CHAPTER 5

Case 5-1

a. Earnings management is the attempt by corporate officers to influence short-term

reported income. It is believed that managers may attempt to manage earnings
because they believe investors are influenced by reported earnings. The methods of
earnings management include the use of production and investment decisions, and
the strategic choice of accounting techniques (including the early adoption of new
accounting standards). In most cases, earnings management techniques are designed
to improve reported income effects; however, such is not always the case. An
alternate explanation is the "Big Bath" theory which suggests that management may
take the opportunity to report more bad news in periods when performance is low to
increase future profits. An argument has also been made that management may
choose to take large write-offs in periods when their performance is otherwise
extremely positive.

b. Some methods that may be used by management to smooth earnings are: postponing
end-of-the-year inventory replacement expenditures for merchandising companies,
postponing the production of products for manufacturing companies, and the early
adoption of new FASB accounting standards such as SFAS No. 109 when it has a
positive effect on reported net income due to the recording of deferred tax benefits.

Arthur Levitt, the former chair of the SEC, has outlined five earnings management
techniques that he believes threaten the integrity of financial reporting

1. Taking a bath
The one-time overstatement of restructuring charges to reduce assets, which
reduces future expenses. The expectation is that the one-time loss is discounted
in the marketplace by analysts and investors who will focus on future earnings.
2. Creative acquisition accounting
Avoiding future expenses by one-time charges for in-process research and
development.
3. “Cookie jar” reserves
Overstating sales returns or warranty costs in good times and using these
overstatements in bad times to reduce similar charges.
4. Abusing the materiality concept

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 Deliberately recording errors or ignoring mistakes in the financial statements
under the assumption that their impact is not significant.
5. Improper revenue recognition
Recording revenue before it is earned. It was noted that over half of the SEC’s
enforcement cases filed in 1999 and 2000 involved improper revenue recognition
issues.
Case 5-2

a. A major purpose of income reporting is to allow investors to predict future cash

flows. Despite the evidence that accounting earnings are good indicators of stock
returns, the use of the transactions approach to income determination along with the
principle of conservatism, and the materiality constraint; have led security analysts to
the conclusion that economic income, rather than accounting income is a better
predictor of future cash flows. Consequently, these individuals have suggested
assessing the quality of earnings to predict future cash flows. Earnings quality is
defined as the degree of correlation between a company's accounting income and its
economic income. Several techniques have been developed to use in assessing
earnings quality including:

1. Compare the accounting principles employed by the company with those

generally used in the industry and by competitions. Do the principles used by
the company inflate earnings?

2. Review recent changes in accounting principles and changes in estimates to

determine if they inflate earnings.

3. Determine if discretionary expenditures, such as advertising, have been

postponed by comparing them to previous periods.

4. Attempt to assess whether some expenses, such as warranty expense, are not
reflected on the income statement.

5. Determine the replacement cost of inventories and other assets. Is the

company generating sufficient cash flow to replace their assets?

6. Review the notes to financial statements to determine if loss contingencies

exist that might reduce future earnings and cash flows.

7. Review the relationship between sales and receivables to determine if

receivables are increasing more rapidly than sales.

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 8. Review the management discussion and analysis section of the annual report
and the auditor's opinion to determine management's opinion of the company's
future and to identify any major accounting issues.

b. The answer to this part of the case is dependent upon the company selected. The
students should be able to address all, or, at least, most of the above issues and
reference the section of the annual report that contained the relevant information.

Case 5-3

a. Income results from economic activity in which one entity furnishes goods or
services to another. To warrant revenue recognition, the earning process must be
substantially complete and there must be realization--a change in assets that is
capable of being objectively measured. Normally this involves an arm's length
exchange transaction with a party external to the entity. The existence and terms of
the transaction may be defined by operation of law, by established trade practice or
may be stipulated in a contract.

Events that give rise to revenue recognition are: the completion of a sale; the
performance of a service; the progress of a long-term construction project, as in
shipbuilding; and the production of a standard interchangeable good (such as a
precious metal or an agricultural product) which has an immediate market, a
determinable market value, and only minor costs of marketing. The passing of time
may also be the event that establishes the recognition of revenues, as in the case of
interest or rental revenue

As a practical consideration, there must be a reasonable degree of certainty in

measuring the amount of revenue. Problems of measurement may arise in estimating
the degree of completion of a contract, the net realizable value of a receivable, or the
value of a nonmonetary asset received in an exchange transaction. In some cases,
while the revenue may be readily measured, it may be impossible to reasonably
estimate the related expenses. In such instances revenue recognition must be deferred
until the matching process can be completed.

b. Bonanza, in effect, is a merchandising firm which collects cash (for stamps) far in
advance of furnishing the goods. In addition, since the data indicates that about five
percent of the stamps sold will never be redeemed, it also has revenue from this
source unless the stamps escheat. Bonanza's revenues from these two sources could
be recognized on one of three major bases. First, all revenue could be recognized
when the stamps are sold--the sales basis or cash-collection basis if all sales are for
cash. Secondly, amounts collected at the time stamps are sold could be treated as an
advance (sometimes referred to as deferred or unearned revenue) until stamps are
exchanged for the merchandise premiums at which time all of the revenue including
that relating to the never-to-redeemed stamps could be recognized. Thirdly, some

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 revenue could be recognized at the time of redemption--this treatment would be
especially appropriate for approximately five percent of the total, the stamps that will
never be redeemed. A modification of this basis would be to recognize the revenue
from the never-to-be-redeemed stamps on a passage-of-time basis.

