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 difficult ! indeed" the ti#e that one is so#eti#es forced to spend on this topic is all out of proportion to its i#portance. Students often do not understand $h an Allo$ance for Bad %ebts account is necessar at all! the do not grasp the notion that although $e feel reasonabl sure that so#e accounts $ill go bad" $e do not &no$ $hich ones the $ill be. Even $hen the do understand this" the chain of transactions involved in esti#ating bad debts" $riting off specific accounts" and boo&ing bad debts recovered" is co#plicated and not eas to follo$. 'f e(perience is an guide" it is quite li&el that at the ti#e this chapter is taught the press $ill be describing a co#pan that has gotten into trouble for overstating its revenue or understating its bad debt or $arrant allo$ance. %iscussion of such a situation $ould be interesting. Cases Stern Corporation (A) is a straightfor$ard proble# in handling accounts receivable and bad debts. MacDonalds Farm, b contrast" has fe$ technical calculations but provides an e(cellent opportunit for a realistic discussion of alternative $a s of #easuring revenue and of valuing assets. Joan Holtz (A) is a different t pe of case. 't is a device for raising several discrete" separable proble#s about the sub)ect #atter of the chapter" fro# $hich the instructor can pic& and choose those he or she $ishes to ta&e up in class. *'t probabl is not feasible to discuss all of the#.+ Bausch & om!, "nc." is an actual case situation involving revenue recognition. Boston Automation S#stems, "nc$ involves a revie$ of the co#pan s revenue recognition practices in the light of the SECs SAB 101. Blaine and Mason, %, deals $ith the issue of gross verses net reporting of revenues.

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Problems
Problem 5-1

Sale Method Jan. Feb. Mar. April Ma J!ne Sales......................................................................................................................................................................................... .1/"000 . 0"000 .11"000 .11"000 .2"000 .11"300 Cost of goods sold.................................................................................................................................................................... -"000 3"/00 0"430 -"130 3"030 0"--3 5ross #argin............................................................................................................................................................................ . 4"/00 ./"000 . 4"330 . 1"030 .1"130 . 4"-/3

"nstallment Method Jan. Feb. Mar. April Ma J!ne Sales......................................................................................................................................................................................... .11"000 .10"000 .11"300 .10"300 .10"300 .2"300 Cost of goods sold.................................................................................................................................................................... -"130 ,"300 4",-3 ,"0/3 ,"0/3 ,"1-3 . 1"030 . 1"300 . ,"0/3 . 1",-3 . 1",-3 .1"1/3 Problem 5-#

Completed Contract Percentage of Completion This $ear %e&t $ear This $ear %e&t $ear 'nco#e e(cluding #otel *000+................................................................................................................................................. .1"/30 .1"/30 .1"/30 .1"/30 'nco#e fro# #otel pro)ect....................................................................................................................................................... 0 -30 430 100 'nco#e before ta(es................................................................................................................................................................. .1"/30 ./"000 .1"-00 .1"330 Problem 5-' To record the $rite6off7 'f Alco# uses the direct $rite6off #ethod66 %r. Bad debt E(pense................................................................. Cr. Accounts Receivable........................................................ 'f Alco# uses the allo$ance #ethod7 %r. Allo$ance for %oubtful Accounts....................................... Cr. Accounts Receivable............................................... To record the partial pa #ent7 'f Alco# uses the direct $rite6off #ethod7 Cash........................................................................................... Bad %ebts Recovered............................................................ *or Bad %ebt E(pense............................................................ .230 .230 .230+ .1"000 .1"000 .1"000 .1"000

,0

'f Alco# uses the allo$ance #ethod7 Either of the above t$o entries or7 Cash........................................................................................... Allo$ance for doubtful accounts........................................... Problem 5-( The Allo$ance for %oubtful Accounts should have a balance of .31"-30 on %ece#ber 11. The supporting calculations are sho$n belo$7 )a s Acco!nt *!tstanding Amo!nt 0613 da s .430"000 1,610 da s 130"000 11643 da s -3"000 4,6,0 da s 43"000 ,16-3 13"000 Balance for Allo$ance for %oubtful Accounts 8*169robabilit of collection.+ The accounts that have been outstanding over -3 da s *.13"000+ and have :ero probabilit of collection $ould be $ritten off i##ediatel and not be considered $hen deter#ining the proper a#ount of the Allo$ance for %oubtful Accounts. b. Accounts Receivable....................................................................... ;ess7 Allo$ance for %oubtful Accounts.......................................... <et Accounts Receivable.................................................... .-13"000 E&pected Percentage +ncollectible, .01 .0, ./0 .13 .30 Estimated +ncollectible . 4"300 2"000 13"000 13"-30 .230 .230

-"300 .31"-30

31"-30 .,01"/30

c. The ear6end bad debt ad)ust#ent $ould decrease the ears before6ta( inco#e b ./2"/30" as sho$n belo$7 Esti#ated a#ount required in the Allo$ance for %oubtful Accounts.................................................................................... Balance in the account after $rite6off of bad accounts but before ad)ust#ent.................................................................................. Required charge to e(pense.............................................................. .31"-30 //"300 ./2"/30

