Larson Industries: A Case on Identifying and Researching Revenue Recognition Issues

Casey J. McNellis Gerhard J. Barone Gonzaga University

Joshua Herbold University of Illinois at Urbana–Champaign

ABSTRACT: Financial accounting students are often provided cues regarding a particular recognition/measurement issue prior to learning the related technical material. Yet, anecdotal evidence from the profession suggests that the identification and framing of complex issues is a necessary skill for emerging professionals. This case provides accounting students a hypothetical scenario that requires them to identify several financial reporting issues, research the relevant authoritative guidance, and arrive at conclusions regarding the appropriate reporting treatment. The recent implementation of the updated revenue recognition guidance per Topic 606 from the Financial Accounting Standards Board’s Accounting Standards Codificationt and IFRS 15 from the International Accounting Standards Board provides a current and relevant setting for this issue identification and evaluation exercise. Results from graduate-level courses at two universities indicate that students perceived great benefits in (1) identifying and framing revenue recognition issues without textbook cues and (2) learning the new authoritative guidance.

Keywords: FASB Codification; IFRS; revenue recognition; professional research.

I. THE CASE

O n February 15, 2019, the Chief Operating Officer of Larson Industries, Pete Moreen, announced a major step forward

for the company:

Today, we have entered into an agreement to sell our industry-leading product, the AM300, to Dynamic Wholesale,

Inc. Starting on May 31, Dynamic will begin offering the AM300 and our gift cards to its customers. Dynamic is one

of the largest wholesalers of consumer goods in the country, and this agreement is vital to the growth of Larson

Industries and the brand awareness of the AM300. This morning I spoke with Dynamic’s Vice President of Logistics,

Suzanne Roberts, who is very excited to carry our flagship product in order to better serve the Dynamic customer base.

Your Role and Task

As planned, Larson shipped the goods (and gift cards) to Dynamic on May 15, and all items were inspected and formally

accepted by Dynamic personnel and were delivered to the warehouses within ten days, available to be sold to Dynamic

customers on May 31. In preparation for closing the company’s books for the May 31 year-end, Chief Financial Officer

Catherine Budge is considering the appropriate accounting treatment of the transactions with Dynamic, including any issues

that may impact the company in subsequent accounting periods. This agreement with Dynamic has many unique features that

Larson has not yet encountered. As an experienced accountant, you have been asked to provide assistance to the CFO by

We appreciate the guidance offered throughout the review process from Valaria P. Vendrzyk (editor), an associate editor, and two anonymous reviewers. The case was completed by accounting students at the University of Montana and Gonzaga University, and we are grateful for their time, effort, and valuable feedback. We also thank Xiaoqing Huang for her help in preparing the manuscript.

Editor’s note: Accepted by Valaria P. Vendrzyk.

Submitted: February 2019 Accepted: January 2020

Published Online: February 2020

65

researching appropriate financial reporting guidance to determine the proper course of action for all of the relevant aspects of

this sales contract. Detailed information on the two companies and their agreement is provided below.

Larson Industries

Larson Industries is one of the leading manufacturers of specialty carpentry and premium craftwork tools. The AM300 is

the company’s most popular, user-friendly, and top-selling product, yet the company also produces other items for specialized

purposes. The tools range in retail price anywhere from $100–$350. However, each product is complemented by a number of

accessories, most of which are sold separately from $0.55–$9.95. The standard AM300 is sold with three hardware accessories

included—accessories that have proven to be the most popular with consumers. Larson sells its products (1) direct to

consumers via its website and factory outlet stores located in large shopping centers and (2) through several retail hardware

stores. With the Dynamic agreement in place, Larson expects that direct-to-consumer sales will account for approximately 50

percent of the company’s total sales in the coming years, while 30 percent will be sold through Dynamic and 20 percent

through other retailers. Of the direct-to-consumer sales, approximately 65 percent will come from the factory outlets, with the

remaining transactions taking place via the company’s website. The accessories are an integral part of its main products, and

Larson has determined that 78 percent of customers who purchased the main products have also purchased additional

accessories via the website or outlets.

The company primarily markets its products through its website, social media, and targeted TV ads. The company also

holds product demonstrations at a variety of industry trade shows, typically with a 15-minute video featuring the company’s

products. The company does a significant amount of marketing to its existing customers through its customer portal on its

website. The customer portal allows customers to create accounts, track previous purchases, and maintain an online shopping

cart. This system provides the company an opportunity to cater to its existing customer base and offer them cutting-edge

products.

The AM300 comes with a three-year manufacturer’s warranty, which covers the basic functionality of the main product.

Additionally, the company is well-known for replacing the included accessories, which are not covered by the warranty, at no

extra charge, during the three-year period for those customers who register the product. The warranty is a hallmark of the

product, and the customers value the accessories replacement provision. Recent history indicates that 80 percent of customers

filed claims related to particular accessories that come with the AM300. Only 4 percent of customers historically have filed

claims related to the main product, and almost all of these claims are made within ten months from the original sale.

Larson also sells gift cards, which are offered through the company as well as at many gift card kiosks of major retailers.

