Chapter 18 Questions

Question 1:
Drew Co. produces expensive equipment for sale on installment contracts.  When there is doubt about
eventual collectibility, the income recognition method least likely to overstate income is
At the time the equipment is completed.
The installment method.
The cost recovery method.
At the time of delivery.
This answer is correct. Profit is deemed to be realized when a sale in the ordinary course of business is
effected, unless the circumstances are such that the collection of the sale price is not reasonably assured.
The most conservative accounting treatment in such instances is the cost recovery method, which defers
the recognition of any profit until the full cost of the item sold has been collected. Subsequent
collections are then considered to be all profit.

Question 2:
In November and December year 1, Dorr Co., a newly organized magazine publisher, received $72,000
for 1,000 3-year subscriptions at $24 per year, starting with the January year 2 issue.  Dorr elected to
include the entire $72,000 in its year 1 income tax return. What amount should Dorr report in its year 1
income statement for subscriptions revenue?
$0
$ 4,000
$24,000
$72,000
This answer is correct. SFAC 5 states that revenues are to be recognized when realized or realizable, and
earned. At 12/31/Y1, none of the subscription revenue has been earned, since magazine delivery will
not begin until year 2. Therefore, unearned subscriptions revenue in the 12/31/Y1 balance sheet is
$72,000 and subscriptions revenue in the year 1 income statement is $0. Note that the treatment of the
$72,000 collection for tax purposes does not determine its treatment for financial accounting purposes.

Question 3:
Lane Co., which began operations on January 1, year 1, appropriately uses the installment method of
accounting. The following information pertains to Lane’s operations for year 1:

 
Installment sales $1,000,000
Regular sales 600,000
Cost of installment sales 500,000
Cost of regular sales 300,000
General and 100,000
administrativeexpenses
Collections on installment sales 200,000

The deferred gross profit account in Lane’s December 31, year 1 balance sheet should be
$150,000
$320,000
$400,000
$500,000
This answer is correct. Under the installment method, gross profit is deferred at the time of sale and is
recognized by applying the gross profit rate to subsequent cash collections.  At the time of sale, gross
profit of $500,000 is deferred ($1,000,000 – $500,000).  The gross profit rate is 50% ($500,000 ÷
$1,000,000).  Since year 1 collections on installment sales were $200,000, gross profit of $100,000
(50% x $200,000) is recognized in year 1.  This recognition of gross profit would decrease the deferred
gross profit account to a 12/31/Y1 balance of $400,000 ($500,000 – $100,000). Note that regular sales,
cost of regular sales, and general and administrative expenses do not affect the deferred gross profit
account.

Question 4:
Weaver Company sells magazine subscriptions for a 1-year, 2-year, or 3-year period.  Cash receipts
from subscribers are credited to magazine subscriptions collected in advance, and this account had a
balance of $1,700,000 at December 31, year 1.  Information for the year ended December 31, year 2, is
as follows:

Cash receipts from subscribers $2,100,000

Magazine subscriptions revenue (credited at 12/31/Y2)1,500,000

In its December 31, year 2 balance sheet, what amount should Weaver report as the balance for
magazine subscriptions collected in advance?
$1,400,000
$1,900,000
$2,100,000
$2,300,000
This answer is correct. The solutions approach is to set up a T- account for the liability.
As receipts are collected, the liability is credited to record the additional subscriptions owed to
customers. In addition, the liability is decreased as revenue from the subscriptions is earned.  Based
upon the information given, Weaver should report $2,300,000 of subscriptions collected in advance at
December 31, year 2.

Question 5:
Tillary Company, which began business on January 1, year 1, appropriately uses the installment sales
method of accounting. The following data are available for year 1:

Installment accounts receivable, December 31, year 1 $200,000

Deferred gross profit, December 31, year 1 (before recognition of realized gross
$140,000
profit)             
Gross profit on sales 40%

 
The cash collections and the realized gross profit on installment sales for the year ended December 31,
year 1, should be

