Expense, 2014 Deferred (7,680) 192,320 Net income $312,480 SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 19A 11 Understand and apply the concepts and procedures of interperiod tax allocation. Accounting for deferred taxes involves the following steps. (1) Calcu- late taxable income and income taxes payable for the year. (2) Compute deferred income taxes at the end of the year. (3) Determine deferred tax expense (benefit) and make the journal entry to record income taxes. (4) Classify deferred tax assets and liabilities as current or noncurrent in the financial statements. DEMONSTRATION PROBLEM Johnny Bravo Company began operations in 2014 and has provided the following information. 1. Pretax financial income for 2014 is $100,000. 2. The tax rate enacted for 2014 and future years is 40%. 3. Differences between the 2014 income statement and tax return are listed below. (a) W arranty expense accrued for financial reporting purposes amounts to $5,000. Warranty deduc- tions per the tax return amount to $2,000. Demonstration Problem 1155 (b) G ross profit on construction contracts using the percentage-of-completion method for books amounts to $92,000. Gross profit on construction contracts for tax purposes amounts to $62,000. (c) Depreciation of property, plant, and equipment for financial reporting purposes amounts to $60,000. Depreciation of these assets amounts to $80,000 for the tax return. (d) A $3,500 fine paid for violation of pollution laws was deducted in computing pretax financial income. (e) Interest revenue earned on an investment in tax-exempt municipal bonds amounts to $1,400. Assume (a) is short-term in nature; assume (b) and (c) are long-term in nature. 4. Taxable income is expected for the next few years. Instructions (a) Compute taxable income for 2014. (b) Compute the deferred taxes at December 31, 2014, that relate to the temporary differences described above. (c) Prepare the journal entry to record income tax expense, deferred taxes, and income taxes payable for 2014. (d) Draft the income tax expense section of the income statement, beginning with “Income before income taxes.” (e) Assume that in 2015 Johnny Bravo reported a pretax operating loss of $100,000. There were no other temporary or permanent differences in tax and book income for 2015. Prepare the journal entry to record income tax expense for 2015. Johnny Bravo expects to return to profitability in 2016. Solution (a) Pretax fi nancial income $100,000 Permanent differences Fine for pollution 3,500
Tax-exempt interest (1,400) Originating temporary differences Excess warranty expense per books ($5,000 2 $2,000) 3,000 Excess construction profi ts per books ($92,000 2 $62,000) (30,000) Excess depreciation per tax ($80,000 2 $60,000) (20,000) Taxable income $ 55,100 (b) Deferred Tax Temporary Difference Future Taxable (Deductible) Amounts Tax Rate (Asset) Liability Warranty costs $ (3,000) 40% $(1,200) Construction contracts 30,000 40% $12,000 Depreciation 20,000 40% 8,000 Totals $47,000 $(1,200) $20,000* (c) Income Tax Expense 40,840 Deferred Tax Asset 1,200 Deferred Tax Liability 20,000 Income Taxes Payable 22,040 Taxable income for 2014 [from part (a)] $55,100 Tax rate 40% Income taxes payable for 2014 $22,040 Deferred tax liability at the end of 2014 [from part (b)] $20,000 Deferred tax liability at the beginning of 2014 –0– Deferred tax expense for 2014 $20,000 Deferred tax asset at the end of 2014 [from part (b)] $ 1,200 Deferred tax asset at the beginning of 2014 –0– Deferred tax benefi t for 2014 $ (1,200) 1156 Chapter 19 Accounting for Income Taxes (d) Income before income taxes $100,000 Income tax expense Current $22,040 Deferred 18,800 40,840 Net income $ 59,160 (e) Income Tax Refund Receivable* 22,040 Deferred Tax Asset** 17,960 Benefi t from Operating Loss Carryback 22,040 Benefi t from Operating Loss Carryforward 17,960 2015 Loss $100,000 *Carryback (55,100) 3 40% 5 $22,040 refund **Carryforward $ 44,900 3 40% 5 $17,960 deferred tax asset No valuation allowance is needed since Johnny Bravo is expected to return to profi tability in 2016. This is positive evidence that the deferred tax asset will be realized. FASB CODIFICATION FASB Codification References [1] FASB ASC 740-10-30-18. [Predecessor literature: “Accounting for Income Taxes,” Statement of Financial Accounting Standards No. 109 (Norwalk, Conn.: FASB, 1992).] [2] FASB ASC 740-10-30-21 & 22. [Predecessor literature: “Accounting for Income Taxes,” Statement of Financial Accounting Standards No. 109 (Norwalk, Conn.: FASB, 1992), paras. 23 and 24.] [3] FASB ASC 740-10-25-6. [Predecessor literature: “Accounting for Uncertainty in Income Taxes,” FASB Interpretation No. 48 (Norwalk, Conn.: FASB, 2006).] [4] FASB ASC 740-10-05. [Predecessor literature: “Accounting for Income Taxes,” Statement of Financial Accounting Standards No. 109 (Norwalk, Conn.: FASB, 1992), paras. 6 and 8.] Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE19-1 Access the glossary (“Master Glossary”) to answer the following. (a) What is a deferred tax asset? (b) What is taxable income? (c) What is the definition of valuation allowance? (d) What is a deferred tax liability? CE19-2 What are the two basic requirements applied to the measurement of current and deferred income taxes at the date of the financial statements? CE19-3 A company wishes to conduct business in a foreign country that attracts businesses by granting “holidays” from income taxes for a certain period of time. Would the company have to disclose this “holiday” to the SEC? If so, what information must be disclosed? CE19-4 When is a company allowed to initially recognize the financial statement effects of a tax position? An additional Codification case can be found in the Using Your Judgment section, on page 1174. Be sure to check the book’s companion website for a Review and Analysis Exercise, with solution. Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS. Brief Exercises 1157 QUESTIONS 1. Explain the difference between pretax financial income 11. Describe the procedures involved in segregating vari- and taxable income. ous deferred tax amounts into current and noncurrent 2. What are the two objectives of accounting for income taxes? categories. 3. Interest on municipal bonds is referred to as a permanent 12. How is it determined whether deferred tax amounts are
