FSA Ques

Walker Company received a letter on November 31, 2003 indicating that Johnson, Inc. would purchase a specialty machine priced at $4,000,000. On February 13, 2004 a binding contract was executed for the machine’s construction. Materials costing $2,000,000 were ordered in December 2003, arrived with an invoice in August, 2004, and were used in the manufacturing process in the first quarter of 2005. After a labor dispute, Walker finally completed manufacture and delivered the machine in December, 2006. Johnson received the first invoice in 2007 and paid the $4,000,000 purchase price in 2007. Walker Company uses the accrual method of accounting. Walker should record the materials used to construct the machine as expenses in the year: ********************************************************************* Ans:The correct answer was D) 2006. Under the accrual concept, income is recognized when the earning activities are substantially completed, risk of ownership has transferred from buyer to seller, and payment is realizable and collectible. Under the matching principle, expenses incurred that directly relate to the sold item are expensed in the same period as the revenue is recognized. ********************************************************************** My Doubt: Consider the case Walker paid $2,000,000 for the materials in Dec 2003. Then how does Walker show the expense in years 2003, 2004, 2005? Is it shown as investment? Because it can be shown as an expense only in 2006. My best guess is it would be inventory. In the balance sheet one asset i.e cash will decrease and another asset i.e inventory will increase. Is this correct??? Thanks for all response and sorry for a long post. **********************************************************************

the expense should be recognized in 2006 due to the matching principle (must be matched with the revenue - not the cash inflow in 2007). when walker ordered the materials, they would DR Work In Progress, CR Cash or A/P. then, upon delivery, you would recongize: CR Revenue, DR Cash or A/R CR Work In Progress, DR COGS note that the work in progress is essentially an inventory item.

That’s right. The material will be recorded as inventory as current asset. Since he paid cash for that, the cash will decrease the same amount. The end result is the same current asset. However, the composition of the current asset is changed. (Quick ratio would be different but current ratio will be the same.) Once it is recognized as expense, it is tranferred from a balance account (inventory) to an income statemnet account (expense).

I don’t think this question is defined clear enough. it just says “accrual method of accounting”, not specific revenue recognition method. From lines, we know this is a long term contract , range from 03 to 07; and material cost is 200,000, didn’t mention money collection or measurable problem. so I’d like to use percentage of completion method to recognize revenue and cost. and it says" material…were used in the manufacturing process in the first quarter of 2005. After a labor dispute, Walker finally completed manufacture and delivered the machine in December, 2006" . Cost should recorded both in 2005 and 2006. If use completed contract method, as the answer, recorded in 2006.

I guess it is complete contract method by default, unless mentioned specailly that the company used percentage of complete method. Please note that not all long term contract can be accounted by percentage of complete method. The critical criteria are whether the seller can estimate with reasonable assurance 1) the progress toward completion of the contractual obligation, 2) the costs to complete the project, and 3) the total revenue.