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CHAPTER 5 REVENUE AND MONETARY ASSETS Changes from Eleventh Edition The chapter has been updated. Approach The sequence of transactions for accounts receivable and bad debts often causes difficulty; indeed, the time that one is sometimes forced to spend on this topic is all out of proportion to its importance. Students often do not understand why an Allowance for Bad Debts account is necessary at all; they do not grasp the notion that although we feel reasonably sure that some accounts will go bad, we do not know which ones they will be. Even when they do understand this, the chain of transactions involved in estimating bad debts, writing off specific accounts, and booking bad debts recovered, is complicated and not easy to follow. If experience is any guide, it is quite likely that at the time this chapter is taught the press will be describing a company that has gotten into trouble for overstating its revenue or understating its bad debt or warranty allowance. Discussion of such a situation would be interesting. Cases Stern Corporation (A) is a straightforward problem in handling accounts receivable and bad debts. Grennell Farm, by contrast, has few technical calculations but provides an excellent opportunity for a realistic discussion of alternative ways of measuring revenue and of valuing assets. Joan Holtz (A) is a different type of case. It is a device for raising several discrete, separable problems about the subject matter of the chapter, from which the instructor can pick and choose those he or she wishes to take up in class. (It probably is not feasible to discuss all of them.) Bausch & Lomb, Inc., is an actual case situation involving revenue recognition. Boston Automation Systems, Inc. involves a review of the company’s revenue recognition practices in the light of the SEC’s SAB 101 (a longer version of the case was included in the Eleventh Edition). Problems Problem 5-1
Sale Method Jan. Feb. Mar. April May June Sales................................................................................................................................................................................... $12,000 $ 8,000 $13,000 $11,000 $9,000 $13,500 Cost of goods sold.............................................................................................................................................................. 7,800 5,200 8,450 7,150 5,850 8,775 Gross margin...................................................................................................................................................................... $ 4,200 $2,800 $ 4,550 $ 3,850 $3,150 $ 4,725
Installment Method Jan. Feb. Mar. April May June Sales................................................................................................................................................................................... $11,000 $10,000 $11,500 $10,500 $10,500 $9,500 Cost of goods sold.............................................................................................................................................................. 7,150 6,500 7,475 6,825 6,825 6,175 $ 3,850 $ 3,500 $ 4,025 $ 3,675 $ 3,675 $3,325
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Accounting: Text and Cases 12e – Instructor’s Manual
Anthony/Hawkins/Merchant
Problem 5-2
Completed Contract Percentage of Completion This Year Next Year This Year Next Year Income excluding motel (000)........................................................................................................................................................ $1,250 $1,250 $1,250 $1,250 Income from motel project.............................................................................................................................................................. 0 750 450 300 Income before taxes........................................................................................................................................................................ $1,250 $2,000 $1,700 $1,550 Problem 5-3 To record the write-off: If Alcom uses the direct write-off method— dr. Bad debt Expense.................................................................. cr. Accounts Receivable......................................................... If Alcom uses the allowance method:
$3,000
dr. Allowance for Doubtful Accounts......................................... cr. Accounts Receivable................................................ To record the partial payment:
$3,000
$3,000
$3,000
If Alcom uses the direct write-off method: Cash........................................................................................... Bad Debts Recovered............................................................ (or Bad Debt Expense............................................................ If Alcom uses the allowance method: Either of the above two entries or: Cash........................................................................................... Allowance for doubtful accounts...........................................
$950 $950 $950) $950 $950
Problem 5-4 The Allowance for Doubtful Accounts should have a balance of $51,750 on December 31. The supporting calculations are shown below: Days Account Outstanding Amount 0-15 days $450,000 16-30 days 150,000 31-45 days 75,000 46-60 days 45,000 61-75 15,000 Balance for Allowance for Doubtful Accounts
Expected Percentage Uncollectible* .01 .06 .20 .35 .50
Estimated Uncollectible $ 4,500 9,000 15,000 15,750 7,500 $51,750
The accounts that have been outstanding over 75 days ($15,000) and have zero probability of collection would be written off immediately and not be considered when determining the proper amount of the Allowance for Doubtful Accounts.
*
(1-Probability of collection.)
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b. Accounts Receivable....................................................................... Less: Allowance for Doubtful Accounts.......................................... Net Accounts Receivable....................................................
$735,000 51,750 $683,250
c. The year-end bad debt adjustment would decrease the year’s before-tax income by $29,250, as shown below: Estimated amount required in the Allowance for Doubtful Accounts.................................................................................... Balance in the account after write-off of bad accounts but before adjustment.................................................................................. Required charge to expense..............................................................
$51,750 22,500 $29,250
Problem 5-5 Green Lawn’s books: dr. Inventory on Consignment........................................................... cr. Finished Goods Inventory.......................................................
