Daily Grind Case

1
Daily Grind Case

• Daily Grind, Inc. (Daily Grind), a public
  company, manufactures and distributes branded
  personal organizers for sale in its
  company-operated retail stores. Daily Grind also
  sells its products to wholesalers through various
  royalty and license arrangements.
• Daily Grind negotiated a License Agreement with
  Pacific Paper Products (Pacific), a major
  manufacturer and distributor of office supplies.
• Pacific will have the right to distribute Daily
  Grind products to a specified retail channel in
  the United States. Based on the current demand
  for Daily Grinds products, Pacific believes that
  inclusion of certain Daily Grind organizers in
  its product mix will increase the awareness of,
  and hence the value of, other Pacific products.
• As consideration under the terms of the License
  Agreement, Pacific will pay Daily Grind a license
  fee of approximately 12 million for the right to
  use the Daily Grind trademarks for an indefinite
  term. Termination of the separate Supply and
  Royalty Agreement (see below) or execution of
  licensing or distribution agreements with
  competitors of Daily Grind constitutes a material
  breach that would cause the License Agreement to
  terminate.

2
Daily Grind Case

• The License Agreement specifies that the license
  fee is earned, payable, and contractually
  non-refundable as of the date of execution of the
  License Agreement.
• Daily Grind and Pacific also entered into a
  separate Supply and Royalty Agreement. Based on
  this agreement, Daily Grind will allow Pacific to
  distribute personal organizers manufactured by
  Daily Grind to a specified retail channel in the
  United States. As part of the Supply and Royalty
  Agreement, Pacific agreed to pay Daily Grind
  quarterly royalty payments based upon a
  predetermined royalty schedule. If Daily Grind
  cannot or does not provide the amount of product
  Pacific requires under the Supply and Royalty
  Agreement, Pacific maintains the right to enter
  into a separate manufacturing contract that would
  allow Pacific to use certain of Daily Grinds
  proprietary production methods.
• The sales terms (e.g., price, discounts) under
  the Supply and Royalty Agreement do not differ
  from the terms of other arrangements Daily Grind
  has with third parties to sell its products. The
  Supply and Royalty Agreement will expire ten
  years from the date of its execution and will
  renew automatically for successive ten-year terms
  thereafter, unless a material breach of contract
  occurs. Termination of the License Agreement (see
  above), non-payment of royalties due, or failure
  to meet sales performance goals would constitute
  a material breach under the terms of the Supply
  and Royalty Agreement. An independent party has
  evaluated the sales performance goals and has
  deemed them to be substantive.

3
Daily Grind Case

• Daily Grind has experience in both license and
  royalty arrangements and believes that both the
  License Agreement and the Supply and Royalty
  Agreement are priced at their respective fair
  values. Further supporting their conclusions,
  Daily Grind plans to engage an independent
  valuation expert to verify that the terms of the
  agreements are at fair value.
• Required Is it appropriate for Daily Grind to
  recognize the 12 million payment from Pacific
  under the terms of the License Agreement as
  revenue upon execution of the License Agreement?

4
Daily Grind Case

• An assessment must be made to determine if, in
  essence, the 12 million nonrefundable fee was to
  obtain the on-going right to obtain and sell
  Daily Grinds products or if Pacific places a
  separate value on the License Agreement.
• With regard to loan origination fees that are
  assessed by a creditor for the origination of a
  loan, paragraph 37 of FASB Statement No. 91,
  states the following The Board concluded that
  loan origination fees and direct loan origination
  costs should be accounted for as components of a
  loan's acquisition cost and recognized as an
  adjustment to the yield of the related loan. The
  Board considered and rejected the argument that
  loan origination is a separate revenue-producing
  activity and concluded that originating loans is
  but one means of acquiring a loan.

5
Daily Grind Case

• SAB No. 101 states, unless the up-front fee is
  in exchange for products delivered or services
  performed that represent the culmination of the
  earnings process, the deferral of revenue is
  appropriate.

6
Daily Grind Case--Conclusion

• 1. Given that termination of the License
  Agreement or the Supply and Royalty Agreement
  would result in termination of the other
  corresponding agreement, signing the License
  Agreement was not a discrete event for which the
  earnings process had been culminated.
• 2. Further, as the License Agreement has an
  indefinite term and the Supply and Royalty
  Agreement has an initial ten-year term that
  renews automatically for successive ten-year
  terms, revenue from the License Agreement should
  be recognized over the initial contract period
  (or longer if the relationship with Pacific is
  expected to extend beyond the initial term and
  Pacific continues to benefit from the payment of
  the up-front fee).

