Question

Cutting Edge is a monthly magazine that has been on the market for 18 months. It currently has a circulation of 1.4 million copies. Negotiations are underway to obtain a bank loan in order to update the magazine's facilities. Cutting Edge is producing close to capacity and expects to grow at an average of 20% per year over the next 3 years.

After reviewing the financial statements of Cutting Edge, Andy Rich, the bank loan officer, had indicated that a loan could be offered to Cutting Edge only if it could increase its current ratio and decrease its debt to equity ratio to a specified level. Jonathan Embry, the marketing manager of Cutting Edge, has devised a plan to meet these requirements. Embry indicates that an advertising campaign can be initiated to immediately increase circulation. The potential customers would be contacted after the purchase of another magazine's mailing list. The campaign would include:

1.An offer to subscribe to Cutting Edge at three-fourths the normal price.

2.A special offer to all new subscribers to receive the most current world atlas whenever requested at a guaranteed price of $2.

3.An unconditional guarantee that any subscriber will receive a full refund if dissatisfied with the magazine.

Although the offer of a full refund is risky, Embry claims that few people will ask for a refund after receiving half of their subscription issues. Embry notes that other magazine companies have tried this sales promotion technique and experienced great success. Their average cancellation rate was 25%. On average, each company increased its initial circulation threefold and in the long run increased circulation to twice that which existed before the promotion. In addition, 60% of the new subscribers are expected to take advantage of the atlas premium. Embry feels confident that the increased subscriptions from the advertising campaign will increase the current ratio and decrease the debt to equity ratio.

You are the controller of Cutting Edge and must give your opinion of the proposed plan.

Instructions

(a)When should revenue from the new subscriptions be recognized?

(b)How would you classify the estimated sales returns stemming from the unconditional guarantee?

(c)How should the atlas premium be recorded? Is the estimated premium claims a liability? Explain.

(d)Does the proposed plan achieve the goals of increasing the current ratio and decreasing the debt to equity ratio?

Answer 1

a) The revenue from the news subscriptions can only be recognized once it is earned . The revenue recognition principle states that, under the accrual basis of accounting, you should only record revenue when an entity has substantially completed a revenue generation process. Thus you record revenue when it haa been earned.

b) In accordance with the Generally Accepted Accounting principles, when a buyer has a right to return the product in future in accordance with formal or informal agreement , a seller may or may not be able to recognize revenue at the time of sale. The seller can record the sales revenue at the time.of sale if the seller can estimate the rate of product returns. However if the seller is unable to make a reasonable estimate of the amount of future product returns, the seller should wait to record revenue until the loss can be estimated of the return privilege expires.

d) Yes the proposed plan will achieve the goals of increasing the current ratio and decreasing the debt to equity ratio.