Wal-Mart Stores: Everyday Low Prices in China
Summary: (Taken From Harvard's site)
Although Wal-Mart, the world's largest company by revenue, was into its 9th year of operations in China, its stores were still losing money. It had created a miracle in the U.S. retail industry by revolutionizing the sector's business model and successfully implementing its model through innovative practices that enabled it to sell national brands at "Every Day Low Prices". The challenge Wal-Mart faced was whether it could transport its successful model to win in a market with many differing characteristics which threatened its low-cost structure and which could nullify its competitive advantage. Concerned with the application of established domestic business models in international expansion. Also sheds light on other globalization issues such as market entry strategy, localization vs. standardization, the effect of regulation changes on the competitive landscape, and firm performance.
Learning Objective: (Taken From Harvard's site)
To address competitive advantage and its sources (differentiation and cost leadership); debate standardization and localization in international expansion and strategy formation--the fit between firm strategies and external environments; provide students with a basic understanding of the concept of competitive advantage and its sources through a discussion of Wal-Mart's success in the U.S.; discuss the challenges of replicating a successful domestic strategy in a different market environment; explore whether a firm is able to transport its competitive advantage from one market to another using the example of Wal-Mart's entry into China; and think about potential strategies that Wal-Mart China should consider going forward.
Subjects Covered: (Taken From Harvard's site)
Competitive strategy, Global strategy, Consumer behavior, Industry standards, Standardization, Competitive advantage, Expansion, Consumer goods, Department stores, Retail stores, Retailers, Retailing, Business & government, Government & business, Multinational corporations, Internationalization, Localization, Public administration, Public sector.
(My Notes)
Users & Objectives:
1. Cassian Cheung- President of Wal-Mart China, recently resigned
2. Sam Walton, founder
3. Joe Hartfield- CEO of Wal-Mart Asia
Competitors:
• world rival- Carrefour, Thailand's Lotus, Uk's Tesco, Germany's Metro
• foreign operators would usually have a dominant market position at their home markets, strong liquidity, and came with long term plans for China
• mostly operated in the form of hypermarkets
Financial position:
• poor financial results for Wal-Mart China
WAL MART US
Strategy in US:
• opened “one horse”, rural, backwater towns ignored by other retailers
• aimed to serve customers who had travel long distances to save money
• grew outside competitors' radar screens to a substantial size to command economies of scale
• public listing provided company with ample resources to finance more rapid expansion
• selling brand name products for less
• offered multiple store formats, including discount stores, supercentres, warehouse stores, and neighbourhood markets
• brought customers from all income levels
• unique combination of culture and strategies at Wal-Mart that set it apart from its competition
• started by opening discount stores in small towns: (1) avoided direct competition from stronger players, (2) due to small populations it served once Wal-Mart opened a store, the town could not support another store of similar size, and (3) rural backwaters also reduced costs due to lower land and real estate prices
Cost Controls:
• one of company's core capabilities
• only worthwhile cost was the one that got their customers to buy a product and everybody played a part in keeping the cost down
• goal: to drive down the price of products to the lowest they could possibly be
• had a huge purchasing power with 68,000 suppliers, “love hate relationship”
• Wal-Mart demanded lower price, high quality, efficient bookkeeping and punctual delivery from their suppliers
• helped suppliers improve inventory management and efficiency by weeding out extra costs
• forced its suppliers to search hard for ways to eliminate the inefficiency in their own processes in order to drive costs to a minimum and to improve the quality of their products
Logistics Management:
• target was to have inventories at half the rate of sales and to have any required delivery arriving on the shelved within one day
• no store was more than a day's drive from its distribution centre
• use of technology gave Wal-Mart great efficiency in the supply chain arrangement and was a distinct competitive advantage, started using electronic data interchange (EDI), satellite technology: able to connect all stores to home office
• enabled it to offer its customers the right product mix at the right time while keeping inventory and associated costs as low as they could possibly be
