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Case 5-3: Joan Holtz (A) Note: This case has been updated from the

Eleventh Edition. Approach These problems are intended to provide


a basis for discussing questions about revenue recognition that are
not dealt with explicitly in the text and that are not sufficiently
involved to warrant the construction of a regular case. Instructors
can pick from among those listed. Some of them can be used as a
take-off point for elaboration and extended discussion by adding
What if? facts.
Answers to Questions
1. If electricity usage tended to be fairly constant from month to
month, one could argue in this case for basing reported revenues
solely on the actual meter readings: the unreported usage in
December would be reported in January, and overall revenues for
this year would not be materially misstated. Stated another way, if
revenues are based solely on meter readings, the December 2006
post-reading usage (which is recorded in January 2007) is, in effect,
assumed to be the same 2007 post-reading usage. Prior to passage
of the 1986 Tax Reform Act, this approach was permitted for income
tax purposes. The 1986 act requires the more acceptable (due to
better matching) practice: estimating actual usage for the part of
December after meters are read and reporting that usage as part of
the revenues of that year. This is more sound accounting, in that
with weather fluctuations and energy conservation efforts, it is
questionable whether the post-reading usage in December 2006
would in fact not differ materially from the post-reading usage in
December 2007. The same problem exists for operators of vending
machines. The postal service has the opposite problem: it receives
cash from stamp sales before all of the stamps are used. It carries a
liability (unearned revenues) for this effect. Both of these examples
illustrate that even when cash is involved, the measurement of
revenue is not necessarily straightforward.
2. This is one of the problems whose true resolution depends on
events that cannot be foreseen at the end of the accounting period.
Some firms count the whole $10,000 as revenue in 2006 on the
grounds that it is in hand and that any specific services are
undefined and/or separately billable. Others take the more
conservative approach of counting only $5,000 as revenue in 2006
on the grounds that the service involved is readiness to serve, and
that this readiness exists equally in each year. I prefer the latter
approach, based on the matching concept.

3. Many would argue that the service involved is the cruise and that
no revenue has been earned until the cruise has been completed.
Others maintain that Raymonds has completed its service of
arranging the cruise, that it is extremely unlikely that events will
happen in 2007 that will change its profit of $20,000, and that the
amount is therefore revenue in 2006. Introduction of the possibility
of a refund lessens the strength of the argument of the latter group.
This position can be weakened further by asking: (a) What if
passengers are dissatisfied and demand (or sue for) a refund? (b)
What if the ship owner performs unsatisfactorily and Raymonds, in
order to protect its reputation, steps in and incurs additional food or
other cost to make the passengers happy? Students should be
reminded to consider two criteria: (1) that the agency has
substantially performed its earning activities and (2) that the
income is reliably measurable.
4. This problem has been debated for many years. Some argue that
the $4 per tree has already been earned, as evidenced by the firm
offer to buy the trees, and that it would be misleading to show no
revenues in 2006 and the full sales value when the trees are sold in
2007. The percentage-of-completion method can be used as an
analogy. Others argue that there has been no transaction, and no
assurance that the trees can be sold for more than $4 in 2007
because market prices may decrease, or pests or fire may destroy
them. Typically, firms facing this issue recognize no revenue until
harvesting the trees.
5. If a professional service firm (architects, engineers, consultants,
lawyers, accountants, and so on) values its jobs in progress at billing
rates, then it is recognizing revenue as the work is performed (time
applied to projects) rather than waiting until the customer is billed.
This is certainly defensible if the firm has a contract (called a time
and materials contract) that obligates the client to pay for all time
applied to the clients project: the critical act of performance is
spending the time on the project, not billing that time. In fact, many
such firms feel that even with fixed-fee contracts, the critical
performance task is spending time on a project as opposed to
delivering some end item to the client; they thus record jobs in
progress at estimated fee, which would be the same as billing rates
for the time applied provided the project is within its professionalhour budget. Of course, whether the revenue is recognized when
the time is applied or when the client is billed does make a
difference in owners equity. Retained earnings will reflect the

