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Case 5- 3: Joan Holtz (A) Note: This case has been updated from the Tenth 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 2001 post-reading usage (which is recorded in January 2002) is, in effect, assumed to be the same 2002 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 more sound accounting, in that with weather fluctuations and energy conservation efforts, it is questionable whether the post-reading usage in December 2001 would in fact not differ materially from the post-reading usage in December 2002. 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. This is one of the problems whose true resolution depends on events that cannot be foreseen at the end of the accounting period. Some firms count the whole $10,000 as revenue in 2001 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 2001 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.

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 Raymonds has completed its service of arranging the cruise, that it is extremely unlikely that events will happen in 2002 that will change its profit of $20,000, and that the amount is therefore revenue in 2001. 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 Raymonds, 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 2001 and the full sales value when the trees are sold in 2002. 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 2002 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 clients 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 2001 and the 60 cent reimbursements made in 2002 are an expense of selling tea in 2002. Those who tie the coupons with coffee would say that the entire 20 percent of coupons redeemed is an expense of selling coffee in 2001 with the amount not yet redeemed being a liability as of December 31, 2001. 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............................................... Cr. Payable to American Express.... Commission Revenue.................. 505 500 5

After the bank remits the $500 cash to American Express, the latter will make the following entry: Dr. Cash............................................... Cr. Travelers Checks Outstanding... 500 500

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. 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 As 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 2001 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.

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-Logics 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 this [the Siberian steel mill] 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 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.3

1 1

The Wall Street Journal, Sequoia Systems Remains Haunted by Phantom Sales, October 30, 1992, p. B8. Ibid. 3 Ibid.