CHAPTER 5 REVENUE AND MONETARY ASSETS

Changes from Tenth Edition The chapter has been updated. The SECs SAB101 Revenue Recognition tests have been added. 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. MacDonalds 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. Blaine and Mason, LLP, deals with the issue of gross verses net reporting of revenues.

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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 4,675 6,825 6,825 6,175 $ 3,850 $ 3,500 $ 6,825 $ 3,675 $ 3,675 $3,325 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: Dr. Allowance for Doubtful Accounts....................................... Cr. Accounts Receivable............................................... To record the partial payment: If Alcom uses the direct write-off method: Cash........................................................................................... Bad Debts Recovered............................................................ (or Bad Debt Expense............................................................ $950 $950 $950) $3,000 $3,000 $3,000 $3,000

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If Alcom uses the allowance method: Either of the above two entries or: Cash........................................................................................... Allowance for doubtful accounts........................................... 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 *(1-Probability of collection.) 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. b. Accounts Receivable....................................................................... Less: Allowance for Doubtful Accounts.......................................... Net Accounts Receivable.................................................... $735,000 Expected Percentage Uncollectible* .01 .06 .20 .35 .50 Estimated Uncollectible $ 4,500 9,000 15,000 15,750 $950 $950

7,500 $51,750

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

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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.) 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 Revenue..................... Costs.......................... Income....................... 20 x 1 $980,000 20 x 2 $1,470,000 20 x 3 $2,205,000 6,720 5,040 6,720 5,040 5,040 3,360 5,040 3,360

721,000 $259,000

1,190,000 $ 280,000

1,715,000 $ 490,000

Revenue equals percentage completed during the year times fixed price.

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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............................................................................... 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);

$161,700

69,300 $231,000

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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 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. 2. 3. Accounts Receivable................................................................... Sales........................................................................................ Cash............................................................................................. Accounts Receivable............................................................... Allowance for Doubtful Accounts............................................... Accounts Receivable............................................................... 9,965,575 9,965,57 9,685,420 9,685,42 26,854 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.

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Under (a), the Accounts Receivable remaining on the books at the end of 2002 is calculated as follows: Accounts Receivable, December 31, 2001.............................. Add increase to A/R from sales on account during 2002........ Less decrease to A/R for accounts for which payment was received during 2002............................................................... Less accounts written off in 2002........................................... $ 988,257 9,965,575 10,953,832

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

Add that portion still due on previously written-off account which was paid in part in 2002 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.............................................................. Allowance for Doubtful Accounts........................ 29,886 29,886

The Allowance for Doubtful Accounts remaining on the books at the end of 1998 is calculated as follows: Allowance for Doubtful Accounts, December 31, 2001.......... Less Accounts Receivable written off in 2002........................ $29,648

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................................. Total allowance for Doubtful Accounts, December 31, 2002..

4,594
7,388

29,886
$37,274

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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 2002 is calculated as follows: Allowance for Doubtful Accounts, December 31, 2001......... Less Accounts Receivable written off in 2002....................... Balance in account................................................................. Add additional bad debt expense............................................ Total Allowance for Doubtful Accounts, December 31, 2002 $29,648 26,854 $2,794 34,453 $37,247

Question 2
Using (a) Balance of accounts as of December 31, 2002:. Accounts Receivable...................................................................... Less allowance for doubtful accounts............................................. $1,242,478 37,274 $1,205,204 Using (b) or (c) $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.

2002
Current ratio.................................................................................. Acid-test ratio............................................................................... Days cash.................................................................................... Days receivables: method (a)....................................................... method (b) or (c)...................................................................... Case 5- 2: Grennell Farm Note: This case has been updated from the Tenth 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. 2.7 1.5 N/A 44.1 44.2

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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 2001, 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 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 Ship the product to the customer and send a sales invoice Receive an order for the product from a customer Collection Method Purchase raw material Convert the raw material to a finished product Inspect the product Production Method Store the product in a warehouse

Usual Method (Delivery Method)

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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 2001 we have $323,370 net income 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.

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GRENNELL FARM Income Statements

Sales................................................................................. Cost of goods sold Beginning inventory............................................ Production........................................................... 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 0 107,730 15,390 92,340 429,660 183,000 $246,660 Method: Collection Production $462,4001 $614,1005 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 33,000 457,500 102,890 560,390 $593,390

$ 30,900 04 25,650 375,000 112,500 544,050 33,000 457,500 53,550 511,050 $544,050

$ 30,900 151,7007 0 375,000 112,500 670,100 33,000 457,500 179,600 637,100 $670,100

Notes: 1 180,000 bushels @ $2.90 - 20,000 bushels @ $2.98 = 160,000 but @ $2.89. 2 2210,000 bushels @ $.513 = $107,730. 3 30,000 bushels physically in inventory plus 30,000 bushels inventory at the elevator, reflecting payment not yet received from the elevator operator. 4 Under the collection method there are no accounts receivable, since sales revenues are 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 = 180,000 bushels @ 0.10 = 30,000 bushels @ $0.27 = $588,000 (value at harvest) 18,000 (gain on sales to elevator) 606,000 8,100 (write-up to year-end value) $614,100

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Given the texts description of the production method, I treat S606,000 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. 7 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 2001 drawings can be determined as follows: Beginning Retained Earnings........................................... Plus: Net Income.............................................................. Less: Ending Retained Earnings....................................... Drawings............................................................. Case 5- 3: Joan Holtz (A) Note: This case has been updated from the Tenth Edition. Approach These problems are intended to provide a basis for discussing questions about revenue recognition that are not dealt with explicitly in the text and that are not sufficiently involved to warrant the construction of a regular case. Instructors can pick from among those listed. Some of them can be used as a take-off point for elaboration and extended discussion by adding 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 2001 post-reading usage (which is recorded in January 2002) is, in effect, assumed to be the same 2002 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 2001 would in fact not differ materially from the post-reading usage in December 2002. 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 2001 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 2001 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. Sales Collections $ 0 $ 0 246,660 197,320 102,890 53,550 $143,770 $143,770 Production $ 0 323,370 179,600 $143,770