Benefits to Workers:
• started profit sharing plans for rank and file workers, 2/3 of the American workforce owned stock in Wal-Mart
• “cross training”: people switched jobs to enable them to understand different parts of the company's operation, which gave them more variation int heir jobs
• financial numbers were also shared with every employee
• position against unions, would rather close a store than allow it to be unionised
• promotes open door policy so that employees could channel complaints
• employees were motivated, happy, and passionate about their job
Competitive Advantage in which customers were looking for:
• Quality of merchandise
• assortment of goods
• price level
• store environment
• customer support
• store hours
• availability of free parking
• Wal- Mart focused on two major drivers: Price and Service
• each Wal-Mart store monitored the prices of about 1500 items in their competitors' stores
• objective: to offer same merchandise at other local stores but at 20% less
• on-going program to lower prices even further when there was the opportunity to do so “roll back”
• “Special Buy”: a product with a special tag that offered everyday items bundled with additional amounts of the same product or another product for a limited time
Customer Service:
• 3 cardinal beliefs: (1) providing great customer service, (2) showing respect for the individual, and (3) striving for excellence
• these beliefs were translated to 10 specific business rules for every executive/ associate
• “Sundown rule” required for employees to answer requests from customers by the end of business hours
Wal Mart China
• 95% of world population was outside U.S
• Wal-mart China has been losing money since they arrived in August 1996
• Wal-Mart in Germany failed because it was hindered by strict union rule,high labour costs, zoning laws and existing competition
• growth in rural areas was much slower
• problems such as, backward infrastructure, diverse regional consumption patterns
• entry into the WTO gave foreign companies more control over wholesaling and distribution
• industry was crowded with both internationally renowned retailers and domestic players
• resulted to high store density in larger cities
• retail market was undergoing continuous consolidation to eliminate weaker operators
• foreign retailers grew rapidly and commanded a market share estimated at only 3% in 2004
• local rivals were competing head on with foreign operators
• supermarket segment was primarily dominated by domestic players
• localised demand, localised supply base, and localised distributio in China also provided domestic players with an edge in establishing strong regional dominance when foreign retailers found it hard to leverage national presence in a regional market
• China saw substantial growth but many factors either a legacy of history or ew phenomena born of reform still impeded the fast development of a national market
Income Disparity
• broadened gap I wealth between rich and poor and between urban and rural populatios
• income below US$500 limit purchases to daily necessities
• US $1000-$2000 purchase consumer durables and commercial housing
• US$2000- look for sophisticated products and advanced information services
• almost impossible to develop a uniformed national merchandising or marketing strategy
• satisfying consumer's demand in different regions became a costly practice
• low income in rural areas raised concerns on Wal-Mart's US-bred strategy of locating stores in smaller communities
• questions whether such areas could support a large supercentre and were forced to re-focus on more expensive, urban locations
Local Protectionism
• local governments had incetives to protect state-owned enterprises under their jurisdiction as they were the base of their political power and a source of private benefits as well as fiscal revenue
• Wal Mart's entrance to Shanghai: published a new commercial plan to restrict the opening of new supercentres in the inner city
• delay in obtaining municipal approval put Wal-Mart in a much disadvantaged position against major competition in Shanghai's retail market
Infrastructure:
• highways were costly to use, toll fees reached as much as 10% or more of total freight costs
• toll collection at the local level was arbitrary and illegal
• under-developed highway network that Wal-Mart depended on increased costs and more waste especially with perishable goods
• backward transportation network greatly added to the cost of inter-regional distribution
• logistics costs were around 20% of GDP compared with just 10-12% I developed markets
Regulatory Restrictions:
• when distribution centre served a large enough number of stores, economies of scale would be achieved therefore pushing costs down
• only three stores were allowed to be launched in one city and only a hadful of cities were open to foreign retailers
