CHAPTER 5

REVENUE AND MONETARY ASSETS

Changes from Eleventh Edition
The chapter has been updated.
Approach
The sequence of transactions for accounts receivable and bad debts often causes difficulty; indeed, the
time that one is sometimes forced to spend on this topic is all out of proportion to its importance. Students
often do not understand why an Allowance for Bad Debts account is necessary at all; they do not grasp
the notion that although we feel reasonably sure that some accounts will go bad, we do not now which
ones they will be. !ven when they do understand this, the chain of transactions involved in estimating bad
debts, writing off specific accounts, and booing bad debts recovered, is complicated and not easy to
follow.
"f e#perience is any guide, it is quite liely that at the time this chapter is taught the press will be
describing a company that has gotten into trouble for overstating its revenue or understating its bad debt
or warranty allowance. Discussion of such a situation would be interesting.
Cases
Stern Corporation (A) is a straightforward problem in handling accounts receivable and bad debts.
Grennell Farm, by contrast, has few technical calculations but provides an e#cellent opportunity for a
realistic discussion of alternative ways of measuring revenue and of valuing assets.
Joan Holtz (A) is a different type of case. "t is a device for raising several discrete, separable problems
about the sub$ect matter of the chapter, from which the instructor can pic and choose those he or she
wishes to tae up in class. %"t probably is not feasible to discuss all of them.&
Bausch & Lomb, Inc., is an actual case situation involving revenue recognition.
Boston Automation Sstems, Inc! involves a review of the company's revenue recognition practices in the
light of the S!('s SAB )*) %a longer version of the case was included in the !leventh !dition&.
Problems
Problem 5-1
Sale Method Jan. Feb. Mar. April Ma J!ne
Sales..................................................................................................................................................................................................... +),,*** + -,*** +).,*** +)),*** +/,*** +).,0**
(ost of goods sold................................................................................................................................................................................ 1,-** 0,,** -,20* 1,)0* 0,-0* -,110
3ross margin........................................................................................................................................................................................ + 2,,** +,,-** + 2,00* + .,-0* +.,)0* + 2,1,0
"nstallment Method Jan. Feb. Mar. April Ma J!ne
Sales..................................................................................................................................................................................................... +)),*** +)*,*** +)),0** +)*,0** +)*,0** +/,0**
(ost of goods sold................................................................................................................................................................................ 1,)0* 4,0** 1,210 4,-,0 4,-,0 4,)10
+ .,-0* + .,0** + 2,*,0 + .,410 + .,410 +.,.,0
)
Accountin"# $e%t an& Cases '(e ) Instructor*s +anual Anthon,Ha-.ins,+erchant
Problem 5-#
Completed Contract Percentage of Completion
$his %ear &e't %ear $his %ear &e't %ear
"ncome e#cluding motel %***&.............................................................................................................................................................. +),,0* +),,0* +),,0* +),,0*
"ncome from motel pro$ect................................................................................................................................................................... * 10* 20* .**
"ncome before ta#es............................................................................................................................................................................. +),,0* +,,*** +),1** +),00*
Problem 5-(
To record the write5off6
"f Alcom uses the direct write5off method7
dr. Bad debt !#pense.................................................................. +.,***
cr. Accounts 8eceivable......................................................... +.,***
"f Alcom uses the allowance method6
dr. Allowance for Doubtful Accounts......................................... +.,***
cr. Accounts 8eceivable................................................ +.,***
To record the partial payment6
"f Alcom uses the direct write5off method6
(ash........................................................................................... +/0*
Bad Debts 8ecovered............................................................ +/0*
%or Bad Debt !#pense............................................................ +/0*&
"f Alcom uses the allowance method6
!ither of the above two entries or6
(ash........................................................................................... +/0*
Allowance for doubtful accounts........................................... +/0*
Problem 5-)
The Allowance for Doubtful Accounts should have a balance of +0),10* on December .). The supporting
calculations are shown below6
*as Acco!nt
+!tstanding Amo!nt
E'pected Percentage
,ncollectible
-
Estimated
,ncollectible
*5)0 days +20*,*** .*) + 2,0**
)45.* days )0*,*** .*4 /,***
.)520 days 10,*** .,* )0,***
2454* days 20,*** ..0 )0,10*
4)510 )0,*** .0* 1,0**
Balance for Allowance for Doubtful Accounts +0),10*
The accounts that have been outstanding over 10 days %+)0,***& and have 9ero probability of collection
would be written off immediately and not be considered when determining the proper amount of the
Allowance for Doubtful Accounts.
:
%)5;robability of collection.&
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<(//0 +cGra-1Hill,Ir-in Chapter 2
b.
Accounts 8eceivable....................................................................... +1.0,***
=ess6 Allowance for Doubtful Accounts.......................................... 0),10*
>et Accounts 8eceivable.................................................... +4-.,,0*
c. The year5end bad debt ad$ustment would decrease the year's before5ta# income by +,/,,0*, as
shown below6
!stimated amount required in the Allowance for Doubtful
Accounts....................................................................................
+0),10*
Balance in the account after write5off of bad accounts but before
ad$ustment.................................................................................. ,,,0**
8equired charge to e#pense.............................................................. +,/,,0*
Problem 5-5
3reen =awn's boos6
dr. "nventory on (onsignment........................................................... -,2**
cr. ?inished 3oods "nventory....................................................... -,2**
>ote that at this point the +),,4** wholesale price %3reen =awn's revenue when these goods are sold& is
irrelevant.
(arson's boos6 >o entry; the goods are not owned by (arson and hence are not inventory on (arson's
boos; similarly, (arson does not as yet owe 3reen =awn for these goods.
3reen =awn's boos6
dr. Accounts 8eceivable................................................................... 0,*2*
(ost of 3oods Sold...................................................................... .,.4*
cr. Sales................................................................................... 0,*2*
"nventory on (onsignment.................................................. .,.4*
%This can be shown as two entries.&
(arson's boos6
dr. (ash or Accounts 8eceivable....................................................... 4,1,*
(ost of 3oods Sold...................................................................... 0,*2*
cr. Sales................................................................................... 4,1,*
Accounts ;ayable................................................................. 0,*2*
%This also can be shown as two entries.&
Problem 5-.
#/ ' ) #/ ' 5 #/ ' .
8evenue..................... +/-*,*** +),21*,*** +,,,*0,***
(osts.......................... 1,),*** ),)/*,*** ),1)0,***
"ncome....................... +,0/,*** + ,-*,*** + 2/*,***
8evenue equals percentage completed during the year times fi#ed price.
.
Accountin"# $e%t an& Cases '(e ) Instructor*s +anual Anthon,Ha-.ins,+erchant
Problem 5-0
The 38@ (ompany's current assets and current liabilities at year5end are shown below.