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Problem 5-5 5reen ;a$ns boo&s7 %r. 'nventor on Consign#ent.......................................................... Cr. =inished 5oods 'nventor ...................................................... 0"400 0"400

<ote that at this point the .1/",00 $holesale price *5reen ;a$ns revenue $hen these goods are sold+ is irrelevant. Carsons boo&s7 <o entr ! the goods are not o$ned b Carson and hence are not inventor on Carsons boo&s! si#ilarl " Carson does not as et o$e 5reen ;a$n for these goods. 5reen ;a$ns boo&s7 %r. Accounts Receivable.................................................................. Cost of 5oods Sold...................................................................... Cr. Sales.................................................................................. 'nventor on Consign#ent.................................................. *This can be sho$n as t$o entries.+ Carsons boo&s7 %r. Cash or Accounts Receivable..................................................... Cost of 5oods Sold...................................................................... Cr. Sales.................................................................................. Accounts 9a able................................................................. *This also can be sho$n as t$o entries.+ Problem 5-Revenue..................... Costs.......................... 'nco#e....................... #. & 1 .200"000 #. & # .1"4-0"000 #. & ' ./"/03"000 ,"-/0 3"040 ,"-/0 3"040 3"040 1"1,0 3"040 1"1,0

-/1"000 ./32"000

1"120"000 . /00"000

1"-13"000 . 420"000

Revenue equals percentage co#pleted during the ear ti#es fi(ed price.

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Problem 5-/ The 5R> Co#pan s current assets and current liabilities at ear6end are sho$n belo$. Current assets7 Cash......................................................................................... Accounts receivable................................................................. ;ess7 Allo$ance for bad debts................................................. <et accounts receivable............................................................ Beginning inventor ................................................................. 9urchases.................................................................................. Available inventor .................................................................. ;ess7 Cost of goods sold........................................................... Ending inventor ...................................................................... Total current assets.............................................................. Current liabilities7 Accounts pa able...................................................................... Current portion of bonds pa able............................................. 'nterest pa able......................................................................... Total current liabilities......................................................... Current ratio ? .1/3"/00 @ .-1"100 ? 1.-, Auic& ratio ? *./1"100 B .1/"000+ @ .-1"100 ? .-0 . /1"100 . 14",30

1"030
1/"000 4,"/00

104"000
/11"000

1,1"-00 ,2"100 .1/3"/00

.10",00 -"-00

/3"000 . -1"100

The above ratios #easure 5R>s abilit to #eet short6ter# obligations. The current ratio indicates that 5R> has -, percent #ore cash and relativel liquid assets that are e(pected to be converted to cash in the short run than it has short6run obligations requiring cash for their satisfaction. This ratio does not necessaril #ean the a#ount of current assets is adequate" ho$ever. =or e(a#ple" the accounts pa able and interest pa able could be obligations due $ithin the ne(t fe$ da s" and it #a not be possible to liquidate accounts receivable and inventories that quic&l . b. Cash E(penses7 Cost of goods sold.................................................................... Cther e(penses......................................................................... Total cash e(penses............................................................................... %a s cash ? ./1"100 @ *./11"000 @ 1,3+ ? 1,.3 da s. This ratio #easures ho$ #an da s of nor#al operating e(penses can be paid $ithout adding to the cash balance. The above ratio indicates that 5R> Co#pan has an apparent stoc&pile of cash. This #eans 5R> is either planning unusual e(penditures during the ne(t period" or is not properl #anaging cash. Cash does not generate a return. There is a trade6off bet$een DinstantE liquidit and the return on #ar&etable securities. So#e students #a argue that purchases" rather than cost of goods sold" should be used in the calculation. This $ould not reflect a true Dstead stateE of operations" since it happened that 5R> built up its inventor b ./1"100 during the ear. The argu#ent for basing the ratio on purchases $ould be stronger if the student e(plicitl assu#es a long6ter# buildup of inventor each ear *to support increasing sales+!

.1,1"-00

,2"100 ./11"000

-1

but then" for consistenc " so#e other cash e(penses should probabl be increased" too" thus resulting in appro(i#atel the sa#e 1,.36da figure. 'n an event" there is no i#plication that such ratio calculations are interpretable $ith great precision. The are #ost #eaningful if calculated for the sa#e co#pan over a period of ears. c. %a s receivables ? <et receivables @ *Credit sales @ 1,3+ ? .1/"000 @ *.1/1"400 ( .-- @ 1,3+.

? 40 da s.
This ratio #easures the average collection period of receivables. Although so#e anal sts use total sales *often because the portion of credit sales is not disclosed+" the above calculation is correct. The result suggests that 5R>s custo#ers are stretching the pa #ent period.

