Memo

Notes: The following is an example memo evaluating a technical accounting issue. Though it is writing in an audit context, it is broadly representative of technical writing used in business. In developing your case report, please keep in mind the following suggestions: 1. Always summarize significant facts of the case so that an unfamiliar reader can reach an informed conclusion by reading solely the memo. 2. Provide a sentence or two before guidance citations to explain why the particular section of the codification is being cited. 3. Develop a clear and logical link between cited GAAP and your analysis of the case facts (i.e. List each GAAP requirement and explain how it is, or is not, met in the case). If you considered alternative treatments, establish which treatment is preferable and explain why.

XYZ Sales Transaction

Background

In February 20XX, ABC Co. (ABC or the Company) entered into an agreement with the XYZ police department to provide 123 in-car video systems and 45 motorcycle video systems. The Company also provided XYZ with a two-year extended warranty and agreed to upgrade the in-car systems to dual simultaneous recording/playback when the technology is developed. The purpose of this memo is to document our evaluation of the Company’s accounting for this contract.

Guidance Consulted

Paragraph 7 of EITF 00-21,[footnoteRef:1] Revenue Arrangements with Multiple Deliverables, establishes the following principles for revenue recognition in situations where there are multiple deliverables: [1: The references in this example memo precede the FASB’s Accounting Standards Codification. ]

· “Revenue arrangements with multiple deliverables should be divided into separate units of accounting if the deliverables in the arrangement meet the criteria in paragraph 9.

· Arrangement consideration should be allocated among the separate units of accounting based on their relative fair values…

· Applicable revenue recognition criteria should be considered separately for separate units of accounting.”

Paragraph 9 provides further guidance on the determining units of account: “In an arrangement with multiple deliverables, the delivered item(s) should be considered a separate unit of accounting if all of the following criteria are met:

a. The delivered item(s) has value to the customer on a standalone basis…

b. There is objective and reliable evidence of the fair value of the undelivered item(s).

c. If the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the vendor.

Accounting Recorded by the Company

When the Company performed their analysis of the contract, they identified two units of accounting: 1) the video systems (inclusive of the subsequent upgrade) and 2) the extended warranty contract. To determine the amount of revenue to recognize for each of the units of account, the Company allocated the total contract value ($1,000,000) to the deliverables based on the Company’s historical average selling price of each item provided under the contract. Due to the size of the contract, the customer received a discount of approximately 10% off this pricing. After the discount was applied on a pro-rata basis to the separate units of account, $900,000 was allocated to the initial sale and $100,000 was allocated to the extended warranty.

At the time of the sale, ABC recorded revenue for the initial sale with a corresponding entry to cost of sales for the cost of supplied product. The Company also recorded a $150,000 accrual contra-inventory (approximately $1,000 per system to be upgraded) based on the engineering department’s estimated cost of parts and labor to replace each unit’s digital video recorder when the upgraded unit becomes available. The $100,000 related to the extended warranty was deferred in ‘Maintenance Contract Revenue’ (account 2501) and will be recognized in income over the term of the warranty.

Analysis of the Transaction

The systems that were initially installed in the police vehicles are fully functional though they only have the ability to record and play video from one camera. These systems, as currently installed, are similar to the other systems currently sold by ABC. In addition, the extended warranty included at no additional cost can be purchased separately by from the Company and ABC routinely sells these on a stand-alone basis. Accordingly, we consider the systems initially installed in the XYZ police vehicles to have value on a stand-alone basis and to be properly recognized in revenue. Additionally, the extended warranty has value on a standalone basis and has been properly deferred over the related warranty period based on its pro rata fair value. Since the dual simultaneous recording/playback feature was stipulated in XYZ’s request for proposal, we note that this feature also has value to the customer. However, this element remains undelivered as of December 31, 20XX.

The single-camera systems and extended warranties have objective fair value based on the prices at which the Company sells these items separately to other customers on a routine basis. Based on discussions with Bob Jones, ABC’s Chief Financial Officer, though the Company does not intend to offer a dual simultaneous recording/playback upgrade on their existing systems, the estimated the relative fair value of the upgrade is $150,000 (equal to the estimated cost of the upgrade). Though the Company does not have historical sales of these upgrades on a stand-alone basis to evidence fair value, we consider this estimate to be reasonable given the low gross margin of approximately 2% realized by the Company on the overall contract with XYZ. Further, Jones has represented that similar upgrades will not be marketed to existing customers who have purchased the single recording technology; however, if such sales occur in future periods, it is expected they will be similarly priced to the fair value attributed under the XYZ contract. Accordingly, we take no exception to this determination of fair value.

We note that the sales document does not contemplate a right of return or purchase price adjustment in the event that ABC does not develop the dual simultaneous recording/playback when the technology. Accordingly, evaluation of requirement 9(c) is not applicable to the XYZ transaction.

Based on these observations, we note that the XYZ transaction has three units of accounting: 1) the systems originally installed in the police vehicles, 2) the upgrade to dual simultaneous recording/playback, and 3) the extended warranty. We concur with management’s approach to allocating the total value of the contract but note that the value ABC assigned to the equipment sale ($900,000) should be bifurcated into $750,000 ($900,000 - $150,000) that should have been recognized at the time of the original installation (since the earnings process for that unit of accounting has been completed) and $150,000 that should be deferred until the upgrades are installed. We concur with management’s determination that $100,000 should be recognized over the term of the extended warranty. (Refer to our testing in P8 and P9 series for further details on the Company’s accounting for deferred warranty and maintenance revenue.)

Adjusting Entries

To remove the sales revenue previously recognized related to the dual simultaneous recording/playback and record an accrual for deferred revenue, we propose the following adjustment to ABC’s December 31, 20XX financial statements:

Debit: Sales $150,000

Credit: Deferred Revenue $150,000

To remove the corresponding cost of sales and accrual recorded in contra-inventory related to the cost to fulfill the upgrade, we propose the following additional adjustment:

Debit: Inventory $150,000

Credit: Cost of Sales $150,000

This cost will be appropriately recognized at the time of upgrade in matching with the revenue to be recognized.

Conclusion

Based on discussions with management, this is a one-time transaction with unique contract terms due to the volume of product purchased and is not expected to set any precedent for material revenue recognition transactions at any point in the future. Aside from the two adjusting entries noted above, we consider management’s accounting for the transaction to be reasonable.

A member firm of Ernst & Young Global Limited

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A member firm of Ernst & Young Global Limited