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Case 5-2: Grennell Farm Note: This case has been updated from the Tenth Edition.

Approach This case is a good illustration of a situation where revenue recognition is not a cut-and-dried question. It also provides excellent reinforcement of the matching concept and statement articulation. The alternatives discussed are: (1) the production method, which recognizes inventory holding gains as revenue; (2) the sales method, which is analogous to the financial accounting method of revenue recognition of most manufacturers and retailers; and (3) the collection method, which recognizes revenues as collected, but is not quite the same as cash-basis accounting (since costs are accrued). While either the production method or sales method is acceptable under GAAP, that is really a moot point since Denise Grey is the sole owner of the incorporated farm, and not bound by GAAP. Once the issue of how much revenue to recognize is resolved, then how much expense to match can be dealt with. Together, these two issues determine how much gross profit Grennell farm will be shown as earning.

Question 1
The calculations shown below for Question 1 show the range of sales figures under different recognition methods. I start with the sales method, then do the collection method, and save the more unusual production method until last. An issue is whether the entire $183,000 annual costs not related to the volume of production should be treated as product or period expense. Unless the instructor for some reason is using this case after Chapter 6, the students may not recognize this as an issue or, if they do, not know how to deal with it in the financial statements. In any event, I think it worthwhile for the instructor to note that these expenses are by definition fixed (do not vary with production volume), but that some (especially a portion of salaries and wages) may be production costs and hence strictly speaking should be used in valuing inventory. (Students often mistakenly use fixed costs and period costs as synonyms.) Of course, the point of Question 1 is not just practice in revenue and expense matching calculations, but thinking about which is the most appropriate method. For tax purposes, Grey will want to use the collection method. For evaluating the performance of the farm in 2001, the production method would seem most useful. This is because there is very little uncertainty concerning the eventual sale of the 30,000-bushel wheat inventory stored at the farm. This inventory exists, not because there are no customers for it, but because the farm manager chose not to sell it, speculating that future prices will be higher. This is the same reasoning that justifies this unusual revenue recognition method as GAAP; the same method is also allowed for precious metals and other minerals where immediate marketability at quoted prices obtains. Also, many professional service firms (e.g., accounting firms) recognize revenue as work is performed by recording jobs in progress at billing rates rather than at cost. The name Unbilled Receivables is often used for this account to emphasize that the revenue has already been recognized, even though it has not yet been billed.

Exhibit A
Collect the cash from the customer Customer acknowledges receipt of the item Ship the product to the customer and send a sales invoice Receive an order for the product from a customer Collection Method Purchase raw material

Usual Method (Delivery Method)

Convert the raw material to a finished product

Inspect the product Production Method Store the product in a warehouse

To generalize the discussion, I put on the board a cash cycle diagram like the one in Exhibit A to this note. Starting with purchases, I go around this wheel and add to its interior the three points at which revenue can be recognized: these correspond to the three methods in the case, including the usual method of recognizing revenue when goods are shipped. When is the correct point to recognize revenue? This diagram points out that the answer is not clear-cut. Conservatism would say do not recognize the revenue until there is very little uncertainty as to receipt of the cash proceeds, driving the revenue recognition toward the collection point. Timeliness would argue for recognizing the revenue when the critical event or performance has taken place, in this instance as soon as a certainly salable product has been produced, i.e., the production method for Grennell. The measurability of income criterion does not help select a method in this instance, as the Question I calculations are feasible for all three methods.

Question 2
The original cost of the land was only $187.50 an acre: it is now appraised (for estate tax purposes) at $1,050 per acre, or $2.1 million. The cost concept says that, at least prior to the transfer of ownership to Grey (and possibly even afterwards), the balance sheet will show the land at its cost, $375,000. However, again GAAP need not prevail here, for Grey is trying to assess the economic attractiveness of the farm. Since she could sell the land for $2.1 million (or more, if the estate tax valuation was below market) and invest the proceeds elsewhere, she will likely want to use the higher valuation in her assessment. (Again, this is an argument often given for stating assets at current values: the asset is, in effect, tying up $2.1 million, not $375,000.) If Grey wants to think of selling only the 100 acres for the development, then she may think of the land value as $2.22 million (1,900 * $1,050 plus $225,000). The point is that the $375,000 historical cost is the least relevant for Greys purposes.