Cases
Case 5-1: Stern Corporation (A) %ote7 &he case has !een 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" particularl about the treat#ent of bad debts recovered" but the ob)ective is to understand the process" and ' do not thin& it is i#portant to get agree#ent as to the Done best #ethodE *if there is such a thing+. This is not a full assign#ent b itself" but is if ta&en together $ith stud of the te(t. Comments on 0!estions

'uestion (
1. /. 1. Accounts Receivable................................................................... Sales........................................................................................ Cash............................................................................................. Accounts Receivable............................................................... Allo$ance for %oubtful Accounts............................................... Accounts Receivable............................................................... 2"2,3"3-3 2"2,3"32",03"4/0 2",03"4/ /,"034 /,"034

*Entries $ould also be #ade to specific accounts receivable" assu#ing that the account on the balance sheet is a control account.+ 4. %ebit Cash .1",-4 *./"100 for one account and .1"3,, as partial pa #ent on another+. The rest of the transaction could be handled in one of three different $a s7 *a+ Credit Allo$ance for %oubtful Accounts .4"324 *./"100 for account collected in full and ./"40, for account collected in part $ith reasonable assurance of future collection of re#ainder+" and debit Accounts Receivables .2/0 *for balance of account partiall collected+. This is preferable. *b+ Credit Bad %ebt E(pense .1",-4 *./"100 B .1"3,,+. *c+ Credit so#e DCther 'nco#eE account .1",-4. 3. The calculation of the Allo$ance for %oubtful Accounts and Accounts Receivable depends upon $hich of the alternatives $as e#plo ed in handling the collection of $ritten6off accounts in 4 above.

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+nder 1a23 the Acco!nts 4ecei5able remaining on the boo6s at the end of #..# is calc!lated as follo7s8 Accounts Receivable" %ece#ber 11" /001.............................. Add increase to A@R fro# sales on account during /00/........ ;ess decrease to A@R for accounts for $hich pa #ent $as received during /00/............................................................... ;ess accounts $ritten off in /00/........................................... . 200"/32"2,3"3-3 10"231"01/

2",03"4/0 1"/,0"41/ /,"034 . 1"/41"330

Add that portion still due on previousl $ritten6off account $hich $as paid in part in /00/ $ith reasonable assurance of future pa #ent of the pa #ent of the re#ainder.....................

2/0 .1"/4/"4-0

The bad debt e(pense is 0.1 percent 8 .1"/4/"4-0 ? .1-"/-4. The entr " therefore" $ould be7 Bad %ebt E(pense.............................................................. Allo$ance for %oubtful Accounts........................ /2"00, /2"00,

The Allo$ance for %oubtful Accounts re#aining on the boo&s at the end of 1220 is calculated as follo$s7 Allo$ance for %oubtful Accounts" %ece#ber 11" /001.......... ;ess Accounts Receivable $ritten off in /00/........................ ./2",40

/,"034
/"-24

Add increase to Allo$ance for %oubtful Accounts for previousl $ritten6off accounts $hich $ere collected during the ear or dee#ed collectible in the future.............................................. Balance in account.................................................................. Add additional bad debt e(pense needed................................. Total allo$ance for %oubtful Accounts" %ece#ber 11" /00/..

4"324
-"100

/2"00,
.1-"/-4

-1

-4

Fnder *b+ or *c+" in the calculation of Accounts Receivable7 the last step in the calculation above is eli#inated" thus leaving an Accountings Receivable balance of .1"/41"330. The Bad %ebt E(pense is calculated and recorded the sa#e as sho$n above. The Allo$ance for %oubtful Accounts re#aining on the boo&s as the end of /00/ is calculated as follo$s7 Allo$ance for %oubtful Accounts" %ece#ber 11" /001......... ;ess Accounts Receivable $ritten off in /00/....................... Balance in account................................................................. Add additional bad debt e(pense............................................ Total Allo$ance for %oubtful Accounts" %ece#ber 11" /00/ ./2",40 /,"034 ./"-24 14"431 .1-"/4-

'uestion )
*sin+ (a) Balance of accounts as of %ece#ber 11" /00/7. Accounts Receivable...................................................................... ;ess allo$ance for doubtful accounts............................................. .1"/4/"4-0 1-"/-4 .1"/03"/04 *sin+ (!) or (c) .1"/41"330 1-"/4.1"/04"111

'uestion ,
'n the ratios used for anal sis of #onetar assets listed belo$" the results are appro(i#atel the sa#e $hether #ethod *a+" *b+" or *c+ is used.

#..#
Current ratio.................................................................................. Acid6test ratio............................................................................... %a s cash.................................................................................... %a s receivables7 #ethod *a+....................................................... #ethod *b+ or *c+...................................................................... Case 5- 2: Grennell Farm %ote7 &his case has !een updated -rom the &enth .dition. Approach This case is a good illustration of a situation $here revenue recognition is not a cut6and6dried question. 't also provides e(cellent reinforce#ent of the #atching concept and state#ent articulation. The alternatives discussed are7 *1+ the production method, $hich recogni:es inventor Dholding gainsE as revenue! */+ the sales method, $hich is analogous to the financial accounting #ethod of revenue recognition of #ost #anufacturers and retailers! and *1+ the collection method, $hich recogni:es revenues as collected" but is not quite the sa#e as cash6basis accounting *since costs are accrued+. >hile either the production #ethod or sales #ethod is acceptable under 5AA9" that is reall a #oot point since %enise 5re is the sole o$ner of the incorporated far#" and not bound b 5AA9. Cnce the issue of ho$ #uch revenue to recogni:e is resolved" then ho$ #uch e(pense to #atch can be dealt $ith. Together" these t$o issues deter#ine ho$ #uch gross profit 5rennell far# $ill be sho$n as earning. /.1.3 <@A 44.1 44./