considered to be “related” to specific asset or liability difference when determining the proper amount to report amounts? for deferred taxes. Explain the meaning of permanent dif- ferences, and give two other examples. 13. At the end of the year, Falabella Co. has pretax financial 4. Explain the meaning of a temporary difference as it relates income of $550,000. Included in the $550,000 is $70,000 i nterest income on municipal bonds, $25,000 fine for to deferred tax computations, and give three examples. dumping hazardous waste, and depreciation of $60,000. 5. Differentiate between an originating temporary differ- Depreciation for tax purposes is $45,000. Compute income ence and a reversing difference. taxes payable, assuming the tax rate is 30% for all periods. 6. The book basis of depreciable assets for Erwin Co. is 14. Addison Co. has one temporary difference at the begin- $900,000, and the tax basis is $700,000 at the end of 2015. ning of 2014 of $500,000. The deferred tax liability estab- The enacted tax rate is 34% for all periods. Determine the lished for this amount is $150,000, based on a tax rate of amount of deferred taxes to be reported on the balance 30%. The temporary difference will provide the following sheet at the end of 2015. taxable amounts: $100,000 in 2015, $200,000 in 2016, and 7. Roth Inc. has a deferred tax liability of $68,000 at the $200,000 in 2017. If a new tax rate for 2017 of 20% is beginning of 2015. At the end of 2015, it reports accounts e nacted into law at the end of 2014, what is the journal receivable on the books at $90,000 and the tax basis at zero entry necessary in 2014 (if any) to adjust deferred taxes? (its only temporary difference). If the enacted tax rate is 15. What are some of the reasons that the components of in- 34% for all periods, and income taxes payable for the come tax expense should be disclosed and a reconciliation period is $230,000, determine the amount of total income between the effective tax rate and the statutory tax rate be tax expense to report for 2015. provided? 8. What is the difference between a future taxable amount 16. Differentiate between “loss carryback” and “loss carry- and a future deductible amount? When is it appropriate forward.” Which can be accounted for with the greater to record a valuation account for a deferred tax asset? certainty when it arises? Why? 9. Pretax financial income for Lake Inc. is $300,000, and its 17. What are the possible treatments for tax purposes of a taxable income is $100,000 for 2015. Its only temporary net operating loss? What are the circumstances that difference at the end of the period relates to a $70,000 d etermine the option to be applied? What is the proper difference due to excess depreciation for tax purposes. treatment of a net operating loss for financial reporting If the tax rate is 40% for all periods, compute the purposes? amount of income tax expense to report in 2015. No 18. What controversy relates to the accounting for net operat- deferred income taxes existed at the beginning of the ing loss carryforwards? year. 10. How are deferred tax assets and deferred tax liabilities 19. What is an uncertain tax position, and what are the general guidelines for accounting for uncertain tax positions? reported on the balance sheet? BRIEF EXERCISES 1 2 BE19-1 In 2014, Amirante Corporation had pretax financial income of $168,000 and taxable income of $120,000. The difference is due to the use of different depreciation methods for tax and accounting purposes. The effective tax rate is 40%. Compute the amount to be reported as income taxes payable at December 31, 2014. 1 2 BE19-2 Oxford Corporation began operations in 2014 and reported pretax financial income of $225,000 for the year. Oxford’s tax depreciation exceeded its book depreciation by $40,000. Oxford’s tax rate for 2014 and years thereafter is 30%. In its December 31, 2014, balance sheet, what amount of deferred tax liability should be reported? 1158 Chapter 19 Accounting for Income Taxes 9 BE19-3 Using the information from BE19-2, assume this is the only difference between Oxford’s pretax
financial income and taxable income. Prepare the journal entry to record the income tax expense, deferred income taxes, and income taxes payable, and show how the deferred tax liability will be classified on the December 31, 2014, balance sheet. 2 5 BE19-4 At December 31, 2014, Appaloosa Corporation had a deferred tax liability of $25,000. At December 31, 2015, the deferred tax liability is $42,000. The corporation’s 2015 current tax expense is $48,000. What amount should Appaloosa report as total 2015 income tax expense? 1 3 BE19-5 At December 31, 2014, Suffolk Corporation had an estimated warranty liability of $105,000 for accounting purposes and $0 for tax purposes. (The warranty costs are not deductible until paid.) The ef- fective tax rate is 40%. Compute the amount Suffolk should report as a deferred tax asset at December 31, 2014. 3 5 BE19-6 At December 31, 2014, Percheron Inc. had a deferred tax asset of $30,000. At December 31, 2015, the deferred tax asset is $59,000. The corporation’s 2015 current tax expense is $61,000. What amount should Percheron report as total 2015 income tax expense? 4 BE19-7 At December 31, 2014, Hillyard Corporation has a deferred tax asset of $200,000. After a careful review of all available evidence, it is determined that it is more likely than not that $60,000 of this deferred tax asset will not be realized. Prepare the necessary journal entry. 5 BE19-8 Mitchell Corporation had income before income taxes of $195,000 in 2014. Mitchell’s current in- come tax expense is $48,000, and deferred income tax expense is $30,000. Prepare Mitchell’s 2014 income statement, beginning with Income before income taxes. 2 3 BE19-9 Shetland Inc. had pretax financial income of $154,000 in 2014. Included in the computation of that amount is insurance expense of $4,000 which is not deductible for tax purposes. In addition, depreciation for tax purposes exceeds accounting depreciation by $10,000. Prepare Shetland’s journal entry to record 2014 taxes, assuming a tax rate of 45%. 2 BE19-10 Clydesdale Corporation has a cumulative temporary difference related to depreciation of $580,000 at December 31, 2014. This difference will reverse as follows: 2015, $42,000; 2016, $244,000; and 2017, $294,000. Enacted tax rates are 34% for 2015 and 2016, and 40% for 2017. Compute the amount Clydesdale should report as a deferred tax liability at December 31, 2014. 7 BE19-11 At December 31, 2014, Fell Corporation had a deferred tax liability of $680,000, resulting from future taxable amounts of $2,000,000 and an enacted tax rate of 34%. In May 2015, a new income tax act is signed into law that raises the tax rate to 40% for 2015 and future years. Prepare the journal entry for Fell to adjust the deferred tax liability. 8 BE19-12 Conlin Corporation had the following tax information. Year Taxable Income Tax Rate Taxes Paid 2012 $300,000 35% $105,000 2013 $325,000 30% $ 97,500 2014 $400,000 30% $120,000 In 2015, Conlin suffered a net operating loss of $480,000, which it elected to carry back. The 2015 enacted tax rate is 29%. Prepare Conlin’s entry to record the effect of the loss carryback. 8 BE19-13 Rode Inc. incurred a net operating loss of $500,000 in 2014. Combined income for 2012 and 2013 was $350,000. The tax rate for all years is 40%. Rode elects the carryback option. Prepare the journal entries to re- cord the benefits of the loss carryback and the loss carryforward. Rode expects to return to profitability in 2015. 4 8 BE19-14 Use the information for Rode Inc. given in BE19-13. Assume that it is more likely than not that the entire net operating loss carryforward will not be realized in future years. Prepare all the journal entries necessary at the end of 2014. 9 BE19-15 Youngman Corporation has temporary differences at December 31, 2014, that result in the follow- ing deferred taxes. Deferred tax liability—current $38,000 Deferred tax asset—current $62,000 Deferred tax liability—noncurrent $96,000 Deferred tax asset—noncurrent $27,000 Indicate how these balances would be presented in Youngman’s December 31, 2014, balance sheet.
