Chapter 05 - Revenue and Monetary Assets

CHAPTER 5 REVENUE AND MONETARY ASSETS

Changes from Twelfth Edition The chapter has been updated. A new case Wareham SC Systems, Inc has been added to replace Boston Automation Systems Inc. Bausch & Lomb, Inc. has been dropped. 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 know which ones they will be. Even when they do understand this, the chain of transactions involved in estimating bad debts, writing off specific accounts, and booking bad debts recovered, is complicated and not easy to follow. If experience is any guide, it is quite likely 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 excellent opportunity for a realistic discussion of alternative ways of measuring revenue and of valuing assets. Joan Holtz (A) is a different type of case. It is a device for raising several discrete, separable problems about the subject matter of the chapter, from which the instructor can pick and choose those he or she wishes to take up in class. (It probably is not feasible to discuss all of them.) Wareham SC Systems involves a review of a companys revenue recognition practices in the light of the SECs SAB 101 (a similar version of this case (Boston Automation Systems, Inc.) was included in the Twelfth Edition).

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Problems Problem 5-1

Sale Method Jan. Feb. Mar. April May June Sales.................................................................................................................................................................................................. $12,000 $ 8,000 $13,000 $11,000 $9,000 $13,500 Cost of goods sold............................................................................................................................................................................. 7,800 5,200 8,450 7,150 5,850 8,775 Gross margin..................................................................................................................................................................................... $ 4,200 $2,800 $ 4,550 $ 3,850 $3,150 $ 4,725

Installment Method Jan. Feb. Mar. April May June Sales.................................................................................................................................................................................................. $11,000 $10,000 $11,500 $10,500 $10,500 $9,500 Cost of goods sold............................................................................................................................................................................. 7,150 6,500 7,475 6,825 6,825 6,175 $ 3,850 $ 3,500 $ 4,025 $ 3,675 $ 3,675 $3,325 Problem 5-2

Completed Contract Percentage of Completion This Year Next Year This Year Next Year Income excluding motel (000)........................................................................................................................................................... $1,250 $1,250 $1,250 $1,250 Income from motel project................................................................................................................................................................ 0 750 450 300 Income before taxes.......................................................................................................................................................................... $1,250 $2,000 $1,700 $1,550 Problem 5-3 To record the write-off: If Alcom uses the direct write-off method dr. Bad debt Expense.................................................................. cr. Accounts Receivable......................................................... If Alcom uses the allowance method: dr. Allowance for Doubtful Accounts........................................ cr. Accounts Receivable................................................ To record the partial payment: If Alcom uses the direct write-off method: Cash........................................................................................... Bad Debts Recovered............................................................ (or Bad Debt Expense............................................................ If Alcom uses the allowance method: Either of the above two entries or: Cash........................................................................................... Allowance for doubtful accounts........................................... $950 $950 $950) $950 $950 $3,000 $3,000 $3,000 $3,000

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Problem 5-4 The Allowance for Doubtful Accounts should have a balance of $51,750 on December 31. The supporting calculations are shown below: Days Account Outstanding Amount 0-15 days $450,000 16-30 days 150,000 31-45 days 75,000 46-60 days 45,000 61-75 15,000 Balance for Allowance for Doubtful Accounts Expected Percentage Uncollectible* .01 .06 .20 .35 .50 Estimated Uncollectible $ 4,500 9,000 15,000 15,750 7,500 $51,750

The accounts that have been outstanding over 75 days ($15,000) and have zero probability of collection would be written off immediately and not be considered when determining the proper amount of the Allowance for Doubtful Accounts. b. Accounts Receivable....................................................................... Less: Allowance for Doubtful Accounts.......................................... Net Accounts Receivable.................................................... $735,000 51,750 $683,250

c. The year-end bad debt adjustment would decrease the years before-tax income by $29,250, as shown below: Estimated amount required in the Allowance for Doubtful Accounts.................................................................................... Balance in the account after write-off of bad accounts but before adjustment.................................................................................. Required charge to expense.............................................................. Problem 5-5 Green Lawns books: dr. Inventory on Consignment.......................................................... cr. Finished Goods Inventory....................................................... 8,400 8,400 $51,750 22,500 $29,250

Note that at this point the $12,600 wholesale price (Green Lawns revenue when these goods are sold) is irrelevant. Carsons books: No entry; the goods are not owned by Carson and hence are not inventory on Carsons books; similarly, Carson does not as yet owe Green Lawn for these goods. Green Lawns books:

(1-Probability of collection.)

