Problems for CFA Level I

Accounting Income and Assets: The Accrual Concept

1. [Revenue recognition criteria] Describe the conditions under which revenue would be
recognized:

(i) At the time of production, but prior to sale

Answer: When payment is assured and production costs can be estimated.

(ii) At the time of sale, but prior to cash collection

Answer: When payment is assured but production costs cannot be estimated.

(iii) Only when cash collection has occured

Answer: When payment is not assured.

2. [Contract accounting] On December 31, 1999, LASI Construction entered into a major
long-term construction with the following terms:

• Total contract price: $3,000,000

• Total expected costs: $2,400,000

Construction is expected to take three years. Production costs and cash flows are
shown in Table 1.

(a) Show the revenue and pretax income for each year under both the percentage-of-
completion and completed contract methods.

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 Projected Production Costs and Cash Flows
Year Costs Incurred Cash Received
2000 900,000 1,000,000
2001 800,000 1,000,000
2002 700,000 1,000,000
Totals 2,400,000 3,000,000

Table 1: Data for Question 2.

Answer: Under the percentage-of-completion method, the revenue recognized

each year is
9
2000 : 24
× 3, 000, 000 = $1, 125, 000
8
2001 : 24
× 3, 000, 000 = $1, 000, 000
7
2002 : 24
× 3, 000, 000 = $875, 000
and thus pretax income each year is

2000 : 1, 125, 000 − 900, 000 = $225, 000

2001 : 1, 000, 000 − 800, 000 = $200, 000
2002 : 875, 000 − 700, 000 = $175, 000

Under the completed contract method, the only revenue is recorded in 2002 as
$3,000,000, costs are then $2,400,000 and thus pretax income is $600,000.

(b) Show the balance sheet accounts at December 31, 2000 resulting from the contract
under the

(i) Percentage-of-completion method

Answer: Since in 2000 the company receives $1,000,000 in cash but records
$1,125,000 as sales, the account construction in progress will show a balance
of $125,000. This balance will remain $125,000 in 2001 and will disappear in
2002. This can be seen in Table 2.
(ii) Completed contract method
Answer: The answer for this one can be seen in Table 3

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 Balance Sheet under the POC Method
2000 2001 2002
Assets
Cash 100,000 300,000 600,000
Construction in progress 125,000 125,000 0
Total assets 225,000 425,000 600,000
Liabilities
Advance billings 0 0 0
Retained earnings 225,000 425,000 600,000
Total liabilities 225,000 425,000 600,000

Table 2: Answer to Question 2(b)(i).

(c) Assume that total projected costs increase by $100,000 and the change in estimate
is made at December 31, 2001. Compute the revenue and pretax income for 2001
under the revised assumptions.
Answer: Assuming that costs in 2001 are still $800,000, the total revenue to be
recognized in 2001 is

900, 000 + 800, 000

× 3, 000, 000 − 1, 125, 000 = $915, 000
2, 400, 000 + 100, 000

and thus pretax income in that year is

915, 000 − 800, 000 = $115, 000.

3. [Balance sheet effects of revenue recognition methods] Lucent’s balance sheet shows
the following accounts:

• Contracts in progress (current assets)

• Advance billings (current liabilities)

(a) Describe the nature of the two accounts listed above.

Answer: The contracts in progress account denotes earnings recognized but un-

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 Balance Sheet under the CC Method
2000 2001 2002
Assets
Cash 100,000 300,000 600,000
Construction in progress 0 0 0
Total assets 100,000 300,000 600,000
Liabilities
Advance billings 100,000 300,000 0
Retained earnings 0 0 600,000
Total liabilities 100,000 300,000 600,000

Table 3: Answer to Question 2(b)(ii).

paid yet. The advance billings account denotes cash already received related to
earnings unrecognized yet.

(b) State the other accounts on the company’s balance sheet to which these accounts
are similar.
Answer: The contracts in progress account is similar to accounts receivable and
advance billings are similar to advances to customers.

(c) Determine the accounting method that Lucent uses to account for its long-term
construction projects.
Answer: It has to be the percentage-of-completion method.

4. [Percentage-of-Completion] On April 1, 2001, Pine Construction enters into a fixed-

price contract to construct an apartment building for $6 million. Pine uses the percentage-
of-completion method. Information related to the contract is given in Table 4.

(a) Calculate the following for both 2001 and 2002:

(i) Revenue recognized

Answer: Costs incurred in 2001 are 20% of total estimated costs, i.e.

20% × 4, 500, 000 = $900, 000

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 December 31, December 31,
2001 2002
Percentage-of-completion 20% 60%
Estimated total construction cost $4,500,000 $4,800,000
Income recognized to date $300,000 $720,000

Table 4: Data for Pine Construction.

and thus revenue recognized in 2001 is

900, 000 + 300, 000 = $1, 200, 000.

