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

(c) How should the atlas premium be recorded? Is the estimated premium claims a liability? Explain.

Short answer

The business entity will record the atlas premium as debit of cash, debit of premium liability and credit of inventory of premium.

Step-by-step solution

Definition of Liability

Any past event that will lead to future sacrifice of the economic benefits is known as liability. Liability can be short-term or long-term depending upon the period it becomes due.

Recording Atlas Premium

Journal entry for recording the estimated liability:

Date	Accounts and Explanation	Debit $	Credit $
	Premium expense	xxx
	Premium liability		xxx

Journal entry upon request of atlas and payment by new subscriber:

Date	Accounts and Explanation	Debit $	Credit $
	Cash	xxx
	Premium liability	xxx
	Inventory of premiums		xxx