Case 2-1 - Solution
Estimated time to complete this case is 1 to 1.5 hrs
1. Thousand Trails’ revenues from membership sales increased
by $40 million or almost 100% in the 1981 - 1983 period.
Two issues need to be addressed with respect to these
revenues. First, revenues were recognized in the year of
the sale even though customers who bought them were
granted “lifetime” privileges from the company. Secondly,
(for a portion of the sales) revenue was recognized prior
to cash collection as sales were made on an installment
basis with an average term of 5 years (61 months).
These two issues speak directly to the two major
criteria underlying revenue recognition;
1. Has the company provided all or substantially all the
service to its customers?
2. Was cash collectibility reasonably assured?
With respect to criterion 1, it can be argued that
part of the lure of membership was the accessibility of
both current and future campgrounds promised by Thousand
Trails. Thus Thousand Trails' service was complete only
when future campgrounds materialized. This point is,
however, not relevant. Under the terms of the membership
sales agreement, however, no refunds were available once
memberships were sold, even if future campsites were not
completed. Thus this criterion suggests that revenue
recognition was appropriate.
The second criterion is more problematic. The potential
for a lag between cash collections and revenue
recognition is highlighted by the following
(interrelated) issues:
• What percentage of sales was made for cash?
• For installment sales, what was the creditworthiness
of the customers and what were the terms of payment?
Note that the customer base was individuals rather
than companies.
These questions, in addition to having relevance for
criterion 2, also reopen consideration of criterion 1.
While it is true that the company did not have to refund
any moneys collected if customers canceled, at the same
time, it had no recourse in terms of collecting any
Solutions Chapter 2- P. 1
unpaid balances upon cancellation. Thus, if customers
stopped paying (effectively canceling their memberships),
previously recognized revenues might have to be reversed.
As customers purchased memberships with the expectation
that future campsites would be opened and/or current ones
would be upgraded, if these expectations were not met
they might well stop paying the remaining balances owed
on their memberships. Thus the appropriateness of the
revenue recognition may well hinge on whether the company
has “provided all or substantially all the service to its
customers”
2. For expense recognition, Thousand Trails’ took the
opposite tack. Expense recognition of preserve
improvements was deferred to years after the actual cash
outlay for those improvements.
Note that Thousand Trails’ “percentage of
completion” method of recognizing expenses differs from
the one discussed in the chapter. In the chapter, the
customer for the project had already contracted for it.
For Thousand Trails, the customer had still to be found.
The appropriateness of their expense recognition
method was clearly a function of whether the planned
sales would occur. Note that management forecast that
total memberships (based on existing preserves) would be
three times the current level. Management forecasts used
as accounting inputs must be examined carefully as
misestimation, whether purposeful or not, may have
significant effects on reported earnings and asset
values.
Taken together with Thousand Trails' revenue
recognition methods, the following picture emerges.
Thousand Trails attempted to have the best of both
worlds. It made large outlays for preserve improvements
based on optimistic estimates of future cash flows.
Current cash outflows were capitalized (deferred to
future periods), while all estimated future cash inflows
were recognized as revenue immediately.
3. Thousand Trails took an “aggressive” position in
recognizing revenues (and expenses). Sales were
recognized in full, although only a portion of the cash
was collected. Expenses, on the other hand, were deferred
to periods following the cash outlay. Given the long
collection period, there was a built-in lag between
present cash outflows and future cash inflows. Thus
Solutions Chapter 2- P. 2
reported income was not a good indicator of near-term
cash flows.
Moving beyond the issue of whether this accounting
complied with GAAP, the implications of the gap between
revenue and expense recognition and cash flows should be
clear. Assuming for the moment that the growth rate could
be maintained, the gap would still indicate potential
liquidity and solvency problems.
However, analysis suggests that maintaining
Thousand Trails' past growth rates was unlikely. The only
way to maintain the growth rate was for membership sales
to grow at the same rate as in the past. These sales
would require new campgrounds, which would result in
further cash outlays and deferral of costs. This cycle
assumed, to some extent, the existence of a large
untapped market. Even if this market existed, the cash
flow (liquidity) constraint could eventually overwhelm
the company.
All markets reach saturation eventually. For every
company that maintains a very high growth rate year after
year (Wal-Mart, for example), there are others that fail
to sustain earlier high rates of growth. In most cases,
the current growth rate of sales and income must be
expected to decline in the future.