The principal expense, merchandise premium costs, should be matched with the
revenue. If all revenue is recognized when stamps are sold, and accrual of the cost of
future premium redemptions would be necessary. In such a case, when stamp
redemptions and related premium issuances occurred, the costs of the premiums
would be charged to the accrued liability account. On the other hand, if stamp sales
were treated as an advance, the deferred revenue would be recognized and the
matching cost of the premiums issued would be recognized with the revenue at the
time of redemption.

Under the third alternative, some predetermined portion, at least, of the revenue from
the never-to-be-redeemed stamps would be recognized when the stamps are sold, but
the recognition of the merchandise premium expense would be deferred until time of
redemption.

Reasonable estimation is crucial to income determination. Under the first alternative

it is necessary to estimate future costs of premium issuances well in advance of the
actual occurrence. In the second case it is necessary to estimate the proportion of
revenue which has already been earned on the basis of premium costs already
incurred. It is a vital certainty that not all stamps sold will ultimately be presented for
redemption. Such factors as the number of stamps required to fill a book, the types of
customers who receive stamps, and the ease of exchanging stamp books for
premiums will all affect the proportion of stamps actually redeemed in relation to the
potential redemptions. The difference between the five percent initial estimate and
the actual proportion of unredeemed stamps affects the accrual of a liability for
redemption of stamps issued under the first method and the rate of transfer of revenue
from the advances account under the second and third methods.

There will be other expenses aside from the costs of premiums issued but they should
be relatively small after the initial promotion period and they should be accounted for
under the usual principles which apply to accrual-basis accounting. Thus, premium
catalogs printed but undistributed would ordinarily be treated as prepaid expenses;
wages and salaries would be treated as expenses when incurred; depreciation, taxes,
and similar expenses would be recognized in the usual manner.

c. Under all of the alternatives Bonanza's major asset (in terms of data given in the
question) would be its inventory of premiums. Another inventory item, perhaps
minor in amount, would be the cost of printing the stamps that were on hand awaiting
sale to dealers. The major account with a credit balance would be either an estimated
liability for cost of redeeming the outstanding stamps under the first alternative or an

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 advance (deferred revenue) account under the second and third alternatives. In view
of the nature of the operation, the inventory account(s) would be included in the
current asset classification and the liability would be classified as current. The
advances could be reported preferably as a current liability or possibly as deferred
credit.

Case 5-4

a. 1. Cost is the amount measured by the current monetary value of economic

resources given up or to be given up in obtaining goods and services. Economic
resources may be given up by transferring cash or other property, issuing capital
stock, performing services, or incurring liabilities.

Costs are classified as unexpired or expired. Unexpired costs are assets and apply
to the production of future revenues. Examples of unexpired costs are
inventories, prepaid expenses, plant and equipment, and investments. Expired
costs, which most costs become eventually, are those that are not applicable to
the production of future revenues and are deducted from current revenues or
charged against retained earnings.

2. Expense in its broadest sense includes all expired costs, i.e., costs which do not
have any potential future economic benefit. A more precise definition limits the
use of the term expense to the expired costs arising from using or consuming
goods and services in the process of obtaining revenues, e.g., cost of goods sold
and selling and administrative expenses.

3. A loss is an unplanned cost expiration and for this reason is often included in the
broad definition of expenses. A more precise definition restricts the use of the
term loss to cost expirations which do not benefit the revenue-producing
activities of the firm. Examples include the unrecovered book value on the sale of
fixed assets and the write-off of goodwill due to unusual events within an
accounting period.

The term loss is also used to refer to the amount by which expenses and exceed
revenues during an accounting period.

b i. Cost of goods sold is an expired cost and may be referred to as an expense in the
broad sense of the term. On the income statement it is most often identified as a
cost. Inventory held for sale which is destroyed by an abnormal casualty should
be classified as a loss.

ii. Bad debts expense is usually classified as an expense. However, some authorities
believe that it is more desirable to classify bad debts as a direct reduction of sales
revenue (an offset to revenue). A material bad debt which was not provided for in

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 the annual adjustment, such as bankruptcy of a major debtor, may be classified as
a loss.

iii. Depreciation expense for plant machinery is a component of factory overhead

and represents the reclassification of a portion of the machinery cost to product
cost (inventory). When the product is sold, the depreciation becomes a part of the
cost of goods sold which is an expense. Depreciation of plant machinery during
an unplanned and unproductive period of idleness, such as during a strike, should
be classified as a loss. The term expense should preferably be avoided when
making reference to production costs.

iv. Organization costs are those costs that benefit the firm for its entire period of
existence and are most appropriately classified as a non-current asset. When there
is initial evidence that a firm's life is limited the organizational costs should be
allocated over the firm's life as an expense, or amortized as a loss when going
concern foresees termination. In practice, however, organization costs are often
written off in early years of a firm's existence.

v. Spoiled goods resulting from normal manufacturing processing should be treated

as a cost of the product manufactured. When the product is sold the cost becomes
an expense. Spoiled goods resulting from an abnormal occurrence should be
classified as a loss.

c. Period costs and product costs are usually differentiated under one of two major
concepts. One concept identifies a cost as a period or product cost according to
whether the cost expires primarily with the passage of time or directly for the
production of revenue. The other concept identifies a cost as a product or a period
cost according to whether or not the cost is included in inventory.

