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Intermediate Accounting Vol 1 Canadian 2nd Edition Lo Solutions Manual Download
Intermediate Accounting Vol 1 Canadian 2nd Edition Lo Solutions Manual Download
Chapter 4
Revenue Recognition
N. Problems
An enterprise creates value at many different points or periods of time. Conceptually, revenue
and associated costs, or income, should be recorded whenever the enterprise creates or adds
value. The discovery of a process or product, manufacturing, distribution, product display, sales,
delivery, credit provision, warranties are all value-adding activities, so revenue/income could be
recognized at all of these points or periods of time.
* It is true that there is significant evidence supporting the efficiency of security prices,
such that those prices reflect information available to market participants.
* Information about a mineral discovery is indeed relevant to the value of a mining
company, so stock price should respond to such information.
* However, accounting’s role is not to simply reflect the information that is already
contained in security prices. Rather, accounting reports should be a source of information
for various purposes, one of them being the valuation of securities.
* The market price for the company’s securities is the result of buying and selling by many
traders who are interpreting information without bias. Allowing companies to record
revenue when they make a mineral discovery (or for similar types of events) gives a great
deal of latitude for making estimates about the value of the discovery, and such estimates
could be severely biased.
* While the mineral discovery may be verifiable by geological engineers to some extent,
numerous estimates are required to translate that discovery to a dollar figure in terms of
future revenue or income.
* Revenue recognition criteria try to balance the demands for relevant information and the
reliability of the recorded revenue, taking into consideration the uncertainty of events, the
motives of management, and the availability of other sources of information.
* The cash basis of revenue recognition would be more reliable since cash receipts are
readily verifiable.
* However, doing so usually delays the recognition of revenue, reducing its timeliness and
relevance to users.
* Cash basis information is generally less useful for making predictions about the future, as
it can fluctuate due to random events affecting the timing of payment.
* While more reliable, the cash basis does not eliminate judgment and overstatements.
Many transactions involve payments in advance of the delivery of goods or provision of
services.
* Restricting revenue recognition to the cash basis can have real consequences on business
activities. For instance, a company would be less willing to sell products on credit; the
supply of credit is essential to the health of the economy.
* Revenue recognition criteria try to balance the reliability of reported revenue with the
demand for relevant information.
a.
* ABC’s investment satisfies the definition of an asset, but it fails the recognition criteria
because the future economic benefits of the R&D are highly uncertain. Therefore, the
investment should be expensed.
* XYZ can recognize the $500 million equity investments as assets because the value of the
shares can be readily determined from quoted prices on stock exchanges.
b.
* Success: While the discovery of the vaccine will likely lead to significant future cash
flows in the form of sales of vaccines, those revenues cannot be recognized until the sales
occur.
* Failure: There are no revenues or income to recognize in this instance. In addition, since
the R&D costs had been expensed, there are no assets to write off when the R&D is
unsuccessful.
c.
* Success: XYZ would record income for the increase in the value of its investment and
correspondingly write up the value of the asset.
* Failure: XYZ would record a loss for the decrease in value of its investment and write off
the asset.
* This approach relies on the efficiency of security markets providing reliable evidence of
the value of the vaccine.
d.
ABC XYZ
Vaccine success Revenue = 0 Gain = $1,950 million
Vaccine failure Revenue = 0 Loss = $50 million
e.
* The differences in accounting between ABC and XYZ are due to the recognition criteria,
particularly in regard to whether there is reasonable certainty in the amounts to be
recognized.
* ABC must defer the recognition of revenue until the actual sale of the malaria vaccine (if
any) while XYZ could indirectly recognize its share of future revenues (net of costs) that
the biotechnology company is expected to earn from the vaccine via the increase in its
stock price.
Method of
Situation recognition Brief explanation
a. A vendor sells tomatoes at a At point of Sale of goods: risk and rewards
farmers’ market. sale transferred.
b. A department store sells and delivers At point of Sale of goods: significant risk and
a washing machine with a three-year sale rewards transferred; remaining
warranty. indemnity risk is small and
estimable.
c. An electronics store sells a At point of Sale of goods: significant risk and
television set with a 14-day “lowest sale rewards transferred; remaining
price” guarantee. (That is, if the indemnity risk is small and
customer finds a lower price on the estimable.
same product offered by the
company or a competitor, the
company will refund the difference
to the customer.)
d. A bus manufacturer signs a contract According Provision of services on long-term
to supply 280 buses over five years to degree of contract. Can also be considered as
for the Toronto transit system. completion sale of goods, with revenue recorded
according to the number of buses
delivered.
e. A university receives students’ According Provision of services. Revenue
course registrations. to degree of earned as courses progress.
completion
f. An insurance company issues a one- Over time Provision of services. Revenue
year insurance policy on a car. earned as time elapses.
g. A company deposits funds into a Over time Provision of services: a deposit
two-year term deposit that earns 4% provides funds to the bank to use for
per year. lending.
h. A company takes a five-year loan Over time Matching with the benefits received
bearing interest at 8% per year. from using funds.
i. A company purchases computers for Over time Matching with the benefits received
its accounting department. over time.
j. A company purchases According Matching with the benefits of
manufacturing equipment that is to units of production and subsequent sales.
expected to produce 50,000 widgets. production
k. A company incurs delivery costs on At point of Matching delivery costs with the
January 3 for a shipment of products sale (before related sales.
sold five days earlier (before the year-end)
year-end).
Component fair
value as
Component percentage of × Actual sale
Pinto fair value total price = Allocation
Car: immediate
15,000 88.24% $18,000 $15,882
recognition
Warranty: defer
2,000 11.76% $18,000 2,118
and amortize
Total 17,000 100.00% $18,000
a.
– Fair value of more
reliably measured = Residual value
Sale price component (car) (warranty)
Nova $15,000 $14,000 $1,000
Pinto 18,000 15,000 3,000
b.