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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 2002 that will change its profit of $20,000, and that the amount is therefore revenue in 2001. Introduction of the possibility of a refund lessens the strength of the argument of the latter group. This position can be weakened further by asking: (a) 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 2001 and the full sales value when the trees are sold in 2002. 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 2002 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 2001 and the 60 cent reimbursements made in 2002 are an expense of selling tea in 2002. Those who tie the coupons with coffee would say that the entire 20 percent of coupons redeemed is an expense of selling coffee in 2001 with the amount not yet redeemed being a liability as of December 31, 2001. 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.............................................................. Cr. Payable to American Express.................... Commission Revenue................................ 505 500 5

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After the bank remits the $500 cash to American Express, the latter will make the following entry: Dr. Cash.............................................................. Cr. Travelers Checks Outstanding.................. 500 500

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 Manufacturer A from inflating its 2001 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

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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 [the Siberian steel mill] and similar sales will ultimately prove to be good business and that the decision to book it as revenue was supported by the revenue recognition policy that we had in place. 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 Case 5-4: Bausch & Lomb, Inc. (A)* Note: This is a new version of the case by the same name that appeared in the Tenth Edition. The issue is the same in both cases. Purpose of the Case Bausch & Lomb, Inc. (B&L) is a manufacturer of optical and health care products headquartered in Rochester, New York. The company implemented a change in their distribution and sales strategy near the end of 1993 that pushed a large amount of conventional contact lens inventories onto distributors. B&L recognized the product shipments associated with the new strategy as revenues. Unfortunately, the conventional lens market took a steep downturn and the company ended up taking back almost all distributor inventories attributable to it even though no formal right of return had been previously granted. In early 1995, B&L disclosed that the U.S. Securities and Exchange Commission (SEC) had launched an inquiry into its accounting procedures. This inquiry was prompted by several items, including how the company recognized revenues pertaining to its failed distribution strategy. These cases have four main objectives. First, they give students the opportunity to consider the importance of materiality in accounting based on relatively simple calculations and analysis. Second, they highlight issues that are important to consider for revenue recognition decisions. Third, they demonstrate the degree of discretion and managerial analysis required in making accounting decisions. Fourth, they provide a context for discussing how regulators such as the SEC influence the financial reporting process. The (A) case, which provides details on B&Ls attempt to create a new distribution strategy and the related impact on the years accounting numbers, should be handed out in advance of class. The (B) case, HBS case 9-101-008, which discusses the failure of the program and the subsequent inventory return,
1 2

The Wall Street Journal, Sequoia Systems Remains Haunted by Phantom Sales, October 30, 1992, p. B8. Ibid. 3 Ibid. * This teaching note was prepared by Professors Gregory S. Miller and Christopher F. Noe. Copyright 2000 President and Fellows of Harvard College, Harvard Business School Teaching Note S-101-018.

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should be handed out during classroom discussion. The (C) case (HBS case 9-101-009), which contains headlines and quotes from articles regarding B&Ls poor performance Sec probe, should also be handed out during the classroom discussion. Suggested Assignment Questions 1. What is the impact of the December 1993 shipments of conventional lenses on the Bausch & Lomb 1993 financial statements? Is the impact significant? 2. Does the new distribution and sales strategy make sense from an operational standpoint? Why or why not? 3. Do you think the product shipments associated with B&Ls new distribution strategy satisfied the FASB criteria for recognizing revenues? Why or why not? Accounting Entries and Materiality The financial information in the body of the (A) case, as well as the exhibits, provide students with sufficient information to produce some numbers for the accounting entries pertaining to the various actions associated with B&Ls new distribution and sales strategy. A quick analysis of these numbers creates an excellent opportunity to discuss the role of materiality in recording and using accounting information. The (A) case reveals that B&Ls 1993 net sales were approximately $22 million higher as a result of the sales strategy. In addition, Exhibit 3 in the (A) case reveals that the companys 1993 ratio of cost of goods sold to net sales was 45%. Thus, the journal entries to record B&Ls 1993 year-end product shipments arising from the sales strategy would look something like the following: Accounts Receivable Revenues COGS Finished Goods Inventory $22 million $22 million $9.9 million $9.9 million

There are two plausible adjustments to the preceding journal entries that some students might make. First, like most companies, B&L was deducting an allowance for doubtful accounts from sales, which is reflected by the fact that the company reported net sales. Although B&L did not break out the amount of the allowance, some students assume non-payment for a certain percentage of all sales made by the company. With respect to the preceding journal entries, this assumption would result in the creation of a contra asset account under accounts receivable that would be offset by an identical reduction in revenues. Second, some students argue that the sales strategy would have caused SG&A expenditures to be incurred. It is impossible to determine the exact amount of SG&A expenditures, if any, that resulted from

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the sales strategy without a much more detailed understanding of B&Ls business activities than its financial statements provide. However, Exhibit 3 in the (A) case reveals that the companys 1993 ratio of SG&A expenses to net sales was 33%. Consequently, some students use this number to allocate SG&A expenses to the sales strategy. For example, a proportional allocation results in the sales strategy bearing $7.25 million of SG&A expenses ($7.25 million = $22 million 33%).