8,400 8,400
Note that at this point the $12,600 wholesale price (Green Lawn’s revenue when these goods are sold) is irrelevant. Carson’s books: No entry; the goods are not owned by Carson and hence are not inventory on Carson’s books; similarly, Carson does not as yet owe Green Lawn for these goods. Green Lawn’s books: dr. Accounts Receivable................................................................... Cost of Goods Sold...................................................................... cr. Sales................................................................................... Inventory on Consignment.................................................. (This can be shown as two entries.)
5,040 3,360 5,040 3,360
Carson’s books: dr. Cash or Accounts Receivable....................................................... Cost of Goods Sold...................................................................... cr. Sales................................................................................... Accounts Payable................................................................. (This also can be shown as two entries.) Problem 5-6 20 x 4 20 x 5 20 x 6 Revenue..................... $980,000 $1,470,000 $2,205,000 Costs.......................... 721,000 1,190,000 1,715,000 Income....................... $259,000 $ 280,000 $ 490,000 Revenue equals percentage completed during the year times fixed price.
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6,720 5,040 6,720 5,040
Accounting: Text and Cases 12e – Instructor’s Manual
Anthony/Hawkins/Merchant
Problem 5-7 The GRW Company’s current assets and current liabilities at year-end are shown below. Current assets: Cash......................................................................................... Accounts receivable................................................................. Less: Allowance for bad debts.................................................. Net accounts receivable............................................................ Beginning inventory................................................................. Purchases.................................................................................. Available inventory.................................................................. Less: Cost of goods sold........................................................... Ending inventory...................................................................... Total current assets.............................................................. Current liabilities: Accounts payable..................................................................... Current portion of bonds payable............................................. Interest payable......................................................................... Total current liabilities......................................................... Current ratio = $125,200 / $71,300 = 1.76 Quick ratio = ($23,100 + $32,800) / $71,300 = .78
$ 23,100 $ 34,650 1,850 32,800 46,200 184,800 231,000 161,700 69,300 $125,200 $38,600 7,700 25,000 $ 71,300
The above ratios measure GRW’s ability to meet short-term obligations. The current ratio indicates that GRW has 76 percent more cash and relatively liquid assets that are expected to be converted to cash in the short run than it has short-run obligations requiring cash for their satisfaction. This ratio does not necessarily mean the amount of current assets is adequate, however. For example, the accounts payable and interest payable could be obligations due within the next few days, and it may not be possible to liquidate accounts receivable and inventories that quickly. b. Cash Expenses: Cost of goods sold.................................................................... Other expenses......................................................................... Total cash expenses...............................................................................
$161,700
69,300 $231,000
Days’ cash = $23,100 / ($231,000 / 365) = 36.5 days. This ratio measures how many days of normal operating expenses can be paid without adding to the cash balance. The above ratio indicates that GRW Company has an apparent stockpile of cash. This means GRW is either planning unusual expenditures during the next period, or is not properly managing cash. Cash does not generate a return. There is a trade-off between “instant” liquidity and the return on marketable securities. Some students may argue that purchases, rather than cost of goods sold, should be used in the calculation. This would not reflect a true “steady state” of operations, since it happened that GRW built up its inventory by $23,100 during the year. The argument for basing the ratio on purchases would be stronger if the student explicitly assumes a long-term buildup of inventory each year (to support increasing sales); but then, for consistency, some other cash expenses should probably be increased, too, thus resulting in approximately the same 36.5-day figure. In any event, there is no implication that such ratio calculations
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are interpretable with great precision. They are most meaningful if calculated for the same company over a period of years. c. Days’ receivables = Net receivables / (Credit sales / 365) = $32,800 / ($323,400 x .77 / 365).
= 48 days. This ratio measures the average collection period of receivables. Although some analysts use total sales (often because the portion of credit sales is not disclosed), the above calculation is correct. The result suggests that GRW’s customers are stretching the payment period.
Cases Case 5-1: Stern Corporation (A) Note: The case has been updated. Approach This case is designed to give practice in handling the various transactions for accounts receivable and bad debts. There can be differences of opinion, particularly about the treatment of bad debts recovered, but the objective is to understand the process, and I do not think it is important to get agreement as to the “one best method” (if there is such a thing). This is not a full assignment by itself, but is if taken together with study of the text. Comments on Questions
Question 1 1.
Accounts Receivable................................................................... 9,965,575 Sales........................................................................................ 9,965,575 2. Cash............................................................................................. 9,685,420 Accounts Receivable............................................................... 9,685,420 3. Allowance for Doubtful Accounts............................................... 26,854 Accounts Receivable............................................................... 26,854 (Entries would also be made to specific accounts receivable, assuming that the account on the balance sheet is a control account.) 4. Debit Cash $3,674 ($2,108 for one account and $1,566 as partial payment on another). The rest of the transaction could be handled in one of three different ways: (a) Credit Allowance for Doubtful Accounts $4,594 ($2,108 for account collected in full and $2,486 for account collected in part with reasonable assurance of future collection of remainder), and debit Accounts Receivables $920 (for balance of account partially collected). This is preferable. (b) Credit Bad Debt Expense $3,674 ($2,108 + $1,566). (c) Credit some “Other Income” account $3,674. 5. The calculation of the Allowance for Doubtful Accounts and Accounts Receivable depends upon which of the alternatives was employed in handling the collection of written-off accounts in 4 above. Under (a), the Accounts Receivable remaining on the books at the end of 2006 is calculated as follows:
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Accounts Receivable, December 31, 2005.............................. Add increase to A/R from sales on account during 2006........
