CHAPTER 4: REVENUE RECOGNITION PROBLEM SOLUTIONS
Assessing Your Recall
4.1
ROI measures performance through expressing the return from an
investment as a proportion of the average amount invested. In order to measure return,
businesses need to determine the change in assets and liabilities from one period to the
next. This is accomplished through the income statement.
4.2
Cash
Acquisition of
inventory
Selling
Activities
Collection
Delivery of
product
Warranty
Service
The cash-to-cash cycle of a retail company includes the following:
a) Cash: initial cash is obtained from investors (shareholders) and creditors (banks and
other lenders)
b) Acquisition of inventory: inventory is purchased from suppliers.
c) Selling activity: includes all activities to promote and sell the product
d) Delivery of product: product is delivered to the customer
e) Collection: collection of cash depends upon price allowances, cash
discounts, uncollectibles, etc.
f) Warranty service: period during which the seller is responsible for
replacement or repair of the product. Future costs incurred to repair or replace products
affects the ultimate amount of cash available at the end of the cycle.
4.3
The three main criteria are that the revenue be earned, that the amount earned can be
measured and that there is reasonable assurance that the amounts earned will be
collected.
4.4
The “earned” criterion consists of two interrelated factors. The first is
that the major revenue generating activities of the company are essentially complete.
The second factor is that the company has incurred the majority of the costs it will incur
in its cash-to-cash cycle and that those remaining are subject to reasonable estimation.
The “realizable” criterion means that the revenues must have been collected in cash by
the company or that the collection of the receivables from credit sales is subject to
reasonable estimation by the company.
4.5
The percentage-of-completion method recognizes revenues (and the
1
related expenses) based on the fraction of work that is done during the current period.
The fraction of work completed during the period is usually estimated by the costs
incurred relative to the total estimated costs to complete the project. The completed
contracts method, on the other hand, postpones the recognition of revenue (and expense)
until the project is completed. All revenues and expenses are then recognized at the end
of the construction period when the project is delivered to the customer.
4.6
The instalment method recognizes income as cash is collected. The amount of income is
determined by multiplying the cash collected by the overall profit margin. Thus with
each payment some of the cost is recovered and some profit is recognized. It is rarely
used in practice because companies can usually estimate the collectibility of instalment
sales and therefore recognize revenue prior to the actual cash collection.
4.7
The matching principle simply states that when revenues are recognized, all costs
necessary to generate those revenues should be matched with the revenues as expenses
on the income statement.
4.8
When a deposit is made by a customer for the future delivery of inventory, no revenue is
recognized. The company has not completed its part of the agreement, namely, the
delivery of the inventory. With respect to the revenue recognition criteria, although it
can measure the potential revenue and the collectibility is assured (it already has the
cash), it has not yet earned the revenue.
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Applying Your Knowledge
4.9
Advertising revenue is recognized as soon as the advertisement is printed in an issue of
the magazine. At this point, the company has completed its commitment to the customer;
it printed the advertisement. It knows how much it has earned and it can estimate the
collectibility of the amount.
The subscription revenue is recognized as each issue is sent. At this point, the company
has completed its part of the contract; it sent the issue. It has probably already collected
the subscription amount from the customer so both the amount and collectibility are
know.
