daily grind case daily grind, inc. (“daily grind”), a public company, manufactures and...
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Daily Grind Case
Daily Grind, Inc. (“Daily Grind”), a public company, manufactures and distributes branded personal organizers for sale in its company-operated retail stores. Daily Grind also sells its products to wholesalers through various royalty and license arrangements.
Daily Grind negotiated a License Agreement with Pacific Paper Products (“Pacific”), a major manufacturer and distributor of office supplies.
Pacific will have the right to distribute Daily Grind products to a specified retail channel in the United States. Based on the current demand for Daily Grind’s products, Pacific believes that inclusion of certain Daily Grind organizers in its product mix will increase the awareness of, and hence the value of, other Pacific products.
As consideration under the terms of the License Agreement, Pacific will pay Daily Grind a license fee of approximately $12 million for the right to use the Daily Grind trademarks for an indefinite term. Termination of the separate Supply and Royalty Agreement (see below) or execution of licensing or distribution agreements with competitors of Daily Grind constitutes a material breach that would cause the License Agreement to terminate.
Daily Grind Case
The License Agreement specifies that the license fee is earned, payable, and contractually non-refundable as of the date of execution of the License Agreement.
Daily Grind and Pacific also entered into a separate Supply and Royalty Agreement. Based on this agreement, Daily Grind will allow Pacific to distribute personal organizers manufactured by Daily Grind to a specified retail channel in the United States. As part of the Supply and Royalty Agreement, Pacific agreed to pay Daily Grind quarterly royalty payments based upon a predetermined royalty schedule. If Daily Grind cannot or does not provide the amount of product Pacific requires under the Supply and Royalty Agreement, Pacific maintains the right to enter into a separate manufacturing contract that would allow Pacific to use certain of Daily Grind’s proprietary production methods.
The sales terms (e.g., price, discounts) under the Supply and Royalty Agreement do not differ from the terms of other arrangements Daily Grind has with third parties to sell its products. The Supply and Royalty Agreement will expire ten years from the date of its execution and will renew automatically for successive ten-year terms thereafter, unless a material breach of contract occurs. Termination of the License Agreement (see above), non-payment of royalties due, or failure to meet sales performance goals would constitute a material breach under the terms of the Supply and Royalty Agreement. An independent party has evaluated the sales performance goals and has deemed them to be substantive.
Daily Grind Case
Daily Grind has experience in both license and royalty arrangements and believes that both the License Agreement and the Supply and Royalty Agreement are priced at their respective fair values. Further supporting their conclusions, Daily Grind plans to engage an independent valuation expert to verify that the terms of the agreements are at fair value.
Required: Is it appropriate for Daily Grind to recognize the $12 million payment from Pacific under the terms of the License Agreement as revenue upon execution of the License Agreement?
Daily Grind Case
An assessment must be made to determine if, in essence, the $12 million nonrefundable fee was to obtain the on-going right to obtain and sell Daily Grind’s products or if Pacific places a separate value on the License Agreement.
With regard to loan origination fees that are assessed by a creditor for the origination of a loan, paragraph 37 of FASB Statement No. 91, states the following: “The Board concluded that loan origination fees and direct loan origination costs should be accounted for as components of a loan's acquisition cost and recognized as an adjustment to the yield of the related loan. The Board considered and rejected the argument that loan origination is a separate revenue-producing activity and concluded that originating loans is but one means of acquiring a loan.”
Daily Grind Case
SAB No. 101 states, “unless the up-front fee is in exchange for products delivered or services performed that represent the culmination of the earnings process, the deferral of revenue is appropriate.”
Daily Grind Case--Conclusion
1. Given that termination of the License Agreement or the Supply and Royalty Agreement would result in termination of the other corresponding agreement, signing the License Agreement was not a discrete event for which the earnings process had been culminated.
2. Further, as the License Agreement has an indefinite term and the Supply and Royalty Agreement has an initial ten-year term that renews automatically for successive ten-year terms, revenue from the License Agreement should be recognized over the initial contract period (or longer if the relationship with Pacific is expected to extend beyond the initial term and Pacific continues to benefit from the payment of the up-front fee).