Under the first concept period costs are all costs which expire within the accounting
period and are only indirectly related to the production of revenue within the period
and product costs are those costs associated with the manufacture of a firm's product
and that generate revenue in the period of its sale. Some costs are easily associated
with the production of revenue, such as the manufacturing or purchase cost of a
product sold, and are designated as product costs. Other costs may be incurred as
costs of doing business and are more difficult to relate to the production of revenue,
such as general and administrative costs, and are classified as period costs. Costs
which cannot be readily identified with the production of revenue in any particular
period, such as the company president's salary which may produce revenue in many
distant future accounting periods, are also classified as period costs because they
cannot be specifically identified with any future accounting period.

Under the second concept product costs include only the costs which are carried
forward to future accounting periods in inventory and all expired costs are period
costs.

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Case 5-5

Step 1: Identify the contract(s) with a customer. A contract is an agreement between two
parties that creates enforceable rights and obligations. In his case Airbus has agreed to sell
airplanes to Emirates.

Step 2: Identify the Performance Obligations in the Contract. According to the terms of
the agreement, Airbus has only one performance obligation, deliver 50 A380s to Emirates.

Step 3: Determine the Transaction Price. The transaction price is the amount of
consideration (for example, payment) to which a company expects to be entitled in exchange
for transferring promised goods or services to a customer, which in this case is $20 billion.

Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract.
In this case, Airbus has only one performance obligation-to deliver 20 A380s to Emirates.

Step 5: Recognize Revenue When (or as) the company Satisfies a Performance
Obligation. Airbus recognizes the $20 billion of revenue as it delivers the A380s to Emirates.
In this case the obligation will be satisfied over time as the A380s are delivered. Airbus
should use the output method and directly measure the value of theA380s as they are
delivered

Case 5-6

Statement of Financial Accounting Concepts No.5, "Recognition and Measurement in

Financial Statements of Business Enterprises." does not suggest major changes in the current
structure and context of financial statements. However, it did suggest that a statement of cash
flows should replace the then required statement of changes in financial position (this change
was subsequently adopted).

In general, SFAC No. 5 attempts to set forth recognition criteria and guidance on what
information should be incorporated into financial statements, and when this information
should be reported. According to this Statement, a full set of financial statements for a period
shows:

1. Financial position at the end of the period.

2. Earnings for the period.
3. Comprehensive income for the period.
4. Cash flows during the period.
5. Investments by and distributions to owners during the period.

The statement of financial position should provide information about an entity's assets,
liabilities, and equity and their relationship to each other at a moment in time. It should also

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delineate the entity's resource structure-major classes and amounts of assets-and its financing
structure-major classes and amounts of liabilities and equity. The statement of financial
position is not intended to show the value of a business, but it should provide information to
users wishing to make their own estimates of the enterprise's value.

Earnings is a measure of entity performance during a period. It measures the extent to which
asset inflows (revenues and gains) exceed asset outflows. The concept of earning provided in
SFAC No. 5 is similar to net income for a period in current practice. However, it excludes
certain adjustments from earlier periods now recognized in the current period. It is expected
that the concept of earnings will continue to be subject to the process of gradual change that
has characterized its development.

Comprehensive income is defined as a broad measure of the effects of transactions and other
events on an entity. It comprises all recognized changes in equity of the entity during a period
from transactions except those resulting from investments by owners and distributions to
owners.

The relationship between earnings and comprehensive income is illustrated as follows.

Revenues
Earnings
Less: Expenses Plus or minus cumulative accounting adjustments
Plus: Gains Plus or minus other nonowner changes in equity
Less: Losses
= Earnings = Comprehensive income

The statement of cash flows should directly or indirectly reflect an entity's cash receipts
classified by major source and its cash payments classified by major uses during a period.
The statement should include cash flow information about its operating, investing and
financing activities.

A statement of investments by and distributions to owners reflects an entity's capital

transactions during a period, that is, the extent to which and in what ways the equity of the
entity increased or decreased from transactions with owners.

Case 5-7

a. The matching concept associates efforts (costs) with accomplishments (revenues).

Expenses are generally recognized when economic benefits are used up in delivering
goods or producing services - i.e., revenues are earned. Expenses are defined in
SFAC No. 6 as outflows or other using up as assets or incurrences of liabilities from
producing goods or providing services, or rendering other activities that constitute the
entity’s ongoing or central operations. This definition is consistent with the matching
concept.

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 The matching concept is important to income reporting because of the going concern
assumption. Since business entities are presumed to be going concerns, enterprise
performance must be assessed at intervals. That is, accountants must report
periodically to investors, creditors and other users. Periodic reporting requires that
accountants report on the performance of the entity during an accounting period so
that users can assess enterprise how well the enterprise is utilizing resources to
generate future cash flows for operations, reinvestment in operations, and dividends
for investors.

b. Expenses, such as cost of goods sold, are directly linked to the production of revenue.
These costs are matched directly to the revenue generated during the accounting
period. Many expenses are associated with the period in which the revenue was
generated. These costs include such items as administrative salaries or electricity for
the sales office. Other expenses are systematically allocated to the periods benefited
by their use. For example, the cost of fixed assets is typically allocated to periods
based on useful life.

c. According to SFAC No. 5, earnings and comprehensive income combined reflect the
extent to which and the ways in which the equity (net assets) of an entity increased or
decreased from all sources other than transactions with owners during the accounting
period. Users need information about the causes of changes in net assets and how
these changes affected ongoing operations. Direct measures of asset and liability
balances at the end of the accounting period are linked to expense and revenue
measurement because financial statements are articulated.