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'uestion (
The calculations sho$n belo$ for Auestion 1 sho$ the range of sales figures under different recognition #ethods. ' start $ith the sales #ethod" then do the collection #ethod" and save the #ore unusual production #ethod until last. An issue is $hether the entire .101"000 Dannual costs not related to the volu#e of productionE should be treated as product or period e(pense. Fnless the instructor for so#e reason is using this case after Chapter ," the students #a not recogni:e this as an issue or" if the do" not &no$ ho$ to deal $ith it in the financial state#ents. 'n an event" ' thin& it $orth$hile for the instructor to note that these e(penses are b definition fi(ed *do not var $ith production volu#e+" but that so#e *especiall a portion of salaries and $ages+ #a be production costs and hence strictl spea&ing should be used in valuing inventor . *Students often #ista&enl use Dfi(ed costsE and Dperiod costsE as s non #s.+ Cf course" the point of Auestion 1 is not )ust practice in revenue and e(pense #atching calculations" but thin&ing about $hich is the #ost appropriate #ethod. =or ta( purposes" 5re $ill $ant to use the collection #ethod. =or evaluating the perfor#ance of the far# in /001" the production #ethod $ould see# #ost useful. This is because there is ver little uncertaint# concerning the eventual sale of the 10"0006bushel $heat inventor stored at the far#. This inventor e(ists" not because there are no custo#ers for it" but because the far# #anager chose not to sell it" speculating that future prices $ill be higher. This is the sa#e reasoning that )ustifies this unusual revenue recognition #ethod as 5AA9! the sa#e #ethod is also allo$ed for precious #etals and other #inerals $here i##ediate #ar&etabilit at quoted prices obtains. Also" #an professional service fir#s *e.g." accounting fir#s+ recogni:e revenue as $or& is perfor#ed b recording )obs in progress at billing rates rather than at cost. The na#e Fnbilled Receivables is often used for this account to e#phasi:e that the revenue has alread been recogni:ed" even though it has not et been billed.

E&hibit A
Collect the cash fro# the custo#er Custo#er ac&no$ledges receipt of the ite# Ship the product to the custo#er and send a sales invoice Receive an order for the product fro# a custo#er Collection Gethod 9urchase ra$ #aterial Convert the ra$ #aterial to a finished product 'nspect the product 9roduction Gethod Store the product in a $arehouse

DFsualE Gethod *%eliver Gethod+

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To generali:e the discussion" ' put on the board a Dcash c cleE diagra# li&e the one in E(hibit A to this note. Starting $ith purchases" ' go around this $heel and add to its interior the three points at $hich revenue can be recogni:ed7 these correspond to the three #ethods in the case" including the DusualE #ethod of recogni:ing revenue $hen goods are shipped. >hen is the DcorrectE point to recogni:e revenueH This diagra# points out that the ans$er is not clear6cut. DConservatis#E $ould sa do not recogni:e the revenue until there is ver little uncertaint as to receipt of the cash proceeds" driving the revenue recognition to$ard the collection point. DTi#elinessE $ould argue for recogni:ing the revenue $hen the Dcritical eventE or Dperfor#anceE has ta&en place" in this instance as soon as a certainl salable product has been produced" i.e." the production #ethod for 5rennell. The #easurabilit of inco#e criterion does not help select a #ethod in this instance" as the Auestion ' calculations are feasible for all three #ethods.

'uestion )
The original cost of the land $as onl .10-.30 an acre7 it is no$ appraised *for estate ta( purposes+ at .1"030 per acre" or ./.1 #illion. The cost concept sa s that" at least prior to the transfer of o$nership to 5re *and possibl even after$ards+" the balance sheet $ill sho$ the land at its cost" .1-3"000. Io$ever" again 5AA9 need not prevail here" for 5re is tr ing to assess the econo#ic attractiveness of the far#. Since she could sell the land for ./.1 #illion *or #ore" if the estate ta( valuation $as belo$ #ar&et+ and invest the proceeds else$here" she $ill li&el $ant to use the higher valuation in her assess#ent. *Again" this is an argu#ent often given for stating assets at current values7 the asset is" in effect" t ing up ./.1 #illion" not .1-3"000.+ 'f 5re $ants to thin& of selling onl the 100 acres for the develop#ent" then she #a thin& of the land value as ./.// #illion *1"200 8 .1"030 plus .//3"000+. The point is that the .1-3"000 historical cost is the least relevant for 5re s purposes.

'uestion ,
Assu#ing 5re agrees that the co#bination of the production #ethod of revenue recognition and the ./.// #illion land valuation best serve her appraisal purposes" then in /001 $e have .1/1"1-0 net inco#e on an o$ners equit invest#ent of ./"40/"100 *.,1-"100 plus .1"043"000 $rite6up of land+" or a 11 percent before6ta( return on invest#ent. >hen one considers future appreciation of the land" this #a $ell be a better invest#ent than 5re $ould be able to #a&e $ith the proceeds fro# selling the far#.