(urrent assets6
(ash......................................................................................... + ,.,)**
Accounts receivable................................................................. + .2,40*
=ess6 Allowance for bad debts.................................................. ),-0*
>et accounts receivable............................................................ .,,-**
Beginning inventory................................................................. 24,,**
;urchases.................................................................................. )-2,-**
Available inventory.................................................................. ,.),***
=ess6 (ost of goods sold........................................................... )4),1**
!nding inventory...................................................................... 4/,.**
Total current assets.............................................................. +),0,,**
(urrent liabilities6
Accounts payable..................................................................... +.-,4**
(urrent portion of bonds payable............................................. 1,1**
"nterest payable......................................................................... ,0,***
Total current liabilities......................................................... + 1),.**
(urrent ratio A +),0,,** B +1),.** A ).14
Cuic ratio A %+,.,)** D +.,,-**& B +1),.** A .1-
The above ratios measure 38@'s ability to meet short5term obligations. The current ratio indicates that
38@ has 14 percent more cash and relatively liquid assets that are e#pected to be converted to cash in the
short run than it has short5run obligations requiring cash for their satisfaction. This ratio does not
necessarily mean the amount of current assets is adequate, however. ?or e#ample, the accounts payable
and interest payable could be obligations due within the ne#t few days, and it may not be possible to
liquidate accounts receivable and inventories that quicly.
b. (ash !#penses6
(ost of goods sold.................................................................... +)4),1**
Ether e#penses......................................................................... 4/,.**
Total cash e#penses............................................................................... +,.),***
Days' cash A +,.,)** B %+,.),*** B .40& A .4.0 days.
This ratio measures how many days of normal operating e#penses can be paid without adding to the cash
balance. The above ratio indicates that 38@ (ompany has an apparent stocpile of cash. This means
38@ is either planning unusual e#penditures during the ne#t period, or is not properly managing cash.
(ash does not generate a return. There is a trade5off between FinstantG liquidity and the return on
maretable securities.
Some students may argue that purchases, rather than cost of goods sold, should be used in the calculation.
This would not reflect a true Fsteady stateG of operations, since it happened that 38@ built up its
inventory by +,.,)** during the year. The argument for basing the ratio on purchases would be stronger if
the student e#plicitly assumes a long5term buildup of inventory each year %to support increasing sales&;
but then, for consistency, some other cash e#penses should probably be increased, too, thus resulting in
appro#imately the same .4.05day figure. "n any event, there is no implication that such ratio calculations
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are interpretable with great precision. They are most meaningful if calculated for the same company over
a period of years.
c. Days' receivables A >et receivables B %(redit sales B .40& A +.,,-** B %+.,.,2** # .11 B .40&.
A 2- days.
This ratio measures the average collection period of receivables. Although some analysts use total sales
%often because the portion of credit sales is not disclosed&, the above calculation is correct. The result
suggests that 38@'s customers are stretching the payment period.
Cases
Case 5-1: Stern Corporation (A)
&ote1 $he case has been up&ate&!
Approach
This case is designed to give practice in handling the various transactions for accounts receivable and bad
debts. There can be differences of opinion, particularly about the treatment of bad debts recovered, but the
ob$ective is to understand the process, and " do not thin it is important to get agreement as to the Fone
best methodG %if there is such a thing&. This is not a full assignment by itself, but is if taen together with
study of the te#t.
Comments on 2!estions
3uestion '
). Accounts 8eceivable................................................................... /,/40,010
Sales........................................................................................ /,/40,010
,. (ash............................................................................................. /,4-0,2,*
Accounts 8eceivable............................................................... /,4-0,2,*
.. Allowance for Doubtful Accounts............................................... ,4,-02
Accounts 8eceivable............................................................... ,4,-02
%!ntries would also be made to specific accounts receivable, assuming that the account on the balance
sheet is a control account.&
2. Debit (ash +.,412 %+,,)*- for one account and +),044 as partial payment on another&. The rest of the
transaction could be handled in one of three different ways6
%a& (redit Allowance for Doubtful Accounts +2,0/2 %+,,)*- for account collected in full and +,,2-4
for account collected in part with reasonable assurance of future collection of remainder&, and debit
Accounts 8eceivables +/,* %for balance of account partially collected&. This is preferable.
%b& (redit Bad Debt !#pense +.,412 %+,,)*- D +),044&.
%c& (redit some FEther "ncomeG account +.,412.
0. The calculation of the Allowance for Doubtful Accounts and Accounts 8eceivable depends upon
which of the alternatives was employed in handling the collection of written5off accounts in 2 above.
,nder 3a45 the Acco!nts 6eceivable remaining on the boo7s at the end of #//. is calc!lated as
follo8s1
0
Accountin"# $e%t an& Cases '(e ) Instructor*s +anual Anthon,Ha-.ins,+erchant
The bad debt e#pense is *.. percent : +),,2,,21- A +.1,,12. The entry, therefore, would be6
Bad Debt !#pense.............................................................. ,/,--4
Allowance for Doubtful Accounts......................... ,/,--4
The Allowance for Doubtful Accounts remaining on the boos at the end of ,**4 is
calculated as follows6
Allowance for Doubtful Accounts, December .), ,**0.......... +,/,42-
=ess Accounts 8eceivable written off in ,**4........................ ,4,-02
,,1/2
Add increase to Allowance for Doubtful Accounts for
previously written5off accounts which were collected during
the year or deemed collectible in the future.............................
2,0/2
Balance in account.................................................................. 1,.--
Add additional bad debt e#pense needed................................. ,/,--4
Total allowance for Doubtful Accounts, December .), ,**4. . +.1,,12
The Allowance for Doubtful Accounts remaining on the boos at the end of ,**4 is calculated as follows6
Hnder %b& or %c&, in the calculation of Accounts 8eceivable6 the last step in the calculation above is
eliminated, thus leaving an Accountings 8eceivable balance of +),,2),00-.
The Bad Debt !#pense is calculated and recorded the same as shown above.
The Allowance for Doubtful Accounts remaining on the boos as the end of ,**4 is calculated as follows6
Allowance for Doubtful Accounts, December .), ,**0......... +,/,42-
=ess Accounts 8eceivable written off in ,**4........................ ,4,-02
Balance in account................................................................. +,,1/2
Add additional bad debt e#pense............................................ .2,20.
Total Allowance for Doubtful Accounts, December .), ,**4 +.1,,21
3uestion (
4sin" (a) 4sin" (b) or (c)
Accounts 8eceivable, December .), ,**0.............................. + /--,,01
Add increase to AB8 from sales on account during ,**4........ /,/40,010
)*,/0.,-.,
=ess decrease to AB8 for accounts for which payment was
received during ,**4............................................................... /,4-0,2,*
),,4-,2),
=ess accounts written off in ,**4............................................ ,4,-02
+ ),,2),00-
Add that portion still due on previously written5off account
which was paid in part in ,**4 with reasonable assurance of
future payment of the payment of the remainder.....................
