Analyze the relationship between measurement and recognition
With the amendment to the agreement, Frantek would no longer have the liability to pay financial penalties to Conte, which is the estimate of the fair value agreed upon by both Frantek and Conte when they signed the agreement. The liability will come into play when Frantek cannot deliver the microcomputer accessory boards according to Conte’s specifications of at least 100,000 boards within 12 months period. Therefore, with the amendment, Frantek can write off the financial penalties from its balance sheet.
Conte also loaned Frantek $6 million, payable in 36 months with accrued interest to assist Frantek with its working capital needs during the development stage of the boards. The amount of the liability is measured at the amount that Conte loan to Frantek plus the accrued interest occurred, which would be recognized at the end of the month. However, with the agreement amendment, Conte purchases of the boards would be paid for by reducing the $6 million loan from Conte to Frantek. This would complicate the revenue and liability recognition and classification for Frantek’s accounting. Therefore, Frantek should ask Conte to make a payment for boards separately while Frantek will pay back the loan to Conte accordingly, in order to create a separate audit trail for both aspects of the new agreement.
As a manufacturer of microcomputer parts and components, Frantek produces the boards according to the agreement with Conte. The cost of the boards should include the direct materials, direct labor, and overhead costs. However, as Frantek encountered some technical difficulties in developing the boards according to Conte’s satisfaction and that boards equipped with a certain manufacturer’s chip did not meet Conte’s operating standards. Frantek had to hire a third-party contractor to replace the chip with a different manufacturer’s chip that met Conte’s standards. The contractor charged Frantek $7 per board to replace the chip. Frantek must also include the cost charged by the contractor into the total costs for the board when calculating the cost of goods sold. With the agreement amendment, Conte will purchase the 41,000 accessory boards in Frantek’s inventory at 110 percent of Frantek’s cost as agreed in the agreement whereby Frantek must be responsible for the chip replacement. In addition, Conte ordered 20,000 of the remaining accessory boards held in Frantek’s inventory to have the chip replaced. As a result, there would be 21,000 of the accessory board with unsatisfactory chips. The value of the ending inventory would consist of Frantek cost only.
Explain recognition criteria in the context of this case.
According to FASB Statement of Financial Accounting Concepts No. 5, revenue is recognized when a transaction occurs and 1) the revenue is realized or realizable and 2) the revenue is earned. Revenue from a transaction must meet both criteria in order to be recognized. Revenue is generally considered realized when cash is received for the sale of a product or performance of a service. Therefore, Frantek will realize the revenue for the 38,000 boards after delivery to Conte. Furthermore, in the agreement, it also required that Conte make royalty payments to Frantek on the basis of a predetermined schedule of units shipped. Therefore, the royalty payment should be recognized as revenue in accordance with the units shipped. However, after the agreement amendment, Conte will pay Frantek the minimum royalty amount of $2 million specified in the original agreement and that Conte will not be liable for any additional royalties. Therefore, it should be realized as revenue when the payment is received.
Relate the effects of uncertainty on the recognition of assets and liabilities
In this case, the effects of uncertainty can cause serious problems about revenue recognition; the 38,000 boards that have been shipped may be recognized as included in the revenue but then at what price? Should the price of these boards be reduced by the amount of penalties? In addition, what proportion of the $2million royalty should be attributed to these boards? There is no royalty payment unless 100,000 boards are shipped. Can the company apportion a part of the expected royalty payment to the 38,000 boards that need to be sent? These are the causes of ambiguity about the recognition of revenue.
There are similar uncertainties about the valuation of inventories. There are 41,000 boards. Should these be treated as finished products? There is vagueness about the manner in which the boards will be shipped. The calculation of the cost price of the boards, if the $7 incurred by Franktek Inc on the boards will be incurred in the cost of the boards or will the 110 percent be calculated after the $7 is added? The real ambiguity is at what price will the inventories be evaluated? If the inventories are overvalued, then the profits of Franktek Inc will get inflated.
The uncertainty about liability recognition pertains to the $6million loan that Conte has given to Franktek Inc. The first uncertainty is whether the royalty of $2 million should be deducted from the $6 million. Second, should the asset of $2 million be recognized on the signing of the agreement or when the last board of the 41,000 stock is shipped? Third, should the sale of the 41,000 boards be recognized with the signing of the agreement?