Exercises 1159 EXERCISES 2 5 E19-1 (One Temporary Difference, Future Taxable Amounts, One Rate, No Beginning Deferred Taxes) South Carolina Corporation has one temporary difference at the end of 2014 that will reverse and cause taxable amounts of $55,000 in 2015, $60,000 in 2016, and $65,000 in 2017. South Carolina’s pretax financial income for 2014 is $300,000, and the tax rate is 30% for all years. There are no deferred taxes at the beginning of 2014. Instructions (a) Compute taxable income and income taxes payable for 2014. (b) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2014. (c) Prepare the income tax expense section of the income statement for 2014, beginning with the line “Income before income taxes.” 2 E19-2 (Two Differences, No Beginning Deferred Taxes, Tracked through 2 Years) The following infor- mation is available for Wenger Corporation for 2013 (its first year of operations). 1. Excess of tax depreciation over book depreciation, $40,000. This $40,000 difference will reverse equally over the years 2014–2017. 2. Deferral, for book purposes, of $20,000 of rent received in advance. The rent will be recognized in 2014. 3. Pretax financial income, $300,000. 4. Tax rate for all years, 40%. Instructions (a) Compute taxable income for 2013. (b) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2013. (c) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2014, assuming taxable income of $325,000. 2 5 E19-3 (One Temporary Difference, Future Taxable Amounts, One Rate, Beginning Deferred Taxes) Bandung Corporation began 2014 with a $92,000 balance in the Deferred Tax Liability account. At the end of 2014, the related cumulative temporary difference amounts to $350,000, and it will reverse evenly over the next 2 years. Pretax accounting income for 2014 is $525,000, the tax rate for all years is 40%, and taxable income for 2014 is $405,000. Instructions (a) Compute income taxes payable for 2014. (b) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2014. (c) Prepare the income tax expense section of the income statement for 2014 beginning with the line “Income before income taxes.” 2 3 E19-4 (Three Differences, Compute Taxable Income, Entry for Taxes) Zurich Company reports pretax 5 6 financial income of $70,000 for 2014. The following items cause taxable income to be different than pretax financial income. 1. Depreciation on the tax return is greater than depreciation on the income statement by $16,000. 2. Rent collected on the tax return is greater than rent recognized on the income statement by $22,000. 3. Fines for pollution appear as an expense of $11,000 on the income statement. Zurich’s tax rate is 30% for all years, and the company expects to report taxable income in all future years. There are no deferred taxes at the beginning of 2014. Instructions (a) Compute taxable income and income taxes payable for 2014. (b) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2014. (c) Prepare the income tax expense section of the income statement for 2014, beginning with the line “Income before income taxes.” (d) Compute the effective income tax rate for 2014. 1160 Chapter 19 Accounting for Income Taxes 2 3 E19-5 (Two Temporary Differences, One Rate, Beginning Deferred Taxes) The following facts relate to 5 Krung Thep Corporation. 1. Deferred tax liability, January 1, 2014, $40,000. 2. Deferred tax asset, January 1, 2014, $0. 3. Taxable income for 2014, $95,000. 4. Pretax financial income for 2014, $200,000. 5. Cumulative temporary difference at December 31, 2014, giving rise to future taxable amounts, $240,000. 6. Cumulative temporary difference at December 31, 2014, giving rise to future deductible amounts, $35,000. 7. Tax rate for all years, 40%. 8. The company is expected to operate profitably in the future.
Instructions (a) Compute income taxes payable for 2014. (b) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2014. (c) Prepare the income tax expense section of the income statement for 2014, beginning with the line “Income before income taxes.” 6 E19-6 (Identify Temporary or Permanent Differences) Listed below are items that are commonly ac- counted for differently for financial reporting purposes than they are for tax purposes. Instructions For each item below, indicate whether it involves: (1) A temporary difference that will result in future deductible amounts and, therefore, will usually give rise to a deferred income tax asset. (2) A temporary difference that will result in future taxable amounts and, therefore, will usually give rise to a deferred income tax liability. (3) A permanent difference. Use the appropriate number to indicate your answer for each. (a) ______ The MACRS depreciation system is used for tax purposes, and the straight-line depreciation method is used for financial reporting purposes for some plant assets. (b) ______ A landlord collects some rents in advance. Rents received are taxable in the period when they are received. (c) ______ Expenses are incurred in obtaining tax-exempt income. (d) ______ Costs of guarantees and warranties are estimated and accrued for financial reporting purposes. (e) ______ Installment sales of investments are accounted for by the accrual method for financial reporting purposes and the installment method for tax purposes. (f) ______ F or some assets, straight-line depreciation is used for both financial reporting purposes and tax purposes but the assets’ lives are shorter for tax purposes. (g) ______ Interest is received on an investment in tax-exempt municipal obligations. (h) ______ Proceeds are received from a life insurance company because of the death of a key officer. (The company carries a policy on key officers.) (i) ______ The tax return reports a deduction for 80% of the dividends received from U.S. corporations. The cost method is used in accounting for the related investments for financial reporting purposes. (j) ______ E stimated losses on pending lawsuits and claims are accrued for books. These losses are tax deductible in the period(s) when the related liabilities are settled. (k) ______ Expenses on stock options are accrued for financial reporting purposes. 2 3 E19-7 (Terminology, Relationships, Computations, Entries) 4 6 Instructions Complete the following statements by filling in the blanks. (a) In a period in which a taxable temporary difference reverses, the reversal will cause taxable income to be _______ (less than, greater than) pretax financial income. (b) If a $76,000 balance in Deferred Tax Asset was computed by use of a 40% rate, the underlying cumu- lative temporary difference amounts to $_______. (c) Deferred taxes ________ (are, are not) recorded to account for permanent differences. (d) If a taxable temporary difference originates in 2014, it will cause taxable income for 2014 to be ________ (less than, greater than) pretax financial income for 2014. (e) If total tax expense is $50,000 and deferred tax expense is $65,000, then the current portion of the expense computation is referred to as current tax _______ (expense, benefit) of $_______. Exercises 1161 (f) If a corporation’s tax return shows taxable income of $100,000 for Year 2 and a tax rate of 40%, how much will appear on the December 31, Year 2, balance sheet for “Income taxes payable” if the company has made estimated tax payments of $36,500 for Year 2? $________. (g) An increase in the Deferred Tax Liability account on the balance sheet is recorded by a _______ (debit, credit) to the Income Tax Expense account. (h) An income statement that reports current tax expense of $82,000 and deferred tax benefit of $23,000 will report total income tax expense of $________. (i) A valuation account is needed whenever it is judged to be _______ that a portion of a deferred tax asset _______ (will be, will not be) realized.