• every store opening had to be approved by the central government
• therefore this made Wal-Mart's expansion very slow
• stores in China were supported by two distribution centres, and they were significantly underused but was required given the slow speed of transportation thus usig the distribution centres did not enable Wal-Mart to reduce costs
• Carrefour expanded quickly to occupy important markets and established network by openly bending Chinese regulations
Lack of IT Network:
• lack of IT network and regulatory ban of satellite usage impaired retailer's effieciency in communicating with its 15,000 local suppliers
Chinese Consumers Culture
1. Many Trips, Little Purchase
• many Chinese spent leisure time in commercial centres instead of staying home and compared prices and quality among different shops
• purchase was often impulsive rather than according to plan
• consumers were brand conscious ad loyalty was very hard to cultivate when consumers always shopped around for best bargain
• people would rather pick up a small amount of goods at one time because most shoppers bked or walked which limited bulk buys
• takes Chinese customer at least 5 trips to buy as much as American shopper got I oe
• average cost of serving customer greatly increased
2. Fresh Means Alive
• freshness of food was an indication of quality
• Customers' demad for absolute freshness with poor transportation network required that a large variety of foods had to be procured locally instead of through Wal-Mart's centralised pocuremet system
• diminished economies of scale and interrupted supply chain meant higher costs insatisfying Chinese customers
3. Shoplifting
• associates morale was to easy to maintain when they were paid low wages and did ot have the upside of stock options
• management turn over was high
• labour official in China's Wal-Mart condemned for squeezing suppliers and making workers suffer
Class Discussion Questions: (Class Note)
1. Why is Wal-Mart successful in the US? What are Wal-Mart's competitive advantages and its sources?
Key Success Factors in US:
• one stop shop- buy things I bulk
• different values
• very patriotic
• low cost
• good logistics
• anti unionization policy
• frugal culture
• creative barriers to entry (rural locations)- small town
• reputation
• squeeze suppliers
• efficient logistics
• hiring practices (reducing benefits paid)
• own store brands
• product mix (only products that sell)
• continuously create value
• economies of scale
2. Should Wal-Mart replicate its domestic model in its original form in China? Why? Can it build the same competitive advantage in China through its success domestic model
3. Provide suggestions on potential strategies that Wal-Mart China should consider in going forward.
Wal Mart in China:(Using what is applicable/ not applicable to China from US key success factors)
• logistics: in store housing to reduce transportation, undercut transports, work with local suppliers who established transportig
• squeezing suppliers: no urgent need to modify, suppliers willing to be squeezed, because too many products/ suppliers already
• frugal culture: keep- anti unionization policy (Not applicable In China)
• create barriers to entry (rural locations)- must be modified, rural areas in China cannot support a Wal-Mart, build near highway (suburbs)
• reputation as U.S icon
• Economies of scale- parter with powerful Carforre is a good idea
Showing posts with label case study. Show all posts
Showing posts with label case study. Show all posts
Saturday, April 4, 2009
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?
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?
BUSINESS CASE: Angela Kellett, Barrister and Solicitor
CASE 3: Angela Kellett, Barrister and Solicitor
Role: • An accounting advisor engaged by a lawyer to help with concerns about an earnout arrangement (payment for the purchase of a business based on performance after the sale has closed).
Key users: • Ms. Kellett and Mr. Jones are the only relevant users. Ms. Kellett will use the report to assist her in assessing the earnout agreement.
Key facts: • Earnout arrangement being proposed for sale of company.
• Selling price will depend on earnings after the sale closes and buyer (role is working for the seller) will prepare the financial statements.
• Ms. Kellett and Mr. Jones are unsophisticated financial statement users.
• Financial statements have a number of “soft spots” that could lead to Mr. Jones being disadvantaged by the earnout arrangement.
Constraints: • The purchaser has suggested the earnout state that the financial statements be prepared using GAAP consistently applied. A clean audit opinion would also be required. Tighter constraints are required because GAAP still provides significant leeway to the new owners that will allow them to disadvantage Mr. Jones.
