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. 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

3.

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 Noncurrent 64.1 Total $84.9 million Operating preserves $43.8 million 13.7% 42.2% 55.9% 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). 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.

C.

Solutions Chapter 2- P. 8

14.{M}A.& B. ATTs adjusted income before nonrecurring charges is computed by adding back the non-recurring charges to reported income. All Data in Billions of $
Revenues Income Reported Restructuring Adjusted 1985 63.2 3.6 0.0 3.6 1986 62.0 1.0 3.2 4.2 1987 60.7 4.1 0.0 4.1 1988 62.1 -2.5 6.7 4.2 1989 61.6 4.8 0.0 4.8 1990 1991 1992 1993 1994 1995 63.2 64.5 66.6 69.4 75.1 79.6 5.4 0.0 5.4 1.4 4.5 5.9 6.5 0.0 6.5 6.5 0.5 7.0 7.9 0.0 7.9 1.2 7.8 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 8 6 Income 4 2 0 1985 1988 1991 1992 1993 1994 -2 -4 1995 1986 1987 1989 1990 80 70 60 Revenues 50 40 30 20 10 0 Reported Adjusted Revenues

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&Ts 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&Ts 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 8 6 Income 4 2 0 1985 1987 1988 1989 1990 1991 1994 -2 -4 1995 1986 1992 1993 80 70 60 Revenues 50 40 30 20 10 0 Reported Adjusted Smoothed Revenues

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 ATTs 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. 403406 of the text, that statement is debatable.]

Solutions Chapter 2- P. 10