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dr. Accounts Receivable................................................................... Cost of Goods Sold...................................................................... cr. Sales................................................................................... Inventory on Consignment.................................................. (This can be shown as two entries.) Carsons books: dr. Cash or Accounts Receivable...................................................... Cost of Goods Sold...................................................................... cr. Sales................................................................................... Accounts Payable................................................................. (This also can be shown as two entries.) Problem 5-6 20 x 4 20 x 5 20 x 6 Revenue..................... $980,000 $1,470,000 $2,205,000 Costs.......................... 721,000 1,190,000 1,715,000 Income....................... $259,000 $ 280,000 $ 490,000 Revenue equals percentage completed during the year times fixed price.

5,040 3,360 5,040 3,360

6,720 5,040 6,720 5,040

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Problem 5-7 The GRW Companys current assets and current liabilities at year-end are shown below. Current assets: Cash......................................................................................... Accounts receivable................................................................. Less: Allowance for bad debts................................................. Net accounts receivable............................................................ Beginning inventory................................................................. Purchases.................................................................................. Available inventory.................................................................. Less: Cost of goods sold........................................................... Ending inventory...................................................................... Total current assets.............................................................. Current liabilities: Accounts payable..................................................................... Current portion of bonds payable............................................. Interest payable......................................................................... Total current liabilities......................................................... Current ratio = $125,200 / $71,300 = 1.76 Quick ratio = ($23,100 + $32,800) / $71,300 = .78 $ 23,100 $ 34,650 1,850 32,800 46,200 184,800 231,000 161,700 69,300 $125,200 $38,600 7,700 25,000 $ 71,300

The above ratios measure GRWs ability to meet short-term obligations. The current ratio indicates that GRW has 76 percent more cash and relatively liquid assets that are expected to be converted to cash in the short run than it has short-run obligations requiring cash for their satisfaction. This ratio does not necessarily mean the amount of current assets is adequate, however. For example, the accounts payable and interest payable could be obligations due within the next few days, and it may not be possible to liquidate accounts receivable and inventories that quickly. b. Cash Expenses: Cost of goods sold.................................................................... Other expenses......................................................................... Total cash expenses............................................................................... Days cash = $23,100 / ($231,000 / 365) = 36.5 days. This ratio measures how many days of normal operating expenses can be paid without adding to the cash balance. The above ratio indicates that GRW Company has an apparent stockpile of cash. This means GRW is either planning unusual expenditures during the next period, or is not properly managing cash. Cash does not generate a return. There is a trade-off between instant liquidity and the return on marketable securities.

$161,700

69,300 $231,000

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Some students may argue that purchases, rather than cost of goods sold, should be used in the calculation. This would not reflect a true steady state of operations, since it happened that GRW built up its inventory by $23,100 during the year. The argument for basing the ratio on purchases would be stronger if the student explicitly assumes a long-term buildup of inventory each year (to support increasing sales); but then, for consistency, some other cash expenses should probably be increased, too, thus resulting in approximately the same 36.5-day figure. In any event, there is no implication that such ratio calculations are interpretable with great precision. They are most meaningful if calculated for the same company over a period of years. c. Days receivables = Net receivables / (Credit sales / 365) = $32,800 / ($323,400 x .77 / 365).

= 48 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 GRWs customers are stretching the payment period.