(j) If the tax return shows total taxes due for the period of $75,000 but the income statement shows total income tax expense of $55,000, the difference of $20,000 is referred to as deferred tax _______ (expense, benefit). 2 3 E19-8 (Two Temporary Differences, One Rate, 3 Years) Button Company has the following two tempo- 5 9 rary differences between its income tax expense and income taxes payable. 2014 2015 2016 Pretax fi nancial income $840,000 $910,000 $945,000 Excess depreciation expense on tax return (30,000) (40,000) (10,000) Excess warranty expense in fi nancial income 20,000 10,000 8,000 Taxable income $830,000 $880,000 $943,000 The income tax rate for all years is 40%. Instructions (a) Assuming there were no temporary differences prior to 2014, prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2014, 2015, and 2016. (b) Indicate how deferred taxes will be reported on the 2016 balance sheet. Button’s product warranty is for 12 months. (c) Prepare the income tax expense section of the income statement for 2016, beginning with the line “Pretax financial income.” 8 E19-9 (Carryback and Carryforward of NOL, No Valuation Account, No Temporary Differences) The pretax financial income (or loss) figures for Jenny Spangler Company are as follows. 2009 $160,000 2010 250,000 2011 80,000 2012 (160,000) 2013 (380,000) 2014 120,000 2015 100,000 Pretax financial income (or loss) and taxable income (loss) were the same for all years involved. Assume a 45% tax rate for 2009 and 2010 and a 40% tax rate for the remaining years. Instructions Prepare the journal entries for the years 2011 to 2015 to record income tax expense and the effects of the net operating loss carrybacks and carryforwards assuming Jenny Spangler Company uses the carryback provi- sion. All income and losses relate to normal operations. (In recording the benefits of a loss carryforward, assume that no valuation account is deemed necessary.) 8 E19-10 (Two NOLs, No Temporary Differences, No Valuation Account, Entries and Income Statement) Felicia Rashad Corporation has pretax financial income (or loss) equal to taxable income (or loss) from 2006 through 2014 as follows. Income (Loss) Tax Rate 2006 $ 29,000 30% 2007 40,000 30% 2008 17,000 35% 2009 48,000 50% 2010 (150,000) 40% 2011 90,000 40% 2012 30,000 40% 2013 105,000 40% 2014 (60,000) 45% 1162 Chapter 19 Accounting for Income Taxes Pretax financial income (loss) and taxable income (loss) were the same for all years since Rashad has been in business. Assume the carryback provision is employed for net operating losses. In recording the benefits of a loss carryforward, assume that it is more likely than not that the related benefits will be realized. Instructions (a) What entry(ies) for income taxes should be recorded for 2010? (b) Indicate what the income tax expense portion of the income statement for 2010 should look like. Assume all income (loss) relates to continuing operations. (c) What entry for income taxes should be recorded in 2011? (d) How should the income tax expense section of the income statement for 2011 appear? (e) What entry for income taxes should be recorded in 2014? (f) How should the income tax expense section of the income statement for 2014 appear? 2 3 E19-11 (Three Differences, Classify Deferred Taxes) At December 31, 2013, Belmont Company had a net 9 deferred tax liability of $375,000. An explanation of the items that compose this balance is as follows. Resulting Balances Temporary Differences in Deferred Taxes 1. Excess of tax depreciation over book depreciation $200,000 2. Accrual, for book purposes, of estimated loss contingency from pending lawsuit that is expected to be settled in 2014. The loss will be deducted on the tax return when paid. (50,000) 3. Accrual method used for book purposes and installment method used for tax purposes for an isolated installment sale of an investment. 225,000 $375,000 In analyzing the temporary differences, you find that $30,000 of the depreciation temporary difference will
reverse in 2014, and $120,000 of the temporary difference due to the installment sale will reverse in 2014. The tax rate for all years is 40%. Instructions Indicate the manner in which deferred taxes should be presented on Belmont Company’s December 31, 2013, balance sheet. 2 3 E19-12 (Two Temporary Differences, One Rate, Beginning Deferred Taxes, Compute Pretax Financial 5 Income) The following facts relate to Duncan Corporation. 1. Deferred tax liability, January 1, 2014, $60,000. 2. Deferred tax asset, January 1, 2014, $20,000. 3. Taxable income for 2014, $105,000. 4. Cumulative temporary difference at December 31, 2014, giving rise to future taxable amounts, $230,000. 5. Cumulative temporary difference at December 31, 2014, giving rise to future deductible amounts, $95,000. 6. Tax rate for all years, 40%. No permanent differences exist. 7. The company is expected to operate profitably in the future. Instructions (a) Compute the amount of pretax financial income for 2014. (b) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2014. (c) Prepare the income tax expense section of the income statement for 2014, beginning with the line “Income before income taxes.” (d) Compute the effective tax rate for 2014. 2 7 E19-13 (One Difference, Multiple Rates, Effect of Beginning Balance versus No Beginning Deferred Taxes) At the end of 2013, Lucretia McEvil Company has $180,000 of cumulative temporary differences that will result in reporting future taxable amounts as shown on the next page. Exercises 1163 2014 $ 60,000 2015 50,000 2016 40,000 2017 30,000 $180,000 Tax rates enacted as of the beginning of 2012 are: 2012 and 2013 40% 2014 and 2015 30% 2016 and later 25% McEvil’s taxable income for 2013 is $320,000. Taxable income is expected in all future years. Instructions (a) Prepare the journal entry for McEvil to record income taxes payable, deferred income taxes, and income tax expense for 2013, assuming that there were no deferred taxes at the end of 2012. (b) Prepare the journal entry for McEvil to record income taxes payable, deferred income taxes, and income tax expense for 2013, assuming that there was a balance of $22,000 in a Deferred Tax Liability account at the end of 2012. 