– Fair value of more
reliably measured
Sale price component (warranty) = Residual value (car)
Nova $15,000 $1,500 $13,500
Pinto 18,000 2,000 16,000
a. The loyalty program creates a multiple deliverable arrangement whereby each sale is a
combination of the delivery of one cup of coffee immediately, and 1/9th of the tenth cup of coffee
for a loyalty customer. Using the relative fair value method and assuming that each customer
consumes the same product each time, then the proceeds from 9 sales need to allocated over 10
transactions, since the 10th one is “free.”
b. Using the residual value method and assuming all customers redeem for a large size, the
journal entries would be as follows:
c. In this scenario, the residual value method would be more appropriate because it uses
only one fair value for a large cup of coffee. In contrast, if the relative fair value method were to
be used, the amount of deferred revenue would differ depending on whether the sale involved a
small, medium, or large cup of coffee, even though the three different deferred revenue amounts
relates to the same product to be delivered in the future. While there is nothing specific in the
standards to prohibit this outcome, it is certainly unsatisfying. To see the different amounts of
deferred revenue, compute the revenue amounts using the relative fair value method (using the
nominal prices as their fair values since other customers not on the loyalty program do pay these
prices):
Component
fair value as Amount
Component percentage × Actual = per free
Small cup sales fair value of total sale price Allocation large cup
100,000 sm cups @ $1.50 150,000 88.24% $150,000 $132,353
10,000 lg cups @ $2.00 20,000 11.76% $150,000 17,647 $1.76
Total 170,000 100.00% $150,000
Component
fair value as Amount per
Component percentage × Actual = free large
Medium cup sales fair value of total sale price Allocation cup
250,000 md cups @ $1.80 450,000 90% $450,000 $405,000
25,000 lg cups @ $2.00 50,000 10% $450,000 45,000 $1.80
Total 500,000 100% $450,000
Component
fair value as Amount per
Component percentage × Actual = free large
Large cup sales fair value of total sale price Allocation cup
320,000 lg cups @ $2.00 640,000 90.91% $640,000 $581,818
32,000 lg cups @ $2.00 64,000 9.09% $640,000 58,182 $1.82
Total 704,000 100.00% $640,000
a. Assuming that the three prices reliably reflect fair value, the sale price should be
allocated using the relative fair value method. Therefore, the amount of revenue that should be
recorded is computed as follows:
Component
fair value as
Component percentage of × Actual sale
fair value total price = Allocation
Car 45,000 90% $45,900 $41,310
Basic service package 3,000 6% $45,900 2,754
Increment for premium
2,000 4% $45,900 1,836
service package
Total 50,000 100% $45,900
The basic service package is for two years, so its value should be allocated over Year 1 and Year
2 ($2,754 / 2 = $1,377). Likewise, the increment for the premium package should be allocated
over Years 3 and 4 ($1,836 / 2 = $918). The revenue for each time period would be as follows.
Upon
delivery Year 1 Year 2 Year 3 Year 4
Car $41,310 $ -- $ -- $ -- $ --
Basic service package -- 1,377 1,377 -- --
Increment for premium
-- -- -- 918 918
service package
Total $41,310 $1,377 $1,377 $918 $918
b. Assuming that the prices for the car and the premium package reflect fair value, the sale
price should be allocated using the relative fair value method. The answer here is similar to that
in part (a) except that the revenue for Years 1 to 4 will differ because the two service
components have been combined.
Component
fair value as
Component percentage of × Actual sale
fair value total price = Allocation
Car 45,000 90% $45,900 $41,310
Premium service pkg 5,000 10% $45,900 4,590
Total 50,000 100% $45,900
Upon
delivery Year 1 Year 2 Year 3 Year 4
Car $41,310 $ -- $ -- $ -- $ --
Premium service pkg -- $1,147.50 $1,147.50 $1,147.50 $1,147.50
Total $41,310 $1,147.50 $1,147.50 $1,147.50 $1,147.50
c. The assumed facts here suggest that the fair values of the service packages are more
reliably determined than the fair value of the car. Therefore, the residual value method seems
more appropriate than the relative fair value method.
–Total
Basic service
sale price package –$45,900
1,500
– Increment for premium service package – 1,800
Residual = amount allocated to car $42,600
a. The phone packages involve multiple deliverables, so it is important to separate the two
streams of revenue: sale of the phone and cellular services. However, the nominal prices for the
two components are not necessarily indicative of the value of the components. For example, the
phone is provided for “free” under Option A, but costs $400 under option B and $600 under
option C.
Option C is the only option with a single deliverable, so the $600 can serve as a benchmark price
for the Raspberry 300. For this option, $600 can be recognized as revenue upon delivery of the
phone.
Option A has total revenue of $1,800 over the 36 months of the contract ($50 × 36 = $1,800). Of
that amount, $600 can be allocated to the phone, while the remaining $1,200 should be allocated
to the service contract, resulting in $33.33 per month ($1,200 / 36).
Likewise, Option B has total revenue of $1,000 over 12 months ($50 × 12 + $400 = $1,000).
Allocating $600 to the phone, the remaining $400 should be recognized over 12 months of the
contract, or $33.33 per month.
b. To ensure the validity of the approach just described, it is important to ascertain whether
the $600 price for the phone under Option C is indeed its fair value. If a significant number of
customers do choose Option C, then those market transactions supports $600 as the fair value. If
no one, or if very few customer choose Option C, then that brings into doubt that $600 is the fair
value of the phone.
The more general point is that prices quoted by the reporting entity may not be truly reflective of
fair value. Consider the possibility for earnings management if all such quoted prices were
accepted as fair values. This the case of the Raspberry 300, if the company artificially set a high
price for Option C, say, $1,000, then accepting $1,000 as the value of the phone that would allow
the company to record $1,000 immediate in revenue (and less later) if customers chose Options
A or B. However, any rational customer will not accept this price because Option B has the same
cost ($400 initially plus $50/month x 12 months = $1,000) but provides both the phone and one
year of service.
The different sources of revenue for REYC warrant different treatment due to their differing
characteristics. The following discusses each in turn.
On the other hand, recognizing the full $50,000 in revenue can be premature. When members
join, they expect and have rights to certain services as long as they remain members in good
standing. Therefore, it can be argued that REYC has obligations to provide services in the future.
From this perspective, criteria (c) noted above has not been satisfied because the transactions is
only partially complete, if at all, at the time of membership initiation. Furthermore, the club is
operated on a break-even basis, implying that the proceeds from the initiation fees would be used
to cover capital and operating costs (e.g., for the clubhouse, outstations); otherwise, the club
would generate large surpluses from the initiation fees. This argument suggests that REYC
should record the initiation fee as deferred revenue. Under this approach, the revenue would be
recognized over the expected life of memberships, which is around 25 years.
On balance, it appears that the deferral approach for initiation fees is more appropriate to reflect
the services that the club is expected to provide to new members over many future years.
the residual for the value of the facilities access. The $2,400 amount of the restaurant credit
could be a reasonable indication of the value of the meals that will be delivered, leaving $7,600
for the value of the facilities access.
On the other hand, there is evidence that the club restaurant charges prices that are 25% below
market. Therefore, an argument can be made to attribute a fair value of $3,200 (= $2,400 / (1 –
0.25)) to the restaurant credit, leaving $6,800 as the residual value for facilities access.
