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CHAPTER 4

Design Pics/Keith Levit/Newscom

Revenue Recognition and the Statement of Income Expanding the Cast to Bring in the Cash Selling popcorn and other snacks doesn’t add up to peanuts. Just look at Cineplex Inc., Canada’s largest movie chain, with 165 theatres and 1,680 screens from coast to coast. In 2016, for every $1 in box office revenues, Cineplex earned $0.60 in concession revenues. Even more significantly, in 2016, Cineplex earned a gross profit of $0.45 on each $1 of box office revenue, but earned a gross profit of $0.77 on each $1 of concession sales! Movie tickets and snacks are part of Cineplex’s revenue model—how it earns cash. Most movie theatres sell snacks because moviegoers want them and they’re profitable. For example, guests at Cineplex theatres spent an average of $5.65 on concessions during each visit in 2016. But Cineplex has expanded the “cast of characters” in its revenue model partly because movie attendance ebbs and flows with the seasons and with the popularity of blockbusters. On the movie side, it’s added Hindi and Punjabi films along with videos and live broadcasts of opera, concert, sports, and theatre productions. Cineplex is also investing heavily in its theatres, opening in 2016 its first “4DX” auditorium in downtown Toronto, which shows 3D movies and features motion seats and environmental effects, such as wind, rain, and snow, that are synchronized with the movie action. It was charging $24.99 a ticket for the 3D experience. It was also planning to install recliner seats in several theatres and expand the number of theatres with the “Barco Escape” technology that have two side screens offering panoramic viewing.

To help reduce its reliance on Hollywood blockbusters, Cineplex continues to diversify into other types of entertainment. In 2016 the company opened its first location of The Rec Room in Edmonton, Alberta. The 5,500 square-metre (60,000 square-foot) facility offers restaurants, live entertainment, a bowling alley, air hockey, and more. Cineplex planned to open 10 to 15 locations of The Rec Room in the next few years. Cineplex’s revenue model grows even larger with its gaming business. It operates 26 XSCAPE Entertainment Centres in its theatres, offering video and interactive games with prizes and even a licensed lounge. Cineplex is staking a claim in the digital entertainment space, too. In 2016 it launched apps for Xbox consoles and Android mobile devices so customers can rent, buy, and watch movies on their Xbox at home or Android devices anywhere. “We remain committed to expanding our business model beyond the box office and into businesses that capitalize on our internal strengths and competencies,” said Cineplex President and CEO Ellis Jacob in the company’s 2016 annual report to shareholders. “This strategy will help us to offset the variations in box office as a result of content fluctuation from the studios.” Cineplex’s main revenue sources and expenses are presented on its consolidated statements of operations. In 2016, Cineplex’s total revenues were $1,478.3 million, which included $712.4 million in box office revenues, $423.9 million in concession revenues, $170.8 million from its various media businesses, and $171.2 million in other revenues. After deducting expenses and income taxes, Cineplex had net income of almost $78.0 million—a happy ending for the company’s shareholders!1

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Revenue Recognition and the Statement of Income

CORE QUESTIONS

LEARNING OBJECTIVES

If you are able to answer the following questions, then you have achieved the related learning objectives.

After studying this chapter, you should be able to:

Revenue and its Significance • What is revenue and why is it of significance to users? • Why is understanding how a company recognizes revenue of significance to users?

1. Explain the nature of revenue and why revenue is of significance to users.

Revenue Recognition • When are revenues recognized?

2. Identify and explain the contract-based approach to revenue recognition.

Other Revenue Recognition Issues • How do the right of returns, warranties, consignment, and third-party sale arrangements affect revenue recognition?

3. Explain how revenue recognition is affected by the right of returns, warranties, consignment, and third-party sale arrangements.

Statement of Income Formats • How does a single-step statement of income differ from a multi-step statement of income?

4. Understand the difference between a single-step statement of income and a multi-step statement of income.

Statement of Comprehensive Income • What is comprehensive income and how does it differ from net income?

5. Understand the difference between comprehensive income and net income.

Presentation of Expenses by Nature or by Function • How does a statement of income presenting expenses by function differ from one presenting expenses by nature of the items?

6. Understand the difference between presenting expenses by function or by nature of the item on the statement of income.

Financial Statement Analysis • What is meant by earnings per share, and how is it calculated?

7. Calculate and interpret a company’s basic earnings per share.

Revenue and Its Significance LEAR NING OBJECTIVE 1 Explain the nature of revenue and why revenue is of significance to users.

In Chapters 1 through 3, four basic financial statements were described, and we saw that two of these, the statement of income and the statement of cash flows, measure the company’s performance across a time period. This chapter discusses the accounting concepts and principles for the recognition of income, provides more detail about the statement of income, and considers some of the challenges that are inherent in performance measurement.


Revenue and Its Significance 4-3

What Is Revenue and Why Is It of Significance to Users? Income is composed of two elements: revenue and gains. The distinction between these has to do with whether the income arises in the course of a company’s ordinary activities, which are those activities that are the company’s normal, ongoing major business activities. Revenues are defined as increases in economic benefits from a company’s ordinary operating activities, while gains result in increases in economic benefits from activities that are outside the course of ordinary operating activities. In other words, revenues result in inflows of assets such as cash or accounts receivable or decreases in liabilities such as unearned revenue and are generated by the transactions a company normally has with its customers, selling them products and/or providing services. There is a huge range of transactions that can be considered normal operating activities because there are so many different types of businesses. For example, the ordinary operating activities for clothing retailers include the sale of clothing and accessories, while the provision of air travel and vacation packages is a normal operating activity for airline companies. Your university or college has a range of activities that are considered normal operating activities. These include providing educational services, selling goods in its bookstore or cafeteria, selling parking passes, and renting rooms in student residences. Revenue is often referred to with other terms, such as sales, fees, interest, dividends, royalties, or rent. As we discussed in Chapter 2, there does not have to be a receipt of cash in order for a company to recognize revenue. This is why the term economic benefit is used when defining revenue. While the economic benefit will normally be an inflow of cash at some point, the sale and the receipt of cash do not have to occur at the same time. In this chapter, we will see examples of revenue transactions for which the cash is received prior to the sale, at the time of sale, or subsequent to the sale. The amount of revenue (or sales) is one of the most significant amounts reported in the financial statements. For a company to be successful, it must generate revenues from what it is in the business of doing. A company’s total revenues must be greater than the expenses incurred to generate them. When total revenues exceed total expenses, a company reports net income. Financial statement users see this as a sign that the company is viable, has the ability to sustain itself or grow, and has the ability to declare dividends. On the other hand, if total expenses exceed total revenues, a company reports a net loss. A loss may signal that all is not well with the company. When losses occur, it is important for management and users to evaluate both the size and cause of the loss. When assessing revenues, financial statement users evaluate both quantity and quality. Quantity is the amount of revenue and whether or not the trend shows an increase or decrease over a number of accounting periods. Quality refers to the source(s) of revenue and the company’s ability to sustain the revenue over the longer term. For example, retail stores often report a key measure: same-store sales. This helps users to determine whether revenue growth is from new locations or increased sales at existing locations. If sales at established stores are increasing year over year, it suggests a high quality of earnings. If, on the other hand, a retailer reports an increase in revenue due to having more locations, but there is a decrease in same-store sales, this may signal an issue with the quality of earnings.

Ethics in Accounting Revenue recognition issues have been at the heart of many accounting scandals. The significance placed on reported revenues can provide an incentive for management to try to maximize it. One of the biggest Canadian financial reporting frauds involved a Calgary-based company, Poseidon Concepts Corp. The company, which had a market capitalization of more than $1.3 billion before the fraud was exposed, was in the business of building and

supplying fracking fluid storage systems to the North American oil and gas industry. When the fraud was investigated, it turned out that the company had been booking fictitious revenues. In fact, more than $100 million in revenues were recorded related to contracts that were either non-existent or uncollectible! Investors lost more than $1 billion as the value of the Poseidon shares they owned evaporated once the fraud was exposed.2


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For Example Canadian Tire Corporation reported the following Financial Statements same-store sales growth for the various segments of its operations: Canadian Tire retail stores Mark’s/Mark’s Work Wearhouse stores FGL Sports stores

Bloomberg/Getty Images

KEY POINTS When assessing revenues, users consider: • quantity by measuring growth • quality by assessing the source of growth (such as same-store sales growth) and how closely revenue growth corresponds with cash flow from operating activities

2016

2015

4.2% 6.1% 6.0%

3.2% (0.5)% 4.4%

From this we can see that, on a percentage basis, the company experienced sales growth in each of its segments in 2016, with the greatest sales growth at its Mark’s stores.3

As we learned in Chapter 2, companies use the accrual basis of accounting. Under the accrual basis, accounting revenues are recognized when they are earned regardless of whether the related cash was received by the company. However, revenues must, at some point, be collected in cash. Cash is essential to a company’s ultimate survival. Another way the quality of earnings is assessed is to compare the cash flow from operations (from the statement of cash flows) with net income (or net earnings). If these two amounts are moving together (both up or both down) and if the cash flow from operating activities is greater than the net income, we consider the earnings to be of higher quality. If the two amounts do not move together and if the cash flow from operating activities is less than the net income, we consider the earnings to be of lower quality. The Key Points show how users assess revenues.

Why Is Understanding How a Company Recognizes Revenue of Significance to Users? Users need to be aware of how companies recognize revenue so that they can make informed judgements about reported revenues. Accounting standards outline approaches or models for revenue recognition rather than providing specific rules, so it is possible that different companies apply them differently. The revenue recognition approach also differs depending on whether a company is using IFRS or ASPE. Therefore, when comparing companies, a user must understand which revenue recognition approach each company is using. Some companies have multiple business activities. For example, Rogers Communications sells Internet services, owns a Major League Baseball team, and publishes several magazines. While Rogers will apply a single revenue recognition model, it will have to apply it to each of its business activities. When analyzing such companies, it is important for users to understand how this has been done. Financial statement users can find information about a company’s approach to revenue recognition in the notes to its financial statements. Accounting standards require companies to disclose this information. These standards also require companies to disclose information that enables financial statement users to understand the nature, amount, timing, and uncertainty of revenues. Management determines the extent of the disclosure required, but it normally includes information on the amount of revenues for each significant geographical market and major product line and by the timing of revenue recognition (goods transferred at a point in time or services transferred over time).

Revenue Recognition LEAR NING OBJECTIVE 2 Identify and explain the contract-based approach to revenue recognition.


Revenue Recognition 4-5

When Are Revenues Recognized? Determining when a company has earned revenue is one of the most critical accounting decisions. We learned in Chapter 2 that, under the accrual basis of accounting, revenues are recognized when they have been earned. Determining when revenue has been earned can be challenging. There are two revenue recognition approaches that are used in determining this: the contract-based approach (which is also known as the asset-liability approach) and the earnings-based approach. Companies preparing their financial statements using IFRS must use the contract-based approach, while companies preparing their financial statements using ASPE must use the earnings-based approach. As the focus of this text is on analyzing the financial statements of public companies, we will concentrate on understanding the basics of the contract-based approach so that you can determine when revenue would be recognized by companies using this approach.

Contract-Based Approach

KEY POINTS

As the name implies, the contract-based approach focuses on the contracts a company has with its customers. A contract is an agreement between two or more parties that creates a combination of rights (the right to be paid by customers, which is also known as the right to receive consideration) and performance obligations (the requirement to provide goods or services to customers). Contracts can be written, oral, or implied by the company’s ordinary business practices. The contract can represent either an asset (when rights exceed obligations) or a liability (when obligations exceed rights). Whether a contract is an asset or a liability depends on the actions that the parties to the contract have taken in terms of their responsibilities under the contract. Under the contract-based approach, changes in a company’s net position in a contract are required before revenues can be recognized. Changes in a company’s net position in a contract occur when there is a change in its rights under the contract, or a change in its performance obligations under the contract. Under the contract-based approach revenues are recognized when a company’s net position in the contract increases; that is, when a company’s rights under the contract increase or when its performance obligations under the contract decrease. Practically, both of these scenarios occur whenever a company satisfies its performance obligations under the contract as, by doing so, its rights under the contract increase and its performance obligations under the contract decrease. The Key Points summarize the contract-based approach. Exhibit 4.1 illustrates how a company’s net position in a contract can change as a result of various actions related to the contract and when revenue would be recognized in relation to that change. The exhibit shows the perspective of the company selling the goods or providing the services.

• Under the contractbased approach, revenue is recognized whenever a company’s net position in a contract increases. • A company’s net position in a contract increases when: - Its rights under the contract increase. - Its performance obligations under the contract decrease. • A company must fulfill a performance obligation in order to increase its net position in a contract and recognize revenue.

EXHIBIT 4.1 Illustration of When Changes in a Company’s Net Contract Position Result in the Recognition of Revenue

Rights under the Contract

Performance Obligations under the Contract

Net Contract Position Required Journal Entry

Company enters into a contract with a customer

No change (because neither party has done anything aside from signing the contract)

No change (because neither party has done anything aside from signing the contract)

No change No journal entry to record.

Company provides goods or services to customer

Increases (because it increases the company’s rights)

Decreases (because it reduces the company’s obligations)

Increases; therefore, recognize revenue DR Accounts Receivable CR Sales Revenue If sale of goods, then also DR Cost of Goods Sold CR Inventory

Company invoices customer for goods or services

No change (because it does not change the extent of responsibilities under contract)

No change (because it does not change the extent of responsibilities under contract)

No change No journal entry to record

Customer pays

Decreases (because it decreases the company’s rights)

No change (because all obligations were already met)

Decreases DR Cash CR Accounts Receivable


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A five-step model, as illustrated in Exhibit 4.2, is used to determine when and how much revenue should be recognized. This model helps to determine when a company has satisfied its performance obligations, resulting in an increase in its net position in the contract, enabling it to recognize revenue.

EXHIBIT 4.2 Five-Step Model of Revenue Recognition Step 1

Step 2

Step 3

Step 4

Step 5

Identify the contract

Identify the performance obligations

Determine the transaction price

Allocate the transaction price to performance obligations

Recognize revenue when each performance obligation is satisfied

We will now look at each of the steps in more detail.

Step 1. Identify the contract. The first step is to determine whether or not there is a contract. If there is, then it is possible to move to the next step in the model (and potentially recognize revenue). If not, that’s it in terms of the model and no revenues can be recognized. A contract exists when all five of the following criteria are met: • There is a legally enforceable agreement between two or more parties. • It has been approved and the parties are committed to their obligations. • Each party’s rights to receive goods or services or payment for those goods and services can be identified. • The contract has commercial substance, meaning that the risk, timing, or amount of the company’s future cash flows is expected to change as a result of the contract. • Collection is considered probable. When assessing collection, probable is defined as “more likely than not,” with consideration given to the customer’s creditworthiness, financial resources, and intention to pay. If each party to the contract has the right to terminate a contract that has not been fully performed without paying any compensation to the other party (or parties) to the contract, then a contract does not exist. If all of the above criteria are not met, then there is no contract. As such, no revenue can be recognized in relation to it. Any consideration received would be recorded as a liability. If goods or services have been transferred to the customer, no receivable would be recorded for consideration that has not been received.