 
Cash collections Realized gross profit
$100,000 $80,000
$100,000 $60,000
$150,000 $80,000
$150,000 $60,000
This answer is correct. As this is the first year of operations, all $140,000 is from year 1 sales. In the
absence of any defaults and repossessions during the year, this represents the total gross profit (GP) for
year 1. Therefore, the total debits to installment AR for year 1 sales (1) can be computed by dividing the
deferred GP by the GP ratio, or $350,000 ($140,000/40%). Next, cash collections (2) can be calculated
as: $350,000 total debits - $200,000 ending balance = $150,000 cash collections. Finally, GP realized in
year 1 (3) would be 40% times cash collections of $150,000 for $60,000 GP realized.
Question 6:
North Co. entered into a franchise agreement with South Co. for an initial fee of $50,000.  North
received $10,000 at the agreement’s signing.  The remaining balance was to be paid at a rate of $10,000
per year, beginning the following year. North’s services per the agreement were not complete in the
current year.  Operating activities will commence next year. What amount should North report as
franchise revenue in the current year?
$0
$10,000
$20,000
$50,000
This answer is correct. The requirement is to determine the amount that should be reported as franchise
revenue. Revenue can be recognized only when all material services or conditions relating to the sale
have been substantially performed by the franchisor. Since North’s services were not complete in the
current year, no revenue can be recognized in the current year.

Question 7:
On December 31, year 1, Reed, Inc. authorized Foy to operate as a franchisee for an initial franchise fee
of $75,000.  Of this amount, $30,000 was received upon signing the agreement and the balance,
represented by a note, is due in three annual payments of $15,000 each beginning December 31, year
2.  The present value on December 31, year 1, of the three annual payments appropriately discounted is
$36,000.  According to the agreement, the nonrefundable down payment represents a fair measure of
the services already performed by Reed; however, substantial future services are required of Reed.
Collectibility of the note is reasonably certain.  On December 31, year 1, Reed should record unearned
franchise fees in respect of the Foy franchise of
$0
$36,000
$45,000
$75,000
This answer is correct.  Franchise fee revenue shall be recognized when all material services have been
substantially performed by the franchisor (i.e., the franchisor has no remaining obligation to refund any
cash received and substantially all of the initial services of the franchisor have been performed).  Of the
initial fee of $75,000, the $30,000 down payment applies to the initial services already performed by
Reed.  Additionally, this amount is not refundable.  Therefore, the $30,000 may be recognized as
revenue in year 1.  The three remaining $15,000 installments relate to substantial future services to be
performed by Reed.  The present value of these payments, $36,000, is recorded as unearned fees and
recognized as revenue once substantial performance has occurred.

Cash 30,000 
Notes Receivable 45,000 
      Discount on NR   9,000
      Franchise revenue   30,000
      Unearned franchise   36,000
fees

Question 8:
On January 1, year 2, Bartell Company sold its idle plant facility to Cooper, Inc. for $1,050,000. On this
date the plant had a net book value of $735,000. Cooper paid $150,000 cash on January 1, year 2, and
signed a $900,000 note bearing interest at 10%. The note was payable in three annual installments of
$390,000 beginning January 1, year 3.  This included interest of $90,000. Bartell appropriately
accounted for the sale under the installment method. Cooper made a timely payment of the first
installment on January 1, year 3.  At December 31, year 3, Bartell has deferred gross profit of
$153,000
$180,000
$225,000
$270,000
This answer is correct. The total gross profit (GP) on the sale is $315,000 (selling price of $1,050,000
less depreciated cost of $735,000), and the GP rate is 30% ($315,000/$1,050,000).  GP recognized in
year 2 is $45,000 (30% x $150,000 down payment), and GP recognized in year 3 is $90,000 [30% x
($390,000 - $90,000)]. This leaves a balance of $180,000 in deferred GP.

GP is recognized only on the portion of the sales price collected, not on the interest collected ($90,000).
A short-cut approach is to multiply the remaining balance in installment notes receivable by the GP rate
($600,000 x 30% = $180,000).
Question 9:
Lang Co. uses the installment method of revenue recognition.  The following data pertain to Lang’s
installment sales for the years ended December 31, year 1 and year 2:

  Year 1 Year 2
Installment receivables at year-end on year 1 $60,000$30,000
sales
Installment receivables at year-end on year 2          --    69,000
sales
Installment sales   80,000   90,000
Cost of sales   40,000   60,000

What amount should Lang report as deferred gross profit in its December 31, year 2 balance sheet?
$23,000
$33,000
$38,000
$43,000
This answer is correct. Under the installment method, gross profit is deferred at the time of sale and is
recognized by applying the gross profit rate to subsequent cash collections. Therefore, at each year-end,
deferred gross profit can be computed by multiplying the gross profit percentage by the AR balance. 
The gross profit percentage for each year is computed by dividing that year’s gross profit by installment
sales.