Objectives: • Identify soft spots in the financial statements and propose ways to protect Mr. Jones from not receiving fair compensation for his business
Issues: • Possible non-arm’s length transactions.
• Inuvik will be a major supplier to other companies that the buyer owns.
• This is a reasonable strategy for the buyer but it creates risks for Mr. Jones because transactions between Inuvik and the other companies are not at arm’s length and the selling price used in the transactions may not be at market value.
• The new owner could require sales to occur at below market value, which would lower Inuvik’s net income and lower the payment to Mr. Jones. Doing this would be beneficial to the new owner.
• Contract should specify that sales to related parties should be at fair value and that independent verification be allowed if requested by Mr. Jones.
• Inventory valuation and write offs/downs.
• The contract protects Mr. Jones from changes in the accounting policies used for inventory because GAAP must be consistently applied.
• However, by its nature specific identification allows for manipulation because the managers can choose the actual items sold (if they are identical).
• Also a significant problem is that Inuvik has a supply of old inventory (that is still used).
• The new owner could decide that this old inventory is obsolete and write it down. This would reduce net income and the payment to Mr. Jones.
• The timing and amount of write downs is often arbitrary and with old, seldom used inventory a reasonable case could probably be made for a write down (with the auditor’s agreement).
• Mr. Jones and the buyer should determine which inventory is still useable and the earnout agreement should specify that that inventory should not be written down or off.
• New equipment purchase and accounting treatment of old equipment.
• New equipment could be amortized using a different amortization policy than the old.
• For example, the old equipment might be amortized using straight-line amortization while the new could have an accelerated method. This would not be a change in accounting policy so it would be allowable.
• Accelerated amortization would result in higher expenses in the first years compared with straight line, which would reduce the payment to Mr. Jones.
• The new owner could also choose a short amortization period.
• Mr. Jones and the buyer should agree on the amortization method that would be used on new equipment and the useful life and salvage value.
• If new equipment is purchased it result in the old equipment to be written down or written off.
• The information provided by Mr. Jones suggests that the old equipment would only be used on a limited basis if new equipment was purchased, which suggests the need for a write down.
• The amount and timing of write downs are subject to considerable judgement by the preparers of the financial statements.
• Mr. Jones and the buyer should agree to how possible write downs of the existing equipment should be dealt with in the earnout arrangement.
• Revenue recognition, returns, and bad debts.
• Inuvik should not be able to change its method of revenue recognition since the contract states that the financial statements must adhere to GAAP consistently applied.
• Change in revenue recognition policy would only be possible if the terms of transactions changed.
• There could be a problem with sales of components made using the new technology because the cost of the warranty may not be measurable (see the warranty issue).
• Otherwise there may be flexibility in setting the amount of bad debts.
• The earnout arrangement should specify the acceptable amount of provision for bad debts.
• Development costs.
• Development costs must have future benefits to be classified as assets (there are detailed rules for determining whether an expenditure can be capitalized as a development cost but students are not expected to know these rules).
• Judgement is required to determine whether they should be written down or off in a period.
• The new owner could elect to write the development costs down or off during the period on the basis that they are impaired.
• The new owner could also shorten the amortization period of the development costs.
• Both of the above two points would reduce net income and the amount of the payout to Mr. Jones.
• Mr. Jones and the buyer should agree on the status of the development costs at the time the sale closes. At that time the development costs should either be written down or off or the parties agree to no changes in how they are accounted for over the earnout period.
• Warranty costs
• Warranty costs should be expensed at the time the associated revenue is recognized (matching).
• Because the actual warranty costs will be incurred in the future it is necessary to estimate them at the time the sale is made.
• For existing products there appears to be a reasonable track record on warranty costs. Mr. Jones and the buyer should agree on the basis for determining the warranty provision (percentage of revenue that should be expensed).
• Without an agreement the buyer could increase the amount of the provision (probably by a small amount on a percentage basis).
• For the new product the issue is more serious.
• It is uncertain what the warranty costs will be for the new products and so the buyer may have significant flexibility in determining the provision.