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94E%%E:: FA4M "ncome Statements

Sales................................................................................. Cost of goods sold Beginning inventor ............................................ 9roduction........................................................... ;ess7 Ending inventor ........................................ Cost of goods sold............................................... 5ross #argin.................................................................... Cther e(penses ................................................................ <et 'nco#e....................................................................... ;alance Sheets Cash.................................................................................. Accounts receivable.......................................................... 'nventor .......................................................................... ;and................................................................................. Buildings and #achiner *net+.......................................... Total assets.......................................................... ;iabilities *current+........................................................... C$ners equit 0................................................................ Co##on stoc& and A9'C.................................... Retained earnings................................................ Total o$ners equit ......................................................... Total liabilities and o$ners equit ................................... Sales .3//"000 0 10-"-10 13"120 2/"140 4/2",,0 101"000 ./4,",,0 Method/ Collection %roduction .4,/"4001 .,14"1003 0 10-"-10 /3",301 0/"000 100"1/0 101"000 .12-"1/0 0 10-"-10 0, 10-"-10 30,"1-0 101"000 .1/1"1-0

. 10"200 32",00 13"120 1-3"000 11/"300 321"120 11"000 43-"300 10/"020 3,0"120 .321"120

. 10"200 04 /3",30 1-3"000 11/"300 344"030 11"000 43-"300 31"330 311"030 .344"030

. 10"200 131"-000 1-3"000 11/"300 ,-0"100 11"000 43-"300 1-2",00 ,1-"100 .,-0"100

%otes7 1 100"000 bushels J ./.20 6 /0"000 bushels J ./.20 ? 1,0"000 but J ./.02. / //10"000 bushels J ..311 ? .10-"-10. 1 10"000 bushels ph sicall in inventor plus 10"000 bushels Dinventor E at the elevator" reflecting pa #ent not et received fro# the elevator operator. 4 Fnder the collection #ethod there are no accounts receivable" since sales revenues are not recogni:ed until the collection is #ade. 3 10"000 bushels J .1.0- B 100"000 bushels J S/.20. Another approach is as follo$s7 /10"000 bushels J ./.00 ? 100"000 bushels J 0.10 ? 10"000 bushels J .0./- ? .300"000 *value at harvest+ 10"000 *gain on sales to elevator+ ,0,"000 0"100 *$rite6up to ear6end value+ .,14"100

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5iven the te(ts description of the production #ethod" ' treat S,0,"000 as an acceptable ans$er" but point out the logic of $riting up the 10"000 bushels on hand for purposes of the ear6end balance sheet. , Although there are 10"000 bushels ph sicall in inventor " under the production #ethod all $heat is counted as sold" and hence is not in inventor in an accounting sense. This includes the .32",00 DrealE receivable plus .2/"100 recorded as revenue on the 10"000 bushels produced but not ph sicall sold. Students #a create a different account for this .2/"100" for e(a#ple" Fnbilled Receivables" $hich is fine. 0 'f ou assu#e that the case state#ent D5rennell $ithdre$ #ost of the earningsE #eans that Retained Earnings at the beginning of the ear $as :ero" then the /001 dra$ings can be deter#ined as follo$s7 Beginning Retained Earnings........................................... 9lus7 <et 'nco#e.............................................................. ;ess7 Ending Retained Earnings....................................... %ra$ings............................................................. Case 5- 3: Joan Holtz (A) %ote7 &his case has !een updated -rom the &enth .dition$ Approach These proble#s are intended to provide a basis for discussing questions about revenue recognition that are not dealt $ith e(plicitl in the te(t and that are not sufficientl involved to $arrant the construction of a regular case. 'nstructors can pic& fro# a#ong those listed. So#e of the# can be used as a ta&e6off point for elaboration and e(tended discussion b adding D>hat ifHE facts. Ans7ers to 0!estions 1. 'f electricit usage tended to be fairl constant fro# #onth to #onth" one could argue in this case for basing reported revenues solel on the actual #eter readings7 the unreported usage in %ece#ber $ould be reported in Kanuar " and overall revenues for this ear $ould not be #ateriall #isstated. Stated another $a " if revenues are based solel on #eter readings" the %ece#ber /001 post6reading usage *$hich is recorded in Kanuar /00/+ is" in effect" assu#ed to be the sa#e /00/ post6reading usage. 9rior to passage of the 120, Ta( Refor# Act" this approach $as per#itted for inco#e ta( purposes. The 120, act requires the #ore acceptable *due to better #atching+ practice7 esti#ating actual usage for the part of %ece#ber after #eters are read and reporting that usage as part of the revenues of that ear. This is #ore sound accounting" in that $ith $eather fluctuations and energ conservation efforts" it is questionable $hether the post6reading usage in %ece#ber /001 $ould in fact not differ #ateriall fro# the post6reading usage in %ece#ber /00/. The sa#e proble# e(ists for operators of vending #achines. The postal service has the opposite proble#7 it receives cash fro# sta#p sales before all of the sta#ps are used. 't carries a liabilit *unearned revenues+ for this effect. Both of these e(a#ples illustrate that even $hen cash is involved" the #easure#ent of revenue is not necessaril straightfor$ard. /. This is one of the proble#s $hose DtrueE resolution depends on events that cannot be forseen at the end of the accounting period. So#e fir#s count the $hole .10"000 as revenue in /001 on the grounds that it is in hand and that an specific services are undefined and@or separatel billable. Cthers ta&e the #ore conservative approach of counting onl .3"000 as revenue in /001 on the grounds that the service involved is Dreadiness to serve"E and that this readiness e(ists equall in each ear. ' prefer the latter approach" based on the #atching concept. Sales Collections . 0 . 0 /4,",,0 12-"1/0 10/"020 31"330 .141"--0 .141"--0 Prod!ction . 0 1/1"1-0 1-2",00 .141"--0

