Case 5 - 3: Joan Holtz (A)

Note: This case has been updated from the Twelfth Edition.

Approach

These problems are intended to provide a basis for discussing questions about revenue recognition that are not dealt with explicitly in the text and that are not sufficiently involved to warrant the construction of a regular case. Instructors can pick from among those listed. Some of them can be used as a take-off point for elaboration and extended discussion by adding “What if?” facts.

Answers to Questions:1. If electricity usage tended to be fairly constant from month to month, one could argue in this

case for basing reported revenues solely on the actual meter readings: the unreported usage in December would be reported in January, and overall revenues for this year would not be materially misstated. Stated another way, if revenues are based solely on meter readings, the December 2009 post-reading usage (which is recorded in January 2010) is, in effect, assumed to be the same 2010 post-reading usage. Prior to passage of the 1986 Tax Reform Act, this approach was permitted for income tax purposes. The 1986 act requires the more acceptable (due to better matching) practice: estimating actual usage for the part of December after meters are read and reporting that usage as part of the revenues of that year. This is moresound accounting, in that with weather fluctuations and energy conservation efforts, it is questionable whether the post-reading usage in December 2009 would in fact not differ materially from the post-reading usage in December 2010. The same problem exists for operators of vending machines. The postal service has the opposite problem: it receives cash from stamp sales before all of the stamps are used. It carries a liability (unearned revenues) for this effect. Both of these examples illustrate that even when cash is involved, the measurement of revenue is not necessarily straightforward.

2. This is one of the problems whose “true” resolution depends on events that cannot be forseen at the end of the accounting period. Some firms count the whole $10,000 as revenue in 2010 on the grounds that it is in hand and that any specific services are undefined and/or separately billable. Others take the more conservative approach of counting only $5,000 as revenue in 2010 on the grounds that the service involved is “readiness to serve,” and that this readiness exists equally in each year. I prefer the latter approach, based on the matching concept.

3. Many would argue that the service involved is the cruise and that no revenue has been earned until the cruise has been completed. Others maintain that Raymond’s has completed its “service” of arranging the cruise, that it is extremely unlikely that events will happen in 2011 that will change its profit of $20,000, and that the amount is therefore revenue in 2010. Introduction of the possibility of a refund lessens the strength of the argument of the latter group. This position can be weakened further by asking: (a) What if passengers are dissatisfied and demand (or sue for) a refund? (b) What if the ship owner performs unsatisfactorily and Raymond’s, in order to protect its reputation, steps in and incurs additional food or other cost to make the passengers happy? Students should be reminded to consider two criteria: (1) that the agency has substantially performed its earning activities and (2) that the income is reliably measurable.

4. This problem has been debated for many years. Some argue that the $4 per tree has already been earned, as evidenced by the firm offer to buy the trees, and that it would be misleading to show no revenues in 2010 and the full sales value when the trees are sold in 2011. The percentage-of-completion method can be used as an analogy. Others argue that there has been

no transaction, and no assurance that the trees can be sold for more than $4 in 2011 because market prices may decrease, or pests or fire may destroy them. Typically, firms facing this issue recognize no revenue until harvesting the trees.

5. If a professional service firm (architects, engineers, consultants, lawyers, accountants, and so on) values its jobs in progress at billing rates, then it is recognizing revenue as the work is performed (time applied to projects) rather than waiting until the customer is billed. This is certainly defensible if the firm has a contract (called a “time and materials contract”) that obligates the client to pay for all time applied to the client’s project: the critical act of performance is spending the time on the project, not billing that time. In fact, many such firms feel that even with fixed-fee contracts, the critical performance task is spending time on a project as opposed to delivering some end item to the client; they thus record jobs in progress at estimated fee, which would be the same as billing rates for the time applied provided the project is within its professional-hour budget. Of course, whether the revenue is recognized when the time is applied or when the client is billed does make a difference in owners’ equity. Retained earnings will reflect the margin on the time applied sooner if the jobs in progress inventory is valued at billing rates rather than at cost.

6. Numerous answers are acceptable. I argue that the coupon has nothing to do with the sale of coffee. Its purpose is to promote the sale of tea. The 60 cent reimbursements made in 2010 and the 60 cent reimbursements made in 2010 are an expense of selling tea in 2010. Those who tie the coupons with coffee would say that the entire 20 percent of coupons redeemed is an expense of selling coffee in 2010 with the amount not yet redeemed being a liability as of December 31, 2010. It is customary that the coupon issuer pay the store a handling fee in addition to the face value of each coupon; here that fee is 10 cents. It is 60 cents per coupon that is the cost, not the 50 cent face value.