Step 2. Identify the performance obligations. The contract must be analyzed to determine the performance obligation(s) contained in it. These are the goods and/or services to be delivered to the customer and are sometimes referred to as the contract deliverables. There may be a single performance obligation to provide goods or services, or multiple performance obligations in which goods or services will be delivered over a period of time. Performance obligations relate to distinct goods or services. Goods or services are considered to be distinct if both of the following criteria are met: • The customer can benefit from the good or service (by using, consuming, or selling it) on its own or with other resources it possesses or can obtain from a third party. • The promise to transfer the goods or services is separate from other promised goods or services in the contract. That is, these goods or services are being purchased as separate items under the contract, rather than forming part of a larger good or service.


Revenue Recognition 4-7

If both of the above criteria are not met, then the goods or services are not considered to be distinct and are bundled with other goods and services to be provided under the contract until a distinct performance obligation is created. For example, if a building company is contracted to construct a house, the bricks, lumber, and other building materials would not be considered to be distinct goods. It would be the construction of the house, using these building materials and the services of the company, that would be considered to be a distinct performance obligation. Review the Key Points regarding performance obligations. It is important to note that a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer are considered to be a single performance obligation. An example of this would be the provision of weekly landscaping services under a three-month contract. Rather than each week’s or month’s services being considered a distinct service, the entire three-month contract would be considered a single distinct service. This is done so that companies can apply the five-step model once rather than having to apply it each time the goods or services are provided. In the case of the landscaping services contract, the revenue to be recognized each week would be consistent and would be determined based on applying the five-step model once, at the beginning of the contract, rather than weekly as the services are provided.

KEY POINTS • Contracts include performance obligations that require a company to provide goods or services. • Performance obligations relate to the provision of distinct goods or services. • Goods or services are distinct if the customer can benefit from them and they are separate from other goods and services to be delivered under the contract.

Step 3. Determine the transaction price. The transaction price is the amount of consideration the company expects to receive in exchange for providing the goods or services. This is a core principle of the contract-based approach: the amount of revenue the seller should recognize should reflect the consideration it expects to receive in exchange for providing the goods or services. The consideration is normally received from the customer, but may also be received from third parties (such as coupons that are reimbursed by manufacturers). The transaction price excludes amounts collected on behalf of third parties (such as sales taxes). The transaction price must reflect any variable consideration. Variable consideration can result if there are discounts, refunds, rebates, price concessions, incentives, performance bonuses, penalties, and so on. The transaction price must include any expected noncash consideration and is reduced by any consideration that will be paid to the customer in relation to discounts, volume rebates, or coupons. When a company makes sales on account, it generally gives commercial customers 30 days (or more), interest-free, to pay their account. To stimulate these customers to pay their accounts more quickly, some companies provide terms, known as sales discounts (or prompt payment discounts), which provide the customer with a discount off the purchase price if they pay within a shorter period of time (sales discounts are summarized in the Key Points). A typical sales discount is “2/10, n/30,” which means that the customer could take a 2% discount if they paid within 10 days of purchase or, if this was not done, the net (or full) amount of the

KEY POINTS • Sales discounts are used to encourage customers to pay their accounts earlier. • Customers who pay within the discount period are entitled to the discount. • Expected sales discounts reduce the transaction price. Take5 Video

The Conceptual Framework Faithful Representation and Performance Obligations The objective of the conceptual framework is to provide financial information that is useful to users. This objective is behind the need for companies to determine whether there is a single or multiple performance obligations in a contract. For example, if a customer purchases a piece of custom jewellery, like a ring, it may include several gemstones and will be manufactured according to the customer’s specifications. It is possible that the jeweller could consider each gemstone and the ring assembly as separate performance obligations. Given that the jeweller will fulfill each

of these performance obligations at the same time (when the ring is delivered to the customer), there would be no benefit in separating them because it would not result in more meaningful financial reporting. The objective of identifying separate performance obligations is to represent faithfully the expected pattern in which goods and services will be transferred to the customer. If these will be delivered at the same time or in the same pattern, then they should be accounted for as a single performance obligation. If they are to be delivered at different times and there is not a consistent transfer pattern, then they should be accounted for as separate performance obligations.


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account would be due within 30 days. If a customer took advantage of a sales discount, then the seller would receive only 98% of the selling price when the customer paid their account. Under the contract-based approach, companies offering sales discounts are required to reduce the transaction price by management’s estimate of the expected sales discounts because they are a form of variable consideration. It is important to note that the customer’s credit risk is not a factor in determining transaction price. This is because credit risk was already assessed in evaluating the probability of collection in Step 1 (identifying whether there was a contract or not).

Step 4. Allocate the transaction price to performance obligations. If, in Step 2, only a single performance obligation was identified, then this step is not required. However, if multiple performance obligations were identified, then a portion of the transaction price determined in Step 3 must be allocated to each of them. The transaction price is allocated on the basis of the stand-alone selling price of each performance obligation. This is the price that the company would sell each good or service (that is, each performance obligation) for separately. Ideally, these prices are determined by using the stand-alone selling price the company charges to customers purchasing the goods or services separately. Once all stand-alone selling prices have been determined, a combined total can be calculated. The transaction price is then allocated to each performance obligation using its relative percentage of the combined total. If stand-alone selling prices are not available, estimates are used. The use of estimates is beyond the scope of an introductory accounting course and is something you will learn about in subsequent accounting courses.

Step 5. Recognize revenue when each performance obligation is satisfied. As each performance obligation is satisfied, the company recognizes revenue equal to the portion of the transaction price that has been allocated to it in Step 4. Performance obligations are satisfied when control of the goods or services are transferred to the customer. Control is transferred if the customer has the ability to direct the use of the asset and obtain substantially all of the remaining benefits from it through its use, consumption, sale, and so on. It is possible that control is transferred at a point in time or over time. If control is transferred over time, then the company must identify an appropriate basis upon which the extent of transfer can be measured each period. Step 5 is summarized in the Key Points. Indicators that control has been transferred include the customer having:

KEY POINTS • Revenue is recognized when performance obligations are satisfied. • Performance obligations are satisfied when control of the goods or services has been transferred to the customer. • Performance obligations can be satisfied at a point in time or over time.

• • • • •

physical possession legal title the risks and rewards of ownership accepted the goods or received the services an obligation to pay

As you can see, the five-step model of revenue recognition is fairly complex and the explanations provided above do not deal with numerous other complexities that can arise. As these additional complexities are beyond the scope of an introductory financial accounting text, we will focus on applying the essential elements of the model to common scenarios. To help with that, Exhibit 4.3 recasts the five-step model into questions that you can answer as you apply each step. EXHIBIT 4.3 Questions Underlying the Five-Step Model of Revenue Recognition Step 1

Step 2

Is there a contract?

What performance obligations are included in the contract?

Step 3

Step 4

Step 5

What is the transaction price?

How should the transaction price be allocated to the performance obligations?

Has a performance obligation been satisfied?


Revenue Recognition 4-9

Using Exhibit 4.3, let’s apply the five-step model to a few common revenue recognition scenarios.

Scenario One: Sale of Goods. On August 5, 2020, Foot Fashions Ltd. receives an order from Big Retail Inc., one of its regular customers, to sell it 500 pairs of shoes at $25 per pair. Foot Fashions accepts the order, which is to be delivered to Big Retail’s warehouse. Big Retail agrees to pay for the order within 15 days of product delivery. The shoes cost Foot Fashions $12 each. Foot Fashions delivered all of the shoes to Big Retail Inc.’s warehouse on August 20, 2020, and an invoice for the order was mailed out that day. Big Retail paid the invoice on September 2, 2020.

Question

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Analysis

Step 1: Is there a contract?

Yes, both parties have agreed to enter into a contract. The quantity, price, and payment terms have been agreed to, and each party’s rights under the contract are clear. The contract is consistent with both parties’ lines of business, meaning it has commercial substance. There are no indications of any concerns regarding collectibility with Big Retail.

Step 2: What performance obligations are included in the contract?

There is a single distinct good being provided under the contract: 500 pairs of shoes.

Step 3: What is the transaction price?

The transaction price is $12,500 (500 pairs of shoes × $25).

Step 4: How should the transaction price be allocated to the performance obligations?

There is no need to allocate the transaction price because there is a single performance obligation.

Step 5: Has a performance obligation been satisfied?

Revenue would be recognized by Foot Fashions once the 500 pairs of shoes have been delivered. Upon delivery, Big Retail has control of the goods, which is indicated by physical possession and the fact that it has the risks and rewards of ownership, it has accepted the shoes, and it has an obligation to pay for them. As such, Foot Fashions would recognize revenue on August 20, 2020.

Foot Fashions would record the following journal entries in relation to these transactions:

Aug. 5

No entry because neither party has performed any obligations under the contract.

Aug. 20

DR Accounts Receivable CR Sales Revenue (500 pairs × $25) DR Cost of Goods Sold CR Inventory (500 pairs × $12)

12,500

DR Cash CR Accounts Receivable

12,500

Sept. 2

12,500 6,000 6,000 12,500

Note that revenue is recognized at a point in time in this case and is not tied to the receipt of cash.

Assess Your Understanding Attempt the following problems and review the solutions provided: • Chapter End Review Problem 4-1 • WileyPLUS Demonstration Problem 4-1


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Revenue Recognition and the Statement of Income

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Scenario Two: Provision of Services. On June 14, 2020, Green Clean Ltd. enters into a contract with Bestwick Inc. to provide cleaning services at Bestwick’s office building for a 12-month period beginning on July 1, 2020. Green Clean will provide cleaning services twice each week throughout the period to Bestwick, which operates a successful IT advisory business. The contract is for $9,600, and Bestwick agrees to pay one-twelfth of the contract on the first of each month. Green Clean prepares its financial statements on a monthly basis.

Question

Analysis

Step 1: Is there a contract?

Yes, both parties have agreed to enter into a contract. The service to be provided, price, and payment terms have been agreed to, and each party’s rights under the contract are clear. The contract is consistent with both parties’ lines of business, meaning it has commercial substance. There are no indications of any concerns regarding collectibility with Bestwick because it is a successful company.

Step 2: What performance obligations are included in the contract?

In this case, there is a series of distinct services that are substantially the same and have the same pattern of transfer to the customer. The cleaning services are the same each time and will be provided 104 times (twice a week for one year) over the contract. Therefore, they are considered to be a single performance obligation.

Step 3: What is the transaction price?

The transaction price is $9,600.

Step 4: How should the transaction price be allocated to the performance obligations?

The transaction price will be allocated to the performance obligation on a monthly basis (because Green Clean prepares its financial statements monthly). $800 ($9,600 ÷ 12) will be allocated to each month.

Step 5: Has a performance obligation been satisfied?

Revenue would be recognized by Green Clean after it has performed the cleaning services for the month. Once the cleaning services have been provided, that portion (1/12) of the performance obligation has been satisfied.

Green Clean would record the following journal entries in relation to these transactions: Jun. 14

No entry because neither party has performed any obligations under the contract.

Even though Green Clean receives payment on August 1, the company cannot recognize any revenue because it has yet to satisfy any of its performance obligations under the contract. Therefore, the payment received represents a liability under the contract. The entry below would be made at the beginning of each month of the contract. Jul.

1

DR Cash CR Unearned Revenue

800 800

At the end of each month, as Green Clean provides the cleaning services and satisfies its performance obligations under the contract, the company would be able to recognize the related revenue. The entry below would be made at the end of each month of the contract. Jul. 31

DR Unearned Revenue CR Service Revenue

Note that revenue is recognized over time in this case.

Assess Your Understanding Attempt the following problems and review the solutions provided: • Chapter End Review Problem 4-2 • WileyPLUS Demonstration Problem 4-2

800 800


Revenue Recognition 4-11

Scenario Three: Sale Involving Multiple Performance Obligations. On September 5, 2020, WorkScape Ltd. enters into a contract with Telcom Co. to provide office furniture and wall products, which will be used to create 100 office workstations for Telcom’s new open office configuration. As part of the contract, Telcom also hired WorkScape to install the office furniture and wall products. Details of the contract are as follows:

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• The total price of the contract is $148,000. • The office furniture would normally retail for $98,000, and wall products would normally retail for $48,000. WorkScape would normally charge $9,000 for installation of this scale. • The office furniture cost WorkScape $68,000, while the wall products cost $31,000. • The contract requires WorkScape to deliver the furniture by September 30, 2020, and that installation be completed by October 15, 2020. • Telcom agrees to pay $125,000 upon delivery of the furniture and wall products, and the balance once installation is complete. WorkScape delivered the furniture and wall products on September 27, 2020, and Telcom made the required payment. The installation was completed on October 12, 2020, and Telcom made the final contract payment on October 28, 2020.

Question

Analysis

Step 1: Is there a contract?

Yes, both parties have agreed to enter into a contract. The goods and services to be provided, price, and payment terms have been agreed to, and each party’s rights under the contract are clear. The contract is consistent with both parties’ lines of business, meaning it has commercial substance. There are no indications of any concerns regarding collectibility with Telcom.

Step 2: What performance obligations are included in the contract?

The contract includes two performance obligations: the supply of office furniture and wall products and their installation. Each of these would be considered distinct goods or services. While the office furniture and wall products are distinct goods, their supply is considered to be a single performance obligation because these items will be transferred to the customer at the same time.

Step 3: What is the transaction price?

The transaction price is $148,000.

Step 4: How should the transaction price be allocated to the performance obligations?

Because there are multiple (two) performance obligations, the transaction price must be allocated to each of them. The allocation will be done on the basis of the stand-alone selling price of each performance obligation.

Performance Obligation

% of Total Stand-Alone Selling Price

Contract Price

Allocation of Contract Price

Supply of office furniture and wall products

$146,000*

94.2%

× $148,000

$139,416

Installation

$ 9,000

5.8%

× $148,000

$

$155,000

100.0%

*

Step 5: Has a performance obligation been satisfied?

Stand-Alone Selling Price

8,584

$148,000

$98,000 + $48,000

The first performance obligation, the supply of the office furniture and wall products, is satisfied on September 27, 2020, when WorkScape delivers these goods. The revenue related to this obligation would be recognized at this point. The second performance obligation, the installation of the office furniture and wall products, is satisfied on October 12, 2020, when these services are provided by WorkScape. The revenue related to this obligation would be recognized at this point.


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Revenue Recognition and the Statement of Income

WorkScape would record the following journal entries in relation to these transactions: Sept. 5

No entry because neither party has performed any obligations under the contract.