4.10 a)
Return
Average investment
ROI
b)
Return
Average investment
ROI
c)
Return
Average investment
ROI
d)
Return
Average investment
ROI
e)
Return
Average investment
ROI
($430 + $490 + $590)/3
$18.80
$503.33
3.74%
5 x $0.3 + (($84.50-$79.40) x 5)
5 x $79.4
$27
$397
6.80%
$1,266 - $1,200
$66
$1,200
5.5%
($635,900 + $670,300)/2
$75.75 - $70.42
$22,900
$653,100
3.51%
$5.33
$70.42
7.57%
3
4.11
a)
Return
Average investment
ROI
b)
Return
Average investment
ROI
c)
Return
Average investment
ROI
d)
Return
Average investment
ROI
e)
Return
Average investment
ROI
$2,000
$90,000
2.22%
$3.75 x 5,000
$18,750
$15,000
125%
(10 x $14.75) – (10 x $7.50)
10 x $7.5
$72.50
$75
96.67%
($1,340,000 + $1,150,000)/12
$210,000 - $160,000
$112,000
$1,245,000
9.00%
$50,000
$160,000
31.25%
4.12
Jones Sales Company
Income Statement
For the Year ending December 31, 2000
Sales
Cost of Goods Sold
Gross Profit
Investment income
Net income
$0 + $126,500 - $12,200
$221,000
(114,300)
106,700
500
$107,200
4
4.13
Tinder Box Furnace Company
Income Statement
For the Year ending December 31, 2001
Sales
Cost of Goods Sold
Gross Profit
Warranty expense
Net income
$1,230,000 - $65,000
$580,000 + $245,000
$1,165,000
(825,000)
340,000
65,000
$275,000
4.14
a) Percentage of completion
Year
1
2
3
4
(4,750 / 16,250) x
20,000,000
(5,000 / 16,250) x
20,000,000
(3,500 / 16,250) x
20,000,000
(3,000 / 16,250) x
20,000,000
b) Completed contract method
Year
Revenue
1
0
2
0
3
0
4
$20,000,000
$20,000,000
Revenue
$5,846,154
Expense
$4,750,000
Profit
$1,096,154
$6,153,846
$5,000,000
$1,153,846
$4,307,692
$3,500,000
$807,692
$3,692,308
$3,000,000
$692,308
$20,000,000
$16,250,000
$3,750,000
Expense
0
0
0
$16,250,000
$16,250,000
Profit
0
0
0
$3,750,000
$3,750,000
5
4.15
Gross profit % = ($250 - $180) / $250 = 28%
$60 x 5 = $300; $300 - $250 = $50 = Interest revenue
Year
1
2
3
4
5
4.16
Accounts
Receivable
$200,000
$150,000
$100,000
$ 50,000
$0
Interest revenue
$10,000
$10,000
$10,000
$10,000
$10,000
Profit
28% x 50,000
28% x 50,000
28% x 50,000
28% x 50,000
28% x 50,000
$14,000
$14,000
$14,000
$14,000
$14,000
a) It would be reasonable for Superior to recognize all of the profit on the sale in the first
year if Superior has reasonable assurance regarding the ultimate collection of the sale
price from Imperial. In addition, no significant costs should remain to be incurred on the
part of Superior, and the risks of ownership should be transferred to Imperial.
b) It would be appropriate to postpone revenue recognition until the actual cash is
received if there is doubt that the receivable from Imperial will be collected, or the
amount of bad debt expense relating to the sale cannot be estimated.
c)
Year
1
2
3
4
Accounts
Receivable
$900,000
$500,000
$150,000
$0
Interest revenue
$105,000
$105,000
$105,000
$105,000
Profit
$1,500 - $975
$525,000
0
0
0
4.17 a)
1.
Percentage of completion method
Year
1
2
3
4
Revenue (millions)
(21.2 / 96) x 120
(36.4 / 96) x 120
(26.0 / 96) x 120
(12.4 / 96) x 120
$ 26.5
$ 45.5
$ 32.5
$ 15.5
$120.0
Expense
(millions)
$21.2
$36.4
$26.0
$12.4
$96.0
Profit (millions)
$ 5.3
$ 9.1
$ 6.5
$ 3.1
$24.0
6
2.
Completed contract method
Year
1
2
3
4
Revenue (millions)
0
0
0
$120
$120
Expense (millions)
0
0
0
$96
$96
Profit (millions)
0
0
0
$24
$24
b) The percentage of completion method should be used to indicate the
performance of Cruise Shipping Inc. under the contract because the revenue is earned
over the course of the contract rather than all at once, upon completion. Since the work is
done over a four year period, the percentage of completion method is most appropriate. If
the collectibility of the amount was in question, using the completed contract method
would be more appropriate.
4.18 a)
1) Percentage of completion method
Period
1
2
3
4
5
(140 / 750) x 1,000,000
(210 / 750) x 1,000,000
(240.5 / 750) x
1,000,000
(90 / 750) x 1,000,000
(69.5 / 750) x 1,000,000
2) Completed contract method
Period
Revenue (millions)
1
0
2
0
3
0
4
0
5
$1,000,000
$1,000,000
Revenue
(millions)
$ 186,667
$ 280,000
$ 320,667
Expense
(millions)
$140,000
$210,000
$240,500
$ 46,667
$ 70,000
$ 80,167
$ 120,000
$ 92,666
$1,000,000
$ 90,000
$ 69,500
$750,000
$ 30,000
$ 23,166
$250,000
Expense (millions)
0
0
0
0
$750,000
$750,000
Profit (millions)
Profit (millions)
0
0
0
0
$250,000
$250,000
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b) The percentage of completion method should be used because the
revenue is earned over the course of the contract rather than all at once, upon
completion. Since the work is done over several periods, the percentage of completion
method is most appropriate. If the collectibility of the amount earned was in question,
using the completed contract method would be more appropriate.