7. The bank would record the sale of $500 travelers checks for $505 as follows:

dr. Cash................................................................ 505cr. Payable to American Express..................... 500

Commission Revenue................................. 5After the bank remits the $500 cash to American Express, the latter will make the following entry:

dr. Cash................................................................ 500cr. Travelers Checks Outstanding................... 500

The account credited is a liability account. This account had a balance of many billions of dollars, which should help students understand why American Express does not itself levy a fee on the issuance of travelers checks: the checks are a great source of interest-free capital to American Express.

8. According to FASB Statement No. 49, Manufacturer A cannot record a sale at all under these circumstances. The merchandise must remain as an asset on Manufacturer A’s balance sheet and a liability should be recorded at the time the $100,000 is received from B. This statement precludes Manufacturer A from inflating its 2010 revenues and income by the sort of repurchase agreement described. FASB 49 was issued to address the perceived abuse of treating such temporary title transfers as sales.

9. FASB Statement No. 45 states that franchise fee revenue should be recognized “when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchiser.” Amortization of initial franchise fees should only take place if

continuing franchise fees are so small that they will not cover the cost of continuing services to the franchisee. Since this exception seems unlikely in this case, the $10,000 franchise fee should be recognized as revenue in the year received, as soon as the training course has been completed. Investors will need to make their own judgment as to what will happen when the market becomes saturated.

10. This item is designed to get students to think about (1) a condition that creates the need for a change in revenue recognition policy, and (2) the potential need for multiple revenue recognition policies for a firm.

Tech-Logic, a manufacturer of computer systems, normally recognizes revenue when its products are shipped, a policy common among manufacturing firms. To adopt that policy, managers at Tech-Logic must have concluded that the two criteria for revenue recognition were met at shipment: (1) Tech-Logic would have substantially performed what is required in order to earn income, and (2) the amount of income Tech-Logic would receive could be reliably measured.

With the sale of the computer systems to the organization in one of the former Soviet Union countries, however, Tech-Logic’s ability to satisfy these two criteria changed. Although the first criterion was still met, the uncertainty about whether (and how much) foreign exchange the customer could obtain left the second criterion in doubt. Hence, Tech-Logic should not recognize revenue for these computer systems at shipment or delivery. An alternative should be to wait until cash (in the form of hard currency) was received to recognize revenue.

This item can also be used to discuss the fact that firms often have more than one revenue recognition policy. Tech-Logic would not completely change its revenue policy to “cash receipt” for all sales at the time it begins to sell computers to organizations in countries where the availability of foreign exchange currency is in doubt. Rather, it would be likely to have two revenue recognition policies; at shipment, for products sold to organizations in countries where the availability of foreign exchange currency is not in doubt; and cash receipt, for products sold to organizations in countries where the availability of foreign exchange currency is in doubt.

Because they manufacture products and provide a variety of services, computer manufacturers often have a variety of revenue recognition policies. For example, a computer manufacturer might recognize revenue for products when they are shipped; for custom software development, when the customer formally accepts the software; and for maintenance services, ratably over the life of the maintenance contract.

Item 10 was inspired by events that occurred at Sequoia Systems in 1992. Sequoia evidenced several instances of aggressively booking revenue. One of these involved a Siberian steel mill. According to The Wall Street Journal:

Executives signed off last year on the sale of a $3 million computer destined for a steel mill in Siberia. But government approvals and hard currency to pay for the system got stalled, even though $2 million of revenue was booked in the fiscal year ended June 30, and another $1 million was going to be taken in the first quarter ended last month, insiders say.1

Sequoia executives stated that they expected the Siberian steel mill sale and similar sales “will ultimately prove to be good business” and that the decision to book it as revenue “was supported by the revenue recognition policy that we had in place.”1 However, under

1 The Wall Street Journal, “Sequoia Systems Remains Haunted by Phantom Sales,” October 30, 1992, p. B8.1 Ibid.

investigation by the SEC and facing lawsuits by shareholders, Sequoia twice restated revenues following the end of fiscal year 1992, reducing originally reported revenues by more than 10 percent.2

2

Case 6-3: Morgan Manufacturing *

Note: Updated from Twelfth Edition.

Morgan Manufacturing is a straightforward case to illustrate how information on the LIFO Reserve can be used to adjust the results of a company on LIFO to make them more comparable to those of a company on FIFO. This case extends the learning developed in question 4 of Case 6-2, Lewis Corporation. Morgan Manufacturing may not require a full class for discussion, and the instructor may want to assign it in conjunction with Lewis Corporation.

