College of Business and Economics Department of Management (MBA Program) Assignment I on Accounting for Decision Making (A4DM)
The realization principle determines when a business should recognize revenue. Listed next are three common business situations involving revenue. After each situation, we give two alternatives as to the accounting period (or periods) in which the business might recognize this revenue. Select the appropriate alternative by applying the realization principle, and explain your reasoning.
- Airline ticket revenue: Most airlines sell tickets well before the scheduled date of the (Period ticket sold; period of flight)
- Sales on account: In June 2011, a San Diego–based furniture store had a big sale, featuring “No payments until 2012.” (Period furniture sold; periods that payments are received from customers)
- Magazine subscriptions revenue: Most magazine publishers sell subscriptions for future delivery of the magazine. (Period subscription sold; periods that magazines are mailed to customers)
Kim Morris purchased Print Shop, Inc., a printing business, from Chris Stanley. Morris made a cash down payment and agreed to make annual payments equal to 40% of the company’s net income in each of the next three years. (Such “earn-outs” are a common means of financing the purchase of a small business.) Stanley was disappointed, however, when Morris reported a first year’s net income far below Stanley’s expectations.
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The agreement between Morris and Stanley did not state precisely how “net income” was to be measured. Neither Morris nor Stanley was familiar with accounting concepts. Their agreement stated only that the net income of the corporation should be measured in a “fair and reasonable manner.” In measuring net income, Morris applied the following policies:
- Revenue was recognized when cash was received from customers. Most customers paid in cash, but a few were allowed 30-day credit terms.
- Expenditures for ink and paper, which are purchased weekly, were charged directly to Supplies Expense, as were the Morris family’s weekly grocery and dry cleaning bills.
- Morris set her annual salary at $60,000, which Stanley had agreed was reasonable. She also paid salaries of $30,000 per year to her husband and to each of her two teenage children. These family members did not work in the business on a regular basis, but they did help out when things got busy.
- Income taxes expense included the amount paid by the corporation (which was computed correctly), as well as the personal income taxes paid by various members of the Morris family on the salaries they earned working for the business.
- The business had state-of-the-art printing equipment valued at $150,000 at the time Morris purchased it. The first-year income statement included a $150,000 equipment expense related to these assets.
- Discuss the fairness and reasonableness of these income-measurement policies. (Remember, these policies do not have to conform to generally accepted accounting But they should be fair and reasonable.)
- Do you think that the net cash flow generated by this business (cash receipts less cash outlays) is higher or lower than the net income as measured by Morris? Explain.
Happy Trails, Inc., is a popular family resort just outside Yellowstone National Park. Summer is the resort’s busy season, but guests typically pay a deposit at least six months in advance to guarantee their reservations.
The resort is currently seeking new investment capital in order to expand operations. The more profitable Happy Trails appears to be, the more interest it will generate from potential investors. Ed Grimm, an accountant employed by the resort, has been asked by his boss to include $2 million of unearned guest deposits in the computation of income for the current year. Ed explained to his boss that because these deposits had not yet been earned they should be reported in the balance sheet as liabilities, not in the income statement as revenue. Ed argued that reporting guest deposits as revenue would inflate the current year’s income and may mislead investors.
Ed’s boss then demanded that he include $2 million of unearned guest deposits in the computation of income or be fired. He then told Ed in an assuring tone, “Ed, you will never be held responsible for misleading potential investors because you are just following my orders.”
- Should Ed Grimm be forced to knowingly overstate the resort’s income in order to retain his job?
- Is Ed’s boss correct in saying that Ed cannot be held responsible for misleading potential investors?