While the latter approach is conceptually better, it is not recommended because it would create a
complex billing system in the club restaurant where meals consumed as part of the $2,400 credit
would be grossed up by 1/3 (e.g., a $24 meal would be recorded as $32) while other meals paid
out-of-pocket would be recorded at face value. The combination of the two types of revenue
would hinder the management of the restaurant as some meals will have much higher margins
than other meals. Ultimately, all $10,000 of the annual membership fee including the $2,400 of
restaurant credit will be recognized in income in the year since the credits cannot be carried over
from year to year. Thus, there is little to be gained by allocating any amount other than $2,400 to
the restaurant meals—financial statement readers (the membership) are better served by seeing
the performance of the club restaurant based on actual prices paid for meals rather than imputed
prices.
These magazines are consignment sales and need to be accounted for as such.
Copies distributed during 2012 1,950,000
Less: Copies distributed during 2012 and returned in 2012 (830,000 – 35,000) (795,000)
Less: Copies distributed during 2012 and returned in 2013 (32,000)
Copies distributed and sold during 2012 1,123,000
Price per copy (Retail price of $4 less 50%) × $2
$2,246,000
The second and third journal entries should be prepared when payments are received at the end
of April, August, and December 2013.
a. First, note that all installment sales made from January to June would have been fully
collected by December 31. Therefore, the amount that remains outstanding can be
computed to be $530,000, as follows:
No. of
Installment payment o/s Total number Amount o/s
Month sales at year-end of payments at year-end
January $ 80,000 0
February 70,000 0
March 90,000 0
April 100,000 0
May 90,000 0
June 100,000 0
July 120,000 x 1 / 4 = $ 30,000
August 110,000 x 2 / 4 = 55,000
September 100,000 x 3 / 4 = 75,000
October 90,000 x 4 / 4 = 90,000
November 130,000 x 4 / 4 = 130,000
December 150,000 x 4 / 4 = 150,000
Installment
accounts
$ 1,230,000 receivable $ 530,000
Gross margin 40%
$ 212,000
b. The amount of deferred gross profit is $212,000, as shown in the table for part (a). This
amount is 40% of the installment accounts receivable.
c. The amount of sales recognized in the year equals the amount of installment sales made
in the year less the amount remaining in receivables at year-end. Thus, the amount is
$1,230,000 – $530,000 = $700,000.
c.
2011 2012
Direction Direction
Amount Amount
(↑↓↔) (↑↓↔)
Revenue ↔ 0 ↑ 8,500,000
Cost of goods sold ↔ 0 ↑ 2,800,000
Gross profit ↔ 0 ↑ 5,700,000
Assets ↔ 0 ↑ 5,700,000
Retained earnings ↔ 0 ↑ 5,700,000
If you had answered that this situation requires retrospective treatment (which is NOT
appropriate under the circumstances), then the following table would be consistent with that
answer. This table is provided for pedagogical purposes only and does not reflect an
acceptable answer.
2012 2011
Direction Direction
Amount Amount
(↑↓↔) (↑↓↔)
Revenue ↓ (4) 16,100,000 ↑ (1) 24,600,000
Cost of goods sold ↓ (5) 5,600,000 ↑ (2) 8,400,000
Gross profit ↓ 10,500,000 ↑ 16,200,000
Assets ↑ 5,700,000 ↑ (3) 16,200,000
Retained earnings ↑ 5,700,000 ↑ 16,200,000
1. 30,000 oz × $820/oz using market price at the end of 2011 (beg. of 2012)
2. 30,000 oz × $280/oz
3. 30,000 oz × ($820 – $280)/oz to write inventory up from cost to market
4. 10,000 oz × $850/oz – 30,000 × $820/oz
5. 10,000 oz × $280/oz – 30,000 oz × $280/oz = -20,000 oz × $280/oz
Path Pavers must use the percentage of completion method, with the amount of trail resurfaced
as an indicator of the percentage complete.
Alternative solution:
(Dollar amounts in millions) 2011 2012 2013 2014 2015 Total
Distance completed in the year 8 km 12 km 12 km 12 km 6 km 50 km
Percentage completed (50 km total) 16% 24% 24% 24% 12% 100%
Contract price $25 $25 $25 $25 $25 $25
Revenue for the year $ 4 $ 6 $ 6 $ 6 $ 3 $25
It is important to note that this alternative is quicker but that it will only work in situations where
the original estimates are completely accurate and not later revised (i.e., there is certainty). Thus,
it is not recommended for general application.
2,000,000
=( × 2,000,000) − 0
8,000,000
= 25% × 2,000,000
= 500,000
Gross profit recognized in 2012:
Cost incurred to date Estimated Gross profit
Gross profit = × −
5,500,000
=( ×1,200,000) − 500,000
8,800,000
= (62.5% ×1,200,000) − 500,000
= 250,000
Since the company is unable to estimate total cost, the company should use the cost recovery
method. In this method, revenue each year prior to completion equals costs incurred. In the final
year, revenue equals the amount that remains to be recognized.
a.
* Total cost = 800
* % complete = 320 / 800 = 40%
* Revenue = 40% × 960m – 144m = $240m
b.
2013
* Total cost = 108 + 792 = 900
* % complete = 108 / 900 = 12%
* Revenue to date = 12% × 960m = $115.2m
2014
* Revenue = 40% × 960m – 115.2m = $268.8m
a. To apply the percentage of completion method, we must use the cost-to-cost approach
since no other estimate of the stage of completion is available.
b.
Billings Revenue or
Year Cash Accts Receivable CIP Inventory on CIP expense
2011 Incur costs 80,000 80,000
Bill client 65,000 65,000
Receive cash 60,000 60,000
Rev & exp recog 20,840 80,000 100,840
Balance 20,000 5,000 100,840 65,000 *20,840
* Revenue and expenses are temporary accounts, which are closed at the end of each period, so
balances do not carry forward.
Note 1: These figures may be computed directly or as plug figures after determining the gross
profit. The direct computation for 2012 is: expected loss accrual = percentage uncompleted ×
total expected loss – previous accruals = 40% × 100,000 – 0 = 40,000. For 2012, expected loss
accrual = 0% × 200,000 – 40,000 = –40,000.
Note 2: Because the expected total cost exceeds the contract price in 2012, the gross profit (loss)
in the year must reflect all of the loss, and reverse any prior profit recorded. Thus, the gross
profit (loss) = 100% × –100,000 – 40,000 = –140,000. Similarly, in 2013 the computation is
gross profit = 100% × –200,000 – –100,000 = –100,000.