Answers to questions:

1. Westwood’s gross margin percentage = $900 divided by $2,000 = 45%; pretax return on sales = $300 divided by $2,000 = 15%; pretax return on assets = $300 divided by $2,240 = 13.4%.

2. Students will quickly recognize that both the inventory and the cost of goods sold accounts are affected. You are likely, however, to have to guide them to recognize what other accounts and financial items are also affected. For example, if inventory is affected, then some other balance sheet account must be affected to keep the balance sheet balanced. Students will likely conclude it must be retained earnings or owners’ equity. If cost of goods sold is affected, then clearly items such as gross margin, pretax net income, tax expense and net income will also be affected. Typically, assuming the norm of continuing inflation and growing inventory, LIFO produces higher cost of goods sold and lower inventory, owners’ equity, gross margin, pretax net income, tax expense, and net income than FIFO. It is possible, therefore, for two companies to have identical underlying economic performance, but the financial measures of performance of the firm using the LIFO method will look worse than the financial measures of the firm using the FIFO method (or the underlying economic performance of the LIFO firm might be even better than that of the FIFO firm, and the LIFO firm’s financial measures can still look worse!).

3. Adjustment to 2010 inventory: $100 LIFO inventory + $70 LIFO reserve = $170 FIFO inventory.

Adjustment to 2010 total assets: $2,170 + $70 = $2,240

Amount to adjust COGS: $70 2006 LIFO reserve-10 2005 LIFO reserve$60 Difference between 2006 LIFO and FIFO COGS

Adjustment to 2010 COGS: $1,110 - $60 = $1,050

Adjustment to 2010 gross margin: $890 + $60 = $950

Adjustment to 2010 pretax net income: $290 + $60 = $350

Adjusted gross margin percentage = $950 divided by $2,000 = 47.5%

Adjusted pretax return on sales $350 divided by $2,000 = 17.5%

Adjusted pretax return on assets $350 divided by $2,240 = 15.6%

4. Once adjusted to FIFO, Morgan’s performance exceeds Westwood’s on each of the three measures, as shown in Exhibit 1. In addition, Morgan has paid less in taxes than Westwood.

**This teaching note was prepared by Julie H. Hertenstein. Copyright © Julie H. Hertenstein.

Pedagogical ApproachYou can begin with a general discussion of why we often want to compare the financial performance of different companies and how our ability to compare companies is affected by the different accounting choices that they make; this issue, of course, is much broader than simply the choice of LIFO or FIFO. In Chapter 5, students encountered different revenue recognition choices which produce different financial results for the same underlying economic events. When firms choose different inventory accounting methods, these affect financial measures, as well. When trying to compare one company on LIFO with another on FIFO, one is trying to compare “apples and oranges.” For purposes of comparison, you would like to get the companies on a common basis. The LIFO reserve, which is frequently available in the inventory footnote or elsewhere in the annual report of a firm using LIFO, allows you to make adjustments to achieve a common basis for comparison.

The three key measures for Morgan are given in the case. You can write them on the board, and put up Westwood’s for comparison when students answer question 1, as shown in the first two lines of Exhibit 1.

As indicated in the answer to question 2, you may need to draw students out on which accounts and measures will be affected by the choice of inventory accounting method, and how this choice affects the financial statement reader’s ability to compare the two companies.

Before proceeding to the calculations in question 3, you may wish to first discuss, conceptually, how you can adjust results to make them more comparable. The first point regarding the adjustments is that you have LIFO reserve information, (and since there is not an analogous FIFO reserve), you must adjust the LIFO company to a FIFO basis. Since the LIFO reserve is the difference between the LIFO and FIFO inventory, it can be used directly to adjust inventory, and similarly, it is also the adjustment to total assets; a comparable adjustment can be made to owners’ equity to keep the balance sheet in balance. The LIFO reserve represents not only the difference between LIFO and FIFO inventory, but also the cumulative difference between LIFO and FIFO cost of goods sold. Thus, the LIFO reserve for two consecutive years can be used to compute the difference between LIFO and FIFO cost of goods sold for the more recent of the two years, which allows you to make adjustments to the income statement as well.

You may want to raise the issue of what to do if you want to compare after-tax results, instead of the pretax measures that the case suggests. Some students may want to adjust the tax expense of the LIFO firm, for example, using the same ratio of tax expense to pretax net income as shown on the LIFO income statement. Others may argue that the tax expense should be unchanged, reflecting the fact that the LIFO company paid lower taxes due to its choice of the LIFO inventory accounting method, a true economic difference between the two firms.

