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Accounting Case Explanation

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CASE 5-3 JOAN HOLTZ (A)*
(1) Electric utility bills.
An electric utility company can estimate with reasonable certainty the expected revenue in a given period by taking into consideration some of the following: customer habits, average historical trends, demand and supply forecasts, and environmental changes. The electric utility industry effectively uses an insurance industry concept—the law of large numbers, to determine with certainty, expected revenue. The law of large numbers states, as the number of participants (customers) in a risk class (low, medium, high kilowatt users) increases, the expected outcome (usage for specific class) remains the same but the standard deviation (variability of usage) continues to drop until the probability that the average outcome (average usage) will be different from the expected outcome (expected usage) becomes negligible. This concept is conceptually similar to the Central Limit Theorem, and thus illustrates on average, the more observations per class, the more the usage tends to be bell-shaped and this usage is used for basing revenues per class. This is one way how the utility company can determine period-end revenue. Another way is if customer usage is consistent from period to period it can base reported revenue on actual meter readings. The unreported usage in December would be reported in January, and overall revenues for this year would not be materially misstated. The utility company can also adjust for seasonal changes in demand (i.e less usage in summer due to daylight savings and more in the winter) and factor this into their calculation. Usually, utility companies send agents to verify meter readings and, if there is a difference, it is reflected in your next statement.
(2) Retainer fee
This is a typical type of fee presented by most professionals to their clients. The key issue with this is one of revenue recognition. There are a few ways in which it is possible to recognize the payment: (1) recognize the retainer on a monthly basis regardless of whether any services have been performed, (2) recognize the fee only as legal advice is furnished, or (3) recognize the full amount when actually received. Under the first option, the retainer is taken into income on a systematic basis and spread evenly over 1-year. The issue with this method relates to costs. It does a poor job of matching billable hours to the funds. Under option 2, revenue is recognized only as advice is furnished and billed to the client. At the end of the 1-year period, any remaining balance left over is taken into income. This method does a better job of matching costs with the revenue it helped earn, but has a tendency to mismatch costs when there is a balance remaining at the end of the service period. One argument for this is that the client failed to take advantage of the advisors readiness to serve and therefore has no corresponding costs, which constitutes a larger profit margin on the specific job. Finally, the last possibility assumes that the firm can reasonably estimate the associated costs up front with the retainer and recognizes both in 2006. This may or may not have tax implications to the firm; it depends on other relevant facts the firm has.
(3) Cruise
In order for Raymond to recognize revenue in ’06 it must satisfy the revenue recognition criteria under current Canadian GAAP. Are the risks and rewards of ownership transferred? Yes, title to the trip has been transferred. Is collectability of the revenue reasonably assured? Yes. Is the revenue measureable? Yes. Has performance been substantially completed? Yes, the agency has arranged the cruise. Therefore, it can record the revenue. If the passengers were entitled to a refund period in ‘07, further analysis will need to be done in order to determine such implications. If the agency is subject to significant and unpredictable amounts of reservations being refunded, and cannot reasonably estimate the number of refunds, then it should wait until after the refund period to record the revenue and costs associated with the sale. If it is able to reasonably estimate such refunds then it can record an allowance, sale, and cost in ’06.
(4) Accretion
Certain industries like that of the nursery owner have certain characteristics that are fundamentally different from others in the way revenue can be recognized. This particular industry has the ability to recognize a sale even before the trees are grown or cut because this type of commodity has an active market where prices and costs are readily determinable. However, there is no guarantee that current prices will be carried forward in the future. Therefore, because of this uncertainty it is reasonable to assume that no revenue should be recognized until an actual bona fide sale is established. Also, the owner has indicated his intention to sell in the following year as he can generate a larger profit then. This should corroborate the argument that no revenue should be recognized until such time.
(5) Unbilled receivables
Using billing rates as opposed to cost indicates that the firm is recognizing revenue as the project is being worked on rather than waiting until the client is actually billed. This could have a substantial impact on income as a result of timing differences between billings and performance and the difference between the two rates used. As a result, it does make a difference to owners’ equity if the firm reports such work as receivables rather than inventory.
(6) Premium coupon
Under current Canadian GAAP, an expense and a liability should be recorded on the 2006 financial statements for the cost of coupons that will be redeemed. However, since 10% have been redeemed in 2006 this will reduce the liability by 50% at the end of 2006. The cost of the premium expense should be the 50-cent coupon plus the 10-cent handling cost. This premium expense would be related to the sale of the instant tea and not the coffee.
(7) Traveler’s checks
The bank would record the following upon sale of the traveler’s check:
Dr. Cash $505
Cr. Payable to AMEX $500
Cr. Commission Revenue $5
The bank would then debit the liability and credit cash for $500 when remitting payment.
American Express would have cash increased for $500 and set up a liability for the traveler’s check outstanding. This check is essentially, an interest-free loan provided by the purchaser to the issuing company (AMEX). And, the liability and cash will decrease as the purchaser uses the checks.
(8) Product repurchase agreement
Manufacturer A cannot record any revenue in 2006 because no sale has actually occurred. The sale and repurchase agreement is essentially a form of financing for manufacturer A. Under the revenue recognition criteria the risks and rewards of ownership have not been transferred. Management still has continuing involvement even after the sale in 2006 and because of this fundamental reason, it therefore is not correct to record the sale. This transaction is similar to that of a sale-and-leaseback where the substance of the transaction is a form of financing as well.
(9) Franchises
Under current Canadian GAAP (AcG- 2: Franchise Fee Revenue), the firm can recognize revenue from initial franchise fees when all material conditions relating to the sale have been substantially performed by the franchisor. This would mean that revenue should be recognized after the 1-week training course is completed. Once the market has become saturated, the most likely event to happen would be a decrease in profits or excess costs over service fees. If this happens, provisions under AcG-2 may need to be used which may include: deferring a portion of the initial fee and amortizing it over the life of the franchise. The amount deferred shall be sufficient to cover estimated costs in excess of continuing franchise fees and provide a reasonable profit on continuing services.
(10) Computer systems
Tech-logic’s biggest concern with this specific contract is with respect to collectability. Under Section 3400.19 if there is uncertainty as to ultimate collection, it may be appropriate to recognize revenue only as cash is received. Considering that this is a new market for the company, and it has no prior experience or available data about this new market, it would be advisable to recognize revenue upon receipt of cash. When it produces its financial statements, it would have to disclose multiple revenue recognition policies to differentiate between domestic and emerging markets.…...

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