• Revenue recognition rules allow for deferral of revenue recognition if it is not possible to make a reasonable estimate of the amount of the warranty provision.
• Mr. Jones and the buyer need to lay out the terms for the warranty on the new product. Some agreeable basis for determining the amount is necessary to avoid surprises described above.
• Goodwill
• Goodwill is not amortized but must be evaluated regularly to determine if it is impaired. If impaired the goodwill should be written down.
• Goodwill is a residual representing the amount of the purchase price of an entity that cannot be attributed to identifiable assets and liabilities. As a result what exactly goodwill is is not known.
• Because of its nature management could decide that a write down of goodwill is required. (The CICA Handbook provides rules for determining whether goodwill is impaired but students are not required to know these rules. However, because of its nature there is considerable judgement and subjectivity in the assessment).
• Management could argue that some or all of the goodwill is impaired with the impact that net income would be reduced and the payment to Mr. Jones decreased.
• Mr. Jones and the buyer should agree on the status of the goodwill at the time the sale closes. At that time the goodwill should either be written down or off or the parties agree to no changes in how it accounted for.
• Manager compensation
• The new manager of Inuvik will be the son of the new owner.
• Compensation will be a related party transaction and may not be at all related to the market value of the work the son does.
• Son could be significantly overpaid to reduce income and reduce the amount that would have to be paid to Mr. Jones.
• Earnout agreement should specify an appropriate wage for the manager, or not include manager compensation in the earnout calculation
Role: • An accounting advisor engaged by a lawyer to help with concerns about an earnout arrangement (payment for the purchase of a business based on performance after the sale has closed).
Key users: • Ms. Kellett and Mr. Jones are the only relevant users. Ms. Kellett will use the report to assist her in assessing the earnout agreement.
Key facts: • Earnout arrangement being proposed for sale of company.
• Selling price will depend on earnings after the sale closes and buyer (role is working for the seller) will prepare the financial statements.
• Ms. Kellett and Mr. Jones are unsophisticated financial statement users.
• Financial statements have a number of “soft spots” that could lead to Mr. Jones being disadvantaged by the earnout arrangement.
Constraints: • The purchaser has suggested the earnout state that the financial statements be prepared using GAAP consistently applied. A clean audit opinion would also be required. Tighter constraints are required because GAAP still provides significant leeway to the new owners that will allow them to disadvantage Mr. Jones.
Objectives: • Identify soft spots in the financial statements and propose ways to protect Mr. Jones from not receiving fair compensation for his business
Issues: • Possible non-arm’s length transactions.
• Inuvik will be a major supplier to other companies that the buyer owns.
• This is a reasonable strategy for the buyer but it creates risks for Mr. Jones because transactions between Inuvik and the other companies are not at arm’s length and the selling price used in the transactions may not be at market value.
• The new owner could require sales to occur at below market value, which would lower Inuvik’s net income and lower the payment to Mr. Jones. Doing this would be beneficial to the new owner.
• Contract should specify that sales to related parties should be at fair value and that independent verification be allowed if requested by Mr. Jones.
• Inventory valuation and write offs/downs.
• The contract protects Mr. Jones from changes in the accounting policies used for inventory because GAAP must be consistently applied.
• However, by its nature specific identification allows for manipulation because the managers can choose the actual items sold (if they are identical).
• Also a significant problem is that Inuvik has a supply of old inventory (that is still used).
• The new owner could decide that this old inventory is obsolete and write it down. This would reduce net income and the payment to Mr. Jones.
• The timing and amount of write downs is often arbitrary and with old, seldom used inventory a reasonable case could probably be made for a write down (with the auditor’s agreement).
• Mr. Jones and the buyer should determine which inventory is still useable and the earnout agreement should specify that that inventory should not be written down or off.
• New equipment purchase and accounting treatment of old equipment.
• New equipment could be amortized using a different amortization policy than the old.