$ 988,257 9,965,575 10,953,832
Less decrease to A/R for accounts for which payment was received during 2006...............................................................
9,685,420 1,268,412 26,854 $ 1,241,558
Less accounts written off in 2006............................................
Add that portion still due on previously written-off account which was paid in part in 2006 with reasonable assurance of future payment of the payment of the remainder.....................
920 $1,242,478
The bad debt expense is 0.3 percent * $1,242,478 = $37,274. The entry, therefore, would be: Bad Debt Expense.............................................................. 29,886 Allowance for Doubtful Accounts......................... 29,886 The Allowance for Doubtful Accounts remaining on the books at the end of 2006 is calculated as follows: Allowance for Doubtful Accounts, December 31, 2005.......... $29,648 Less Accounts Receivable written off in 2006........................ 26,854 2,794 Add increase to Allowance for Doubtful Accounts for previously written-off accounts which were collected during the year or deemed collectible in the future............................. Balance in account.................................................................. Add additional bad debt expense needed.................................
29,886
Total allowance for Doubtful Accounts, December 31, 2006. .
$37,274
4,594 7,388
The Allowance for Doubtful Accounts remaining on the books at the end of 2006 is calculated as follows: Under (b) or (c), in the calculation of Accounts Receivable: the last step in the calculation above is eliminated, thus leaving an Accountings Receivable balance of $1,241,558. The Bad Debt Expense is calculated and recorded the same as shown above. The Allowance for Doubtful Accounts remaining on the books as the end of 2006 is calculated as follows: Allowance for Doubtful Accounts, December 31, 2005......... Less Accounts Receivable written off in 2006........................ Balance in account................................................................. Add additional bad debt expense............................................ Total Allowance for Doubtful Accounts, December 31, 2006
$29,648 26,854 $2,794 34,453 $37,247
Question 2 Using (a)
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Using (b) or (c)
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Balance of accounts as of December 31, 2006: Accounts Receivable...................................................................... Less allowance for doubtful accounts.............................................
$1,242,478 37,274 $1,205,204
$1,241,558 37,247 $1,204,311
Question 3 In the ratios used for analysis of monetary assets listed below, the results are approximately the same whether method (a), (b), or (c) is used.
2006 Current ratio.................................................................................. Acid-test ratio............................................................................... Days’ cash..................................................................................... Days’ receivables: method (a)....................................................... method (b) or (c)......................................................................
2.7 1.5 N/A 44.1 44.2
Case 5- 2: Grennell Farm Note: This case has been updated from the Eleventh Edition. Approach This case is a good illustration of a situation where revenue recognition is not a cut-and-dried question. It also provides excellent reinforcement of the matching concept and statement articulation. The alternatives discussed are: (1) the production method, which recognizes inventory “holding gains” as revenue; (2) the sales method, which is analogous to the financial accounting method of revenue recognition of most manufacturers and retailers; and (3) the collection method, which recognizes revenues as collected, but is not quite the same as cash-basis accounting (since costs are accrued). While either the production method or sales method is acceptable under GAAP, that is really a moot point since Denise Grey is the sole owner of the incorporated farm, and not bound by GAAP. Once the issue of how much revenue to recognize is resolved, then how much expense to match can be dealt with. Together, these two issues determine how much gross profit Grennell farm will be shown as earning.
Question 1 The calculations shown below for Question 1 show the range of sales figures under different recognition methods. I start with the sales method, then do the collection method, and save the more unusual production method until last. An issue is whether the entire $183,000 “annual costs not related to the volume of production” should be treated as product or period expense. Unless the instructor for some reason is using this case after Chapter 6, the students may not recognize this as an issue or, if they do, not know how to deal with it in the financial statements. In any event, I think it worthwhile for the instructor to note that these expenses are by definition fixed (do not vary with production volume), but that some (especially a portion of salaries and wages) may be production costs and hence strictly speaking should be used in valuing inventory. (Students often mistakenly use “fixed costs” and “period costs” as synonyms.) Of course, the point of Question 1 is not just practice in revenue and expense matching calculations, but thinking about which is the most appropriate method. For tax purposes, Grey will want to use the collection method. For evaluating the performance of the farm in 2005, the production method would seem most useful. This is because there is very little uncertainty concerning the eventual sale of the 30,000-bushel wheat inventory stored at the farm. This inventory exists, not because there are no customers for it, but because the farm manager chose not to sell it, speculating that future prices will be higher. This is the same reasoning that justifies this unusual revenue recognition method as GAAP; the same method is also allowed for precious metals and other minerals where immediate marketability at 7
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quoted prices obtains. Also, many professional service firms (e.g., accounting firms) recognize revenue as work is performed by recording jobs in progress at billing rates rather than at cost. The name Unbilled Receivables is often used for this account to emphasize that the revenue has already been recognized, even though it has not yet been billed.
