Accounting Issues: Service Revenue, Accounts Receivable, Prepaid Advertising, Alan Summit Receivable

Service Revenue

KSEC has included service revenue of $22,100 as a result of a number of one-year service policies sold late in December as an “experiment.” These service policies became effective on January 1, 20X8, or shortly thereafter.

The policies are sold at an average of $600 per year per customer; the $22,100 represents the total cash received as of year-end (debit cash, credit service revenue). The $600 per customer amount was arrived at by an analysis of previous service provided on a “fee for service” basis to customers. The average cost to KSEC wasapproximately $200 per visit, with an average of 1.7visits per year to customers. While the service policies allow unlimited visits for service, KSEChas restrictedthe number of policies available due to difficulties in calculating the costs associated with such policies. KSEC estimates that the number service calls is likely to increase to about 4 per year; the cost is expected to decrease to around $150 per call. So, at this point, the program is projected to break even. The aggressive pricing of the service policies is due to (1) the experimental nature of the program and (2) a desire to maintain long-term customer loyalty for future purchases of equipment.

What entry or disclosure, if any, is necessary in this circumstance?

At year-end KSEC has $110,000 in accounts receivables from officers on the books. The Board of Directors approved these loans which are in the form of “demand” notes. One of the staff assistants asked whether there was any intent to require officers to pay back these loans. Kate Kiefer and Jan Wiggs, who each owe 1/2 of the total amount outstanding, agreed that while not much thought had been given to it, they imagined that they might someday repay the loans. On the other hand, they thought that the Board of Directors might forgive the loans some year in lieu of their annual bonus.

What entry or disclosure, if any, is necessary in this circumstance?

On November 1, 20X7 KSEC paid $30,000 in advance for eight months of advertising on radio station KNEWZ, a local news station. The entry was recorded with a debit to prepaid advertising and a credit to cash. At December 31, 20X7 KSEC expensed $7,500 (debit to advertising expense and credit to prepaid advertising for 2 of the 8 months). Earlier, on December 29, 20X7 KSEC received a letter from KNEWZ indicating that the radio station was changing its format on January 1, 20X7 to “classic heavy metal.” In brief, news is being replaced by old songs of Phish, Ozzie Osbourne, and Metallica. It will now use the call letters KDEV.

Accounts Receivable From Officers

Although KSEC has no real data on this, it is management’s impression that most Ozzie Osbourne fans buy less sporting equipment systems than news station listeners. Accordingly, management attempted to cancel the agreement and receive a refund. Regrettably, the contract for the advertising provides no assurances about a change in station format and KSEC’s lawyerssay that obtaining any recovery in a court proceeding is doubtful. KDEV has refused any attempts at renegotiation and has suggested that KSEC might be surprised at the number of customers that might respond to the commercials. KDEV is even willing to work with KSEC to redo commercials eliminating the old ones that used the “sappy sounding” news announcers and replacing them with commercials using their new announcers; KDEV is willing to record these commercials for no additional cost. KSEC management still questions whether the advertising will be well placed but does believe that there may be a few listeners who might respond to the advertisement. KSEC legal counsel suggests that it is not worth pursuing this matter further.

What entry or disclosure, if any, is necessary in this circumstance?

Alan Summit Company (Alan Summit) owes KSEC $82,000 for a sports equipment that was purchased in March of 20X7. Alan Summit has run into financial difficulties due to dramaticdecreases in the selling price of climbing equipment during recent years. In August of 20X7 Kate Kiefer (KSEC president) and Jan Wiggs (KSEC controller) established a repayment schedule in which Alan Summit would repay $10,000 per month (plus interest). While the first payment was made in September (bringing the debt down from $92,000 to $82,000), no further payments have been received. (Alan Summit has continued to make small purchases from KSEC on a “cash” basis.)

Your discussion with management indicates that Alan Summit received a “going concern” modification from its auditors for the year ended 8/30/X7 (the audit report was dated 10/22/X7). The going concern modification arose due to a question concerning whether Alan Summit can obtain new financing when needed, on June 30, 20X8. However, the situation is not entirely bleak for Alan Summit’s future as layoffs of 1/3 of the company’s employees resulted in a situation in which Alan Summit operated at break even for the year ended 8/30X7. Alan Summit has discussed filing for bankruptcy with bankruptcy legal counsel and at this point believes it is unnecessary. But, if it becomes necessary, counsel suggests that creditors shouldn’t expect to receive more than 50 cents on the dollar. Management has suggested to you that 70 cents on the dollar is more likely if bankruptcy ensues. Your analysis at the date of both the Alan Summit audited annual statements (8/30/X7) and the interim statements (11/30/X7) indicates that if bankruptcy is declared, a recovery of 50-60 cents on the dollar (with no amount more probable than another in that range) is likely. Yet, it’s difficult to know what the situation will be in the future.

