CHAPTER 5

REVENUE AND MONETARY ASSETS

Changes from Eleventh Edition
The chapter has been updated.
Approach
The sequence of transactions for accounts receivable and bad debts often causes difficulty; indeed, the
time that one is sometimes forced to spend on this topic is all out of proportion to its importance. Students
often do not understand why an Allowance for Bad Debts account is necessary at all; they do not grasp
the notion that although we feel reasonably sure that some accounts will go bad, we do not 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.)
Bausch & Lomb, Inc., is an actual case situation involving revenue recognition.
Boston Automation Systems, Inc. involves a review of the companys revenue recognition practices in the
light of the SECs SAB 101 (a longer version of the case was included in the Eleventh Edition).
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

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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:

$3,000

dr. Allowance for Doubtful Accounts.........................................

cr. Accounts Receivable................................................
To record the partial payment:

$3,000

$3,000

$3,000

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

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.

(1-Probability of collection.)

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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..............................................................

$51,750
22,500
$29,250

Problem 5-5
Green Lawns books:
dr. Inventory on Consignment...........................................................
cr. Finished Goods Inventory.......................................................

8,400
8,400

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:
dr. Accounts Receivable...................................................................
Cost of Goods Sold......................................................................
cr. Sales...................................................................................
Inventory on Consignment..................................................
(This can be shown as two entries.)

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

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.

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...............................................................................

$161,700

69,300
$231,000

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.
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

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are interpretable with great precision. They are most meaningful if calculated for the same company over
a period of years.
c. Days receivables = 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 updated.
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
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).
(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 2006 is calculated as
follows:

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Anthony/Hawkins/Merchant

Accounts Receivable, December 31, 2005..............................

Add increase to A/R from sales on account during 2006........

$ 988,257
9,965,575
10,953,832

Less decrease to A/R for accounts for which payment was

received during 2006...............................................................

9,685,420
1,268,412
26,854
$ 1,241,558

Less accounts written off in 2006............................................

Add that portion still due on previously written-off account

which was paid in part in 2006 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 2006 is
calculated as follows:
Allowance for Doubtful Accounts, December 31, 2005..........
$29,648
Less Accounts Receivable written off in 2006........................
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.................................

29,886

Total allowance for Doubtful Accounts, December 31, 2006. .

$37,274

4,594
7,388

The Allowance for Doubtful Accounts remaining on the books at the end of 2006 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 2006 is calculated as follows:
Allowance for Doubtful Accounts, December 31, 2005.........
Less Accounts Receivable written off in 2006........................
Balance in account.................................................................
Add additional bad debt expense............................................
Total Allowance for Doubtful Accounts, December 31, 2006

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

Question 2
Using (a)

Using (b) or (c)

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Chapter 5

Balance of accounts as of December 31, 2006:

Accounts Receivable......................................................................
Less allowance for doubtful accounts.............................................

$1,242,478
37,274
$1,205,204

$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.

2006
Current ratio..................................................................................
Acid-test ratio...............................................................................
Days cash.....................................................................................
Days receivables: method (a).......................................................
method (b) or (c)......................................................................

2.7
1.5
N/A
44.1
44.2

Case 5- 2: Grennell Farm

Note: This case has been updated from the Eleventh Edition.
Approach
This case is a good illustration of a situation where revenue recognition is not a cut-and-dried question. It
also provides excellent reinforcement of the matching concept and statement articulation. The alternatives
discussed are: (1) the production method, which recognizes inventory holding gains as revenue; (2) the
sales method, which is analogous to the financial accounting method of revenue recognition of most
manufacturers and retailers; and (3) the collection method, which recognizes revenues as collected, but is
not quite the same as cash-basis accounting (since costs are accrued). While either the production method
or sales method is acceptable under GAAP, that is really a moot point since Denise Grey is the sole owner
of the incorporated farm, and not bound by GAAP. Once the issue of how much revenue to recognize is
resolved, then how much expense to match can be dealt with. Together, these two issues determine how
much gross profit Grennell farm will be shown as earning.

