300 SECTION 1 The Role of Accounting as an Information System quarter 1997, which usually sell best in the fourth quarter, as well as unusually high sales of barbeque grills for the fourth quarter. Soon after, Sunbeam announced a first quarter loss of $44.6 million, and Sunbeam’s stock price fell 25 percent. It eventually came to light that Dunlap and Sunbeam had been using a “bill and hold” strategy with retail buyers. This involved selling products at large discounts to retailers before they normally would buy and then holding the products in third-party warehouses, with delivery at a later date. Many felt Sunbeam had deceived shareholders by artificially inflating earnings and the company’s stock price. A class-action lawsuit followed, alleging that Sunbeam and Dunlap violated federal securities laws, suggesting the motivation to inflate the earnings and stock price was to allow Sunbeam to complete hundreds of millions of dollars of debt financing in order to complete some ongoing mergers. Shareholders alleged damages when Sunbeam’s subsequent earnings decline caused a huge drop in the stock price. Required: 1. How might Sunbeam’s 1997 “bill and hold” strategy have contributed to artificially high earnings in 1997? 2. How would the strategy have led to the unusually high accounts receivable Paine Webber noticed? 3. How might Sunbeam’s 1997 “bill and hold” strategy have contributed to a 1998 earnings decline? 4. How does earnings management of this type affect earnings quality? Two accounting students were discussing the timing of revenue recognition for long-term construction contracts. The discussion focused on which method was most like the typical revenue recognition method of recognizing revenue at the point of product delivery. Bill argued that recognizing revenue upon project completion was preferable because it was analogous to recognizing revenue at the point of delivery. John disagreed and supported recognizing revenue over time, stating that it was analogous to accruing revenue as a performance obligation was satisfied. John also pointed out that an advantage of recognizing revenue over time is that it provides information sooner to users. Required: Discuss the arguments made by both students. Which argument do you support? Why? Willingham Construction is in the business of building high-priced, custom, single-family homes. The company, headquartered in Anaheim, California, operates throughout the Southern California area. The construction period for the average home built by Willingham is six months, although some homes have taken as long as nine months. You have just been hired by Willingham as the assistant controller and one of your first tasks is to evaluate the company’s revenue recognition policy. The company presently recognizes revenue upon completion for all of its projects and management is now considering whether revenue recognition over time is appropriate. Required: Write a 1- to 2-page memo to Virginia Reynolds, company controller, describing the differences between the effects of recognizing revenue over time and upon project completion on the income statement and balance sheet. Indicate any criteria specifying when revenue should be recognized. Be sure to include references to GAAP as they pertain to the choice of method. Do not address the differential effects on income taxes nor the effect on the financial statements of switching between methods. Performance and profitability of a company often are evaluated using the financial information provided by a firm’s annual report in comparison with other firms in the same industry. Ratios are useful in this assessment. Required: Obtain annual reports from two corporations in the same primary industry. Using techniques you learned in this chapter and any analysis you consider useful, respond to the following questions: 1. How do earnings trends compare in terms of both the direction and stability of income? 2. Which of the two firms had greater earnings relative to resources available? 3. How efficiently are current assets managed? 4. Has each of the companies achieved its respective rate of return on assets with similar combinations of profit margin and turnover? 5. Are there differences in accounting methods that should be taken into account when making comparisons? Note: You can obtain copies of annual reports from friends who are shareholders, the investor relations department of the corporations, from a friendly stockbroker, or from EDGAR (Electronic Data Gathering, Analysis, and Retrieval) on the Internet ( www.sec.gov ). You are a part-time financial advisor. A client is considering an investment in common stock of a waste recycling firm. One motivation is a rumor the client heard that the company made huge investments in a new fuel creation process. Unable to confirm the rumor, your client asks you to determine whether the firm’s assets had recently increased significantly. Because the firm is small, information is sparse. Last quarter’s interim report showed total assets of $324 million, approximately the same as last year’s annual report. The only information more current than that is a press release last week in which the company’s management reported “record net income for the year of $21 million, Judgment Case 5–12 Revenue recognition; longterm construction contracts ● LO5–9 Communication Case 5–13 Long-term contract; revenue recognition over time vs. upon project completion ● LO5–9 Analysis Case 5–14 Evaluating profitability and asset management; obtain and compare annual reports from companies in the same industry ● LO5–10 Judgment Case 5–15 Relationships among ratios; Chapters 3 and 5 ● LO5–10
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