/,*
+),,2,,21-
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<(//0 +cGra-1Hill,Ir-in Chapter 2
Balance of accounts as of December .), ,**46
Accounts 8eceivable...................................................................... +),,2,,21- +),,2),00-
=ess allowance for doubtful accounts............................................. .1,,12 .1,,21
+),,*0,,*2 +),,*2,.))
3uestion 5
"n the ratios used for analysis of monetary assets listed below, the results are appro#imately the same
whether method %a&, %b&, or %c& is used.
#//.
(urrent ratio.................................................................................. ,.1
Acid5test ratio............................................................................... ).0
Days' cash..................................................................................... >BA
Days' receivables6 method %a&....................................................... 22.)
method %b& or %c&...................................................................... 22.,
Case 5 -2: Grennell Farm
&ote6 $his case has been up&ate& 6rom the 7le8enth 7&ition.
Approach
This case is a good illustration of a situation where revenue recognition is not a cut 5and5dried question. "t
also provides e#cellent reinforcement of the matching concept and statement articulation. The alternatives
discussed are6 %)& the pro&uction metho&, which recogni9es inventory Fholding gainsG as revenue; %,& the
sales metho&, which is analogous to the financial accounting method of revenue recognition of most
manufacturers and retailers; and %.& the collection metho&, which recogni9es revenues as collected, but is
not quite the same as cash5basis accounting %since costs are accrued&. @hile either the production method
or sales method is acceptable under 3AA;, that is really a moot point since Denise 3rey is the sole owner
of the incorporated farm, and not bound by 3AA;. Ence the issue of how much revenue to recogni9e is
resolved, then how much e#pense to match can be dealt with. Together, these two issues determine how
much gross profit 3rennell farm will be shown as earning.
3uestion '
The calculations shown below for Cuestion ) show the range of sales figures under different recognition
methods. " start with the sales method, then do the collection method, and save the more unusual
production method until last. An issue is whether the entire +)-.,*** Fannual costs not related to the
volume of productionG should be treated as product or period e#pense. Hnless the instructor for some
reason is using this case after (hapter 4, the students may not recogni9e this as an issue or, if they do, not
now how to deal with it in the financial statements. "n any event, " thin it worthwhile for the instructor
to note that these e#penses are by definition fi#ed %do not vary with production volume&, but that some
%especially a portion of salaries and wages& may be production costs and hence strictly speaing should be
used in valuing inventory. %Students often mistaenly use Ffi#ed costsG and Fperiod costsG as synonyms.&
Ef course, the point of Cuestion ) is not $ust practice in revenue and e#pense matching calculations, but
thining about which is the most appropriate method. ?or ta# purposes, 3rey will want to use the
collection method. ?or evaluating the performance of the farm in ,**0, the production method would
seem most useful. This is because there is very little uncertaint concerning the eventual sale of the
.*,***5bushel wheat inventory stored at the farm. This inventory e#ists, not because there are no
customers for it, but because the farm manager chose not to sell it, speculating that future prices will be
higher. This is the same reasoning that $ustifies this unusual revenue recognition method as 3AA;; the
same method is also allowed for precious metals and other minerals where immediate maretability at
1
Accountin"# $e%t an& Cases '(e ) Instructor*s +anual Anthon,Ha-.ins,+erchant
quoted prices obtains. Also, many professional service firms %e.g., accounting firms& recogni9e revenue as
wor is performed by recording $obs in progress at billing rates rather than at cost. The name Hnbilled
8eceivables is often used for this account to emphasi9e that the revenue has already been recogni9ed,
even though it has not yet been billed.
!#hibit A
(ollect the cash
from the customer
(ustomer acnowledges
receipt of the item
(ollection Iethod ;urchase raw material
Ship the product to the
customer and send a
sales invoice
FHsualG Iethod
%Delivery Iethod&
(onvert the raw material
to a finished product
8eceive an order for the product
from a customer ;roduction Iethod
"nspect the product
Store the product in
a warehouse
To generali9e the discussion, " put on the board a Fcash cycleG diagram lie the one in !#hibit A to this
note. Starting with purchases, " go around this wheel and add to its interior the three points at which
revenue can be recogni9ed6 these correspond to the three methods in the case, including the FusualG
method of recogni9ing revenue when goods are shipped. @hen is the FcorrectG point to recogni9e
revenueJ This diagram points out that the answer is not clear5cut. F(onservatismG would say do not
recogni9e the revenue until there is very little uncertainty as to receipt of the cash proceeds, driving the
revenue recognition toward the collection point. FTimelinessG would argue for recogni9ing the revenue
when the Fcritical eventG or FperformanceG has taen place, in this instance as soon as a certainly salable
product has been produced, i.e., the production method for 3rennell. The measurability of income
criterion does not help select a method in this instance, as the Cuestion " calculations are feasible for all
three methods.
3uestion (
The original cost of the land was only +)-1.0* an acre6 it is now appraised %for estate ta# purposes& at
+),*0* per acre, or +,.) million. The cost concept says that, at least prior to the transfer of ownership to
3rey %and possibly even afterwards&, the balance sheet will show the land at its cost, +.10,***. Kowever,
again 3AA; need not prevail here, for 3rey is trying to assess the economic attractiveness of the farm.
Since she could sell the land for +,.) million %or more, if the estate ta# valuation was below maret& and
invest the proceeds elsewhere, she will liely want to use the higher valuation in her assessment. %Again,
this is an argument often given for stating assets at current values6 the asset is, in effect, tying up +,.)
million, not +.10,***.& "f 3rey wants to thin of selling only the )** acres for the development, then she
may thin of the land value as +,.,, million %),/** : +),*0* plus +,,0,***&. The point is that the
+.10,*** historical cost is the least relevant for 3rey's purposes.
3uestion 5
Assuming 3rey agrees that the combination of the production method of revenue recognition and the
+,.,, million land valuation best serve her appraisal purposes, then in ,**0 we have +.,.,.1* net income
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<(//0 +cGra-1Hill,Ir-in Chapter 2
on an owner's equity investment of +,,2-,,)** %+4.1,)** plus +),-20,*** write5up of land&, or a ).
percent before5ta# return on investment. @hen one considers future appreciation of the land, this may
well be a better investment than 3rey would be able to mae with the proceeds from selling the farm.
96E&&E:: FA6M
"ncome Statements
+etho&#
Sales Collection 9ro&uction
Sales................................................................................. +0,,,*** +24,,2**
)
+4)2,)**
0
(ost of goods sold
Beginning inventory............................................ * * *
;roduction
,
.......................................................... )*1,1.* )*1,1.* )*1,1.*
=ess6 !nding inventory........................................ )0,./* ,0,40*
.
