(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. They are producing close to capacity and expect to grow at an average of 20% per year over the next 3 years.

After reviewing the financial statements of Cutting Edge, Gary Hall, 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.

Alexander Popov, the marketing manager of Cutting Edge, has devised a plan to meet these requirements.

Popov 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 3/4 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, Popov claims that few people will ask for a refund after receiving half of their subscription issues. Popov 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. Popov 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

(a) When should revenue from the new subscriptions be recognized?

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

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

(d) Does the proposed plan achieve the goals of increasing the current ratio and decreasing the debt to equity ratio?