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1. Gan $ould argue that the service involved is the cruise and that no revenue has been earned until the cruise has been co#pleted. Cthers #aintain that Ra #onds has co#pleted its DserviceE of arran+in+ the cruise" that it is e(tre#el unli&el that events $ill happen in /00/ that $ill change its profit of ./0"000" and that the a#ount is therefore revenue in /001. 'ntroduction of the possibilit of a refund lessens the strength of the argu#ent of the latter group. This position can be $ea&ened further b as&ing7 *a+ >hat if passengers are dissatisfied and de#and *or sue for+ a refundH *b+ >hat if the ship o$ner perfor#s unsatisfactoril and Ra #onds" in order to protect its reputation" steps in and incurs additional food or other cost to #a&e the passengers happ H Students should be re#inded to consider t$o criteria7 *1+ that the agenc has su!stantiall# per-ormed its earning activities and */+ that the inco#e is relia!l# measura!le. 4. This proble# has been debated for #an ears. So#e argue that the .4 per tree has alread been earned" as evidenced b the fir# offer to bu the trees" and that it $ould be #isleading to sho$ no revenues in /001 and the full sales value $hen the trees are sold in /00/. The percentage6of6co#pletion #ethod can be used as an analog . Cthers argue that there has been no transaction" and no assurance that the trees can be sold for #ore than .4 in /00/ because #ar&et prices #a decrease" or pests or fire #a destro the#. T picall " fir#s facing this issue recogni:e no revenue until harvesting the trees. 3. 'f a professional service fir# *architects" engineers" consultants" la$ ers" accountants" and so on+ values its )obs in progress at billing rates" then it is recogni:ing revenue as the $or& is perfor#ed *ti#e applied to pro)ects+ rather than $aiting until the custo#er is billed. This is certainl defensible if the fir# has a contract *called a Dti#e and #aterials contractE+ that obligates the client to pa for all ti#e applied to the clients pro)ect7 the critical act of perfor#ance is spending the ti#e on the pro)ect" not billing that ti#e. 'n fact" #an such fir#s feel that even $ith fi(ed6fee contracts" the critical perfor#ance tas& is spending ti#e on a pro)ect as opposed to delivering so#e end ite# to the client! the thus record )obs in progress at esti#ated fee" $hich $ould be the sa#e as billing rates for the ti#e applied provided the pro)ect is $ithin its professional6hour budget. Cf course" $hether the revenue is recogni:ed $hen the ti#e is applied or $hen the client is billed does #a&e a difference in o$ners equit . Retained earnings $ill reflect the #argin on the ti#e applied sooner if the )obs in progress inventor is valued at billing rates rather than at cost. ,. <u#erous ans$ers are acceptable. ' argue that the coupon has nothing to do $ith the sale of coffee. 'ts purpose is to pro#ote the sale of tea. The ,0 cent rei#burse#ents #ade in /001 and the ,0 cent rei#burse#ents #ade in /00/ are an e(pense of selling tea in /00/. Those $ho tie the coupons $ith coffee $ould sa that the entire /0 percent of coupons redee#ed is an e(pense of selling coffee in /001 $ith the a#ount not et redee#ed being a liabilit as of %ece#ber 11" /001. 't is custo#ar that the coupon issuer pa the store a handling fee in addition to the face value of each coupon! here that fee is 10 cents. 't is ,0 cents per coupon that is the cost" not the 30 cent face value. -. The ban& $ould record the sale of .300 travelers chec&s for .303 as follo$s7 %r. Cash.............................................................. Cr. 9a able to A#erican E(press.................... Co##ission Revenue................................ 303 300 3

00

After the ban& re#its the .300 cash to A#erican E(press" the latter $ill #a&e the follo$ing entr 7 %r. Cash.............................................................. Cr. Travelers Chec&s Cutstanding.................. 300 300