*
4
(ost of goods sold............................................... /,,.2* -,,*-* )*1,1.*
3ross margin.................................................................... 2,/,44* .-*,.,* 0*4,.1*
Ether e#penses ................................................................ )-.,*** )-.,*** )-.,***
>et "ncome....................................................................... +,24,44* +)/1,.,* +.,.,.1*
;alance Sheets
(ash.................................................................................. + .*,/** + .*,/** + .*,/**
Accounts receivable.......................................................... 0/,4** *
2
)0),1**
1
"nventory.......................................................................... )0,./* ,0,40* *
=and................................................................................. .10,*** .10,*** .10,***
Buildings and machinery %net&.......................................... )),,0** )),,0** )),,0**
Total assets.......................................................... 0/.,./* 022,*0* 41*,)**
=iabilities %current&........................................................... ..,*** ..,*** ..,***
Ewners' equity
-
................................................................
(ommon stoc and A;"(.................................... 201,0** 201,0** 201,0**
8etained earnings................................................ )*,,-/* 0.,00* )1/,4**
Total owners' equity......................................................... 04*,./* 0)),*0* 4.1,)**
Total liabilities and owners' equity................................... +0/.,./* +022,*0* +41*,)**
&otes1
)
)-*,*** bushels L +,./* 5 ,*,*** bushels L +,./- A )4*,*** but L +,.-/.
,
,)*,*** bushels L +.0). A +)*1,1.*.
.
.*,*** bushels physically in inventory plus ,*,*** bushels FinventoryG at the elevator, reflecting
payment not yet received from the elevator operator.
2
Hnder the collection method, there ae no accounts receivable since sales revenues aer not recogni9ed
until the collection is made.
0
.*,*** bushels L +..*1 D )-*,*** bushels L S,./*. Another approach is as follows6
,)*,*** bushels L +,.-* A +0--,*** %value at harvest&
)-*,*** bushels L *.)* A )-,*** %gain on sales to elevator&
4*4,***
.*,*** bushels L +*.,1 A -,)** %write5up to year5end value&
+4)2,)**
3iven the te#t's description of the production method, " treat +4*4,*** as an acceptable answer, but point
out the logic of writing up the .*,*** bushels on hand for purposes of the year5end balance sheet.
4
Although there are .*,*** bushels physically in inventory, under the production method all wheat is
counted as sold, and hence is not in inventory in an accounting sense.
/
Accountin"# $e%t an& Cases '(e ) Instructor*s +anual Anthon,Ha-.ins,+erchant
1
This includes the +0/,4** FrealG receivable plus +/,,)** recorded as revenue on the .*,*** bushels
produced but not physically sold. Students may create a different account for this +/,,)**, for e#ample,
Hnbilled 8eceivables, which is fine.
-
"f you assume that the case statement F3rennell withdrew most of the earningsG means that 8etained
!arnings at the beginning of the year was 9ero, then the ,**0 drawings can be determined as follows6
Sales Collections Prod!ction
Beginning 8etained !arnings........................................... + * + * + *
;lus6 >et "ncome.............................................................. ,24,44* )/1,.,* .,.,.1*
=ess6 !nding 8etained !arnings....................................... )*,,-/* 0.,00* )1/,4**
Drawings............................................................. +)2.,11* +)2.,11* +)2.,11*
Case 5 -3: Joan Holtz (A)
&ote6 $his case has been up&ate& 6rom the 7le8enth 7&ition!
Approach
These problems are intended to provide a basis for discussing questions about revenue recognition that
are not dealt with e#plicitly in the te#t and that are not sufficiently involved to warrant the construction of
a regular case. "nstructors can pic from among those listed. Some of them can be used as a tae5off point
for elaboration and e#tended discussion by adding F@hat ifJG facts.
Ans8ers to 2!estions
). "f 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 readings6 the unreported usage in December
would be reported in Manuary, and overall revenues for this year would not be materially misstated.
Stated another way, if revenues are based solely on meter readings, the December ,**4 post 5reading
usage %which is recorded in Manuary ,**1& is, in effect, assumed to be the same ,**1 post5reading
usage. ;rior to passage of the )/-4 Ta# 8eform Act, this approach was permitted for income ta#
purposes. The )/-4 act requires the more acceptable %due to better matching& practice6 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 post5reading usage in December ,**4 would in
fact not differ materially from the post5reading usage in December ,**1. The same problem e#ists for
operators of vending machines. The postal service has the opposite problem6 it receives cash from
stamp sales before all of the stamps are used. "t carries a liability %unearned revenues& for this effect.
Both of these e#amples illustrate that even when cash is involved, the measurement of revenue is not
necessarily straightforward.
,. This is one of the problems whose FtrueG resolution depends on events that cannot be forseen at
the end of the accounting period. Some firms count the whole +)*,*** as revenue in ,**4 on the
grounds that it is in hand and that any specific services are undefined andBor separately billable.
Ethers tae the more conservative approach of counting only +0,*** as revenue in ,**4 on the
grounds that the service involved is Freadiness to serve,G and that this readiness e#ists equally in each
year. " prefer the latter approach, based on the matching concept.
.. Iany would argue that the service involved is the cruise and that no revenue has been earned
until the cruise has been completed. Ethers maintain that 8aymond's has completed its FserviceG of
arran"in" the cruise, that it is e#tremely unliely that events will happen in ,**1 that will change its
profit of +,*,***, and that the amount is therefore revenue in ,**4. "ntroduction of the possibility of a
refund lessens the strength of the argument of the latter group. This position can be weaened further
)*
<(//0 +cGra-1Hill,Ir-in Chapter 2
by asing6 %a& @hat if passengers are dissatisfied and demand %or sue for& a refundJ %b& @hat if the
ship owner performs unsatisfactorily and 8aymond's, in order to protect its reputation, steps in and
incurs additional food or other cost to mae the passengers happyJ Students should be reminded to
consider two criteria6 %)& that the agency has substantiall per6orme& its earning activities and %,& that
the income is reliabl measurable.
2. This problem has been debated for many years. Some argue that the +2 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 ,**4 and the full sales value when the trees are sold in ,**1. The
percentage5of5completion method can be used as an analogy. Ethers argue that there has been no
transaction, and no assurance that the trees can be sold for more than +2 in ,**1 because maret
prices may decrease, or pests or fire may destroy them. Typically, firms facing this issue recogni9e no
revenue until harvesting the trees.
0. "f a professional service firm %architects, engineers, consultants, lawyers, accountants, and so on&
values its $obs in progress at billing rates, then it is recogni9ing revenue as the wor is performed
%time applied to pro$ects& rather than waiting until the customer is billed. This is certainly defensible
if the firm has a contract %called a Ftime and materials contractG& that obligates the client to pay for all
time applied to the client's pro$ect6 the critical act of performance is spending the time on the pro$ect,
not billing that time. "n fact, many such firms feel that even with fi#ed5fee contracts, the critical
performance tas is spending time on a pro$ect as opposed to delivering some end item to the client;
they thus record $obs in progress at estimated fee, which would be the same as billing rates for the
time applied provided the pro$ect is within its professional5hour budget. Ef course, whether the
revenue is recogni9ed when the time is applied or when the client is billed does mae a difference in
owners' equity. 8etained earnings will reflect the margin on the time applied sooner if the $obs in
progress inventory is valued at billing rates rather than at cost.