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Once the basic numbers are recorded, the instructor can turn to the issue of materiality. It is useful to pose an opened ended question, such as We all agree on the numbers, so is this a big deal for B&L? Students frequently have addressed this question in broadly differing ways. Some will look at the $22 million compared to $1.8 billion of sales and say it doesnt matter. Others will compare the $12.1 impact to the $156.6 in net income, or look at the impact on the trends in earnings. It is useful to allow several more quantitative answers before beginning to push students on why they choose one method of determining performance vs. another. Many students will focus on why it changes their views as equity holders, but some will also bring up the perspective of debt holders, employees, or board members. Depending on which view they have taken, students may have a differing opinion on whether this impact is material. While definitions of materiality may vary, this discussion generally leads to the conclusion that something is material if it would change the opinion of. a relatively informed user of the financial statements. It is useful to end this discussion by pointing out that materiality depends on the question being asked, requiring management to attempt to anticipate all of the various ways the information may be used before determining if it is material. The New Distribution and Sales Strategy It is useful to start the broader class discussion with an analysis of the new distribution and sales strategy. Many instructors find it helpful to use boxes and draw the current basic strategy on the boar4. This strategy shows B&L selling and delivering directly to large retail customers, such as LensCrafters, while using distributors to service the many smaller retail customers. The new strategy has all conventional lens sales and servicing being provided by the distributors. The basic change is straightforward and causes very little confusion. Once all students agree on the mechanics of the change, the instructor can begin a discussion regarding whether this change makes sense from a business perspective. For the purposes of this discussion, it is useful to limit the students to considering the change from an operational perspective. Will this new strategy really free up resources to focus on new items? How will the larger retail clients respond to the need to delft with distributors for this one item? Do the distributors have the operational knowledge and financial acumen to manage this large block of inventory? While students often try to introduce the impact of accounting in this discussion (i.e. I would do it because would make our books look better), it is more productive to tell them we first must make a decision on whether this strategy makes sense for the business, then we will determine the accounting impact of any changes we make. 11~is discussion is frequently heated and by the end most students see some merit to the new strategy even if it is not the method they would follow. Next the discussion should shift to consider whether this transaction should be recorded as revenue in the 1993 financial statements. Exhibit 7 in the (A) case describes the FASB criteria for recognition of revenues and gains. Whether a company can recognize revenues centers upon two basic questions. First, has the company accomplished what it must do in order to enjoy the benefits of the revenues? Second, will the revenues ever be realized? The first question does not appear to be crucial for B&L. Revenues were recognized at the time of product shipment, which is not at all unusual. However, some students will

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argue that B&L still must provide significant sales and marketing support to retain the viability of the brand. If this is the only revenue recognition case being taught, it is useful to provide some time for that discussion. (An excellent case to illustrate the earned criterion for revenue recognition is Circuit City Stores, HBS no. 191-086.) The second question has the potential to create a more productive debate among students.

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Some students who think that B&L was not justified in recognizing revenues because of concerns over realizability claim that the year-end timing of the sales strategy is suspect. They also point to the fact that the sales strategy, regardless of when it was implemented, was very aggressive. To support this view, some students refer to Exhibit 6 in the (A) case, which shows the percentage of U.S. soft contact lens wearers using conventional lenses during 1992-93 to be declining. Still other students who are skeptical of B&Ls accounting choice, point to Exhibits 1 and 2 in the (A) case. Displaying yearly increases in net sales and earnings from continuing operations before nonrecurring charges for a decade leading through 1993, these graphs cause some students to speculate that the sales strategy was motivated by pressure to continue showing a positive trend in operating performance. While most students agree that timing was clearly important to B&L, they point out that the timing issues alone do not impact the eventual payment of the amounts owed. These students frequently feel that a disclosure of the change in policy and its impact on sales would be sufficient. This provides a good opportunity to discuss the importance of disclosures in Management Discussion and Analysis in form 10-K filed with the United States.

Some students who support B&Ls accounting choice emphasize that companies generally recognize revenues at the of product shipment, and that B&L lacked a formal return policy. They also highlight the fact that the sale; strategy did not involve moving into a different line of business or geographic area where new distributor relationships were being developed. As such, realizability should not have been a concern because the (A). Case makes no mention of the company ever having distributor payment problems. Students opposed to recognition often counter with the argument that this is a huge increase in inventories for the suppliers and the sheer size may push the distributors into insolvency. They point out the large credit line increases and low net worth information provided in the text of the (A) case. Other students who do not think that realizability should have been a concern argue that the sales strategy involved B&L voluntarily giving up a portion of its conventional lens business. These students point to Exhibit 6 in the (A) case, which shows that conventional lenses still accounted for the majority of the 1993 U.S. contact lens market. In light of this strategic move, the distributors should have had more business than before, which could have actually increased their probability of paying for inventories versus historical levels. Appealing to Exhibit 8 in the (A) case, still other students who support B&Ls accounting choice justify their position by pointing out that the company received a clean audit option in 1993. However, skeptics are once again able to undermine this argument by stressing that auditors may rely on materiality in making the decision or simply have misunderstood the transaction. An argument that more knowledgeable students make in B&Ls favor concerns the ability of companies to sell accounts receivable for cash, otherwise known as factoring. Factoring allows companies to meet more stringently the realizability criterion for recognizing revenue. If this issue does not come out naturally in the classroom discussion, an instructor can bring up the subject by asking students whether they would still have a problem with B&Ls accounting choice if the company had sold off the accounts receivable attributable to the sales strategy.

