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1. What pre SAB 101 revenue recognition policies has Wareham SC Systems adopted? Which of these policies are most likely to be impacted by SAB

1. What pre SAB 101 revenue recognition policies has Wareham SC Systems adopted? Which of these policies are most likely to be impacted by SAB 101?

2. Why might Soma Desai be concerned about the impact of SAB 101 on Wareham SC Systems revenue? Be as specific as possible.

3. What revenue recognition accounting is required by the facts of each of the sale transactions received by Soma Desai? Justify your conclusions.

4. What administrative actions should Soma Desai take to prepare Wareham SC Systems for the adoption of SAB 101? Be specific

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Case 5-4 Wareham SC Systems, Inc." Revenue Recognition Policy Soma Desai, the chief financial officer of Wareham SC Systems, Inc., was reviewing the revenue recognition practices of the company's three divisions. Wareham SC Systems was a capital equipment and testing instru- ment manufacturer and supplier to a variety of highly cyclical electronics-based industries, including the semiconductor industry. Desai undertook the review in anticipation of disclosing in the company's third quar- ter 2000 Form 10-Q filing with the Securities and Exchange Commission (SEC) the possible impact on the company's financial statements of the revenue recognition and reporting guidelines set forth in the SEC's recently issued Staff Accounting Bulletin No 101, Revenue Recognition in Financial Statements (SAB 101). SAB 101 had to be adopted no later than the fourth quarter of 2000. As a test of her own understanding of SAB 101, Desai selected from each of the company's three divi- sions a limited number of representative sale transac- tions to review. Wareham SC Systems sales and net income for the last three year was (thousands). According to the company's 1999 annual report, its revenue recognition policy was as follows: Product revenue is recognized upon shipment. The Company's products are generally subject to warranty, and the Company provides for such estimated costs when product revenue is recog- nized. The Company recognizes service revenues as the services are provided or ratably over the period of the related contract, as applicable. The Company unbundles service revenue from product sales and installation services and maintenance services based upon amounts charged when such elements are separately sold. For certain contracts, revenue is recognized using the percentage-of- completion accounting method based upon an efforts-expended method. In all cases, changes to total estimated costs and anticipated losses, if any, are recognized in the period in which determined. SAB 101 1999 1998 1997 Net Sales $1,790,912 $1,489,151 $1,266,274 Net Income $ 191,694 $ 102,117 $ 127,608 . Under US GAAP guidelines, the general rule govern- ing revenue recognition is: Revenue should be recognized when it is earned and realized or realizable. Because the general rule had been abused by some companies, more specific criteria for revenue recognition were prescribed by the SEC in SAB 101. As a result, In addition to testing her understanding of SAB 101, Desai wondered what administrative actions she should take to prepare Wareham SC Systems for a suc- cessful adoption of SAB 101. The efforts-expended model recognizes revenue from long- term contracts as the work on the contract progresses. Typically, the revenue recognized to date is the percentage the costs to date bear to the contract's estimated total costs after giving effect to costs to complete based upon the most recent information. * Copyright 2003 President and Fellows of Harvard College. Harvard Business School case 110-015. uninstalled equipment sold for $19.5 million. In each of the installation contracts, the division's controller estimated that the fair value of the installation service The division was experienced in the production and in- stallation of the type of equipment involved in each of the two sales arrangements under review and had a history of successfully installing the type of equipment involved. sales that guaranteed that the delivered equipment The division provided a warranty on all equipment would meet the division's published specifications and be free of defects in materials and workmanship. 138 Part 1 Financial Accounting Cataumet Devices, Inc. revenue was now considered to be earned and realized or The Glendale Division entered into a sales arrange- realizable when the following conditions were met: ment with Cataumet Devices, Inc., a new customer, to Persuasive evidence of an order arrangement exists; deliver a version of its standard product modified as Delivery of the ordered goods has occurred or ser- necessary to be integrated into the customer's new as- vices have been rendered; sembly line while still meeting all of the standard The seller's price to the buyer is fixed or deter- published vendor specifications with regard to perfor- minable; and mance. The customer could reject the equipment if it Collectibility of the sale proceeds is reasonably failed to meet the standard published performance assured. specifications or could not be satisfactorily integrated into the new line. The division had never modified its Glendale Division: Selected equipment to work on an integrated basis in the type of assembly line the customer had proposed. In re- Transactions sponse to the request, the division designed a version