The measurement of earnings using a balance sheet approach is consistent with the
financial capital maintenance concept of income determination. This concept is
critical to determining the return on invested capital. A return on capital occurs only
if there has been an increase in net assets during the period exclusive of investments
by and distributions to owners. Hence, financial capital maintenance and thus a
balance sheet approach to income measurement is relevant to investor decision
making.

d. The measurement of deferred income taxes uses the asset/liability approach. Under
this approach the deferred tax asset and liability balances are determined. Income tax
expense is equal to the current provision for income tax plus the change in the
deferred tax asset and or liability balance.

Aging of accounts receivable provides balance sheet measure of net realizable value.
The resulting balance in the allowance account is used to measure the amount of bad
debt expense in the income statement.

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 Measures of cost of goods sold utilize a balance sheet approach. Typically, the cost
of inventory is determined, then cost of goods sold is computed as a residual amount.

Case 5-8

a. If two estimates of an amount that is to be received or paid in the future are about
equally likely, the concept of conservatism dictates using the less optimistic estimate.

b. Conservatism has affected financial reporting because there is a tendency for

accountants to recognize losses, but not gains. For example, loss contingencies are
accrued when they are probable and the amount of the potential loss is reasonably
estimable. Similar gain contingencies are not accrued. In accounting for sale-
leasebacks where more than a minor portion is leased back, losses on sales are
recognized; whereas, gains are deferred. Lower-of-cost-or-market is used for
inventory whereby the carrying value of inventory is written down to market if it is
lower, but not up to market if market is higher.
It should be noted that The FASB has recently moved to lessen the impact of
conservatism in financial reporting. That is, while conservatism appeared in SFAC
No. 2 it was removed in SFAC No. 8. In SFAC No. 8 the FASB, uses the term
faithful representation instead of the term reliability as a fundamental quality that
make accounting information useful for decision making. Prudence (conservatism)
which was an aspect of reliability in SFAC No. 2 is not considered an aspect of
faithful representation. The FASB’s rationale for this decision was that including it as
an aspect of faithful representation would be inconsistent with the characteristic of
neutrality. That is, if financial information is biased in a way that encourages users to
take or avoid predetermined actions, that information is not neutral.

c. No. If an economic loss has occurred, it should be reported. There is no reason that
a similar occurrence for a gain should not also be reported. Accountants should
report what has happened during the accounting period in an unbiased objective way.
Gains happen as well as losses. If they are not also reported, the reporting of gains
and losses in the income statement will not be what it purports to be.

d. No. Physical capital maintenance implies that earnings occur when the physical
capacity exclusive of owner transactions increases during the accounting period.
Physical capital is the replacement cost of a company’s net assets. Replacement cost
can increase or decrease. Such a concept of earnings would recognize increases and
decreases in current value (gains and losses) during the accounting. However, these
changes would be considered capital maintenance adjustments, rather than earnings
adjustments. Physical capital maintenance matches current cost with current period
revenues. Holding gains and losses would be excluded from the income statement.

e. Yes, and no. Financial capital maintenance basically accommodates any measure of
asset value, whether or not conservative. Whatever measurements are used, changes
in assets and liabilities would flow through the income statement. Nevertheless, an
argument could be made that financial capital is maintained only if the measurements
reflect the purchasing power of dollars invested in the company. If so, measures

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 based on price level changes, specific or general could arguably be preferred to
historical cost. If so, gains and losses should both be recognized.

FASB ASC 5-1 Revenue Recognition

A search for revenue recognition resulted in over 90 different places in the FASB
ASC where revenue recognition is discussed.

FASB ASC 5-2 Recognition of Franchise Fee Revenue

Accounting for franchise fee revenue is found at FASB ASC 952-605-25. It is found
by searching franchise fee revenue.

FASB ASC 5-3 Real Estate Sales

The answer is found at FASB ASC 360-20-40-3 and FASB ASC 360-20-40-27 and
can be found by searching for real estate sales.

FASB ASC 5-4 Current Value

Search current value

274 Personal Financial Statements
     10 Overall
          05 Background

FASB ASC 5-5 Accounting for Inflation

Search inflation
255 Changing Prices
10 Overall

FASB ASC 5-6 Revenue and Gains

Use revenue link

FASB ASC 5-7 Accounting for Long-term Construction Contracts

Search long term construction

605 Revenue Recognition

35 Construction-Type and Production-Type Contracts\

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FASB ASC 5-8 Use of the Installment and Cost Recovery Methods

Search installment method.