Question 1
The calculations shown below for Question 1 show the range of sales figures under different recognition
methods. I start with the sales method, then do the collection method, and save the more unusual
production method until last. An issue is whether the entire $183,000 annual costs not related to the
volume of production should be treated as product or period expense. Unless the instructor for some
reason is using this case after Chapter 6, the students may not recognize this as an issue or, if they do, not
know how to deal with it in the financial statements. In any event, I think it worthwhile for the instructor
to note that these expenses are by definition fixed (do not vary with production volume), but that some
(especially a portion of salaries and wages) may be production costs and hence strictly speaking should be
used in valuing inventory. (Students often mistakenly use fixed costs and period costs as synonyms.)
Of course, the point of Question 1 is not just practice in revenue and expense matching calculations, but
thinking about which is the most appropriate method. For tax purposes, Grey will want to use the
collection method. For evaluating the performance of the farm in 2005, the production method would
seem most useful. This is because there is very little uncertainty concerning the eventual sale of the
30,000-bushel wheat inventory stored at the farm. This inventory exists, not because there are no
customers for it, but because the farm manager chose not to sell it, speculating that future prices will be
higher. This is the same reasoning that justifies this unusual revenue recognition method as GAAP; the
same method is also allowed for precious metals and other minerals where immediate marketability at
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quoted prices obtains. Also, many professional service firms (e.g., accounting firms) recognize revenue as
work is performed by recording jobs in progress at billing rates rather than at cost. The name Unbilled
Receivables is often used for this account to emphasize that the revenue has already been recognized,
even though it has not yet been billed.

Exhibit A
Collect the cash
from the customer
Customer acknowledges
receipt of the item

Collection Method

Ship the product to the

customer and send a
sales invoice

Usual Method
(Delivery Method)

Receive an order for the product

from a customer

Production Method

Purchase raw material

Convert the raw material
to a finished product
Inspect the product

Store the product in

a warehouse
To generalize the discussion, I put on the board a cash cycle diagram like the one in Exhibit A to this
note. Starting with purchases, I go around this wheel and add to its interior the three points at which
revenue can be recognized: these correspond to the three methods in the case, including the usual
method of recognizing revenue when goods are shipped. When is the correct point to recognize
revenue? This diagram points out that the answer is not clear-cut. Conservatism would say do not
recognize the revenue until there is very little uncertainty as to receipt of the cash proceeds, driving the
revenue recognition toward the collection point. Timeliness would argue for recognizing the revenue
when the critical event or performance has taken place, in this instance as soon as a certainly salable
product has been produced, i.e., the production method for Grennell. The measurability of income
criterion does not help select a method in this instance, as the Question I calculations are feasible for all
three methods.

Question 2
The original cost of the land was only $187.50 an acre: it is now appraised (for estate tax purposes) at
$1,050 per acre, or $2.1 million. The cost concept says that, at least prior to the transfer of ownership to
Grey (and possibly even afterwards), the balance sheet will show the land at its cost, $375,000. However,
again GAAP need not prevail here, for Grey is trying to assess the economic attractiveness of the farm.
Since she could sell the land for $2.1 million (or more, if the estate tax valuation was below market) and
invest the proceeds elsewhere, she will likely want to use the higher valuation in her assessment. (Again,
this is an argument often given for stating assets at current values: the asset is, in effect, tying up $2.1
million, not $375,000.) If Grey wants to think of selling only the 100 acres for the development, then she
may think of the land value as $2.22 million (1,900 * $1,050 plus $225,000). The point is that the
$375,000 historical cost is the least relevant for Greys purposes.

Question 3
Assuming Grey agrees that the combination of the production method of revenue recognition and the
$2.22 million land valuation best serve her appraisal purposes, then in 2005 we have $323,370 net income
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on an owners equity investment of $2,482,100 ($637,100 plus $1,845,000 write-up of land), or a 13

percent before-tax return on investment. When one considers future appreciation of the land, this may
well be a better investment than Grey would be able to make with the proceeds from selling the farm.

GRENNELL FARM
Income Statements
Sales.................................................................................
Cost of goods sold
Beginning inventory............................................
Production2..........................................................
Less: Ending inventory........................................
Cost of goods sold...............................................
Gross margin....................................................................
Other expenses ................................................................
Net Income.......................................................................
Balance Sheets
Cash..................................................................................
Accounts receivable..........................................................
Inventory..........................................................................
Land.................................................................................
Buildings and machinery (net)..........................................
Total assets..........................................................
Liabilities (current)...........................................................
Owners equity8................................................................
Common stock and APIC....................................
Retained earnings................................................
Total owners equity.........................................................
Total liabilities and owners equity...................................