Under the completed contract method, no revenue would be recognized until the contract is
completed. However, it is still necessary to recognize any expected losses so that the financial
statements are not overstated. Therefore, the amounts for revenue and profit/loss should be:
2011 2012 2013
Revenue – current year 0 0 1,900,000
Expenses 0 0 2,100,000
Gross profit (loss) before 0 (200,000)
Less: Expected loss accrual (reversal) 0 100,000 (100,000)
Gross profit (loss) 0 (100,000) (100,000)
The question only asks for the gross profit or loss, so we can simply apply these formulas.
For the completed contract method, no profit is recognized until the end of the contract.
However, any expected losses are recognized in their entirety in the year anticipated. The gross
profits (losses) for the four years are shown in the following table. It is important to note that the
loss is not reversed in 2013 when the project becomes profitable again—all profits are deferred
to the date of contract completion.
c. ( in $ thousands)
Costs incurred
Dr. WIP 6,500
Cr. Cash, A/P 6,500
Dr. A/R
Billings 4,000
Cr. Billings on construction 4,000
Dr. Cash
Collections 4,200
Cr. A/R 4,200
d.
Project completion
Dr. Billings on construction 12,000
Cr. WIP 12,000
a. ( in $ thousands)
Notes 1 2 3 Total
Cost incurred to date A 13,000 40,000 54,000
Estimated cost to complete B 37,000 18,000 0
Estimated total cost C=A+B 50,000 58,000 54,000
Contract price D 60,000 60,000 60,000
Estimated gross profit D–C 10,000 2,000 6,000
% complete E=A/C 26% 68.97% 100%
Gross profit to date F=D×E 2,600 1,380 6,000
Gross profit previously recognized G 0 2,600 1,380
Current gross profit F–G 2,600 –1,220 4,620 $ 6,000
b.
( in $ thousands)
Costs incurred
Dr. WIP 27,000
Cr. Cash, A/P 27,000
Billings
Dr. A/R 25,000
Cr. Billings on construction in progress 25,000
Dr. Cash
Collections 20,000
Cr. A/R 20,000
c.
Dr. Billings on construction in progress 60,000
Cr. WIP 60,000
d.
* If the cost to complete is $22 million, estimated total cost would be $62 million, resulting
in a projected loss.
* The entire projected loss must be recognized immediately, and any prior profits reversed.
* Profit (loss) to be recorded = 100% × –2,000,000 – 2,600,000 = –$4,600,000.
a.
i.
* Estimated total gross profit = 20% × $1.9 billion = $380m
* Estimated total cost = (1 – 20%) × $1.9 billion = $1,520m
* 2003 Gross profit = % complete × estimated GP – GP previously recognized
* 2003 Gross profit = 228m / 1,520m × 380m – 0
* 2003 Gross profit = 57m
ii.
Dr. COGS 228m
Dr. WIP 57m
Cr. Revenue (15% × 1,900m) 285m
b.
i.
Est. total costs: 2003–2005 $ 684m
2006 380m
Beyond 2006 912m
Total $1,976m > $1,900m contract price
Since a loss is projected, record 100% of loss.
2006 gross profit (loss) = 100% × estimated GP – GP previously recognized
= 100% × –76m − 76m
= –$152m
(GP previously recognized = $760m – $684m = $76m)
ii.
% complete = (684m + 380m) / 1,976m = 1,064m / 1,976m = 53.85% (rounded)
Dr. COGS 380.000m
Dr. Expected loss 35.074m
Cr. WIP (46.15% × -76m) 35.074m
Cr. WIP (53.85% × -76m − 76m) 116.926m
Cr. Revenue (53.85% × 1900m − 760m) 263.074m
(The combined reduction in WIP equals 35.074m + 116.926m = 152m)
a. ( in $ millions)
1 2 3 4 Total
Costs incurred to date 480 1,250 2,660 3,750
Estimated cost to complete 2,520 1,875 1,140 0
Estimated total cost 3,000 3,125 3,800 3,750
% complete 16% 40% 70% 100%
Contract price 3,600 3,600 3,600 3,600
Cumulative revenue 576 1,440 2,520 3,600
Less: revenue previously recognized 0 576 1,440 2,520
Current-year revenue 576 864 1,080 1,080 3,600
b. (in $ millions)
Costs incurred
Dr. CIP 480
Cr. Cash, A/P 480
Dr. A/R
Billings 500
Cr. Billings on construction in progress 500
Dr. Cash
Collections 450
Cr. A/R 450
c.
Dr. Billings on construction in progress 3,600
Cr. CIP 3,600
d.
1 2 3 4 Total
Costs incurred to date 480 1,250 2,660 3,750
Estimated cost to complete 2,520 1,875 940 0
Estimated total cost 3,000 3,125 3,600 3,750
% complete 16% 40% 73.9% 100%
Contract price 3,600 3,600 3,600 3,600
Cumulative revenue 576 1,440 2,660 3,600
Less: revenue previously recognized 0 576 1,440 2,660
Current-year revenue 576 864 1,220 940 3,600
a. In addition to general revenue recognition policies, the company describes five other
revenue recognition policies:
(i) revenue from subscriptions;
(ii) multiple deliverables;
(iii) whether services for installation and implementation are grouped together with the
related product;
(iv) whether to report the gross revenue or net margin on sales of other company’s
products; and
(v) the basis for recognizing revenue on long-term contracts.
b. For multiple deliverables, the company generally uses the relative fair value method for
allocating revenue to the different components. The portion of Note 1 relating to revenue
recognition indicates, “The amount recognized as revenue for each component is the fair
value of the element in relation to the fair value of the arrangement as a whole.”
Note 21 identifies the amount of deferred revenue on services. This amount relates to
premiums received on insurance and Roadside Assistance Club memberships that remain
unearned at year-end (i.e., the portion of insurance or membership that had not expired).
These disclosures allow a better understanding of the source of growth for Canadian Tire.
Whereas as total revenue from all sources grew by 12.7% (from $9,213m to $10,387m),
most of the growth came from the sale of goods (from $7,854m to $8,998m), an increase of
14.6%. Further reading reveals that some of that growth in sale came from the purchase of
another company, Forzani Group Ltd. (abbreviated as “FGL Sports” in the annual report).
a. Bombardier uses the cost-to-cost approach to estimate the percentage of completion. When
the company anticipates a loss on a contract, it recognizes the entire loss in the period
when it identifies the loss. Note 2 on page 146 contains this information.
b. From Note 15, we can see that Bombardier had work-in-process inventories of $1,737
million in “Production Contracts” and $335 million in “Service contracts,” for a total of
$2,072 million. These amounts are net of billings and advances received of $4,818 million
($4,773m + $45m). The gross amount before netting out the billings and advances was
$6,890 million ($6,510m + $380m).
O. Mini-Cases
* Global Crossing was under pressure to maintain the confidence of lenders who have
advanced them $7 billion and equity investors who have valued the company at $40
billion.