4.19
Percentage of completion method
Year
2000
2001
2002
2003
(110.75 / 325) x 500,000
Loss = (511,250 - 500,000) +
59,635
No profit or loss remains to
be recognized
No profit or loss remains to
be recognized
Revenue
(millions)
$170,385
$ 29,615
Expense
(millions)
$110,750
$100,500
Profit
(millions)
$ 59,635
$ (70,885)
$200,000
$200,000
$0
$100,000
$100,000
$0
$500,000
$$511,250
($11,250)
4.20
Year
Revenue
Interest
1
75,000
$6,0001
2
0
$3,0003
1
$3,600 + $2,400 = $6,000
2
$75,000 - $30,000 - $20,000 = $25,000
3
$1,800 + $1,200 = $3,000
4
$25,000 - $15,000 - $10,000 = $0
Expense
Accounts
Receivable
$25,0002
$04
$60,000
$0
Profit
$15,000
$0
4.21 a) Percentage of Completion Method ( answers in thousands)
Estimated Costs:
Year 2000
Year 2001
Year 2002
Total Estimated Costs
Contract Revenues
Estimated Cost
Profit
$3,532.5
2,747.5
1,570.0
$7,850.0
$10,000
7,850
$2,150
8
Year
2000
2001
2002
Degree of Completion
$3,532.5/$7,850 = 45%
$2,747.5/$7,850 = 35%
$1,570/$7,850 = 20%
Revenue1
$4,500
3,500
2,000
Expense2
$3,532.5
2,747.5
1,570.0
Profit
$967.5
752.5
430.0
100%
$10,000
$7,850.0
$2,150.0
1
2
Degree of Completion x Contract Price; Contract Price = $10,000
Cost incurred during period
b) Completed Contract Method (answers in thousands)
Year
2000
2001
2002
2003
4.22
Revenue
---$10,000
Expense
----$7,850
Profit
---$2,150
$10,000
$7,850
$2,150
a) Sonya’s cash-to-cash cycle begins when she pays cash for trees that she
plants on a plot of land, continues through six growing seasons with the outlay of cash
for their care, and ends with the outlay of more cash for their harvesting so they can
finally be sold to create a cash inflow. As she plants a new plot each year, she has six
continuing cycles.
b) The general revenue recognition options that are open to Sonya, as
discussed in this chapter, are revenue recognition at the time of sale, at the time of
contract signing, at the time of production, and at the time of collection. Because of the
uncertainties involved in the planting, growing, harvesting, and sale of Christmas trees
over such a long period of time, Sonya should use the time of sale to recognize revenues.
Recognition of revenues at the time of collection would probably not be relevant if her
sales are cash sales.
c) Recognizing revenues at the time of sale implies that all costs of growing
the trees should be deferred as inventory assets until the tees are harvested and sold,
when they would be recognized as expenses and matched to the resulting revenues. To
be able to match her costs to specific trees, Sonya would have to keep track of all costs
incurred for each plot of land separately. Essentially this would mean that Sonya would
keep track of six groups of inventory.
9
4.23
a) Terry has two separate cash-to-cash cycles. The speculative design
business has cash outflows while the games are being developed, then has cash inflows
only if the games are sold. The custom design business has a much shorter cash-to-cash
cycle, with monthly cash outflows and monthly or less frequent cash inflows coming in
after the invoices for the work are sent out.
b) Terry could recognize revenues at the time of sale, at the time of contract
signing, at the time of production, or at the time of collection of cash. For the
speculative design, the time of sale basis would providing the best information. For
hourly rate custom design, the percentage of completion basis (production) may be
appropriate as Terry has a paying customer up front and the revenue is earned on an
hourly basis as the work is done. However, if this work is normally completed within a
short period of time, recognizing revenue when the work is complete would be
appropriate.