Cases
Case 5-1: Stern Corporation (A) Note: The case has been update from the Twelfth Edition. 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 objective is to understand the process, and I do not think it is important to get agreement as to the one best method (if there is such a thing). This is not a full assignment by itself, but is if taken together with study of the text. Comments on Questions

Question 1
Accounts Receivable................................................................... 9,965,575 Sales........................................................................................ 9,965,575 2. Cash............................................................................................. 9,685,420 Accounts Receivable............................................................... 9,685,420 3. Allowance for Doubtful Accounts............................................... 26,854 Accounts Receivable............................................................... 26,854 (Entries would also be made to specific accounts receivable, assuming that the account on the balance sheet is a control account.) 4. Debit Cash $3,674 ($2,108 for one account and $1,566 as partial payment on another). The rest of the transaction could be handled in one of three different ways: (a) Credit Allowance for Doubtful Accounts $4,594 ($2,108 for account collected in full and $2,486 for account collected in part with reasonable assurance of future collection of remainder), and debit Accounts Receivables $920 (for balance of account partially collected). This is preferable. (b) Credit Bad Debt Expense $3,674 ($2,108 + $1,566). 1.

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(c) Credit some Other Income account $3,674. 5. The calculation of the Allowance for Doubtful Accounts and Accounts Receivable depends upon which of the alternatives was employed in handling the collection of written-off accounts in 4 above. Under (a), the Accounts Receivable remaining on the books at the end of 2010 is calculated as follows: Accounts Receivable, December 31, 2009.............................. Add increase to A/R from sales on account during 2010........ Less decrease to A/R for accounts for which payment was received during 2010............................................................... Less accounts written off in 2010........................................... $ 988,257 9,965,575 10,953,832 9,685,420 1,268,412 26,854 $ 1,241,558

Add that portion still due on previously written-off account which was paid in part in 2010 with reasonable assurance of future payment of the payment of the remainder.....................

920 $1,242,478

The bad debt expense is 0.3 percent * $1,242,478 = $37,274. The entry, therefore, would be: Bad Debt Expense.............................................................. 29,886 Allowance for Doubtful Accounts........................ 29,886 The Allowance for Doubtful Accounts remaining on the books at the end of 2010 is calculated as follows: Allowance for Doubtful Accounts, December 31, 2009.......... $29,648 Less Accounts Receivable written off in 2010........................ 26,854 2,794 Add increase to Allowance for Doubtful Accounts for previously written-off accounts which were collected during the year or deemed collectible in the future............................. Balance in account.................................................................. Add additional bad debt expense needed................................. Total allowance for Doubtful Accounts, December 31, 2010..

4,594
7,388

29,886
$37,274

The Allowance for Doubtful Accounts remaining on the books at the end of 2010 is calculated as follows: Under (b) or (c), in the calculation of Accounts Receivable: the last step in the calculation above is eliminated, thus leaving an Accountings Receivable balance of $1,241,558. The Bad Debt Expense is calculated and recorded the same as shown above. The Allowance for Doubtful Accounts remaining on the books as the end of 2010 is calculated as follows:

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Allowance for Doubtful Accounts, December 31, 2009......... Less Accounts Receivable written off in 2010....................... Balance in account................................................................. Add additional bad debt expense............................................ Total Allowance for Doubtful Accounts, December 31, 2010

$29,648 26,854 $2,794 34,453 $37,247

Question 2
Using (a) Balance of accounts as of December 31, 2010: Accounts Receivable...................................................................... Less allowance for doubtful accounts............................................. $1,242,478 37,274 $1,205,204 Using (b) or (c) $1,241,558 37,247 $1,204,311

Question 3
In the ratios used for analysis of monetary assets listed below, the results are approximately the same whether method (a), (b), or (c) is used.

2010
Current ratio.................................................................................. Acid-test ratio............................................................................... Days cash.................................................................................... Days receivables: method (a)....................................................... method (b) or (c)...................................................................... Case 5- 2: Grennell Farm Note: This case has been updated from the Twelfth Edition. Please see the printed Instructors Resource Manual for the Harvard Teaching Notes. Case 5- 3: Joan Holtz (A) Note: This case has been updated from the Twelfth Edition. Approach These problems are intended to provide a basis for discussing questions about revenue recognition that are not dealt with explicitly in the text and that are not sufficiently involved to warrant the construction of a regular case. Instructors can pick from among those listed. Some of them can be used as a take-off point for elaboration and extended discussion by adding What if? facts. Answers to Questions 2.7 1.5 N/A 44.1 44.2