* Also not stated in the facts, there were probably also explicit debt covenants.
Conclusion:
* Taken in isolation, there are possibly reasonable arguments for Global Crossing’s
accounting treatments.
* However, the nature of the transactions and the way they were recorded—asymmetrically
for sales and purchases of fibre capacity—indicate that this is not a simple matter of
applying judgment to instances where there are a range of alternatives. Rather, it
suggested a deliberate decision to inflate profits. The practice is not appropriate and
highly unethical.
* The fact that other companies also engaged in similar practices suggests a concerted
effort to collude and mislead financial statement users. This fact illustrates the perils of
following industry practice.
* This case highlights the necessity to look at a company’s operations holistically rather
than in a piecemeal fashion.
Note: A fact deliberately left out of the case is that much of the transfer of fibre-optic capacity
was conducted in reciprocal swaps (e.g., Global Crossing transferred capacity to Qwest at the
same time that Qwest transferred similar capacity back to Global Crossing). Omission of this fact
is to make the case more open-ended, allowing for more thorough discussion of issues.
To: CFO
From: Controller
Subject: Impact of Product Service Plan on accounting for products sold
The accounting issues relating to the Product Service Plan (PSP, or the Plan) principally concern
the transfer of risk and rewards of ownership, which is a key determinant of whether revenue
recognition criteria have been satisfied. In International Financial Reporting Standards (IFRS),
paragraph 14 of IAS 18 contains the following guidance:
¶14 Revenue from the sale of goods shall be recognized when all the following conditions
have been satisfied:
(a) the entity has transferred to the buyer the significant risks and rewards of
ownership of the goods;
(b) the entity retains neither continuing managerial involvement to the degree usually
associated with ownership nor effective control over the goods sold;
(c) the amount of revenue can be measured reliably;
(d) it is probable that the economic benefits associated with the transaction will flow
to the entity; and
(e) the costs incurred or to be incurred in respect of the transaction can be measured
reliably.
While our sale of products clearly satisfies criteria (b), (c), and (d), the provision of the PSP
possibly results in our company bearing a sufficient level of indemnity risk relating to the
product during the Plan’s coverage period such that criterion (a) is not satisfied. In addition, we
will need to satisfy criterion (e) by collecting data on the costs of providing the PSP so that we
can properly match the expense to the period when we record the revenue.
Adding to the complication is the proposal to offer the PSP, or some portion of it, for free as part
of the product purchase. These transactions, if the proposal goes ahead, would more closely tie
the indemnity risk to the product and make it more difficult to separate the sale of the product
from the service provided by the PSP (see below).
Deferring revenue recognition until the expiration of the Plan would be the prudent/conservative
accounting policy. Another similar alternative is to defer and recognize revenue over the period
covered by the PSP.
However, following either of these two alternatives would create two separate revenue
recognition policies: revenue deferral for products sold with PSPs, and revenue recognition at
point of sale for products sold without PSPs (which is the policy that the vast majority of
companies follow for the sale of goods and which complies with the revenue recognition criteria
of IFRS).
Furthermore, having these two revenue recognition policies can lead to dysfunctional managerial
actions. Assuming that the PSPs are profitable, we do not want to discourage sales of these
Plans. However, requiring deferral of revenue for products sold with PSPs means that store
managers would have incentives to sell products without PSPs, as the revenue for those products
would be recognized in full immediately.
A more reasonable approach would be to treat the PSP as a service separate from the product that
the Plan covers. Doing so allows a single, consistent revenue recognition policy for products sold
with and without PSPs.
This approach is justified by the fact that the Plan is a service in substance the same as an
insurance policy, and it is separable from the product just as auto insurance is separable from the
purchase of a car. Indeed, our PSPs are reinsured with American Bankers Insurance Company of
Florida.
As a service, we should follow the revenue recognition criteria of paragraph 20 of IAS 18:
¶20 When the outcome of a transaction involving the rendering of services can be estimated
reliably, revenue associated with the transaction shall be recognized by reference to the
stage of completion of the transaction at the end of the reporting period. The outcome of
a transaction can be estimated reliably when all of the following conditions are satisfied:
(a) the amount of revenue can be measured reliably;
(b) it is probable that the economic benefits associated with the transaction will flow
to the entity;
(c) the stage of completion of the transaction at the end of the reporting period can be
measured reliably; and
(d) the costs incurred for the transaction and the costs to complete the transaction can
be measured reliably.
Given that the Plan covers multiple years, we should recognize revenue over the period of
coverage. For simplicity, a straight-line method may be adequate. However, the nature of
product breakdowns is that they tend to occur more frequently later rather than sooner. In
addition, we have recourse to the manufacturer in instances where the product becomes defective
during the manufacturer’s warranty period. Thus, we should recognize revenue on the PSPs in a
fashion that is lower initially and higher later on to reflect the stage of completion of the service
provided. We should conduct more analysis of service records to determine the appropriate
percentage of revenue we can recognize.
In conclusion, I believe that it is most reasonable to separate the service revenue for the Product
Service Plan from the sale of goods revenue. Doing so complies with IFRS, provides consistent
accounting treatment for different types of sales, and does not create perverse operational
incentives.
To: File
From: David
Subject: Financial Accounting Issues for Penguins in Paradise (PIP)
The bank will also be relying on the financial statements to ensure that the operations are under
control. They will likely want to see statements that maximize revenue since part of the interest
payment on the loan varies with gross revenue.
The client and promoter, Darth Garbinsky, will be relying on the financial statements to calculate
his participation payment. Like all the other investors, he will want net income to be high in
order to maximize his own income.
In the assessment of acceptable accounting policies, we should bear in mind that, in this instance,
accounting policies have a direct impact on PIP’s cash flows. That is, high reported income
results in higher cash outflows. However, in the first stages of the life of the play, expenses will
likely exceed revenues. Early recognition of expenses will not impact payments in the early
(loss) years but will increase future net income and the participation payments, which are based
on operating profits.
Due to the uncertainty regarding the future success of Penguins in Paradise, we should err on the
side of caution and recommend conservative/prudent accounting policies that have the least risk
of overstating assets and income.
Royalty rights
Accounting for the royalty rights payments to PIP is very important because of the impact this
amount will have on the participation payments to investors.
We must first determine whether the amount paid to PIP for the royalty rights is an income item
or a capital item. A royalty payment is very similar to a dividend. The investors will receive a
royalty (or participation) payment that is based on their initial contribution. The payment that
they receive could also be considered a return of their investment. Both of these facts imply that
the payments to PIP by the investors are on account of capital.
