Question

Revenue Recognition: Sparrow Film Productions (SPF) wished to expand its production facilities so it borrowed $10,000,000 from First National Bank early in 2018. As a condition of making this loan, the bank requires that the business maintain a current ratio of at least 2 to 1. Business has been pretty good in 2018, but the cost of the expansion has brought the current ratio down below the target. In fact, on December 15, Jack Sparrow, the owner of SPF estimates that the year-end current ratio will be only 1.90 to 1. (A little short of the bank's requirements.) Jerry quickly looks through the signed contracts and sees an unpcoming project that will be started and completed in February 2019 for $500,000. Jerry is thinking about recording the $500,000 as revenue in 2018 instead of in 2019. If he does this, the current ratio at the end of 2018 will be above the required current ratio of 2 to 1. Required: 1. Assume Jerry decides to include the $500,000 as 2018 revenue. Journalize the transaction on 12/31 assuming the cash will be collected in February of 2019. 2. Explain why it would be unethical for Jerry to record the February revenue in 2018. Identify the accounting principle(s) relevant to this situation and give the reasons for your conclusion. This part should be 3-4 sentences. 3. Cite all references used including url or page number (even if you use the textbook). 4. If you were advising Jerry, what else could Jerry do to improve his current ratio that would be acceptable under ethical standards? (2-3 sentences)

Answer 1

(1): Journal entry will be:

	Debit	Credit
Accounts Receivables	500,000
Revenue		500,000

(2): It will be unethical for Jerry to record the February revenue in 2018 as the revenue is pertaining to a project that will start and be completed in February 2019. The project is not even starting in the year 2018 and hence even a portion of revenues from the project cannot be booked in 2018.

The accounting principle relevant to this situation is the principle set forth by IASB as well as GAAP. As per this principle revenue should be recognized when the reporting organization satisfies a performance obligation. In this case as the performance obligation is not satisfied the transaction price cannot be allocated to performance obligation and hence revenue cannot be recognized.

(3): References:

https://www.fasb.org/revrec#section_2

https://www.bdo.com/services/assurance/revenue-recognition/overview

(4): My advice to Jerry would be to do the following things in order to ensure that current ratio is improved in an ethical manner:

(a): Switch from short term to long term debt – Jerry should make use of long term debt to finance the business and not short term debt. This will reduce the amount of current liabilities and hence will improve the current ratio.

(b): Sell useless assets – Jerry should identify the unproductive assets being held by the business and that are of no use for the company. By selling these assets cash balances will increase and this will improve the current ratio.