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1. If electricity usage tended to be fairly constant from month to month, one could argue in this case for basing reported revenues solely on the actual meter readings: the unreported usage in December would be reported in January, and overall revenues for this year would not be materially misstated. Stated another way, if revenues are based solely on meter readings, the December 2009 post-reading usage (which is recorded in January 2010) is, in effect, assumed to be the same 2010 post-reading usage. Prior to passage of the 1986 Tax Reform Act, this approach was permitted for income tax purposes. The 1986 act requires the more acceptable (due to better matching) practice: estimating actual usage for the part of December after meters are read and reporting that usage as part of the revenues of that year. This is moresound accounting, in that with weather fluctuations and energy conservation efforts, it is questionable whether the post-reading usage in December 2009 would in fact not differ materially from the post-reading usage in December 2010. The same problem exists for operators of vending machines. The postal service has the opposite problem: it receives cash from stamp sales before all of the stamps are used. It carries a liability (unearned revenues) for this effect. Both of these examples illustrate that even when cash is involved, the measurement of revenue is not necessarily straightforward. 2. This is one of the problems whose true resolution depends on events that cannot be forseen at the end of the accounting period. Some firms count the whole $10,000 as revenue in 2010 on the grounds that it is in hand and that any specific services are undefined and/or separately billable. Others take the more conservative approach of counting only $5,000 as revenue in 2010 on the grounds that the service involved is readiness to serve, and that this readiness exists equally in each year. I prefer the latter approach, based on the matching concept. 3. Many would argue that the service involved is the cruise and that no revenue has been earned until the cruise has been completed. Others maintain that Raymonds has completed its service of arranging the cruise, that it is extremely unlikely that events will happen in 2011 that will change its profit of $20,000, and that the amount is therefore revenue in 2010. Introduction of the possibility of a refund lessens the strength of the argument of the latter group. This position can be weakened further by asking: (a) What if passengers are dissatisfied and demand (or sue for) a refund? (b) What if the ship owner performs unsatisfactorily and Raymonds, in order to protect its reputation, steps in and incurs additional food or other cost to make the passengers happy? Students should be reminded to consider two criteria: (1) that the agency has substantially performed its earning activities and (2) that the income is reliably measurable. 4. This problem has been debated for many years. Some argue that the $4 per tree has already been earned, as evidenced by the firm offer to buy the trees, and that it would be misleading to show no revenues in 2010 and the full sales value when the trees are sold in 2011. The percentage-of-completion method can be used as an analogy. Others argue that there has been no transaction, and no assurance that the trees can be sold for more than $4 in 2011 because market prices may decrease, or pests or fire may destroy them. Typically, firms facing this issue recognize no revenue until harvesting the trees.

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5. 6. If a professional service firm (architects, engineers, consultants, lawyers, accountants, and so on) values its jobs in progress at billing rates, then it is recognizing revenue as the work is performed (time applied to projects) rather than waiting until the customer is billed. This is certainly defensible if the firm has a contract (called a time and materials contract) that obligates the client to pay for all time applied to the clients project: the critical act of performance is spending the time on the project, not billing that time. In fact, many such firms feel that even with fixed-fee contracts, the critical performance task is spending time on a project as opposed to delivering some end item to the client; they thus record jobs in progress at estimated fee, which would be the same as billing rates for the time applied provided the project is within its professional-hour budget. Of course, whether the revenue is recognized when the time is applied or when the client is billed does make a difference in owners equity. Retained earnings will reflect the margin on the time applied sooner if the jobs in progress inventory is valued at billing rates rather than at cost. 7. Numerous answers are acceptable. I argue that the coupon has nothing to do with the sale of coffee. Its purpose is to promote the sale of tea. The 60 cent reimbursements made in 2010 and the 60 cent reimbursements made in 2010 are an expense of selling tea in 2010. Those who tie the coupons with coffee would say that the entire 20 percent of coupons redeemed is an expense of selling coffee in 2010 with the amount not yet redeemed being a liability as of December 31, 2010. It is customary that the coupon issuer pay the store a handling fee in addition to the face value of each coupon; here that fee is 10 cents. It is 60 cents per coupon that is the cost, not the 50 cent face value. 8. The bank would record the sale of $500 travelers checks for $505 as follows: dr. Cash............................................................... 505 cr. Payable to American Express.................... 500 Commission Revenue................................ 5 After the bank remits the $500 cash to American Express, the latter will make the following entry: dr. Cash............................................................... 500 cr. Travelers Checks Outstanding................... 500 The account credited is a liability account. This account had a balance of many billions of dollars, which should help students understand why American Express does not itself levy a fee on the issuance of travelers checks: the checks are a great source of interest-free capital to American Express. 9. According to FASB Statement No. 49, Manufacturer A cannot record a sale at all under these circumstances. The merchandise must remain as an asset on Manufacturer As balance sheet and a liability should be recorded at the time the $100,000 is received from B. This statement precludes Manufacturer A from inflating its 2010 revenues and income by the sort of repurchase agreement described. FASB 49 was issued to address the perceived abuse of treating such temporary title transfers as sales. 10. FASB Statement No. 45 states that franchise fee revenue should be recognized when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchiser. Amortization of initial franchise fees should only take place if continuing franchise fees are so small that they will not cover the cost of continuing services to the franchisee. Since this exception seems unlikely in this case, the $10,000 franchise fee should be recognized as revenue in the year received, as soon as the training course has been completed. Investors will need to make their own judgment as to what will happen when the market becomes saturated.