Question 3
Assuming Grey agrees that the combination of the production method of revenue recognition and the $2.22 million land valuation best serve her appraisal purposes, then in 2001 we have $323,370 net income on an owners equity investment of $2,482,100 ($637,100 plus $1,845,000 write-up of land), or a 13 percent before-tax return on investment. When one considers future appreciation of the land, this may well be a better investment than Grey would be able to make with the proceeds from selling the farm.

GRENNELL FARM Income Statements


Sales $522,000 0 107,730 15,390 92,340 429,660 183,000 $246,660 Method: Collection Production $462,4001 $614,1005 0 107,730 25,6503 82,080 380,320 183,000 $197,320 0 107,730 06 107,730 506,370 183,000 $323,370

Sales ............................................................................... Cost of goods sold Beginning inventory ........................................... Production.......................................................... Less: Ending inventory....................................... Cost of goods sold .............................................. Gross margin .................................................................. Other expenses .............................................................. Net Income ..................................................................... Balance Sheets Cash ............................................................................... Accounts receivable ........................................................ Inventory ........................................................................ Land ............................................................................... Buildings and machinery (net) ........................................ Total assets ........................................................ Liabilities (current) ......................................................... Owners equity8 .............................................................. Common stock and APIC ................................... Retained earnings ............................................... Total owners equity ....................................................... Total liabilities and owners equity .................................

$ 30,900 59,600 15,390 375,000 112,500 593,390 33,000 457,500 102,890 560,390 $593,390

$ 30,900 04 25,650 375,000 112,500 544,050 33,000 457,500 53,550 511,050 $544,050

$ 30,900 151,7007 0 375,000 112,500 670,100 33,000 457,500 179,600 637,100 $670,100

Notes: 1 180,000 bushels @ $2.90 - 20,000 bushels @ $2.98 = 160,000 but @ $2.89. 2 2210,000 bushels @ $.513 = $107,730. 3 30,000 bushels physically in inventory plus 30,000 bushels inventory at the elevator, reflecting payment not yet received from the elevator operator. 4 Under the collection method there are no accounts receivable, since sales revenues are not recognized until the collection is made. 5 30,000 bushels @ $3.07 + 180,000 bushels @ S2.90. Another approach is as follows: 210,000 bushels @ $2.80 = 180,000 bushels @ 0.10 = 30,000 bushels @ $0.27 = $588,000 (value at harvest) 18,000 (gain on sales to elevator) 606,000 8,100 (write-up to year-end value) $614,100

Given the texts description of the production method, I treat S606,000 as an acceptable answer, but point out the logic of writing up the 30,000 bushels on hand for purposes of the year-end balance sheet. 6 Although there are 30,000 bushels physically in inventory, under the production method all wheat is counted as sold, and hence is not in inventory in an accounting sense. 7 This includes the $59,600 real receivable plus $92,100 recorded as revenue on the 30,000 bushels produced but not physically sold. Students may create a different account for this $92,100, for example, Unbilled Receivables, which is fine. 8 If you assume that the case statement Grennell withdrew most of the earnings means that Retained Earnings at the beginning of the year was zero, then the 2001 drawings can be determined as follows: Sales Collections $ 0 $ 0 246,660 197,320 102,890 53,550 $143,770 $143,770 Production $ 0 323,370 179,600 $143,770

Beginning Retained Earnings ......................................... Plus: Net Income ........................................................... Less: Ending Retained Earnings ..................................... Drawings ..........................................................

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