Sales
$522,000

Method:
Collection Production
$462,4001
$614,1005

0
107,730
15,390
92,340
429,660
183,000
$246,660

0
107,730
25,6503
82,080
380,320
183,000
$197,320

0
107,730
06
107,730
506,370
183,000
$323,370

$ 30,900
59,600
15,390
375,000
112,500
593,390
33,000

$ 30,900
04
25,650
375,000
112,500
544,050
33,000

$ 30,900
151,7007
0
375,000
112,500
670,100
33,000

457,500
102,890
560,390
$593,390

457,500
53,550
511,050
$544,050

457,500
179,600
637,100
$670,100

Notes:
1
180,000 bushels @ $2.90 - 20,000 bushels @ $2.98 = 160,000 but @ $2.89.
2
210,000 bushels @ $.513 = $107,730.
3
30,000 bushels physically in inventory plus 20,000 bushels inventory at the elevator, reflecting
payment not yet received from the elevator operator.
4
Under the collection method, there ae no accounts receivable since sales revenues aer not recognized
until the collection is made.
5
30,000 bushels @ $3.07 + 180,000 bushels @ S2.90. Another approach is as follows:
210,000 bushels @ $2.80 = $588,000 (value at harvest)
180,000 bushels @ 0.10 =
18,000 (gain on sales to elevator)
606,000
30,000 bushels @ $0.27 =
8,100 (write-up to year-end value)
$614,100
Given the texts description of the production method, I treat $606,000 as an acceptable answer, but point
out the logic of writing up the 30,000 bushels on hand for purposes of the year-end balance sheet.
6
Although there are 30,000 bushels physically in inventory, under the production method all wheat is
counted as sold, and hence is not in inventory in an accounting sense.

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This includes the $59,600 real receivable plus $92,100 recorded as revenue on the 30,000 bushels
produced but not physically sold. Students may create a different account for this $92,100, for example,
Unbilled Receivables, which is fine.
8
If you assume that the case statement Grennell withdrew most of the earnings means that Retained
Earnings at the beginning of the year was zero, then the 2005 drawings can be determined as follows:
Sales
Collections Production
Beginning Retained Earnings...........................................
$0
$0
$0
Plus: Net Income..............................................................
246,660
197,320
323,370
Less: Ending Retained Earnings.......................................
102,890
53,550
179,600
Drawings.............................................................
$143,770
$143,770
$143,770
Case 5- 3: Joan Holtz (A)
Note: This case has been updated from the Eleventh 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
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 2006 post -reading
usage (which is recorded in January 2007) is, in effect, assumed to be the same 2007 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 more sound accounting, in that with weather fluctuations and energy
conservation efforts, it is questionable whether the post-reading usage in December 2006 would in
fact not differ materially from the post-reading usage in December 2007. 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 2006 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 2006 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 2007 that will change its
profit of $20,000, and that the amount is therefore revenue in 2006. Introduction of the possibility of a
refund lessens the strength of the argument of the latter group. This position can be weakened further
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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 2006 and the full sales value when the trees are sold in 2007. 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 2007 because market
prices may decrease, or pests or fire may destroy them. Typically, firms facing this issue recognize no
revenue until harvesting the trees.

5.

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.

6.

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 2006 and the 60
cent reimbursements made in 2007 are an expense of selling tea in 2007. Those who tie the coupons
with coffee would say that the entire 20 percent of coupons redeemed is an expense of selling coffee
in 2006 with the amount not yet redeemed being a liability as of December 31, 2006. 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.

7.

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.
8.

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
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Manufacturer A from inflating its 2006 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.
9.

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.

10.

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 this ;obthe Siberian steel mill;cb and similar sales will
1

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

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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. 2 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. 3
Case55:BostonAutomation.Systems,Inc.*
Note:AshorterversionoftheEleventhEditioncase.
David Fisher, the chief financial officer of Boston Automation Systems, Inc. a capital equipment
manufacturingandtestinginstrumentsuppliertoavarietyofelectronicbasedindustries,includingthe
semiconductor industry, was reviewing the revenue recognition practices of the companys three
divisions.Thereviewwasundertakeninanticipationofdisclosinginthecompanysthirdquarter2000
Form10QfilingwiththeSecuritiesandExchangeCommission(SEC)andthepossibleimpactonthe
companyoftherevenuerecognitionandreportingguidelinessetforthintheSECsStaffAccounting
BulletinNo.101,RevenueRecognitioninFinancialStatements(SAB101).SAB101hadtobeadopted
nolaterthanthefourthquarterof2000.
In particular, Fisher was concerned about the effect of SAB 101s guidelines covering customers
acceptanceandunfulfilledsellerobligationsonthecompanysrevenuerecognitionpractices.Fishers
staffhadbeenstudyingthisaspectofSAB101andthecompanysrevenuerecognitionpracticesfor
several months. As a test of his own understanding of the issue, Fisher selected from each of the
companysthreedivisionsalimitednumberofrepresentativesaletransactionstoreview.Ineachsituation
thequestionFisherposedwas,
Assuming all other revenue recognition criteria are met other than the issues raised by any
customeracceptanceprovisions,whenshouldrevenueberecognized?
StudentsareaskedtoassumetheroleofFisherandreachconclusionsastotheappropriaterevenue
recognitiondecisionineachofthesaletransactionsreviewedbyFisher. 1
TeachingPlan
Theclassdiscussioncanopenwithabrieffinancialanalysisofthecompanysperformanceandthen
proceedintheorderofthequestionslistedattheendofthecase.
Thefinancialanalysisshouldfocusonthecompanyshighsalesgrowthandits1998problemsand1999
recovery. This discussion will provide some insight and background into why changing revenue
recognitionmethodsissoimportanttothiscompany.
Question 1 is designed to ensure that students identify the companys current revenue recognition
accountingpolicies.ThisknowledgewillbeusedlaterintheclasstohighlighttheseriousthreatSAB101
2
3

