(Revenue and expense recognition principles)after the presentation of your repor
ID: 2350198 • Letter: #
Question
(Revenue and expense recognition principles)after the presentation of your report on the examination of the financial statements to the board of directors of piper publishing company, one of the new directors expresses surprise that the income statement assumes that an equal proportion of the revenue is earned with the publication of every issue of the company's magazine. she feels that the "crucial event" in the process of earning revenue in the magazine business is the cash sale of the subscription. she says that she does not understand why most of the revenue cannot be "recognized" in the period of the sale. (a)list the various accepted times for recognizing revenue in hte accounts and explain when the methods are appropriate (b)discuss the propriety of timing the recognition of revenue in piper publishing company's accounts with: (1)the cash sale of the magazine subscription (2)the publication of the magazine every month (3)both events, by recognizing a portion of the revenue with the cash sale of the magazine subcription and a portion of the revenue with the publication of the magazine every monthExplanation / Answer
CA 2-5 (a) The various accepted times of recognizing revenue in the accounts are as follows: (1) Time of sale. This time is currently acceptable when the costs and expenses related to the particular transaction are reasonably determinable at the time of sale and when the collection of the sales price is reasonably certain. (2) At completion. This time is currently acceptable in extractive industries where the salability of the product at a quoted price is likely and in the agricultural industry where there is a quoted price for the product and only Iow additional costs of delivery to the market remain. (3) During production. This time is currently acceptable when the revenue is known from the contract and total cost can be estimated to determine percentage of completion. (4) At collection. This time is currently acceptable when collections are received in installments, when there are substantial “after costs” that unless anticipated would have the effect of overstating income on a sales basis in the period of sale, and when collection risks are high. (b) (1) The “crucial event”–that is, the most difficult task in the cycle of a complete transaction–in the process of earning revenue may or may not coincide with the rendering of service to the subscriber. The new director suggests that they do not coincide in the magazine business and that revenue from subscription sales and advertising should be recognized in the accounts when the difficult task of selling is accomplished and not when the magazines are published to fill the subscriptions or to carry the advertising. The director’s view that there is a single crucial event in the process of earning revenue in the magazine business is questionable even though the amount of revenue is determinable when the subscription is sold. Although the firm cannot prosper without good advertising contracts and while advertising rates depend substantially on magazine sales, it also is true that readers will not renew their subscriptions unless the content of the magazine pleases them. Unless subscriptions are obtained at prices that provide for the recovery in the first subscription period of all costs of selling and filling those subscriptions, the editorial and publishing activities are as crucial as the sale in the earning of the revenue. Even if the subscription rate does provide for the recovery of all associated costs within the first period, however, the editorial and publishing activities still would be important since the firm has an obligation (in the amount of the present value of the costs expected to be incurred in connection with the editorial and publication activities) to produce and deliver the magazine. Not until this obligation is fulfilled should the revenue associated with it be recognized in the accounts since the revenue is the result of accomplishing two difficult economic tasks (selling and filling subscriptions) and not just the first one. The director’s view also presumes that the cost of publishing the magazines can be computed accurately at or close to the time of the subscription sale despite uncertainty about possible changes in the prices of the factors of production and variations in efficiency. Hence, only a portion–not most–of the revenue should be recognized in the accounts at the time the subscription is sold. (2) Recognizing in the accounts all the revenue in equal portions with the publication of the magazine every month is subject to some of the same criticism from the standpoint of theory as the suggestion that all or most of the revenue be recognized in the accounts at the time the subscription is sold. Although the journalistic efforts of the magazine are important in the process of earning revenue, the firm could not prosper without magazine sales and the advertising that results from paid circulation. Hence, some revenue should be recognized in the accounts at the time of the subscription sale. This alternative, even though it does not recognize revenue in the accounts quite as fast as it is earned, is preferable to the first alternative because a greater proportion of the process of earning revenue is associated with the monthly publication of the magazine than with the subscription sale. For this reason, and because the task of estimating the amount of revenue associated with the subscription sale often has been considered subjective, recognizing revenue in the accounts with the monthly publication of the magazine has received support even though it does not meet the tests of revenue recognition as well as the next alternative. (3) Recognizing in the accounts a portion of the revenue at the time a cash subscription is obtained and a portion each time an issue is published meets the tests of revenue recognition better than the other two alternatives. A portion of the net income is recognized in the accounts at the time of each major or crucial event. Each crucial event is clearly discernible and is a time of interaction between the publisher and subscriber. A legal sale is transacted before any revenue is recognized in the accounts. Prior to the time the revenue is recognized in the accounts, it already has been received in distributable form. Finally, the total revenue is measurable with more than the usual certainty, and the revenue attributable to each crucial event is determinable using reasonable (although sometimes conceptually unsatisfactory) assumptions about the relationship between revenue and costs when the costs are indirect.
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