of its standard equipment that was modified as be- Wareham SC System's Glendale Division was an equip- lieved necessary to operate in the new assembly line. ment manufacturer whose main product was generally The modified equipment still met all of the standard sold in a standard model. The contracts for sale of that published performance specifications, and the divi- model provided for customer acceptance to occur after sion believed the equipment would meet the requested the equipment was received and tested by the customer. specifications when integrated into the new assembly The acceptance provisions stated that if the equipment line. However, the division was unable to replicate the did not perform to the division's published specifica- new assembly line conditions in its testing. tions, the customer could return the equipment for a full refund or a replacement unit, or could require the divi- Advanced Technology Division: sion to repair the equipment so that it performed by ei- Selected Transactions ther a formal sign-off by the customer or by the passage of 90 days without a claim under the acceptance provi- sions. Title to the equipment passed upon delivery to the Wareham SC System's Advanced Technology Division customer. The division did not perform any installation developed, manufactured, and sold complex manufac- or other services on the equipment it sold. It tested each turing equipment. Desai selected two of the division's piece of equipment against the division's specifications sales transactions involving a similar piece of equip. before shipment. Payment was due under the division's ment for review. (Although Advanced Technology sold normal payment terms, which was 30 days after cus- its equipment separately to some customers without tomer acceptance. installation-meaning a general contractor would in- In each of the following Glendale Division sales stall the equipment-the sales transactions selected by transactions reviewed by Desai, the above facts applied, Desai involved installation of the equipment by Ad- in addition to those described in each of the Glendale vanced Technology employees.) The division sold its Division sales transactions selected for review. installation service on a time and materials basis. The Onsetcom, Inc. Onsetcom, Inc., a new Glendale Division customer, placed an order for a standard model of the division's main product. The sales contract included a customer- approximated $500,000. acceptance clause. It was based on the product meet- ing the division's published specifications for a stan- dard model. Before shipping the equipment to Onsetcom, the division demonstrated that the equip- ment shipped met the required specifications. There was no reason to believe that the equipment would not operate in the same way in the customer's facility. attive customer's facility, no other parties had installed the divisions equipment in the past. Frequently, although the divisions met its manufacturing and shipping deadlines, the customer would request that the division delay the final installation until a certain phase of the project was completed. The customer then tested and accepted the equipment. Payment of 90% of the total arrangement fee was due upon delivery and the re- maining 10% was due upon final acceptance. The cost of the installation services was approximately 1% to 3% of the total arrangement fee. Technical Devices Division: Selected Transactions products, based on previously installed units. The equipment was extensively tested throughout the manufacturing process, which could range from 3 to 12 months, so the division was confident when the ma- chine was shipped that it would ultimately perform in accordance with the customer's specifications. Initial customer acceptance usually took place at the division's facility prior to shipment. Because of the size of the equipment, it was often partially disassem- bled for shipment and reassembled at the customer's site. The division, to minimize future warranty claims and due to the specialized nature of the equipment, vsed its own engineers to install and set up its products Title to the equipment passed to the customer upon delivery. Sandham, Inc. Sandham, Inc. ordered equipment that would be inte- grated into a larger production line that included other manufacturer's equipment. Advanced Technology had previously developed its own internal specifications for the model and demonstrated that the equipment met those specifications. At Sandham's request, the contract included a number of customer-specific tech- nical and performance criteria regarding speed, qual- ity, interaction with other equipment, and reliability. Because of the nature of the equipment, the division was unable to demonstrate that the equipment would meet the customer-specific specifications before in- stallation. The contract included a customer-acceptance provision that obligated the division to demonstrate that the installed equipment met all specified criteria before customer acceptance. If customer acceptance was not achieved within 120 days of installation, Sandham could require the division to remove the equipment and refund all payments. Payment terms were 80% due 30 days after delivery, and 20% due 30 days after customer acceptance. XL Semi, Inc. The Advanced Technology Division also manufac- tured equipment to produce semiconductor wafers. The equipment was complex and sold for prices rang- ing from $500,000 to $10 million per unit. The equip- ment ordered by XL Semi sold for $9 