Ibid.
Ibid.

The Glendale Division and Advanced Technology Division sale transactions reviewed by Fisher and the teaching notes
discussion of these sale transactions are based primarily on case examples included in Exhibit A of the Securities and Exchange
Commissions Staff Accounting Bulletin No. 101: Revenue Recognition in Financial Statements---Frequently Asked Questions
and Answers.

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posestothecompany.ItmayhavetodefermorerevenuethanitdidbeforeitadoptedSAB101.
Question2s purposeistogivethe subsequent class discussion of the individual sale transactions a
managerialperspective,whichshouldhelptomakewhatcouldbeadullaccountingdiscussionmore
relevanttothestudents.TherevenuerecognitiondecisionsFishermustmakeinthenextquarterhave
potentiallysignificantadverseconsequencesforthecompany.Theaccountingdecisionsareimportant
managerialdecisions.
Question3shouldtakeupthebulkoftheclass.Aseachsaletransactionaccountingissueisresolved,the
instructorshouldasktheclasstoexplaintheaccountingentriesrequiredbytheconclusion.Totestthe
studentsunderstandingoftheirconclusions,theinstructorshouldasktheclasstoreconsiderthefactsofa
resolved situation with modifications. For example, in the Technical Devices Division example the
instructormightchangethecasefactsbystatingthedivisionseldom,ifeverinthepastacceptedproduct
returnsfromdistributors.Then,theinstructorshouldask,Doesthisfactchangealteryourdecision?
The final questionshouldlead to anopen discussion, whichthe instructor shouldfocus onwhether
accountingstandardsshouldbestatedingeneralprinciples(revenueshouldberecognizedwhenearned
andrealized)ordetailedguides(SAB101).Thisisafundamentalaccountingstandardsettingissue.For
example,manybelievetheInternationalAccountingStandardsCommittees(IASC)approachtowriting
standards is preferable to the Financial Accounting Standards Boards (FASB) approach. The IASC
writesstandardsintermsofgeneralprincipleswithsomeguidelinesontheirapplicationandthenleavesit
uptomanagementtoapplythestandardinawaythatreflectstheparticularfactsofthesituation.In
contrast,theFASBwritesstandardsthataremorelikecookbooks.TheyaremorelikeSAB101,which
isverydetailedinitsguidanceandmuchmorerestrictiveinitspermitteduseofjudgment.
SAB 101
The general rule governing revenue recognition is:

Revenue should not be recognized until it is realizable and earned.

Because the general rule has been abused by some companies, more specific criteria for revenue
recognition have been prescribed by the SEC in SAB 101. As a result, revenue is now considered to be
realized and earned when:

Persuasive evidence of an order arrangement exists,

Delivery of the ordered goods has occurred or services have been rendered:
The sellers prince to the buyer is fixed or determinable, and,
Collectibility of the sale proceeds is reasonably assured.

Persuasive Evidence
Purchase order and sale agreement documentation practices vary widely between customers, companies,
and industries. The SEC appears to be willing to accept as persuasive evidence of an agreement these
practices as long as there is some form of written or electronic evidence that a binding final customer
purchase authorization, including the terms of sale, is in the hands of the seller before revenue is
recognized.
Delivery

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Typically revenue is recognized when delivery has occurred and the customer has taken title and assumed
the risks and rewards of ownership of the goods specified in the customers purchase order or sales
agreement. More specifically,

Delivery is not considered to have occurred unless the product has been delivery to the
customers place of business.
If uncertainty exists about a customers acceptance of a product or service, revenue should not be
recognized even if the product is delivered or the service performed.
Revenue should not be recognized until the seller has substantially completed or fulfilled the
terms specified in the purchase order or sales agreement.
In licensing and similar arrangements, delivery does not occur for revenue recognition purpose
until the license term begins.