Exhibit A Collect the cash from the customer Customer acknowledges receipt of the item
Collection Method
Ship the product to the customer and send a sales invoice
“Usual” Method (Delivery Method)
Receive an order for the product from a customer
Production Method
Purchase raw material Convert the raw material to a finished product Inspect the product
Store the product in a warehouse To generalize the discussion, I put on the board a “cash cycle” diagram like the one in Exhibit A to this note. Starting with purchases, I go around this wheel and add to its interior the three points at which revenue can be recognized: these correspond to the three methods in the case, including the “usual” method of recognizing revenue when goods are shipped. When is the “correct” point to recognize revenue? This diagram points out that the answer is not clear-cut. “Conservatism” would say do not recognize the revenue until there is very little uncertainty as to receipt of the cash proceeds, driving the revenue recognition toward the collection point. “Timeliness” would argue for recognizing the revenue when the “critical event” or “performance” has taken place, in this instance as soon as a certainly salable product has been produced, i.e., the production method for Grennell. The measurability of income criterion does not help select a method in this instance, as the Question I calculations are feasible for all three methods.
Question 2 The original cost of the land was only $187.50 an acre: it is now appraised (for estate tax purposes) at $1,050 per acre, or $2.1 million. The cost concept says that, at least prior to the transfer of ownership to Grey (and possibly even afterwards), the balance sheet will show the land at its cost, $375,000. However, again GAAP need not prevail here, for Grey is trying to assess the economic attractiveness of the farm. Since she could sell the land for $2.1 million (or more, if the estate tax valuation was below market) and invest the proceeds elsewhere, she will likely want to use the higher valuation in her assessment. (Again, this is an argument often given for stating assets at current values: the asset is, in effect, tying up $2.1 million, not $375,000.) If Grey wants to think of selling only the 100 acres for the development, then she may think of the land value as $2.22 million (1,900 * $1,050 plus $225,000). The point is that the $375,000 historical cost is the least relevant for Grey’s purposes.
Question 3 Assuming Grey agrees that the combination of the production method of revenue recognition and the $2.22 million land valuation best serve her appraisal purposes, then in 2005 we have $323,370 net income 8
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on an owner’s equity investment of $2,482,100 ($637,100 plus $1,845,000 write-up of land), or a 13 percent before-tax return on investment. When one considers future appreciation of the land, this may well be a better investment than Grey would be able to make with the proceeds from selling the farm.
GRENNELL FARM Income Statements Sales................................................................................. Cost of goods sold Beginning inventory............................................ Production2.......................................................... Less: Ending inventory........................................ Cost of goods sold............................................... Gross margin.................................................................... Other expenses ................................................................ Net Income....................................................................... Balance Sheets Cash.................................................................................. Accounts receivable.......................................................... Inventory.......................................................................... Land................................................................................. Buildings and machinery (net).......................................... Total assets.......................................................... Liabilities (current)........................................................... Owners’ equity8................................................................ Common stock and APIC.................................... Retained earnings................................................ Total owners’ equity......................................................... Total liabilities and owners’ equity...................................
Sales $522,000
Method: Collection Production $462,4001 $614,1005
0 107,730 15,390 92,340 429,660 183,000 $246,660
0 107,730 25,6503 82,080 380,320 183,000 $197,320
0 107,730 06 107,730 506,370 183,000 $323,370
$ 30,900 59,600 15,390 375,000 112,500 593,390 33,000
$ 30,900 04 25,650 375,000 112,500 544,050 33,000
$ 30,900 151,7007 0 375,000 112,500 670,100 33,000
457,500 102,890 560,390 $593,390
457,500 53,550 511,050 $544,050
457,500 179,600 637,100 $670,100
Notes: 1 180,000 bushels @ $2.90 - 20,000 bushels @ $2.98 = 160,000 but @ $2.89. 2 210,000 bushels @ $.513 = $107,730. 3 30,000 bushels physically in inventory plus 20,000 bushels “inventory” at the elevator, reflecting payment not yet received from the elevator operator. 4 Under the collection method, there ae no accounts receivable since sales revenues aer not recognized until the collection is made. 5 30,000 bushels @ $3.07 + 180,000 bushels @ S2.90. Another approach is as follows: 210,000 bushels @ $2.80 = $588,000 (value at harvest) 180,000 bushels @ 0.10 = 18,000 (gain on sales to elevator) 606,000 30,000 bushels @ $0.27 = 8,100 (write-up to year-end value) $614,100 Given the text’s description of the production method, I treat $606,000 as an acceptable answer, but point out the logic of writing up the 30,000 bushels on hand for purposes of the year-end balance sheet. 6 Although there are 30,000 bushels physically in inventory, under the production method all wheat is counted as sold, and hence is not in inventory in an accounting sense.