3 4 E19-14 (Deferred Tax Asset with and without Valuation Account) Jennifer Capriati Corp. has a deferred tax asset account with a balance of $150,000 at the end of 2013 due to a single cumulative temporary differ- ence of $375,000. At the end of 2014, this same temporary difference has increased to a cumulative amount of $450,000. Taxable income for 2014 is $820,000. The tax rate is 40% for all years. No valuation account related to the deferred tax asset is in existence at the end of 2013. Instructions (a) Record income tax expense, deferred income taxes, and income taxes payable for 2014, assuming that it is more likely than not that the deferred tax asset will be realized. (b) Assuming that it is more likely than not that $30,000 of the deferred tax asset will not be realized, prepare the journal entry at the end of 2014 to record the valuation account. 3 4 E19-15 (Deferred Tax Asset with Previous Valuation Account) Assume the same information as E19-14, 5 except that at the end of 2013, Jennifer Capriati Corp. had a valuation account related to its deferred tax asset of $45,000. Instructions (a) Record income tax expense, deferred income taxes, and income taxes payable for 2014, assuming that it is more likely than not that the deferred tax asset will be realized in full. (b) Record income tax expense, deferred income taxes, and income taxes payable for 2014, assuming that it is more likely than not that none of the deferred tax asset will be realized. 2 5 E19-16 (Deferred Tax Liability, Change in Tax Rate, Prepare Section of Income Statement) Novotna 7 9 Inc.’s only temporary difference at the beginning and end of 2013 is caused by a $3 million deferred gain for tax purposes for an installment sale of a plant asset, and the related receivable (only one-half of which
is classified as a current asset) is due in equal installments in 2014 and 2015. The related deferred tax liabil- ity at the beginning of the year is $1,200,000. In the third quarter of 2013, a new tax rate of 34% is enacted into law and is scheduled to become effective for 2015. Taxable income for 2013 is $5,000,000, and taxable income is expected in all future years. Instructions (a) Determine the amount reported as a deferred tax liability at the end of 2013. Indicate proper classification(s). (b) Prepare the journal entry (if any) necessary to adjust the deferred tax liability when the new tax rate is enacted into law. (c) Draft the income tax expense portion of the income statement for 2013. Begin with the line “Income before income taxes.” Assume no permanent differences exist. 2 3 E19-17 (Two Temporary Differences, Tracked through 3 Years, Multiple Rates) Taxable income 7 and pretax financial income would be identical for Huber Co. except for its treatments of gross profit on installment sales and estimated costs of warranties. The income computations shown on page 1164 have been prepared. 1164 Chapter 19 Accounting for Income Taxes Taxable income 2013 2014 2015 Excess of revenues over expenses (excluding two temporary differences) $160,000 $210,000 $90,000 Installment gross profi t collected 8,000 8,000 8,000 Expenditures for warranties (5,000) (5,000) (5,000) Taxable income $163,000 $213,000 $93,000 Pretax fi nancial income 2013 2014 2015 Excess of revenues over expenses (excluding two temporary differences) $160,000 $210,000 $90,000 Installment gross profi t earned 24,000 –0– –0– Estimated cost of warranties (15,000) –0– –0– Income before taxes $169,000 $210,000 $90,000 The tax rates in effect are 2013, 40%; 2014 and 2015, 45%. All tax rates were enacted into law on January 1, 2013. No deferred income taxes existed at the beginning of 2013. Taxable income is expected in all future years. Instructions Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2013, 2014, and 2015. 2 3 E19-18 (Three Differences, Multiple Rates, Future Taxable Income) During 2014, Kate Holmes Co.’s first 7 year of operations, the company reports pretax financial income at $250,000. Holmes’s enacted tax rate is 45% for 2014 and 40% for all later years. Holmes expects to have taxable income in each of the next 5 years. The effects on future tax returns of temporary differences existing at December 31, 2014, are summarized as follows. Future Years 2015 2016 2017 2018 2019 Total Future taxable (deductible) amounts: Installment sales $32,000 $32,000 $32,000 $ 96,000 Depreciation 6,000 6,000 6,000 $6,000 $6,000 30,000 Unearned rent (50,000) (50,000) (100,000) Instructions (a) Complete the schedule below to compute deferred taxes at December 31, 2014. (b) Compute taxable income for 2014. (c) Prepare the journal entry to record income taxes payable, deferred taxes, and income tax expense for 2014. Future Taxable December 31, 2014 (Deductible) Tax Deferred Tax Temporary Difference Amounts Rate (Asset) Liability Installment sales $ 96,000 Depreciation 30,000 Unearned rent (100,000) Totals $ 2 3 E19-19 (Two Differences, One Rate, Beginning Deferred Balance, Compute Pretax Financial Income) 9 Andy McDowell Co. establishes a $100 million liability at the end of 2014 for the estimated site-cleanup costs at two of its manufacturing facilities. All related closing costs will be paid and deducted on the tax return in 2015. Also, at the end of 2014, the company has $50 million of temporary differences due to excess depreciation for tax purposes, $7 million of which will reverse in 2015. The enacted tax rate for all years is 40%, and the company pays taxes of $64 million on $160 million of taxable income in 2014. McDowell expects to have taxable income in 2015. Instructions (a) Determine the deferred taxes to be reported at the end of 2015. (b) Indicate how the deferred taxes computed in (a) are to be reported on the balance sheet. Exercises 1165 (c) Assuming that the only deferred tax account at the beginning of 2014 was a deferred tax liability of
