Collage of Business and Economics

Management Department

Master of Business Administration Program

Modality: - Regular

Course: - Accounting for Decision Making

Assignment on Accounting Decision making

Prepared By: - Kaba Garoma (Mr.)

Mohamed Harun (Mr.)

Yonas Asressahegn (Mr.)

Submitted to: - Mulugeta Demme. (PhD)

Haramaya Ethiopia

May 2021
CASE 1
The realization principle determines when a business should recognize revenue. Listed next are
three common business situations involving revenue. After each situation, we give two
alternatives as to the accounting period (or periods) in which the business might recognize this
revenue. Select the appropriate alternative by applying the realization principle, and explain your
reasoning.
a) Airline ticket revenue: Most airlines sell tickets well before the scheduled date of the
flight.(Period ticket sold; period of flight)
b) Sales on account: In June 2011, a San Diego–based furniture store had a big sale,
featuring “No payments until 2012.” (Period furniture sold; periods that payments are
received from customers)
c) Magazine subscriptions revenue: Most magazine publishers sell subscriptions for future
delivery of the magazine. (Period subscription sold; periods that magazines are mailed to
customers)

Solution to Case I

Back ground
By definition, the realization principle defines the business should realize and record up
on the exact selling point of the product or rendering of services. Not prior to or after exact
selling point. That means revenue should be realized in the period that services are rendered to
customers or goods are delivered to customers.
Using this principle as a guide, the three independent situations are analyzed below:

a) Using Period of flight as reference:

Back ground
The nature of airline business is somewhat different from other sectors of transportation
services. If someone wants to go to Addis Ababa, he may have many alternatives ways of
transportation. From the slowest to the fastest On foot, Mules back, Tri wheelers, Bicycles,

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Motor Bicycles, Buses, Trains, Airlines. If you prefer to go by bus, you can directly pay and go.
In fact there are some buses which use reservation system.
For an Airline business, reservation and payment in advance is almost mandatory. But the
system is highly flexible. In the case of Ethiopian Airlines, you will get all your paid money if
you cancelled your inland flight and portions of money after some penalties deducted in an
international flight tickets. In effect your cancellation may harm the airline which is the
opportunity cost of reserving a seat. Hence, the airlines introduced some waiting systems to
absorb the opportunity cost of flying with empty seat.
Analysis and Conclusion
Airlines earn revenue by rendering services, which is offering transportation to their
customers. Passengers get the service of transportation often referred as CHANGE OF PLACE.
The behavior of realization and recording of revenues involve time tables in which the ticket are
sold and the passenger has done his flight. At the time of selling ticket, the cash flow of the
passenger decreases with an increase in airline. Hence cash is flown inward which should not be
accounted in realization of revenue and should be recognized in the accounting period in which
this service is rendered. Not when the tickets are sold. Selling tickets is not like selling goods.
The ticket is not a “product” it is merely a receipt showing that the customer has already made
payment for services to be rendered in the future. If the customer wants to cancel his flight, he
/she can ask for reimbursements. The amount paid in advance (at period of ticketing) at that
specific period is equivalent to an asset for the passenger and liability for the airline. This is
because there are possibilities that the passenger may cancel his trip.
Doing in other ways, suppose the airliner has a policy of realizing all ticket sales as
revenues at the point of selling tickets (before the service is rendered), assuming 5 percent of the
passengers reschedule or cancel their flight, it could lead to recording as revenue but this would
lead to repetitive adjustments reversals and corrections which will again increases the work load
on accountants.
Being the nature of the airline described above, as to when shall we recognize and record
unearned ticket revenue or ticket revenue lies at the times of sales of ticket and the times of flight
service concluded. The ticket sales date should not be taken as a base for realization or record of
revenue. Hence, in airline type businesses, revenue recognition and record shall better be done
upon completion of service delivery.