Revenue Recognition Over Time
Completed Contract Method
Completed Contract Method
Percentage-of-Completion
Method
Percentage-of-Completion
Method
Long-term Construction
Contracts
Long-term Construction
Contracts
Percentage-of-Completion Method
Cost incurred to dateCost incurred to date
Gross profit estimateGross profit estimate
Measuring Progress Toward Completion
Estimate of project’s total cost
Estimate of project’s total cost
Percentage-of-Completion Method
Total costs incurred to date Percent complete = Most recent estimate of total project cost
Let’s look at an example.
Percentage-of-Completion Method
Year 1 Year 2 Year 3Cost incurred to date $250,000 $800,000 $1,200,000Estimated cost to complete 1,000,000 425,000 0Progress billing to date 250,000 775,000 1,400,000
Year 1 Year 2 Year 3Cost incurred to date $250,000 $800,000 $1,200,000Estimated cost to complete 1,000,000 425,000 0Progress billing to date 250,000 775,000 1,400,000
Geller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company. Presented below is information about the contract.
Let’s see how Geller will account for the revenues and cost of this project using the percentage-of-completion
method.
Description Debit CreditConstruction in progress 250,000
Cash, materials, etc. 250,000
Accounts receivable 250,000
Billings on construction contract 250,000
Cash 225,000
Accounts receivable 225,000
General Journal
Percentage-of-Completion Method
Contra account to CIP
Description Debit CreditConstruction in progress 250,000
Cash, materials, etc. 250,000
Accounts receivable 250,000
Billings on construction contract 250,000
Cash 225,000
Accounts receivable 225,000
General Journal
Percentage-of-Completion Method
Construction in Progress
- Billings on Construction ContractDebit Balance (Unbilled Receivable)
Classified as an asset
Construction in Progress
- Billings on Construction ContractCredit Balance (Overbilled Receivable)
Classified as a liability
Description Debit CreditConstruction in progress 250,000
Cash, materials, etc. 250,000
Accounts receivable 250,000
Billings on construction contract 250,000
Cash 225,000
Accounts receivable 225,000
Cost of construction 250,000
Construction in progress 30,000
Revenue from long-term contract 280,000
General Journal
Percentage-of-Completion Method
Percentage-of-Completion Method
Description Debit CreditConstruction in progress 250,000
Cash, materials, etc. 250,000
Accounts receivable 250,000
Billings on construction contract 250,000
Cash 225,000
Accounts receivable 225,000
Cost of construction 250,000
Construction in progress 30,000
Revenue from long-term contract 280,000
Revenue from long-term contract 280,000
Cost of construction 250,000
Retained earnings 30,000
General Journal
Closing EntryClosing Entry
Description Debit CreditConstruction in progress 550,000
Cash, materials, etc. 550,000
General Journal
Percentage-of-Completion Method
$800,000 - $250,000 last year = $550,000
Description Debit CreditConstruction in progress 550,000
Cash, materials, etc. 550,000
Accounts receivable 525,000
Billings on construction contract 525,000
General Journal
Percentage-of-Completion Method
$775,000 - $250,000 last year = $525,000
Description Debit CreditConstruction in progress 550,000
Cash, materials, etc. 550,000
Accounts receivable 525,000
Billings on construction contract 525,000
Cash 470,000
Accounts receivable 470,000
General Journal
Percentage-of-Completion Method
$695,000 - $225,000 last year = $470,000
Description Debit CreditConstruction in progress 550,000
Cash, materials, etc. 550,000
Accounts receivable 525,000
Billings on construction contract 525,000
Cash 470,000
Accounts receivable 470,000
Cost of construction 550,000
Construction in progress 84,340
Revenue from long-term contract 634,340
General Journal
Percentage-of-Completion Method
Percentage-of-Completion Method
Description Debit CreditConstruction in progress 550,000
Cash, materials, etc. 550,000