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At this point in the classroom discussion, many students will likely be confused over whether revenue recognition pertaining to the sales strategy was appropriate. However, an instructor should expect this and use the uncertainty on the part of students to make the points that accounting often requires the use of judgment and that sometimes accounting choices are difficult to make. Once the students have had an opportunity to discuss the issues, it is useful to use a role-play to bring this portion of the class to an end. Many instructors find it helpful to assign one doubting student the role of the CFO who must make the final call regarding recognition while another student is assigned the part of Johnson, the divisional president. Johnson then presents the facts to support the request to treat this transaction as revenue. The facts should include that it is a viable strategy change, the goods have been shipped and the distributors all have long histories with B&L. The CFO is given an opportunity to counter based on their understanding of the accounting rules. This discussion can become quite heated. A similar role-play assigns one student as an auditor. The instructor then lays the facts out to the student: the goods have been shipped, you see the signed contracts, and as an auditor you have confirmed these accounts receivable via letter and phone with the distributors1. In either case, the CFO/auditor generally agrees to book the revenues. A quick poll of the class at this point will show that most students agree the amount should be booked as revenue, but that many feel uncomfortable with this decision and how it relates to the economics. After these points have been made, the (B) case can be handed out and the next area for student discussion can be broached. The (B) case discusses the product returns and pricing discounts related to contact lens and a related problem with sunglasses. It reduced B&Ls 1994 pretax operating earnings by $20 million. However, too many assumptions are required to produce exact numbers for the portion of this related to the $22 million in sales discussed at the beginning of the case. The portion of the charge related to the contact lens, the fraction of distributor inventories that were actually returned, the amount of inventory write-downs (if any) on returned products, the extent of pricing discounts on retained products, and the possibility of B&L continuing to push inventories onto distributors after the end of 1993 are some of these assumptions. Nonetheless, an instructor might want to point out that even under a very rosy cost scenario, the sales strategy would have increased the companys 1993 pretax operating earnings by only $12.1 million ($12.1 million = $22 million - $9.9 million). Thus, the $20 million pretax charge dearly consists of more than just the return of the 1993 year-end product shipments. Many students will believe that these subsequent returns indicate B&L should not have recognized the revenues in the first place. It may be useful to point out that the (B) case states that accepting this return was an unprecedented event for B&L. This presents a good opportunity to discuss the importance of making estimates for accounting transactions and the fact that these estimates may be flawed. It is useful to point, out to the students that just as they did not know the returns would occur when they discussed the (A) case, the managers would have had to speculate at year end 1993. The (B) case also presents the potential to discuss the role of reserves for doubtful accounts. While the exact amount of B&Ls reserve is not dear, it is likely that some reserves were taken when the original shipments were made. Once the accounting issues have been discussed, students can be asked what they would do if they were
1

The information on auditor confirmation is not included in the case and will need to be provided by the instructor.

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the CEO of B&L. How would they restore the markets confidence in the company? Would they need to make adjustment to their relationship with distributors? This discussion should help students to understand the difficulties managers can face when the market questions the veracity of their accounting. Since operational and financial reporting crisis often occur at the same time, this challenge is faced more frequently that many students realize. Once the impact of the merchandise return has been fully discussed, the (C) case can be handed out. It: consists of headlines and quotes from several articles published in December of 1994 and January of 1995. The first article questions the choices made by B&L and alleges that the new sales strategy was purely an accounting trick. The second article is a response by B&L. The final article is an earnings

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announcement that also discloses that the SEC is investigating the company. Combined, these excerpts should provide the students with a feel for the position management is currently in: the company is performing poorly, getting pejorative press, and now scrutiny from the SEC. This case allows further discussion of dealing with a company facing an operating and public perception crisis. However, it also introduces the role of the SEC as an enforcement agency. While most students are aware of this role in general, experience teaching the case indicates that even those with a strong background in accounting/finance have not considered the implications of this role. One potential impact of the SEC investigating accounting choices of publicly held companies is that the financial reporting process becomes more reliable. This occurs because managers are less likely to take liberties with accounting choices if they know there is a possibility of getting tangled up with the SEC. It is worth pointing out, however, that this does not necessarily have to be the case. Having independent accountants, outside directors, institutional shareholders, and financial analysts, as well as other mechanisms in place to monitor managers could provide sufficient oversight to ensure the reliability of financial statements. Another potential impact of SEC investigations is that managers feel any use of discretion will be secondguessed if the ex post outcome is unfavorable. This may lead managers to be overly conservative in making estimates to avoid an investigation and censure if the firm experiences a period of poor performance. Such overly conservative accounting can reduce the informational relevance of accounting information. In fact, in the extreme it may lead managers and auditors to lobby for mechanical rules for which application cannot be second-guessed rather than those that allow discretion and communication. If that is the case, the existence of the SEC can lead to less relevant financial information. Regardless of whether or not students agree with the SECs stance towards B&L, it is important for an instructor to point out that regulatory action can impose substantial costs on firms and have potentially serious consequences for managers. Thus, managers should consider how regulatory agencies such as the SEC are likely to respond to their accounting choices, even those that survive auditor scrutiny. Finally, an instructor may want to ask the students to consider what their next action would be if they were Bausch & Lombs senior officers. Once students have discussed this, it may be useful to tell them the eventual outcome for B&L and the other interested parities. In response to the SEC probe, Price Waterhouse, B&Ls independent accountants, hired a second outside auditor to review the dealings in .question. Despite identifying certain transactions wrongly recorded as sales, this investigation produced support for the position that the accounting treatment of B&Ls new sales strategy was appropriate in aggregate. On December 6, 1995, B&L held a meeting with investors to ease concerns about the companys recent troubles. What else has to happen, a representative from one of B&Ls largest shareholders asked Dan Gill, for you to resign? Exactly one week later, B&L announced that Gill would step down by year-end.