Performance
SAB 101 requires substantial performance of the sales arrangement by the seller and acceptance by the
customer of the product or services rendered before revenue can be recognized SAB 101 notes:

A seller should substantially complete to fulfill the terms specified in the sales arrangements, and
After delivery or performance, if uncertainty exists about acceptance, revenue should not be
recognized until after acceptance occurs.

There are two exceptions to the above requirement. Assuming all of the other recognition criteria are met,
the first exception is that revenue in its entirety can be recognized if the sellers remaining performance
obligation is inconsequential or perfunctory. In this case, any related future costs must be accrued and
expensed when revenue is recognized.
A remaining performance obligation is not inconsequential or perfunctory if:

The remaining performance obligation is essential to the functionality of the delivered products or
services.
Failure to complete the activities would result in the customer receiving full or partial refund or
rejecting the product or services rendered to date.

In considering if a remaining performance obligation is or is not inconsequential or perfunctory, the SEC

staff has indicated that the following factors, which are not all-inclusive, would be considered.

The seller does not have a demonstrated history of completing the remaining tasks in a timely
manner and reliably estimating their costs.
The cost or time to perform the remaining obligations for similar contracts historically has varied
significantly from one instance to another.
The skills or equipment required to complete the remaining activity are specialized or are not
readily available in the marketplace.
The cost of completing the obligation or the fair value of that obligation is more than significant
in relation to such items as the contract fee, gross profit, and operating income.

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The period before the remaining obligation will be extinguished is lengthy. Registrants should
consider whether reasonably possible variations in the period to complete performance affect the
certainty that the remaining obligations will be completed successfully and on budget.
The timing of payment of a portion of the sales price is coincident with completing performance
of the remaining activity.

The second exception is a multiple-element deliverables sales arrangement. In this case, a portion of the
contract revenue may be recognized when the seller has substantially completed or fulfilled the terms of a
separate contract element. Pending additional accounting guidance, on multiple-element revenue
arrangements, the SEC indicated that it will accept any reasoned method of accounting for multipleelement arrangements that is applied, consistently and disclosed appropriately. The SEC will not object to
a method that includes the following conditions.

To be considered a separate element, the product or service represents a separate earnings

process.
Revenue is allocated among the elements based on their fair value.
If an undelivered element is essential to the functionality of a delivered element, no revenue is
allocated to the delivered element until the undelivered element is delivered.

In the case where a customer is not obligated to pay a portion of the contract price allocable to delivered
equipment until installation or similar service, recognition of revenue on the delivered equipment may be
recognized if the installation is not essential to the functionality of the equipment. Examples of indicators
that installation is not essential to the functionality of the equipment include:

The equipment is a standard product.

Installation does not significantly alter the equipments capabilities.
Other companies are available to perform that job.

Conversely, examples of indicators that the installation is essential to the functionality of the equipment
include:

The installation involves significant changes to the features or capabilities of the equipment or
building complex interfaces or connections.
The installation services are unavailable from other vendors.
Contractual customer acceptance provisions must be satisfied before revenue can be recognized.

Customer acceptance provisions typically come in one of four forms:

1.

Acceptance provisions in arrangements that purport to be for trial or evaluation purposes.

In substance, these transactions are consignment-type sales, and revenue should not be recognized until
earlier of acceptance or the acceptance provisions lapses.
2.
3.

Acceptance provisions that grant a right of return or exchange on the basis of subjective matters.
Acceptance provisions that grant a right of replacement on the basis of seller-specified objective
criteria.

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Revenue can be recognized rather than deferred so long as a provision can be reasonably determined for
the amount of future returns based upon historical return experience of a similar sufficiently large volume
of homogeneous transaction.
4. Acceptance provisions based on customer-specified objective criteria.
Formal customer sign-off provides the best evidence of acceptance. In its absence, revenue can be
recognized rather than deferred if the seller can reliably demonstrate that a delivered product meets the
customer-specified objective criteria.
Consignment-Type Transactions
Products shipped pursuant to a consignment arrangement should not be recorded as revenue since the
consignee has not assumed the risks and rewards of ownership. This is long-standing rule. SAB 101 goes
further. It states that the following characteristics in a transaction preclude revenue recognition even if
title to the product has passed to the buyer:

The buyer has the right to return the product and

the buyer does not pay the seller at the time of sale, and the buyer is not obligated to pay the
seller at a specified date or dates;
the buyer does not pay the seller at the time of sale but rather is obligated to pay at a
specified date or dates, and the buyers obligation to pay is contractually or implicitly
excused until the buyer resells the product or subsequently consumes or uses the product;
the buyers obligation to the seller would be changed (e.g., the seller would forgive the
obligation or grant a refund) in the event of theft or physical destruction or damage of the
product;
the buyer acquiring the product for resale does not have economic substance apart from that
provided by the seller, or
the seller has significant obligations for future performance to directly bring about resale of
the product by the buyer.
The seller is required to repurchase the product (or a substantially identical product or processed
goods of which the product is a component) at specified prices that are not subject to change
except for fluctuations due to finance and holding costs, and the amounts to be paid by the seller
will be adjusted, as necessary to cover substantially all fluctuations in costs incurred by the buyer
in purchasing and holding the product (including interest). The indicators of the latter condition
include:
The seller provides interest-free or significantly below market financing to the buyer
beyond the sellers customary sales terms and until the products are resold.