The account credited is a liabilit account. This account had a balance of #an billions of dollars" $hich should help students understand $h A#erican E(press does not itself lev a fee on the issuance of travelers chec&s7 the chec&s are a great source of interest6free capital to A#erican E(press. 0. According to FASB Statement 0o$ 12, Ganufacturer A cannot record a sale at all under these circu#stances. The #erchandise #ust re#ain as an asset on Ganufacturer As balance sheet and a liabilit should be recorded at the ti#e the .100"000 is received fro# B. This state#ent precludes Ganufacturer A fro# inflating its /001 revenues and inco#e b the sort of repurchase agree#ent described. FASB 12 $as issued to address the perceived abuse of treating such te#porar title transfers as sales. 2. FASB Statement 0o$ 13 states that franchise fee revenue should be recogni:ed D$hen all #aterial services or conditions relating to the sale have been substantiall perfor#ed or satisfied b the franchiser.E A#orti:ation of initial franchise fees should onl ta&e place if continuing franchise fees are so s#all that the $ill not cover the cost of continuing services to the franchisee. Since this e(ception see#s unli&el in this case" the .10"000 franchise fee should be recogni:ed as revenue in the ear received" as soon as the training course has been co#pleted. 'nvestors $ill need to #a&e their o$n )udg#ent as to $hat $ill happen $hen the #ar&et beco#es saturated. 10. This ite# is designed to get students to thin& about *1+ a condition that creates the need for a change in revenue recognition polic " and */+ the potential need for #ultiple revenue recognition policies for a fir#. Tech6;ogic" a #anufacturer of co#puter s ste#s" nor#all recogni:es revenue $hen its products are shipped" a polic co##on a#ong #anufacturing fir#s. To adopt that polic " #anagers at Tech6;ogic #ust have concluded that the t$o criteria for revenue recognition $ere #et at ship#ent7 *1+ Tech6;ogic $ould have substantiall perfor#ed $hat is required in order to earn inco#e" and */+ the a#ount of inco#e Tech6;ogic $ould receive could be reliabl #easured. >ith the sale of the co#puter s ste#s to the organi:ation in one of the for#er Soviet Fnion countries" ho$ever" Tech6;ogics abilit to satisf these t$o criteria changed. Although the first criterion $as still #et" the uncertaint about $hether *and ho$ #uch+ foreign e(change the custo#er could obtain left the second criterion in doubt. Ience" Tech6;ogic should not recogni:e revenue for these co#puter s ste#s at ship#ent or deliver . An alternative should be to $ait until cash *in the for# of hard currenc + $as received to recogni:e revenue. This ite# can also be used to discuss the fact that fir#s often have #ore than one revenue recognition polic . Tech6;ogic $ould not co#pletel change its revenue polic to Dcash receiptE for all sales at the ti#e it begins to sell co#puters to organi:ations in countries $here the availabilit of foreign e(change currenc is in doubt. Rather" it $ould be li&el to have t$o revenue recognition policies! at ship#ent" for products sold to organi:ations in countries $here the availabilit of foreign e(change currenc is not in doubt! and cash receipt" for products sold to organi:ations in countries $here the availabilit of foreign e(change currenc is in doubt. Because the #anufacture products and provide a variet of services" co#puter #anufacturers often have a variet of revenue recognition policies. =or e(a#ple" a co#puter #anufacturer #ight recogni:e revenue for products $hen the are shipped! for custo# soft$are develop#ent" $hen the

01

custo#er for#all accepts the soft$are! and for #aintenance services" ratabl over the life of the #aintenance contract. 'te# 10 $as inspired b events that occurred at Sequoia S ste#s in 122/. Sequoia evidenced several instances of aggressivel boo&ing revenue. Cne of these involved a Siberian steel #ill. According to &he 4all Street Journal/ E(ecutives signed off last ear on the sale of a .1 #illion co#puter destined for a steel #ill in Siberia. But govern#ent approvals and hard currenc to pa for the s ste# got stalled" even though ./ #illion of revenue $as boo&ed in the fiscal ear ended Kune 10" and another .1 #illion $as going to be ta&en in the first quarter ended last #onth" insiders sa .1 Sequoia e(ecutives stated that the e(pected this Lthe Siberian steel #illM and si#ilar sales D$ill ulti#atel prove to be good businessE and that the decision to boo& it as revenue D$as supported b the revenue recognition polic that $e had in place.E # Io$ever" under investigation b the SEC and facing la$suits b shareholders" Sequoia t$ice restated revenues follo$ing the end of fiscal ear 122/" reducing originall reported revenues b #ore than 10 percent.1 Case 5-4: Bausch & Lomb, Inc. (A)* Note: This is a new version of the case by the same name that appeared in the Tenth Edition. The issue is the same in both cases. Purpose of the Case Bausch N ;o#b" 'nc. *BN;+ is a #anufacturer of optical and health care products headquartered in Rochester" <e$ Oor&. The co#pan i#ple#ented a change in their distribution and sales strateg near the end of 1221 that pushed a large a#ount of conventional contact lens inventories onto distributors. BN; recogni:ed the product ship#ents associated $ith the ne$ strateg as revenues. Fnfortunatel " the conventional lens #ar&et too& a steep do$nturn and the co#pan ended up ta&ing bac& al#ost all distributor inventories attributable to it even though no for#al right of return had been previousl granted. 'n earl 1223" BN; disclosed that the F.S. Securities and E(change Co##ission *SEC+ had launched an inquir into its accounting procedures. This inquir $as pro#pted b several ite#s" including ho$ the co#pan recogni:ed revenues pertaining to its failed distribution strateg . These cases have four #ain ob)ectives. =irst" the give students the opportunit to consider the i#portance of #aterialit in accounting based on relativel si#ple calculations and anal sis. Second" the highlight issues that are i#portant to consider for revenue recognition decisions. Third" the de#onstrate the degree of discretion and #anagerial anal sis required in #a&ing accounting decisions. =ourth" the provide a conte(t for discussing ho$ regulators such as the SEC influence the financial reporting process. The *A+ case" $hich provides details on BN;s atte#pt to create a ne$ distribution strateg and the related i#pact on the ears accounting nu#bers" should be handed out in advance of class. The *B+ case" IBS case 261016000" $hich discusses the failure of the progra# and the subsequent inventor return"
1 /