On the other hand, in order for the investors to earn a royalty, the critical event that must take
place is the production of the play. The cost of producing the play is the cost of earning the
income. In addition, the original contributions will not be refunded to the investors.
If the amount paid to PIP by the investors is considered to be on account of income, we must
determine the period in which the amount should be recognized. The critical event here is the
signing of the contract. Also, no future services have to be provided. These facts suggest that the
amount should be recognized as income immediately.
However, if net income is earned and a royalty payment is made by PIP, it will be based on
future net income. Expenses will be incurred in the future, and therefore the amount paid to PIP
by investors should be matched to the period in which the expense is incurred. In addition, by
recognizing the investors’ payments to PIP as income in future periods we would obtain a better
matching of expenses since the production is in a future period.
I recommend that the investor payments to PIP be treated as income and recognized in future
years.
amount is non-refundable. In addition, the amount paid cannot be applied against future ticket
prices and no future services are to be rendered.
Government grant
We must determine whether the government grant is attributable to income or capital. The
treatment of this amount will affect the royalty program. If the amount is taken into income
immediately, the participation payments will increase.
If the amount is offset against an asset that will be depreciated, then the participation payments
derived from the grant will be paid over time. If the grant is tied to hiring Canadians to perform
in the play, then the amount should be credited against related labour expenses. If the grant has
to be spent on costumes and sets made in Canada, then the amount should be netted against the
related assets.
In order to decide how this amount should be recognized, we must determine what the 50%
content rule pertains to—against what purchases should it be offset? We must also determine the
length of time that the rules apply in case the amount has to be repaid at a later date.
Bank loan
The 5% fixed interest should be expensed. However, there is some uncertainty regarding how to
record the payment to the bank that is based on the play’s success. For the current year (2011),
we could accrue for an amount based on expected future profits. Alternatively, we could record
the expense in a future period when PIP recognizes the revenue that generates the royalty. Given
the difficulty in estimating future revenue, I recommend not recognizing interest expense for the
1% royalty in 2011.
Start-up costs
We need to determine whether start-up costs fit the definition of “true operating expense.” If not,
then the royalty payment to investors will not be based on net income for financial statement
reporting purposes.
As these expenses have been incurred in the start-up phase of operations, the amounts can be
recognized in either the current year or deferred to future years. Arguments can be made for
either treatment. There is no certainty that the play will succeed, so to be conservative the
amount should be expensed in the current period. On the other hand, the amounts do relate to
production in future years, and in order to match expenses with revenues, the amounts should be
expensed in future periods.
Overview
As a public corporation, the company’s financial statements will be used by stakeholders for a
variety of purposes, including the evaluation of the company and its management. As a result,
the managers have incentives to increase or smooth earnings to influence the share price or to
present a favourable impression of themselves. In addition, the company is expanding rapidly
and therefore may need to raise capital. By using accounting choices to increase earnings or
otherwise improve the appearance of the financial statements, management may be attempting to
reduce the cost of financing by lowering the cost of debt or increasing the selling price of shares.
While the company may have a competing objective of minimizing taxes, to the extent that the
financial accounting policies apply to tax filings it is likely that management would choose
accounting policies that increase income.
Since PFC is publicly traded, the company must comply with IFRS.
Penalty payment
PFC received a $2 million payment from a contractor who built a theatre complex for PFC in
Montreal. The payment was for completing the project late. If my assumption about PFC’s bias
toward choosing income-increasing accounting policies is correct, management will want to
record the penalty as revenue.
Arguments could be made for treating the penalty payment either as income or as a reduction in
the capital cost of the complex on the balance sheet. If PFC incurred additional costs because of
the delay in opening the new complex, then the penalty should be used to offset the costs, which
may have been expensed or deferred. If the related costs had been expensed when incurred, then
the penalty payment should be recognized in income to offset those expenses. In contrast, if the
related costs were considered pre-opening costs and had been capitalized, then the penalty
payment should be used to reduce those capitalized assets.
Thus, if the penalty payment is compensation for lost revenue or profit, then an argument could
be made for treating the penalty as income, in which case we need to consider whether separate
disclosure is warranted given that the payment is non-recurring. Financial statement users would
find separate disclosure informative because the portion of revenue and income that is non-
recurring has different valuation implications.
begins its run or even after it begins to run. In that case, it will be necessary to refund the
purchase price of tickets to buyers.
PFC would likely prefer to recognize revenue earlier, upon the sale of the tickets, in order to
increase income and lower the cost of financing. If revenue were to be recognized at this early
stage, it would be necessary to match costs against the revenue. However, there would be
considerable uncertainty about those costs. Pre-production costs are not fully known, and the
actual cost of putting on the performances, including wages, advertising, overhead, and so on,
cannot be known with reasonable certainty.
Interest on ticket proceeds: PFC earns a significant amount of interest by holding the money paid
in advance by ticket purchasers. The interest revenue could be treated as income or deferred
revenue. Again, management’s preference will be to recognize the interest revenue immediately.
This position can be justified on the basis that any ticket refunds involve only the ticket price, not
any accrued interest. On the other hand, interest may have been factored into the advance
subscription price that is discounted relative to ticket prices in the future. If this is the case, then
treating the interest as deferred revenue makes more sense.
Pre-production costs: PFC has incurred significant costs in advance of the opening of “Rue St.
Jacques.” We must determine whether these costs should be capitalized and amortized, or
expensed as incurred. In principle, capitalization as an asset and amortization over the life of the
show is reasonable as long as the show is expected to generate adequate revenue to cover costs.
However, it is difficult to determine whether a theatre production will be successful. The long
run of the show in Paris and advance ticket sales suggest that the show will be a success.
However, the situation could easily take a turn for the worse if the actual show receives poor
reviews from critics.
If PFC chooses to capitalize the pre-production costs, they must be amortized over a reasonable
period of time. One method is to use a cost-recovery method, where costs would be matched
against revenue dollar for dollar until the pre-production costs are covered. A second alternative
is to amortize the costs over the estimated life of the show.
Under the capitalization alternative, we must also ensure that only costs pertaining to “Rue St.
Jacques” are capitalized. Management might try to include costs related to other activities (e.g., a
less successful show) among the costs for “Rue St. Jacques.”
Ongoing production costs after the show opens should be expensed as incurred, which matches
the recognition of ticket revenues.
Sale of theatres
PFC began selling theatres recently where economic conditions justified the sale of a particular
theatre. This year, a significant part of net income was generated through the sale of theatres.
PFC has included the proceeds from these sales as revenue on the income statement (as opposed
to treating them as gains or losses on disposition) because it considers such as an ongoing part of
its operations. However, the sales could also be considered incidental to ongoing operations, in
which case the gains and losses would not be included in revenues. Including the proceeds from
the sale of theatres is consistent with management’s objective of making the financial statements
more attractive for going to the capital markets, to the extent that revenues could be increased
(although net income would be unaffected).