c) Accounting for costs incurred would depend on the kind of business. For
speculative games, all costs incurred would be deferred as inventory assets until the
games are sold, at which time the costs would be recognized as expenses to match to the
revenues being earned. If Terry finds that any speculative games are found not to be
salable, the cost associated with those games would be recognized as expenses. For
custom designs, Terry would either recognize costs as they are incurred (for the hourly
rate contracts) or defer the costs until the project is completed (for the fixed fee
contracts). In all cases, costs should be matched with revenue.
d) The main difficulties with this business appear to be the requirement
that a stream of games be continually produced and that the cash flows need to be
controlled. We should recommend that Terry produce a cash budget showing all
expected cash inflows and outflows, as a continual supply of cash will be needed to be
able to assure a continual flow of new games that can be marketed. We might
recommend that Terry try to achieve a steady custom design business to produce the cash
needed to produce the games for the speculative designs. Terry might also try to
convince Kim to accept the same type of contract that Sandy has for the speculative
game design in order to reduce the required cash outflows for wages.
Management Perspective Problems
4.24
The “quality” of earnings refers to how certain an analyst is that the earnings reported in
a company’s income statement will result in actual cash flows. If two companies were in
the same industry and one of them recognized revenues earlier in the cash to cash cycle
than the other then its earnings would likely have lower quality in the eyes of the analyst.
The reason for this is that the earlier in the cycle that revenues are recognized the more
uncertainty there is as to their actual collection. The relative quality of earnings for two
companies in very different industries may be hard to judge due the differences in their
cash to cash cycles.
4.25
If a company is thinking of going public, it might have an incentive to
misstate its income statement via its revenue recognition policies. For example, if it
recognizes revenue earlier in the cash-to-cash cycle, it can increase its net income, and
attract a higher price from the share issuance. If a company did change its revenue
recognition policy in order to enhance earnings, investors should realize what it is doing
10
from its financial statements and related notes. Changes in accounting policy as well as
the effects of such changes on net income must be disclosed in the notes to the financial
statements, according to GAAP.
4.26
Meeting your sales target is influenced by the revenue recognition principles
of the company because the earlier in the cash-to-cash cycle that revenue is recognized,
the closer you can be to achieving the sales target. For example, if a large order is placed
near the year-end, but the products are not shipped until the next year, recognizing this
revenue in the current period can help you to meet your sales target.
4.27
If the products sold in Brazil are priced in reals then you run the risk of each sale being
worth less in dollar terms as the exchange rate increases unless, of course, you can fully
adjust the real to compensate for the changing exchange rate. If you can, then you would
want to sell more units earlier in the year as real earned in the last portion of the year are
worth less in dollar terms than those at the beginning of the year. Another possibility
would be to enter into some exchange rate hedging agreement to protect the dollar level
of sales from extreme fluctuation in the exchange rate
Another possible solution to mitigate the exchange risk would be to price your goods in
dollar terms. Therefore, as the exchange rate changes you still receive the same dollar
amount for each sale. This puts the exchange risk on the customer. Depending on the
market this may or may not be acceptable to the customer.
4.28
Typically a company would want to choose a revenue recognition method for tax
purposes that would delay the recognition of revenue. This postpones the payment of
taxes on the revenue and is usually in the best interests of the taxpayer. On the other
hand, for financial reporting purposes shareholders will want to see a more up-to-date
and accurate picture of what has been sold and would prefer that revenues be recognized
earlier than they might be for tax purposes. Management, in particular, might like to see
revenues recognized as early as possible since their management compensation plan may
be tied to reported net income.
4.29
It might be appropriate for the toy company to recognize revenue at the time of shipment
as long as it could reliably estimate the impact of returns. Just as you would estimate
bad debts, the toy company must estimate and record an allowance for sales returns. To
record revenues without any recognition of the effect of sales returns would not be
appropriate since all of the revenues would not have been earned. If there is high
uncertainty as to the amount of toys that might be returned then the uncertainties of
realizing the revenues would be such that the company should not record revenues at
time of shipment. Consignment sales are typical of this nature where title does not pass
to the buyer but resides with the seller until the goods are ultimately sold the final
consumer.
4.30
Goods in transit are a problem for both the buyer and the seller. The issue comes down
to who owns the goods at year-end. The sale contract typically specifies exactly when
title passes to the goods and therefore determines when the risk of ownership passes
from the seller to the buyer. The FOB terms are important. For instance, if the goods
were shipped FOB shipping point, then the goods would belong to the Australian
customer once they had left the dock in Vancouver. On the other hand, if they were
11
shipped FOB destination then they would belong to the Vancouver exporter until they
are delivered on the dock to the Australian customer. In some cases title may pass at sea
when the ship crosses a certain geographic landmark.