Sept. 27

DR Cash DR Accounts Receivable* CR Sales Revenue DR Cost of Goods Sold CR Inventory†

Oct. 12 Oct. 28

DR Accounts Receivable CR Service Revenue DR Cash CR Accounts Receivable

125,000 14,416 139,416 99,000 99,000 8,584 8,584 23,000 23,000

*

Technically, this would be recorded as a Contract Asset, but for purposes of introductory accounting, it is acceptable to use Accounts Receivable. † $68,000 + $31,000

Assess Your Understanding Attempt the following problems and review the solutions provided: Take5 Video

• Chapter End Review Problem 4-3 • WileyPLUS Demonstration Problem 4-3

The Conceptual Framework Faithful Representation, Comparability, and Approaches to Revenue Recognition Private companies using ASPE to prepare their financial statements use an earnings-based approach rather that the contract-based approach to determine when revenue should be recognized. Rather than focusing on changes in the net position in a contract to determine when revenue has been earned, the earnings-based approach focuses on the earnings process. Under the earnings-based approach, revenue is recognized when the earnings process is substantially complete. Accounting standard setters have developed revenue recognition criteria that are used to help management and other financial statement users determine when the earnings process is complete and revenue has been earned. There are revenue recognition criteria for the sale of goods and other revenue recognition criteria that can be used for the provision of services: Sale of Goods Revenue from the sale of goods can be recognized when all of the following criteria are met: 1. The risks and rewards of ownership have been transferred to the customer. 2. The seller has no continuing involvement or control over the goods. 3. The amount of consideration to be received can be measured with reasonable assurance. 4. Collection is reasonably assured.

Provision of Services Revenue from the provision of services can be recognized when all of the following criteria are met: 1. The service has been performed. 2. The amount of consideration to be received can be measured with reasonable assurance. 3. Collection is reasonably assured. If we applied these criteria to the sale of goods and provision of services scenarios we worked through earlier in the chapter for the contract-based approach, we would arrive at identical accounting treatment. This would be the case for many contracts related to common retail transactions. For other, more complex contracts, the accounting treatment would differ depending upon the approach that was used. It is important to note that each approach to determining when revenue has been earned focuses on a different financial statement. The contract-based approach focuses on the statement of financial position, determining if revenue has been earned by looking at the net change in contract assets and liabilities, while the earnings-based approach focuses on the statement of income, determining if revenue has been earned by looking at the earnings process itself. Standard setters developed the contract-based approach with the belief that “there will be more agreement on whether an asset has increased or a liability has decreased than there is currently on what an earnings process is and whether it is complete.” The International Accounting Standards Board believes that use of the contract-based approach will mean that companies “can recognize revenue more consistently.” This will enhance the faithful representation of reported revenues, by improving neutrality and freedom from error, while also improving comparability across companies.4


Other Revenue Recognition Issues 4-13

Other Revenue Recognition Issues LEARNING OBJECTIVE 3 Explain how revenue recognition is affected by the right of returns, warranties, consignment, and third-party sale arrangements.

How Do the Right of Returns, Warranties, Consignment, and Third-Party Sale Arrangements Affect Revenue Recognition? There are a variety of contractual arrangements that can affect the timing and amount of revenue a company recognizes. We will explore four common arrangements: right of returns, warranties, consignment sales, and third-party sales.

Right of Returns Many companies provide a period in which customers can return goods for a variety of reasons (such as they were the wrong goods or they arrived damaged). When a customer returns goods, the seller may offer a refund (either in cash or as a reduction of accounts receivable, if the customer’s payment is still outstanding). It may also replace the product or offer the customer a reduction in the sales price, which is known as an allowance, if they are willing to keep the goods. Being able to assess the extent of sales returns and allowances is important information for management because it helps them evaluate product quality, either the quality of goods purchased from suppliers or the quality of the company’s own manufacturing process. If a company makes sales with a right of return, management must estimate the extent of expected returns because they affect the estimated transaction price (Step 3 of the five-step model). The amount of expected returns is another form of variable consideration. A refund liability is established for the amount of expected returns because management expects the company will have to return (as a refund or credit) this portion of the consideration received from the customer. Let’s return to the sale of goods scenario used earlier in the chapter and add a return estimate. On August 5, 2020, Foot Fashions Ltd. receives an order from Big Retail Inc., one of its regular customers, to sell it 500 pairs of shoes at $25 per pair. Foot Fashions accepts the order, which is to be delivered to Big Retail’s warehouse. Big Retail agrees to pay for the order within 15 days of product delivery. The shoes cost Foot Fashions $12 each. Foot Fashions delivers all of the shoes to Big Retail Inc.’s warehouse on August 20, and Foot Fashions’ management estimates a return rate of 4%. It expects the returned goods to be scrapped on September 2, Big Retail paid for the order. On September 12, Big Retail returns 15 pairs of shoes and receives a cash refund. Foot Fashions would record the following journal entries in relation to these transactions: Aug. 20

Sept. 2 Sept. 12

DR Accounts Receivable CR Refund Liability (12,500 × 4%) CR Sales Revenue DR Cost of Goods Sold CR Inventory (500 pairs × $12)

12,500

DR Cash CR Accounts Receivable

12,500

DR Refund Liability CR Cash

500 12,000 6,000 6,000 12,500 375 375


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Revenue Recognition and the Statement of Income

For Example Canadian Tire’s return policy for consumers, which is detailed on the company’s Financial Statements website, is as follows: “Unopened items in original packaging returned with a receipt within 90 days of purchase will receive a refund to the original method of payment or will receive an exchange. Items that are opened, damaged and/or not in resalable condition may not be eligible for a refund or exchange.”5

Warranties KEY POINTS • Assurance warranties are not considered to be a separate performance obligation. • Service warranties are considered to be a separate performance obligation. • Service warranties are purchased separately, generally have a long term, and the seller is not legally required to provide them.

It is common for companies to offer warranties on their products (see the Key Points for a brief explanation of warranties). Sometimes warranty coverage is included in the price of the product, which is called an assurance warranty. Customers may also be given the option to purchase separate warranty coverage, which is called a service warranty. A service warranty is considered to be a separate performance obligation (Step 2 of the five-step model) and, as such, a portion of the transaction price must be allocated to it. Assurance warranties are not considered to be separate performance obligations, so there is no need to allocate the transaction price. We will discuss assurance warranties further in Chapter 9. Factors that indicate that the warranty is a service warranty include: • The warranty is priced or negotiated separately. • The warranty coverage period is longer. The longer it is, the more likely the warranty is a service warranty. • The warranty is not required by law.

Consignment Sales Consignment arrangements are another common situation to be considered in determining when revenue can be recognized. You may be familiar with consignment stores and may have used one either as a seller or buyer. For example, some student unions operate consignment arrangements for used textbooks. The student (the owner or consignor) leaves their used textbook with the student union office (the consignee). When the book sells, the student union collects the full payment. It keeps its commission and gives the balance to the student who was selling the book. If the book does not sell within a specified time, it is returned to the student. In terms of recognizing revenue when there is a consignment arrangement, the consignor would not recognize any revenue when they transfer goods to the consignee (because they retain control of them). At the time the goods are sold, both the consignor and the consignee would recognize revenue. The consignor’s transaction price (Step 3 of the five-step model) would be the net amount (the selling price less consignee’s commission), while the consignee’s transaction price (Step 3 of the five-step model) would be the amount of the commission. Factors that would indicate a consignment arrangement include: • The company transferring the goods continues to control them until a future sale occurs. • The company transferring the goods is able to require them to be returned. • The company receiving the goods does not have an obligation to pay for them until a future sale occurs.

For Example Vancouver-based Ritchie Bros. Auctioneers Incorporated is the world’s largest auctioneer of used industrial equipment. During the year ended December 31, 2016, the company sold equipment that generated gross auction proceeds of U.S. $4.3 billion. From this, the company earned auction revenues of U.S. $424 million. The vast majority of the equipment the company auctions is held on consignment by the company pending the Bloomberg/Getty Images auction. While Ritchie Bros. takes possession of the used equipment prior to auctioning it off, it is on a consignment basis and is not recorded as company inventory. In other words, Ritchie Bros. is the consignee. As such, when the equipment is sold, there is no cost of goods sold. The difference between the gross auction proceeds of U.S. $4.3 billion and the auction revenues of U.S. $424 million is the amount due to the owner of the used equipment (the consignor) from the sale.6


Statement of Income Formats 4-15

Third-Party Sales Sometimes a company is involved in third-party sales, either selling goods on behalf of a third party or using a third party to sell its goods. Travel sites like Expedia are an example of this. Customers purchase flights, hotel rooms, car rentals, and other travel services on the site and make payments to Expedia for them. Expedia keeps a portion of these payments (its commission or ticketing fee), but pays the balance to the companies that will be providing the services (airlines, hotels, car rental companies, and so on). The revenue recognition question is whether the full amount (or gross amount) of the payment would be considered to be revenue or just the commission or ticketing fee (or net amount) the company retains for providing the booking service. The answer to this question depends on whether the company’s performance obligation is to provide the goods or services (in which case it is considered to be a principal) or to arrange for a third party to provide the goods or services (in which case it is considered to be an agent). If the company is considered to be a principal, then the transaction price (Step 3 of the fivestep model) would be the gross amount. If the company is considered to be an agent, then the transaction price (Step 3 of the five-step model) would be the net amount. Information about agents is summarized in the Key Points. Factors that would indicate that a company is serving as agent rather than principal include: • • • •

A third party is responsible for providing the goods or services. The company receives consideration in the form of a commission. The company does not establish the prices of the goods or services. The company has no risk related to holding inventory.

For Example Expedia Inc. explains in the notes to the company’s financial statements that the company has “determined net presentation is appropriate for the majority of revenue transactions.” The company goes on to explain that it acts “as the agent in the transaction, passing reservations booked by the traveler to the relevant travel provider. We receive commissions or ticketing fees from the travel supplier and/or traveler. For Bloomberg/Getty Images certain agency airline, hotel and car transactions, we also receive fees from global distribution systems partners that control the computer systems through which these reservations are booked.”7

Statement of Income Formats LEARNING OBJECTIVE 4 Understand the difference between a single-step statement of income and a multi-step statement of income.

In Chapter 1, we learned that the objective of the statement of income was to measure the company’s performance in terms of the results of its operating activities for a month, quarter, or year. A company’s income was the difference between the revenues it earned during the period and the expenses incurred during the same period to earn that revenue. In this chapter, we have discussed the contract-based approach to revenue recognition to help give us a better understanding of when revenues are earned and can be reported on the statement of income. In this part of the chapter, we will revisit the statement of income and discuss a couple of the different formats used to prepare it. Understanding the way in which information is presented in these formats will help you to interpret the information presented.

KEY POINTS • Companies acting as agents only include their commission or fees when determining the transaction price. • Agents are not responsible for providing the goods, they receive a commission or fee for arranging the sale, they do not establish the selling price for the goods or services, and they have no risks related to holding any inventory.


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How Does a Single-Step Statement of Income Differ from a Multi-Step Statement of Income? There are two main formats that can be used to prepare a statement of income: the single-step format and the multi-step format. When a company uses a single-step statement of income, all items of revenue are presented first regardless of the source, together with a total revenue amount. This is followed by a list of all expense items, including income taxes, together with a total expense amount. The total expense amount is subtracted from the total revenue amount to calculate net income or loss for the period. In other words, one arithmetic step is required to arrive at net income (loss). Exhibit 4.4 illustrates the format of a single-step statement of income. EXHIBIT 4.4

Single-Step Statement of Income Format Take5 Video

SHARPNESS LTD. Statement of Income For the year ended December 31, 2020 Revenues Sales revenue Interest revenue Total revenues

$500,000 25,000 525,000

Expenses Cost of goods sold Wages expense

415,000 30,000

Rent expense

9,000

Utilities expense

7,000

Depreciation expense

6,000

Interest expense

4,000

Income tax expense Total expenses Net income

10,800 481,800 $ 43,200

While the single-step statement presents all of the required information, it presents it in a way that requires users to complete their own analysis to determine important measures such as gross profit (or gross margin) or net income from operating activities (net income without incidental revenues such as interest or dividend income). A multi-step statement of income can alleviate these issues. As the name suggests, the multi-step statement of income requires several steps to reach a company’s net profit or loss. The results of each step provide the user with a key piece of information. A typical multi-step statement includes five steps, as shown in Exhibit 4.5. EXHIBIT 4.5

The Five Steps of the MultiStep Statement of Income

1. Sales revenue (or revenue)

The revenues reported in this step are the revenues earned by the company from its operating activities—what the company is in the business of doing. Operating activities can be the sale of goods or services.

2. Gross profit (or gross margin)

As discussed in Chapter 1, this is the difference between sales revenue and the cost of goods sold. This step is required for retail companies, but not for companies selling services because they do not have any cost of goods sold. continued


Statement of Income Formats 4-17

EXHIBIT 4.5

Gross profit is a key performance measure for retail companies. Dividing gross profit by net sales revenue results in the gross profit margin percentage. You can use the gross profit and gross profit margin percentage to evaluate a company’s performance over time or compare it with other companies in the same industry. 3. Profit from operations (or operating income)

This is the difference between gross profit and the company’s operating expenses. Operating expenses, such as advertising, depreciation, rent, and wages, are subtracted from gross profit (retail company) or from revenues (service company).

4. Profit before income tax expense (or income before income taxes)

This step factors in all of the company’s non-operating activities. This includes activities that a company engaged in during the year that are not part of its normal operating activities. This includes revenues such as interest earned on employee loans or dividends received from short-term investments and expenses such as interest paid on loans. Incidental revenues are added to profit from operations, while any incidental expenses are subtracted, to determine profit before income tax expense.

5. Net income (loss) (or profit)

This is the final step in preparing a multi-step statement of income. Income tax expense (or the provision for income taxes) is subtracted from profit before income tax to arrive at the net income (loss) for the accounting period.

The Five Steps of the Multi-Step Statement of Income (continued)

Exhibit 4.6 illustrates the format of a multi-step statement of income. EXHIBIT 4.6

Multi-Step Statement of Income Format

SHARPNESS LTD. Statement of Income For the year ended December 31, 2020 Sales revenue Cost of goods sold Gross profit

$500,000 415,000 85,000

Operating expenses Wages expense

30,000

Rent expense

9,000

Utilities expense

7,000

Depreciation expense

6,000

Total operating expenses

52,000

Operating income

33,000

Other revenues and expenses Interest revenue

25,000

Interest expense

(4,000)

Income before income tax Income tax expense Net income

54,000 10,800 $ 43,200

As you can see from Exhibits 4.4 and 4.6, the choice of format has no effect on the revenues, expenses, and net income amounts reported. Each presents information on the company’s performance in different ways, which can have an impact on the understanding of those results. The benefit of a multi-step statement of income is that it allows the reader to easily identify


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Revenue Recognition and the Statement of Income

KEY POINT Statements of income prepared using a multi-step format present key measures, including gross profit and profit from operating activities, making analysis easier for decision makers.

gross profit and profits earned from operating activities separately from other revenues and expenses related to non-operating activities. This can be important information for decision makers such as shareholders, potential investors, and creditors. The Key Point briefly explains the benefit of a multi-step format. Exhibits 4.4 and 4.6 illustrate the single-step and multi-step formats, but in practice, companies are free to use hybrid formats in which some parts of the statement follow a single-step format, while other parts follow a multi-step format. There is nothing in the accounting standards that prohibits a company from using whatever model it believes presents its financial performance in the most relevant way for the financial statement users.

Assess Your Understanding Attempt the following problems and review the solutions provided: • Chapter End Review Problem 4-4 Take5 Video

• WileyPLUS Demonstration Problem 4-4

Statement of Comprehensive Income LEAR NING OBJECTIVE 5 Understand the difference between comprehensive income and net income.