If the sales can be considered a part of ongoing operations, we should consider whether there
should be separate disclosure of revenue from theatre sales. Burying this revenue with revenues
from other sources makes it more difficult for users to predict future revenues.
We should also consider whether the sale of theatres constitutes discontinued operations, which
would require separate disclosure. With the available information, it does not seem appropriate
to consider these theatre sales as discontinued operations, as PFC is not ceasing to operate movie
theatres completely.
If theatre sales are considered part of ongoing operations, then theatres that are available for sale
should be classified as inventory rather than property, plant, and equipment.
a.
As requested, I have prepared a draft report to Tom Mullins on the issues raised during your
meeting with him.
In order to recommend accounting policies for your new business, we must first identify the
likely users of HVHL’s financial statements and their information needs and objectives. This will
provide a basis for choosing among accounting policy alternatives.
You, Tom, have explicitly requested that the accounting policies be simple and not too costly.
You will be concerned about presenting a good financial position to attract investors. The other
users of HVHL’s financial statements are as follows:
* The bank will be concerned about liquidity and the ability of HVHL to repay its debt.
The bank would prefer information that focuses on cash flow and the valuation of its
security.
* Investors will require some form of current value information to evaluate HVHL’s
performance.
* The Canada Revenue Agency requires historical cost information to assess income taxes.
The bank and the investors are concerned with liquidity and performance evaluation. For this
purpose, some form of current-value information would be most useful.
Current-value information, sometimes called “fair value,” is more relevant to HVHL’s users
since the objective of the business is to realize gains from holding houses over a long period of
time. The houses should be valued at some form of market value, so that users could determine
unrealized holding gains and losses and thereby evaluate management’s decision-making ability.
This information would be costly, and the values determined would be very subjective since
there will be much uncertainty about the date on which HVHL will eventually gain title to the
property and the market prices at that time.
Although current-value information is costly, the users’ need for this type of information
outweighs the costs, and HVHL must provide this information to attract and retain investors.
There are several different methods of calculating current-value information. HVHL could obtain
independent appraisals of each of the houses as at the financial statement dates. This process
would be costly but would provide the most accurate information since the appraisals would
consider such aspects as the state of repair of the property, and so on. The cost could be reduced
by having appraisals performed on a rotational basis only. That is, HVHL could have a few
homes appraised each year so that all homes are appraised at least once over, say, a five-year
period.
An alternative method is to value the properties based on the present value of future cash flows.
This method would not be practical for HVHL, as no hard estimate of the timing and amount of
future cash flows would be available.
I recommend that market appraisals be performed on a rotational basis to determine the current
value of the homes to reduce the cost of revaluation.
Accounting policies
Asset valuation
We must first determine the nature of the asset before deciding upon the appropriate accounting
and reporting treatment for the properties. The homes could be considered as any of the
following assets:
* inventory, since they are held specifically for resale;
* capital assets, since they will be held for a long period of time and they produce income
through capital appreciation;
* prepaid expenses, since Tom does not have legal title to the property until the death of the
senior citizens; or
* an equity instrument, since they represent an “interest” in real property.
The classification of the homes as short-term or long-term assets must also be considered,
because the date of eventual sale of the homes is uncertain.
I recommend that the homes be recorded as long-term assets, "Interest in Homes," since
management intends to keep the homes for several years. Detailed note disclosure will be
required to explain the unique nature of the "reverse mortgages."
Revenue recognition
HVHL's operations of purchasing "reverse mortgages" in houses will result in two types of
revenue being recognized over the life of each property venture.
Discount
HVHL pays less than the market value of the home since it receives a "reverse mortgage" only,
and not legal title to the home. The difference between the market value of the home at the time
of purchase and the purchase price of the home is the discount. This discount can be compared to
rent or interest earned over the holding period of the home.
I recommend that the discount be taken into income over the expected remaining life of the
senior citizen because revenue is earned over this period. Thus, its revenue-generating activity is
being performed as the home is held over time. The revenue can be measured (difference
between market value and purchase price), and collectibility is assured since HVHL gains title to
the home at the death of the last inhabitant. This method of recognizing the discount revenue
meets your objective of providing financial statements that are relevant to HVHL's unique
business and that will attract investors.
1. Capital appreciation could be estimated at the date that the "reverse mortgage" is
purchased and taken into income over the expected remaining life of the senior citizen.
However, this would involve much uncertainty and estimation of future market value and
life spans. Another similar alternative is to recognize actual capital appreciation or
depreciation annually. This would entail an annual appraisal for each home. The change
in the market value of the home between financial statement dates would be recorded as
revenue for the period. This method could result in significant fluctuations in income and
asset values between years, depending on the volatility of the real estate market. It would
also be costly to obtain annual appraisals. However, relevant information about HVHL's
operations would be provided.
2. Capital appreciation could be recognized when the last inhabitant dies. This method
would be more conservative than the first alternative since revenue would not be
recognized until a market value at the time that HVHL obtains legal title could be
determined.
3. Capital appreciation could be recognized when HVHL finally sells the home. This would
be the most conservative option. No uncertainty exists regarding life spans or market
values between the date of death and the date that the home is resold. This method would
be appropriate only if the actual selling of the home is a significant act in the revenue-
earning process.
I recommend that the capital appreciation be recognized when the last survivor of the home dies.
This is the point at which HVHL obtains legal title to the home, and the decision to hold the
home is a separate management decision that should be reported separately in the financial
statements. Thus, the capital appreciation between the time that the "reverse mortgage" is
purchased and the death of the last survivor will be recorded at the time of death. Any
depreciation in the market value of the homes should be recorded in the period that it occurs so
that assets are not overstated.
The subsequent appreciation or depreciation arising between the time of death and the eventual
resale of the home would be reported when the home is sold, as a gain or loss on holding the
home subsequent to obtaining legal title. This revenue recognition policy meets your objective of
being simple and inexpensive, and it provides relevant information to the users.
I recommend that the legal fees be capitalized since they must be incurred to obtain the "reverse
mortgage" in the home. However, the bank interest should be expensed for the reason stated
above.
The costs incurred in producing and distributing the proposed offering document will be
substantial. These costs should be excluded from the determination of income and should be
reported as a reduction in shareholders' equity.
b. Both adverse selection and moral hazard have important implications for the proposed
business. Adverse selection will result in a pool of seniors that are potentially much less
profitable than would be expected from a random sample from the population. Moral hazard will
result in homes that may be less valuable than anticipated.