$10,000,000, draft the income tax expense portion of the income statement for 2014, beginning with the line “Income before income taxes.” (Hint: You must first compute (1) the amount of temporary difference underlying the beginning $10,000,000 deferred tax liability, then (2) the amount of tempo- rary differences originating or reversing during the year, and then (3) the amount of pretax financial income.) 2 3 E19-20 (Two Differences, No Beginning Deferred Taxes, Multiple Rates) Teri Hatcher Inc., in its first 9 year of operations, has the following differences between the book basis and tax basis of its assets and liabilities at the end of 2013. Book Basis Tax Basis Equipment (net) $400,000 $340,000 Estimated warranty liability $200,000 $ –0– It is estimated that the warranty liability will be settled in 2014. The difference in equipment (net) will r esult in taxable amounts of $20,000 in 2014, $30,000 in 2015, and $10,000 in 2016. The company has taxable income of $520,000 in 2013. As of the beginning of 2013, the enacted tax rate is 34% for 2013–2015, and 30% for 2016. Hatcher expects to report taxable income through 2016. Instructions (a) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2013. (b) Indicate how deferred income taxes will be reported on the balance sheet at the end of 2013. 2 3 E19-21 (Two Temporary Differences, Multiple Rates, Future Taxable Income) Nadal Inc. has two tem- 7 9 porary differences at the end of 2013. The first difference stems from installment sales, and the second one results from the accrual of a loss contingency. Nadal’s accounting department has developed a schedule of future taxable and deductible amounts related to these temporary differences as follows. 2014 2015 2016 2017 Taxable amounts $40,000 $50,000 $60,000 $80,000 Deductible amounts (15,000) (19,000) $40,000 $35,000 $41,000 $80,000 As of the beginning of 2013, the enacted tax rate is 34% for 2013 and 2014, and 38% for 2015–2018. At the beginning of 2013, the company had no deferred income taxes on its balance sheet. Taxable income for 2013 is $500,000. Taxable income is expected in all future years. Instructions (a) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2013. (b) Indicate how deferred income taxes would be classified on the balance sheet at the end of 2013. 2 3 E19-22 (Two Differences, One Rate, First Year) The differences between the book basis and tax basis of 9 the assets and liabilities of Castle Corporation at the end of 2013 are presented below. Book Basis Tax Basis Accounts receivable $50,000 $–0– Litigation liability 30,000 –0– It is estimated that the litigation liability will be settled in 2014. The difference in accounts receivable will result in taxable amounts of $30,000 in 2014 and $20,000 in 2015. The company has taxable income of $350,000 in 2013 and is expected to have taxable income in each of the following 2 years. Its enacted tax rate is 34% for all years. This is the company’s first year of operations. The operating cycle of the business is 2 years. Instructions (a) Prepare the journal entry to record income tax expense, deferred income taxes, and income taxes payable for 2013. (b) Indicate how deferred income taxes will be reported on the balance sheet at the end of 2013. 1166 Chapter 19 Accounting for Income Taxes 4 7 E19-23 (NOL Carryback and Carryforward, Valuation Account versus No Valuation Account) Spamela 8 Hamderson Inc. reports the following pretax income (loss) for both financial reporting purposes and tax purposes. (Assume the carryback provision is used for a net operating loss.) Year Pretax Income (Loss) Tax Rate 2012 $120,000 34% 2013 90,000 34% 2014 (280,000) 38% 2015 220,000 38% The tax rates listed were all enacted by the beginning of 2012. Instructions (a) Prepare the journal entries for the years 2012–2015 to record income tax expense (benefit) and income taxes payable (refundable) and the tax effects of the loss carryback and carryforward, assuming that
at the end of 2014 the benefits of the loss carryforward are judged more likely than not to be realized in the future. (b) Using the assumption in (a), prepare the income tax section of the 2014 income statement beginning with the line “Operating loss before income taxes.” (c) Prepare the journal entries for 2014 and 2015, assuming that based on the weight of available evi- dence, it is more likely than not that one-fourth of the benefits of the loss carryforward will not be realized. (d) Using the assumption in (c), prepare the income tax section of the 2014 income statement beginning with the line “Operating loss before income taxes.” 4 7 E19-24 (NOL Carryback and Carryforward, Valuation Account Needed) Beilman Inc. reports the follow- 8 ing pretax income (loss) for both book and tax purposes. (Assume the carryback provision is used where possible for a net operating loss.) Year Pretax Income (Loss) Tax Rate 2012 $120,000 40% 2013 90,000 40% 2014 (280,000) 45% 2015 120,000 45% The tax rates listed were all enacted by the beginning of 2012. Instructions (a) Prepare the journal entries for years 2012–2015 to record income tax expense (benefit) and income taxes payable (refundable), and the tax effects of the loss carryback and loss carryforward, assuming that based on the weight of available evidence, it is more likely than not that one-half of the benefits of the loss carryforward will not be realized. (b) Prepare the income tax section of the 2014 income statement beginning with the line “Operating loss before income taxes.” (c) Prepare the income tax section of the 2015 income statement beginning with the line “Income before income taxes.” 4 7 E19-25 (NOL Carryback and Carryforward, Valuation Account Needed) Meyer reported the following 8 pretax financial income (loss) for the years 2012–2016. 