&he 4all Street Journal, DSequoia S ste#s Re#ains Iaunted b 9hanto# Sales"E Cctober 10" 122/" p. B0. 'bid. 1 'bid. 8 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 classroo# discussion. The *C+ case *IBS case 261016002+" $hich contains headlines and quotes fro# articles regarding BN;s poor perfor#ance Sec probe" should also be handed out during the classroo# 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 t$o plausible ad)ust#ents to the preceding )ournal entries that so#e students #ight #a&e. =irst" li&e #ost co#panies" BN; $as deducting an allo$ance for doubtful accounts fro# sales" $hich is reflected b the fact that the co#pan reported net sales. Although BN; did not brea& out the a#ount of the allo$ance" so#e students assu#e non6pa #ent for a certain percentage of all sales #ade b the co#pan . >ith respect to the preceding )ournal entries" this assu#ption $ould result in the creation of a contra asset account under accounts receivable that $ould be offset b 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

01

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

03

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 $ho are s&eptical of BN;s accounting choice" point to E&hibits 1 and # in the *A+ case. %ispla ing earl increases in net sales and earnings fro# continuing operations before non6 recurring charges for a decade leading through 1221" these graphs cause so#e students to speculate that the sales strateg $as #otivated b pressure to continue sho$ing a positive trend in operating perfor#ance. >hile #ost students agree that ti#ing $as clearl i#portant to BN;" the point out that the ti#ing issues alone do not i#pact the eventual pa #ent of the a#ounts o$ed. These students frequentl feel that a disclosure of the change in polic and its i#pact on sales $ould be sufficient. This provides a good opportunit to discuss the i#portance of disclosures in DGanage#ent %iscussion and Anal sisE in for# 106P filed $ith the Fnited 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. Cnce the students have had an opportunit to discuss the issues" it is useful to use a role6pla to bring this portion of the class to an end. Gan instructors find it helpful to assign one doubting student the role of the C=C $ho #ust #a&e the final call regarding recognition $hile another student is assigned the part of Kohnson" the divisional president. Kohnson then presents the facts to support the request to treat this transaction as revenue. The facts should include that it is a viable strateg change" the goods have been shipped and the distributors all have long histories $ith BN;. The C=C is given an opportunit to counter based on their understanding of the accounting rules. This discussion can beco#e quite heated. A si#ilar role6pla assigns one student as an auditor. The instructor then la s the facts out to the student7 the goods have been shipped" ou see the signed contracts" and as an auditor ou have Dconfir#edE these accounts receivable via letter and phone $ith the distributors1. 'n either case" the C=C@auditor generall agrees to boo& the revenues. A quic& poll of the class at this point $ill sho$ that #ost students agree the a#ount should be boo&ed as revenue" but that #an feel unco#fortable $ith this decision and ho$ it relates to the econo#ics. 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 infor#ation on auditor confir#ation is not included in the case and $ill need to be provided b 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 BN; related to the conventional lens ship#ents. Er#in 'anancone" divisional controller" and Purt Gatsu#oto" director of distributor sales" had colluded to underta&e fraud. This fraud included signing side agree#ents granting the right of return of products" renting $arehouse space for distributors to store the increased inventor " and including ship#ents that occurred after ear6 end in the1221 results. The SEC concluded top #anage#ent had not been a$are of these actions" but $as accountable for having a poor oversight environ#ent. This outco#e is useful to discuss for t$o reasons. =irst the fraud indicates that so#e of the &e facts used in deter#ining $hether revenue should be recogni:ed $ere based on erroneous infor#ation. The ne$ facts sho$ that the revenue should not have been recogni:ed. Io$ever" top #anage#ent had to rel on the infor#ation the $ere given in reaching a deter#ination.. The SEC did not challenge #anage#ents decision based on that infor#ation. Second" although the SEC stated that Kohnson $as not involved in the fraud" he still $as censured for failure to #aintain a proper oversight and control environ#ent. This provides a cautionar tale to the students 6 as a top #anager the are responsible for #anaging the control environ#ent of their fir#. 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
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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 ason! ""#: Gross $ers%s &et 'e(en%e 'eportin) (A)*

%ote8 &his is a ne5 case -or the .le6enth .dition$ Sit!ation 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 Strateg 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
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Cop right Q /000 b the 9resident and =ello$s of Iarvard College. Iarvard Business School Teaching <ote 361016041.

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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 E&ec!ti5e *fficer 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.

Pers!asi5e "ndicators 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

E#erging 'ssues Tas& =orce Consensus 22612" Kul /0" /000.

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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 4e<!ests 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.
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E#erging 'ssues Tas& =orce Consensus 22612" Kul /0" /000.

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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. S!mmar 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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