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Example 4 Product Warranty That is Not a Peformance Obligation 5 17 2012 Ex 4A defective units LCM Prepared by

VIEWS: 3 PAGES: 22

									5/17/2012                                   Ex 4A defective units LCM                    Prepared by Teresa Gordon

                    Revenue Recognition Exposure Draft 2010, beginning paragraph IG16
 Example 4 - product warranty that is not a performance obligation
           1,000 units of product sold
 $      1,000.00 price per unit
       1,000,000 Total sales
 $        600.00 Cost per product (finished goods inventory)
         600,000 Total COGS
              1% Estimated returns for replacement of defective products during first 90 days
              10 Estimated units to be returned
             990 Estimated "real" sales in units
 $        150.00 Assumed cost of repairs for returned units
 $        950.00 Price for a refurbinshed unit (instead of $1,000)
 $        450.00 A logical value for WIP inventory but not per LCM rules in ASC 330-10-35
                    See ASC 330-10-35 quotes below
 $        400.00 Normal profit margin                                                                         40%
 $        200.00 Profit margin on refurbished items                                                           21%
                    Therefore exception in ASC 330-10-35-5 does not apply
 $        600.00 Applying ceiling and floor rules (see below), to get value of defective unit
Net Realizable Value
Estimated selling price in the ordinary course of business less reasonably predictable costs of completion and
disposal.
                                                                                                  less cost to
                                                                             selling price
 Market = middle value of                               $         600.00                           complete
 $        800.00 NRV                                    Ceiling           $           950.00 $            150.00
 $        600.00 Replacement cost
 $        480.00 NRV less normal profit margin          Floor             $           800.00 NRV
 less normal profit margin on sales of                 40%                $          (320.00) Less profit
                                                                          $           480.00 Floor

At date of shipping or delivery (Dec 1)                                         Debit               Credit
                   Accounts receivable (or cash)                                 1,000,000
                   Sales revenue                                                                       990,000
                   Liability to replace defective products*                                             10,000
             990 Cost of goods sold                                                594,000
           1,000 Inventory                                                                             600,000
                   Right to receive defective units                                     6,000
*This is not a performance obligation

January 31 (no products have been replaced but conditions have changed
New estimate of defective products =                            12
                 instead of original estimate of                10
Modification of contract (?) entry
$        1,000 Liability to replace defective products*                                                      2,000
                 Sales revenue                                                          2,000
$          600 Cost of goods sold                                                                            1,200
                 Right to receive defective units                                       1,200


7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx                                                                     Page 1
5/17/2012                                   Ex 4A defective units LCM                   Prepared by Teresa Gordon



Scenario 1 - defective units are returned exactly in accord with modification
             12 Inventory                              $       600.00                                    7,200
$       600.00 Work in process inventory                                               7,200
                  Right to receive defective units                                                       7,200
                  Cost of goods sold                                                   7,200
                  Adjust inventory to actual and zero out contract asset

              12 Sales                                                                                 12,000
           1,000 Accounts receivable (no change)                                                          -
                    Liability to replace defective products*                           12,000
                    Adjust liability to zero and reduce sales as necessary          1,629,600        1,629,600
*This is not a performance obligation
        400,000 Net income impact                                        988 good units sold
$         400.00 Gross profit for good units                        395,200
              12 Additional revenue                                    4,800
$         400.00 Profit on returned units                              4,800
Note there is no "penalty" for shipping bad products             TRUE
in either the initial or following periods. This doesn't seem right to me.
Scenario 1
                                        Liability to replace defective products*
                                                                     10,000           (10,000)
                                                                       2,000          (12,000)
                                                   12,000                                  -
                                                       -                                   -

Scenario 1
                                                 Contract Asset
                                               6,000                                   6,000
                                               1,200                                   7,200
                                                                  7,200                  -




7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx                                                                 Page 2
5/17/2012                                   Ex 4A defective units LCM                    Prepared by Teresa Gordon



Scenario 2 - experience is different than estimated
After the modification above, what if customers only return 8 items
within 90 days (insteaed of 12)?                                                Debit               Credit
             8 Inventory                           $        600.00                                           4,800
$       600.00 Work in process inventory                                                4,800
               Right to receive defective units                                                              7,200
               Cost of goods sold                  plug                                 7,200
               Adjust inventory to actual and zero out contract asset

                8 Sales                                 plug                                            12,000
            1,000 Accounts receivable (no change)                                                          -
                  Liability to replace defective products                           12,000
                  Adjust liability to zero and reduce sales as necessary            24,000              24,000

