Case II (External Memo to Management): Stanley & Sons due March 23 @ 5pm

*The following is based on a Deloitte Trueblood Case

Stanley & Sons Inc. (the Company) assists clients by designing and implementing solutions that reduce the overall costs of its customers supply chains. The Company provides Just-In-Time (JIT) inventory management of spare parts used in its customers manufacturing processes to reduce cycle times and lower inventory-related costs.

The Company entered into a supply management contract (the Agreement) with Tadduni Partners (the Customer), an unrelated third party, to provide spare parts management services, including sourcing, procurement, repair, transport and delivery, and warehouse management.

The key terms of the agreement are as follows:

Purchase Process

A Customer provides the Company with a plan at the beginning of the year with a forecast of spare parts that it needs as part of its manufacturing process. On the basis of this plan, the Company purchases spare parts from third-party vendors and ships the spare parts directly to the Customers location. The Agreement states that the Customer determines the product and service specifications and that no changes or modifications can occur without the Customers consent. The Company purchases spare parts directly from vendors. Note that although the Company purchased the spare parts according to the plan, the Customer is not obligated or committed to purchase these spare parts.

The Company directly purchases from third-party vendors; the Customer is not involved in the purchasing process. Vendors name the Company in their invoices; the Customer is not named in the invoice. The Company is responsible for all payments to its vendors in purchasing the spare parts.

When spare parts are purchased by the Company, the vendor ships the spare parts directly to the Customers warehouse; however, the Customer does not purchase and obtain title to the spare parts in its warehouse until it issues a purchase order (P.O.) to the Company. At this point, the title of the inventory for which a P.O. has been authorized transfers from the Company to the Customer.

The Company is responsible for the quality of the product sold to the Customer, who has the right to return any defective product to the Company.

Purchase of spare parts by the Company is generally made in advance of receiving a P.O. from the Customer, and the Company is obligated to pay the vendors within the agreed-upon payment terms irrespective of whether the spare parts are sold to the Customer or payment is collected from the Customer.

The Company has latitude in vendor selection and negotiates pricing with its vendors. The Company sets the price it charges the Customer on the basis of the Companys cost plus a predetermined mark-up. If the Company is able to achieve certain cost savings for the Customer (on the basis of its ability to negotiate pricing with its vendors), it is entitled to bonus payments that are based on a percentage of such savings. Therefore, the better the Company does in negotiating savings for the Customer, the greater the margin it earns on each sale.

Spare parts inventory that is not purchased by the Customer as part of the P.O. process (because parts are obsolete or requirements have changed) remain the property of the Company. If the Company is not able to sell the inventory to other parties, the Customer will reimburse the Company for 50 percent of the cost of the unsold parts.

Warehouse Operations

The spare parts are held in the Customers warehouse, allowing immediate access to the spare parts, which avoids the cost of storage for the Company.

Although inventory is held in the Customers warehouse, risk of loss or damage remains with the Company, and insurance is paid for by the Company.

The Company has dedicated employees stationed at each Customers warehouse. These employees handle the day-to-day issues with spare parts received into the warehouse.

The Companys and Customers inventory systems are interfaced, allowing the Company to monitor stock levels.

Shipping Terms

As noted above, the spare parts are shipped directly from the vendors to the Customers warehouse. The Company retains title and risk of loss during shipping and at the Customers warehouse until a P.O. is issued by the Customer to purchase the spare parts. After the Customer issues the P.O., the title transfers, and the Company recognizes revenue.

Company Fee

The Company receives 5.5 percent as a consumption fee for spare parts that are consumed (i.e., purchased) by the Customer from the warehouse. In addition, as noted above, the Company earns other fees according to its ability to negotiate favorable pricing on the spare parts.

Required:

Write a memo to Stanley & Sons (Company) Management explaining whether they should record revenue on a gross or net basis in their contract with Tadduni Partners (Customer) under the new revenue recognition standard (Topic 606).

Because this memo is addressed to external management, writing quality is especially important. You want to explain the relevant part of the codification to Management to make it understandable and include ASC citations, so they can find the relevant sections if they wish. You then want to come to a conclusion on the correct accounting treatment (gross vs. net) and discuss the indicators and factors that lead you to that conclusion.

The question of whether the Company recognize gross vs. net revenue depends on whether the Company is acting as principal or an agent in the contract. This is discussed in the Codification in ASC 606-10-55-36 through ASC 606-10-55-39. In particular, ASC 606-10-55-39 provides the criteria for whether an entity is acting as a principal or an agent.

Your memo should be double spaced in 12 point font. It should be long as necessary to communicate your points effectively, and no longer.