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He was replaced by an outside director, William H. Waltrip, who agreed to serve as interim CEO until a permanent replacement was found. On January 24, 1996, B&L voluntarily restated two years of financial results in an initial step by Waltrip to rebuild the companys tarnished image. Net income for 1993 was cut by $17.6 million, while 1994 net income was increased by an identical amount. These changes were made to reverse questionable sunglass and contact lens sales made during 1993. However, Waltrip maintained that B&L did not materially breach accounting rules. On January 1, 1997, William M. Carpenter succeeded Waltrip. After having joined B&L in March of 1995 to head its eyewear division, Carpenter held the joint title of president and COO immediately prior to becoming CEO. By late 1997 none of the senior managers from the winter of 1994 remained with the company. The SEC investigation found errors at B&L related to the conventional lens shipments. Ermin Ianancone, divisional controller, and Kurt Matsumoto, director of distributor sales, had colluded to undertake fraud. This fraud included signing side agreements granting the right of return of products, renting warehouse space for distributors to store the increased inventory, and including shipments that occurred after yearend in the1993 results. The SEC concluded top management had not been aware of these actions, but was accountable for having a poor oversight environment. This outcome is useful to discuss for two reasons. First the fraud indicates that some of the key facts used in determining whether revenue should be recognized were based on erroneous information. The new facts show that the revenue should not have been recognized. However, top management had to rely on the information they were given in reaching a determination.. The SEC did not challenge managements decision based on that information. Second, although the SEC stated that Johnson was not involved in the fraud, he still was censured for failure to maintain a proper oversight and control environment. This provides a cautionary tale to the students - as a top manager they are responsible for managing the control environment of their firm. On November 18, 1997, B&L announced that the company had settled the charges brought against it by the SEC. Resulting in a one-time, after-tax charge of approximately $13 million, the settlement did not require B&L to admit wrongdoing, but the company agreed to refrain from similar violations in the future. Reflecting on this outcome, Thomas C. Newkirk, associate director of enforcement at the SEC, expressed concern that accounting like B&Ls may be occurring in a lot of other companies. Separately, B&L announced a preliminary agreement to pay $42 million in order to settle a shareholder class-action lawsuit brought about by the events surrounding the SEC probe. Case 5-5: Boston Automation. Systems, Inc. Note: A new case with the Eleventh Edition. David Fisher, the chief financial officer of Boston Automation Systems, Inc. a capital equipment manufacturing and testing instrument supplier to a variety of electronic-based industries, including the semiconductor industry, was reviewing ~he revenue recognition practices of the companys three

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divisions. The review was undertaken in anticipation of disclosing in the companys third quarter 2000 Form 10-Q filing with the Securities and Exchange Commission (SEC) the possible impact on the company of the revenue recognition and reporting guidelines set forth in the SECs Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (SAB 101). SAB 101 had to be adopted no later than the fourth quarter of 2000. In particular, Fisher was concerned about the effect of SAB 101s guidelines covering customers acceptance and unfulfilled seller obligations on the companys revenue recognition practices. Fishers staff had been studying this aspect of SAB 101 and the companys revenue recognition practices for several months. As a test of his own understanding of the issue, Fisher selected from each of the companys three divisions a limited number of representative sale transactions to review. In each situation the question Fisher posed was, Assuming all other revenue recognition criteria are met other than the issues raised by any customer acceptance provisions, when should revenue be recognized?

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Students are asked to assume the role of Fisher and reach conclusions as to the appropriate revenue recognition decision in each of the sale transactions reviewed by Fisher.1 Teaching Plan The class discussion can open with a brief financial analysis of the companys performance and then proceed in the order of the questions listed at the end of the case. The financial analysis should focus on the companys high sales growth and its 1998 problems and 1999 recovery. This discussion will provide some insight and background into why changing revenue recognition methods is so important to this company. Question 1 is designed to ensure that students identify the companys current revenue recognition accounting policies. This knowledge will be used later in the class to highlight the serious threat SAB 101 poses to the company. It may have to defer more revenue than it did before it adopted SAB 101. Question 2s purpose is to give the subsequent class discussion of the individual sale transactions a managerial perspective, which should help to make what could be a dull accounting discussion more relevant to the students. The revenue recognition decisions Fisher must make in the next quarter have potentially significant adverse consequences for the company. The accounting decisions are important managerial decisions. Question 3 should take up the bulk of the class. As each sale transaction accounting issue is resolved, the instructor should ask the class to explain the accounting entries required by the conclusion. To test the student understanding of their conclusions, the instructor should ask the class to reconsider the facts of a resolved situation with modifications. For example, in the Technical Devices Division example the instructor might change the case facts by stating the division seldom, if ever in the past accepted product returns from distributors. Then, the instructor should ask, Does this fact change alter your decision? The final question should lead to an open discussion, which the instructor should focus on whether accounting standards should be stated in general principles (revenue should be recognized when earned and realized) or detailed guides (SAB 101). This is a fundamental accounting standard setting issue. For example, many believe the International Accounting Standards Committees (IASC) approach to writing standards is preferable to the Financial Accounting Standards Boards (FASB) approach. The IASC writes standards in terms of general principles with some guidelines on their application and then leaves it up to management to apply the standard in a way that reflects the particular facts of the situation. In
1

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.

Copyright 2000 President and Fellows of Harvard College. Harvard Business School Teaching Note 5-103-051

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contrast, the FASB writes standards that are more like cook books. They are more like SAB 101, which is very detailed in its guidance and much more restrictive in its permitted use of judgment.

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Revenue Recognition Methods Boston Automation Systems has adopted the following revenue recognition policies. 1. Recognize revenue upon product shipment 2. Recognize service revenue ratably as service is provided over the period of the related contract. 3. Recognize long-term contract revenue using the percentage-of-completion accounting method 4. Revenue from multi-deliverables contracts is allocated to each deliverable based upon the amounts charged for each deliverable when sold separately. The company provides estimated warranty costs when product revenue is recognized. The instructor should ask students to explain the accounting entries for each revenue recognition policy as it is identified by the class. At the end of this part of the discussion the instructor should ask a student to explain the accounting entries the company will make to record the cumulative effect adjustment resulting from the change in accounting principles. The recognition policy most likely to be impacted by SAB 101 is recognize revenue upon product shipment. In particular, those sale transactions that involve customer acceptance and unfulfilled obligations subsequent to shipment. While the students do not know it, the instructor should be aware that SAB 101 specifically excludes the percentage-of-completion accounting method from its scope. Fishers Concerns An examination of Boston Automation Systems consolidated financial statements clearly shows that the company has been growing both its sales and net income at a double-digit rate. If more revenue must be deferred as a result of applying SAB 101, this high growth rate might be harder to manage or achieve in the future. On the other hand, deferral of product sale revenue (when combined with the unearned service revenue already .on the balance sheet) may dampen some of the cyclical industry effect on the volatility of its companys revenues and earnings. A change in the revenue recognition methods may lead some to question the companys rebound from its 1998 problems (excess inventory and lower profits.) The Advanced Technology Division appears to be the division that will most likely to be impacted by SAB 101. It sales transactions involve complex equipment and appear often to involve significant installation and equipment performance obligations. The troubled Technical Devices Divisions sales strategy shift and the related inventory loading of its