Accounts receivable 525,000
Billings on construction contract 525,000
Cash 470,000
Accounts receivable 470,000
Cost of construction 550,000
Construction in progress 84,340
Revenue from long-term contract 634,340
Revenue from long-term contract 634,340
Cost of construction 550,000
Retained earnings 84,340
General Journal
Closing EntryClosing Entry
Percentage-of-Completion Method
Year 1 Year 2 Year 3Costs to date $250,000 $800,000 $1,200,000Cost to complete 1,000,000 425,000 0Estimated total cost $1,250,000 $1,225,000 $1,200,000Percent complete to date 20.00% 65.31% 100.00%
Percent completed earlier -20.00%Percent completed this year 45.31%
Total revenue 1,400,000$ 1,400,000$ Percent completed this year 20.00% 45.31%Revenue this year 280,000$ 634,340$ Revenue recorded earlierRevenue in last yearCosts this year 250,000 550,000 Gross profit 30,000$ 84,340$
Percentage-of-Completion Method
Year 1 Year 2 Year 3Costs to date $250,000 $800,000 $1,200,000Cost to complete 1,000,000 425,000 0Estimated total cost $1,250,000 $1,225,000 $1,200,000Percent complete to date 20.00% 65.31% 100.00%
Percent completed earlier -20.00%Percent completed this year 45.31%
Total revenue 1,400,000$ 1,400,000$ 1,400,000$ Percent completed this year 20.00% 45.31%Revenue this year 280,000$ 634,340$ Revenue recorded earlier 914,340 Revenue in last year 485,660$ Costs this year 250,000 550,000 400,000 Gross profit 30,000$ 84,340$ 85,660$
Percentage-of-Completion Method
Description Debit CreditConstruction in progress 400,000
Cash, materials, etc. 400,000
Accounts receivable 625,000
Billings on construction contract 625,000
Cash 405,000
Accounts receivable 405,000
Cost of construction 400,000
Construction in progress 85,660
Revenue from long-term contract 485,660
Revenue from long-term contract 485,660
Cost of construction 400,000
Retained earnings 85,660
General Journal
Percentage-of-Completion Method
Description Debit CreditBillings on construction contract 1,400,000 Construction in progress 1,400,000
General JournalDescription Debit CreditBillings on construction contract 1,400,000 Construction in progress 1,400,000
General Journal
Entry to transfer title to the customer.
Year 1 250,000 30,000
Year 2 550,000 84,340
Year 3 400,000 85,660
1,400,000
Construction in Progress250,000 Year 1525,000 Year 2625,000 Year 3
1,400,000
Billings on Construction Contract
A Thought Exercise E5-11
Requirement 1Construction in progress = Costs
incurred + Profit recognized $100,000 = ? + $20,000
Actual costs incurred in 2003 = $80,000
A Thought Exercise E5-11
Requirement 2Billings = Cash collections + Acc. Rec.$94,000 = ? + $30,000
Cash collections in 2003 = $64,000
A Thought Exercise E5-11Requirement 3Let A = Actual cost in 2003Let T = Actual cost in 2003 + Estimated cost to completeThus, A/T = % complete and A/T * (Price – T) = Profit recognized in 2003
T * (A/T) * (Price – T) = T * (Profit)A * (Price – T) = T * (Profit)$80,000 * ($1,600,000 – T) = T * $20,000Dividing both sides by $20,000:4 * ($1,600,000 – T) = TThus, $6,400,000 – 4T = T$6,400,000 = 5TT = $1,280,000 = $80,000 + Estimated cost to
complete
Estimated cost to complete = $1,280,000 - 80,000 = $1,200,000
Completed Contract Method
Year 1 Year 2 Year 3Cost incurred to date $250,000 $800,000 $1,200,000Estimated cost to complete 1,000,000 425,000 0Progress billing to date 250,000 775,000 1,400,000Cash collections to date 225,000 695,000 1,100,000Contract price $1,400,000
Year 1 Year 2 Year 3Cost incurred to date $250,000 $800,000 $1,200,000Estimated cost to complete 1,000,000 425,000 0Progress billing to date 250,000 775,000 1,400,000Cash collections to date 225,000 695,000 1,100,000Contract price $1,400,000
Geller Construction entered into a three-year contract to build a containment vessel for Southeast Power Company. Presented below is information about the contract.
Let’s see how Geller will account for the revenues and cost of this project
using the completed contract method.
