Quiang and his accounting course (A)
‘Your course unfortunately doesn't give me the answer to a great many real-life problems,' said Quiang to his accounting professor. ‘I've read carefully the text and listened to you attentively, but every once in a while I run across something that doesn't seem to fit the rules.'
‘Not all of life's complications can be covered in a first-year course,' the professor replied. ‘As is the case with law, medicine or indeed any of the professions, many matters are dealt with in advanced courses, and others are not settled in any classroom. Nevertheless, some problems that are not specifically discussed can be solved satisfactorily by relating them to principles that you already have learned. Let's take revenue recognition as a particularly difficult case in point. If you write down some of the matters about which you are now uncomfortable, I will gladly discuss them with you - that is, after you have given some thought as to the most reasonable solution.'
A week later, Quiang returned with the following list:
1. Electric utility bills
When an electric utility customer uses electricity, the electric company has earned revenues. It is obviously impossible, however, for the company to read all of its customers' meters on the evening of 31 December. How does the electric company know its revenue for a given year? Explain.
2. Retainer fee
A law firm received a ‘retainer' of EUR 20,000 on 1 February 2005 from a client. In return it agreed to provide him with general legal advice upon request for one year. In addition, the client would be billed for regular legal services such as representation in litigation. There was no way of knowing how often, or when, the client would request advice, and it was quite possible that no such advice would be requested. How much of the EUR 20,000 should be considered as revenue in 2005? Why?
3. Cruise
Viaggimmagine srl, a travel agency based in Milan, chartered a cruise ship for two weeks beginning 12 March 2005 for EUR 400,000. In return the ship's owner agreed to pay all costs of the cruise. In 2004, Viaggimmagine sold all available space on the ship for EUR 520,000. It incurred EUR 80,000 in selling and other costs in doing so. The amount of EUR 520,000 was received in cash from passengers in 2004. Viaggimmagine paid EUR 100,000 as an advance payment to the ship owner in 2004. How much, if any, of EUR 520,000 should be recognised as revenue in 2004? Does the question of whether passengers were entitled to a refund in 2005 if they cancelled their reservations make any difference to the answer? Why?
4. Accretion
A nursery owner had one plot of land containing Christmas trees that were four years old on 1 November 2004. The owner had incurred costs of EUR 6 per tree up to that time. A wholesaler offered to buy the trees for EUR 10 each and to pay in addition all costs of cutting and bundling, and transporting them to market. The nursery owner declined this offer, deciding that it would be more profitable to let the trees grow for one more year. Only a trivial amount of additional cost would be involved. The price of Christmas trees varies with their height. Should the nursery owner recognise any revenue from these trees in 2004?
5. ‘Unbilled' receivables
The balance sheet of an architectural enterprise shows a significant asset labelled ‘unbilled receivables'. The firm says this asset represents projects in progress, valued at the rates at which the customers will be charged for the architects' time. Why would an enterprise do this instead of valuing projects in progress at their cost, as a manufacturing firm would value its inventory in progress? Does it make any difference in the owners' equity for the architectural enterprise to report such work in progress as receivables rather than as inventory? Why?
6. Franchises
A national real estate brokerage enterprise has become highly successful by selling franchises to local real estate brokers. It charges EUR 30,000 for the initial franchise fee and a service fee of 5 per cent of the broker's revenue thereafter. For this it permits use of its well-known name, and provides a one-week initial training course, a nationwide referral system, and various marketing and management aids.
Currently, the franchise fee accounts for 25 per cent of the European revenues, but the enterprise expects that the EU market will be saturated within the next three years, and thereafter the enterprise will have to depend on the service fee and new sources of revenue that it may develop. Should it recognise EUR 30,000 as revenues in the year in which the franchise agreement is signed? Why? If it does, what will happen to its profits after the market has become saturated? Why?