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distribution channels might lead to an adverse earning quality reaction by investors if the division booked the mechanical testing device sales immediately and investors learned of it. Fisher should be concerned about this possibility. Fisher might find the cumulative effect adjustment troublesome. It will be a charge to earnings and a credit to deferred revenues. Some investors may react negatively to this one-time charge thinking it implies the company had been too aggressive in its past revenue recognition practices by recording revenue (and earnings) prematurely. Fisher should also recognize that the companys general revenue recognition policy needs to change. In the future revenue should be recognized upon delivery (not shipment) since title passes to the customer upon delivery. Sales Transactions Fishers decisions on the appropriate revenue recognition accounting for each of the sales transactions he reviewed is presented below. Trycom, Inc. While the SEC staff presumed that customer acceptance provisions are substantive provisions that generally result in revenue deferral, that presumption can be overcome. Although the contract includes a customer acceptance clause, acceptance is based on meeting the divisions published specifications for a standard model. The division demonstrates that the equipment shipped meets the specifications before shipment, and the equipment is expected to operate the same in the customers environment as it does in the sellers. In this situation, the division should evaluate the customer acceptance provision as a warranty. If the division can reasonably and reliably estimate the amount of warranty obligation, revenue should be recognized upon delivery of the equipment with an appropriate liability for probable warranty obligations. White Electronics Company Although the contract includes a customer acceptance clause that is based, in part, on a customer specific criterion, the division demonstrates that the equipment shipped meets the objective criterion, as well as the published specifications, before shipment. Therefore, the division should evaluate the customer acceptance provision as a warranty. If the division can reasonably and reliably estimate the amount of warranty obligations, it should recognized revenue upon delivery of the equipment; with an appropriate liability for probably warranty obligations. Silicon Devices, Inc. This contract includes a customer acceptance clause that is based, in part, on a customer specific criterion,

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and the division cannot demonstrate that the equipment shipped meets that criterion before shipment. Accordingly, the contractual customer acceptance provision is substantive and is not overcome upon shipment. Therefore, the division should wait until the product is successfully integrated at its customers location and meets the customer-specific criteria before recognizing revenue. While this is best evidenced by formal customer acceptance, other objective evidence that the equipment has met the customerspecific criteria may also exist (e.g., confirmation from the customer that the specifications were met). Analog Technology, Inc. While the division believes that its equipment can be made to meet the customers specifications, it is unable to demonstrate that it has delivered what the customer ordered until installation and testing occurs. Accordingly, it would be inappropriate for the division to recognize any revenue until it has demonstrated that it has delivered equipment meeting the specifications set forth in the contract. This would normally occur upon customer acceptance.

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Specialty Semiconductor, Inc. Upon delivery, the division has completed the earnings process and met the delivery criterion with respect to the equipment because it has demonstrated that the equipment delivered to the customer meets the requirements of the customers order. However, because the customer is not obligated to pay the division if installation of the equipment is not completed, no revenue may be recognized until installation is complete and the customer becomes obligated to pay. Conversely, if the division has an enforceable claim at the balance sheet date through which it can realize some or all of the. $20 million fee even if it failed to fulfill the installation obligation, deferral of a lesser amount, but not less than the estimated fair value of ~he installation (i.e., $500,000), would be appropriate. Alternatively, if the divisions policy is to defer all revenue until installation is complete, recognition of the $20,000,000 fee upon completion of installation would be appropriate. The divisions policy should be appropriately disclosed and consistently applied. Micro Applications, Inc. Upon delivery, the division has completed the earnings process and met the delivery criterion with respect to the equipment because it has demonstrated that the equipment delivered to the customer meets the requirements of the customers order. In addition, the buyers obligation to pay the fee is not contingent upon completion of installation. Therefore, the division should recognize the revenue allocable to the equipment, $19,500,000, as revenue upon delivery. The remaining $500,000 of the arrangement fee should be recognized when installation is performed. Alternatively, if the divisions policy is to defer all revenue until installation is complete, recognition of the $20,000,000 fee upon completion of installation would be appropriate. This policy should be appropriately disclosed and consistently applied. XL Semi, Inc. The XL Semi, Inc., order is one unit for accounting purposes, rather than an equipment sale, and an 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, because neither deliverable can be purchased from another unrelated vendor, the separate deliverables in the arrangement do not meet the criteria for segmentation. Further, due to the specialized skill involved in the installation of the equipment, installation is considered to be substantive, rather than inconsequential or perfunctory. There is a strong presumption that the revenue recognition should be delayed until customers acceptance is obtained following the completion of installation. Technical Devices Division The passing of title, the absence of evidence that the distributors do not have the capability to pay for the

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devices and the products established market acceptance support immediate revenue recognition with a provision for anticipated returns. However, the unsettled state of the product market, the uncertainty surrounding the future sales level, and the absence of historical return data for distributor sales to high volume customers argues for revenue deferral on the grounds that return provisions cannot be estimated reliably.