4. >umerous answers are acceptable. " argue that the coupon has nothing to do with the sale of
coffee. "ts purpose is to promote the sale of tea. The 4* cent reimbursements made in ,**4 and the 4*
cent reimbursements made in ,**1 are an e#pense of selling tea in ,**1. Those who tie the coupons
with coffee would say that the entire ,* percent of coupons redeemed is an e#pense of selling coffee
in ,**4 with the amount not yet redeemed being a liability as of December .), ,**4. "t 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 )* cents. "t is 4* cents per coupon that is the cost, not the 0* cent face value.
1. The ban would record the sale of +0** travelers checs for +0*0 as follows6
dr. (ash............................................................... 0*0
cr. ;ayable to American !#press..................... 0**
(ommission 8evenue................................ 0
After the ban remits the +0** cash to American !#press, the latter will mae the following entry6
dr. (ash............................................................... 0**
cr. Travelers (hecs Eutstanding................... 0**
The account credited is a liability account. This account had a balance of many billions of dollars,
which should help students understand why American !#press does not itself levy a fee on the
issuance of travelers checs6 the checs are a great source of interest5free capital to American
!#press.
-. According to FASB Statement :o! ;<, Ianufacturer A cannot record a sale at all under these
circumstances. The merchandise must remain as an asset on Ianufacturer A's balance sheet and a
liability should be recorded at the time the +)**,*** is received from B. This statement precludes
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Accountin"# $e%t an& Cases '(e ) Instructor*s +anual Anthon,Ha-.ins,+erchant
Ianufacturer A from inflating its ,**4 revenues and income by the sort of repurchase agreement
described. FASB ;< was issued to address the perceived abuse of treating such temporary title
transfers as sales.
/. FASB Statement :o! ;2 states that franchise fee revenue should be recogni9ed Fwhen all material
services or conditions relating to the sale have been substantially performed or satisfied by the
franchiser.G Amorti9ation of initial franchise fees should only tae place if continuing franchise fees
are so small that they will not cover the cost of continuing services to the franchisee. Since this
e#ception seems unliely in this case, the +)*,*** franchise fee should be recogni9ed as revenue in
the year received, as soon as the training course has been completed. "nvestors will need to mae their
own $udgment as to what will happen when the maret becomes saturated.
)*. This item is designed to get students to thin about %)& a condition that creates the need for a
change in revenue recognition policy, and %,& the potential need for multiple revenue recognition
policies for a firm.
Tech5=ogic, a manufacturer of computer systems, normally recogni9es revenue when its products are
shipped, a policy common among manufacturing firms. To adopt that policy, managers at Tech5=ogic
must have concluded that the two criteria for revenue recognition were met at shipment6 %)&
Tech5=ogic would have substantially performed what is required in order to earn income, and %,& the
amount of income Tech5=ogic would receive could be reliably measured.
@ith the sale of the computer systems to the organi9ation in one of the former Soviet Hnion
countries, however, Tech5=ogic's ability to satisfy these two criteria changed. Although the first
criterion was still met, the uncertainty about whether %and how much& foreign e#change the customer
could obtain left the second criterion in doubt. Kence, Tech5=ogic should not recogni9e 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 recogni9e revenue.
This item can also be used to discuss the fact that firms often have more than one revenue recognition
policy. Tech5=ogic would not completely change its revenue policy to Fcash receiptG for all sales at
the time it begins to sell computers to organi9ations in countries where the availability of foreign
e#change currency is in doubt. 8ather, it would be liely to have two revenue recognition policies; at
shipment, for products sold to organi9ations in countries where the availability of foreign e#change
currency is not in doubt; and cash receipt, for products sold to organi9ations in countries where the
availability of foreign e#change currency is in doubt.
Because they manufacture products and provide a variety of services, computer manufacturers often
have a variety of revenue recognition policies. ?or e#ample, a computer manufacturer might
recogni9e 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.
"tem )* was inspired by events that occurred at Sequoia Systems in )//,. Sequoia evidenced several
instances of aggressively booing revenue. Ene of these involved a Siberian steel mill. According to
$he =all Street Journal#
!#ecutives signed off last year on the sale of a +. million computer destined for a steel mill in
Siberia. But government approvals and hard currency to pay for the system got stalled, even
though +, million of revenue was booed in the fiscal year ended Mune .*, and another +) million
was going to be taen in the first quarter ended last month, insiders say.
)
Sequoia e#ecutives stated that they e#pected this ;obthe Siberian steel mill;cb and similar sales Fwill
)
$he =all Street Journal, FSequoia Systems 8emains Kaunted by ;hantom Sales,G Ectober .*, )//,, p. B-.
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ultimately prove to be good businessG and that the decision to boo it as revenue Fwas supported by the
revenue recognition policy that we had in place.G
#
Kowever, under investigation by the S!( and facing
lawsuits by shareholders, Sequoia twice restated revenues following the end of fiscal year )//,, reducing
originally reported revenues by more than )* percent.
.
Case 5-5: Boston Automation. Systems, Inc.
*
Note: A shorter version of the Eleventh Edition case.
David Fisher, the chief financial officer of Boston Automation Systems, Inc. a capital equipment
manufacturing and testing instrument supplier to a variety of electronic-based industries, including the
semiconductor industry, was reviewing the revenue recognition practices of the companys three
divisions. The review was undertaken in anticipation of disclosing in the companys third quarter 2000
Form 10-Q filing with the Securities and Exchange Commission (SEC) and the possible impact on the
company of the revenue recognition and reporting guidelines set forth in the SECs Staff Accounting
Bulletin No. 101, Revenue Recognition in Financial Statements (SAB 101). SAB 101 had to be adopted
no later than the fourth quarter of 2000.
In particular, Fisher was concerned about the effect of SAB 101s guidelines covering customers
acceptance and unfulfilled seller obligations on the companys revenue recognition practices. Fishers
staff had been studying this aspect of SAB 101 and the companys revenue recognition practices for
several months. As a test of his own understanding of the issue, Fisher selected from each of the
companys three divisions a limited number of representative sale transactions to review. In each situation
the question Fisher posed was,
Assuming all other revenue recognition criteria are met other than the issues raised by any
customer acceptance provisions, when should revenue be recognized?
Students are asked to assume the role of Fisher and reach conclusions as to the appropriate revenue
recognition decision in each of the sale transactions reviewed by Fisher.