The seller pays interest cost on behalf of the buyer under a third-party financing
arrangement or
The seller has a practice of refunding (or intends to refund) a portion of the original sales
price representative of interest expense for the period from when the buyer paid the seller
until the buyer resells the product.
The seller guarantees the resale value of equipment to a purchaser, and the transaction
does not qualify for sale-type lease accounting. This transaction should be recorded as an
operating lease.
The product is delivered for demonstration purposes.

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RevenueRecognitionMethods
BostonAutomationSystemshasadoptedthefollowingrevenuerecognitionpolicies.
1.
2.
3.
4.

Recognizerevenueuponproductshipment
Recognizeservicerevenueratablyasserviceisprovidedovertheperiodoftherelatedcontract.
Recognizelongtermcontractrevenueusingthepercentageofcompletionaccountingmethod
Revenue from multideliverables contracts is allocated to each deliverable based upon the
amountschargedforeachdeliverablewhensoldseparately.
5. Thecompanyprovidesestimatedwarrantycostswhenproductrevenueisrecognized.
Theinstructorshouldaskstudentstoexplaintheaccountingentriesforeachrevenuerecognitionpolicyas
itisidentifiedbytheclass.Attheendofthispartofthediscussiontheinstructorshouldaskastudentto
explaintheaccountingentriesthecompanywillmaketorecordthecumulativeeffectadjustmentresulting
fromthechangeinaccountingprinciples.
TherecognitionpolicymostlikelytobeimpactedbySAB 101isrecognize revenueuponproduct
shipment. In particular, those sale transactions that involve customer acceptance and unfulfilled
obligationssubsequenttoshipment.
Whilethestudentsdonotknowit,theinstructorshouldbeawarethatSAB101specificallyexcludesthe
percentageofcompletionaccountingmethodfromitsscope.
FishersConcerns
AnexaminationofBostonAutomationSystemsconsolidatedfinancialstatementsclearlyshowsthatthe
companyhasbeengrowingbothitssalesandnetincomeatadoubledigitrate.Ifmorerevenuemustbe
deferredasaresultofapplyingSAB101,thishighgrowthratemightbehardertomanageorachievein
thefuture.Ontheotherhand,deferralofproductsalerevenue(whencombinedwiththeunearnedservice
revenuealreadyonthebalancesheet)maydampensomeofthecyclicalindustryeffectonthevolatilityof
itscompanysrevenuesandearnings.Achangeintherevenuerecognitionmethodsmayleadsometo
questionthecompanysreboundfromits1998problems(excessinventoryandlowerprofits.)
TheAdvancedTechnologyDivisionappearstobethedivisionthatwillmostlikelytobeimpactedby
SAB 101. It sales transactions involve complex equipment and appear often to involve significant
installationandequipmentperformanceobligations.
ThetroubledTechnicalDevicesDivisionssalesstrategyshiftandtherelatedinventoryloadingofits
distributionchannelsmightleadtoanadverseearningqualityreactionbyinvestorsifthedivisionbooked
themechanicaltestingdevicesalesimmediatelyandinvestorslearnedofit.Fishershouldbeconcerned
aboutthispossibility.
Fishermightfindthecumulativeeffectadjustmenttroublesome.Itwillbeachargetoearningsanda
credit todeferredrevenues. Someinvestors may react negatively tothis onetime charge thinking it
implies the company had been too aggressive in its past revenue recognition practices by recording
revenue(andearnings)prematurely.
Fishershouldalsorecognizethatthecompanysgeneralrevenuerecognitionpolicyneedstochange.In