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 Therefore, in such service businesses, revenue is better recognized after service is
rendered. If it is recognized in the opposite there would happen overstatement of revenue
as well for that specific period since cancellation and rescheduling are unanticipated.

b) Using Period furniture sold as reference. In this case the furniture store delivers goods
to its customers on credit bases as of June 2011. (The dates of purchase on account which
are not specifically indicated. But one can certainly tell dates from June 1 to June 30 in a
probability or combinations. No specific dates can be taken for sales of furniture on
account. But we can take June 2011 as a period.) The collection period is somewhat
indicated at the beginning of January 2012 (6 months period). Until 2012, no revenue is
recognized. The latest we can recognize revenue is January 1, 2012.(Which is in the latest
of 2012) This is the period in which revenue should be recognized, even though the
account receivable may not be collected for many months after January 2012. Collection
of an account receivable does not produce revenue; this action merely converts one asset
(receivable) into another (cash).
Please note that all dates are written on G.C.
G.C.

c) Periods those magazines are mailed to customers. The “goods” that a magazine
publisher delivers to its customers are magazines. Thus, the publisher does not earn its
revenue until the magazines are delivered to the customers. (For practical purposes, the
act of mailing the magazine may be viewed as “delivery.”)

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CASE 2
Kim Morris purchased Print Shop, Inc., a printing business, from Chris Stanley. Morris made a
cash down payment and agreed to make annual payments equal to 40 percent of the company’s
net income in each of the next three years. (Such “earn-outs” are a common means of financing
the purchase of a small business.) Stanley was disappointed, however, when Morris reported a
first year’s net income far below Stanley’s expectations.
The agreement between Morris and Stanley did not state precisely how “net income” was to be
measured. Neither Morris nor Stanley was familiar with accounting concepts. Their agreement
stated only that the net income of the corporation should be measured in a “fair and reasonable
manner.”
In measuring net income, Morris applied the following policies:
1. Revenue was recognized when cash was received from customers. Most customers paid in
cash, but a few were allowed 30-day credit terms.
2. Expenditures for ink and paper, which are purchased weekly, were charged directly to
Supplies Expense, as were the Morris family’s weekly grocery and dry cleaning bills.
3. Morris set her annual salary at $60,000, which Stanley had agreed was reasonable. She
also paid salaries of $30,000 per year to her husband and to each of her two teenage
children.These family members did not work in the business on a regular basis, but they
did help out when things got busy.
4. Income taxes expense included the amount paid by the corporation (which was computed
correctly), as well as the personal income taxes paid by various members of the Morris
family on the salaries they earned working for the business.
5. The business had state-of-the-art printing equipment valued at $150,000 at the time Morris
purchased it. The first-year income statement included a $150,000 equipment expense
related to these assets.
Instructions

a) Discuss the fairness and reasonableness of these income-measurement policies. (Remember,

these policies do not have to conform to generally accepted accounting principles. But they
should be fair and reasonable. )
b) Do you think that the net cash flow generated by this business (cash receipts less cash
outlays) is higher or lower than the net income as measured by Morris? Explain.

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Solution to Case II
Background
Printing business is a service rendering business with product delivery. You need printed pad of
receipts from a printing company. You did not buy the paper pad; rather you buy the print
service. If you want to buy a paper pad, you will go to stationary, not to printing company. So
what you buy from the printing company is not a product. Rather it is a printing service.
Customers go to the printing company, make payment in advance, take an appointment, and
collect the printed product. This is the cycle.
Analysis and Conclusion
Ones we see the nature of business as a service, realization and reporting of revenue would be
simple. Sale of such business company in total is selling of product. But portion sale of a
company cannot be treated as sell of product. Hence in this case the agreement encompasses sell
of operations of a company implicitly as it is described 40% of profit share to be paid for the
seller over the next three years of time. That means some portion of the company is sold on
account. A portion of the sale is receivable.
What is recognized from this flow is that the amount of cash received from the buyer can be
immediately recognized as revenue and the remaining portion as a receivable on their
corresponding collection period. From the given case with different scenarios, what can we
respond is as follows. What is fair is what is correct and what is reasonable is a situation where
we deduce the reason as a center for convinces. With this in mind, we have reached up on the
following conclusions.

a) Discussion of “fairness and reasonableness” of income measurement policies:

1) Given that most revenue is received in cash and that credit terms are constant,
recognizing revenue on a cash basis will cause little distortion in annual results. Thus, it
appears “fair and reasonable”—at least for the first two years. But we should consider
that in the last (third) year of the agreement, this policy will exclude from net income
credit sales in December. Stanley may expect some adjustment for this. What is
recommended is the separate treatment of month December of the third year or closure
of policy using some forecasting technics. Latter after the lapse of the contract, some
adjustments and corrections to records be made which might have lesser effects in the
process of realization.