1
Teaching Plan
The class discussion can open with a brief financial analysis of the companys performance and then
proceed in the order of the questions listed at the end of the case.
The financial analysis should focus on the companys high sales growth and its 1998 problems and 1999
recovery. This discussion will provide some insight and background into why changing revenue
recognition methods is so important to this company.
Question 1 is designed to ensure that students identify the companys current revenue recognition
accounting policies. This knowledge will be used later in the class to highlight the serious threat SAB 101
,
"bid.
.
"bid.
:
)
The 3lendale Division and Advanced Technology Division sale transactions reviewed by ?isher and the teaching note's
discussion of these sale transactions are based primarily on case e#amples included in !#hibit A of Fthe Securities and !#change
(ommission'sG Staff Accounting Bulletin >o. )*)6 F8evenue 8ecognition in ?inancial Statements555?requently Ased Cuestions
and Answers.G
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Accountin"# $e%t an& Cases '(e ) Instructor*s +anual Anthon,Ha-.ins,+erchant
poses to the company. It may have to defer more revenue than it did before it adopted SAB 101.
Question 2s purpose is to give the subsequent class discussion of the individual sale transactions a
managerial perspective, which should help to make what could be a dull accounting discussion more
relevant to the students. The revenue recognition decisions Fisher must make in the next quarter have
potentially significant adverse consequences for the company. The accounting decisions are important
managerial decisions.
Question 3 should take up the bulk of the class. As each sale transaction accounting issue is resolved, the
instructor should ask the class to explain the accounting entries required by the conclusion. To test the
students understanding of their conclusions, the instructor should ask the class to reconsider the facts of a
resolved situation with modifications. For example, in the Technical Devices Division example the
instructor might change the case facts by stating the division seldom, if ever in the past accepted product
returns from distributors. Then, the instructor should ask, Does this fact change alter your decision?
The final question should lead to an open discussion, which the instructor should focus on whether
accounting standards should be stated in general principles (revenue should be recognized when earned
and realized) or detailed guides (SAB 101). This is a fundamental accounting standard setting issue. For
example, many believe the International Accounting Standards Committees (IASC) approach to writing
standards is preferable to the Financial Accounting Standards Boards (FASB) approach. The IASC
writes standards in terms of general principles with some guidelines on their application and then leaves it
up to management to apply the standard in a way that reflects the particular facts of the situation. In
contrast, the FASB writes standards that are more like cook books. They are more like SAB 101, which
is very detailed in its guidance and much more restrictive in its permitted use of judgment.
SA; 1/1
The general rule governing revenue recognition is6
8evenue should not be recogni9ed until it is reali9able and earned.
Because the general rule has been abused by some companies, more specific criteria for revenue
recognition have been prescribed by the S!( in SAB )*). As a result, revenue is now considered to be
reali9ed and earned when6
;ersuasive evidence of an order arrangement e#ists,
Delivery of the ordered goods has occurred or services have been rendered6
The seller's prince to the buyer is fi#ed or determinable, and,
(ollectibility of the sale proceeds is reasonably assured.
9ersuasi8e 78i&ence
;urchase order and sale agreement documentation practices vary widely between customers, companies,
and industries. The S!( appears to be willing to accept as persuasive evidence of an agreement these
practices as long as there is some form of written or electronic evidence that a binding final customer
purchase authori9ation, including the terms of sale, is in the hands of the seller before revenue is
recogni9ed.
>eli8er
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Typically revenue is recogni9ed when delivery has occurred and the customer has taen title and assumed
the riss and rewards of ownership of the goods specified in the customer's purchase order or sales
agreement. Iore specifically,
Delivery is not considered to have occurred unless the product has been delivery to the
customer's place of business.
"f uncertainty e#ists about a customer's acceptance of a product or service, revenue should not be
recogni9ed even if the product is delivered or the service performed.
8evenue should not be recogni9ed until the seller has substantially completed or fulfilled the
terms specified in the purchase order or sales agreement.
"n licensing and similar arrangements, delivery does not occur for revenue recognition purpose
until the license term begins.
9er6ormance
SAB )*) requires substantial performance of the sales arrangement by the seller and acceptance by the
customer of the product or services rendered before revenue can be recogni9ed SAB )*) notes6
A seller should substantially complete to fulfill the terms specified in the sales arrangements, and
After delivery or performance, if uncertainty e#ists about acceptance, revenue should not be
recogni9ed until after acceptance occurs.
There are two e#ceptions to the above requirement. Assuming all of the other recognition criteria are met,
the first e#ception is that revenue in its entirety can be recogni9ed if the seller's remaining performance
obligation is inconsequential or perfunctory. "n this case, any related future costs must be accrued and
e#pensed when revenue is recogni9ed.
A remaining performance obligation is not inconsequential or perfunctory if6
The remaining performance obligation is essential to the functionality of the delivered products or
services.
?ailure to complete the activities would result in the customer receiving full or partial refund or
re$ecting the product or services rendered to date.
"n considering if a remaining performance obligation is or is not inconsequential or perfunctory, the S!(
staff has indicated that the following factors, which are not all5inclusive, would be considered.
The seller does not have a demonstrated history of completing the remaining tass in a timely
manner and reliably estimating their costs.
The cost or time to perform the remaining obligations for similar contracts historically has varied
significantly from one instance to another.
The sills or equipment required to complete the remaining activity are speciali9ed or are not
readily available in the maretplace.
The cost of completing the obligation or the fair value of that obligation is more than significant
in relation to such items as the contract fee, gross profit, and operating income.
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Accountin"# $e%t an& Cases '(e ) Instructor*s +anual Anthon,Ha-.ins,+erchant
The period before the remaining obligation will be e#tinguished is lengthy. 8egistrants should
consider whether reasonably possible variations in the period to complete performance affect the
certainty that the remaining obligations will be completed successfully and on budget.
The timing of payment of a portion of the sales price is coincident with completing performance
of the remaining activity.
The second e#ception is a multiple5element deliverables sales arrangement. "n this case, a portion of the
contract revenue may be recogni9ed when the seller has substantially completed or fulfilled the terms of a
separate contract element. ;ending additional accounting guidance, on multiple5element revenue
arrangements, the S!( indicated that it will accept any reasoned method of accounting for multiple5
element arrangements that is applied, consistently and disclosed appropriately. The S!( will not ob$ect to
a method that includes the following conditions.
To be considered a separate element, the product or service represents a separate earnings
process.
8evenue is allocated among the elements based on their fair value.
"f an undelivered element is essential to the functionality of a delivered element, no revenue is
allocated to the delivered element until the undelivered element is delivered.
"n the case where a customer is not obligated to pay a portion of the contract price allocable to delivered
equipment until installation or similar service, recognition of revenue on the delivered equipment may be
recogni9ed if the installation is not essential to the functionality of the equipment. !#amples of indicators
that installation is not essential to the functionality of the equipment include6
The equipment is a standard product.