7
Revenue Recognition Over Time
Completed Contract Method
Long-term Construction Contracts
Percentage-of-Completion Method
8
Percentage-of-Completion Method
Measuring Progress Toward Completion
Cost incurred to date
Estimate of projects total cost
Gross profit estimate
9
Percentage-of-Completion Method
10
Percentage-of-Completion Method
Geller Construction entered into a three-year
contract to build a containment vessel for
Southeast Power Company. Presented below is
information about the contract.
Lets see how Geller will account for the
revenues and cost of this project using the
percentage-of-completion method.
11
Percentage-of-Completion Method
12
Percentage-of-Completion Method


13
Percentage-of-Completion Method
14
Percentage-of-Completion Method
15
Percentage-of-Completion Method
16
Percentage-of-Completion Method
17
Percentage-of-Completion Method

18
Percentage-of-Completion Method
19
Percentage-of-Completion Method
800,000 - 250,000 last year 550,000
20
Percentage-of-Completion Method
775,000 - 250,000 last year 525,000
21
Percentage-of-Completion Method
695,000 - 225,000 last year 470,000
22
Percentage-of-Completion Method
23
Percentage-of-Completion Method
24
Percentage-of-Completion Method
25
Percentage-of-Completion Method
26
Percentage-of-Completion Method
27
Percentage-of-Completion Method
Entry to transfer title to the customer.
28
A Thought Exercise E5-11
29
A Thought Exercise E5-11

• Requirement 1
• Construction in progress Costs incurred
  Profit recognized
• 100,000 ? 20,000
• Actual costs incurred in 2003 80,000

30
A Thought Exercise E5-11

• Requirement 2
• Billings Cash collections Acc. Rec.
• 94,000 ? 30,000
• Cash collections in 2003
• 64,000

31
A Thought Exercise E5-11

• Requirement 3
• Let A Actual cost in 2003
• Let T Actual cost in 2003 Estimated cost to
  complete
• Thus, A/T complete
• and A/T (Price T) Profit recognized in
  2003
• T (A/T) (Price T) T (Profit)
• A (Price T) T (Profit)
• 80,000 (1,600,000 T) T 20,000
• Dividing both sides by 20,000
• 4 (1,600,000 T) T
• Thus, 6,400,000 4T T
• 6,400,000 5T
• T 1,280,000 80,000 Estimated cost to
  complete
• Estimated cost to complete 1,280,000 - 80,000
  1,200,000

32
A Thought Exercise E5-11

• Requirement 4
• 80,000 X 1,280,000
• X 6.25

33
Completed Contract Method
Geller Construction entered into a three-year
contract to build a containment vessel for
Southeast Power Company. Presented below is
information about the contract.
Lets see how Geller will account for the
revenues and cost of this project using the
completed contract method.
34
Completed Contract Method
Gross profit is not recognized until project is
complete.
Entries are identical to the entries for
percentage of completion.
35
Completed Contract Method
Gross profit is not recognized until project is
complete.
Entries are identical to the entries for
percentage of completion.
36
Completed Contract Method
Gross profit is recognized in year 3 since
project is complete.
37
Completed Contract Method
Entry to transfer title to the customer.
38
Significant Uncertainty of Collectibility
When uncertainties about collectibility exist,
revenue recognition is delayed.

• Installment Sales Method
• Cost Recovery

39
Installment Sales Method

• Sale and cost of sale recorded as usual.
• Compute gross margin rate on the installment
  sales.
• Recognize gross margin as cash is received.
• Gross margin not realized is deferred until a
  future period.

40
Installment Sales Method
Clarke, Inc. had the following installment sales
in addition to its regular sales.
41
Installment Sales Method
Clarke, Inc. had the following installment sales
in addition to its regular sales.
At Dec. 31, 2005, Clarke, Inc. is still owed
30,000 from the 2004 sales and 75,000 from the
2005 sales.
42
Installment Sales Method
During 2003, Clarke collected 100,000 on its
installment sales.
Deferred gross profit is the difference between
the selling price and the cost of the inventory.
43
Installment Sales Method
This entry records the Realized Gross Profit by
adjusting the Deferred Gross Profit account.
44
Installment Sales Method
During 2004, Clarke collected 50,000 on its 2003
installment sales and 195,000 on its 2004
installment sales.
45
Installment Sales Method
During 2004, Clarke collected 50,000 on its 2003
installment sales and 195,000 on its 2004
installment sales.
46
Installment Sales Method
47
Installment Sales Method
48
Installment Sales Method
Balance Sheet
49
Cost Recovery Method
Clarke, Inc. had the following installment sales
in addition to its regular sales. The company
uses the cost recovery method to account for
installment sales.
45,000 200,000 22.50
50
Cost Recovery Method
The following schedule shows the pattern of cash
collections for the three year period.
Under the cost recovery method profit is not
recognized until the seller has recovered all of
the cost of the goods sold.
51
Cost Recovery Method
The entries are exactly the same as under the
Installment MethodEXCEPT that there is not an
entry to realize gross profit. Since we have not
collected cash in excess of COGS, no gross profit
is recognized in 2003.
52
Cost Recovery Method
In 2004, lets concentrate on the entries
relating to 2003 sales only.
Now can we recognize some profit?
53
Cost Recovery Method
Here are the entries we would make in 2005
relating to 2003 sales.
We have fully recovered the 155,000 cost during
2005, so the entire deferred gross profit will be
recognized.