• For example, the old equipment might be amortized using straight-line amortization while the new could have an accelerated method. This would not be a change in accounting policy so it would be allowable.
• Accelerated amortization would result in higher expenses in the first years compared with straight line, which would reduce the payment to Mr. Jones.
• The new owner could also choose a short amortization period.
• Mr. Jones and the buyer should agree on the amortization method that would be used on new equipment and the useful life and salvage value.
• If new equipment is purchased it result in the old equipment to be written down or written off.
• The information provided by Mr. Jones suggests that the old equipment would only be used on a limited basis if new equipment was purchased, which suggests the need for a write down.
• The amount and timing of write downs are subject to considerable judgement by the preparers of the financial statements.
• Mr. Jones and the buyer should agree to how possible write downs of the existing equipment should be dealt with in the earnout arrangement.
• Revenue recognition, returns, and bad debts.
• Inuvik should not be able to change its method of revenue recognition since the contract states that the financial statements must adhere to GAAP consistently applied.
• Change in revenue recognition policy would only be possible if the terms of transactions changed.
• There could be a problem with sales of components made using the new technology because the cost of the warranty may not be measurable (see the warranty issue).
• Otherwise there may be flexibility in setting the amount of bad debts.
• The earnout arrangement should specify the acceptable amount of provision for bad debts.
• Development costs.
• Development costs must have future benefits to be classified as assets (there are detailed rules for determining whether an expenditure can be capitalized as a development cost but students are not expected to know these rules).
• Judgement is required to determine whether they should be written down or off in a period.
• The new owner could elect to write the development costs down or off during the period on the basis that they are impaired.
• The new owner could also shorten the amortization period of the development costs.
• Both of the above two points would reduce net income and the amount of the payout to Mr. Jones.
• Mr. Jones and the buyer should agree on the status of the development costs at the time the sale closes. At that time the development costs should either be written down or off or the parties agree to no changes in how they are accounted for over the earnout period.
• Warranty costs
• Warranty costs should be expensed at the time the associated revenue is recognized (matching).
• Because the actual warranty costs will be incurred in the future it is necessary to estimate them at the time the sale is made.
• For existing products there appears to be a reasonable track record on warranty costs. Mr. Jones and the buyer should agree on the basis for determining the warranty provision (percentage of revenue that should be expensed).
• Without an agreement the buyer could increase the amount of the provision (probably by a small amount on a percentage basis).
• For the new product the issue is more serious.
• It is uncertain what the warranty costs will be for the new products and so the buyer may have significant flexibility in determining the provision.
• Revenue recognition rules allow for deferral of revenue recognition if it is not possible to make a reasonable estimate of the amount of the warranty provision.
• Mr. Jones and the buyer need to lay out the terms for the warranty on the new product. Some agreeable basis for determining the amount is necessary to avoid surprises described above.
• Goodwill
• Goodwill is not amortized but must be evaluated regularly to determine if it is impaired. If impaired the goodwill should be written down.
• Goodwill is a residual representing the amount of the purchase price of an entity that cannot be attributed to identifiable assets and liabilities. As a result what exactly goodwill is is not known.
• Because of its nature management could decide that a write down of goodwill is required. (The CICA Handbook provides rules for determining whether goodwill is impaired but students are not required to know these rules. However, because of its nature there is considerable judgement and subjectivity in the assessment).
• Management could argue that some or all of the goodwill is impaired with the impact that net income would be reduced and the payment to Mr. Jones decreased.
• Mr. Jones and the buyer should agree on the status of the goodwill at the time the sale closes. At that time the goodwill should either be written down or off or the parties agree to no changes in how it accounted for.
• Manager compensation
• The new manager of Inuvik will be the son of the new owner.
• Compensation will be a related party transaction and may not be at all related to the market value of the work the son does.
• Son could be significantly overpaid to reduce income and reduce the amount that would have to be paid to Mr. Jones.
• Earnout agreement should specify an appropriate wage for the manager, or not include manager compensation in the earnout calculation
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