CASE STUDY: International Productions Corporation

CASE 4: International Productions Corporation

In this case students are asked to advise the preparer of the financial statements. As a result responses should include consideration of all users and their objectives followed by a ranking of the objectives. The analysis that follows should be consistent with the ranking of the objectives. Different ranking of objectives are possible and different rankings should be assessed on their merit; that is, the support offered in the response. Similar rankings can be evaluated differently depending on the support. Similarly, the same recommendation can be evaluated differently depending on the support. Students should be rewarded for developing arguments in the vein presented. It is important to keep in mind that the students are in introductory accounting so it can’t be expected that they will be able to develop comprehensive arguments. Even though GAAP is a constraint in this question there should be no expectation that they will know the details of GAAP (such as CICA Handbook sections). Recommendations should be consistent with GAAP principles and concepts—if they are consistent then students should be rewarded. Student responses should be written in role and should be supportive of the CEOs objectives. Coverage of the issues below is not necessarily comprehensive. Additional valid points can be raised and should be recognized.

Role: • Advisor to the CEO and largest shareholder of IPC. Given the ongoing need for capital the CEO would likely want to take an aggressive stance on accounting issues so as to give confidence to lenders and equity investors. Advisor should try and support this view but stay within the constraints. Recommendations have to supported and reasonable if there is to be credibility. Auditors are involved so any recommendations have to be consistent with GAAP and otherwise be fair, while in accordance with GAAP.
Key users: • Lenders
• Prospective lenders (IPC is expanding rapidly and will likely continue to need access to capital)
• Non-management equity investors
• Prospective equity investors
Key facts: • IPC is rapidly expanding.
• Ongoing supply of cash is required to finance new shows and existing shows in new venues. Existing and prospective equity investors and lenders will use the financial statements to assess the attractiveness of their investments or the desirability of making new or additional investment.
• The CEO owns 30% of IPC’s equity. He will have a strong interest in ensuring an ongoing supply of capital to support the company. If cash flow is cut off or interrupted IPC would be is significant trouble and the CEOs wealth would be significantly impaired.
• The issues that have to be addressed are “soft” issues. There are no obvious solutions to them and, more importantly, actual users of the financial statements cannot definitively determine that they are right or wrong.
Constraints: • GAAP. IPC is audited so the financial statements are likely to be prepared in accordance with GAAP. Bank lenders and non-management equity investors would likely require this.
Objectives: • Income maximization
• Tax minimization
• Stewardship
• Cash flow prediction
• Performance/management evaluation
• From the perspective of the stakeholders, tax minimization, stewardship, cash flow prediction, and performance/management evaluation would be a sensible ranking. Tax minimization would conserve needed cash and the other three mentioned objectives would provide users with insights about IPC that would be useful for making decisions from there perspectives (more specific discussion of these objectives would be appropriate).
• From the perspective of the CEO (the preparer) the objective of income maximization might be more important so that he can attempt to keep investors and prospective investors satisfied and willing to provide needed capital.
• (Different rankings of objectives are possible and acceptable, if supported.)
Issues: • Penalty
• CEO would want to recognize the penalty as revenue in full in the current period to increase income.
• If penalty is paid to compensate for lost revenue or profit because of the delay this treatment makes sense. By opening the theatre later than intended revenue was lost. The penalty simply replaces the revenue/profit that was been lost.
• If the penalty is considered revenue in 2004 there is also question of how it should be disclosed—segregated as an unusual item or included in ordinary revenue.
• The penalty is clearly unusual, but it may be replacing revenues/profits that will be recurring. Including the amount in ordinary income would mean that stakeholders would include the amount in any forecasts of future earnings.
• An alternative treatment for the penalty would be to net it against the cost of the theatre.
• Since the penalty is effectively a reduction in the cost IPC pays to the construction company it makes sense to record the cost of the theatre at the net amount. In this alternative the benefit from the penalty would be spread over the life of the theatre.
• This second alternative would serve an objective of income smoothing
• Accounting, What Could be Better?
• Revenue recognition from sale of tickets
► When should ticket revenue be recognized: on performance or on sale of tickets.
► CEO would prefer recognizing revenue when tickets are sold but there is little support for that critical event. Performance clearly occurs when the show is performed.
► If the show is not performed tickets would have to be refunded.
► Would also be difficult to estimate the costs associated with the revenue—would have to know future production costs and allocate them to individual tickets.
► Recognize revenue on performance—facts prevail here.
• Interest revenue
► Should the interest revenue be recognized as earned or deferred?
► CEO would want to recognize as earned because it would increase income.
► Recognizing as earned is justified because the interest is not related to the show being produced and interest will not be returned to customers if the tickets have to be refunded.