605-10-25-3

FASB ASC 5-9 Matching

Search matching – over 30 hits

FASB ASC 5-10 Conservatism

Search conservatism

852 Reorganizations > 20 Quasi-Reorganizations > 30 Initial Measurement

FASB ASC 5-11 Materiality

Search materiality - 18 hits

Room for Debate

Debate 5-1 Concepts of Capital Maintenance

Team 1 Arguments in favor of the physical capital maintenance concept

1. The concept of physical capital maintenance is concerned with maintaining

productive capacity. Productive capacity is provided by the company’s assets, and
capital is defined as the operating assets of the entity. Assets must eventually be
replaced in order to maintain the current level of productive capacity. Hence,
measurement of assets at their replacement cost is consistent with this theory.

2. Under the physical capital maintenance concept current period revenues are matched
with the current cost of the assets used to generate the revenue. The resulting
periodic income is referred to as distributable or sustainable income because as a
result of calculating depreciation and cost of goods sold based on their replacement
cost, net income reflects the amount that can be distributed to stockholders without
impairing the productive capacity of the entity. Thus, income is not recognized until
provision has been made to replace these assets.

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 Most going concerns expect to operate in the future at a rate of physical activity equal
to the current level. Hence, periodic income should not be recognized until provision
has been made to maintain the physical plant at the current level.

3. The major strength of the physical capital maintenance concept is based on the notion
that an increase in enterprise wealth as a result of price changes is excluded from
income. According to SFAC No. 5, holding gains and losses are treated as
adjustments to equity rather than income. Thus, the concept recognizes that long-run
survival of the entity is dependent upon its ability to generate enough income to
replace the productive capacity of its existing assets.

4. Another strength of the physical capital maintenance concept is that it provides

insight regarding the amount of dividends that may be paid to investors without
impairing the entity’s ability to replace existing assets.

5. The concept recognizes that fact that enterprises attempt to maintain share prices by
maintaining operating flows. Presumably by maintaining a given level of operating
capacity, the ability to maintain operating flows is greatly enhanced.

Team 2 Arguments in favor of the financial capital maintenance concept.

1. Capital, under the financial capital maintenance concept is defined as the monetary
values of assets contributed by owners at the time they were contributed. This is the
traditional, dominant view of capital maintenance in accounting. The primary
emphasis of the financial capital maintenance concept is on the exchange transaction
and events that affect the operations and status of the business entity. Hence, most of
the information that would be provided under this concept is derived from actual
experiences and is thus historical in nature.

2. Under the financial capital maintenance concept, income results from matching
revenues with the cost of generating revenues. Revenues are recognized by applying
the realization principle. Accordingly, they are recognized when the earnings process
is complete or virtually complete and when an exchange (transactions with
customers) has taken place. Costs are matched directly with revenues (e.g., cost of
goods sold), directly with the period in which revenues occurred (e.g., utility bills),
and allocated to periods in which revenue is generated (e.g., depreciation).

3. The financial capital maintenance concept presumes that historical cost is the
significant and relevant measurement approach. The major strength of this concept is
that it is generally understood by users. According to SFAC No. 8, understandability
is a desirable of useful accounting information.

4. Historical cost is objective and provides neutral, unbiased measures of the results of
financial transactions and events. Because it is transactions based, the measurements

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 are verifiable and the approach is relatively easy to apply in practice. Moreover,
since revenues are not recognized until realized, the financial capital maintenance
concept is conservative.

5. Because adjustments are not made to historical cost for changes in the price level,
financial transactions are reported in terms of dollars invested by stockholders.
Hence, the concept of financial capital maintenance enables accountants to fulfill
their stewardship role to owners.

Debate 5-2 Economic versus Accounting Income

Team 1 Argue in favor of the economist’s view of income

Economists generally agree that the objective of measuring income is to determine

how much better off a company has become during the accounting period. This view
of income is consistent with the notion of “real income”, or increases in economic
wealth. Under this view, a company has income if it is better off at the end of the
accounting period than at the beginning of the period and the increase is wealth is not
due to investments by owners or distributions to owners.

The amount of income during the period is equal to the maximum amount that could
be distributed to owners and still leave the company as well off as it was in the
beginning of the period. This notion is consistent with accounting for assets at
current value. Economic income would take preservation of the physical plant into
consideration, but would also adjust for changes in price levels. The difference
between economic income and that derived from the physical capital maintenance
concept is that economic income would include holding gains and losses, while
physical capital maintenance income would not.

According to SFAC No. 8, relevant information about an entity should provide

predictive ability. Because current values represent the market’s assessment of the
value of assets and hence take into consideration the future cash flows that they
would generate, income measurement utilizing current values should provide
information relevant to predict future cash flows.

The economic view of income is consistent with recognition of income during

production. It is not based on the sale of the asset to customers. Instead it is
presumed that the enterprise is in business to realize cash from the production of
goods and the provision of services, but that the production process itself is earning
the eventual cash inflow. Hence, revenue recognition is based on expectations
regarding future events rather than on the transactions as they occur. By the same
token, costs would be recognized as they are incurred, rather than be matched against
revenue that is recognized in accordance with the realization principle.

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Team 2 Argue in favor of the accountant’s concept of income

Accountants feel that the elements of financial statements should be reported when
there is evidence of an exchange. Revenue should be recognized only when it is
earned. Accountants should not record revenue that is anticipated. Instead, the
existence of revenue should be verified with evidence that an exchange has taken
place. Income measurement should be based on matching efforts (costs) with
accomplishments (revenues) that have actually occurred.

The accountant’s concept of income is anchored on the historical cost model and is
consistent with the concept of financial capital maintenance. See, Team 2 under
Issue 1 for arguments favoring these concepts.