Given the “lifetime” nature of membership sales,
customers do not return for second purchases, and future
membership sales are purely a function of demographics
and population trends. Note it took at least three years
to reach a membership level of 50,000. How long might it
take to reach its forecast of 100,000 more members on its
current campgrounds? The increase in memberships was
dependent to some extent on new campgrounds being opened,
which, again would require expansion of the market. The
answer to this question exists outside the financial
reports. Demographic and population trends, competition,
and other factors would need to be examined; parameters
which require data from outside of the financial
statements.
4. Once saturation is reached, the company's main source of
income would be annual dues and interest on installment
sales rather than membership sales. Thus, for “long-run”
analytic purposes, we must recognize that these recurring
components of income are more important than income from
membership sales, which had historically been the most
prominent factor.
Solutions Chapter 2- P. 3
This does not mean that historical membership
sales are irrelevant. On the contrary, they are the
primary inputs in estimating the level of future annual
membership dues. This underscores the use of financial
statements in general, and the income statement in
particular, as (part of) a database used to predict the
company's future.
5. Assets represent economic resources that provide future
benefits. Consistent with a long-run “going concern”
perspective of the firm, these future benefits can be
• their earnings generating ability; or
• their cash collectibility.
Fixed assets and inventory, for example, are assets
primarily because they help generate future sales and
earnings. In the Thousand Trails case, operating preserves
represent such assets. Receivables, which arise after the
earnings generating process has been completed, are
forecasts of cash collections. They are an asset to the
extent that they will result in the collection of cash.
The service has already been provided; conversion to cash
is now awaited.
Our previous discussion indicated some question as
to the eventual collectibility of Thousand Trails’
receivables due to both the creditworthiness of the
customers and the limits to growth.
Furthermore the cash outflows for operating
preserves and improvements therein are assets if they are
expected to provide future services. Our analysis
questions this assumption. For the operating preserves to
be an asset, nearly three times the current membership
levels would have to be reached. If anticipated future
sales do not materialize and a ready market1 for the
assets does not exist, then the carrying value of the
assets should be viewed as nothing more than unexpired
costs; “expenses waiting to happen.” When there is no
expectation of future revenues, there is nothing to
1
For the operating preserves, although the land may have had some market
value (for alternative uses), most of the carrying cost was for
improvements. These have value only if used as campgrounds, which, we
have already pointed out, depended on the achievement of optimistic
assumptions.
Solutions Chapter 2- P. 4
“match” those expenses against, and the carrying amount of
the assets will be overstated.
To a great extent therefore, these assets
(receivables and operating preserves) exist only as a
function of Thousand Trails' revenue and expense
recognition methods.
The seriousness of this issue can be brought home
if we take a peek at Exhibit 3C-2 (text p.121). Thousand
Trails' December 31, 1983, balance sheet shows that
approximately 85% of Thousand Trails' assets of $151.8
million consisted of receivables (56%) and operating
preserves (29%):
% of Total Assets
Receivables (net of allowance)
Current $20.8 million 13.7%
Noncurrent 64.1 42.2%
Total $84.9 million 55.9%
Operating preserves $43.8 million 28.8%
Take these “assets” away and there are few assets left.
Solutions Chapter 2- P. 5
PROBLEMS - Ch. 2
6.{S}A. (i) and (ii)
19X6: Revenue = 20% x $6 million = $1.2 million
Costs incurred = 20% x $4.5 million = $.9 million.
(Income recognized is $.3 million difference.)
19X7: Revenue = 60% x $6 million = $3.6 - $1.2 = $2.4
million
Costs incurred (cumulative) = 60% x $4.8 million =
$2.88 million. As 19X6 recognition was $.9 million,
19X7 recognition must be $ 1.98 million ($2.88 -
$0.9).
(Income recognized is $.42 million difference,
making cumulative recognition $.72 million for two
years.)
B. There should be no effect; expenditures that do not
contribute to the completion of the project do not affect
revenue or income under the percentage of completion
method.
Solutions Chapter 2- P. 6
11.{M} This problem provides a good opportunity to discuss the
subtleties and implications of revenue and expense
recognition criteria.2
A. Revenue recognition is predicated on the following two
criteria:
(1) Collectibility of cash
(2) Provision of service.
Criterion (1) is satisfied as the license fee is paid in
advance.
The focus of the question becomes criterion (2) -
provision of service. Some students will argue that the
service is only provided when the games are actually
played. This argument holds only for the revenues from
the season tickets themselves not the license fee - as
the former is refundable if games aren't played
(player's strike) or if the team "folds". The license
fee is presumably nonrefundable no matter what happens.
Thus, it is reasonable to recognize the full amount of
the license fee as revenue immediately.