What Is Comprehensive Income and How Does It Differ from Net Income? KEY POINTS • Comprehensive income = Net income + other comprehensive income • Comprehensive income includes gains and losses from revaluing financial statement items to fair value or from changes in foreign exchange rates. • These transactions are not included in net income because they are not transactions with third parties, but they are included in comprehensive income.

In addition to reporting net income, public companies must report comprehensive income in their financial statements. Comprehensive income is the total change in the shareholders’ equity (or net assets) of the enterprise from non-owner sources. It is equal to net income plus other comprehensive income. Accounting standards require that certain gains and losses be reported as other comprehensive income rather than being included in net income. These gains and losses normally arise when certain financial statement items are revalued, either to fair value or as a result of changes in foreign currency exchange rates. As these revaluation transactions are not with third parties, they are considered to be unrealized. They are excluded from net income, but are included in other comprehensive income. These revaluation transactions are beyond the scope of an introductory accounting course, but it is important that you have a basic understanding of the difference between net income and total comprehensive income. Other comprehensive income is added to net income to arrive at the total comprehensive income. Comprehensive income and its components are an integral part of the financial statements. The items that make up other comprehensive income can either be presented on the statement of income, immediately below net income, or in a separate statement of comprehensive income. The starting point for this statement is net income. In either case, the final total is the total comprehensive income for the period. To illustrate, Exhibit 4.7 presents Loblaw Companies Limited’s consolidated statements of earnings, while Exhibit 4.8 presents the company’s separate consolidated statements of comprehensive income. The Key Points also briefly explain comprehensive income.


Presentation of Expenses by Nature or by Function 4-19

EXHIBIT 4.7

Loblaw Companies Limited’s 2016 Consolidated Statements of Earnings

LOBLAW COMPANIES LIMITED Consolidated Statements of Earnings For the years ended December 31, 2016 and January 2, 2016 (millions of Canadian dollars except where otherwise indicated) 2016

2015

$46,385

$45,394

Cost of Merchandise Inventories Sold

33,213

32,846

Selling, General and Administrative Expenses

11,080

10,947

$ 2,092

$ 1,601

653

644

Revenue

Operating Income Net interest expense and other financing charges (note 6) Earnings Before Income Taxes

$ 1,439

Income taxes (note 7) Net Earnings

$

449 $

Financial Statements

957 368

990

$

589

EXHIBIT 4.8

Loblaw Companies Limited’s 2016 Consolidated Statements of Comprehensive Income

LOBLAW COMPANIES LIMITED Consolidated Statements of Comprehensive Income For the years ended December 31, 2016 and January 2, 2016 (millions of Canadian dollars)

Net Earnings

2016

2015

$ 990

$589

$

$ 14

Financial Statements

Other comprehensive income (loss), net of taxes Items that are or may be subsequently reclassified to profit of loss: Foreign currency translation adjustment gain Unrealized (loss) gain on cash flow hedges (note 30)

11 (1)

1

Items that will not be reclassified to profit or loss: Net defined benefit plan actuarial gains (note 26)

33

143

43

$158

$1,033

$747

Other comprehensive income

$

Total Comprehensive Income

Presentation of Expenses by Nature or by Function LEARNING OBJECTIVE 6 Understand the difference between presenting expenses by function or by nature of the item on the statement of income.

How Does a Statement of Income Presenting Expenses by Function Differ from One Presenting Expenses by Nature of the Items? Accounting standards offer companies the choice of presenting their expenses by function or by nature when preparing their statements of income. Function refers to what functional area


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Revenue Recognition and the Statement of Income

of the business the expenses were related to. Examples of functional areas are cost of sales, administrative activities, or selling and distribution activities. The nature of the expense refers to what the expense actually was, rather than the purpose for which it was incurred. Statements of income presenting expenses by nature include expense items such as employee wages, depreciation expense, cost of goods sold, advertising expenses, and rent expense. So far in the text, we have generally been preparing statements of income by the nature of the expenses by simply listing the various expense account balances. The choice of presenting expenses based on their nature or function rests with management. Accounting standard setters have taken the position that management should use whichever method they believe presents the most reliable and relevant information. Note that preparing statements of income by function requires management to exercise judgement in terms of which expenses are allocated to which function. For example, wages must be allocated to the various functions. No such judgement is required when the statement of income is prepared by nature of the expenses. For example, wages are simply presented as “wages expense.” Standard setters stipulate that companies that prepare their statements of income on a functional basis must also present information on the nature of the expenses in the notes to the company’s financial statements. Specifically, companies must provide information on depreciation and amortization expenses and employee benefits expenses. Exhibit 4.9 is the consolidated statements of comprehensive income for Brick Brewing Co. Limited, a brewer based in Kitchener, Ontario, that operates two production facilities and distributes its products across Canada. It is an example of a statement of income that presents expenses by function. With this presentation, users can assess the expenses related to different functions. For example, we can calculate that the company’s selling, marketing, and administration expenses increased by $1,880,628 from 2016 to 2017, and increased by almost 1 percentage point as a percentage of sales (20.5% in 2017 and 19.6% in 2016). Similar analysis could be done for other functional areas. However, with this presentation format, it is not possible to determine the amount incurred for specific expenses, such as the company’s total wage expense. For this information, we would have to look at the notes to the company’s financial statements. (See Exhibit 4.10, which presents an extract from the notes to Brick Brewing Co. Limited’s financial statements that discloses the company’s expense information by nature of the expense.)

EXHIBIT 4.9

Brick Brewing Co. Limited’s 2017 Statements of Comprehensive Income

BRICK BREWING CO. LIMITED Statements of Comprehensive Income Years ended January 31, 2017 and 2016

Financial Statements Notes

January 31, 2017

January 31, 2016

Revenue

7

$45,176,380

$37,609,568

Cost of sales

8

29,464,917

27,075,078

15,711,463

10,534,490

8

9,248,039

7,367,411

Other expenses

8,9

643,273

641,474

Finance costs

10

478,181

478,945

Gross profit Selling, marketing and administration expenses

Gain on disposal of property, plant and equipment

Income before tax Income tax expense Net income and comprehensive income for the year

11

(205,912)

5,341,970

2,252,572

1,345,158

658,392

$ 3,996,812

$ 1,594,180


Financial Statement Analysis 4-21

EXHIBIT 4.10

Excerpt from Brick Brewing Co. Limited’s Notes to the 2017 Financial Statements

BRICK BREWING CO. LIMITED Excerpt from Notes to Financial Statements

Financial Statements

8. Expenses By Nature Expenses relating to depreciation, amortization, impairment and personnel expenses are included within the following line of items on the statements of comprehensive income: January 31, 2017

January 31, 2016

$2,368,344

$2,462,649

487,214

500,222

20,400

20,400

Cost of sales

6,386,669

6,016,270

Selling, marketing and administrative expenses

3,934,754

3,048,498

120,214

32,945

Depreciation of property, plant & equipment Cost of sales Other expenses Amortization of intangible assets Other expenses Salaries, benefits and other personnelrelated expenses

Other expenses

The Conceptual Framework Relevance, Faithful Representation, and the Statement of Income Relevance is a fundamental qualitative characteristic in the conceptual framework. According to this characteristic, to be useful, financial information must matter to financial statement users. This is one of the factors that management must consider when deciding whether to present the statements of income by function or by nature of the items. In some cases, it may be more meaningful to users to present the company’s expenses by function (such as sales and marketing costs, administration costs, and distribution expenses). In other cases, it may be more meaningful to report by nature of the expenses (such as wage expense, advertising expense, and rent expense). As noted previously, when companies present their statement of income by function, they must use judgement to

allocate costs to the various functions. In doing so, they must also ensure that these allocations are representationally faithful, meaning that the expenses are allocated to functions in a manner that is consistent with where these expenses were actually incurred. As an example, some universities present their expenses by function (such as academic, student services, and administration). When doing so, they would need to make decisions about how to allocate costs such as the salaries of department heads, faculty deans, and so on. They would need to consider whether these costs were related to academic activities or if they were administrative costs. Perhaps a case could be made that a portion should be allocated to each function. As a student, you might want to assess how much your institution spends on academic activities relative to administration. In doing so, these types of allocation decisions made by management will be relevant to you.8

Financial Statement Analysis LEARNING OBJECTIVE 7 Calculate and interpret a company’s basic earnings per share. Now that you have an understanding of the various ways that revenue can be recognized and the components of the statement of income, let’s use that information to have a closer look at how we can measure performance. Most financial statement users are interested in the company’s


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performance. Senior management can receive bonuses based on the company meeting earnings targets, specified as either overall amounts or percentage increases. Creditors such as banks are interested because profitable companies are able to service their debt (pay interest and repay loans principal). Common shareholders (investors) want to know how well the company they have invested in is performing and whether there are sufficient earnings to pay dividends. Potential investors use earnings numbers when assessing whether shares of the company could be a good investment. In the next section, we will discuss earnings per share, one of the primary earnings-based measures that provides users with information about a company’s performance.

What Is Meant by Earnings per Share, and How Is It Calculated? Earnings per share (EPS) is a measure used by many financial statement users. The earnings per share figure expresses net income, after deducting preferred dividends, on a per-share basis. It is one of the most frequently cited financial measures, appearing in company news releases and the business media, as a key measure of a company’s performance. Accounting standards require that EPS be reported either on the statement of income or in a note accompanying the financial statements. There are a couple of variations of the earnings per share ratio. For now, we will focus on the basic earnings per share ratio. This ratio is determined as follows.

Basic earnings per share =

Net income − Preferred dividends Weighted average number of common shares outstanding*

*If the number of issued common shares changes during the year (because new shares were issued or previously issued shares were repurchased by the company), then this must be factored into the calculation.

Exhibit 4.11 illustrates the EPS calculation when there has been no change in the number of common shares during the period.

EXHIBIT 4.11

Basic EPS Calculation (When No Change in Numbers of Common Shares)

Montgomery Ltd. reported net income of $625,000 for the year ended December 31, 2020. During the year, the company also declared and paid dividends of $30,000 on the company’s preferred shares. At the beginning of the year, Montgomery had 250,000 common shares outstanding. No shares were issued or repurchased during the year. Basic earnings per share =

=

Net income − Preferred dividends Weighted average number of common shares outstanding $625,000 – $30,000 250,000

= $2.38

This EPS amount could be compared with the EPS of prior periods to determine whether earnings had improved on a per-share basis over prior periods or with the EPS results of other companies to compare relative per-share profitability, which can be used to assess share prices. Typically, a higher EPS will result in a higher share price.

Exhibit 4.12 illustrates the basic EPS calculation when there has been a change in the number of common shares during the period. When this happens, a weighted average number of shares must be used. A weighted average calculation is demonstrated below using the Montgomery example from Exhibit 4.11, except that the company issued 50,000 common shares at the beginning of April 2020.


Summary 4-23

EXHIBIT 4.12

Before we can calculate basic EPS, we must determine the weighted average number of shares outstanding as follows: 250,000 shares × 3/12* = 62,500 shares 300,000 shares × 9/12** = 225,000 shares Weighted average = 287,500 shares Basic earnings per share =

=

Basic EPS Calculation (When Number of Common Shares Changes)

Net income − Preferred dividends Weighted average number of common shares outstanding $625,000 – $30,000 287,500

= $2.07

Again, this EPS amount could be compared with the EPS of prior periods to determine whether earnings had improved on a per-share basis over prior periods or with the EPS results of other companies to compare relative per-share profitability. *January to March = 3 months **April to December = 9 months

For Example The 2016 and 2015 basic EPS results for three of Canada’s largest food retailers were as follows: 2016*

2015*

Loblaw Companies Limited

$2.40

$1.44

Metro Inc.

$2.41

$2.03

Empire Company Limited

$0.58

($7.78)

Bloomberg/Getty Images

These results show us that in 2016, Metro Inc. achieved the highest EPS, which was more than four times higher than that of Empire. Empire achieved the greatest year-over-year increase in its basic EPS, recovering from a significant loss in the prior year.9 *Note that all three companies have different year ends, so these EPS numbers cover different 12-month periods. Loblaw’s fiscal year ends on the Saturday closest to December 31, while Metro’s fiscal year ends on the last Saturday in September and Empire’s fiscal year ends on the first Saturday in May. The EPS figures for Loblaw and Metro are for periods ending in 2016 and 2015, while those for Empire are for the period ending in May 2017 and 2016.

As you learned in this chapter, the statement of income shows how much income was earned in a period using the accrual basis of accounting. In the next chapter we’ll look at the statement of cash flows, which uses the cash basis of accounting to show the various inflows and outflows of cash.

Review and Practice Summary Explain the nature of revenue and why revenue is of significance to users. 1

• Revenues are inflows of economic benefits from a company’s ordinary operating activities (the transactions a company normally has with its customers in relation to the sale of goods or services).

• Revenues are not tied to the receipt of cash because other economic benefits such as accounts receivable can result. • For a company to be successful, it must generate revenues in excess of the expenses it incurs doing so. • Users assess the quantity of revenues (changes in the amount of revenues) and the quality of revenues (the source of any growth and how closely any change in revenues corresponds with changes in cash flows from operating activities).


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Revenue Recognition and the Statement of Income

• Consignment arrangements involve the consignor transferring their goods to a consignee who, in turn, sells them to the customer. The goods remain in the control of the consignor and the consignee is only entitled to a commission upon sale of the goods. The consignee only recognizes the amount of the commission, rather than the total selling price of the goods, as revenue.

Identify and explain the contract-based approach to revenue recognition.

2

• There are two approaches to revenue recognition used in accounting standards: a contract-based approach, which is required under IFRS, and an earnings-based approach, which is required under ASPE.

• Third-party sales involve an agent arranging sales on behalf of a principal. The principal is responsible for providing the goods or services to customers, and the agent receives a commission or fee for arranging the sale. The agent only recognizes as revenue the commission or fee, rather than the gross amount of the sale.

• Under the contract-based approach, a company recognizes revenue whenever its net position in a contract increases. This occurs when the company’s rights under a contract increase or its obligations under the contract decrease. • A five-step model is used to determine when revenue should be recognized and what amount that should be. The steps are: (1) identify the contract; (2) identify the performance obligations; (3) determine the transaction price; (4) allocate the transaction price to the performance obligations; and (5) recognize revenue when each performance obligation is satisfied.

Understand the difference between a single-step statement of income and a multi-step statement of income.

4

• A single-step statement of income has two parts. All revenues are reported together in one section and all expenses are reported together in another section. The source of the revenues and the nature of the expenses are not considered.

• A contract is a legally enforceable agreement that has been approved by the parties and to which they are committed. It specifies the rights and obligations of each party, it has commercial substance, and collection of payment is considered probable.

• On a multi-step statement of income, the revenues earned from operations are presented separately from incidental revenues such as interest or dividends. Some expenses, such as cost of goods sold, are presented separately from other expenses. Multi-step statements of income also provide users with key measures such as gross profit and income from operations.

• Performance obligations relate to distinct goods or services. Goods or services are considered to be distinct if the customer can benefit from them through use, consumption, or by selling it on its own or with other resources the customer has or can access. • The transaction price is the amount of consideration the seller expects to receive in exchange for providing the goods or services. If the amount is variable, as a result of discounts, refunds, rebates, incentives, and so on, then the transaction price should reflect this, so that it reflects the amount the seller expects to receive after these amounts have been factored in.