Debate 5-3 Current value measures

Team 1

The definition of an asset implies that assets are held to provide future benefits. A
company’s future benefits are derived from its use of assets held by it. Future benefit
to a company would logically be related to expected future profits and the resultant
future cash inflows. Thus, it is reasonable to assume that the measurement of assets
should reflect those expectations. We argue that this goal is best met by reporting
assets at current value, measured using exit prices.

Current value embodies expectations regarding future earning power of net assets.
Since assets are held because they provide future benefit, their measurement should
be based on their current value in use – that is, by entry values.

An entry value is the current estimated fair market price of the asset. It is the cost
that a company would incur to replace an existing asset (its replacement cost).
According to Edwards and Bell, current entry prices allow the assessment of
managerial decisions to hold assets by segregating current value income (holding
gains and losses) from current operating income. Under the assumption that
operations will continue, this dichotomy allows the long-run profitability of the
enterprise to be assessed. The recurring and relatively controllable profits can be
evaluated vis-à-vis those factors that affect operations over time but are beyond the
control of management. Replacement cost provides a measure of the cost to replace
the current operating capacity and, hence, a means of evaluating how much the firm
can distribute to stockholders and still maintain its productive capacity.

We do not believe that exit values provide appropriate asset measures because they
measure what a company could receive if they sell the asset, not what the asset is
worth to company while they keep it.

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Team 2

Since the company already owns the assets, it will not have to replace them. Hence,
replacement cost is not relevant. We agree that the value of the asset should be tied
to its expected benefit to the company. However, we believe that companies benefit
by future cash flows that will result from the asset, not on cash flows to purchase
assets already owned. According to Sterling, entry value is irrelevant to what could
be realized upon sale of those assets and to their current purchase since they are
already owned. Moreover, replacement cost does not measure the capacity to make
decisions to buy, hold, or sell in the marketplace.

Chambers and Sterling contend that exit prices have decision relevance. Accordingly,
during each accounting period, management decides whether to hold, sell, or replace
the assets. It is argued that exit prices provide users with better information to
evaluate liquidity and thus the ability of the enterprise to adapt to changing economic
stimuli. Because management has the option of selling the asset, exit price provides a
means of assessing downside risk. It measures the current sacrifice of holding the
asset and thereby provides a guide for evaluating management’s stewardship
function.

A recent FASB pronouncement agrees with Chambers and Sterling. SFAS No. 157
defines fair value as exit price. According to the pronouncement, fair value is the
price that would be received to sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement date. This definition
emphasizes that fair value is market based rather than entity specific.

To summarize, we believe that exit value captures the reasons why management
buys, holds, and sells assets. It thus discloses the value of those assets to the entity,
and thus is decision-relevant to financial statement users.

WWW

Case 5-9

a. Multiple deliverables revenue arrangements occur when a business sells a product

and a service at the same time. The seller will often provide a service and collect
revenue for the service over a designated period of time per the contract signed by the
buyer and the seller.

b. According to the FASB ASC, the following steps are used to determine if a company
may have a revenue recognition issue related to a multiple deliverable revenue
arrangement. Evaluate all deliverables in an arrangement to determine whether they
represent separate units of accounting. To qualify as separate units of accounting, the
deliverable must have value to a customer on a standalone basis. That is, the item has
value if it can be sold separately by any other vendor or the customer could resell the
delivered item on a standalone basis, and the the arrangement contains a general right

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 of return relative to the delivered item in which delivery or performance of the
undelivered item is considered probable and substantially in control of the vendor. If
a delivered item does not meet both of these criteria it does not qualify as a separate
unit of accounting and would be combined with other deliverables in the
arrangement. Note, if no general right of return is offered then you will account for
delivered items as a separate unit of accounting. If it is determined that there are
separate units of accounting then the Company must determine the selling price of
the deliverables by using Vendor Specific Objective Evidence (VSOE), or Third
Party Evidence (TPE), by making the best estimate of the selling price (cost plus a
reasonable profit margin is acceptable).

Case 5-10

Under previous GAAP Albert Company does not have reliable evidence of fair value for the
implementation/installation services and so the equipment and implementation/installation
services were accounted for as one unit of accounting. Albert Company determines it would
be appropriate to recognize the $100,000 of revenue as the services are provided.

Under FASB ASC 606, because the equipment has standalone value to the customer and no
general right of return exists, the separation criteria has been met. Therefore, both the
equipment and the services are accounted for as separate units of accounting. A selling price
must be determined for each unit of accounting and a portion of the $100,000 fee must be
allocated to each deliverable.

Albert Company has decided to recognize the portion of the fee allocated to the equipment
upon delivery and the remaining portion of the fee as services are provided. To determine the
fee allocated for the equipment, the company must follow the following selling price
hierarchy:

1. Vendor Specific Objective Evidence (VSOE)

2. Third-Party Evidence (TPE)
3. Best Estimate

In considering the hierarchy of evidence, an entity must first determine the selling prices by
using VSOE if it exists, otherwise TPE must be used. If neither VSOE nor TPE for the selling
price exist for a deliverable, an entity must use its best estimate of the selling price for that
deliverable to allocate the consideration among the deliverables in an arrangement.