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thefuturerevenueshouldberecognizedupondelivery(notshipment)sincetitlepassestothecustomer
upondelivery.
SalesTransactions
Fishersdecisionsontheappropriaterevenuerecognitionaccountingforeachofthesalestransactionshe
reviewedispresentedbelow.
Trycom,Inc.
While the SEC staff presumed that customer acceptance provisions are substantive provisions that
generallyresultinrevenuedeferral,thatpresumptioncanbeovercome.Althoughthecontractincludesa
customeracceptanceclause,acceptanceisbasedonmeetingthedivisionspublishedspecificationsfora
standardmodel.Thedivisiondemonstratesthattheequipmentshippedmeetsthespecificationsbefore
shipment,andtheequipmentisexpectedtooperatethesameinthecustomersenvironmentasitdoesin
the sellers. In this situation, the division should evaluate the customer acceptance provision as a
warranty.Ifthedivisioncanreasonablyandreliablyestimatetheamountofwarrantyobligation,revenue
shouldberecognizedupondeliveryoftheequipmentwithanappropriateliabilityforprobablewarranty
obligations.
WhiteElectronicsCompany
Althoughthecontractincludesacustomeracceptanceclausethatisbased,inpart,onacustomerspecific
criterion,thedivisiondemonstratesthattheequipmentshippedmeetstheobjectivecriterion,aswellas
the published specifications, before shipment. Therefore, the division should evaluate the customer
acceptanceprovisionasawarranty.Ifthedivisioncanreasonablyandreliablyestimatetheamountof
warrantyobligations,itshouldrecognizedrevenueupondeliveryoftheequipment;withanappropriate
liabilityforprobablywarrantyobligations.
SiliconDevices,Inc.
Thiscontractincludesacustomeracceptanceclausethatisbased,inpart,onacustomerspecificcriterion,
andthedivisioncannotdemonstratethattheequipmentshippedmeetsthatcriterionbeforeshipment.
Accordingly,thecontractualcustomeracceptanceprovisionissubstantiveandis not overcome upon
shipment.Therefore,thedivisionshouldwaituntiltheproductissuccessfullyintegratedatitscustomers
locationandmeetsthecustomerspecificcriteriabeforerecognizingrevenue.Whilethisisbestevidenced
by formal customer acceptance, other objective evidence that the equipment has met the customer
specificcriteriamayalsoexist(e.g.,confirmationfromthecustomerthatthespecificationsweremet).
AnalogTechnology,Inc.
Whilethedivisionbelievesthatitsequipmentcanbemadetomeetthecustomersspecifications,itis
unabletodemonstratethatithasdeliveredwhatthecustomerordereduntilinstallationandtestingoccurs.
Accordingly,itwouldbeinappropriateforthedivisiontorecognizeanyrevenueuntilithasdemonstrated
thatithasdeliveredequipmentmeetingthespecificationssetforthinthecontract.Thiswouldnormally
occuruponcustomeracceptance.
SpecialtySemiconductor,Inc.

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Upondelivery,thedivisionhascompletedtheearningsprocessandmetthedeliverycriterionwithrespect
totheequipmentbecauseithasdemonstratedthattheequipmentdeliveredtothecustomermeetsthe
requirementsofthecustomersorder.However,becausethecustomerisnotobligatedtopaythedivision
if installationof the equipment is not completed, no revenue maybe recognized until installationis
completeandthecustomerbecomesobligatedtopay.Conversely,ifthedivisionhasanenforceableclaim
atthebalancesheetdatethroughwhichitcanrealizesomeorallofthe$20millionfeeevenifitfailedto
fulfilltheinstallationobligation,deferralofalesseramount,butnotlessthantheestimatedfairvalueof
theinstallation(i.e.,$500,000),wouldbeappropriate.
Alternatively,ifthedivisionspolicyistodeferallrevenueuntilinstallationiscomplete,recognitionof
the$20,000,000feeuponcompletionofinstallationwouldbeappropriate.Thedivisionspolicyshould
beappropriatelydisclosedandconsistentlyapplied.
MicroApplications,Inc.
Upondelivery,thedivisionhascompletedtheearningsprocessandmetthedeliverycriterionwithrespect
totheequipmentbecauseithasdemonstratedthattheequipmentdeliveredtothecustomermeetsthe
requirementsofthecustomersorder.Inaddition,thebuyersobligationtopaythefeeisnotcontingent
uponcompletionofinstallation.Therefore,thedivisionshouldrecognizetherevenueallocabletothe
equipment, $19,500,000, as revenue upon delivery. The remaining $500,000 of the arrangement fee
shouldberecognizedwheninstallationisperformed.
Alternatively,ifthedivisionspolicyistodeferallrevenueuntilinstallationiscomplete,recognitionof
the $20,000,000 fee upon completion of installation would be appropriate. This policy should be
appropriatelydisclosedandconsistentlyapplied.
XLSemi,Inc.
TheXLSemi,Inc.,orderisoneunitforaccountingpurposes,ratherthananequipmentsale,andan
installation sale. Installation of the equipment would affect the quality of use and the value to the
customer of the equipment. Likewise, the equipment is essential to the value of the installation.
Additionally,becauseneitherdeliverablecanbepurchasedfromanotherunrelatedvendor,theseparate
deliverablesinthearrangementdonotmeetthecriteriaforsegmentation.Further,duetothespecialized
skillinvolvedintheinstallationoftheequipment,installationisconsideredtobesubstantive,ratherthan
inconsequentialorperfunctory.Thereisastrongpresumptionthattherevenuerecognitionshouldbe
delayeduntilcustomersacceptanceisobtainedfollowingthecompletionofinstallation.
TechnicalDevicesDivision
Thepassingoftitle,theabsenceofevidencethatthedistributorsdonothavethecapabilitytopayforthe
devicesandtheproductsestablishedmarketacceptancesupportimmediaterevenuerecognitionwitha
provisionforanticipatedreturns. However,the unsettledstate of the productmarket, the uncertainty
surroundingthefuturesaleslevel,andtheabsenceofhistoricalreturndatafordistributorsalestohigh
volumecustomersarguesforrevenuedeferralonthegroundsthatreturnprovisionscannotbeestimated
reliably.
Thedistributorsunusualextendedpaymentterms,reflectingtheexpectedsellthroughofthemechanical
testingdevicescoupledwiththedivisionspastgenerousunwrittenreturnpracticessuggestthattheso