4.31
The selling company still bears the risks of owning the accounts receivable, because the
purchaser has recourse if it is unable to collect. Therefore, the transaction should be
treated as a borrowing of funds, rather than as an outright sale of accounts receivable.
4.32
Since ESPN has not performed its part of the bargain, i.e. to run the advertisements and
the customers has only put down a 20% deposit, this contract should probably be treated
as mutually unexecuted and no revenues should be recognized until the commercials are
aired. The $2,000,000 should be treated as a liability for customer deposits (or unearned
revenues) in the financial statements on December 31.
4.33
Although the cash has been received, the criteria for revenue recognition have not been
satisfied because the GAP still bears the risks of owning the merchandise and must fulfill
its obligation to holders of the gift certificates. Thus, the gift certificates should be
recognized in the financial statements as unearned revenue.
4.34
The question here is whether the software company has “earned” its
revenues at the time the software is delivered to the customer. Because the software
requires customization to the buyer’s system and the problem states that this can take
several months it is likely that this is a major part of the earnings process for the
company (i.e. the customization service). Therefore, you can argue that the revenues
from the product should be deferred and recognized rationally over the customization
period. Recognition at time of shipment would not seem appropriate since if no
customization is done the product is highly likely to be returned to the company.
4.35 Old inventory suggests that it is either damaged or obsolete. In either case it
is not likely to generate revenues in the future and therefore should not be considered an
asset on the books of the company. The company should write off the cost of the
inventory which will reduce the balance sheet value of inventory and increase the cost of
the inventory (the cost of goods sold) or it might be reported as a loss separate from the
cost of goods sold. Management may have been keeping the inventory so as to avoid the
negative impact on the income statement, particularly if the amount was significant.
There could be numerous reasons for this, one of which might be that management is
compensated based on a bonus plan which is calculated based on reported net income.
Reading and Interpreting Published Financial Statements
4.36
To decide which method is most appropriate for Zale Company, the revenue recognition
criteria should be assessed. The first of those is whether the revenue has been earned.
The question here is how certain the company is that those items place in layaway will
result in an eventual sale to the customer. The best evidence of a sale would be data
from past layaways sales that indicate whether the customer actually completes the
transaction or whether they return to ask for their money back. If most layaways result in
ultimate sale and the percentage that does not represent sales can be reasonably
estimated there seems to be no reason not to recognize the layaways as sales. If only a
small percentage of the layaways result in ultimate sales then it would be inappropriate
12
to recognize them at the initial layaway. The reasonable expectation of collectibility is
not as difficult to meet in this case since the sale is being paid for in advance. The
company retains the inventory and if the customer does not complete the sale the only
amounts at risk are the profit from the sale and possible risk of holding inventory that
cannot be sold because of changes in fashion (which is relatively low in the jewelry
business).
4.37 Catalog costs are incurred by companies such as Eddie Bauer to generate
revenues from mail order sales. The matching concept would seem to indicate that these
costs should be matched against the revenues that are generated from the catalog. These
expenses should probably be deferred and recognized over the period for which the
catalog is effective to best match revenues and expenses.
4.38 a) 1998 - $360 million; 1997 - $400 million.
b) Air Canada’s revenue recognition policy is appropriate because passenger
and cargo revenue have been earned once the transportation is provided. The value of
unused transportation, on the other hand, represents an obligation to provide services in
the future, and thus forms part of current liabilities. For an airline, the critical event in
the earnings process is the physical transportation of passengers or cargo. It is not
appropriate to recognize revenue prior to providing this transportation.
c) Free trips that arise as a result of frequent flier programs should be
accrued as a liability as the points are credited to customer accounts.