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This includes the $59,600 “real” receivable plus $92,100 recorded as revenue on the 30,000 bushels produced but not physically sold. Students may create a different account for this $92,100, for example, Unbilled Receivables, which is fine. 8 If you assume that the case statement “Grennell withdrew most of the earnings” means that Retained Earnings at the beginning of the year was zero, then the 2005 drawings can be determined as follows: Sales Collections Production Beginning Retained Earnings........................................... $0 $0 $0 Plus: Net Income.............................................................. 246,660 197,320 323,370 Less: Ending Retained Earnings....................................... 102,890 53,550 179,600 Drawings............................................................. $143,770 $143,770 $143,770 Case 5- 3: Joan Holtz (A) Note: This case has been updated from the Eleventh Edition. Approach These problems are intended to provide a basis for discussing questions about revenue recognition that are not dealt with explicitly in the text and that are not sufficiently involved to warrant the construction of a regular case. Instructors can pick from among those listed. Some of them can be used as a take-off point for elaboration and extended discussion by adding “What if?” facts. Answers to Questions 1. If electricity usage tended to be fairly constant from month to month, one could argue in this case for basing reported revenues solely on the actual meter readings: the unreported usage in December would be reported in January, and overall revenues for this year would not be materially misstated. Stated another way, if revenues are based solely on meter readings, the December 2006 post -reading usage (which is recorded in January 2007) is, in effect, assumed to be the same 2007 post-reading usage. Prior to passage of the 1986 Tax Reform Act, this approach was permitted for income tax purposes. The 1986 act requires the more acceptable (due to better matching) practice: estimating actual usage for the part of December after meters are read and reporting that usage as part of the revenues of that year. This is more sound accounting, in that with weather fluctuations and energy conservation efforts, it is questionable whether the post-reading usage in December 2006 would in fact not differ materially from the post-reading usage in December 2007. The same problem exists for operators of vending machines. The postal service has the opposite problem: it receives cash from stamp sales before all of the stamps are used. It carries a liability (unearned revenues) for this effect. Both of these examples illustrate that even when cash is involved, the measurement of revenue is not necessarily straightforward. 2.
This is one of the problems whose “true” resolution depends on events that cannot be forseen at the end of the accounting period. Some firms count the whole $10,000 as revenue in 2006 on the grounds that it is in hand and that any specific services are undefined and/or separately billable. Others take the more conservative approach of counting only $5,000 as revenue in 2006 on the grounds that the service involved is “readiness to serve,” and that this readiness exists equally in each year. I prefer the latter approach, based on the matching concept.
3.
Many would argue that the service involved is the cruise and that no revenue has been earned until the cruise has been completed. Others maintain that Raymond’s has completed its “service” of arranging the cruise, that it is extremely unlikely that events will happen in 2007 that will change its profit of $20,000, and that the amount is therefore revenue in 2006. Introduction of the possibility of a refund lessens the strength of the argument of the latter group. This position can be weakened further 10
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by asking: (a) What if passengers are dissatisfied and demand (or sue for) a refund? (b) What if the ship owner performs unsatisfactorily and Raymond’s, in order to protect its reputation, steps in and incurs additional food or other cost to make the passengers happy? Students should be reminded to consider two criteria: (1) that the agency has substantially performed its earning activities and (2) that the income is reliably measurable. 4.
This problem has been debated for many years. Some argue that the $4 per tree has already been earned, as evidenced by the firm offer to buy the trees, and that it would be misleading to show no revenues in 2006 and the full sales value when the trees are sold in 2007. The percentage-of-completion method can be used as an analogy. Others argue that there has been no transaction, and no assurance that the trees can be sold for more than $4 in 2007 because market prices may decrease, or pests or fire may destroy them. Typically, firms facing this issue recognize no revenue until harvesting the trees.
5.
If a professional service firm (architects, engineers, consultants, lawyers, accountants, and so on) values its jobs in progress at billing rates, then it is recognizing revenue as the work is performed (time applied to projects) rather than waiting until the customer is billed. This is certainly defensible if the firm has a contract (called a “time and materials contract”) that obligates the client to pay for all time applied to the client’s project: the critical act of performance is spending the time on the project, not billing that time. In fact, many such firms feel that even with fixed -fee contracts, the critical performance task is spending time on a project as opposed to delivering some end item to the client; they thus record jobs in progress at estimated fee, which would be the same as billing rates for the time applied provided the project is within its professional-hour budget. Of course, whether the revenue is recognized when the time is applied or when the client is billed does make a difference in owners’ equity. Retained earnings will reflect the margin on the time applied sooner if the jobs in progress inventory is valued at billing rates rather than at cost.
6.
Numerous answers are acceptable. I argue that the coupon has nothing to do with the sale of coffee. Its purpose is to promote the sale of tea. The 60 cent reimbursements made in 2006 and the 60 cent reimbursements made in 2007 are an expense of selling tea in 2007. Those who tie the coupons with coffee would say that the entire 20 percent of coupons redeemed is an expense of selling coffee in 2006 with the amount not yet redeemed being a liability as of December 31, 2006. It is customary that the coupon issuer pay the store a handling fee in addition to the face value of each coupon; here that fee is 10 cents. It is 60 cents per coupon that is the cost, not the 50 cent face value.