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calledsaleisinsubstanceaconsignmenttypetransaction.Revenueshouldberecognizedbythedivision
onadistributorsellthroughbasis.
Thedivisionsexcessinventorychargeraisesthequestion:Wasanyofthiswrittendowninventory
resoldduring1999and,ifso,whatwasthecostofgoodssold?Typicallyexcessinventoryiswritten
downtozerocost.
Fishershouldmakethisinquirysincetheprofitearnedonthesubsequentsaleofwrittendownexcess
inventoryshouldbedisclosedunderGAAP.
CookbookRulesVersusGeneralPrinciples
There are two basic approaches to standard setting: Issue detailed rules or standards that set forth
accountingprinciplesintheformofgeneralprinciples.
The tendency of the FASB has been to publish, accounting standards with detailed implementation
requirementsandguidelines.Thisapproachtostandardsettinghasbeencharacterizedasacookbook
approach.Itistheresultofaneedonthepartofpracticingpublicaccountants,forguidanceinthe
application of accounting standards, investors seeking uniform accounting by companies to facilitate
intercompanycomparisons,andageneralbeliefthatthisapproachwillproducefinancialstatementsthat
arefairtoallwhorelyuponthem.Withoutdetailedstandards,thesupportersofthisapproachclaim,
somemanagementwilltakeadvantageofthelackofguidancetoissuemisleadingstatementsthatwill
lowertheconfidenceofstatementusersinallfinancialstatements.
Thesupportersofthepropositionthataccountingprinciplesshouldembodyprinciplesratherthandetailed
rulesclaimaccountingrulescannotcovereverysituation.Asaresulttherewillalwaysbesomesituations
thatruleswillmissbutwhichwouldbecoveredbyawellstatedgeneralprinciple.
AccountingforEquityTransactions
Iftimepermits,theinstructormightwanttousethecompanysunusualaccountingforequitytransactions
tocoveraccountingforequitytransactions.Theunusualaccountingincludesaccountingforastocksplit
asadividend(debitcommonstock,creditpaidincapital)liketransaction(butnochangetoretained
earnings)toavoidchangingtheparvalueofthesplitstockandthereductionofcommonstockandpaid
incapitaltoreflecttheacquisitionofitsownstock(notreasurystockaccount)asifitwascanceledwhen
infacttherequiredstockisnotcancelled(itisoutstandingbutnotissued).Theinstructormayalsowant
toincludeinthisdiscussiontheaccountingforthestockoptiontaxbenefits(acapitalratherthanan
incometransaction.)
Summary
Clearly, theSECs experience has led it toconclude after reviewing revenue recognitionaccounting
practicesinsituationssimilartothosedescribedinthecasethattheapplicationofgeneralprinciples,does
not always lead to the appropriate accounting decision. The SECs response was to provide more
guidanceintheareaofrevenuerecognitionthanwasprovidedbythegeneralprinciplethatrevenue
shouldberecognizedwhenitisearnedandrealized.ThisSECresponsehadaprofoundimpactonthe
revenuerecognitionpracticesofmanycompanies.Forexample,itrangedfromretailerschangingtheway
they accounted for layaway plans (revenue was deferred rather than recognized immediately) to

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manufacturerslikeBostonAutomationSystemswithsignificantpostdeliveryobligations(theyhadto
deferratherthanrecognizeincomeimmediately).

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