• Users of a single-step statement of income can determine measures such as gross margin and income from operations, but they are not presented on the statement itself. 5 Understand the difference between comprehensive income and net income.

• If there are multiple performance obligations, then the transaction prices must be allocated to each of them. This is done using the stand-alone selling price for each obligation and determining the percentage of each relative to the combined total.

• Companies are required to report net income and comprehensive income. • Comprehensive income is equal to net income plus other comprehensive income.

• Revenue is recognized when each performance obligation is satisfied through the transfer of goods or the provision of services. A performance obligation is deemed to have been satisfied when control of the goods or services has been transferred to the customer.

Explain how revenue recognition is affected by the right of returns, warranties, consignment, and third-party sale arrangements.

• Other comprehensive income includes gains and losses resulting from the revaluation of certain financial statement items to fair value or as a result of changes in foreign currency exchange rates. Because these revaluation transactions are not transactions with third parties, they are not included in net income but are included in other comprehensive income.

3

• If goods are sold with a right of return, management must estimate the extent of expected refunds and reduce the estimated transaction price by this amount. A refund liability is established for the expected refund amount. • There are two types of warranties: assurance warranties and service warranties. Service warranties are sold separate from the warrantied goods and typically have a longer warranty coverage period. Service warranties are considered to be a separate performance obligation, so a portion of the transaction price must be allocated to it. Assurance warranties are not considered to be a separate performance obligation.

Understand the difference between presenting expenses by function or by nature of the item on the statement of income.

6

• Companies can present their expenses by function or by nature on the statement of income. Function refers to the functional area of the business (such as sales, distribution, and administration), while nature refers to the type of expense (such as wages, rent, and insurance). • Management can choose which method to use. If they choose to present expenses by function, then they must disclose information on the nature of the expenses in the notes to the company’s financial statements.


Chapter End Review Problem 4-2

Calculate and interpret a company’s basic earnings per share.

7

• The earnings per share ratio can be determined by dividing net income less preferred dividends by the weighted average number of common shares outstanding.

4-25

• EPS expresses net income, after preferred dividends, on a pershare basis. • EPS is one of the most commonly cited financial measures and companies are required to report their EPS on the statement of income or disclose it in the notes to their financial statements.

Key Terms Agent (4-15) Assurance warranty (4-14) Basic earnings per share (4-22) Commercial substance (4-6) Comprehensive income (4-18) Consignee (4-14) Consignment (4-14) Consignor (4-14) Control (4-8)

Distinct goods or services (4-6) Earnings per share (EPS) (4-22) Function (4-19) Multi-step statement of income (4-16) Nature (4-19) Net position in a contract (4-5) Ordinary activities (4-3) Other comprehensive income (4-18) Performance obligation (4-5)

Principal (4-15) Revenue recognition criteria (4-12) Right to receive consideration (4-5) Sales discounts (4-7) Service warranty (4-14) Single-step statement of income (4-16) Stand-alone selling price (4-8) Statement of comprehensive income (4-18) Variable consideration (4-7)

Abbreviations Used EPS

Earnings per share

Synonyms Gross profit | Gross margin Net income | Net earnings

Chapter End Review Problem 4-1 Big T Tires Ltd. entered into a contract to sell 1,000 winter tires to Auto Parts Ltd. on September 2, 2020. Auto Parts Ltd. is a major automotive parts chain operating in Atlantic Canada. The contract specified the price of the tires was $60 per tire and that the tires were to be delivered to Auto Parts’ warehouse no later than October 1, 2020. Auto Parts agreed to pay for the tires within 15 days of delivery. Big T Tires delivered all of the tires to Auto Parts’ warehouse on September 26, 2020, and mailed an invoice for the order that day. Auto Parts paid the invoice on October 10, 2020. The tires costs Big T Tires $46 each.

Required

b. Prepare all of the required journal entries for the above transactions based on your analysis in part “a.” STRATEGIES FOR SUCCESS • Be sure to apply facts from the problem to answer the question related to each step in the five-step model. • Remember that identifying performance obligations is key and that performance obligations are met when control of the goods or services is transferred to the buyer.

a. Determine how much revenue Big T Tires would be able to recognize in September 2020. Use the five-step model for revenue recognition in preparing your response.

Chapter End Review Problem 4-2 On August 10, 2020, Confitech Ltd. enters into a contract with Legal Co. to provide mobile shredding services at Legal Co.’s offices for a three-month period beginning on September 1, 2020. The contract requires Confitech to bring one of its unmarked mobile shredding trucks to Legal Co.’s office every Friday morning throughout the contract period. The contract is for $6,000, and Confitech agrees to

shred up to 80 copier paper boxes of confidential documents each month and take the contents to the local landfill. Any additional boxes will be shred at a cost of $30 per box, with Confitech invoicing these amounts at the end of each month. Legal Co. agreed to pay one-third of the contract on the first day of each month. Confitech prepares its financial statements on a monthly basis.


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Revenue Recognition and the Statement of Income

The actual number of boxes shredded was as follows: September

October

November

95 boxes

72 boxes

90 boxes

b. Prepare all of the required journal entries for the above transactions based on your analysis in part “a.” STRATEGIES FOR SUCCESS

All payments required under the contract were made by Legal Co., including the charges for excess shredding, which were paid on October 10 and December 8.

Required a. Determine how much revenue Confitech would be able to recognize in each month of the contract. Use the five-step model for revenue recognition in preparing your response.

• Be sure to apply facts from the problem to answer the question related to each step in the five-step model. • Remember that identifying performance obligations is key and that performance obligations are met when control of the goods or services is transferred to the buyer.

Chapter End Review Problem 4-3 On October 1, 2020, Image Ltd. enters into a contract with Health Co. to sell it two MRI machines, install the machines, and provide training for 50 of Health Co.’s employees on how to use the machines. Details of the contract are as follows: • The total price of the contract is $6.1 million. • The MRI machines can be purchased for $3.1 million each and installed by independent contractors. These machines cost Image Ltd. $2.7 million each. • Image Ltd. does installation work when its customers change locations or move their MRI machines as part of hospital redevelopments. Image Ltd. normally charges $100,000 per machine for installation. • Image Ltd. normally charges $1,000 per employee for training. • The contract requires Image to deliver the MRI machines by October 25, 2020, and that installation be completed by November 15, 2020. Training is to be completed by November 30, 2020.

• Health Co. agreed to pay $3 million upon delivery of the MRI machines and the balance once installation and training are complete. Image Ltd. delivered the MRI machines on October 22, 2020, and Health Co. made the required payment two days later. The installation of the machines was completed on November 13, 2020, and staff training was completed on November 28, 2020. Health Co. made the final contract payment on December 18, 2020.

Required a. Determine how much revenue Image Ltd. would be able to recognize in each month of the contract. Use the five-step model for revenue recognition in preparing your response. b. Prepare all of the required journal entries for the above transactions based on your analysis in part “a.”

Chapter End Review Problem 4-4 The following information was taken from Ngo Inc.’s financial records at October 31, 2020:

Administrative expenses Cost of goods sold Depreciation expense

2020

2019

$ 152,000

$ 134,000

1,042,000

972,000

227,000

198,000

Financing expenses

27,000

18,000

Income tax expense

52,000

37,000

Interest income

2,000

1,000

Utilities expense

22,000

19,000

2,095,000

1,876,000

205,000

178,000

Sales revenue Selling expenses

Required a. Prepare a comparative multi-step statement of income for Ngo Inc. b. Determine Ngo’s gross margin percentage for 2019 and 2020. Did this improve or worsen?

STRATEGIES FOR SUCCESS • As the name implies, preparing a multi-step statement of income is a matter of following steps. Start by identifying revenues from ordinary activities, which are normally referred to as sales. If the company is a retailer, subtract cost of goods sold from sales revenue to determine gross profit. The next step is to subtract all of the ordinary expenses incurred to generate income from gross profit to determine profit from operations. Other revenues and expenses are then subtracted from profit from operations to determine profit before tax. Income tax expense is subtracted from this to arrive at net income. • Gross margin percentage is determined by dividing gross profit by sales revenue. A higher gross margin percentage is better than a lower one, as this indicates that a larger portion of the selling price of goods is available to cover the company’s other expenses.


Solutions to Chapter End Review Problems

Solutions to Chapter End Review Problems Suggested Solution to Chapter End Review Problem 4-1 a. Question

Analysis

Step 1: Is there a contract?

Yes, both parties have agreed to enter into a contract. The quantity, price, and payment terms have been agreed to, and each party’s rights under the contract are clear. The contract is consistent with both parties’ lines of business, meaning it has commercial substance. There are no indications of any concerns regarding collectibility with Auto Parts Ltd., which is a major chain in Atlantic Canada.

Step 2: What performance obligations are included in the contract?

There is a single distinct good being provided under the contract: 1,000 tires.

Step 3: What is the transaction price?

The transaction price is $60,000 (1,000 tires × $60).

Step 4: How should the transaction price be allocated to the performance obligations?

There is no need to allocate the transaction price because there is a single performance obligation.

Step 5: Has a performance obligation been satisfied?

Revenue would be recognized by Big T Tires once it delivered the 1,000 tires. Upon delivery, Auto Parts has control of the goods, which is indicated by physical possession, it has the risks and rewards of ownership, it has accepted the tires, and it has an obligation to pay for them. As such, Big T Tires would recognize revenue on September 26, 2020.

b. Sept. 26

Oct. 10

DR Accounts Receivable CR Sales Revenue DR Cost of Goods Sold CR Inventory (1,000 tires × $46) DR Cash CR Accounts Receivable

60,000 60,000 46,000 46,000 60,000 60,000

Suggested Solution to Chapter End Review Problem 4-2 a. Question

Analysis

Step 1: Is there a contract?

Yes, both parties have agreed to enter into a contract. The service to be provided, price, and payment terms have been agreed to, and each party’s rights under the contract are clear. The contract is consistent with both parties’ lines of business, meaning it has commercial substance. There are no indications of any concerns regarding collectibility with Legal Co.

Step 2: What performance obligations are included in the contract?

In this case, there is a series of distinct services that are substantially the same and have the same pattern of transfer to the customer (the shredding services are the same each time and will be provided 12 times (once a week for three months) over the contract). Therefore they are considered to be a single performance obligation. continued

4-27


4-28 CH A PT ER 4

Revenue Recognition and the Statement of Income

Question

Analysis

Step 3: What is the transaction price?

The transaction price is $6,000.

Step 4: How should the transaction price be allocated to the performance obligations?

The transaction price will be allocated to the performance obligation on a monthly basis (as Confitech prepares its financial statements monthly). $2,000 ($6,000 ÷ 3) will be allocated to each month. Confitech will also need to record revenue for any additional shredding services performed.

Step 5: Has a performance obligation been satisfied?

Revenue would be recognized by Confitech after it has performed the shredding services for the month. Once the monthly shredding services have been provided, that portion (1/3) of the performance obligation has been satisfied.

b. Sept. 1

Sept. 30

Sept. 30

Oct.

1

Oct. 10

Oct. 31

Nov. 1

Nov. 30

Nov. 30

Dec. 8

DR Cash CR Unearned Revenue

2,000

DR Unearned Revenue CR Service Revenue

2,000

2,000

2,000

DR Accounts Receivable CR Service Revenue (15 boxes × $30)

450 450

DR Cash CR Unearned Revenue

2,000 2,000

DR Cash CR Accounts Receivable

450 450

DR Unearned Revenue CR Service Revenue

2,000

DR Cash CR Unearned Revenue

2,000

DR Unearned Revenue CR Service Revenue

2,000

2,000

2,000

2,000

DR Accounts Receivable CR Service Revenue (10 boxes × $30)

300

DR Cash CR Accounts Receivable

300

300

300

Suggested Solution to Chapter End Review Problem 4-3 a. Question

Analysis

Step 1: Is there a contract?

Yes, both parties have agreed to enter into a contract. The goods and services to be provided, price, and payment terms have been agreed to, and each party’s rights under the contract are clear. The contract is consistent with both parties’ lines of business, meaning it has commercial substance. There are no indications of any concerns regarding collectibility with Health Co.

Step 2: What performance obligations are included in the contract?

The contract includes three distinct performance obligations: the supply of the MRI machines, installation of the machines, and training of the employees. Each of these would be considered distinct goods or services.

Step 3: What is the transaction price?

The transaction price is $6,100,000.

continued


Solutions to Chapter End Review Problems Question

Analysis

Step 4: How should the transaction price be allocated to the performance obligations?

As there are multiple performance obligations, the transaction price must be allocated to each of them. The allocation will be done on the basis of the stand-alone selling price of each performance obligation.

Step 5: Has a performance obligation been satisfied?

Performance Obligation

% of Total Stand-Alone Stand-Alone Selling Price Selling Price

Contract Price

Allocation of Contract Price

Supply of MRI machines

$6,200,000

96.1%

× $6,100,000 $5,862,100

Installation

$ 200,000

3.1%

× $6,100,000 $ 189,100

Training

$

50,000

0.8%

× $6,100,000 $

$6,450,000

100.0%

48,800

$6,100,000

The first performance obligation, the supply of the MRI machines, is satisfied on October 22, 2020, when Image Ltd. delivers these goods. The revenue related to this obligation would be recognized at this point. The second performance obligation, the installation of the MRI machines, is satisfied on November 13, 2020, when these services are provided by Image Ltd. The revenue related to this obligation would be recognized at this point. The third performance obligation, the employee training, is satisfied on November 28, 2020, when the training was completed.

b. Oct. 22

Oct. 24

Nov. 13

Nov. 28

Dec. 18

DR Accounts Receivable CR Sales Revenue DR Cost of Goods Sold CR Inventory

5,862,100

DR Cash CR Accounts Receivable

3,000,000

5,862,100 5,400,000 5,400,000

3,000,000

DR Accounts Receivable CR Service Revenue

189,100

DR Accounts Receivable CR Service Revenue

48,800

DR Cash CR Accounts Receivable

189,100

48,800 3,100,000 3,100,000

Suggested Solution to Chapter End Review Problem 4-4 a. NGO INC. Statement of Income For the year ended October 31

Sales revenue

2020

2019

$2,095,000

$1,876,000

Cost of goods sold

1,042,000

972,000

Gross profit

1,053,000

904,000

Selling expenses

205,000

178,000

Depreciation expense

227,000

198,000

Operating expenses

continued

4-29


4-30 CH A PT ER 4

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NGO INC. Statement of Income For the year ended October 31 Administrative expenses

152,000

Utilities expense

134,000

22,000

19,000

Total operating expenses

606,000

529,000

Profit from operations

447,000

375,000

Other revenues and expenses Interest income

2,000

1,000

Financing expenses

(27,000)

(18,000)

Profit before income tax

422,000

358,000

52,000

37,000

$ 370,000

$ 321,000

Income tax expense Net income b.

Gross profit percentage

2020

2019

$1,053,000 = 0.503 or 50.3%

$ 904,000 = 0.482 or 48.2%

$2,095,000

$1,876,000

Ngo’s gross profit percentage improved in 2020 because it was 2.1% higher, meaning that a higher percentage of the company’s sales revenue was available to cover the company’s expenses.