"nstallation does not significantly alter the equipment's capabilities.
Ether companies are available to perform that $ob.
(onversely, e#amples of indicators that the installation is essential to the functionality of the equipment
include6
The installation involves significant changes to the features or capabilities of the equipment or
building comple# interfaces or connections.
The installation services are unavailable from other vendors.
(ontractual customer acceptance provisions must be satisfied before revenue can be recogni9ed.
(ustomer acceptance provisions typically come in one of four forms6
). Acceptance provisions in arrangements that purport to be for trial or evaluation purposes.
"n substance, these transactions are consignment5type sales, and revenue should not be recogni9ed until
earlier of acceptance or the acceptance provisions lapses.
,. Acceptance provisions that grant a right of return or e#change on the basis of sub$ective matters.
.. Acceptance provisions that grant a right of replacement on the basis of seller5specified ob$ective
criteria.
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<(//0 +cGra-1Hill,Ir-in Chapter 2
8evenue can be recogni9ed rather than deferred so long as a provision can be reasonably determined for
the amount of future returns based upon historical return e#perience of a similar sufficiently large volume
of homogeneous transaction.
2. Acceptance provisions based on customer5specified ob$ective criteria.
?ormal customer sign5off provides the best evidence of acceptance. "n its absence, revenue can be
recogni9ed rather than deferred if the seller can reliably demonstrate that a delivered product meets the
customer5specified ob$ective criteria.
Consi"nment1$pe $ransactions
;roducts shipped pursuant to a consignment arrangement should not be recorded as revenue since the
consignee has not assumed the riss and rewards of ownership. This is long5standing rule. SAB )*) goes
further. "t states that the following characteristics in a transaction preclude revenue recognition even if
title to the product has passed to the buyer6
The buyer has the right to return the product and
the buyer does not pay the seller at the time of sale, and the buyer is not obligated to pay the
seller at a specified date or dates;
the buyer does not pay the seller at the time of sale but rather is obligated to pay at a
specified date or dates, and the buyer's obligation to pay is contractually or implicitly
e#cused until the buyer resells the product or subsequently consumes or uses the product;
the buyer's obligation to the seller would be changed %e.g., the seller would forgive the
obligation or grant a refund& in the event of theft or physical destruction or damage of the
product;
the buyer acquiring the product for resale does not have economic substance apart from that
provided by the seller, or
the seller has significant obligations for future performance to directly bring about resale of
the product by the buyer.
The seller is required to repurchase the product %or a substantially identical product or processed
goods of which the product is a component& at specified prices that are not sub$ect to change
e#cept for fluctuations due to finance and holding costs, and the amounts to be paid by the seller
will be ad$usted, as necessary to cover substantially all fluctuations in costs incurred by the buyer
in purchasing and holding the product %including interest&. The indicators of the latter condition
include6
The seller provides interest5free or significantly below maret financing to the buyer
beyond the seller's customary sales terms and until the products are resold.
The seller pays interest cost on behalf of the buyer under a third5party financing
arrangement or
The seller has a practice of refunding %or intends to refund& a portion of the original sales
price representative of interest e#pense for the period from when the buyer paid the seller
until the buyer resells the product.
The seller guarantees the resale value of equipment to a purchaser, and the transaction
does not qualify for sale5type lease accounting. This transaction should be recorded as an
operating lease.
The product is delivered for demonstration purposes.
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Accountin"# $e%t an& Cases '(e ) Instructor*s +anual Anthon,Ha-.ins,+erchant
Revenue Recognition Methods
Boston Automation Systems has adopted the following revenue recognition policies.
1. Recognize revenue upon product shipment
2. Recognize service revenue ratably as service is provided over the period of the related contract.
3. Recognize long-term contract revenue using the percentage-of-completion accounting method
4. Revenue from multi-deliverables contracts is allocated to each deliverable based upon the
amounts charged for each deliverable when sold separately.
5. The company provides estimated warranty costs when product revenue is recognized.
The instructor should ask students to explain the accounting entries for each revenue recognition policy as
it is identified by the class. At the end of this part of the discussion the instructor should ask a student to
explain the accounting entries the company will make to record the cumulative effect adjustment resulting
from the change in accounting principles.
The recognition policy most likely to be impacted by SAB 101 is recognize revenue upon product
shipment. In particular, those sale transactions that involve customer acceptance and unfulfilled
obligations subsequent to shipment.
While the students do not know it, the instructor should be aware that SAB 101 specifically excludes the
percentage-of-completion accounting method from its scope.
Fishers Concerns
An examination of Boston Automation Systems consolidated financial statements clearly shows that the
company has been growing both its sales and net income at a double-digit rate. If more revenue must be
deferred as a result of applying SAB 101, this high growth rate might be harder to manage or achieve in
the future. On the other hand, deferral of product sale revenue (when combined with the unearned service
revenue already on the balance sheet) may dampen some of the cyclical industry effect on the volatility of
its companys revenues and earnings. A change in the revenue recognition methods may lead some to
question the companys rebound from its 1998 problems (excess inventory and lower profits.)
The Advanced Technology Division appears to be the division that will most likely to be impacted by
SAB 101. It sales transactions involve complex equipment and appear often to involve significant
installation and equipment performance obligations.
The troubled Technical Devices Divisions sales strategy shift and the related inventory loading of its
distribution channels might lead to an adverse earning quality reaction by investors if the division booked
the mechanical testing device sales immediately and investors learned of it. Fisher should be concerned
about this possibility.
Fisher might find the cumulative effect adjustment troublesome. It will be a charge to earnings and a
credit to deferred revenues. Some investors may react negatively to this one-time charge thinking it
implies the company had been too aggressive in its past revenue recognition practices by recording
revenue (and earnings) prematurely.
Fisher should also recognize that the companys general revenue recognition policy needs to change. In
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<(//0 +cGra-1Hill,Ir-in Chapter 2
the future revenue should be recognized upon delivery (not shipment) since title passes to the customer
upon delivery.
Sales Transactions
Fishers decisions on the appropriate revenue recognition accounting for each of the sales transactions he
reviewed is presented below.
Trycom, Inc.
While the SEC staff presumed that customer acceptance provisions are substantive provisions that
generally result in revenue deferral, that presumption can be overcome. Although the contract includes a
customer acceptance clause, acceptance is based on meeting the divisions published specifications for a
standard model. The division demonstrates that the equipment shipped meets the specifications before
shipment, and the equipment is expected to operate the same in the customers environment as it does in
the sellers. In this situation, the division should evaluate the customer acceptance provision as a
warranty. If the division can reasonably and reliably estimate the amount of warranty obligation, revenue
should be recognized upon delivery of the equipment with an appropriate liability for probable warranty
obligations.