       400,000      Net income impact                              992 good units sold
$       400.00      Gross profit for good items:               396,800
             8      Gross profit for replacement items           3,200               400
$       400.00      Profit on returned units                     3,200
                                                             TRUE
Scenario 2
                                     Liability to replace defective products*
                                                                  10,000           (10,000)
                                                                    2,000          (12,000)
                                                12,000                                 -
                                                                                       -

Scenario 2
                                                  Contract Asset
                                                6,000                                   6,000
                                                1,200                                   7,200
                                                                   7,200                  -


THIS IS A DANGEROUS STANDARD AND SUBJECT TO ABUSE:
A company can ship products known to be defective and still book the full amount of the
gross profit. The loss will show up only in FUTURE periods when the expenditures to
repair the defective items are incurred.
Obviously, part of the problem is the lower of cost or market rules which make it hard to get
to anything other than replacement cost as the valuation for the defective units - even if one
must consume the entire profit margin in refurbishment costs!
                   $400 in this example which would wipe out the profits entirely

 IS IT TIME TO CHANGE OR SPECIFY THAT THE "IMPAIRED INVENTORY" BE CARRIED AT REPLACEMENT COST
LESS COST TO COMPLETE?
 In this example, that would be $600 - $150 = $450 per unit into "work in process inventory"


7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx                                                                     Page 3
5/17/2012                                      Ex 4A defective units LCM                      Prepared by Teresa Gordon




ASC 330-10-35-3
> Adjustments to Lower of Cost or Market
35-3 The rule of lower of cost or market is intended to provide a means of measuring the residual usefulness of an
inventory expenditure. The term market is therefore to be interpreted as indicating utility on the inventory date and may
be thought of in terms of the equivalent expenditure which would have to be made in the ordinary course at that date to
procure corresponding utility.

35-4 As a general guide, utility is indicated primarily by the current cost of replacement of the goods as they would be
obtained by purchase or reproduction. In applying the rule, however, judgment must always be exercised and no loss shall
be recognized unless the evidence indicates clearly that a loss has been sustained. There are therefore exceptions to such
a standard. Replacement or reproduction prices would not be appropriate as a measure of utility when the estimated
sales value, reduced by the costs of completion and disposal, is lower, in which case the realizable value so determined
more appropriately measures utility.


35-5 Furthermore, when the evidence indicates that cost will be recovered with an approximately normal profit upon
sale in the ordinary course of business, no loss shall be recognized even though replacement or reproduction costs are
lower. This might be true, for example, in the case of production under firm sales contracts at fixed prices, or when a
reasonable volume of future orders is assured at stable selling prices.

ASC 330-10-10-1 A major objective of accounting for inventories is the proper determination of income through the process o
Market
As used in the phrase lower of cost or market, the term market means current replacement cost (by purchase or by reproduc
 a. Market shall not exceed the net realizable value
 b. Market shall not be less than net realizable value reduced by an allowance for an approximately normal profit margin.




7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx                                                                            Page 4
5/17/2012                              Ex 4A defective units LCM   Prepared by Teresa Gordon




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5/17/2012                              Ex 4A defective units LCM   Prepared by Teresa Gordon




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7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx                                            Page 7
            5/17/2012                                   Ex 4A defective units LCM                 Prepared by Teresa Gordon




ome through the process of matching appropriate costs against revenues.

y purchase or by reproduction, as the case may be) provided that it meets both of the following conditions:

y normal profit margin.




            7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx                                                               Page 8
5/17/2012                                   Ex 4B return units scrapped                   Prepared by Teresa Gordon

 VARIATION          Revenue Recognition Exposure Draft 2010, beginning paragraph IG16
 Example 4 - product warranty that is not a performance obligation
           1,000 units of product sold
 $      1,000.00 price per unit
       1,000,000 Total sales
 $        600.00 Cost per product (finished goods inventory)
         600,000 Total COGS
               1% Estimated returns for replacement of defective products during first 90 days
               10 Estimated units to be returned
             990 Estimated "real" sales in units
 $           -      Defective units are scrapped (no value)
 $           -      Price for a refurbinshed unit (instead of $1,000)
 $        600.00 A logical value for WIP inventory but not per LCM rules in ASC 330-10-35
                    See ASC 330-10-35 quotes below
 $        400.00 Normal profit margin                                                                           40%
 $       (600.00) Profit margin on refurbished items
                    Therefore exception in ASC 330-10-35-5 does not apply
 $           -      Applying ceiling and floor rules (see below), to get value of defective unit
Net Realizable Value
Estimated selling price in the ordinary course of business less reasonably predictable costs of completion and
disposal.
                                                                                                    less cost to
                                                                               selling price
 Market = middle value of                                 $           -                              complete
 $           -      NRV                                   Ceiling           $              -     $              -
 $        600.00 Replacement cost
 $           -      NRV less normal profit margin         Floor             $              -     NRV
 less normal profit margin on sales of                   40%                $              -     Less profit
                                                                            $              -     Floor