Assignment Material Discussion Questions DQ4-1 Identify and explain the difference between the contract-based and earnings-based approaches to revenue recognition. DQ4-2 Explain, in your own words, each of the five steps used to determine when and how much revenue should be recognized under the contract-based approach. DQ4-3 Explain what is meant if a company’s net contract position has increased. DQ4-4 Explain the meaning of “performance obligation.” DQ4-5 What is the most common point at which revenue is recognized for the sale of goods? Why is this the case? DQ4-6 Explain when revenue should be recognized from the provision of services under the contract-based approach. DQ4-7 Describe the accounting treatment for a deposit made by a customer for the future delivery of goods. Refer to the five-step model in your explanation. DQ4-8 Explain what is meant by stand-alone selling price and how it is determined.

DQ4-11 Explain the difference between assurance and service warranties, and how they affect the recognition of revenue under the contract-based approach. DQ4-12 Explain the difference between the consignor and consignee in a consignment arrangement. When would each recognize revenue? DQ4-13 Explain why a multi-step statement of income provides users with better information than a single-step statement of income does. Identify some of this information. DQ4-14 Identify and briefly describe the major sections of a multistep statement of income. DQ4-15 How does the single-step statement of income differ from the multi-step statement of income? Do they produce different net income amounts? Explain. DQ4-16 What kinds of items are included on the statement of comprehensive income?

DQ4-9 Explain what sales discounts are and how they are accounted for under the contract-based approach to revenue recognition.

DQ4-17 Explain the difference between a statement of income with expenses presented by nature and one with expenses presented by function. Does one require more judgement on the part of management? Why or why not?

DQ4-10 If a company provides customers with the right to return goods, explain how this impacts the recognition of revenue under the contract-based approach.

DQ4-18 Explain what the basic earnings per share ratio tells users, including why net income is reduced by preferred dividends as part of the ratio calculation.


Application Problems Series A 4-31

Application Problems Series A AP4-1A (Revenue recognition criteria) The following are independent situations. 1. The insurance policy on your car starts February 1, 2020, and covers one year. You paid the insurance company $1,800 on January 28, 2020. 2. Porter Airlines sold you a non-refundable one-way ticket in October 2020 for your flight home at Christmas. The cost of the ticket was $398. 3. You went for your annual dental checkup on April 5, 2020. The fees were $125, and the dentist’s office requires payment within 30 days of the visit. You paid the bill on April 30, 2020. 4. The Winnipeg Jets sell season tickets in one section of the arena for $6,087 per seat. The season begins in September, ends in March, and covers 41 games. You bought one season’s ticket and paid for it in July 2020 for the 2020–21 season.

Required For each of the above situations, from the perspective of the company you purchased the goods or services from, determine: a. the performance obligation(s) included in the contract, b. the transaction price, and c. when the performance obligation(s) would be satisfied, resulting in revenue recognition. AP4-2A

(Revenue recognition)

TreeHold Corp. designs and builds custom harvesting equipment for logging companies across Canada. The company, which is publicly traded, has a May 31 year end. On February 18, 2020, TreeHold signed a contract with Coastal Harvesting Ltd. to design and build 25 custom harvesters that can harvest wood at the steep grades found along much of the Pacific coast timber stands included in Coastal’s harvesting leases. The following events took place in 2020 in relation to the contract: 1. February 18: Officials from TreeHold and Coastal sign the contract. The contract was for $4.1 million. TreeHold is to design, manufacture, and deliver the 25 machines to Coastal’s operations centre in Duncan, British Columbia. TreeHold’s management estimates that the design component of the contract would be valued at $510,000 if contracted for separately, while the machine construction component of the contract would be valued at $4 million if the machines were purchased separately. TreeHold agrees to provide a three-year assurance-type warranty for the machines, and the company’s management estimates that the warranty claims would total $230,000 based on past experience. Coastal agrees to pay a $1,250,000 deposit within 10 days of signing the contract and to pay the balance within 15 days of the equipment being delivered. 2. February 25: Coastal pays the deposit specified in the contract. 3. March 28: TreeHold’s engineering staff complete the equipment design and it is approved by officials from Coastal. 4. May 18: TreeHold completes construction of the 25 harvesters. 5. May 20: The 25 harvesters are loaded onto TreeHold’s trucks and are delivered to Coastal’s operation centre in Duncan later that day. 6. June 2: Coastal pays the balance owing on the contract.

Required a. Using the five-step model for revenue recognition, determine when and how much revenue TreeHold would be able to recognize for the year ended May 31, 2020. Round percentages to the nearest two decimal places. b. Prepare TreeHold’s required journal entries for all of the dates appearing above along with any other necessary journal entries for the contract based on your analysis in part “a.” AP4-3A (Revenue recognition) Chow Publications Inc. is a publicly traded media company focused on products for the home chef market. The company publishes a monthly magazine that can be purchased at newsstands and is available for annual subscriptions (either paper copy or digital copy). Chow Publications sells annual subscriptions for $50 (paper copies) or $40 (digital copies). Subscriptions are paid in advance and are non-cancellable. Chow sold for cash 115,000 subscriptions on December 1, 2020, of which 30% were digital subscriptions.


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Single issues can be purchased on newsstands. Chow Publications uses various magazine distributors across Canada to rack it at newsstands, charging the newstands $5 per copy. Normally 25,000 copies are sent out each month, with 15% of these being returned unsold. Of the 25,000 magazines sent out in December 2020, all were sold on account, and none of the returned magazines are expected to be resold and, as a result, are sent to recycling. Unsold nagazines are returned by newstands in the following month.

Required a. Determine how much revenue Chow Publications would be able to recognize in December 2020. Use the five-step model for revenue recognition in preparing your response. Round the per magazine price to three decimal places. ie. $4.965 b. Prepare the required summary journal entries for the contract based on your analysis in part “a.” AP4-4A (Revenue recognition) GoWeb IT Inc. is a public company that manufactures and sells IT systems and also provides IT training and support. GoWeb’s customers can purchase IT system hardware or support services separately, but the company also offers hardware and support services as a package. On June 14, 2020, Western Power Ltd., one of GoWeb’s customers, purchased an equipment and support package. The contract with Western is for $4.2 million and includes hardware and three years of support services. The hardware that was purchased would normally sell for $3.2 million, and support services would be valued at $1.3 million if purchased separately. The hardware cost GoWeb $2.6 million and was delivered on June 30, 2020. GoWeb’s management expects that about half of the support services will be provided in July 2020 as the new hardware is installed. The balance of the support is expected to be provided evenly over the remainder of the contract. The contract also calls for Western to make a $1.2-million payment to GoWeb within 30 days of signing the contract and then $1 million on January 1, 2021, 2022, and 2023. Western is a successful company and GoWeb’s management has no concerns about collectibility.

Required a. Assuming that GoWeb provides the goods and services as expected under the contract and Western makes its payments as required, determine when and how much revenue GoWeb would be able to recognize in each year of the contract. Use the five-step model for revenue recognition in preparing your response. Round percentages to the nearest two decimal places. b. Prepare the required summary journal entries and any required adjusting journal entries for the contract based on your analysis in part “a.” GoWeb has a calendar year end and records adjusting journal entries monthly. AP4-5A (Revenue recognition) Cool-IT Ltd. manufactures and sells air conditioning equipment to retailers across North America. In 2020, Cool-IT signed a two-year contract with BigMart Ltd. to supply it with 60,000 units at a price of $75 per unit. Cool-IT’s cost to manufacture these units is $52. The following schedule summarizes the production, delivery, and payments in relation to the contract. Production costs are recorded to inventory: 2020 Air conditioning units delivered

2021

Total

38,000

22,000

60,000

Production costs incurred

$1,976,000

$1,144,000

$3,120,000

Cash payments received

$2,430,000

$1,770,000

$4,200,000

Required a. Determine how much revenue Cool-IT would be able to recognize in 2020 and 2021. Use the five-step model for revenue recognition in preparing your response. b. Prepare the required summary journal entries for the contract based on your analysis in part “a.” c. How would your answer to part “a” change if Cool-IT allowed BigMart to return any air conditioners that were returned by its customers as defective? Based on past experience, Cool-It’s management estimated a return rate of 2% and that the air conditioners being returned would need to be scrapped. AP4-6A (Revenue recognition) Beach Life Ltd. operates an online booking service restricted to beachfront properties around the world. Users of the company’s website booked beach rentals totalling $7.8 million in 2020. Bookings are fully


Application Problems Series A 4-33

paid for at the time of reservation and are 50% refundable if the reservation is cancelled any time up to 21 days before the reservation date. After that date, the reservations are non-cancellable. Under the terms of the company’s listing agreements with property owners, Beach Life charges a fee of 12% of the total reservation and electronically transfers the balance of cash collected directly to the property owner’s bank five days before the reservation date. Of the 2020 bookings, 90% had been completed before Beach Life’s December 31 year end. The balance was still within the cancellation period.

Required Determine how much revenue Beach Life would be able to recognize in 2020. Use the five-step model for revenue recognition in preparing your response. AP4-7A (Revenue recognition and statement of income) Kabili Bites Ltd. operates a chain of restaurants across Canada. Most of the company’s business is from customers who enjoy in-restaurant lunches and dinners and pay before they leave. The company also provides catered food for functions outside of the restaurant. Catering customers are required to pay a 40% deposit at the time of booking the event. The remaining 60% is due on the day of the function. During 2020, the restaurant chain collected $7,036,000 from restaurant and catered sales. At year end, December 31, 2020, the catered sales amount included $121,000 for a convention scheduled for January 12, 2021. Kabili Bites Ltd. paid $3,298,000 for food supplies during the year and $1,248,000 for wages for the chefs and other restaurant staff. The restaurant owed $62,000 in wages to its staff at year end, which will be paid on January 4, 2021, as part of the normal weekly pay schedule.

Required a. Prepare as much of the multi-step statement of income for Kabili Bites Ltd. as you can, showing the amount of sales and any other amounts that should be included. Show all calculations. b. Using the five-step revenue recognition method, explain when Kabili Bites can recognize revenues from its various revenue streams. c. Did Kabili Bites have a cost of goods sold? Why or why not? d. What other expenses do you think the company probably has? AP4-8A (Statement of income presentation) The statement of income for DiTuri Manufacturing Inc. for the years 2018 to 2020 is presented below. DITURI MANUFACTURING INC. Statement of Income For the year ended October 31 (in thousands of dollars) 2020 Sales Revenue

$

?

2019

2018

$1,364

$1,118

Cost of goods sold

949

?

?

Gross margin

687

?

448

?

136

112

Administrative expenses

131

109

89

Depreciation expense

110

98

?

Operating income

283

270

145

Investment income

10

?

12

Financing expenses

24

18

?

269

?

142

Operating Expenses Store expenses

Earnings before income taxes Income tax expense Net earnings

?

52

$215

$ 208

Required

Calculate the missing amounts on the statement of income.

28 $

?


4-34 CH A PT ER 4

Revenue Recognition and the Statement of Income

AP4-9A (Statement of income presentation) You have been provided with the following account balances for Webber Ltd. for the years ended November 30, 2020, and 2021: Advertising expense Cost of goods sold General and administrative expenses Income tax expense

2021

2020

$ 310,000

$ 320,000

1,764,000

1,456,000

112,000

105,000

82,000

102,000

5,200

6,100

Interest revenue Rent expense

36,000

27,000

Sales revenue

3,150,000

2,800,000

Utilities expense

88,000

76,000

Wages expense

504,000

492,000

Required a. Prepare a multi-step, comparative statement of income for Webber for 2020 and 2021. b. Determine Webber’s gross margin percentage for each year. In which year was Webber more successful in this area? c. Did the year with the superior gross margin percentage also have the largest net income? Explain why this may or may not be the case. AP4-10A (Statement of income presentation) The following account balances are taken from Sherwood Ltd.’s adjusted trial balance at June 30, 2020: Debit Sales revenue Advertising expense

Credit $1,250,000

$125,000

Cost of goods sold

596,000

General and administrative expenses

40,000

Selling expenses

75,000

Depreciation expense

70,000

Interest expense

37,000

Interest revenue

44,000

Income tax expense

10,700

Wages expense

165,000

Utilities expense

106,000

Required a. Prepare a single-step statement of income for the year ended June 30, 2020. b. Prepare a multi-step statement of income for the year ended June 30, 2020. c. Compare the two statements and comment on the usefulness of each one. AP4-11A (Statement of income presentation: nature vs. function) Navaria Inc. manufactures and sells chair lift mobility aids. These are chairlift systems designed for inhome use to aid persons with mobility challenges. The company sells its systems online and through a network of independent sales agents. Installation of the systems is done by independent contractors hired directly by Navaria’s customers. The following information was taken from Navaria’s financial records for the year ended June 30, 2020: (in thousands of dollars) Administrative expenses Cost of goods sold

$

9,550 79,159

Other expenses

641

Financing expenses

825


Application Problems Series B 4-35

(in thousands of dollars) Interest revenue

630

Income tax expense

4,953

Sales revenue

Engineering activities

119,728

Wages

Rental of Equipment

$1,927

$65

0

$524

774

33

0

128

3,586

0

5,866

26

Research and development activities Sales and marketing activities

Advertising $

Depreciation

Required a. Prepare a multi-step statement of income for the year ended June 30, 2020 that reports expenses by nature. b. Prepare a multi-step statement of income for the year ended June 30, 2020 that reports expenses by function. AP4-12A (Statement of income presentation: basic EPS) The following information was taken from Riddell Ltd.’s adjusted trial balance as at April 30, 2020: Sales revenue

$1,045,800

Interest revenue

7,200

Utilities expense

24,000

Insurance expense

6,000

Cost of goods sold

396,000

Distribution expenses

230,250

Administrative expenses

90,250

Depreciation expense

81,000

Interest expense

16,500

Income tax expense

56,700

Dividends declared—Common shares

15,000

Dividends declared—Preferred shares

20,000

Required a. Prepare a single-step statement of income for the year ended April 30, 2020. b. Prepare a multi-step statement of income for the year ended April 30, 2020. c. Determine Riddell’s gross margin percentage for the year. d. If Riddell had 35,000 common shares outstanding throughout the year, determine the company’s basic earnings per share.

Application Problems Series B AP4-1B

(Revenue recognition criteria)

The following are independent situations. 1. You bought a printer from Best Buy’s online site and paid with your credit card on June 14, 2020. The printer was delivered on June 18. You paid the credit card balance on July 15. 2. You bought furniture from Leon’s on December 19, 2020, during a promotion and took it home that day. The selling price of the furniture was $1,100 and payment is due January 2, 2022. 3. On March 14, 2020, you purchased a travel pass on VIA Rail for $500 that enables you to unlimited rail travel for the months of April, May, and June 2020. The pass is non-refundable. 4. You decide you need a new smart phone. You can purchase an iPhone from Rogers Communications. The current promotion indicates there is no cost for the phone if you sign up for a two-year phone and data plan at $50 per month.