Prepaid Advertising

The sales agreement for the sports equipment allows KSEC to repossess the equipment at any time prior to bankruptcy. But, because the equipment is used and specific to Alan Summit’s applications, management believes that the equipment could be sold for a (net) of between$20,000 and $30,000. Also, management points out that such an action would not be considered positively by either Alan Summit or a number of other companies that KSEC is attempting to attract as clients. Accordingly, KSEC has resisted this option and does not intend to pursue it at this time.

Your analysis of the interim statements (unaudited) reveals that Alan Summit operated at a slight profit during the first quarter and that climbing equipment prices have increased approximately 15 percent. However, experts disagree widely as to future climbing equipment prices as there is some concern that a significant increase in climbing equipment from India may enter the USmarket. Finally, Alan Summit management, although noncommittal on details, suggests that it believes that it will be able to continue repayments on the debt within the “next few months.” But your feeling is that it is probable that Alan Summit will be forced to file for bankruptcy. No allowance for this account is currently included in the allowance for doubtful accounts.

What, if any, loss reserve (and/or note disclosure) should be reflected in the financial statements?

Included in KSEC’s inventory (valued using the LIFO method) are the following:

• $100,000 (cost) of sports equipment which manufacturers ceased producing in the middle of 20X7. Although the wholesale value of the sports equipment now is only about $60,000, the retail value (if they could all be sold today, which they can’t be) is approximately $110,000. The selling costs of these specific equipment are considered negligible, and a normal profitmargin is approximately 25% of sales price. The retail market is “thin” and it will take some time to sell the equipment. Management intends to sell all of the equipment at retail and believes that the retail value of the equipment is likely to decrease at an average rate of 5 percent every quarter for the next year; thus, on average equipment with a retail value of $1,000 on 12/31/X3 would have an average retail value of $950 and $900 during the first two quarters of 20X8, respectively. Management believes that the equipment will be sold within the next year as follows--first quarter 40% of inventory, second quarter 35%, third quarter 20 %, and fourth quarter 5% at market values at the time of sale. These projections seem reasonable. It is currently February 15 and younote that sales are right on schedule and that retail prices have dropped a bit from year-end, as projected.
• Because of discontinuance of the above equipment, many suppliers of parts for the equipment have chosen to quit manufacturing the items with the result that shortages are occurring. As a result, KSEC’s $50,000 inventory of parts for these machines has increased in value and would now cost $65,000 to replace (its retail value is $110,000). Historically, the normal profit margin on sales of parts is 40% of sales price. Also, management has pointed out to you that equipment in inventory that don’t sell could be used for parts. But management does not anticipate the need to do this.
• Historically, KSEC (and competitors) have in general separated Equipment from Parts when calculating the lower of cost or market for inventory.

Does KSEC need to record an inventory write-down to reflect a lower of cost or market value? If so, how much?

On “Bring Your Daughters and Sons to Work Day” at Winglo Corporation not only did Sandy Gilhaus, a Winglo employee, bring her ten year old daughter Sarah to work, but KSEC also demonstrated new sport equipment at Winglo on that day. After the demonstration of a highly sophisticated machine, Sandy attempted to adjust the monitor on the machine. She inadvertently knocked the machine off the desk and onto the floor. It shattered with a piece of the metal striking Sarah’s right big toe. To make a long story short, Sarah’s toe needed four stitches to stop the bleeding and Sandy has blamed the demonstrator of the machine for placing it in a dangerous position. The damages to this point have been minimal as Sandy drove Sarah to their HMO and paid the $20 copay for an office visit. Yet, the Gilhaus family has sued KSEC for the following:

Likely future plastic surgery $ 5,000

Emotional distress to Sarah 500,000

Emotional distress to Sandy 1,200,000

Total $1,705,000

KSEC’s lawyers believe that this case, with the possible exception of the plastic surgery (for which the HMO won’t pay), is frivolous. KSEC has no insurance to cover this sort of liability. If this case goes to court, KSEC’s on staff attorneys will handle the case. To eliminate any possiblebad press from this case, KSEC’s lawyers suggested settling for a “nuisance value” of $10,000.Sarah’s family rejected this offer out of hand and asked for $200,000 to settle this out of court. KSEC has decided, at least at this point, to refuse any further settlement offer.

In their lawyer’s letter to you KSEC’s lawyers indicated that they believe that KSEC has “just and meritorious defense available” to fight this case. Furthermore, KSEC’s legal counsel for the case indicated that while she agrees that this case is largely frivolous, litigation involving a young child is somewhat of a “crap shoot” and that making a definite prediction on the outcomeof the case is impossible. In the end she believes the judgment will likely be $5,000 for the plastic surgery. What entry or disclosure, if any, is necessary in this circumstance?