[SOLVED] Bonanza Trading Stamps, Inc., was formed early

Bonanza Trading Stamps, Inc., was formed early this year to sell trading stamps throughout the Southwest to retailers, who distribute the stamps free to their customers. Books for accumulating the stamps and catalogs illustrating the merchandise for which the stamps may be exchanged are given free to retailers for distribution to stamp recipients. Centers with inventories of merchandise premiums have been established for redemption of the stamps. Retailers may not return unused stamps to Bonanza. The following schedule expresses Bonanzaâ€™s expectations of the percentages of a normal monthâ€™s activity that will be attained. For this purpose, a normal monthâ€™s activity is defined as the level of operations expected when expansion of activities ceases or tapers off to a stable rate. Bonanza expects to attain this level in the third year and to average $2 million per month in stamp sales throughout the third year.

Required: a. Discuss the factors to be considered in determining when revenue should be recognized in measuring the income of a business enterprise. b. Discuss the accounting alternatives that should be considered by Bonanza Trading Stamps for the recognition of its revenues and related expenses. c. For each accounting alternative discussed in (b), give balance sheet accounts that should be used and indicate how each account should be classified. Answer: a. Income results from economic activity in which one entity furnishes goods or services to another. To warrant revenue recognition, the earning process must be substantially complete and there must be realization--a change in assets that is capable of being objectively measured. Normally this involves an arm's length exchange transaction with a party external to the entity. The existence and terms of the transaction may be defined by operation of law, by established trade practice or may be stipulated in a contract. Events that give rise to revenue recognition are: the completion of a sale; the performance of a service; the progress of a long-term construction project, as in shipbuilding; and the production of a standard interchangeable good (such as a precious metal or an agricultural product) which has an immediate market, a determinable market value, and only minor costs of marketing. The passing of time may also be the event that establishes the recognition of revenues, as in the case of interest or rental revenue. As a practical consideration, there must be a reasonable degree of certainty in measuring the amount of revenue. Problems of measurement may arise in estimating the degree of completion of a contract, the net realizable value of a receivable, or the value of a nonmonetary asset received in an exchange transaction. In some cases, while the revenue may be readily measured, it may be impossible to reasonably estimate the related expenses. In such instances revenue recognition must be deferred until the matching process can be completed. b. Bonanza, in effect, is a merchandising firm which collects cash (for stamps) far in advance of furnishing the goods. In addition, since the data indicates that about five percent of the stamps sold will never be redeemed, it also has revenue from this source unless the stamps escheat. Bonanza's revenues from these two sources could be recognized on one of three major bases. First, all revenue could be recognized when the stamps are sold--the sales basis or cash-collection basis if all sales are for cash. Secondly, amounts collected at the time stamps are sold could be treated as an advance (sometimes referred to as deferred or unearned revenue) until stamps are exchanged for the merchandise premiums at which time all of the revenue including that relating to the never-to-redeemed stamps could be recognized. Thirdly, some revenue could be recognized at the time of redemption--this treatment would be especially appropriate for approximately five percent of the total, the stamps that will never be redeemed. A modification of this basis would be to recognize the revenue from the never-to-be-redeemed stamps on a passageoftime basis. The principal expense, merchandise premium costs, should be matched with the revenue. If all revenue is recognized when stamps are sold, and accrual of the cost of future premium redemptions would be necessary. In such a case, when stamp redemptions and related premium issuances occurred, the costs of the premiums would be charged to the accrued liability account. On the other hand, if stamp sales were treated as an advance, the deferred revenue would be recognized and the matching cost of the premiums issued would be recognized with the revenue at the time of redemption. Under the third alternative, some predetermined portion, at least, of the revenue from the nevertoberedeemed stamps would be recognized when the stamps are sold, but the recognition of the merchandise premium expense would be deferred until time of redemption. Reasonable estimation is crucial to income determination. Under the first alternative it is necessary to estimate future costs of premium issuances well in advance of the actual occurrence. In the second case it is necessary to estimate the proportion of revenue which has already been earned on the basis of premium costs already incurred. It is a vital certainty that not all stamps sold will ultimately be presented for redemption. Such factors as the number of stamps required to fill a book, the types of customers who receive stamps, and the ease of exchanging stamp books for premiums will all affect the proportion of stamps actually redeemed in relation to the potential redemptions. The difference between the five percent initial estimate and the actual proportion of unredeemed stamps affects the accrual of a liability for redemption of stamps issued under the first method and the rate of transfer of revenue from the advances account under the second and third methods. There will be other expenses aside from the costs of premiums issued but they should be relatively small after the initial promotion period and they should be accounted for under the usual principles which apply to accrualbasis accounting. Thus, premium catalogs printed but undistributed would ordinarily be treated as prepaid expenses; wages and salaries would be treated as expenses when incurred; depreciation, taxes, and similar expenses would be recognized in the usual manner. c. Under all of the alternatives Bonanza's major asset (in terms of data given in the question) would be its inventory of premiums. Another inventory item, perhaps minor in amount, would be the cost of printing the stamps that were on hand awaiting sale to dealers. The major account with a credit balance would be either an estimated liability for cost of redeeming the outstanding stamps under the first alternative or an advance (deferred revenue) account under the second and third alternatives. In view of the nature of the operation, the inventory account(s) would be included in the current asset classification and the liability would be classified as current. The advances could be reported preferably as a current liability or possibly as deferred credit.

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Merchandise Actual Premium Stamp Redemptions Month Stamp Purchases Sales (%) (%) (%) 6 30 40 10 12 60 60 45 18 80 80 70 24 06 90 80 30 100 100 95

Question: Bonanza Trading Stamps, Inc., was formed early

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