7.
The bank would record the sale of $500 travelers checks for $505 as follows:
dr. Cash............................................................... 505 cr. Payable to American Express..................... 500 Commission Revenue................................ 5 After the bank remits the $500 cash to American Express, the latter will make the following entry: dr. Cash............................................................... 500 cr. Travelers Checks Outstanding................... 500 The account credited is a liability account. This account had a balance of many billions of dollars, which should help students understand why American Express does not itself levy a fee on the issuance of travelers checks: the checks are a great source of interest-free capital to American Express. 8.
According to FASB Statement No. 49, Manufacturer A cannot record a sale at all under these circumstances. The merchandise must remain as an asset on Manufacturer A’s balance sheet and a liability should be recorded at the time the $100,000 is received from B. This statement precludes 11
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Manufacturer A from inflating its 2006 revenues and income by the sort of repurchase agreement described. FASB 49 was issued to address the perceived abuse of treating such temporary title transfers as sales. 9.
FASB Statement No. 45 states that franchise fee revenue should be recognized “when all material services or conditions relating to the sale have been substantially performed or satisfied by the franchiser.” Amortization of initial franchise fees should only take place if continuing franchise fees are so small that they will not cover the cost of continuing services to the franchisee. Since this exception seems unlikely in this case, the $10,000 franchise fee should be recognized as revenue in the year received, as soon as the training course has been completed. Investors will need to make their own judgment as to what will happen when the market becomes saturated.
10.
This item is designed to get students to think about (1) a condition that creates the need for a change in revenue recognition policy, and (2) the potential need for multiple revenue recognition policies for a firm. Tech-Logic, a manufacturer of computer systems, normally recognizes revenue when its products are shipped, a policy common among manufacturing firms. To adopt that policy, managers at Tech-Logic must have concluded that the two criteria for revenue recognition were met at shipment: (1) Tech-Logic would have substantially performed what is required in order to earn income, and (2) the amount of income Tech-Logic would receive could be reliably measured. With the sale of the computer systems to the organization in one of the former Soviet Union countries, however, Tech-Logic’s ability to satisfy these two criteria changed. Although the first criterion was still met, the uncertainty about whether (and how much) foreign exchange the customer could obtain left the second criterion in doubt. Hence, Tech-Logic should not recognize revenue for these computer systems at shipment or delivery. An alternative should be to wait until cash (in the form of hard currency) was received to recognize revenue. This item can also be used to discuss the fact that firms often have more than one revenue recognition policy. Tech-Logic would not completely change its revenue policy to “cash receipt” for all sales at the time it begins to sell computers to organizations in countries where the availability of foreign exchange currency is in doubt. Rather, it would be likely to have two revenue recognition policies; at shipment, for products sold to organizations in countries where the availability of foreign exchange currency is not in doubt; and cash receipt, for products sold to organizations in countries where the availability of foreign exchange currency is in doubt. Because they manufacture products and provide a variety of services, computer manufacturers often have a variety of revenue recognition policies. For example, a computer manufacturer might recognize revenue for products when they are shipped; for custom software development, when the customer formally accepts the software; and for maintenance services, ratably over the life of the maintenance contract. Item 10 was inspired by events that occurred at Sequoia Systems in 1992. Sequoia evidenced several instances of aggressively booking revenue. One of these involved a Siberian steel mill. According to The Wall Street Journal: Executives signed off last year on the sale of a $3 million computer destined for a steel mill in Siberia. But government approvals and hard currency to pay for the system got stalled, even though $2 million of revenue was booked in the fiscal year ended June 30, and another $1 million was going to be taken in the first quarter ended last month, insiders say. 1
Sequoia executives stated that they expected this ;obthe Siberian steel mill;cb and similar sales “will 1
The Wall Street Journal, “Sequoia Systems Remains Haunted by Phantom Sales,” October 30, 1992, p. B8.
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ultimately prove to be good business” and that the decision to book it as revenue “was supported by the revenue recognition policy that we had in place.” 2 However, under investigation by the SEC and facing lawsuits by shareholders, Sequoia twice restated revenues following the end of fiscal year 1992, reducing originally reported revenues by more than 10 percent. 3 Case 55: Boston Automation. Systems, Inc. * Note: A shorter version of the Eleventh Edition case. David Fisher, the chief financial officer of Boston Automation Systems, Inc. a capital equipment manufacturing and testing instrument supplier to a variety of electronicbased industries, including the semiconductor industry, was reviewing the revenue recognition practices of the company’s three divisions. The review was undertaken in anticipation of disclosing in the company’s third quarter 2000 Form 10Q filing with the Securities and Exchange Commission (SEC) and the possible impact on the company of the revenue recognition and reporting guidelines set forth in the SEC’s 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 101’s guidelines covering customer’s acceptance and unfulfilled seller obligations on the company’s revenue recognition practices. Fisher’s staff had been studying this aspect of SAB 101 and the company’s revenue recognition practices for several months. As a test of his own understanding of the issue, Fisher selected from each of the company’s 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? 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 company’s performance and then proceed in the order of the questions listed at the end of the case. The financial analysis should focus on the company’s 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 company’s current revenue recognition accounting policies. This knowledge will be used later in the class to highlight the serious threat SAB 101 2 3
Ibid. Ibid.