Vendor Specific Objective Evidence

The price charged for a deliverable when it is sold separately.
For a deliverable not yet being sold separately, the price established by management having
the relevant authority (it must be probable that the price, once established, will not change
before the separate introduction of the deliverable into the marketplace).

Third-Party Evidence

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Third-party evidence of selling price is the price of the vendor’s or any competitor’s largely
interchangeable products or services in standalone sales to similarly situated customers.

Estimated Selling Price

The vendor’s best estimate should be consistent with the objective of determining VSOE of
selling price for the deliverable; that is, the price at which the vendor would transact if the
deliverable were sold by the vendor regularly on a standalone basis. The vendor shall
consider market conditions as well as entity-specific factors when estimating the selling
price.

Case 5-11

a. A performance obligation is a promise in a contract to provide a product or service to

a customer. This promise may be explicit, implicit, or possibly based on customary
business practice.

b. In determining if a performance obligation exists, a company must provide a distinct

product or service to the customer.

c. To determine whether a company must account for multiple performance obligations,

the company’s promise to sell the goods or service to a customer must be separately
identifiable from other promises contained in the contract That is, the company must
determine whether its promise is to transfer individual goods and services to the
customer or to transfer a combined item containing individual goods or service.
Case 5-12

a. Generally, the sale of the computers and the assurance warranty will constitute one
performance obligation and the sale of the service type warrantees constitutes a
second performance obligation. However, if Logan determines that all or a portion of
its warranty obligation constitutes a separate performance obligation the company
must assign a portion of the selling price to the assurance warrantee and create a
separate performance obligation.

b. Revenue from the sale of the computers and the assurance warranty should generally
be recognized when Logan delivers the computers to customers. Revenue from the
service type warrantee constitutes a performance obligation that is satisfied over
time. This revenue will usually be recorded using an input measure of costs incurred
to satisfy the performance obligation.

Case 5-13

a. Morgan Company estimates the expected value to be $185,000 ((100,000 x .30) +

(300,000 x .35) + (500,000 x .10)).

b. In this case, Morgan Company would be limited to including $100,000 in the

estimated transaction price until it became probable that the next bonus level (i.e.,

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 $300,000) would be achieved. This is because any amount over $100,000 would be
subject to subsequent reversal, unless $300,000 was received.
Case 5-14

Woodlawn Hospital will aggregate the amounts associated with each possible outcome to
arrive at the estimated adjustment amount of $9.0 million, resulting in a revenue estimate of
$51.0 million. This amount is calculated as follows:

Possible Probability Probability Total

adjustment weighted revenue
amounts amounts recognized
0 10% $0 $60.0 million
$10 45% $4.5 million $55.5 million
million
$ 5 million 30% $1.5 million $54.0 million
$20 15% $3.0 million $51.0 million
million
$9.0 million

Before finalizing the estimate, management must evaluate the probability that, when the
uncertainty is resolved, the amount earned will be significantly less than $51.0 million. That
is, they must conclude that it is probable that a significant reversal of cumulative revenue will
not occur. If not, the estimate must be limited to the amount that is not probable of significant
reversal.

Assuming management concludes that no part of the $51.0 million should be constrained,
Woodlawn Hospital will accrue an estimated third-party settlement liability of $9.0 million to
adjust Medicare revenue for the contract year to $51.0 million.

Case 5-15

The TV services added by the customer are a distinct performance obligation. These services
are being charged at relative standalone selling price (as adjusted for the selling costs avoided
by transacting with an existing customer). The TV services are a new contractual
arrangement, and there is no impact to the accounting for the existing data and voice services.

Note: while this case is fairly simple, further complexities could arise with contract
modifications. For example, the modification could provide the customer with a discount on
new or existing services, the contract period could be extended for all services, or additional
deliverables (such as equipment) could be introduced.

Case 5-16

a. At contract inception, Putnam will exclude the $200,000 bonus from the transaction
price because it cannot conclude that it is probable that a significant reversal in the

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 amount of cumulative revenue recognized will not occur. Completion of the building
is highly susceptible to factors outside the entity’s influence, including weather and
regulatory approvals. In addition, the entity has limited experience with similar types
of contracts.

b. Using the input measure of 60 percent, Putnam determines that the cumulative
revenue and costs recognized for the first year are as follows:

Revenue $ 600,000
Costs $ 420,000
Gross profit $ 180,000

c. Putnam will account for the contract modification as if it were part of the original
contract. Putnam recognizes additional revenue of $91,200 [(51.2 percent
complete × $1,350,000 modified transaction price) — $600,000 revenue
recognized to date] at the date of the modification as a cumulative catch-up
adjustment.
Case 5-17

a. Some costs are recognized as expenses on the basis of a presumed direct association
with specific revenue. This presumed direct association has been identified both as
“associating cause and effect” and as “matching (expense recognition principle).”

Direct cause-and-effect relationships can seldom be conclusively demonstrated, but

many costs appear to be related to particular revenue, and recognizing them as
expenses accompanies recognition of the revenue. Generally, the expense recognition
principle requires that the revenue recognized and the expenses incurred to produce
the revenue be given concurrent periodic recognition in the accounting records. Only
if effort is properly related to accomplishment will the results, called earnings, have
useful significance concerning the efficient utilization of business resources. Thus,
applying the expense recognition principle is a recognition of the cause-and-effect
relationship that exists between expense and revenue.