Description Debit CreditConstruction in progress 250,000
Cash, materials, etc. 250,000
Accounts receivable 250,000
Billings on construction contract 250,000
Cash 225,000
Accounts receivable 225,000
General Journal
Completed Contract Method
Entries are identical to the entries for
percentage of completion.
Gross profit is
not recognized
until project is complete.
Description Debit CreditConstruction in progress 550,000
Cash, materials, etc. 550,000
Accounts receivable 525,000
Billings on construction contract 525,000
Cash 470,000
Accounts receivable 470,000
General Journal
Completed Contract Method
Entries are identical to the
entries for percentage of completion.
Gross profit is
not recognized
until project is complete.
Completed Contract Method
Description Debit CreditConstruction in progress 400,000
Cash, materials, etc. 400,000
Accounts receivable 625,000
Billings on construction contract 625,000
Cash 405,000
Accounts receivable 405,000
Cost of construction 1,200,000
Construction in progress 200,000
Revenue from long-term contract 1,400,000
Revenue from long-term contract 1,400,000
Cost of construction 1,200,000
Retained earnings 200,000
General JournalGross
profit is recognized in year 3
since project is complete.
Completed Contract Method
Description Debit CreditBillings on construction contract 1,400,000 Construction in progress 1,400,000
General JournalDescription Debit CreditBillings on construction contract 1,400,000 Construction in progress 1,400,000
General Journal
Entry to transfer title to the customer.
Year 1 250,000 Year 2 550,000 Year 3 400,000 Year 3 200,000
1,400,000
Construction in Progress250,000 Year 1525,000 Year 2625,000 Year 3
1,400,000
Billings on Construction Contract
Significant Uncertainty of Collectibility
1. Installment Sales Method
2. Cost Recovery
1. Installment Sales Method
2. Cost Recovery
When uncertainties about collectibility exist, revenue
recognition is delayed.
When uncertainties about collectibility exist, revenue
recognition is delayed.
Sale and cost of sale recorded as usual.
Compute gross margin rate on the installment sales.
Recognize gross margin as cash is received.
Gross margin not realized is deferred until a future period.
Installment Sales Method
2003 2004 2005Installment sales $200,000 $250,000 $275,000Cost of sales 155,000 190,000 220,000Gross profit $45,000 $60,000 $55,000
Gross profit percentage 22.50% 24.00% 20.00%
Installment Sales Method
Clarke, Inc. had the following installment sales in addition to its regular sales.
$45,000 ÷ $200,000 = 22.50%$45,000 ÷ $200,000 = 22.50%
Installment Sales Method
2003 2004 2005Installment sales $200,000 $250,000 $275,000Cost of sales 155,000 190,000 220,000Gross profit $45,000 $60,000 $55,000
Gross profit percentage 22.50% 24.00% 20.00%
Clarke, Inc. had the following installment sales in addition to its regular sales.
2003 2004 2005Installment sales 200,000$ 250,000$ 275,000$ Cash Collected:From 2003 Sales (100,000) (50,000) (50,000) From 2004 Sales (195,000) (25,000) From 2005 Sales (200,000)
Cash Collections At Dec. 31, 2005, Clarke, Inc. is still
owed $30,000 from the 2004
sales and $75,000 from the 2005
sales.
Installment Sales Method
During 2003, Clarke collected $100,000 on its installment sales.
During 2003, Clarke collected $100,000 on its installment sales.
Description Debit CreditInstallment sales receivable 2003 200,000
Inventory 155,000
Deferred gross profit 2003 45,000
Cash 100,000
Installment sales receivable 2003 100,000
General Journal
Deferred gross profit is the difference between the selling price and the cost of
the inventory.
Installment Sales Method
Description Debit CreditInstallment sales receivable 2003 200,000
Inventory 155,000
Deferred gross profit 2003 45,000
Cash 100,000
Installment sales receivable 2003 100,000
Deferred gross profit 2003 22,500
Realized gross profit 22,500
($100,000 collected x 22.50%)
General Journal
This entry records the Realized Gross Profit by adjusting the Deferred Gross
Profit account.
Installment Sales Method Deferred gross profit 2004
Cash 245,000
Installment sales receivable 2003
Installment sales receivable 2004
Deferred gross profit 2003 11,250
Deferred gross profit 2004 46,800
Realized gross profit
During 2004, Clarke collected $50,000 on its 2003 installment sales and $195,000 on its 2004 installment sales.
