Crazy Connor Cooper is a somewhat eccentric yet enthusiastic businessman who believes in the social responsibility of business. Incidentally, he is also interested in making enough money to live a comfortable life. As a supporter of the ecology movement, he is very concerned with the hunting of animals for industrial purposes, such as the making of furs, shoes, and ladies handbags. As a consequence, he formed Reptile Factory Enterprise (RFP), a company with a mission of promoting crocodiles as household pets. (The choice of the animal was purely coincidental.) He plans to catch crocodiles in Southeast Asia and sell them in the United States.1 The senior leadership team of the company consists of Mr. Connor Cooper (President), Brian Chu (Vice President of Production, who is in charge of catching crocodiles), Marco Diaz (Vice President of Sales), and Shelley Maze (Vice President of Operations, who is in charge of administrative functions including cash collection from customers). Facilities Planning The first task facing Mr. Cooper was to raise capital. This required estimating future capital needs by projecting the physical facilities and working capital needed for the business. Mr. Cooper's estimates showed that he would need a fleet of boats to catch crocodiles in Southeast Asia and a holding tank in the State of Gould to keep them alive in captivity after they are shipped. Because of the need to extend liberal credit terms to skeptical customers, the company needed working capital to carry inventories and receivables. Finally, the company needed a large start up investment for sales and an advertising campaign. The firm also needed funds to hire new employees and to rent office space in the State of Gould. Mr. Cooper asked Shelley Maze to prepare a forecast of activity to plan facility needs and to translate it into capital needed to start the business. First Year Results Based on the forecast provided by Ms. Maze, Mr. Cooper and his ecology minded friends raised the capital for acquiring the facilities. He leased ten boats in Southeast Asia, a 20,000 square foot warehouse with a holding tank for the crocodiles in the State of Gould, and a 2,500 square foot office in the State of Gould. Both the warehouse and the office were leased from Clyde Property Management (CPM) for three years, beginning January 1, 2008. The company opened its door for business on January 1, 2008. Marco Diaz launched an aggressive sales and advertising campaign built around the slogan that crocodiles were warm, friendly and greatly misunderstood creatures that deserved loving care. He designed a slick marketing campaign built initially around the slogan: "Crocodiles -- don't handbag them, handle them with love." During its first year, the company spent approximately $300,000 to catch 500 crocodiles. Of these, 300 crocodiles were sold and shipped to customers at a selling price of $1,000 per crocodile. Shipping costs of $50 per crocodile were paid for during the year. Customers were given liberal credit terms and only $160,000 from an equivalent 200 customers was collected during the first year. Ms. Maze estimated that as much as 20% of the sales price will be spent in collection costs and bad debts expenses. At the end of the first year, Mr. Cooper consulted with his other two colleagues and estimated that he could catch and sell 600 to 800 crocodiles for the next year. Because of the companys apparent success, Mr. Cooper wanted to expand its facilities. This meant getting funds to rent more boats and warehouse space. He believed that he could now overcome the skepticism of banks and ask for a loan. On January 2, 2009, Mr. Cooper notified Clyde Property Management that he no longer needed their current warehouse and office space. He would be vacating the properties by January 30th in order to move into larger facilities. 1 Assume that Mr. Cooper has somehow managed to obtain permits to sell live crocodiles legally. He asked Ms. Maze to prepare an income statement for the bank in accordance with generally accepted accounting principles (GAAP). In addition, since the executives were on a profit-sharing scheme, it was necessary to determine profits in order to pay year-end bonuses. Ms. Maze entrusted this task to her young staff accountant, Luis Norman, who had only recently graduated from college and was on his first job. After he familiarized himself with the facts, Norman realized that he needed to look up the GAAP accounting rules for preparing an income statement. At that same moment, he also realized with some consternation that he had sold his college accounting textbook when the course was over. Norman headed to his college library to find the relevant reference material. A review of his old accounting textbook told him that two GAAP principles were particularly relevant for his current task. The first was the matching principle, which requires that costs and revenues be matched by time periods. The other was the principle of revenue recognition. His next step was to copy and read the relevant sections of these principles from the pronouncements of the Financial Accounting Standards Board. Attachment 1 shows the results of Norman's research into the appropriate GAAP rules for preparing income statements. On first reading the material, Norman thought it was going to be easy to prepare an income statement. He remembered learning that for most businesses revenue was earned when good were sold (that is, when title passed from the seller to the buyer). However, as he read the statements of the FASB, he realized that revenues could be recognized when production was complete or when cash was collected. According to the FASB standard, "revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues.2 Norman realized that in order to determine the revenues for 2008, he must first determine when the earning process is complete. This, however, was not a usual business. Therefore, Norman was not sure when Reptile Factory Enterprise was "entitled to the benefits represented by the revenues". In order to determine the critical point in the operations cycle when the business could do this, he decided to talk to the three top executives. His first conversation was with Brian Chu, V.P. Production. Brian told him that catching crocodiles was the most critical activity for the business since it is difficult to trap them suckers and you can lose a few limbs in the process if you are not careful. Norman next spoke to Marco Diaz, V.P. Sales. Marco pointed out that while catching may be a dangerous activity, no one is likely to buy a crocodile because it is risky for us to catch them. He felt the companys success this year was largely due to his clever holiday season advertising campaign with its theme of: this year give that special someone something live! Someday they can produce their own shoes, handbags, and belts. Norman's final conversation was with Shelley Maze, V.P. of Operations. She told Norman that, in her opinion, the crucial activity for the business was cash collection. As she put it: Brian and Marco have never tried collecting cash. If they did, they would find out in a hurry that it is difficult to collect cash from people who keep crocodiles as pets. Besides, we don't have a collection agency that is willing to repossess live crocs! 2Financial Accounting Standards Board, Statement of Concepts # 5, Paragraph 83. The Lawyers Call Even as Norman was puzzling over how to proceed, he received a call from Ms. Shelley Maze. "Luis, I just heard from our lawyers. Apparently, Clyde Property Management (the property management company that leased us the warehouse and office space) is claiming that we had no right to break the lease. We are being sued for an amount equal to the balance of the lease term and for punitive damages. Later that day Luis received the memo from the lawyers.

Assume that you have been hired as a consultant by Shelley Maze to help her and Luis Norman. She has asked you for your help on the GAAP income statements and the legal issues arising from the lease cancellation. Please answer the following questions:

1. Compute the net income per crocodile assuming that only one crocodile was caught, sold, and collected on in this year. Assume the costs of shipping the 500 crocodiles from Southeast Asia to the State of Gould is part of the $300,000 cost of catching them. The $50 shipping cost is the cost of shipping each crocodile from the holding tank in the State of Gould to the customer.

2. a. Prepare three income statements for the year assuming that revenue is to be recognized when:

1. Crocodiles have been caught (i.e. production complete).

2. Crocodiles have been sold and delivered

3. Cash collections are complete

b. What income would you report for 2008? Why?

3. What compensatory damages, if any, are owed to Clyde Property Management?

4. What punitive damages, if any, are owed to Clyde Property Management? 5. Show the journal entry to record the legal liability arising from the potential lawsuit. (If you find there is no liability, show the entry needed if there were liability)