Apex Computer Company manufactures and sells large, mainframe computers.

The
computers range in price from $1 to $3 million and gross profit averages 40% of sales
price. The company has a liberal trade-in policy. Customers are allowed to trade in their
computers for a new generation machine anytime within three years of sale. The trade-in
allowance granted will vary depending on the number of years between original sale and
trade-in. However, in all cases, the allowance is expected to be approximately 25% higher
than the prevailing market price of the computer.

As an example, in 2011 a customer who purchased a computer in 2009 for $2 million (the
computer cost Apex $1,200,000 to manufacture) decided to trade it in for a new
computer. The sales price of the new computer was $2.5 million and a trade-in allowance
of $600,000 was granted on the old machine. As a result of the trade-in allowance, the
customer had to pay only $1.9 million ($2.5 million less $600,000) for the new computer.
The old computer taken back by Apex had a resale value of $480,000. The new computer
cost $1.5 million to manufacture. The company accounted for the trade-in by recognizing
revenue of $2,380,000 ($1.9 million received in cash + $480,000 value of old computer).

Required:
Does the company's revenue recognition policy for trade-ins seem appropriate? If not,
describe the problem created by the liberal trade-in policy.

SOLUTION

The revenue recognition policy is questionable. The liberal trade-in policy causes gross
profit to be overstated on the original sale and understated on the trade-in sale. This
results from the granting of a trade-in allowance for the old computer that is greater than
the old computer's resale value. Using the company's recognition policy, gross profit
recognized on the two sales would be as follows:

Original sale Trade-in sale

Sales price $2,000,000 $2,380,000
Cost of goods sold 1,200,000 1,500,000
Gross profit $ 800,000 $ 880,000

Gross profit percentage 40% 37%

Of course, there is no guarantee that the customer will exercise the trade-in option.
If, however, a large percentage of customers do exercise the option, and the
distortion in gross profit is material, the company should adopt a revenue
recognition policy that results in a more stable gross profit percentage for the two
transactions.