2012 $240,000 2013 350,000 2014 120,000 2015 (570,000) 2016 180,000 Pretax financial income (loss) and taxable income (loss) were the same for all years involved. The enacted tax rate was 34% for 2012 and 2013, and 40% for 2014–2016. Assume the carryback provision is used first for net operating losses. Problems 1167 Instructions (a) Prepare the journal entries for the years 2014–2016 to record income tax expense, income taxes payable (refundable), and the tax effects of the loss carryback and loss carryforward, assuming that based on the weight of available evidence, it is more likely than not that one-fifth of the benefits of the loss carryforward will not be realized. (b) Prepare the income tax section of the 2015 income statement beginning with the line “Income (loss) before income taxes.” EXERCISES SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of exercises. PROBLEMS 2 3 P19-1 (Three Differences, No Beginning Deferred Taxes, Multiple Rates) The following information is 5 available for Remmers Corporation for 2014. 1. Depreciation reported on the tax return exceeded depreciation reported on the income statement by $120,000. This difference will reverse in equal amounts of $30,000 over the years 2015–2018. 2. Interest received on municipal bonds was $10,000. 3. Rent collected in advance on January 1, 2014, totaled $60,000 for a 3-year period. Of this amount, $40,000 was reported as unearned at December 31, 2014, for book purposes. 4. The tax rates are 40% for 2014 and 35% for 2015 and subsequent years. 5. Income taxes of $320,000 are due per the tax return for 2014. 6. No deferred taxes existed at the beginning of 2014. Instructions (a) Compute taxable income for 2014. (b) Compute pretax financial income for 2014. (c) Prepare the journal entries to record income tax expense, deferred income taxes, and income taxes payable for 2014 and 2015. Assume taxable income was $980,000 in 2015. (d) Prepare the income tax expense section of the income statement for 2014, beginning with “Income before income taxes.” 3 5 P19-2 (One Temporary Difference, Tracked for 4 Years, One Permanent Difference, Change in Rate) The 6 pretax financial income of Truttman Company differs from its taxable income throughout each of 4 years
as follows. Pretax Taxable Year Financial Income Income Tax Rate 2014 $290,000 $180,000 35% 2015 320,000 225,000 40% 2016 350,000 260,000 40% 2017 420,000 560,000 40% Pretax financial income for each year includes a nondeductible expense of $30,000 (never deductible for tax purposes). The remainder of the difference between pretax financial income and taxable income in each period is due to one depreciation temporary difference. No deferred income taxes existed at the beginning of 2014. Instructions (a) Prepare journal entries to record income taxes in all 4 years. Assume that the change in the tax rate to 40% was not enacted until the beginning of 2015. (b) Prepare the income statement for 2015, beginning with Income before income taxes. 1168 Chapter 19 Accounting for Income Taxes 2 5 P19-3 (Second Year of Depreciation Difference, Two Differences, Single Rate, Extraordinary Item) The 6 9 following information has been obtained for the Gocker Corporation. 1. Prior to 2014, taxable income and pretax financial income were identical. 2. Pretax financial income is $1,700,000 in 2014 and $1,400,000 in 2015. 3. On January 1, 2014, equipment costing $1,200,000 is purchased. It is to be depreciated on a straight- line basis over 5 years for tax purposes and over 8 years for financial reporting purposes. (Hint: Use the half-year convention for tax purposes, as discussed in Appendix 11A.) 4. Interest of $60,000 was earned on tax-exempt municipal obligations in 2015. 5. Included in 2015 pretax financial income is an extraordinary gain of $200,000, which is fully taxable. 6. The tax rate is 35% for all periods. 7. Taxable income is expected in all future years. Instructions (a) Compute taxable income and income taxes payable for 2015. (b) Prepare the journal entry to record 2015 income tax expense, income taxes payable, and deferred taxes. (c) Prepare the bottom portion of Gocker’s 2015 income statement, beginning with “Income before income taxes and extraordinary item.” (d) Indicate how deferred income taxes should be presented on the December 31, 2015, balance sheet. 2 3 P19-4 (Permanent and Temporary Differences, One Rate) The accounting records of Shinault Inc. show 5 the following data for 2014 (its first year of operations). 1. Life insurance expense on officers was $9,000. 2. Equipment was acquired in early January for $300,000. Straight-line depreciation over a 5-year life is used, with no salvage value. For tax purposes, Shinault used a 30% rate to calculate depreciation. 3. Interest revenue on State of New York bonds totaled $4,000. 4. Product warranties were estimated to be $50,000 in 2014. Actual repair and labor costs related to the warranties in 2014 were $10,000. The remainder is estimated to be paid evenly in 2015 and 2016. 5. Gross profit on an accrual basis was $100,000. For tax purposes, $75,000 was recorded on the install- ment-sales method. 6. Fines incurred for pollution violations were $4,200. 7. Pretax financial income was $750,000. The tax rate is 30%. Instructions (a) Prepare a schedule starting with pretax financial income in 2014 and ending with taxable income in 2014. (b) Prepare the journal entry for 2014 to record income taxes payable, income tax expense, and deferred income taxes. 5 7 P19-5 (NOL without Valuation Account) Jennings Inc. reported the following pretax income (loss) and 8 9 related tax rates during the years 2010–2016. Pretax Income (loss) Tax Rate 2010 $ 40,000 30% 2011 25,000 30% 2012 50,000 30% 2013 80,000 40% 2014 (180,000) 45% 2015 70,000 40% 2016 100,000 35% Pretax financial income (loss) and taxable income (loss) were the same for all years since Jennings began business. The tax rates from 2013–2016 were enacted in 2013. Instructions (a) Prepare the journal entries for the years 2014–2016 to record income taxes payable (refundable), i ncome tax expense (benefit), and the tax effects of the loss carryback and carryforward. Assume that Jennings elects the carryback provision where possible and expects to realize the benefits of any loss carryforward in the year that immediately follows the loss year.