At date of shipping or delivery (December)                                       Debit                Credit
                   Accounts receivable (or cash)                                   1,000,000
                   Sales revenue                                                                         990,000
                   Liability to replace defective products*                                               10,000
             990 Cost of goods sold                                                  594,000
           1,000 Inventory                                                                               600,000
                   Right to receive defective units                                      6,000
*This is not a performance obligation

January 31 (no products have been replaced but conditions have changed
New estimate of defective products =                            12
                 instead of original estimate of                10
Modification of contract (?) entry
$        1,000 Liability to replace defective products*                                                        2,000
                 Sales revenue                                                           2,000
$          600 Cost of goods sold                                                                              1,200
                 Right to receive defective units                                        1,200


7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx                                                                       Page 9
5/17/2012                                  Ex 4B return units scrapped                 Prepared by Teresa Gordon



Scenario 1 - defective units are returned exactly in accord with modification
              12 Inventory                             $       600.00                                   7,200
$            -    Work in process inventory                                             -
                  Right to receive defective units                                                      7,200
                  Cost of goods sold                   plug                          14,400
                  Adjust inventory to actual and zero out contract asset

              12 Sales                                     Plug                                       12,000
           1,000 Accounts receivable (no change)                                                         -
                   Liability to replace defective products*                           12,000
                   Adjust liability to zero and reduce sales as necessary          1,629,600        1,629,600
*This is not a performance obligation
        392,800 Net income impact                                       988 good units sold
$         400.00 Gross profit for good units                       395,200
              12 Loss on defective units                             (2,400)
$        (200.00) Unit loss ($1,000-600-600)                         (2,400)
Here there IS A PENALTY for shipping defective                  TRUE
units but it would be quite RARE given our LCM inventory rules
Scenario 1
                                       Liability to replace defective products*
                                                                    10,000           (10,000)
                                                                      2,000          (12,000)
                                                  12,000                                  -
                                                      -                                   -

Scenario 1
                                                 Contract Asset
                                               6,000                                  6,000
                                               1,200                                  7,200
                                                                  7,200                 -




7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx                                                               Page 10
5/17/2012                                   Ex 4B return units scrapped                   Prepared by Teresa Gordon



Scenario 2 - experience is different than estimated
After the modification above, what if customers only return 8 items
within 90 days (insteaed of 12)?                                                 Debit               Credit
                8 Inventory                           $        600.00                                         4,800
$             -   Work in process inventory                                                -
                  Right to receive defective units                                                            7,200
                  Cost of goods sold                  plug                           12,000
                  Adjust inventory to actual and zero out contract asset

                8 Sales                                 plug                                             12,000
            1,000 Accounts receivable (no change)                                                           -
                  Liability to replace defective products                            12,000
                  Adjust liability to zero and reduce sales as necessary             24,000              24,000

       395,200      Net income impact                                 992 good units sold
$       400.00      Gross profit for good items:                  396,800
             8      Loss on defective units                        (1,600)             (200)
$      (200.00)     Unit loss ($1,000-600-600)                     (1,600)
                                                                TRUE
Scenario 2
                                     Liability to replace defective products*
                                                                  10,000            (10,000)
                                                                    2,000           (12,000)
                                                12,000                                  -
                                                                                        -

Scenario 2
                                                     Contract Asset
                                                   6,000                                 6,000
                                                   1,200                                 7,200
                                                                      7,200                -


THIS IS A DANGEROUS STANDARD AND SUBJECT TO ABUSE:
A company can ship products known to be defective and still book the full amount of the
gross profit. The loss will show up only in FUTURE periods when the expenditures to
repair the defective items are incurred.
Obviously, part of the problem is the lower of cost or market rules which make it hard to get
to anything other than replacement cost as the valuation for the defective units - even if one
must consume the entire profit margin in refurbishment costs!
                   $400 in this example which would wipe out the profits entirely

 IS IT TIME TO CHANGE OR SPECIFY THAT THE "IMPAIRED INVENTORY" BE CARRIED AT REPLACEMENT COST
LESS COST TO COMPLETE?
 In this example, that would be $600 - $150 = $450 per unit into "work in process inventory"


7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx                                                                     Page 11
5/17/2012                                       Ex 4B return units scrapped                     Prepared by Teresa Gordon




ASC 330-10-35-3
> Adjustments to Lower of Cost or Market

35-3 The rule of lower of cost or market is intended to provide a means of measuring the residual usefulness of an inventory expenditure
market is therefore to be interpreted as indicating utility on the inventory date and may be thought of in terms of the equivalent expendit
would have to be made in the ordinary course at that date to procure corresponding utility.