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 2) Charging weekly expenditures for business supplies directly to expense is
reasonable, but considering the Morris family’s grocery and dry cleaning bills as
expenses of the business is neither fair nor reasonable. It is not in accordance with
separation of owner from the business entity.
3) Morris’s salary of $60,000 is “fair and reasonable” because it has been agreed upon
by both parties. But to make additional salary payments of $90,000 per year to
Morris family members who worked only on a part-time basis does not seem to meet
the “fair and reasonable” criteria.
4) Income taxes on the Morris family’s salaries are personal expenses, not expenses of
the business. It is neither fair nor reasonable to deduct these taxes in computing the
income of the corporation. It is not in accordance with separation of owner from the
business entity.

5) It is not reasonable to report the entire $150,000 value of the equipment as an

expense in the first-year income statement. This equipment will be used by the
company for many years to generate revenue. By assigning the entire cost of the
equipment to the first year of operations, Morris has violated the matching principle.

On the other hand, if we want to make the whole value as an expense, we need to
be at the end of the depreciation time of those equipment’s and hence the value
150,000 is the book value (not the initial value) of an asset during the policy/contract
period.

c) Cash flow case discussion

The state-of-the-art printing equipment valued at $150,000 is an asset, not an expense. By
reporting the equipment’s entire $150,000 value as an expense in the company’s first-
year income statement, the net income computed by Morris was probably significantly
lower than the net cash flow generated by the business. See Section b item no 5 as
reference.

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CASE 3

Happy Trails, Inc., is a popular family resort just outside Yellowstone National Park. Summer is
the resort’s busy season, but guests typically pay a deposit at least six months in advance to
guarantee their reservations.
The resort is currently seeking new investment capital in order to expand operations. The more
profitable Happy Trails appears to be, the more interest it will generate from potential investors.
Ed Grimm, an accountant employed by the resort, has been asked by his boss to include $2
million of unearned guest deposits in the computation of income for the current year. Ed
explained to his boss that because these deposits had not yet been earned they should be reported
in the balance sheet as liabilities, not in the income statement as revenue. Ed argued that
reporting guest deposits as revenue would inflate the current year’s income and may mislead
investors.
Ed’s boss then demanded that he include $2 million of unearned guest deposits in the
computation of income or be fired. He then told Ed in an assuring tone, “Ed, you will never be
held responsible for misleading potential investors because you are just following my orders.”
Instructions
a) Should Ed Grimm be forced to knowingly overstate the resort’s income in order to retain
his job?
b) Is Ed’s boss correct in saying that Ed cannot be held responsible for misleading potential
investors? Discuss.

Solution to Case III

Back ground
The nature of business of resort: Resorts are places where people spare their vacation time trough
entertaining, hunting, swimming, camping … Most beautiful resorts of the world use
memberships and prior bookings in order to accommodate their customers’ different needs. They
usually reserve rooms, boats, special swimming pool reservations, private spa etc. The
reservation even can extend to reservation of rooms with specific room numbers, specific boat
number, special massaging staff with her identity etc. Currently, customers usually pay using
online payment systems in advance of their utilization. The nature of this service sector is mostly

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of luxury and most of the customers are not price sensitive rather they focus on the level of
satisfaction they derive. In most cases, if the customer fails to meet to reach the facilities on time,
the days of the bookings which he/she has not used will not be reimbursed. This is the
opportunity cost lost due to reservation. The resort has reserved for specific customer. If the
customer fails to come, upon certain flexibility of company policy, he has to inform in advance
especially three to five days before cancellation.
Analysis and conclusion
In a professional way of looking, if the resort has a return of money based on specific
rules such as information of cancellation before five days, some percentage of penalties assumed,
can reimburse the portion of prepayment. Therefore, revenue should be recorded and recognized
when the service is delivered to the customer.
However, in the absence of such return and usage company rules, revenue can be
recognized at the time of payment for reservation. Because whether the customers come to the
resort or not, ones it is paid and will not be returned.
So, what determines the recognition of prepayments as revenues or not, is the company
policy towards assuming the recognition.
But, as an accountant, for this specific case, we would not advise to treat unearned
revenues as revenues as indicated in the case.