*
1
The Glendale Division and Advanced Technology Division sale transactions reviewed by Fisher and the teaching note’s discussion of these sale transactions are based primarily on case examples included in Exhibit A of “the Securities and Exchange Commission’s” Staff Accounting Bulletin No. 101: “Revenue Recognition in Financial Statements---Frequently Asked Questions and Answers.”
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poses to the company. It may have to defer more revenue than it did before it adopted SAB 101. Question 2’s 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 students’ 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 Committee’s (IASC) approach to writing standards is preferable to the Financial Accounting Standards Board’s (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 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. SAB 101 The general rule governing revenue recognition is:
Revenue should not be recognized until it is realizable and earned.
Because the general rule has been abused by some companies, more specific criteria for revenue recognition have been prescribed by the SEC in SAB 101. As a result, revenue is now considered to be realized and earned when:
Persuasive evidence of an order arrangement exists, Delivery of the ordered goods has occurred or services have been rendered: The seller’s prince to the buyer is fixed or determinable, and, Collectibility of the sale proceeds is reasonably assured.
Persuasive Evidence Purchase order and sale agreement documentation practices vary widely between customers, companies, and industries. The SEC appears to be willing to accept as persuasive evidence of an agreement these practices as long as there is some form of written or electronic evidence that a binding final customer purchase authorization, including the terms of sale, is in the hands of the seller before revenue is recognized. Delivery
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Typically revenue is recognized when delivery has occurred and the customer has taken title and assumed the risks and rewards of ownership of the goods specified in the customer’s purchase order or sales agreement. More specifically,
Delivery is not considered to have occurred unless the product has been delivery to the customer’s place of business. If uncertainty exists about a customer’s acceptance of a product or service, revenue should not be recognized even if the product is delivered or the service performed. Revenue should not be recognized until the seller has substantially completed or fulfilled the terms specified in the purchase order or sales agreement. In licensing and similar arrangements, delivery does not occur for revenue recognition purpose until the license term begins.
Performance SAB 101 requires substantial performance of the sales arrangement by the seller and acceptance by the customer of the product or services rendered before revenue can be recognized SAB 101 notes:
A seller should substantially complete to fulfill the terms specified in the sales arrangements, and After delivery or performance, if uncertainty exists about acceptance, revenue should not be recognized until after acceptance occurs.
There are two exceptions to the above requirement. Assuming all of the other recognition criteria are met, the first exception is that revenue in its entirety can be recognized if the seller’s remaining performance obligation is inconsequential or perfunctory. In this case, any related future costs must be accrued and expensed when revenue is recognized. A remaining performance obligation is not inconsequential or perfunctory if:
The remaining performance obligation is essential to the functionality of the delivered products or services. Failure to complete the activities would result in the customer receiving full or partial refund or rejecting the product or services rendered to date.
In considering if a remaining performance obligation is or is not inconsequential or perfunctory, the SEC staff has indicated that the following factors, which are not all-inclusive, would be considered.
The seller does not have a demonstrated history of completing the remaining tasks in a timely manner and reliably estimating their costs. The cost or time to perform the remaining obligations for similar contracts historically has varied significantly from one instance to another. The skills or equipment required to complete the remaining activity are specialized or are not readily available in the marketplace. The cost of completing the obligation or the fair value of that obligation is more than significant in relation to such items as the contract fee, gross profit, and operating income.
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The period before the remaining obligation will be extinguished is lengthy. Registrants should consider whether reasonably possible variations in the period to complete performance affect the certainty that the remaining obligations will be completed successfully and on budget. The timing of payment of a portion of the sales price is coincident with completing performance of the remaining activity.
The second exception is a multiple-element deliverables sales arrangement. In this case, a portion of the contract revenue may be recognized when the seller has substantially completed or fulfilled the terms of a separate contract element. Pending additional accounting guidance, on multiple-element revenue arrangements, the SEC indicated that it will accept any reasoned method of accounting for multipleelement arrangements that is applied, consistently and disclosed appropriately. The SEC will not object to a method that includes the following conditions.
To be considered a separate element, the product or service represents a separate earnings process. Revenue is allocated among the elements based on their fair value. If an undelivered element is essential to the functionality of a delivered element, no revenue is allocated to the delivered element until the undelivered element is delivered.
In the case where a customer is not obligated to pay a portion of the contract price allocable to delivered equipment until installation or similar service, recognition of revenue on the delivered equipment may be recognized if the installation is not essential to the functionality of the equipment. Examples of indicators that installation is not essential to the functionality of the equipment include:
The equipment is a standard product. Installation does not significantly alter the equipment’s capabilities. Other companies are available to perform that job.