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Revenue Recognition and the Statement of Income

Required For each of the above situations, determine: a. the performance obligation(s) included in the contract, b. the transaction price, and c. when the performance obligation(s) would be satisfied, resulting in revenue recognition. AP4-2B (Revenue recognition) Derby Transportation Inc. designs and builds trains for rail networks across Canada. The company, which is publicly traded, has an October 31 year end. On March 15, 2020, Derby Transportation signed a contract with OM Corridor Corp. to design and build 10 high-speed trains, with each train consisting of seven passenger cars. The high-speed train will operate between Ottawa and Montreal. The following events took place in 2020 in relation to the contract: 1. March 15: At the signing ceremony, officials from Derby and OM sign a contract, which is for $11 million. Derby is to design, manufacture, and deliver the 10 trains to OM’s train yards in Montreal. Derby’s management estimates that the design component of the contract would be valued at $2 million if contracted for separately, while the manufacturing of the ten trains would be valued at a total $10 million if they were purchased separately. Derby agreed to provide a two-year assurance-type warranty for the trains, and the company’s management estimates that the warranty claims would total $500,000 based on experience. OM agrees to pay a $5.1 million deposit within 14 days of signing the contract and to pay the balance within 45 days of the trains receiving final approval and certification from the Transportation Safety Board. 2. March 29: OM pays the deposit specified in the contract. 3. May 9: Derby’s engineering staff complete the train design and it is approved by officials from OM as well as the Transportation Safety Board. 4. August 1: Derby completes construction of the 10 trains. 5. September 1: The 10 trains are delivered according to the contract to OM’s Montreal train yards. 6. September 30: After testing for safety compliance, the trains receive final approval from OM and the Transportation Safety Board and are certified to carry passengers. 7. November 15: OM pays the balance owing on the contract.

Required a. Using the five-step model for revenue recognition, determine when and how much revenue Derby would be able to recognize for the year ended October 31, 2020. Round percentages to nearest two decimal places. b. Based on your analysis in part “a,” prepare all of the journal entries required by Derby in relation to the contract. If no journal entry is required, explain why that is the case. AP4-3B

(Revenue recognition)

Gourmand Dinner Box Inc. is a catering company that sells meal kits that its customers can take home and quickly prepare. The company sells its meal kits at local grocery stores and has recently begun to offer a monthly subscription service, which delivers meal kits to the customer’s home. Single meal kits can be purchased at grocery stores. Approximately 10% of the kits shipped to grocery stores each month are returned unsold and are then discarded. Gourmand charges the grocery stores $15 for each meal kit. In December 2020, Gourmand began selling three-month subscriptions for $900. Subscriptions are paid in advance and are non-cancellable. Gourmand sold 800 subscriptions on December 1, 2020 which entitle the subscriber to 15 meal kits each month beginning in December 2020. During December, 4,500 meal kits were sold, on account, to grocery stores and all required subscriber meals were delivered. Grocery stores have 30-day terms of payment with Gourmand.

Required a. Determine how much revenue Gourmand Dinner Box would be able to recognize in December 2020. Use the five-step model for revenue recognition in preparing your response. b. Based on your analysis in part “a,” prepare the required journal entries for the contract. Gourmand records adjusting journal entries monthly. Ignore any related costs to prepare the meal kits. AP4-4B (Revenue recognition) ADM Ltd. is a public company that manufactures and sells satellite systems and provides support services. ADM’s customers can purchase satellites or support services separately, but the company also offers satellite systems that include training and support as a package. On October 1, 2020, First Web Ltd. purchased a satellite and support package from ADM. The contract is for $100 million and includes the satellite and


Application Problems Series B 4-37

10 years of support services once the satellite is delivered in orbit. The satellite that was purchased by First Web would normally sell for $95 million and 10 years of support services would be valued at $15 million if purchased separately. ADM’s management expects the satellite to be delivered in orbit by October 1, 2021. The support is expected to be provided evenly for 10 years after delivery of the satellite. The contract requires First Web to make a $15-million payment to ADM within 30 days of signing the contract and then $35 million on October 1, 2021, with the balance to be paid annually over 10 years once the satellite is delivered in orbit on October 1, 2021. First Web has secured financing to pay for the satellite system and so ADM’s management has no concerns related to collectability.

Required a. Assuming that ADM provides the goods and services as and when expected under the contract and First Web makes its payments as required, determine when and how much revenue ADM would be able to recognize in each of the first three fiscal years ending December 31 (2020, 2021, 2022) of the contract. Use the five-step model for revenue recognition in preparing your response. Round percentages to the nearest two decimal places. b. Based on your analysis in part “a,” prepare the required journal entries for 2020, 2021 and 2022. Assume ADM records adjusting journal entries at December 31 each year. AP4-5B (Revenue recognition) Sound Sleeper Ltd. manufactures and sells mattresses to retailers across Canada. In 2020, Sound Sleeper signed a two-year contract with Zzz Ltd. to supply it with 40,000 mattresses at a price of $100 per unit. Sound Sleeper’s cost to manufacture a mattress is $25. Sound Sleeper provides Zzz with 30-day credit terms from the date of delivery. The following schedule summarizes the production, delivery, and payments in relation to the contract: 2020 Mattresses delivered

2021

Total

15,000

25,000

40,000

Manufacturing costs incurred

$ 375,000

$ 625,000

$1,000,000

Cash payments received

$1,400,000

$2,450,000

$3,850,000

Required a. Determine how much revenue Sound Sleeper would be able to recognize in 2020 and 2021. Use the five-step model for revenue recognition in preparing your response. b. Prepare the required summary journal entries for the contract based on your analysis in part “a.” c. How would your answer to part “a” change if Sound Sleeper allowed Zzz to return any mattresses that were returned by customers who found them uncomfortable? Based on experience, Sound Sleeper’s management estimated a return rate of 1% and that the mattresses being returned would be donated to local shelters. AP4-6B (Revenue recognition) Millionaire Ride Ltd. operates an online booking service for luxury car rentals around the world. Users of the company’s website booked luxury cars totalling $8.4 million in 2020. Bookings are fully paid for at the time of reservation and are fully refundable if the reservation is cancelled any time up to 20 days before the reservation date. After that date, the reservations are non-cancellable. Under the terms of the company’s listing agreements with luxury car owners, Millionaire Ride charges a fee of 10% of the total reservation and electronically transfers the balance of cash collected directly to the car owner’s bank five days before the reservation date. Of the 2020 bookings, 75% had been completed before Millionaire Ride’s December 31 year end. The balance of the bookings were still within the cancellation period.

Required Determine how much revenue Millionaire Ride would be able to recognize in 2020. Use the five-step model for revenue recognition in preparing your response. AP4-7B (Revenue recognition and statement of income) Kohlrabi Electronics Ltd. operates an online electronics business selling hardware and software. Customers confirm the goods ordered and pay for their purchase before Kohlrabi ships the merchandise they have ordered. The company also provides IT consulting services to larger customers. Customers who require consulting services sign a contract and are required to pay a 20% deposit at the time of signing. The remaining 80% is due on the delivery of the final consulting report. During 2020, the online business collected $6,097,000 from hardware and software sales. At year end, August 31, 2020, the IT consulting services had collected $897,000 cash which included $260,000


4-38 CH A PT ER 4

Revenue Recognition and the Statement of Income

for services scheduled to be completed by December 31, 2020. Kohlrabi paid $2,199,000 for the hardware and software inventory sold during the year and $1,447,000 for wages to technical and warehouse staff. The company owed $56,000 in wages to its staff at year end, which will be paid on September 11, 2020, as part of the normal weekly pay schedule.

Required a. Prepare as much of the single-step statement of income for Kohlrabi Electronics Ltd. as you can, presenting the amount of sales revenue for each revenue stream and any other amounts that should be included. Show all calculations. b. Using the five-step revenue recognition method, explain when Kohlrabi Electronics can recognize revenues from its various revenue streams. c. Did Kohlrabi have a cost of goods sold? Why or why not? d. What other expenses do you think the company probably has? AP4-8B (Statement of income presentation) The statement of income for J. T. Stone Manufacturing Inc. for the years 2020 to 2022 is below. J. T. Stone Manufacturing Inc. Statement of Income For the year ended August 31 Sales revenue Cost of goods sold

2022

2021

$500,000

$476,000

400,000

?

300,000

?

$ 61,000

$ 75,000

37,000

?

30,000

9,200

9,000

8,500

?

7,100

6,700

Gross profit

2020 $

?

Operating expenses Wages expense Rent expense Utilities expense Depreciation expense

6,000

6,000

6,000

59,400

57,100

?

?

3,900

?

Interest revenue

5,000

?

1,000

Interest expense

?

Total operating expenses Profit from operations Other revenues and expenses

Profit before income tax

(500)

41,600

5,500

?

8,320

?

4,860

?

$ 4,400

Income tax expense Net income

(1,000)

$

$

?

Required Determine the missing amounts. AP4-9B (Statement of income presentation) You have been provided with the following account balances for Broiler Ltd. for the years ended September 30, 2020, and 2021: 2021

2020

$ 220,000

$ 300,000

1,546,000

1,366,000

General and administrative expenses

222,000

155,000

Income tax expense

500,000

75,000

3,200

4,000

Rent expense

15,000

12,000

Sales revenue

3,750,400

2,450,000

Advertising expense Cost of goods sold

Interest revenue

Utilities expense

90,000

66,000

Wages expense

403,000

376,000


Application Problems Series B 4-39

Required a. Prepare a multi-step comparative statement of income for Broiler Ltd. for 2020 and 2021. b. Determine Broiler’s gross margin percentage for each year. In which year was Broiler more successful in this area? c. Did the year with the superior gross margin percentage also have the largest net income? Explain why or why not. AP4-10B (Statement of income presentation) The following account balances are taken from Ballistik Ltd.’s adjusted trial balance at January 31, 2020: Debit Sales revenue Wages expense Cost of goods sold

Credit $5,275,000

$ 175,000 3,645,000

General and administrative expenses

66,000

Utilities expenses

105,000

Depreciation expense

95,000

Interest expense

33,000

Interest revenue

50,000

Income tax expense

150,700

Advertising expense

125,000

Selling expenses

196,000

Required a. Prepare a single-step statement of income for the year ended January 31, 2020. b. Prepare a multi-step statement of income for the year ended January 31, 2020. c. Compare the two statements and comment on the usefulness of each one. AP4-11B (Statement of income presentation: nature vs. function) Cartier Custom Homes Inc. manufactures and sells pre-fab homes. These homes are manufactured in a controlled environment to ensure a consistent and higher quality, which results in greater customer satisfaction. The company sells its homes online and through a network of independent sales agents. Onsite installation of the homes is done by independent contractors hired directly by Cartier’s customers. The following information was taken from Cartier’s financial records for the year ended March 31, 2020: (in thousands of dollars) Administrative expenses Cost of goods sold Other expenses Financing expenses Dividend revenue Income tax expense Sales revenue

$

10,645 1,650,159 1,761 65,125 2,730 167,753 2,671,928

Wages

Rental of Equipment

$107,000

$1,765

Research and development activities

5,764

Sales and marketing activities

2,596

Architectural activities

Advertising $

Depreciation

0

$7,252

6,300

0

1,118

0

3,678

500

Required a. Prepare a multi-step statement of income for the year ended March 31, 2020, that reports expenses by nature. b. Prepare a multi-step statement of income for the year ended March 31, 2020, that reports expenses by function.


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Revenue Recognition and the Statement of Income

AP4-12B (Statement of income presentation: basic EPS) The following information was taken from Egeland Ltd.’s adjusted trial balance as at July 31, 2020: Sales revenue Interest expense Cost of goods sold Utilities expense

$2,788,800 44,000 1,556,000 16,000

Depreciation expense

216,000

Distribution expenses

414,000

Administration expenses

279,000

Advertising expense

64,000

Interest revenue

19,200

Income tax expense

77,000

Dividends declared—Common shares

30,000

Dividends declared—Preferred shares

15,000

Required a. Prepare a single-step statement of income for the year ended July 31, 2020. b. Prepare a multi-step statement of income for the year ended July 31, 2020. c. Determine Egeland’s gross margin percentage for the year. d. If Egeland had 80,000 common shares outstanding throughout the year, determine the company’s basic earnings per share.

User Perspective Problems UP4-1 (Revenue recognition and earnings) Financial analysts frequently refer to the quality of a company’s earnings. By quality, they mean that the earnings are showing growth and are good predictors of future earnings.

Required If you were looking for evidence of a company’s quality of earnings, what would you look for on the financial statements? UP4-2 (Revenue recognition) Suppose that your company sells appliances to customers under sales contracts that allows them to pay for the appliance in monthly payments over one year. Credit checks are performed at the time of sale.

Required Using the contract-based approach, describe when revenue would be recognized for this type of sale. UP4-3 (Revenue recognition) Chargeit Inc. imports and distributes cellphone chargers and fully-charged portable backup power stations to gas stations and other small retailers. Chargeit has a standard contract that it enters into with each gas station or retailer, which stipulates the following: 1. The gas stations and retailers are required to place Chargeit’s product display unit on or adjacent to the cash counter. 2. Chargeit is responsible for servicing the display unit, in terms of restocking it, and its employees will visit each gas station or retailer at least twice each month to count the number of products in the display unit, determine the number of products sold, and restock the display units.


User Perspective Problems 4-41

3. The gas stations or retailers are required to pay only for the products sold to customers, receive 20% of each sale, and remit the balance to Chargeit at the end of each month. 4. The gas stations and retailers are responsible for any products stolen from the Chargeit display station. 5. The contract is cancellable by either party with 30 days’ notice, and all unsold product and the display unit must be returned to Chargeit.

Required Explain when Chargeit would recognize revenue under the contract-based approach. Also explain how the gas stations and retailers would recognize revenue under the contract-based approach. UP4-4

(Revenue recognition)

Kidlet Toys Ltd. designs and manufactures toys for the early childhood education market. The company sells its products to national toy retailers as well as to independent toy stores across North America. The company allows its customers to return any unsold products within 90 days of receiving the products from Kidlet. The rationale for this policy is to stimulate sales, especially among the independent toy stores. Returned toys are discarded.

Required Explain when Kidlet would recognize revenue under the contract-based approach. Also explain what the company would have to do to determine the amount of revenue that could be recognized. UP4-5 (Revenue recognition policy and sales targets) Suppose that you are the vice-president in charge of marketing and sales in a large company. You want to boost sales, so you have developed an incentive plan that will provide a bonus to the salespeople based on the revenue they generate.

Required At what point would you recommend that the company count a sale toward the bonus plan: when the salesperson generates a purchase order, when the company ships the goods, or when the company receives payment for the goods? Explain. UP4-6 (Revenue recognition) Sound Co. sells memberships to an online music streaming service. Memberships are available for 1-month, 6-month, and 12-month periods. The memberships are non-refundable.

Required Using the five-step model, explain when Sound Co. would recognize revenue from the membership sales. UP4-7 (Advertising revenue recognition) Suppose the sports channel on television sells $10 million in advertising slots to be aired during the games that it broadcasts during the FIFA World Cup. Suppose also that these slots are contracted out during the month of October with a down payment of $2 million. The ads will be aired in June and July of the following year, with 40% of the ads airing in June and the balance in July.

Required If the sports channel’s fiscal year end is December 31 and the company uses the contract-based approach, how should it recognize this revenue in its financial statements? UP4-8 (Revenue recognition for gift certificates) Suppose that a national clothing retailer sells gift cards for merchandise. During the Christmas holiday period, it issues $500,000 in gift cards.

