Case 5 - 3: Joan Holtz (A)

Note: This case has been updated from the Tenth Edition.
Approach
These problems are intended to provide a basis for discussing questions about
revenue recognition that are not dealt with explicitly in the text and that are not
sufficiently involved to warrant the construction of a regular case. Instructors can
pick from among those listed. Some of them can be used as a take-off point for
elaboration and extended discussion by adding !hat if"# facts.
Answers to Questions
$. If electricity usage tended to be fairly constant from month to month% one could
argue in this case for basing reported revenues solely on the actual meter
readings: the unreported usage in &ecember would be reported in 'anuary% and
overall revenues for this year would not be materially misstated. Stated another
way% if revenues are based solely on meter readings% the &ecember ())$
post-reading usage *which is recorded in 'anuary ())(+ is% in effect% assumed to
be the same ())( post-reading usage. ,rior to passage of the $-./ Tax 0eform
1ct% this approach was permitted for income tax purposes. The $-./ act
requires the more acceptable *due to better matching+ practice: estimating actual
usage for the part of &ecember after meters are read and reporting that usage as
part of the revenues of that year. This is more sound accounting% in that with
weather fluctuations and energy conservation efforts% it is questionable whether
the post-reading usage in &ecember ())$ would in fact not differ materially
from the post-reading usage in &ecember ())(. 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. 2oth of these examples illustrate
that even when cash is involved% the measurement of revenue is not necessarily
straightforward.
(. This is one of the problems whose true# resolution depends on events that
cannot be foreseen at the end of the accounting period. Some firms count the
whole 3$)%))) as revenue in ())$ on the grounds that it is in hand and that any
specific services are undefined and4or separately billable. 5thers take the more
conservative approach of counting only 36%))) as revenue in ())$ 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.
7. 8any would argue that the service involved is the cruise and that no revenue
has been earned until the cruise has been completed. 5thers maintain that
0aymond9s has completed its service# of arranging the cruise% that it is
extremely unlikely that events will happen in ())( that will change its profit of
3()%)))% and that the amount is therefore revenue in ())$. Introduction of the
possibility of a refund lessens the strength of the argument of the latter group.
This position can be weakened further by asking: *a+ !hat if passengers are
dissatisfied and demand *or sue for+ a refund" *b+ !hat if the ship owner
performs unsatisfactorily and 0aymond9s% in order to protect its reputation%
steps in and incurs additional food or other cost to make the passengers happy"
Students should be reminded to consider two criteria: *$+ that the agency has
substantially performed its earning activities and *(+ that the income is reliably
measurable.
:. This problem has been debated for many years. Some argue that the 3: 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 ())$ and the full sales
value when the trees are sold in ())(. The percentage-of-completion method
can be used as an analogy. 5thers argue that there has been no transaction% and
no assurance that the trees can be sold for more than 3: in ())( because market
prices may decrease% or pests or fire may destroy them. Typically% firms facing
this issue recogni;e no revenue until harvesting the trees.
6. If a professional service firm *architects% engineers% consultants% lawyers%
accountants% and so on+ values its <obs in progress at billing rates% then it is
recogni;ing revenue as the work is performed *time applied to pro<ects+ rather
than waiting until the customer is billed. This is certainly defensible if the firm
has a contract *called a time and materials contract#+ that obligates the client to
pay for all time applied to the client9s pro<ect: the critical act of performance is
spending the time on the pro<ect% 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 pro<ect as opposed to delivering some end item to the client= they thus
record <obs in progress at estimated fee% which would be the same as billing
rates for the time applied provided the pro<ect is within its professional-hour
budget. 5f course% whether the revenue is recogni;ed when the time is applied
or when the client is billed does make a difference in owners9 equity. 0etained
earnings will reflect the margin on the time applied sooner if the <obs in
progress inventory is valued at billing rates rather than at cost.
/. >umerous 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 /) cent
reimbursements made in ())$ and the /) cent reimbursements made in ())(
are an expense of selling tea in ())(. Those who tie the coupons with coffee
would say that the entire () percent of coupons redeemed is an expense of
selling coffee in ())$ with the amount not yet redeemed being a liability as of
&ecember 7$% ())$. 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 $)
cents. It is /) cents per coupon that is the cost% not the 6) cent face value.