  Year 1 Year 2
Installment sales (A) $80,000 $90,000
Cost of sales     (60,000)
(40,000)
Gross profit (B) $40,000 $30,000
Gross profit % (B ÷ A)        50%        33
1/3%

The 12/31/Y2 deferred gross profit is computed by multiplying the gross profit percentages by the year-
end receivables resulting from that year’s sales.

  Year 1 Year 2
12/31/Y2 AR from year 1 sales$30,000  
12/31/Y2 AR from year 2 sales  $69,000
      x x 33 1/3%
50%
  $15,000 $23,000

Therefore, 12/31/Y2 deferred GP is $38,000 ($15,000 + $23,000).

Question 10:
Winn Co. sells subscriptions to a specialized directory that is published semiannually and shipped to
subscribers on April 15 and October 15. Subscriptions received after the March 31 and September 30
cutoff dates are held for the next publication. Cash from subscribers is received evenly during the year
and is credited to deferred subscription revenue. Data relating to year 2 are as follows:

Deferred subscription revenue, $ 

1/1/Y2 750,000
Cash receipts from subscribers 3,600,000

In its December 31, year 2 balance sheet, Winn should report deferred subscription revenue of
$2,700,000
$1,800,000
$1,650,000
$ 900,000
This answer is correct. The 12/31/Y2 balance of deferred subscription revenue should reflect the
liability for subscriptions still outstanding at that time.  The 12/31/Y1 deferred revenue ($750,000)
would have been earned when the April 15 directory was mailed, and therefore is no longer a liability. 
The cash collected through the September 30 cutoff date (9/12 x $3,600,000 = $2,700,000) would also
have been earned when the April 15 and October 15 directories were mailed (note that the cash was
received evenly throughout the year).  However, the cash collected after September 30 (3/12 x
$3,600,000 = $900,000) will not be earned until the 4/15/Y3 directory is mailed, and therefore is
deferred revenue at 12/31/Y2.

Question 11:
Macklin Co. entered into a franchise agreement with Heath Co. for an initial fee of $50,000. Macklin
received $10,000 when the agreement was signed. Heath signed an 8% interest bearing-note for
$40,000. The note was to be paid at a rate of $10,000 per year, starting the next year.  All services were
performed by Macklin and the refund period had expired.  Operations started in the current year. 
What amount should Macklin recognize as revenue in the current year?
$0
$10,000
$20,000
$50,000
This answer is correct. Revenue on a franchise agreement should be recognized when the franchisor
has substantially performed all material services and conditions, and collectibility is reasonably assured.
All services are performed and the refund period has expired.

Question 12:
Entor Co. sold equipment to Pane Co. for $50,000.  The equipment had a net book amount of $30,000.
The collections were $20,000 in the first year, $15,000 in the next year, and $15,000 in the last year. 
What is the amount of gross profit for the third year if Entor used the installment-sales accounting
method for the transaction?
$0
$5,000
$6,000
$15,000
This answer is correct. The requirement is to determine the gross profit for the third year.  The total
gross profit on the equipment is $50,000 – $30,000 = $20,000.  Under the installment-sales method,
gross profit is recognized proportionally with the amount of the installment payment each year.  The
gross profit that should be recognized in year 3 is $15,000/($20,000 + $15,000 + $15,000) = 30% of the
total revenue.  Therefore, this answer is correct because $6,000 (30% × $20,000 total gross profit) of
gross profit should be recognized in year 3.

Question 13:
For financial statement purposes, the installment method of accounting may be used if the
Collection period extends over more than 12 months.
Installments are due in different years.
Ultimate amount collectible is indeterminate.
Percentage-of-completion method is inappropriate.
This answer is correct. The profit on a sale in the ordinary course of business is considered to be
realized at the time of the sale unless it is uncertain whether the sales price will be collected. The Board
concluded that use of the installment method of accounting is not acceptable unless this uncertainty
exists.

Question 14:
Cash collection is a critical event for income recognition in the
Cost-recovery method Installment method
Yes Yes
Yes No
No Yes
No No
This answer is correct. Under the cost recovery method no profit of any type is recognized until
cumulative cash receipts exceed the cost of the asset sold. Under the installment method, gross profit is
deferred at the time of sale and is recognized by applying the gross profit rate to subsequent cash
collections. Both methods require the collection of cash before income is recognized.