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11. 12. This item is designed to get students to think about (1) a condition that creates the need for a change in revenue recognition policy, and (2) the potential need for multiple revenue recognition policies for a firm. Tech-Logic, a manufacturer of computer systems, normally recognizes revenue when its products are shipped, a policy common among manufacturing firms. To adopt that policy, managers at Tech-Logic must have concluded that the two criteria for revenue recognition were met at shipment: (1) Tech-Logic would have substantially performed what is required in order to earn income, and (2) the amount of income Tech-Logic would receive could be reliably measured. With the sale of the computer systems to the organization in one of the former Soviet Union countries, however, Tech-Logics ability to satisfy these two criteria changed. Although the first criterion was still met, the uncertainty about whether (and how much) foreign exchange the customer could obtain left the second criterion in doubt. Hence, Tech-Logic should not recognize revenue for these computer systems at shipment or delivery. An alternative should be to wait until cash (in the form of hard currency) was received to recognize revenue. This item can also be used to discuss the fact that firms often have more than one revenue recognition policy. Tech-Logic would not completely change its revenue policy to cash receipt for all sales at the time it begins to sell computers to organizations in countries where the availability of foreign exchange currency is in doubt. Rather, it would be likely to have two revenue recognition policies; at shipment, for products sold to organizations in countries where the availability of foreign exchange currency is not in doubt; and cash receipt, for products sold to organizations in countries where the availability of foreign exchange currency is in doubt. Because they manufacture products and provide a variety of services, computer manufacturers often have a variety of revenue recognition policies. For example, a computer manufacturer might recognize revenue for products when they are shipped; for custom software development, when the customer formally accepts the software; and for maintenance services, ratably over the life of the maintenance contract. Item 10 was inspired by events that occurred at Sequoia Systems in 1992. Sequoia evidenced several instances of aggressively booking revenue. One of these involved a Siberian steel mill. According to The Wall Street Journal: Executives signed off last year on the sale of a $3 million computer destined for a steel mill in Siberia. But government approvals and hard currency to pay for the system got stalled, even though $2 million of revenue was booked in the fiscal year ended June 30, and another $1 million was going to be taken in the first quarter ended last month, insiders say.1 Sequoia executives stated that they expected the Siberian steel mill sale and similar sales will ultimately prove to be good business and that the decision to book it as revenue was supported by the revenue recognition policy that we had in place.1 However, under investigation by the SEC and facing lawsuits by shareholders, Sequoia twice restated revenues following the end of fiscal year 1992, reducing originally reported revenues by more than 10 percent.2

1 1

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

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Chapter 05 - Revenue and Monetary Assets

Case 5-4: Wareham SC Systems, Inc. Note: This case is new to the Thirteenth Edition. Please see the printed version of the Instructors Resource Manual for the Harvard Teaching Note.

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