?. The bank would record the sale of 36)) travelers checks for 36)6 as follows:
&r. @ash............................................... 6)6
@r. ,ayable to 1merican Axpress..... 6))
@ommission 0evenue.................. 6
1fter the bank remits the 36)) cash to 1merican Axpress% the latter will make the
following entry:
&r. @ash............................................... 6))
@r. Travelers @hecks 5utstanding. . . 6))
The account credited is a liability account. This account had a balance of many
billions of dollars% which should help students understand why 1merican
Axpress does not itself levy a fee on the issuance of travelers checks: the checks
are a great source of interest-free capital to 1merican Axpress.
.. 1ccording to FASB Statement No. 49, 8anufacturer 1 cannot record a sale at
all under these circumstances. The merchandise must remain as an asset on
8anufacturer 19s balance sheet and a liability should be recorded at the time the
3$))%))) is received from 2. This statement precludes 8anufacturer 1 from
inflating its ())$ revenues and income by the sort of repurchase agreement
described. FASB 49 was issued to address the perceived abuse of treating such
temporary title transfers as sales.
-. FASB Statement No. 4 states that franchise fee revenue should be
recogni;ed when all material services or conditions relating to the sale have
been substantially performed or satisfied by the franchiser.# 1morti;ation 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 3$)%))) franchise fee
should be recogni;ed as revenue in the year received% as soon as the training
course has been completed. Investors will need to make their own <udgment as
to what will happen when the market becomes saturated.
$). This item is designed to get students to think about *$+ a condition that
creates the need for a change in revenue recognition policy% and *(+ the potential
need for multiple revenue recognition policies for a firm.
Tech-Bogic% a manufacturer of computer systems% normally recogni;es revenue
when its products are shipped% a policy common among manufacturing firms.
To adopt that policy% managers at Tech-Bogic must have concluded that the two
criteria for revenue recognition were met at shipment: *$+ Tech-Bogic would
have substantially performed what is required in order to earn income% and *(+
the amount of income Tech-Bogic would receive could be reliably measured.
!ith the sale of the computer systems to the organi;ation in one of the former
Soviet Cnion countries% however% Tech-Bogic9s ability to satisfy these two
criteria changed. 1lthough 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. Dence% Tech-Bogic should not recogni;e revenue for
these computer systems at shipment or delivery. 1n alternative should be to
wait until cash *in the form of hard currency+ was received to recogni;e
revenue.
This item can also be used to discuss the fact that firms often have more than
one revenue recognition policy. Tech-Bogic would not completely change its
revenue policy to cash receipt# for all sales at the time it begins to sell
computers to organi;ations in countries where the availability of foreign
exchange currency is in doubt. 0ather% it would be likely to have two revenue
recognition policies= at shipment% for products sold to organi;ations in countries
where the availability of foreign exchange currency is not in doubt= and cash
receipt% for products sold to organi;ations in countries where the availability of
foreign exchange currency is in doubt.
2ecause they manufacture products and provide a variety of services% computer
manufacturers often have a variety of revenue recognition policies. Eor
example% a computer manufacturer might recogni;e 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 $) was inspired by events that occurred at Sequoia Systems in $--(.
Sequoia evidenced several instances of aggressively booking revenue. 5ne of
these involved a Siberian steel mill. 1ccording to The !all Street "ournal#
Axecutives signed off last year on the sale of a 37 million computer destined
for a steel mill in Siberia. 2ut government approvals and hard currency to
pay for the system got stalled% even though 3( million of revenue was
booked in the fiscal year ended 'une 7)% and another 3$ million was going to
be taken in the first quarter ended last month% insiders say.
$
Sequoia executives stated that they expected this Fthe Siberian steel millG 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
Dowever% under investigation by the SA@ and facing lawsuits by
shareholders% Sequoia twice restated revenues following the end of fiscal year
$--(% reducing originally reported revenues by more than $) percent.
7
$
The !all Street "ournal, Sequoia Systems 0emains Daunted by ,hantom Sales%# 5ctober 7)% $--(% p. 2..
$
Ibid.
7
Ibid.