During 2004, Clarke collected $50,000 on its 2003 installment sales and $195,000 on its 2004 installment sales.
Installment Sales Method Deferred gross profit 2004 60,000
Cash 245,000
Installment sales receivable 2003 50,000
Installment sales receivable 2004 195,000
Deferred gross profit 2003 11,250
Deferred gross profit 2004 46,800
Realized gross profit 58,050
During 2004, Clarke collected $50,000 on its 2003 installment sales and $195,000 on its 2004 installment sales.
During 2004, Clarke collected $50,000 on its 2003 installment sales and $195,000 on its 2004 installment sales.
Cash collections - 2004 195,000 24.00% 46,800 58,050$
Cash collections - 2004 195,000 24.00% 46,800 58,050$
Description Debit CreditInstallment sales receivable 2005 275,000
Inventory 220,000
Deferred gross profit 2005 55,000
Cash 275,000
Installment sales receivable 2003 50,000
Installment sales receivable 2004 25,000
Installment sales receivable 2005 200,000
Deferred gross profit 2003 11,250
Deferred gross profit 2004 6,000
Deferred gross profit 2005 40,000
Realized gross profit 57,250
General Journal
Cash Collection on Installment Sales in 2005
2003 50,000$ 22.50% 11,250$ 2004 25,000 24.00% 6,000 2005 200,000 20.00% 40,000
275,000$ 57,250$
Installment Sales Method
Cost Recovery Method
2003 2004 2005Installment sales $200,000 $250,000 $275,000Cost of sales 155,000 190,000 220,000Gross profit $45,000 $60,000 $55,000
Gross profit percentage 22.50% 24.00% 20.00%
Clarke, Inc. had the following installment Clarke, Inc. had the following installment sales in addition to its regular sales. The sales in addition to its regular sales. The
company uses the company uses the cost recovery method to to account for installment sales.account for installment sales.
$45,000 ÷ $200,000 = 22.50%$45,000 ÷ $200,000 = 22.50%
Cost Recovery Method
The following schedule shows the pattern of cash collections for the three year period.
Year of Sale 2003 2004 20052003 $100,000 $50,000 $50,0002004 195,000 25,0002005 200,000
COGS 155,000$ 190,000$ 220,000$
Year of CollectionYear of Sale 2003 2004 2005
2003 $100,000 $50,000 $50,0002004 195,000 25,0002005 200,000
COGS 155,000$ 190,000$ 220,000$
Year of Collection
Under the cost recovery method profit is not recognized until the
seller has recovered all of the cost of the goods sold.
Cost Recovery Method
Description Debit CreditInstallment receivable 2003 200,000
Inventory 155,000
Deferred gross profit 2003 45,000
Cash 100,000
Installment receivable 2003 100,000
General Journal
The entries are exactly the same as under the Installment Method—EXCEPT that there is not an entry to realize gross profit. Since we have not
collected cash in excess of COGS, no gross profit is recognized in 2003.
Cost Recovery MethodIn 2004, let’s concentrate on the
entries relating to 2003 sales only.
Description Debit CreditCash 50,000
Installment receivable 2003 50,000
General JournalDescription Debit Credit
Cash 50,000
Installment receivable 2003 50,000
General Journal
2003
Cost of goods sold 155,000$
Cash collections - 2003 (100,000)
Cash collections - 2004 (50,000)
Unrecovered cost 5,000
We have not fully recovered the
cost, so no profit is recognized in 2004.
2003
Cost of goods sold 155,000$
Cash collections - 2003 (100,000)
Cash collections - 2004 (50,000)
Unrecovered cost 5,000
We have not fully recovered the
cost, so no profit is recognized in 2004.
Now can we recognize some profit?
Cost Recovery MethodHere are the entries we would make in
2005 relating to 2003 sales.
Description Debit CreditCash 50,000
Installment receivable 2003 50,000
Deferred gross profit 45,000
Realized gross profit 45,000
General Journal
We have fully recovered the $155,000 cost during 2005, so the entire deferred gross
profit will be recognized.