million. The XL Semi order was typical . In the case of semiconductor equipment, the division published the performance specification (often stated in ranges) of its equipment based on results of prototype testing or, for established Wareham SC System's Technical Devices Division developed, manufactured, and marketed a variety of electrical, electronic, and mechanical testing devices for use in production control, product testing, and re- search laboratory applications. The division used a combination of direct sales by its own sales force and independent distributors to market its products. Typi- cally, the distributor network was used to sell products to low-volume customers, since most high-volume cus- tomers preferred to deal directly with the division. Unlike Wareham SC System's other divisions, whose profitability rose and fell with changes in the business cycle, the Technical Devices Division under its current management had steadily increased its prof- its each quarter over a span of 37 consecutive quarters. New Strategy Only a few days before Desai was scheduled to begin her review of selected sales arrangements, the Technical Devices Division announced a change in its sales strat- egy. The direct marketing and shipment of the divi- sion's mechanical testing devices to high-volume cus- tomers would end.? In the future, all of this business would be channeled through the division's indepen- dent distributors so that the division could free up re- sources to complete in the growing and increasingly more profitable and competitive electronic and electrical testing product markets. While it was not announced, Desai believed the change in sales strategy was moti- vated by a recognition by the division management that demand for mechanical testing devices was declining, uncertain, and increasingly less profitable. 2 High volume customers bought all of the division's products, including mechanical testing devices. Prior to the strategy change, distributor's were limited to selling to low-volume customers. 140 Part 1 Financial Accounting She also suspected the division anticipated difficulties in reaching the quarter's profit goals. As a result of the division's sales strategy shift, dis- tributors were asked to increase their mechanical test- ing device inventory levels from their current several- weeks sales to as much as two-years sales. Moreover, these purchases had to be made, delivered, and have the title taken by September 30, the day the division closed its third quarter for financial reporting purposes. Dis- tributors that did not comply were told they would lose their Technical Devices Division distributorships. To help the dealers finance their larger inventories of mechanical testing devices, the division permitted dis- tributors to make five small monthly payments follow- ing delivery with a final balloon payment of roughly 60% of the original amount owed six months after the initial deliveries. The monthly payment schedule was based on the distributor's expected sell-through of in- ventories. The normal payment terms extended to dis- tributors was 1% upon delivery net 20 days. While the division had not contractually agreed to take back any excess dealer inventories of mechanical testing devices, the division's past generous practices of allowing dealer returns of excess inventories led nearly all of the dealers to believe there was little risk to them in the new sales strategy. All but one of its company's distributors accepted the division's ultima- tion and payment schedule. In 1998 the division had recorded a $23 million ex- cess inventory charge, primarily for its excess me- chanical testing instrument inventory. cerns about Ashaban Industries' ability to pay for the order and the division's ability to collect in the event of nonpayment. They noted that Ashaban and the division had been unable to secure bank, local government or international development agency payment guaran- tees. The concerned senior management also noted that contract law in Ashaban Industries' home country was evolving and it was hard to know what they were or how they might be interpreted. Later, just before the equipment was shipped, these same concerned man- agers noted that there was increasing unrest in the country and local importers seemed to be having diffi- culty obtaining foreign currency to pay for their for- eign currency denominated imports. Despite these misgivings, based on Ashaban Industries assurances that Wareham SC Systems would be paid, the division accepted the purchase order and shipped the equipment. Ashaban Industries, Ltd. Just as the third quarter of 2000 was to close, the Techni- cal Devices Division delivered, and the Ashaban Indus- tries, Ltd., the customer, accepted a $2 million order for mechanical testing equipment. Ashaban Industries in- tended to use local contractors to install the equipment. Ashaban Industries was a newly formed private company located in one of the former Soviet Re- publics established during the early 1990's as indepen- dent countries following the dissolution of the Soviet Union. Ashaban Industries was a new customer. Is was also the division's first customer among the now indepen- dent former Soviet Union Republics, which was a mar- ket that some of the division's top management had long hoped to penetrate, From the beginning of the negotiations preceding the signing of the Ashaban Industries firm purchase order, some of the division's top management had con

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