[The discussion can be enhanced by considering what
would happen if the Raptors did not sell the ticket and
license fee separately but rather sold lifetime season
tickets --- i.e. one payment up front entitled the buyer
to attend all games forever without additional payment.
The first issue that would have to be addressed is
similar to the above; i.e. what is refundable if games
are canceled? If it was assumed that nothing is
refundable then would one recognize the full amount as
revenue immediately even though no games were played?
This would lead to the team recognizing revenues without
as yet incurring expenditures in performing the service.
If one argued that the revenues should be recognized
pro-rata -- over how many years should the revenues be
recognized? Remember the tickets are sold as a
"lifetime" right. Finally, if one made the pro-rata
argument for this latter case, one would have to argue
as to why it is different than the license portion in
the case where there is a separate license and season
ticket fee.]
2
Conceptually, the issues in this problem are similar to those in the Thousand
Trails case. The license fee is similar to the initial membership sales and the
season tickets are similar to the annual membership dues.
Solutions Chapter 2- P. 7
B. A corporation that purchased the license fee would have
a “lifetime” asset. For accounting purposes, therefore,
it should probably not recognize any expense for the
license fee. Practically speaking, however, one would
expect the firm to amortize the fee over some arbitrary
number of years (probably 40).
C. In analyzing expected earnings, license fees for a given
seat sold are a one-time event. Although licenses for
other seats may be sold in future years, as capacity is
fixed, in the long run revenues from license fees are
nonrecurring. The long-run earnings potential depends on
season ticket sales.
The license fees, however, provide a valuable input
in forecasting future season ticket sales. It is
reasonable to assume that (relative to a season ticket
holder without a license) there is a greater probability
that a licensee will either buy season-tickets
themselves or (if they are not interested) they will
try to find someone to sell their license to who would
be willing to buy season tickets.
Thus, the number of licensees acts as a base or
threshold level for anticipated season tickets sold each
year. The more licenses sold the higher the expected
recurring revenues from season ticket sales.
Solutions Chapter 2- P. 8
14.{M}A.& B. ATT’s adjusted income before nonrecurring charges is computed by adding
back the non-recurring charges to reported income.
All Data in Billions of $
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995
Revenues 63.2 62.0 60.7 62.1 61.6 63.2 64.5 66.6 69.4 75.1 79.6
Income
Reported 3.6 1.0 4.1 -2.5 4.8 5.4 1.4 6.5 6.5 7.9 1.2
Restructuring 0.0 3.2 0.0 6.7 0.0 0.0 4.5 0.0 0.5 0.0 7.8
Adjusted 3.6 4.2 4.1 4.2 4.8 5.4 5.9 6.5 7.0 7.9 9.0
Comparing the adjusted and reported amounts, we find that the adjusted amounts follow a smooth
pattern mirroring that of the revenue stream. The reported amounts however are erratic and
although, overall, the trend is upwards, the path is volatile and follows no discernible pattern.
10 80
8 70
60
6
Revenues
50 Reported
Income
4
40 Adjusted
2 Revenues
30
0
20
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
-2 10
-4 0
C. At first glance it would seem that if the objective is to forecast future reported recurring
operating data then the adjusted data are more relevant. They follow a smooth trend consistent
with that of revenues, are recurring in nature and are not subject to random fluctuation.
However, the repetitive nature of AT&T’s “non-recurring” restructuring charges indicates that
the firm is engaging in smoothing/big bath behavior. The firm is storing costs and periodically
charging them out in order to make “recurring” operating income look better. Thus, to analyze
AT&T’s actual economic performance or future earnings power the non-recurring items must
be considered and the reported operating income used. Over the 11 year period, nonrecurring
items totaled $22.7 billion. Charging an average of approximately $2 billion to each year
results in the “smoothed” line on the graph (below). It still follows the pattern implied by
revenues, albeit at a much lower level.
10 80
8 70
60
6
Reported
Revenues
50
Income
4 Adjusted
40
Smoothed
2
30 Revenues
0
20
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
-2 10
-4 0
Solutions Chapter 2- P. 9
D. AT&T adopted SFAS 121 in 1995 and took a $7.8 billion pretax restructuring charge that
year. Included in that restructuring charge is a charge for asset impairments as provided by
SFAS 121. That charge did affect ATT’s reported results. However, the adoption of SFAS
121 did not affect the results as AT&T claims that it would have made the identical charge
whether or not SFAS 121 was in effect. (Given the empirical findings discussed in pp. 403-
406 of the text, that statement is debatable.]
Solutions Chapter 2- P. 10