Examples of expenses that are usually recognized by associating cause and effect are
sales commissions, freight-out on merchandise sold, and cost of goods sold or
services provided.

b. Some costs are assigned as expenses to the current accounting period because
1. Their incurrence during the period provides no discernible future benefits;
2. They are measures of assets recorded in previous periods from which no future
benefits are expected or can be discerned;
3. They must be incurred each accounting year, and no build-up of expected future
benefits occurs;
4. By their nature they relate to current revenues even though they cannot be
directly associated with any specific revenues;

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 5. The amount of cost to be deferred can be measured only in an arbitrary manner
or great uncertainty exists regarding the realization of future benefits, or both;
6. Uncertainty exists regarding whether allocating them to current and future
periods will serve any useful purpose.

Thus, many costs are called “period costs” and are treated as expenses in the period
incurred because they have neither a direct relationship with revenue earned nor can
their occurrence be directly shown to give rise to an asset. The application of this
principle of expense recognition results in charging many costs to expense in the
period in which they are paid or accrued for payment. Examples of costs treated as
period expenses would include officers’ salaries, advertising, research and
development, and auditors’ fees.
c. A cost should be capitalized, that is, treated as a measure of an asset when it is
expected that the asset will produce benefits in future periods. The important concept
here is that the incurrence of the cost has resulted in the acquisition of an asset, a
future service potential. If a cost is incurred that resulted in the acquisition of an asset
from which benefits are not expected beyond the current period, the cost may be
expensed as a measure of the service potential that expired in producing the current
period’s revenues. Not only should the incurrence of the cost result in the acquisition
of an asset from which future benefits are expected, but also the cost should be
measurable with a reasonable degree of objectivity, and there should be reasonable
grounds for associating it with the asset acquired. Examples of costs that should be
treated as measures of assets are the costs of merchandise on hand at the end of an
accounting period, costs of insurance coverage relating to future periods, and the cost
of self-constructed plant or equipment.
d. In the absence of a direct basis for associating asset cost with revenue and if the asset
provides benefits for two or more accounting periods, its cost should be allocated to
these periods (as an expense) in a systematic and rational manner. Thus, when it is
impractical, or impossible, to find a close cause-and-effect relationship between
revenue and cost, this relationship is often assumed to exist. Therefore, the asset cost
is allocated to the accounting periods by some method. The allocation method used
should appear reasonable to an unbiased observer and should be followed
consistently from period to period. Examples of systematic and rational allocation of
asset cost would include depreciation of fixed assets, amortization of intangibles, and
allocation of rent and insurance.
e. A cost should be treated as a loss when no revenue results. The matching of losses to
specific revenue should not be attempted because, by definition, they are expired
service potentials not related to revenue produced. That is, losses result from events
that are not anticipated as necessary in the process of producing revenue.

There is no simple way of identifying a loss because ascertaining whether a cost

should be a loss is often a matter of judgment. The accounting distinction between an
asset, expense, loss, and prior period adjustment is not clear-cut. For example, an
expense is usually voluntary, planned, and expected as necessary in the generation of
revenue. But a loss is a measure of the service potential expired that is considered

89
 abnormal, unnecessary, unanticipated, and possibly nonrecurring and is usually not
taken into direct consideration in planning the size of the revenue stream.

Case 5-18
a. Accounting for the penalty as a charge to the current period is justified if the penalty
is considered the result of an unusual event (the assessment) occurring within the
period. Installation of the air pollution control equipment should prevent the
assessment of further penalties.
b. Accounting for the penalty as a correction of prior periods is justified if the penalty is
considered a result of the business activities of prior periods, rather than a result of an
event of the current and future periods. The penalty is assessed to correct damage
which occurred as a result of production of prior periods and thus represents a cost of
production which was omitted from the reported results of those prior periods.
Further justification is provided by the fact that determination of the amount of the
penalty was presumably made by someone other than management (the Pollution
Control Agency) and could not be reasonably estimated before determination.
A prior period adjustment should be reported as an adjustment of the current year’s
beginning balance of retained earnings, as previously reported. If statements of prior
periods are presented, they should be restated to include the portion of the penalty
allocable to each period, with appropriate adjustments to other items affected, such as
retained earnings, liabilities, and earnings per share.

Accounting for the penalty as a capitalizable item to be amortized over future periods
is justified if the penalty is viewed as a payment made to benefit future periods. If the
penalty is not paid, Global Warming Company will not be allowed to operate in
future periods; thus, the penalty is similar to a license to do business. Since the
amortized expense will recur from period to period, it should be included in income
from continuing operations. Amortization should be computed in a rational and
systematic manner.

Case 5-19

Repo 105 is an accounting maneuver where a short-term loan is classified as a sale. In a Repo
105 transaction, the company sells assets (generally securities) and the cash obtained through
this sale is then used to pay down debt. This allows the company to appear to reduce its
leverage by temporarily paying down liabilities—just long enough to be reflected on the
company’s published balance sheet. Subsequently, after the company’s annual report is
released, the company borrows cash and repurchases its original assets.

Case 5-20

The answer to this case requires the student to visit the WWW to answer the questions about
a company’s current financial statements.

Financial Analysis Case

90
 a. The students’ answers will vary depending on the company selected. To assess their
company’s quality of earnings, they should use the eight techniques outlined on
pages 153 and 154 of the text.
b. Answers will vary

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