(b) Indicate the effect the 2014 entry(ies) has on the December 31, 2014, balance sheet. (c) Prepare the portion of the income statement, starting with “Operating loss before income taxes,” for 2014. (d) Prepare the portion of the income statement, starting with “Income before income taxes,” for 2015. Problems 1169 2 3 P19-6 (Two Differences, Two Rates, Future Income Expected) Presented below are two independent 9 situations related to future taxable and deductible amounts resulting from temporary differences existing at December 31, 2014. 1. Mooney Co. has developed the following schedule of future taxable and deductible amounts. 2015 2016 2017 2018 2019 Taxable amounts $300 $300 $300 $ 300 $300 Deductible amount — — — (1,600) — 2. Roesch Co. has the following schedule of future taxable and deductible amounts. 2015 2016 2017 2018 Taxable amounts $300 $300 $ 300 $300 Deductible amount — — (2,300) — Both Mooney Co. and Roesch Co. have taxable income of $4,000 in 2014 and expect to have taxable income in all future years. The tax rates enacted as of the beginning of 2014 are 30% for 2014–2017 and 35% for years thereafter. All of the underlying temporary differences relate to noncurrent assets and liabilities. Instructions For each of these two situations, compute the net amount of deferred income taxes to be reported at the end of 2014, and indicate how it should be classified on the balance sheet. 2 5 P19-7 (One Temporary Difference, Tracked 3 Years, Change in Rates, Income Statement Presenta- 7 tion) Crosley Corp. sold an investment on an installment basis. The total gain of $60,000 was reported for financial reporting purposes in the period of sale. The company qualifies to use the installment-sales method for tax purposes. The installment period is 3 years; one-third of the sale price is collected in the period of sale. The tax rate was 40% in 2014, and 35% in 2015 and 2016. The 35% tax rate was not enacted in law until 2015. The accounting and tax data for the 3 years is shown below. Financial Tax Accounting Return 2014 (40% tax rate) Income before temporary difference $ 70,000 $70,000 Temporary difference 60,000 20,000 Income $130,000 $90,000 2015 (35% tax rate) Income before temporary difference $ 70,000 $70,000 Temporary difference –0– 20,000 Income $ 70,000 $90,000 2016 (35% tax rate) Income before temporary difference $ 70,000 $70,000 Temporary difference –0– 20,000 Income $ 70,000 $90,000 Instructions (a) Prepare the journal entries to record the income tax expense, deferred income taxes, and the income taxes payable at the end of each year. No deferred income taxes existed at the beginning of 2014. (b) Explain how the deferred taxes will appear on the balance sheet at the end of each year. (Assume Installment Accounts Receivable is classified as a current asset.) (c) Draft the income tax expense section of the income statement for each year, beginning with “Income before income taxes.” 2 3 P19-8 (Two Differences, 2 Years, Compute Taxable Income and Pretax Financial Income) The informa- 5 9 tion shown below and on page 1170 was disclosed during the audit of Elbert Inc. 1. Amount Due Year per Tax Return 2014 $130,000 2015 104,000 1170 Chapter 19 Accounting for Income Taxes 2. On January 1, 2014, equipment costing $600,000 is purchased. For financial reporting purposes, the company uses straight-line depreciation over a 5-year life. For tax purposes, the company uses the elective straight-line method over a 5-year life. (Hint: For tax purposes, the half-year convention as discussed in Appendix 11A must be used.) 3. In January 2015, $225,000 is collected in advance rental of a building for a 3-year period. The entire $225,000 is reported as taxable income in 2015, but $150,000 of the $225,000 is reported as unearned revenue in 2015 for financial reporting purposes. The remaining amount of unearned revenue is to be recognized equally in 2016 and 2017. 4. The tax rate is 40% in 2014 and all subsequent periods. (Hint: To find taxable income in 2014 and 2015, the related income taxes payable amounts will have to be “grossed up.”)
5. No temporary differences existed at the end of 2013. Elbert expects to report taxable income in each of the next 5 years. Instructions (a) Determine the amount to report for deferred income taxes at the end of 2014, and indicate how it should be classified on the balance sheet. (b) Prepare the journal entry to record income taxes for 2014. (c) Draft the income tax section of the income statement for 2014, beginning with “Income before income taxes.” (Hint: You must compute taxable income and then combine that with changes in cumulative temporary differences to arrive at pretax financial income.) (d) Determine the deferred income taxes at the end of 2015, and indicate how they should be classified on the balance sheet. (e) Prepare the journal entry to record income taxes for 2015. (f) Draft the income tax section of the income statement for 2015, beginning with “Income before income taxes.” 2 3 P19-9 (Five Differences, Compute Taxable Income and Deferred Taxes, Draft Income Statement) 5 6 Wise Company began operations at the beginning of 2015. The following information pertains to this company. 9 1. Pretax financial income for 2015 is $100,000. 2. The tax rate enacted for 2015 and future years is 40%. 3. Differences between the 2015 income statement and tax return are listed below: (a) Warranty expense accrued for financial reporting purposes amounts to $7,000. Warranty deduc- tions per the tax return amount to $2,000. (b) Gross profit on construction contracts using the percentage-of-completion method per books amounts to $92,000. Gross profit on construction contracts for tax purposes amounts to $67,000. (c) Depreciation of property, plant, and equipment for financial reporting purposes amounts to $60,000. Depreciation of these assets amounts to $80,000 for the tax return. (d) A $3,500 fine paid for violation of pollution laws was deducted in computing pretax financial income. (e) Interest revenue recognized on an investment in tax-exempt municipal bonds amounts to $1,500. 4. Taxable income is expected for the next few years. (Assume (a) is short-term in nature; assume (b) and (c) are long-term in nature.) Instructions (a) Compute taxable income for 2015. (b) Compute the deferred taxes at December 31, 2015, that relate to the temporary differences described above. Clearly label them as deferred tax asset or liability. (c) Prepare the journal entry to record income tax expense, deferred taxes, and income taxes payable for 2015. (d) Draft the income tax expense section of the income statement, beginning with “Income before income taxes.” PROBLEMS SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of problems. Concepts for Analysis 1171 CONCEPTS FOR ANALYSIS CA19-1 (Objectives and Principles for Accounting for Income Taxes) The amount of income taxes due to the government for a period of time is rarely the amount reported on the income statement for that period as income tax expense. Instructions (a) Explain the objectives of accounting for income taxes in general-purpose financial statements. (b) Explain the basic principles that are applied in accounting for income taxes at the date of the financial statements to meet the objectives discussed in (a). (c) List the steps in the annual computation of deferred tax liabilities and assets. CA19-2 (Basic Accounting for Temporary Differences) Dexter Company appropriately uses the asset- liability method to record deferred income taxes. Dexter reports depreciation expense for certain machinery purchased this year using the modified accelerated cost recovery system (MACRS) for income tax purposes and the straight-line basis for financial reporting purposes. The tax deduction is the larger amount this year. Dexter received rent revenues in advance this year. These revenues are included in this year’s taxable income. However, for financial reporting purposes, these revenues are reported as unearned revenues, a current liability. Instructions (a) What are the principles of the asset-liability approach? (b) How would Dexter account for the temporary differences?