Required If the company’s fiscal year end is December 31, how should it recognize the issuance of these gift cards in its financial statements at year end? Explain your answer in relation to the contract-based approach to revenue recognition.


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Revenue Recognition and the Statement of Income

UP4-9

(Revenue recognition on software sales)

Suppose that Solution Software Company produces inventory-tracking software that it sells to retail companies. The software keeps track of what inventory is on hand and where it is located. It automatically adjusts the information when items are sold and alerts the company when new inventory needs to be ordered. The software package sells for $100,000 and the company agrees to customize it to the buyer’s operations, which normally takes several months.

Required If the fiscal year end is September 30 and the company sells 10 software units in August, how should it recognize these sales in the financial statements at year end? Use the contract-based approach to revenue recognition to support your answer. UP4-10 (Statement of income: expense presentation) You are a member of the executive of the students’ union at your university. As one of the few executive members with some knowledge of financial accounting, you have been tasked with responding to a request from the office of the university’s vice-president of finance. She has asked the student union to provide its thoughts on the university’s move to present the expenses on its statement of operations (statement of income) by function rather than by nature. The VP is proposing two functions: (1) instruction/ student support and (2) ancillary.

Required a. What concerns might the student union have with this proposal? b. What recommendation(s) would you suggest the student union make in relation to the proposal?

Work in Progress WIP4-1

(Revenue recognition)

You are studying with your study group when one of your group members makes the following statement: “Under the contract approach, companies recognize revenue whenever their net position in a contract improves. As such, when a customer places an order and makes a deposit, the seller can recognize revenue as their net position has improved as they have received cash, which increases contract assets.”

Required Explain whether or not your group member’s rationale is correct. WIP4-2

(Sales discounts)

You are studying with some classmates and are reviewing each other’s responses to the following questions: “Why do companies offer sales discounts to customers? How would a sales discount 1/10; n/45 be interpreted?” Your classmate responds as follows: “Companies offer sales discounts so that they can earn revenue quicker or sell inventory quicker. A sales discount of 1/10; n/45 means that the buyer has to pay one tenth of the invoice amount within 45 days.”

Required Identify how your classmate’s answer could be substantively improved. WIP4-3

(Sales discounts)

You are studying with some classmates and are reviewing each other’s responses to the following questions: “Why do companies offer sales discounts to customers? How would a sales discount 1/10; n/45 on a $2,000 purchase be interpreted?” Your classmate responds as follows: “Companies offer sales discounts in order to increase the amount of revenue they earn and to speed up the collection of cash from customers. If you are offered a sales discount of 1/10; n/45 on a $2,000 purchase, it means that you must pay before 10 days and, if you do, you will get 10% off, so you will only have to pay $1,800 to settle the account.”


Reading and Interpreting Published Financial Statements 4-43

Required Identify how your classmate’s answer could be substantively improved. WIP4-4

(Consignment arrangements)

During a study session, one of your classmates states the following: “Companies that are consignors in a consignment arrangement are essentially in the same position as agents in third-party sale arrangements. They receive a commission whenever the consigned goods are sold.”

Required Evaluate your classmate’s response. Identify the elements that are correct and incorrect.

Reading and Interpreting Published Financial Statements RI4-1 (Revenue recognition and statement of income presentation) Ten Peaks Coffee Company Inc. is a Burnaby, British Columbia-based specialty coffee company. The company provides green coffee decaffeination services as well as green coffee handling and storage services. Exhibit 4.13 contains an excerpt from Ten Peaks’ 2016 annual report.

EXHIBIT 4.13 Ten Peaks Coffee Company Inc.’s 2016 Consolidated Statements of Income

TEN PEAKS COFFEE COMPANY INC. Consolidated Statements of Income (Tabular amounts in thousands of Canadian dollars) for the Note Revenue

12 months ended December 31, 2016 $ 81,927

12 months ended December 31, 2015 $ 83,641

Cost of sales

(69,877)

(72,328)

Gross profit

12,050

11,313

(2,398)

(2,341)

Operating expenses Sales and marketing expenses Occupancy expenses Administration expenses Total operating expenses Operating income

(136)

(137)

(4,499)

(4,961)

(7,033)

(7,439)

5,017

3,874

(4)

21

Non-operating or other Finance (expense) income Gain on risk management activities

1,073

Loss on derivative financial instruments

(435)

Gain (loss) on foreign exchange Total non-operating Income before tax Income tax expense

— (1,158)

91

(892)

725

(2,029)

5,742 12

Net income for the year

1,845

(1,593) $

4,149

(533) $

1,312

$

0.17

Earnings per share Basic and diluted (per share)

22

$

0.46


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Required a. Calculate Ten Peaks’ gross profit percentage for 2016 and 2015. Has it improved? b. Using the financial statements in Appendix A, calculate Dollarama’s gross profit percentage for the same periods. How do they compare with Ten Peaks’ percentages? c. Does Ten Peaks prepare its consolidated income statement using a single-step or a multi-step approach? d. Does Ten Peaks present its expenses by function or by nature? Does this approach require a higher level of management judgement when preparing the statement?

RI4-2 (Revenue recognition and statement of income presentation) Gildan Activewear Inc. is a Montreal-based company that manufactures and sells activewear, socks, and underwear. The company’s brands include Gildan, Gold Toe, and Anvil. The company also manufactures products through licensing arrangements with Under Armour and New Balance brands. Exhibit 4.14 presents the company’s consolidated statements of earnings and comprehensive income for the years ended January 1, 2017, and January 3, 2016.

EXHIBIT 4.14 Gildan Activewear Inc.’s 2016 Consolidated Statements of Earnings and Comprehensive Income

GILDAN ACTIVEWEAR INC. Consolidated Statements of Earnings and Comprehensive Income Fiscal years ended January 1, 2017 and January 3, 2016 (in thousands of U.S. dollars, except per share data) 2016

2015 (15 months)

Net sales Cost of sales

$2,585,070

$2,959,238

1,865,367

2,229,130

Gross profit

719,703

730,108

Selling, general and administrative expenses (note 16(a))

336,433

387,963

11,746

14,908

371,524

327,237

Restructuring and acquisition-related costs (note 17) Operating income Financial expenses, net (note 14(c)) Earnings before income taxes Income tax expense (note 18) Net earnings

19,686

17,797

351,838

309,440

5,200

4,526

346,638

304,914

Other comprehensive income (loss), net of related income taxes: Cash flow hedges (note 14(d))

39,518

8,825

Actuarial loss on employee benefit obligations (note 12(a))

(5,239)

(10,000)

34,279

(1,175)

Comprehensive income

$ 380,917

$ 303,739

Basic(1)

$

1.47

$

1.26

Diluted(1)

$

1.47

$

1.25

Earnings per share: (note 19)

(1) All earnings per share data and share data reflect the effect of the two-for-one stock split which took effect on March 27, 2015.


Reading and Interpreting Published Financial Statements 4-45

Required a. Gildan reports “net sales” on its consolidated statements of earnings. Explain what this means. b. Calculate the amount of Gildan’s gross profit percentage for 2016 and 2015. Has it improved? c. Using the financial statements in Appendix A, calculate Dollarama’s gross profit percentages for the same periods. How do they compare with Gildan’s percentages? d. Does Gildan prepare its consolidated statements of earnings using a single-step or a multi-step approach? e. Does Gildan present its expenses by function or by nature? Does this approach require a higher level of management judgement when preparing the statement?

RI4-3 (Revenue recognition and statement of income presentation) Maple Leaf Foods Inc. produces value-added meat products for customers across North America, the United Kingdom, and Japan. Exhibit 4.15 presents the company’s consolidated statements of earnings for the years ended December 31, 2016, and 2015.

EXHIBIT 4.15 Maple Leaf Foods Inc.’s 2016 Consolidated Statements of Earnings

MAPLE LEAF FOODS INC. Consolidated Statements of Net Earnings Fiscal years ended December 31 (in thousands of Canadian dollars, except per share data) Notes Sales Cost of goods sold Gross margin

2016

2015

$3,331,812

$3,292,932

2,740,866

2,911,791

$ 590,946

$ 381,141

324,820

288,055

Selling, general and administrative expenses Earnings before the following:

$ 266,126

$

93,086

Restructuring and other related costs

12

(6,570)

(33,825)

Other income (expense)

18

(3,596)

(1,899)

Earnings before interest and income taxes Income expenses and other financing costs

$ 255,960 19

Earnings before income taxes Income taxes expense Earnings per share attributable to common shareholders:

20

$

52,651

4,711

67,891

11,071

$ 181,702

$

41,580

$

1.35

$

0.30

$

1.32

$

0.29

21

Basic earnings per share Diluted earnings per share Weighted average number of shares (millions)

57,362

6,367 $ 249,593

Net earnings

$

21

Basic

134.2

140.2

Diluted

137.6

141.7

Required a. Calculate Maple Leaf’s gross profit percentage for 2016 and 2015. Has it improved? b. Does Maple Leaf present its expenses by function or by nature? Does this approach require a higher level of management judgement when preparing the statement?


4-46 CH A PT ER 4

Revenue Recognition and the Statement of Income

RI4-4

(Revenue recognition and statement of income presentation)

High Liner Foods Inc. processes and markets seafood products throughout Canada, the United States, and Mexico under the High Liner and Fisher Boy brands. It also produces private label products and supplies restaurants and institutions. Exhibit 4.16 presents High Liner Foods’ consolidated statement of income for 2016 and 2015.

EXHIBIT 4.16 High Liner Foods Incorporated’s 2016 Consolidated Statement of Income

HIGH LINER FOODS INCORPORATED Consolidated Statement of Income (in thousands of United States dollars, except per share amounts) Fifty-two weeks ended Notes Revenues

December 31, 2016 956,016

$ 1,001,507

Cost of sales

753,179

799,843

Gross profit

202,837

201,664

Distribution expenses

43,610

48,037

Selling, general and administrative expenses

96,978

93,597

2,327

Impairment of property, plant and equipment

$

January 2, 2016

5

Business acquisition, integration and other expenses Results from operating activities Finance costs

25

Income before income taxes

4,787

7,473

55,135

52,557

14,296

16,247

40,839

36,310

8,737

5,707

Income taxes Current

17

Deferred

17

(848)

Total income tax expense

1,022

7,889

Net income

6,729

$

32,950

$

29,581

Earnings per common share Basic

18

$

1.07

$

0.96

Diluted

18

$

1.06

$

0.95

Weighted average number of shares outstanding Basic

18

30,917,412

30,818,804

Diluted

18

31,174,788

31,264,671

Required a. Has High Liner Foods used a single-step or a multi-step income statement? What aspects of the statement influenced your answer? b. Calculate High Liner Foods’ gross profit percentage for 2016 and 2015. Did the company’s gross profit, as a percentage of its revenue, increase or decrease? c. Calculate High Liner Foods’ net profit rate (net earnings divided by net sales) for 2016 and 2015. Did the company’s net profit, as a percentage of its revenue, increase or decrease?


Cases 4-47

Cases C4-1

Quebec Supercheese Company

Quebec Supercheese Company (QSC) produces many varieties of cheese that are sold in every province in Canada, mainly through large grocery stores and specialty cheese shops. The cheese is produced at its factory in Montreal and shipped across Canada using commercial refrigerated trucks that pick up the cheese at the factory loading dock. The purchasers pay for the trucking and assume responsibility for the cheese as soon as the trucks pick it up at the factory. In accordance with the contract-based approach to revenue recognition, QSC recognizes the sale as soon as the trucks load the cheese, because control is transferred to the purchasers at this point. QSC is not happy with these arrangements because it has received many complaints from purchasers about spoilage. Even though the purchasers and their truckers have full responsibility for this spoilage, many disputes have occurred because the truckers insist the cheese is spoiled when they pick it up. QSC is considering setting up its own fleet of trucks to deliver its cheese across Canada. It estimates that the additional freight costs can be regained through the higher prices it would charge for including shipping in the price. If the company makes the deliveries, the control over the cheese will not transfer until the cheese is delivered. QSC’s president was not happy when she learned that sales would be recognized and recorded only upon delivery to the customer, since she knew that an average of five days’ sales are in transit at all times because of the distances involved. One day’s sales total approximately $100,000 on average. The effect of this change would be an apparent drop in sales of $500,000 and a $50,000 decrease in net income in the year of the change.

Required Respond to the president’s concerns about the impact of changing the point at which the company recognizes revenue.

C4-2

Mountainside Appliances

Danielle Madison owns a store called Mountainside Appliances Ltd. that sells several different brands of refrigerators, stoves, dishwashers, washers, and dryers. Each of the appliances comes with a factory warranty on parts and labour that is usually one to three years. For an additional charge, Danielle offers customers more extended warranties. These extended warranties come into effect after the manufacturers’ warranties end.

Required Using the contract-based approach to revenue recognition, discuss how Danielle should account for the revenue from the extended warranties.

C4-3

Furniture Land Inc.

Furniture Land Inc. is a producer and retailer of high-end custom-designed furniture and uses the contract-based approach to revenue recognition. The company produces only to special order and requires a one-third down payment before any work begins. The customer is then required to pay one-third at the time of delivery and the balance within 30 days after delivery. It is now February 1, 2020, and Furniture Land has just accepted $3,000 as a down payment from H. Gooding, a wealthy stockbroker. Per the contract, Furniture Land is to deliver the custom furniture to Gooding’s residence by June 15, 2020. Gooding is an excellent customer and has always abided by the contract terms in the past. If Furniture Land cannot make the delivery by June 15, the contract terms state that Gooding has the option of cancelling the sale and receiving a full reimbursement of any down payment. It is estimated that Furniture Land’s cost to design and manufacture the furniture ordered by Gooding will be $6,300.

Required As Furniture Land’s accountant, describe when the company should be recognizing revenue. Prepare all journal entries related to the sale.


4-48 CH A PT ER 4

Revenue Recognition and the Statement of Income

Endnotes 1

Don Groves, “Cineplex Bets Big on The Rec Room as One Way to Lessen Reliance on Hollywood,” Forbes.com, March 8, 2017; David Friend, The Canadian Press, “Cineplex Opens 4DX Movie Theatre Experience in Downtown Toronto,” Globalnews.ca, November 4, 2016; Cineplex Inc. 2016 annual report. 2 The Canadian Press, “Former Poseidon Concepts executive pays US$75K to settle SEC fraud charges,” Canadian Business, February 6, 2015; Tim Kiladze, “The Poseidon Misadventure,” Report on Business, November 2016. 3 Canadian Tire Corporation, Limited 2016 annual report.

4

ASPE 3400 (Revenue); International Accounting Standards Board, “Discussion Paper: Preliminary Views on Revenue Recognition in Contracts with Customers,” December 2008. 5 With information from www.canadiantire.ca/en/customer-service/ returns.html; accessed September 9, 2017. 6 Ritchie Bros. Auctioneers Incorporated 2016 annual report. 7 Expedia Inc., 2016 annual report. 8 IFRS Conceptual Framework. 9 Loblaw Companies Limited 2016 annual report; Metro Inc., 2016 annual report; Empire Company Limited 2017 annual report.

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