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The distributors unusual extended payment terms, reflecting the expected sell-through of the mechanical testing devices coupled with the divisions past generous unwritten return practices suggest that the socalled sale is in substance a consignment-type transaction. Revenue should be recognized by the division on a distributor sell-through basis. The divisions excess inventory charge raises the question: Was any of this written down inventory resold during 1999 and, if so, what was the cost of goods sold? Typically excess inventory is written down to zero cost. Fisher should make this inquiry since the profit earned on the subsequent sale of written-down excess inventory should be disclosed under GAAP. Cookbook Rules Versus General Principles There are two basic approaches to standard setting: Issue detailed rules or standards that set forthaccounting principles in the form of general principles. The tendency of the FASB has been to publish, accounting standards with detailed implementation requirements and guidelines. This approach to standard setting has been characterized as a cookbook approach. It is the result of a need on the part of practicing public accountants, for guidance in the application of accounting standards, investors seeking uniform accounting by companies to facilitate intercompany comparisons, and a general belief that this approach will produce financial statements that are fair to all who rely upon them. Without detailed standards, the supporters of this approach claim, some management will take advantage of the lack of guidance to issue misleading statements that will lower the confidence of statement users in all financial statements. The supporters of the proposition that accounting principles should embody principles rather than detailed rules claim accounting rules cannot cover every situation. As a result there will always be some situations that rules will miss but which would be covered by a well-stated general principle. Accounting for Equity Transactions If time permits, the instructor might want to use the companys unusual accounting for equity transactions to cover accounting for equity transactions. The unusual accounting includes accounting for a stock split as a dividend (debit common stock, credit paid in capital) like transaction (but no change to retained earnings) to avoid changing the par value of the split stock and the reduction of common stock and paidin capital to reflect the acquisition of its own stock (no treasury stock account) as if it was canceled when in fact the required stock is not cancelled (it is outstanding but not issued). The instructor may also want to include in this discussion the accounting for the stock option tax benefits (a capital rather than an income transaction.)

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Summary Clearly, the SECs experience has led it to conclude after reviewing revenue recognition accounting practices in situations similar to those described in the case that the application of general principles, does not always lead to the appropriate accounting decision. The SECs response was to provide more guidance in the area of revenue recognition than was provided by the general principle that revenue should be recognized when it: is earned and realized. This SEC response had a profound impact on the revenue recognition practices of many companies. For example, it ranged from retailers changing the way they accounted for lay-a-way plans (revenue was deferred rather than recognized immediately) to manufacturers like Boston Automation Systems with significant post-delivery obligations (they had to defer rather than recognized income immediately. Case 5-6 : Blaine and Mason, LLP: Gross Versus Net Revenue Reporting (A)* Note: This is a new case for the Eleventh Edition. Situation Lynn Wilson, the managing partner of the Technical Resources department of Blaine and Mason, LLP, a large regional public accounting firm, must review a number of requests for technical assistance from the audit staff on the issue of gross versus net reporting of revenues by audit clients. The audit staff assistance requests are the result of the Securities and Exchange Commissions (SEC) release in December, 1999 of Staff Accounting Bulletin No. 101, Revenue Recognition (SAB 101), and a July 2000 Emerging Issues Task Force consensus covering the same issue. Both of these publications deal with applying generally accepted accounting principles to determine when it was appropriate for a company to report revenue on a gross basis when acting as a principle versus on a net basis when acting as an agent. Wilsons decisions on the cases referred to her group were of considerable importance to a number of Blaine and Masons client companies, particularly those internet firms valued on a multiple of sales basis. Students are required to assume Wilsons position and resolve a number of case situations presented to her by the audit staff. Teaching Strategy It is useful to start the case discussion with question 1. The purpose of this discussion is to give the class perspective on the case issue from a managerial point of view. This discussion should highlight the managerial and equity valuation significance of the case issue. This managerial and valuation point of view should be carried over into the discussion of the resolution of the accounting issues. It will make the discussion more relevant and more comprehensive in its perspective. The next phase of the class should focus on asking the students, which indicators they believe are the most persuasive in determining if gross revenue reporting is appropriate. This discussion provides an opportunity to review SAB 101, the EITF staff report and the EITF consensus. It will also encourage students to take a stronger position on the significance of specific indicators, which should carry over into
*

Copyright 2000 by the President and Fellows of Harvard College. Harvard Business School Teaching Note 5-101-041.

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a more spirited discussion of the resolution of the case examples.

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The last part of the class should deal with question 3. The instructor should not feel compelled to cover all of the situations presented. Attempting to cover all of the situations may result in an inadequate discussion of each issue. The instructor should select those two or three situations that will motivate a robust discussion of the issue by his or her class and deal with them initially. There is no need to deal with each situation in order. In fact, the instructor may wish to alert the students prior to the class which situations he or she will be focusing on in class. Chief Executive Officer Concerns Typically, the chief executive officer of a publicly-traded start-up company similar to those listed in the case that has been reporting revenues on a gross bases might prefer to continue gross revenue recognition for his or her company for these reasons: Revenues might be a significant factor in the companys stock valuation. In contrast to net revenues, gross revenues might be more indicative of the level of transaction activity. Gross revenues might suggest a larger scale business activity which in turn might suggest a more established and substantial business than net revenue recognition might indicate. Switching from gross to net revenue reporting might confuse investors as well as raise questions about the credibility of the companys past financial statements and current management.

Persuasive Indicators Students often state that the most persuasive indicator of gross revenue reporting is whether or not the seller assumes the risks and rewards of ownership. As a general statement this is probably correct, but it needs to be made more operational. The class should be challenged to make the general test operational. The principal operational test suggested most probably will be whether or not the seller is the primary obligor in the sales arrangement from the customers perspective. A primary obligor has a strong case to recognize revenue on a gross basis. Again, the class should be pushed to be more specific. With reference to the primary obligor test, EITF 99-19 noted: The company is the primary obligor in the arrangement -- Whether a supplier or a company is responsible for providing the product or service desired by the customer is a strong indicator of the companys role in the transaction. If a company is responsible for fulfillment, including the acceptability of the product(s), or service(s) ordered or purchased by the customer, that fact is a strong indicator that a company has risks and rewards of a principal in the transaction and that it should record revenue gross based on the amount: billed to the customer. Representations (written or otherwise) made by a company during marketing and the terms of the sales contract generally will provide evidence as to whether the company or the supplier is responsible for fulfilling the ordered product or service. Responsibility for arranging transportation for the

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product ordered by a customer is not responsibility for fulfillment.1

Emerging Issues Task Force Consensus 99-19, July 20, 2000.