margin on the time applied sooner if the jobs in progress inventory


is valued at billing rates rather than at cost.
6. Numerous answers are acceptable. I argue that the coupon has
nothing to do with the sale of coffee. Its purpose is to promote the
sale of tea. The 60 cent reimbursements made in 2006 and the 60
cent reimbursements made in 2007 are an expense of selling tea in
2007. Those who tie the coupons with coffee would say that the
entire 20 percent of coupons redeemed is an expense of selling
coffee in 2006 with the amount not yet redeemed being a liability as
of December 31, 2006. It is customary that the coupon issuer pays
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 travellers checks for $505
as follows: dr. Cash............................................................... 505
cr. Payable to American Express.................... 500
Commission Revenue................................ 5
After the bank remits the $500 cash to American Express, the latter
will make the following entry:
dr. Cash............................................................... 500
cr. Travellers Checks Outstanding................... 500
The account credited is a liability account. This account had a
balance of many billions of dollars, which should help students
understand why American Express does not itself levy a fee on the
issuance of travellers 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
2006 revenues and income by the sort of repurchase agreement
described. FASB 49 was issued to address the perceived abuse of
treating such temporary title transfers as sales.
9. FASB Statement No. 45 states that franchise fee revenue should
be recognized when all material services or conditions relating to
the sale have been substantially performed or satisfied by the
franchiser. Amortization of initial franchise fees should only take
place if continuing franchise fees are so small that they will not
cover the cost of continuing services to the franchisee. Since this

exception seems unlikely in this case, the $10,000 franchise fee


should be recognized as revenue in the year received, as soon as
the training course has been completed. Investors will need to make
their own judgment as to what will happen when the market
becomes saturated.
10. This item is designed to get students to think about (1) a
condition that creates the need for a change in revenue recognition
policy, and (2) the potential need for multiple revenue recognition
policies for a firm. Tech-Logic, a manufacturer of computer systems,
normally recognizes revenue when its products are shipped, a policy
common among manufacturing firms. To adopt that policy,
managers at Tech-Logic must have concluded that the two criteria
for revenue recognition were met at shipment: (1) Tech-Logic would
have substantially performed what is required in order to earn
income, and (2) the amount of income Tech-Logic would receive
could be reliably measured. With the sale of the computer systems
to the organization in one of the former Soviet Union countries,
however, Tech-Logics ability to satisfy these two criteria changed.
Although the first criterion was still met, the uncertainty about
whether (and how much) foreign exchange the customer could
obtain left the second criterion in doubt. Hence, Tech-Logic should
not recognize revenue for these computer systems at shipment or
delivery. An alternative should be to wait until cash (in the form of
hard currency) was received to recognize revenue. This item can
also be used to discuss the fact that firms often have more than one
revenue recognition policy. Tech-Logic would not completely change
its revenue policy to cash receipt for all sales at the time it begins
to sell computers to organizations in countries where the availability
of foreign exchange currency is in doubt. Rather, it would be likely to
have two revenue recognition policies; at shipment, for products
sold to organizations in countries where the availability of foreign
exchange currency is not in doubt; and cash receipt, for products
sold to organizations in countries where the availability of foreign
exchange currency is in doubt. Because they manufacture products
and provide a variety of services, computer manufacturers often
have a variety of revenue recognition policies. For example, a
computer manufacturer might recognize revenue for products when
they are shipped; for custom software development, when the
customer formally accepts the software; and for maintenance
services, ratably over the life of the maintenance contract. Item 10
was inspired by events that occurred at Sequoia Systems in 1992.
Sequoia evidenced several instances of aggressively booking

revenue. One of these involved a Siberian steel mill. According to


The Wall Street Journal: Executives signed off last year on the sale of
a $3 million computer destined for a steel mill in Siberia. But
government approvals and hard currency to pay for the system got
stalled, even though $2 million of revenue was booked in the fiscal
year ended June 30, and another $1 million was going to be taken in
the first quarter ended last month, insiders say.1 Sequoia executives
stated that they expected this; 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. 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.

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