To understand why these two information asymmetries are so important for this business, it is
essential to understand the nature of the “reverse mortgages.” A bank that offers a conventional
mortgage to homeowners is a creditor: in exchange for loaning the homeowner a fixed sum of
money, the bank has a fixed claim on the home and other assets of the borrowers. In contrast,
HVHL’s reverse mortgage is an equity claim: in exchange for paying the seniors a fixed sum,
HVHL obtains the uncertain value of the home at some uncertain future date.
If the real estate markets in which HVHL intends to operate are reasonably active, there will be
little information asymmetry between the seniors and HVHL. However, the seniors will always
have an information advantage regarding their own life expectancy given that they have private
knowledge about their own health, the healthiness of their current and past lifestyles, past
illnesses, and their families’ history of diseases. Given this information advantage, rational
seniors will choose between a conventional or reverse mortgage based on their personal
circumstances. Specifically, seniors who are in relatively good health and expect long life
expectancies will choose the reverse mortgage because they receive the cash up front and have
no need to repay any amount until their death, which they expect to be far into the future. Other
seniors who are in relatively poor health and have short life expectancies will choose a
conventional mortgage because they expect fewer payments on the mortgage over the remainder
of their lives. Thus, the adverse selection will result in HVHL attracting seniors who will tend to
live the longest, not those who will die relatively soon and who are most profitable from
HVHL’s perspective. (In a way, this is a macabre business.) HVHL must anticipate the adverse
selection and pay a correspondingly lower amount for the reverse mortgage, which of course will
reduce the attractiveness of the product to seniors.
The realization that conventional and reverse mortgages are debt and equity contracts,
respectively, suggests that moral hazard will be a concern, just as it is for firms that issue debt or
equity. When homeowners obtain a mortgage, they retain the equity in the home and therefore
they are self-interested in maintaining the value of their home. When they obtain a reverse
mortgage, they have sold the entire equity interest in the home, since all proceeds upon the
senior’s death go to HVHL. Consequently, seniors who have reverse mortgages do not have an
interest in maintaining the value of the home.
c. The discussion in part (b) highlights what should be expected to happen if senior citizens
act rationally and choose the financial product that is in their best interest. However, HVHL’s
business plan involves a segment of the population that is particularly vulnerable. While many
seniors are physically and mentally fit, there are many who are more frail and not fully capable
of making financial decisions rationally. Would it be ethical for HVHL to sell reverse mortgages
to such seniors when it is unclear whether it is in the interest of the seniors? HVHL’s business
becomes more successful if it is able to attract seniors who will die relatively soon, so is it a good
business practice to target the seniors who are the most frail? What regulations might be
appropriate to prevent abuses by companies such as HVHL?
* The public needs financial reports to evaluate the government’s performance. To meet
the needs of the public, government accounting should provide an unbiased or
conservative representation of government performance.
* The government needs financial reports for planning purposes. To meet the government’s
needs, accounting should facilitate long-term planning and provide appropriate incentives
to manage public funds.
* B.C.’s policy could be used to manage public expectations about the government’s ability
to spend on social services over the long term.
* B.C.’s policy to recognize revenue over several years is consistent with accrual
accounting. That is, record revenue as the earnings process is completed.
* Doing so avoids “windfall” surpluses that trigger overspending by the government.
* Doing so also allows for better long-term management of public funds.
* Such a policy would provide more relevant information as it gives a fairer depiction of
the government’s financial performance to the public because future revenues are more
predictable.
* Alberta and Saskatchewan’s policy of recognizing revenue all at once is closer to cash
accounting.
* Cash accounting tends to produce reliable numbers.
* However, the amounts tend to be “lumpy,” making it difficult to predict the future.
* Such a policy is not conducive to long-term planning.
* Ebner does not appear to understand the basic principles of accrual accounting.
* If he did understand accrual accounting, then he has presented a biased view against the
B.C. government by alleging secrecy or a cover-up.
* Following accrual accounting is not being secretive; rather, it is being prudent.
* The title of the article is inappropriately sensational.
Epilogue
On February 20, 2009, less than three months after the publication of the article, Alberta
projected a $1 billion deficit for the year ending March 2009, when only six months ago the
province had forecast an $8.5 billion surplus. Alberta’s April 2009 budget for the fiscal year
ending March 2010 projected a deficit of $4.7 billion. The dramatic reversal in fortunes resulted
from plunging commodity prices as the world sank into a deep recession. Meanwhile, B.C.
continued to project a surplus for the year ending March 2009 and a deficit of only $495 million
for the next fiscal year.
a. Alternative 1: Revenue would be recognized once the consignee sells the goods to customers
because risks and rewards have been transferred to customers. At that point, PLC retains
no continuing managerial involvement, the amount can be measured reliably and the
economic benefits would flow to PLC when the consignees remit payment to PLC.
However, PLC would not be able to recognize any sales when merchandises are shipped
to the consignee stores.
Alternative 3: Revenue would be recognized once the franchisee has signed the franchise
documents for the initial franchise fee, however some of the revenue must be deferred until
future obligations of the franchisor is fulfilled. Deferred revenue would then be recognized
over the period of the contract. Furthermore, ongoing franchise revenue would be
recognized annually.
b. Alternative 1: The main concern with this alternative would be that net income could be
lower as we would lose sales from the retail stores currently purchasing the products. These
stores would now act as our agent to try to sell our products for us, charging us a
commission. A minor concern would be that whether PLC had a sophisticated inventory
tracking system to account for the inventory on consignment. Furthermore, we must also
consider that if too many stores were selling the products, it would undermine the sales at
our retail boutique.
Alternative 2: The main concern here would be the issue of collectability. There might be
uncertainty with the collectability of the installment account receivables, as credit risks of
customers become a bigger concern when they now have longer period to pay. Since we
cannot be completely certain whether the clients will be able to pay the full amount, we
might also need to be conservative when accounting for these sales, delaying the
recognition of gross profits until payment is received.
Alternative 3: The main concern here would be the costs associated with becoming a
franchisor and whether investors would be willing to become franchisees. Considering
the business had a mere net income of $80,000 this year, it is hard to imagine PLC could
afford to establish franchises in the same city without undermining sales in its own store.
As the franchisor, PLC would also need to incur expenses to exercise adequate oversight
on its franchisees.
c. In this situation, it is more likely PLC would go for alternative 2. Simply put, extending
credit to existing or potential customers was probably the easiest alterative that PLC
could adopt in this situation to boost sales. Alternative 3 of starting a franchise was probably
unrealistic given the size and business life cycle stage of PLC. Alternative 1 was
implementable, but it is uncertain how much additional sales PLC could make on
consignment given that PLC has already been selling its products to other retailers.