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 Percentage-of- Completion Method Long-term Construction Contracts

Percentage-of-Completion Method Cost incurred to date Gross profit estimate Measuring Progress Toward Completion 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 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.

Percentage-of-Completion Method $250,000 ÷ $1,250,000 = 20%

Percentage-of-Completion Method

Contra account to CIP

Percentage-of-Completion Method Classified as an asset Classified as a liability

Percentage-of-Completion Method

Closing Entry

Percentage-of-Completion Method $800,000 ÷ $1,225,000 = 65.31%

Percentage-of-Completion Method

$800,000 - $250,000 last year = $550,000

Percentage-of-Completion Method $775,000 - $250,000 last year = $525,000

Percentage-of-Completion Method $695,000 - $225,000 last year = $470,000

Percentage-of-Completion Method

Closing Entry

Percentage-of-Completion Method

Entry to transfer title to the customer.

A Thought Exercise E5-11

Requirement 1 Construction in progress = Costs incurred + Profit recognized $100,000 = ? + $20,000 Actual costs incurred in 2003 = $80,000

A Thought Exercise E5-11 Requirement 2 Billings = Cash collections + Acc. Rec. $94,000 = ? + $30,000 Cash collections in 2003 = $64,000

A Thought Exercise E5-11 Requirement 3 Let A = Actual cost in 2003 Let T = Actual cost in Estimated cost to complete Thus, 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 * $20,000 Dividing both sides by $20,000: 4 * ($1,600,000 – T) = T Thus, $6,400,000 – 4T = T $6,400,000 = 5T T = $1,280,000 = $80,000 + Estimated cost to complete Estimated cost to complete = $1,280, ,000 = $1,200,000

A Thought Exercise E5-11 Requirement 4 $80,000 = X * $1,280,000 X = 6.25%

Completed Contract Method 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.

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 Entries are identical to the entries for percentage of completion. Gross profit is not recognized until project is complete.

Completed Contract Method Gross profit is recognized in year 3 since project is complete.

Completed Contract Method Entry to transfer title to the customer.

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.

 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

Clarke, Inc. had the following installment sales in addition to its regular sales. $45,000 ÷ $200,000 = 22.50%

Installment Sales Method Clarke, Inc. had the following installment sales in addition to its regular sales. 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. Deferred gross profit is the difference between the selling price and the cost of the inventory.

Installment Sales Method This entry records the Realized Gross Profit by adjusting the Deferred Gross Profit account.

Installment Sales Method During 2004, Clarke collected $50,000 on its 2003 installment sales and $195,000 on its 2004 installment sales.

Installment Sales Method During 2004, Clarke collected $50,000 on its 2003 installment sales and $195,000 on its 2004 installment sales.

Installment Sales Method

Balance Sheet

Cost Recovery Method Clarke, Inc. had the following installment sales in addition to its regular sales. The company uses the to account for installment sales. Clarke, Inc. had the following installment sales in addition to its regular sales. The company uses the cost recovery method to account for installment sales. $45,000 ÷ $200,000 = 22.50%

Cost Recovery Method The following schedule shows the pattern of cash collections for the three year period. 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 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 Method In 2004, let’s concentrate on the entries relating to 2003 sales only. Now can we recognize some profit?

Cost Recovery Method Here are the entries we would make in 2005 relating to 2003 sales. We have fully recovered the $155,000 cost during 2005, so the entire deferred gross profit will be recognized.