Following the conceptual discussion, the actual calculations can be examined and the results posted on the board, as shown in Exhibit 1. From these results, students will quickly observe that Morgan’s performance was better on all three measures. They may also conclude that the productivity improvements that Charles Crutchfield had implemented were, indeed, reflected in Morgan’s financial performance measures.

Exhibit 1

Gross Margin % Pretax Return on Sales Pretax Return on AssetsMorgan (LIFO)........................................................................................................................................................................................44.5% 14.5% 13.4%Westwood (LIFO)...................................................................................................................................................................................45.0% 15.0% 13.4%Morgan (Adjusted)..................................................................................................................................................................................47.5% 17.5% 15.6%

Case 6-4: Joan Holtz (B) *

Note: In discussing some of these questions. it may be useful to construct simple numerical examples, perhaps related to the illustrations in the text. Joan Holtz (B) is an extension of Joan Holtz (A) in Chapter 5. The case is unchanged from the Eleventh Edition.

1. The ultimate effect, over the life of an entity, is the same under all three methods. For a given accounting period, however, the methods result in different net income. If purchase discounts are deducted from purchases, they reduce the net purchase costs, and affect net income in the period in which the goods are sold. If reported as other income of the period, they affect net income in an earlier period than in the first method. If discounts not taken are recorded as an expense, cost of goods sold reflects the full amount of the discount, and discounts not taken decrease income in what is perhaps a later period.

Another difference is that cost of goods sold, and hence the gross margin percentage, differs under each of these methods.

Of course, the amounts involved are usually small, so the above differences often are not material

2. There should be a credit to Inventory, to reduce it to the amount found from the physical inventory. The debit may be either to Cost of Goods Sold or to an operating expense item. Literally, the shrinkage cost could not have been a cost of the goods that actually were sold, for these goods were not sold. The practice of debiting of Cost of Goods Sold is often followed, however. For management purposes, it is desirable to identify the amount of shrinkage, wherever it is reported.

3. It is incorrect to say that the LIFO method “assumes” anything about the physical flow of the goods. LIFO advocates know that physically the goods tend to move on a FIFO basis. LIFO is based on a belief about economic flows, as explained in the text.

**This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

4. In the examples given, the economics of the operations of the automobile dealer are best reflected by the FIFO method (or even better by the specific identification method, which probably approximates FIFO), and the economics of the operations of the hardware dealer are best reflected by the LIFO method. Even so, the automobile dealer would not necessarily be wrong to use LIFO; it might regard the income tax savings as being more important than a correct showing of economic income.

5. a. This generalization is valid.

b. This generalization is usually valid, as indicated in the text. However, any such generalization about LIFO may not be valid if the physical size of the inventory is reduced so that the original “LIFO layers” are carried to Cost of Goods Sold.

c. Assuming that income tax rates remain unchanged, and that the physical size of the inventory remains unchanged, and disregarding the present value of money, this generalization is valid.

6. Although the LIFO inventory as a whole will normally be reported at less than current costs, it can easily happen that individual items are worth less than their LIFO cost because of obsolescence or damage. These items should be written down.

7. Since there would be no additional revenue for four years, and since barrels, warehousing costs, and interest are charged to expense, profit would be reduced by the amount of these additional costs. In the first full year, these amounts of 200,000 additional gallons would be:

Barrels @ $0.70.......................................................................................................................................................................................$140,000Warehousing @ $0.20.............................................................................................................................................................................40,000Interest @ $0.10......................................................................................................................................................................................20,000

On each gallon added to inventory, the warehousing and interest costs would cumulate for four years, and profits would be decreased correspondingly.

The argument against including these costs in inventory is that they are not costs of producing whiskey. The production process has been completed before the whiskey is stored. The contrary argument is that these costs are incurred in order to bring the whiskey to a salable condition and they therefore should be included as inventory cost. This argument is strongest for the barrels, and next strong for the warehousing costs. Many people argue that in no circumstances can interest be considered a cost of production; rather, it is a cost of financing. Yet, if this were a four-year construction project rather than aging whiskey, GAAP would require capitalization of construction debt financing costs. (This is not described in the text until Chapter 7.) In any event, unless these costs are included in inventory, profits will decrease at the very time that the increase in production indicates that the company is prospering.