Conversely, examples of indicators that the installation is essential to the functionality of the equipment include:
The installation involves significant changes to the features or capabilities of the equipment or building complex interfaces or connections. The installation services are unavailable from other vendors. Contractual customer acceptance provisions must be satisfied before revenue can be recognized.
Customer acceptance provisions typically come in one of four forms: 1.
Acceptance provisions in arrangements that purport to be for trial or evaluation purposes.
In substance, these transactions are consignment-type sales, and revenue should not be recognized until earlier of acceptance or the acceptance provisions lapses. 2. 3.
Acceptance provisions that grant a right of return or exchange on the basis of subjective matters. Acceptance provisions that grant a right of replacement on the basis of seller-specified objective criteria.
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Revenue can be recognized rather than deferred so long as a provision can be reasonably determined for the amount of future returns based upon historical return experience of a similar sufficiently large volume of homogeneous transaction. 4. Acceptance provisions based on customer-specified objective criteria. Formal customer sign-off provides the best evidence of acceptance. In its absence, revenue can be recognized rather than deferred if the seller can reliably demonstrate that a delivered product meets the customer-specified objective criteria. Consignment-Type Transactions Products shipped pursuant to a consignment arrangement should not be recorded as revenue since the consignee has not assumed the risks and rewards of ownership. This is long-standing rule. SAB 101 goes further. It states that the following characteristics in a transaction preclude revenue recognition even if title to the product has passed to the buyer:
The buyer has the right to return the product and the buyer does not pay the seller at the time of sale, and the buyer is not obligated to pay the seller at a specified date or dates; the buyer does not pay the seller at the time of sale but rather is obligated to pay at a specified date or dates, and the buyer’s obligation to pay is contractually or implicitly excused until the buyer resells the product or subsequently consumes or uses the product; the buyer’s obligation to the seller would be changed (e.g., the seller would forgive the obligation or grant a refund) in the event of theft or physical destruction or damage of the product; the buyer acquiring the product for resale does not have economic substance apart from that provided by the seller, or the seller has significant obligations for future performance to directly bring about resale of the product by the buyer. The seller is required to repurchase the product (or a substantially identical product or processed goods of which the product is a component) at specified prices that are not subject to change except for fluctuations due to finance and holding costs, and the amounts to be paid by the seller will be adjusted, as necessary to cover substantially all fluctuations in costs incurred by the buyer in purchasing and holding the product (including interest). The indicators of the latter condition include: The seller provides interest-free or significantly below market financing to the buyer beyond the seller’s customary sales terms and until the products are resold.
The seller pays interest cost on behalf of the buyer under a third-party financing arrangement or The seller has a practice of refunding (or intends to refund) a portion of the original sales price representative of interest expense for the period from when the buyer paid the seller until the buyer resells the product. The seller guarantees the resale value of equipment to a purchaser, and the transaction does not qualify for sale-type lease accounting. This transaction should be recorded as an operating lease. The product is delivered for demonstration purposes.
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Revenue Recognition Methods Boston Automation Systems has adopted the following revenue recognition policies. 1. 2. 3. 4.
Recognize revenue upon product shipment Recognize service revenue ratably as service is provided over the period of the related contract. Recognize longterm contract revenue using the percentageofcompletion accounting method Revenue from multideliverables contracts is allocated to each deliverable based upon the amounts charged for each deliverable when sold separately. 5. 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 percentageofcompletion accounting method from its scope. Fisher’s Concerns An examination of Boston Automation System’s consolidated financial statements clearly shows that the company has been growing both its sales and net income at a doubledigit 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 company’s revenues and earnings. A change in the revenue recognition methods may lead some to question the company’s 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 Division’s sales strategy shift and the related inventory loading of its 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 onetime 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 company’s general revenue recognition policy needs to change. In
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the future revenue should be recognized upon delivery (not shipment) since title passes to the customer upon delivery. Sales Transactions Fisher’s 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 division’s 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 customer’s environment as it does in the seller’s. 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, 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 customer’s location and meets the customerspecific criteria before recognizing revenue. While this is best evidenced by formal customer acceptance, other objective evidence that the equipment has met the customer specific 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 customer’s 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. Specialty Semiconductor, Inc.
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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 customer’s 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 the installation (i.e., $500,000), would be appropriate. Alternatively, if the division’s 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 division’s 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 customer’s order. In addition, the buyer’s 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 division’s 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 customer’s 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 devices and the product’s 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. The distributor’s unusual extended payment terms, reflecting the expected sellthrough of the mechanical testing devices coupled with the division’s past generous unwritten return practices suggest that the so
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called sale is in substance a consignmenttype transaction. Revenue should be recognized by the division on a distributor sellthrough basis. The division’s 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 writtendown 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 forth accounting 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 wellstated general principle. Accounting for Equity Transactions If time permits, the instructor might want to use the company’s 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 paid in 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.) Summary Clearly, the SEC’s 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 SEC’s 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 layaway plans (revenue was deferred rather than recognized immediately) to
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manufacturers like Boston Automation Systems with significant postdelivery obligations (they had to defer rather than recognize income immediately).
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