Question 15:
On December 31, year 1, Moon, Inc. authorized Luna Co. to operate as a franchisee for an initial
franchise fee of $100,000. Luna paid $40,000 on signing the agreement and signed an interest-free
note to pay the balance in three annual installments of $20,000 each, beginning December 31, year 2. 
On December 31, year 1, the present value of the note, appropriately discounted, is $48,000.  Services
for the initial fee will be performed in year 2. In its December 31, year 1 balance sheet, what amount
should Moon report as unearned franchise fees?
$0
$48,000
$88,000
$100,000
This answer is correct. The requirement is to determine the amount that Moon should report as
unearned franchise fees. Franchise fee revenue is recognized when all material services have been
substantially performed by the franchiser. Substantial performance means that the franchiser has
performed substantially all of the required initial services and has no remaining obligation to refund
any cash received. As of December 31, year 1, the date the agreement was signed, no services have been
performed. Therefore, this answer is correct because the entire $88,000 must be recognized as
unearned franchise fees in the December 31, year 1 balance sheet.

Question 16:
Asp Co. appropriately uses the installment method of revenue recognition to account for its credit sales. 
The following information was abstracted from Asp’s December 31, year 2, financial statements:

  Year 2 Year 1
Sales $1,500,000 $1,000,000
Accounts receivable:    
      Year 2 sales      900,000  
       Year 1 sales      540,000      
600,000
Deferred gross profit:   
      Year 2 sales      252,000  
      Year 1 sales            
108,000 120,000

What was Asp’s gross profit percentage for year 2 sales?

20% 
25% 
28% 
40% 
This answer is correct.  The installment method recognizes revenue as cash is collected.  In year 2,
accrual basis sales were $1,500,000.  The balance in accounts receivable attributable to the year 2 sales
was $900,000, which indicates that revenue recognized under the installment method would be
$600,000 ($1,500,000 – $900,000). The gross profit percentage can be calculated by examining the
relationship between the deferred gross profit of $252,000 for the year 2 sales, and the year 2 sales,
which have not yet been collected.  Therefore, this answer is correct because the gross profit percentage
for year 2 sales is calculated as $252,000/$900,000 = 28%.

Question 17:
Magazine subscriptions collected in advance are reported as
A contra account to magazine subscriptions receivable in the asset section of the balance sheet.
Deferred revenue in the liability section of the balance sheet.
Deferred revenue in the stockholders’ equity section of the balance sheet.
Magazine subscription revenue in the income statement in the period collected. Answer Explanations
This answer is correct because deposits and prepayments received for goods or services to be provided
in the future are deferred revenues. These would be reported as liabilities because an enterprise has an
obligation to provide goods or services to those who have paid in advance.

Question 18:
Esker Inc. specializes in real estate transactions other than retail land sales.  On January 1, year 1, Esker
consummated a sale of property to Kame Ltd.  The amount of profit on the sale is determinable and
Esker is not obligated to perform any additional activities to earn the profit.  Kame’s initial and
continuing investments were adequate to demonstrate a commitment to pay for the property.  However,
Esker’s receivable may be subject to future subordination. Esker should account for the sale using the
Deposit method.
Reduced profit method.
Cost recovery method.
Full accrual method.
This answer is correct. The problem states that the sale has been consummated and that Kame’s initial
and continuing investments are adequate to demonstrate a commitment to pay for the property.
However, the fact that Esker’s receivable is subject to future subordination precludes recognition of the
profit in full. Instead, the cost recovery method must be used to account for the sale.

Question 19:
According to the cost recovery method of accounting, gross profit on an installment sale is recognized in
income
After cash collections equal to the cost of sales have been received.
In proportion to the cash collections.
On the date the final cash collection is received.
On the date of sale.
This answer is correct. Installment methods of recognizing revenue are appropriate only when
"collection of the sale price is not reasonably assured." Under the cost recovery method, gross profit is
deferred and recognized only when the cumulative receipts exceed the cost of the asset sold.

Question 20:
Which of the following should be expensed as incurred by a franchise with an estimated useful life of
10 years?
Amount paid to the franchisor for the franchise.
Periodic payments to a company, other than the franchisor, for that company’s franchise.
Legal fees paid to the franchisee’s lawyers to obtain the franchise.
Periodic payments to the franchisor based on the franchisee’s revenues.
This answer is correct. The requirement is to determine which of the following outflows should be
expensed as incurred by the franchisee. Continuing franchise fees, based on revenues, should be
reported as expenses when incurred.