Here is the scenario:
Outdoors R Us owns several membership-based campground resorts throughout the Southwest. The company sells campground sites to new members, usually during a get-acquainted visit and tour. The campgrounds offer a wider array of on-site facilities than most. New members sign a multi-year contract, pay a down payment, and make monthly installment payments. Because no credit check is made and many memberships originate on a spur-of-the-moment basis, cancellations are not uncommon.
Business has been brisk during its first three years of operations, and since going public in 2000; the market value of its stock has tripled. The first sign of trouble came in 2013 when the new sales dipped sharply.
One afternoon, two weeks before the end of the fiscal year, Diane Rice, CEO, and Gene Sun, controller, were having active discussions in Sun’s office.
Sun: I’ve thought more about our discussion yesterday. Maybe something can be done about profits.
Rice: I hope so. Our bonuses and stock value are riding on this period’s performance.
Sun: We’ve been recording unearned revenues when new members sign up. Rather than recording liabilities at the time memberships are sold, I think we can justify reporting sales revenue for all memberships sold.
Rice: What will be the effect on profits?
Sun: I haven’t run the numbers yet, but let’s just say very favorable.
Consider these questions:
1. Why do you think liabilities had been recorded previously?
2. Is the proposal ethical?
3. Who would be affected if the proposal were implement?
Comment 1. Hi Class,
The reason why the unearned revenue liabilities had been being recorded in the first place is because the members make a refundable down payment on the contract and their own records indicate a certain percentage of cancellations. Therefore, the initial payment can’t be counted on because no service has been provided yet. As the book says “When revenue recognition is delayed, but some advanced payment is received, the seller reports an unearned revenue liability until delivery has occurred.”
Obviously, recording the entire amount of sales as revenue all at once would increase profits. However, they’re setting themselves up to take a big hit within a few months since they can expect some cancellations. Those would have to be recorded as an expense when refunded. It would be unethical to report the revenue in this situation.
Aside from misrepresenting financials to stockholders, implementing the proposal could impact the customers. The decision might have a snowball effect when Sun and Rice realize what’s going to happen to profits when they have to record the cancellations as expenses. It’s possible they could start making it harder to get a refund in order to continue to hide the first decision. Eventually the reputation of the business would decline.
Comment 2. Hi Class,
I usually have to do some re-reading and lots of thinking before I post my initial discussion, but this week’s prompt is a slam-dunk. Gene Sun’s proposal of recording the memberships as revenue when new members sign up is a clear violation of the realization principle. The realization principle has 2 criteria that dictate when revenue can be recognized: 1) “earnings process is judged to be complete or virtually complete”, and 2) “there is reasonable certainty of the collectability of the asset to be received”. Gene’s suggestion does not meet either criterion. The earnings process is nowhere near complete when members sign up because their membership spans over a multi-year contract, which means the company has a responsibility (liability) to provide the membership service in the future. And because the prompt tells us that “cancellations are not uncommon”, there is not reasonable certainty that the company will get the money for all memberships.
The correct way to record these membership transactions is to debit the asset account cash or accounts receivable and credit the liability account unearned revenue (perhaps payment advance for the initial down payment). Adjusting entries would then be made as the memberships are provided and used each month.
If the CEO followed Gene’s suggestion, revenue (and therefore net income) would be overstated. They are also setting themselves up for failure in future periods when the revenue that should have been spread out over multiple years was only recorded in the first year. Investors would be misleading by the 2013 financial statements and could make poor decisions based off the inaccurate information. There’s a good chance Gene would lose his job after this unethical practice comes to light.