8. There is a rule (from FASB Statement No.-53) for determining cost of sales for T.V. movies. It is to amortize film costs in the ratio of

Gross revenue for the film for the current periodAnticipated total gross revenues for the film fromthe beginning of the current period until the end

of its useful life

The denominator of this ratio must be reviewed periodically to reflect current information. The new ratio is then applied to unrecovered film costs. Arguments can be made for ratios of 10/13 or 10/16 in the first year. The 10/16 ratio ($625,000) is perhaps better due to the belief that at least $300,000 in revenue will come from reruns. Correspondingly, the ratio to be used in the second year would be 1/2 ($300,000/$600,000). This would result in amortization of $187,500 in year two [1/2 x ($1,000,000 - $625,000)], with the final $187,500 of cost matched against the final $300,000 of revenue. The $100,000 spent on advertising and promotion of the initial showing does not benefit the future showings of the film. This is therefore not a capitalizable cost and should be expensed in the period incurred. Therefore it does not affect the ratios used above.

Case 7 - 1: Stern Corporation (B )*

Note: This case is updated from the Twelfth Edition.

ApproachThis is a straightforward problem, designed for use in connection with study of the text. I find it useful to put T-accounts on the board or on a Vugraph and post entries to them as they are given. The account titles given in the balance sheet should be used.

The case assumes individual unit depreciation. It may be desirable to ask at some point what the entries would be if composite or group depreciation were used.

Comments on Questions

Question 1

1. Cash.........................................................................................................................................................................................................3,866Accumulated Depreciation, Factory Machinery ....................................................................................................................................27,367

Factory Machinery ............................................................................................................................................................................31,2332. Tools Used (Expense) ............................................................................................................................................................................7,850

Tools...................................................................................................................................................................................................7,850(Note the contrast between depreciation and a direct write-off.)

3. (a) Depreciation Expense..............................................................................................................................................................................278Accumulated Depreciation, Automotive Equipment.........................................................................................................................278(The additional depreciation is 1/6 x .20 x $8,354. Note that the half-year convention is not used. Note that if the depreciation incurred in 2006 is disregarded, the loss will be overstated.)

(b) Cash.........................................................................................................................................................................................................2,336Accumulated Depreciation, Automotive Equipment..............................................................................................................................5,458Loss on Sale of Other Assets...................................................................................................................................................................560

Automotive Equipment......................................................................................................................................................................8,354(There can be a discussion of the proper showing of the loss on the income statement.)

4. Patent Amortization Expense..................................................................................................................................................................11,250Patent..................................................................................................................................................................................................11,250

5. Cash.........................................................................................................................................................................................................75Accumulated Depreciation, Office Machines.........................................................................................................................................1,027

Gain on Sale of Other Assets.............................................................................................................................................................75Office Machines.................................................................................................................................................................................1,027(The gain is preferably combined with the loss on Item 3, with entries to a “Loss or Gain” account. It is shown separately here for clarity.)

6. (a) Depreciation Expense.........................................................................................................................................................................37Accumulated Depreciation..........................................................................................................................................................37

(.75 x .10 x $490)(b) Cash ...................................................................................................................................................................................................80

Accumulated Depreciation, Furniture and Fixtures...........................................................................................................................432Furniture and Fixtures..................................................................................................................................................................490Gain on Sale of Other Assets.......................................................................................................................................................22

7. Depreciation Expense.........................................................................................................................................................................398,779Accumulated Depreciation, Building..........................................................................................................................................48,105Accumulated Depreciation, Factory Machinery..........................................................................................................................330,935

**This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

Accumulated Depreciation, Furniture and Fixtures.....................................................................................................................5,599Accumulated Depreciation, Automotive Equipment....................................................................................................................................................................................9,989Accumulated Depreciation, Office Machines..............................................................................................................................4,151

(Note that depreciation is calculated after the earlier entries have been recorded and that depreciation on factory machinery is not calculated on the $85,000 of fully depreciated assets.)

Question 2

GrossAccumulatedDepreciation Net

Land.........................................................................................................................................................................................................$ 186,563 $ 186,563Building................................................................................................................................................................................................... 2,405,259 $ 711,484 1,693,775Factory machinery .................................................................................................................................................................................. 3,394,352 1,945,926 1,448,426Furniture and fixtures ............................................................................................................................................................................. 55,994 45,604 10,390Automotive equipment ........................................................................................................................................................................... 49,944 41,965 7,979Office machines ...................................................................................................................................................................................... 41,507 31,129 10,378Tools ....................................................................................................................................................................................................... 53,444 53,444Patent....................................................................................................................................................................................................... 45,000 _________ 45,000

Total..................................................................................................................................................................................................$6,232,063 $2,776,108 $3,455,955