35-4 As a general guide, utility is indicated primarily by the current cost of replacement of the goods as they would be obtained by purch
reproduction. In applying the rule, however, judgment must always be exercised and no loss shall be recognized unless the evidence indica
a loss has been sustained. There are therefore exceptions to such a standard. Replacement or reproduction prices would not be appropriat
of utility when the estimated sales value, reduced by the costs of completion and disposal, is lower, in which case the realizable value so de
appropriately measures utility.



35-5 Furthermore, when the evidence indicates that cost will be recovered with an approximately normal profit upon sale in the ordinar
business, no loss shall be recognized even though replacement or reproduction costs are lower. This might be true, for example, in the case
under firm sales contracts at fixed prices, or when a reasonable volume of future orders is assured at stable selling prices.

ASC 330-10-10-1 A major objective of accounting for inventories is the proper determination of income through the process o
Market
As used in the phrase lower of cost or market, the term market means current replacement cost (by purchase or by reproduc
 a. Market shall not exceed the net realizable value
 b. Market shall not be less than net realizable value reduced by an allowance for an approximately normal profit margin.




7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx                                                                              Page 12
5/17/2012                             Ex 4B return units scrapped   Prepared by Teresa Gordon




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5/17/2012                               Ex 4B return units scrapped   Prepared by Teresa Gordon




            -

       990,000    sales
      (594,000)   COGS
        (2,000)   modification
         1,200    modification
        12,000    Sales - second shipment
       (14,400)   COGS
       392,800    gross profit reported




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5/17/2012                               Ex 4B return units scrapped   Prepared by Teresa Gordon




       990,000    sales
      (594,000)   COGS
        (2,000)   modification
         1,200    modification
        12,000    Sales - second shipment
       (12,000)   COGS
       395,200    gross profit reported




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             5/17/2012                                 Ex 4B return units scrapped                Prepared by Teresa Gordon




  of an inventory expenditure. The term
 s of the equivalent expenditure which



 would be obtained by purchase or
 d unless the evidence indicates clearly that
 ces would not be appropriate as a measure
ase the realizable value so determined more




ofit upon sale in the ordinary course of
true, for example, in the case of production
 ling prices.

ome through the process of matching appropriate costs against revenues.

y purchase or by reproduction, as the case may be) provided that it meets both of the following conditions:

y normal profit margin.




             7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx                                                             Page 16
5/17/2012                                                                                                                                                          Prepared by Teresa Gordon


Example 4 - product warranty that is not a performance obligation
     1,000 units of product sold                       A NON-GAAP SOLUTION THAT WOULD BE BETTER THAN THE ED
$ 1,000.00 price per unit
 1,000,000 Total sales
$ 600.00 Cost per product (finished goods inventory)
   600,000 Total COGS
        1% Estimated returns for replacement of defective products during first 90 days
        10 Estimated units to be returned
       990 Estimated "real" sales in units
$ 150.00 Assumed cost of repairs for returned units                    Refurbished units sell for     $    950.00
$ 450.00 A logical value for WIP inventory given desire for normal profit margin to be reported for resale at regular price
              HOWEVER See ASC 330-10-35 quotes below
$ 400.00 Normal profit margin                                                                   40%
$ 200.00 Profit margin on refurbished items                                                     21%
              Therefore exception in ASC 330-10-35-5 does not apply (even though there is still a profit)
              Applying ceiling and floor rules (see below), LCM=       $      600.00
Example 4 - possible "fix" to LCM problem, compared to "scrapped units" sheet
Note that I did NOT make the modification to the original estimate in this set
                                                                                 Example 4            Adjusted WIP Inventory        Abnormal Loss Approach      Implied by ED Solution
                                                                           (without modification)         Possible "FIX" No. 1         Possible "FIX" No. 2          Worthless Scenario
At date of shipping or delivery:                                           Debit          Credit          Debit         Credit         Debit         Credit        Debit          Credit
             Accounts receivable (or cash)                                1,000,000                      1,000,000                    1,000,000                    1,000,000
             Sales (of good product)                                                       990,000                       990,000                      990,000                       990,000
             Liability to replace defective products                                        10,000                        10,000                       10,000                        10,000

