Question

CA18-6 (Recognition of Revenue from Subscriptions) 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

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

Short answer

The revenue must be reported afteradjusting the customer’s expected returns, and the business entity must recognize an asset account and refund liability.

Step-by-step solution

Definition of Sales Return

The merchandise that a customer return to the business entity due to a defect or any other return is reported as a sales return.

Classification of Estimated Sales Return from Unconditional Guarantee

1. The business entity must recognize revenue for the products transferred, considering the expected returns from the customer.
2. Asset must be recognized to reflect the right to recover inventory from customers and settlement of refund liability.

Note: If the sales are recorded at the gross amount on the point of sale, then no assets and liabilities are recorded until the end of the fiscal period.