White Electronics Company
Although the contract includes a customer acceptance clause that is based, in part, on a customer specific
criterion, the division demonstrates that the equipment shipped meets the objective criterion, as well as
the published specifications, before shipment. Therefore, the division should evaluate the customer
acceptance provision as a warranty. If the division can reasonably and reliably estimate the amount of
warranty obligations, it should recognized revenue upon delivery of the equipment; with an appropriate
liability for probably warranty obligations.
Silicon Devices, Inc.
This contract includes a customer acceptance clause that is based, in part, on a customer specific criterion,
and the division cannot demonstrate that the equipment shipped meets that criterion before shipment.
Accordingly, the contractual customer acceptance provision is substantive and is not overcome upon
shipment. Therefore, the division should wait until the product is successfully integrated at its customers
location and meets the customer-specific criteria before recognizing revenue. While this is best evidenced
by formal customer acceptance, other objective evidence that the equipment has met the customer-
specific criteria may also exist (e.g., confirmation from the customer that the specifications were met).
Analog Technology, Inc.
While the division believes that its equipment can be made to meet the customers specifications, it is
unable to demonstrate that it has delivered what the customer ordered until installation and testing occurs.
Accordingly, it would be inappropriate for the division to recognize any revenue until it has demonstrated
that it has delivered equipment meeting the specifications set forth in the contract. This would normally
occur upon customer acceptance.
Specialty Semiconductor, Inc.
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Accountin"# $e%t an& Cases '(e ) Instructor*s +anual Anthon,Ha-.ins,+erchant
Upon delivery, the division has completed the earnings process and met the delivery criterion with respect
to the equipment because it has demonstrated that the equipment delivered to the customer meets the
requirements of the customers order. However, because the customer is not obligated to pay the division
if installation of the equipment is not completed, no revenue may be recognized until installation is
complete and the customer becomes obligated to pay. Conversely, if the division has an enforceable claim
at the balance sheet date through which it can realize some or all of the $20 million fee even if it failed to
fulfill the installation obligation, deferral of a lesser amount, but not less than the estimated fair value of
the installation (i.e., $500,000), would be appropriate.
Alternatively, if the divisions policy is to defer all revenue until installation is complete, recognition of
the $20,000,000 fee upon completion of installation would be appropriate. The divisions policy should
be appropriately disclosed and consistently applied.
Micro Applications, Inc.
Upon delivery, the division has completed the earnings process and met the delivery criterion with respect
to the equipment because it has demonstrated that the equipment delivered to the customer meets the
requirements of the customers order. In addition, the buyers obligation to pay the fee is not contingent
upon completion of installation. Therefore, the division should recognize the revenue allocable to the
equipment, $19,500,000, as revenue upon delivery. The remaining $500,000 of the arrangement fee
should be recognized when installation is performed.
Alternatively, if the divisions policy is to defer all revenue until installation is complete, recognition of
the $20,000,000 fee upon completion of installation would be appropriate. This policy should be
appropriately disclosed and consistently applied.
XL Semi, Inc.
The XL Semi, Inc., order is one unit for accounting purposes, rather than an equipment sale, and an
installation sale. Installation of the equipment would affect the quality of use and the value to the
customer of the equipment. Likewise, the equipment is essential to the value of the installation.
Additionally, because neither deliverable can be purchased from another unrelated vendor, the separate
deliverables in the arrangement do not meet the criteria for segmentation. Further, due to the specialized
skill involved in the installation of the equipment, installation is considered to be substantive, rather than
inconsequential or perfunctory. There is a strong presumption that the revenue recognition should be
delayed until customers acceptance is obtained following the completion of installation.
Technical Devices Division
The passing of title, the absence of evidence that the distributors do not have the capability to pay for the
devices and the products established market acceptance support immediate revenue recognition with a
provision for anticipated returns. However, the unsettled state of the product market, the uncertainty
surrounding the future sales level, and the absence of historical return data for distributor sales to high
volume customers argues for revenue deferral on the grounds that return provisions cannot be estimated
reliably.
The distributors unusual extended payment terms, reflecting the expected sell-through of the mechanical
testing devices coupled with the divisions past generous unwritten return practices suggest that the so-
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<(//0 +cGra-1Hill,Ir-in Chapter 2
called sale is in substance a consignment-type transaction. Revenue should be recognized by the division
on a distributor sell-through basis.
The divisions excess inventory charge raises the question: Was any of this written down inventory
resold during 1999 and, if so, what was the cost of goods sold? Typically excess inventory is written
down to zero cost.
Fisher should make this inquiry since the profit earned on the subsequent sale of written-down excess
inventory should be disclosed under GAAP.
Cookbook Rules Versus General Principles
There are two basic approaches to standard setting: Issue detailed rules or standards that set forth
accounting principles in the form of general principles.
The tendency of the FASB has been to publish, accounting standards with detailed implementation
requirements and guidelines. This approach to standard setting has been characterized as a cookbook
approach. It is the result of a need on the part of practicing public accountants, for guidance in the
application of accounting standards, investors seeking uniform accounting by companies to facilitate
intercompany comparisons, and a general belief that this approach will produce financial statements that
are fair to all who rely upon them. Without detailed standards, the supporters of this approach claim,
some management will take advantage of the lack of guidance to issue misleading statements that will
lower the confidence of statement users in all financial statements.
The supporters of the proposition that accounting principles should embody principles rather than detailed
rules claim accounting rules cannot cover every situation. As a result there will always be some situations
that rules will miss but which would be covered by a well-stated general principle.
Accounting for Equity Transactions
If time permits, the instructor might want to use the companys unusual accounting for equity transactions
to cover accounting for equity transactions. The unusual accounting includes accounting for a stock split
as a dividend-(debit common stock, credit paid in capital) like transaction (but no change to retained
earnings) to avoid changing the par value of the split stock and the reduction of common stock and paid-
in capital to reflect the acquisition of its own stock (no treasury stock account) as if it was canceled when
in fact the required stock is not cancelled (it is outstanding but not issued). The instructor may also want
to include in this discussion the accounting for the stock option tax benefits (a capital rather than an
income transaction.)
Summary
Clearly, the SECs experience has led it to conclude after reviewing revenue recognition accounting
practices in situations similar to those described in the case that the application of general principles, does
not always lead to the appropriate accounting decision. The SECs response was to provide more
guidance in the area of revenue recognition than was provided by the general principle that revenue
should be recognized when it is earned and realized. This SEC response had a profound impact on the
revenue recognition practices of many companies. For example, it ranged from retailers changing the way
they accounted for lay-a-way plans (revenue was deferred rather than recognized immediately) to
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Accountin"# $e%t an& Cases '(e ) Instructor*s +anual Anthon,Ha-.ins,+erchant
manufacturers like Boston Automation Systems with significant post-delivery obligations (they had to
defer rather than recognize income immediately).
,,