• Pre-production costs
► Should production costs incurred before the show begins its run be capitalized and amortized over the life of the show or expensed as incurred.
► CEO would want to capitalize (and amortize over as long a period as possible) to increase income.
► Capitalizing costs is appropriate and makes sense if the show can produce revenue to cover the pre-productions costs.
► Capitalizing and amortizing makes for better matching of costs to revenues.
► Evidence suggests that the show will be a success. Over $21MM in tickets have been sold for the first 40 weeks. The show has also been a long running success in Europe.
► However, the show has not yet sold enough tickets to be profitable. Taking the pre-production costs ($15MM) and the weekly operating costs ($250K) makes for total costs for the first 40 weeks of $25MM versus revenues of $21,840,000.
► Key question is how to amortize these costs. From the CEOs standpoint, the longer the better. A long amortization period would make IPC look better in the eyes of stakeholders. (The treatment used would be very difficult for stakeholders to assess.) Could argue for a lengthy run (say five years) over which to amortize the costs.
► Weekly production costs should be expensed as incurred.
► The argument for expensing is conservatism—uncertainty about the success of the show, but evidence suggests this should not be a concern.
► Tax minimization would be best served by expensing as incurred.
► Students should use the quantitative data in their analyses.
• Accounting for sale of real estate
• Issue here is whether sale of theatres is a normal part of operations or incidental.
• If it is normal then sale amounts should be included in revenue and costs somewhere in operating costs.
• If incidental the amount would be reported as a gain on sale.
• Arguments could be made for each treatment. If IPC is effectively in the real estate business because it buys and sells real estate (using the real estate for a theatre in the interim) then treating the sales of real estate as revenue makes sense.
• It is likely that revenue from sale of theatres is much more variable than revenue from selling movie tickets, concessions, etc. For that reason it would probably be desirable for stakeholders to have the different types of revenue reported separately. There is no requirement that the types of revenue be reported separately. (Segment disclosure does not apply to private companies—students are not expected to know this though.)
• The CEO would probably want to disclose little about the different types of revenue because in the current year at least the sale of theatres has generated a large amount of revenue. This could convey a level of ongoing success to stakeholders that would affect forecasts and ultimately improve IPC’s ability to raise capital.
• Classic movie library
• Revenue recognition from $1MM contract
► Revenue could be recognized on signing of contract, ratably over the life of the contract, as each movie is shown, or at the completion of the contract.
► CEO would prefer recognition on signing, but this is premature because IPC has not delivered the promised access to the movies. In other words, the obligation to fulfill the contract has not been met. If for some reason IPC cannot deliver the movies as required it does not get the revenue. (Amount of revenue, cost, and collectability are assumed not to be problems here.)
► Completed contract is too late because movies presumably would have been delivered over the four years of the contract.
► Ratably and as movies are shown are both viable alternatives.
► As the movies are shown is straightforward. IPC becomes entitled to cash when a movie is shown. Thus this method links cash with revenue. Once a movie is shown there is no uncertainty about the ability of IPC to deliver a film as required. If the broadcaster does not make full access of the library it will still be required to make a payment to make the total $1,000,000. This payment would be made and recognized at the end of the contract.
► Ratably makes sense because what the broadcaster has purchased is access to the film library over four years. Exactly when access will be used is unclear at the outset. However, the revenue is earned with the passage of time. This method could create a significant disconnect with cash flow if the broadcaster does not use films from the library over the life of the contract.
► For purposes of increasing income it is not clear which of ratably and as the movies are shown is preferred. Which method generates more revenue early will depend on how the broadcaster makes use of the library. If it uses a lot of films right away the “as used method” will generate more profit early. If it does not make use of the library right away the “ratably” method will generate more income sooner. The ratably method provides for more predictable income flows ($250,000 per year).
► Students should discuss “performance” in their responses.
• Valuation of the library
► Is the library overvalued on the books of IPC and should it be written down?
► The CEO would not want the library written down because of the negative effect on earnings.
► There has been little interest in the library in its first year. However, a contract has been signed with a broadcaster.
► The recent contract establishes a market for the content of the library, so it is arguable that other broadcasters will eventually come calling.
► The library is has an unlimited life (the movies don’t wear out) so there is plenty of time to generate revenue from the library.
► It could be argued that the lack of interest and a single contract worth 20% of the cost of the library suggests that it is overvalued and should be written down.
► While the latter argument has some validity an acceptable argument can be made for not writing down the library.
► Under any circumstances this is a challenging issue to resolve. The net recoverable amount associated with the library is highly uncertain. Can another $4,000,000 in sales be generated?