4.39
i)Sales of its products are very similar to sales of any product, so the
normal revenue recognition policies for product sales is appropriate. Revenue is
recognized when ownership of the product is transferred to the purchaser. Discounts and
allowances for future estimated returns represent reductions in revenue, and, as a result,
are offset against gross revenue.
ii) It is likely that the sale of communication systems, including integration and
installation services, occur over a period of time as the work is complete. Because the
future revenue and probable future costs are known to Mitel, it is appropriate to
recognize revenue as the work is completed, the percentage of completion method.
iii) Revenue from service should be recognized at the time the service is rendered. At
this time, the work is complete, the revenue is earned and the amount that has been
earned is known. Unless there is some question about collectibility, revenue does not
need to be delayed beyond the completion of the service.
iv) If billings (fees) are received in advance of the services being provided, then the fees
should not be recognized as revenues until the services have been provided during the
terms of the agreements. The revenue is not earned until the service is complete.
4.40
a) GAAP states that revenue should be recognized when the revenue has been
earned, the revenue is measurable and its collectibility is reasonably assured. The
consideration of the most timely (i.e., soonest) recognition should also be considered.
As royalties are payable to the government based on the value of the minerals extracted,
they are not revenues to mining companies and should not be shown as such.
Queenstake has therefore appropriately deducted them from revenues. Queenstake also
appears to have difficulties with the measurability consideration as the actual mineral
content of ore can only be estimated after a proper chemical analysis is performed. Thus
13
Queenstake appears to use the best estimate of the mineral content that is being sold to
the purchaser, with the final figures being determined after the analysis is undertaken.
All adjustments to the estimated mineral content are treated as adjustments to the
revenue that was already recorded.
b) Queenstake could also recognize revenues from sales of gold and silver when the
minerals have been mined and are already for sale, as these items are treated as if they
were equivalent to cash. Another alternative would be to wait until the final weights of
all the minerals were known with certainty.
4.41 i) If earning freight revenues occurs over a long period of time, the
percentage of completion method is appropriate.
ii)
Revenues from shipping operations are earned as containers are
shipped, and it is thus appropriate to recognize revenue on the basis of completed
voyages. In addition, the costs that are attributable to these operations should be
matched to the related revenue and recognized in the same period as the revenue.
iii)
Revenues from crude oil and gas are recognized at product delivery,
because at this point in the earnings process, the seller no longer
bears the risks of ownership, and the revenue is measurable.
iv)
It is appropriate to recognize coal and mineral sales revenue upon
shipment from the plant provided that the terms of the sale are FOB shipping point, so
that the buyer bears the risks of ownership once the coal and minerals have left the
seller’s plant.
v)
Revenues from hotel operations are earned and usually collectible
when the services are provided to customers. Thus, it is appropriate to recognize hotel
revenue at this point in the earnings process.
4.42
a) As a manager in the company offering the reverse mortgages, the
decision about how much money to loan to the homeowner should be based
on the current appraisal value of the home, the selling price of similar homes, the
expected demographic or economic changes affecting the real estate market, and the age
of the homeowner.
b) I would recognize revenue at the inception of the loan only to the extent
that one-time costs related to extending the loan are offset. The remainder of the revenue
would be recognized over the life of the agreement as interest is earned on the
outstanding balance of the loan.
c) The payments made to the homeowners would be treated a long-term
receivable, and the expenses incurred in administering the agreement would be matched
to the related revenue, as it is recognized.
d) Ethical dilemmas include attempting to offer less money up front so that the
revenues earned will be higher but which could cause financial hardship for the retired
individuals. Another ethical dilemma might be encouraging the retired individuals to
move out of the home into care facilities so that the property reverts to the company.
Beyond the Book
Answers to this question will be dependent on the company selected.
14
Case
4.44
a) Revenue recognition guidelines generally require that a sale be recognized when the
title of the goods is transferred to the buyer. Title to goods that are shipped FOB
shipping point is transferred when the goods are picked up by the buyer’s truck from the
factory. If goods are sold FOB destination, the title does not pass until the goods are
received by the buyer from the trucks. Thus if the selling policy changes from FOB
shipping point to FOB destination, it will appear that QSC has a drop in sales as the
selling point will be delayed by the extra shipping time because the product will be the
responsibility of QSC for the extra shipping time. However, this apparent drop will
occur only in the year of the change as subsequent years will record the last five days’
sales as the first five days’ sales of the year.
b) If QSC continues to sell its cheese FOB shipping point, it will not suffer the apparent
dorp in sales. It could control the shipping by offering to ship the cheese in its own
trucks and recover the additional costs by pricing its product at the old rate plus shipping.