Assess the limitations of current measurement and recognition criteria.
The source of current measurement and recognition criteria is provided by the FASB. This statement of the FASB recognizes the limitations of the current measurement and recognition criteria: As stated by FASB, “Applying the realization and earnings process approach to revenue recognition in Concepts Statement 5 can lead to conflicts with the definitions of assets and liabilities in Concepts Statement 6. That is because, in certain instances, the realization and earnings process approach results in the recognition of deferred debits and deferred credits that do not meet the definitions of assets and liabilities. The definitions of assets and liabilities are the keystones of the elements definitions in the Conceptual Framework, as evidenced by the Board's decision to define revenues and expenses in terms of changes in assets and liabilities. Earnings process and realization have yet to be defined precisely and in a manner that can be applied consistently across a range of industries and transactions. It is difficult to consistently identify when the earnings process and realization occur in multiple-element revenue-generating arrangements.” (FASB, 2008)
In case of Franktek Inc. the FASB recognition criteria can be applied. That is revenues can arise as a result of an unconditional right to receive consideration and the extinguishing of the reporting entity’s performance obligations (FASB,2008). As Franktek Inc’s performance obligation on 41,000 units is not extinguished it is not a sale. The current FASB guidance about liability recognition is that the liability should be recognized at the price it could be exchanged with a customer in a current transaction. (FASB, 2008) In the case of the $6 million liability that Franktek Inc has currently it would be very difficult to recognize at the end of the first year. Estimates may be made and these can lead to ambiguities and uncertainties the current FASB requirement prescribe disclosures about valuations techniques. It specifically prescribes exceptions to fair value measurements (FASB, 2008). These measurements if applied to Franktek Inc would give ambiguous results.
How to Resolve the Issues
For Frantek, it is recommended that the revenue be recognized only on the 38,000 boards that have been shipped, as this is what the FASB recommends. Although Conte has the right to order Frantek to replace the unsatisfactory chip in the remaining 41,000 boards, they would not be recognized as Frantek’s revenue if the remaining boards are not delivered to Conte. For any boards not ordered for chip replacement, Frantek will recognize this as their revenue whenever they have been shipped to Conte.
Frantek has to produce the boards according to the agreement with Conte over the certain period of time, the cost of the boards, which include the direct materials, direct labor, and overhead costs, will vary. Therefore it is our recommendation that Frantek should use FIFO or first-in, first-out inventory system for inventory valuation. The valuation of the inventories is that a fair value of the stock should be calculated for the balance 41,000 pieces that are in stock. The requirement that 20,000 boards need to be updated has no effect on the current stock valuation.
In order to assist Frantek with its working capital needs during the development stage of the boards, Conte loaned Frantek $6 million, payable in 36 months with accrued interest. Frantek has to recognize the loan from Conte and issues the notes payable for the amount of $6 million to Conte. As Frantek has to pay back to Conte within the period of 36 months, which is longer than one year, then Conte’s loan to Frantek would be regarded as long-term loan. Both the loan and the interest on the loan for one year should be shown as liabilities on the balance sheet.
Conclusion
In all of these issues there is a direct relationship between the measurement and recognition and these can only be recognized when they are certain and fully measurable. There are limitations on this case and certain assumptions needed to be made by both companies, such as assuming the cost of the inventory is worth less than the market value. The full impact depends upon the contract that has been signed and the full terms of the change as well as the accounting policies that are in place. However, the numerous changes that were made to the original agreement will have caused several changes to the financial reporting of Frantek and hopefully it has been outlined here in a successful manner.
References
Abdolmohammadi, M. & McQuade, R. Applied Research in Financial Reporting: Text & Cases. The McGraw Hill Companies, New York, New York, 2002.
Brigham Eugene F, Ehrhardt Michael C, (2007), Financial Management: Theory & Practice, South-Western College Publishing.
Briner Russell F, (2001, March), Subtle Issues in Revenue Recognition, CPA Journal
Financial Accounting Standards Board. (2008). Facts about FASB. Retrieved January 28, 2009 from the World Wide Web:
Williams Jan, Haka Sue, Bettner Mark S, Carcello Joseph V, (2006), Financial Accounting, McGraw-Hill/Irwin