        990 Cost of goods sold                                            594,000                             594,000                   594,000                      594,000
     1,000 Inventory                                                                       600,000                       600,000                      600,000                       600,000
               Right to receive defective units                             6,000                               6,000                     6,000                        6,000
Scenario 1
What if customers actually return 13 items within 90 days?
         13 Inventory                                  $         600.00                      7,800                          7,800                       7,800                         7,800
               Work in process inventory               $         450.00     7,800                               5,850                     7,800                            -
               Right to receive defective units                                              6,000                          6,000                       6,000                         6,000
               Cost of goods sold                      plug                 6,000                               7,950                     6,000                       13,800
Remove replacement units from inventory, zero out contract asset, recognize
defective units with any difference adjusted to cost of goods sold
For all variations other than "Fix 1," returned inventory is at $600 LCM


        3 Cost of goods sold (abnormal costs)                600                                                                          1,800
            Work in process inventory                                                                                                                   1,800
Recognize abnormal amounts of wasted materials, labor and other costs



7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx                                              Ex 4C (possible fix)                                                                           Page 17
5/17/2012                                                                                                                                        Prepared by Teresa Gordon


         13 Sales                                      plug                    10,000                     10,000                  10,000                                10,000
               Accounts receivable (no change)                                    -                          -                       -                                     -
               Liability to replace defective products           10,000                        10,000                  10,000                      10,000
Adjust liability to zero and reduce sales as necessary        1,623,800     1,623,800       1,623,800   1,623,800   1,625,600   1,625,600       1,623,800           1,623,800
Scenario 1
       987 Gross profit for good units shipped                     400        394,800            400     394,800         400     394,800                400           394,800
         13 Gross profit for replacement units                     400          5,200            250       3,250         400       5,200                400             5,200
               Less abnormal loss and waste of materials                                                                          (1,800)               600            (7,800)
               Total gross profit recognized                                  400,000                    398,050                 398,200                              392,200
                                                                                                                                            (OR $200 loss per defective unit)




7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx                                 Ex 4C (possible fix)                                                                           Page 18
5/17/2012                                                                                                                                                          Prepared by Teresa Gordon


Example 4 - possible "fix" to LCM problem, compared to "scrapped units" sheet
Note that I did NOT make the modification to the original estimate in this set Example 4            Adjusted WIP Inventory        Abnormal Loss Approach      Implied by ED Solution
                                                                         Solution per ED Example        Possible "FIX" No. 1         Possible "FIX" No. 2          Worthless Scenario
Scenario 2                                                               Debit          Credit          Debit         Credit         Debit         Credit          Debit              Credit
What if customers only return 8 items within 90 days?
         8 Inventory                                 $        600.00                       4,800                          4,800                       4,800                                4,800
$ 450.00 Work in process inventory                                          4,800                            3,600                      4,800                              -
             Right to receive defective units                                              6,000                          6,000                       6,000                                6,000
             Cost of goods sold                      plug                   6,000                            7,200                      6,000                         10,800
             Adjust inventory to actual and zero out contract asset

       -    Cost of goods sold (abnormal costs)              600
            Work in process inventory
Recognize abnormal amounts of wasted materials, labor and other costs

             Sales                                     plug                               10,000                         10,000                      10,000                               10,000
             Accounts receivable (no change)                                                 -                              -                           -                                    -
             Liability to replace defective products                       10,000                           10,000                     10,000                         10,000
             Adjust liability to zero and reduce sales as necessary        20,800         20,800            20,800       20,800        20,800        20,800           20,800              20,800
Scenario 2
       992 Gross profit for good units shipped                                400      396,800                400      396,800            400       396,800                400          396,800
         8 Gross profit for replacement units                                 400        3,200                250        2,000            400         3,200                400            3,200
            Less abnormal loss and waste of materials                                                                                                                      600           (4,800)
            Total gross profit recognized                                              400,000                         398,800                      400,000                             395,200
Note that "abnormal loss" has no effect unless the defective returns were UNDER-ESTIMATED                                                                     (OR $200 loss per defective unit)




7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx                                            Ex 4C (possible fix)                                                                                  Page 19
5/17/2012                                                          Prepared by Teresa Gordon




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5/17/2012                                                          Prepared by Teresa Gordon




  990,000    Revenue - orig
 (594,000)   COGS - orig
   10,000    Revenue at expiration
  (13,800)   addl cogs
  392,200




7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx   Ex 4C (possible fix)                    Page 21
5/17/2012                                                          Prepared by Teresa Gordon




  990,000    Revenue - orig
 (594,000)   COGS - orig
   10,000    Revenue at expiration
  (10,800)   addl cogs
  395,200




7959ed8a-308c-4116-9687-3ff9ec3e7b4b.xlsx   Ex 4C (possible fix)                    Page 22

								
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