Then title to the cheese will transfer to the buyer upon pickup by the trucks. Thus the
sale can be recognized as soon as the cheese leaves the factory. QSC can guarantee the
quality of the cheese as it would be using its own trucks, so it would not suffer the
apparent drop in sales and would have more control over shipping. Of course some
buyers may not want to use QSC’s trucks, so this scheme would not be fully effective.
Critical Thinking Questions
4.45 a) The government commission and taxes must be remitted to the Provincial
Liquor Control Boards, and Big Rock, although collecting these amounts from
customers, does not benefit from the amounts collected.
b) Government commissions and taxes should not be included in the revenues of Big
Rock, and are appropriately deducted from gross revenue on the financial statements.
The reason for excluding these items from revenues is that this portion of the amount
collected from customers does not increase the net assets of Big Rock, since the
receivable from the customer is offset through an equal payable to the Provincial Liquor
Control Board.
4.46
General Comments
The purpose of this question is to examine the proposed treatment of an accounting issue
that is not specifically covered by generally accepted accounting principles.
1. Method 1 is to assess whether the frequent flyer plan results in a liability consistent
with the definition of “liabilities” (i.e. “probable future sacrifices of economic benefits
arising from present obligations of a particular entity to transfer assets or provide
services to other entities in the future as a result of past transactions or events”) Because
the flights for which individuals typically apply frequent flyer miles don’t operate at full
capacity (i.e. nonbusiness travel), there generally is no future sacrifice because no
income is lost from filling a “paying” seat with a frequent flyer. Thus, using the
conceptual framework to assess whether to recognize a liability, it appears that liability
recognition is not warranted.
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Method 2 is to assess whether there is an analogous situation in the literature that may be
applied to the issue under investigation. The frequent flyer obligation may be considered
to be similar to product warranties. However, the deferred revenue approach is not
appropriate for frequent flyer plans since it was established in Method 1 that revenue
typically is not lost as a result of these plans. The frequent flyer obligation also may
seem to some to be similar to the receipt of deposits and prepayments for goods or
services to be provided in the future, such as magazine subscriptions. However, unlike
such prepayments, airlines are not obligated to sacrifice cash in the future. This and
several other features makes this a poor analogy.
Method 3 is to evaluate the issue from an alternative perspective. For the liability issue
raised by the frequent flyer plan, the alternative perspective is revenue recognition. That
is, when payment for travel is received by an airline, is a portion of the revenue related to
the frequent flyer plan unearned revenue? Arguments can be made that some revenue
has not been earned (e.g. future obligation exists to provide a service) as well as that
there is no unearned revenue (e.g. there is no revenue attached to the frequent flyer plan
since the plan is not an ongoing major part of the entity’s operations and because little or
no future revenue is lost when frequent flyer miles are used, the airlines has performed
substantially what is must do to be entitled to the benefits from the revenue from the
original ticket sale). (Method 3 addresses the linkage between revenue and liability
recognition).
2. The author recommends that the three-pronged approach applied above results in the
conclusion that the strongest arguments are made for treating the frequent flyer plans as
loss contingencies. Students should support or refute this conclusion.
4.47
General comments
The purpose of this question is to provide the students with a company that sells items
different from a retail company. Alliance Atlantis sells entertainment products like
television series. Students must go back to the revenue recognition criteria, examine the
nature of the products this company sells, and identify the critical points in the revenue
recognition process. The difference between this company and a regular retail company
is emphasized to the students by having them identify the similarities and differences
between Alliance and a company that manufactures television sets.
Students must recognize that Alliance produces two kinds of products –
those for which it has a buyer and those for which it does not. When Alliance
develops a pilot program for a television series without having a prearranged
buyer, it is really producing an item of inventory that it expects to sell. Thus
it is very similar to a company that manufactures a television set that it
expects to sell. For Alliance, the critical points in the revenue recognition
process are the incurrence of costs to produce the pilot, the finalizing of the
pilot so it is ready for viewing by prospective buyers, the signing of the
contract for the sale of the series, and the production of weekly shows that
will be shown on particular stations. Of these, the most important points are
the signing of the contract and the production of the weekly shows, as these
are acts that show that revenue will be or has been earned. Because this
whole process could take several weeks or months, it is important for
students to recognize that the costs of producing these pilot shows would
have to be accrued until revenue was recognized so that matching could
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occur. They should also recognize that if Alliance cannot find a buyer for the
pilot series, it will need to expense all of those accrued costs because there
will be no revenue against which they can be matched.
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