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The other most persuasive indicator of the appropriateness of gross revenue reporting mentioned by students is that the seller assumes a significant general inventory risk. Typically, the assumption of this risk justifies gross revenue recognition. Again, students should be pushed to be more specific. EITF 99-19 discussed this indicator: The company has general inventory risk (before customer order is placed or upon customer return)--Unmitigated general inventory risk is a strong indicator that a company has risks and rewards as a principal in the transaction and, therefore, that it should record revenue gross based on the amount billed to the customer. General inventory risk exists if a company takes title to a product before that product is ordered by a customer (that is, maintains the product in inventory) or will take title to the product if it is returned by the customer (that is, back-end inventory risk) and the customer has a right of return. Evaluation of this indicator should include arrangements between a company and a supplier that reduce or mitigate the companys risk level. For example, a companys risk may be reduced significantly or essentially eliminated if the company has the right to return unsold products to the supplier or receives inventory price protection from the supplier. A similar and equally strong indictor of gross reporting exists if a customer arrangement involves services and the company is obligated to compensate the individual service provider(s) for work performed regardless of whether the customer accepts that work.2 Irrespective of where the class discussion comes on what are the most persuasive indicators, the instructor should remind the class that none of the indicators should be considered presumptive or determinative. The relative strength of each indicator in each particular case should be considered. Staff Requests The case presents seven situations that the audit staff has brought to Wilson for resolution. EITF 99-19 includes seven of these situations along with staff comments. If the instructor wishes to present more situations to his or her class, EITF 99-19 includes another five situations. Furniturehome.com Some indicators support gross revenue reporting. Other indicators support net revenue reporting. Net revenue reporting is appropriate. The company is not the primary obligor and its fee is a fixed percentage of customer billing. Indicators suggesting gross revenue reporting might be appropriate include physical inventory loss risk during shipping and credit card charge risk. The net revenue reporting indicators are more persuasive than the gross revenue reporting indicators. Shoe Stop, Inc. Gross revenue reporting is supported. The company is the primary obligor; it is responsible for fulfillment and customer complaints; it has general inventory risk; it sets prices; and has the credit risk.
2

Emerging Issues Task Force Consensus 99-19, July 20, 2000.

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The later is a weak indicator, but the other indicators are strong indicators. There are no net revenue reporting indicators. Cheapohfly.com Net revenue reporting is appropriate. The strongest and only indicator supporting this conclusion is that the airline is the primary obligor from the customer perspective. Weaker indicators supporting gross revenue reporting include pricing latitude, intransit ticket loss risk and credit risk. Grainco, Inc. Net Revenue reporting is appropriate for the companys grain merchandising operations. Net reporting indicators include: producer is primary obligor; the company earns a fixed percentage fee; and the producer has the credit risk for the gross billing. The fact that the company has the physical loss risk for grain stored on its premises is not a strong gross revenue-reporting indicator. Specialty Furniture Products, Inc. Gross revenue reporting is appropriate. The indicators supporting this conclusion are the company has pricing latitude; supplier selection discretion; and its profit is a gross profit based on the difference between negotiated selling and buying prices. The company also has credit risk, a weaker indicator for gross revenue reporting. It is unclear who is the primary obligor. Budget Travel, Inc. Gross revenue reporting is appropriate, but the conclusion is not clear-cut. Gross revenue reporting is supported by the fact the company has a general inventory risk for tickets purchased by it; pricing latitude; risk of ticket loss during delivery and credit risk. The airline appears to be the primary obligor, but the company assists customers resolving complaints, which is a primary obligor function. Gettingin.com Net revenue reporting is appropriate. The net revenue reporting indicators are that the college is the primary obligor (it reviews and denies or accepts applications) and it sets the admission fee. The companys fee is a fixed percentage of this amount. The credit card risk assumed by the company is a gross revenue reporting indicator, but not a strong one. Sales Arrangement Change In order for a net-revenue reporting company to qualify for gross revenue reporting would in most cases require a change in the way it does business so that it becomes the primary obligor or assumes a general inventory risk. Typically, this is not acceptable to management because of increased cost or greater

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business risk considerations. For example, Furniturehome.com might strengthen its case for gross revenue reporting if it assumed more inventory risk, but it is unlikely management would take this action. It would be a costly change in its business model. In other cases, the company can not assume the primary obligor role because of institutional and other insurmountable constraints. For example, Gettingin.com can not make admissions decisions for the universities it deals with and it is unlikely that it would be interested in establishing its own university system. Summary The issue of gross versus net reporting of revenue has assumed greater importance in recent years with the rapid expansion of the number of companies selling goods and services over the Internet. A number of these companies do not stock inventory, use third party shippers and service providers on their behalf, and assume minimal, if any, obligor responsibilities. In many cases revenues are the principal basis for valuing these companies. Not surprisingly, many of these companies have opted for gross revenue recording, which in the opinion of some accounting observers was inappropriate in many cases. These developments caused the SEC to look closer at this revenue recording practices of both Internet and non-internet companies. SAB 101 was the result of these inquires. SAB 101 is a landmark publication. For the first time a powerful regulatory body addressed in detail the issue of gross versus net revenue reporting. Later, the EITF followed the SECs lead and in essence made the SECs position on this issue an official generally accepted accounting principle for SEC registrant and non-registrant companies. Today, if a company wants to record gross revenues, it can make a strong case if it is the primary obligor or assumes a general inventory risk. Nearly all other indicators of gross revenue reporting are far weaker by comparison.

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