In 2002, costs incurred to date are

60% × 4, 800, 000 = $2, 880, 000.

Since costs in 2001 are $900,000, costs in 2002 must be

2002 Costs = 2, 880, 000 − 900, 000 = $1, 980, 000.

Revenue recognized in 2002 is then

1, 980, 000 + (720, 000 − 300, 000) = $2, 400, 000.

(ii) Costs incurred

Answer: See (a).

(b) Assume that during 2002, Pine purchases and pays for $0.3 million of products
and services that will be used in construction during 2003. Describe the impact
of these expenditures on Pine’s revenue recognition for 2002.
Answer: There is no effect since these expenditures do not contribute to the
completion of the project.

5. The Able, Baker, Charlie and David companies are identical in every respect except
for their revenue recognition method:

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 (i) Able recognizes sales when an order is received.

(ii) Baker recognizes sales at the time of production.

(iii) Charlie recognizes sales at the time of shipment.

(iv) David recognizes sales when cash is collected.

After the first year of operations, Charlie’s closing inventory was $30,000 and accounts
receivable was $50,000. Backorders, for which production had not yet started, were
$10,000. Charlie recognized sales of $100,000 for the year.

(a) Assuming that each company charges a markup of 100% over cost, calculate sales,
cost of goods sold and net income for each company during the year.
Answer: All companies being the same, they all have shipped $100,000 of goods
during the year, they all received

100, 000 − 50, 000 = $50, 000

in cash payments, and the market value of their inventory at year-end is 2 ×

30, 000 = $60, 000.
Able’s sales recognized are

100, 000 + 60, 000 + 10, 000 = $170, 000,

its cost of goods sold is .5 × 170, 000 = $85, 000 and its net income is $85,000.
Baker’s sales recognized are

100, 000 + 60, 000 = $160, 000,

its cost of goods sold is .5 × 160, 000 = $80, 000 and its net income is $80,000.
Charlie’s sales recognized are $100,000, its cost of goods sold is .5 × 100, 000 =
$50, 000 and its net income is $50,000.
David’s sales recognized are $50,000, its cost of goods sold is .5×50, 000 = $25, 000
and its net income is $25,000.

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 (b) Ignoring income taxes, state which company will have the largest cash balance at
year-end.
Answer: The cash balance is the same for all companies at year-end.

(c) State which company will report the largest cash from operations.
Answer: The cash from operations is the same for all companies.

6. [Provision for bad debts] Nucor [NUE], a large U.S. steel producer, reported the
amounts in Table 5 (millions of $).

Years Ended December 31

1997 1998 1999 2000
Allowance for
Doubtful Accounts
Opening balance 14.6 18.0 16.3 21.1
Charged to earnings 4.2 (1.4) 5.3
Write-offs
(net of recoveries) (0.8) (0.3) (0.5)
Closing balance 18.0 16.3 21.1 27.6

Other Financial Data

Accounts receivable (net) 386.4 299.2 393.8 350.2
Sales 4,184.5 4,151.2 4,009.3 4,586.1
Pretax income 460.2 415.3 379.2 478.3

Table 5: Data for Question 6.

(a) Compute the following ratios:

(i) Ending balance of reserves to gross receivables for all years

Answer:
18.0 16.3
1997: = 4.45% 1998: = 5.17%
386.4 + 18.0 299.2 + 16.3
21.1 27.6
1999: = 5.09% 2000: = 7.31%
393.8 + 21.1 350.2 + 27.6

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 (ii) Accounts written off to revenues for 1997 to 1999
Answer:
0.8 0.3 0.5
1997: = .019% 1998: = .007% 1999: = .012%
4, 184.5 4, 151.2 4, 009.3

(b) Assuming that Nucor had expensed accounts written off rather than accruing a
reserve for bad debts, compute pretax income for 1997 through 2000.
Answer:

1997: 460.2 + 4.2 − 0.8 = 463.6 1998: 415.3 − 1.4 − 0.3 = 413.6
1999: 379.2 + 5.3 − 0.5 = 384.0 2000: 478.3 + 0.0 − 0.0 = 478.3

(c) Assuming that Nucor had maintained its bad debt reserve at the 1997 ratio of
gross receivables, compute the effect on pretax income for 1998 through 2000.

(d) Discuss two reasons that might explain the level of reserve accrual by Nucor for
1998 through 2000.

Nucor did not disclose the charge to earnings and writeoffs in 2000. Nucor’s
CFO told one of the authors that :“the amounts are clearly immaterial, bad debt
writeoffs for the last six years averaged .02% of sales, and in no year were more
than .03% of sales.”

(e) Evaluate the CFO’s statement that the amounts are immaterial, stating one ar-
gument that supports his statement and one argument against it.

(f) Explain why a chief financial officer would prefer not to disclose the charge to
earnings and writeoffs.

(g) Explain why a financial analyst would want those disclosures.