application problem 2

E3-8. The concept of materiality

All large U.S. companies have policies in which all expenditures under a certain dollar amount are expensed. Many of these expenditures are for assets, items that are useful to the company beyond the period in which they were purchased.

• Explain the proper accounting treatment for expenditures for items that are expected to generate benefits in the future.
• Explain why it might make economic sense to expense some of these items. Upon what exception to the principles of financial accounting would such a decision be based?

P3-3. The irrelevance of original cost

Three years ago Yeagley and Sons purchased the three assets listed in the following table. The chief financial officer, Kathy Dillon, is presently trying to decide what to do with each asset. She has three choices for each asset: (1) sell it, (2) sell it and replace it with an equivalent asset, or (3) keep it. The following information is provided to aid her decision.

Asset	Original Cost	Replacement Cost	Fair Market Value	Present Value of Future Cash Flows Produced by Old Asset	Present Value of Future Cash Flows of Equivalent Asset
A	$4,000	$1,000	$1,500	$2,500	$5,000
B	 1,500	 2,000	   500	 2,500	 3,500
C	 2,000	 3,500	 3,000	 2,500	 5,000

REQUIRED:

• Assuming that Kathy chooses to keep Asset A and Asset B and sell and replace Asset C, evaluate her decisions. What decisions should she have made? Support your choices.
• How useful was the original cost of each asset in the evaluation of Kathy’s decisions?
• Assume that Kathy proceeds with her decisions. According to generally accepted accounting principles, at what dollar amount would each asset be carried on Yeagley’s balance sheet? What principles of financial accounting would be involved?

ID3-2 Aggressive revenue recognition in the Internet industry

Many Internet firms “gross up” their revenues by reporting the entire sales price a customer pays at their site, when in fact the company keeps only a small percentage of that amount. Take The Priceline Group, Inc., for example, the company made famous by those William Shatner ads about “naming your own price” for airline tickets and hotel rooms. In SEC filings for the year ended 2014, Priceline reported that it earned over $2.1 billion in merchant revenues, but that included the full amount customers paid for tickets, hotel rooms, and rental cars. Traditional travel agencies call that amount “gross bookings,” not revenues. And much like traditional travel agencies, Priceline keeps only a small portion of the “gross bookings,” namely, the difference between the customers’ accepted bids and the price it pays for the merchandise or service. The rest, which Priceline calls “cost of revenues,” are paid to the airlines and hotels that supply the tickets and rooms. In 2014, those costs came to $858 million, leaving Priceline just $1.3 billion.

REQUIRED

• Comment on Priceline’s method of booking “revenue.”
• Like Priceline, many Internet companies reported losses in the early years, forcing analysts to focus on other reported numbers. For example, at one time Priceline’s stock price per share was 23 times its revenue per share, and 214 times its gross profit (revenue − product costs) per share. Can you think of a reason why Priceline might want to include “gross bookings” as revenue?
• Why do you think that the SEC is clamping down on unethical accounting practices of Internet companies—most importantly, including as revenue “gross” versus “net” bookings?

 

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