The Larson gift cards can be redeemed at any factory outlet or on the website. Customers are able to store gift card value online

through their customer accounts, and thus the gift card amounts can be applied to online purchases. Typically, 25 percent of

outstanding gift cards at the end of any given year hold a balance of $1 or less.

Dynamic Wholesale Inc.

Dynamic Wholesale Inc. operates a number of warehouses that offer a variety of goods to consumers. While the company

offers some grocery items, the bulk of its operations involve the sale of durable items. The company is well-known for its

product demonstrations that are similar to live 30-minute infomercials for these durable products. Large crowds of shoppers

often gather around demonstrations throughout the store, and Dynamic is the industry leader in this form of product promotion.

The company is also well-known for its return policy, which allows customers full refunds, with a valid receipt, for up to six

months following sale transactions. Customers who return items without receipts are allowed to exchange returned goods for

other goods within the same department as the original purchase. A major draw for warehouse customers is the Dynamic store

credit card, which entitles customers to a 5 percent discount on purchases when paying with the card. Because of Dynamic’s

prowess in the wholesale space, the company does not accept manufacturer coupons.

Agreement between Larson and Dynamic

The purchase order from Dynamic called for 1 million standard AM300s priced at $152 each to be shipped on May 15,

terms n/90, so that Dynamic had the opportunity to accept the shipment and place the goods on warehouse floors by May 31.

The agreement transfers legal title of the goods to Dynamic at the point of delivery at the warehouses. Dynamic will price the

goods at $249.99, the same price offered at Larson’s stores and website. The company also indicated interest in purchasing 1

million more products from Larson within the next year. However, the company currently did not have the warehouse capacity

to house the products and company managers were not certain as to when inventory would need to be reordered. Larson offered

to ‘‘reserve’’ the additional products for Dynamic and instructed inventory personnel to set the inventory aside on separate

66 McNellis, Barone, and Herbold

Issues in Accounting Education Volume 35, Number 2, 2020

pallets at the shipping locations, and told the accounts receivable department to send an invoice immediately to confirm

Dynamic’s interest in the additional goods.

The transaction, while mutually beneficial for both companies, came with certain risks that Dynamic and Larson addressed

in the initial purchase contract. Because the agreement represented a new venture into the wholesale space, one of Larson’s

concerns was that the AM300 would not sell efficiently at the $249.99 price point. Such a situation could halt any future orders

from Dynamic, potentially taking away Larson’s momentum in this part of the supply chain. Accordingly, Larson included in

the agreement a volume discount to Dynamic in a two-tiered plan. First, if Dynamic purchases a total of 1.5 million products

within six months (i.e., an additional 500,000 goods beyond the initial 1 million products ordered), Larson will provide a 10

percent retroactive discount on all 1.5 million products. Second, for any purchases beyond the 1.5 million products within the

six months, Larson will offer a 12 percent discount to the additional purchases.

In accordance with the risk of idle warehouse inventory, Larson was also worried that Dynamic may be prompted to offer

significant store discounts to free up warehouse space. The volume discounts would certainly allow Dynamic to do so without

sacrificing its expected profit margin for the AM300. Store discounts, however, could send a negative signal to the consumer

market about the relative quality of the AM300. To alleviate these concerns, Larson offered price protections to Dynamic,

stipulating that Dynamic would not offer any trade discounts to customers, aside from the standard 5 percent discount provided

to consumers using the Dynamic store credit card, and that any unsold items could be returned to Larson within the first 60 days

after May 31. Larson includes this price protection clause in its agreements with all business customers. This part of the

agreement was viewed favorably by Dynamic, whose chief concern was the inventory risk it was undertaking.

While Larson was interested in protecting the perception of its flagship product, it was also intently focused upon

increasing sales volume of the AM300 through a targeted plan. At the time of the agreement, Larson was developing a

manufacturer’s coupon, entitling customers to $50 off the AM300, with a 60-day expiration date. The coupon would allow

customers to redeem it on purchases from Larson’s website and factory outlets or at any retailer that accepts manufacturer

coupons. Retailers that accept the coupon could present any coupons received from customers to Larson for reimbursement of

the $50. Larson felt as though such a coupon gave the company control over the perception of product quality more effectively

than if the retailers/wholesalers had license to discount the product at differing price points. When Dynamic learned of Larson’s

plans, however, they became concerned that this coupon could drive sales away from its warehouses, especially with the price

protection agreement in place and Dynamic’s general policy with regard to manufacturer coupons. To counter, Dynamic

offered to accept Larson’s coupon as long as Larson did not honor coupon reimbursement requests from any other retailers,

thereby removing other retailers’ incentive to accept the coupon. Accordingly, the final coupon, limit one per customer, was to

be included in major newspapers across the country on May 31, explicitly redeemable only at Larson and at the point-of-sale at

Dynamic.

In order to promote the success of the agreement, Dynamic arranged product demonstrations of the AM300 at all of its

warehouses on the first weekend of each month from June–August 2019. The demonstration will be by Jackson Marketing

Services. With regard to the aforementioned perceptions of quality, though, Larson was skeptical about the nature of the

product demonstrations, as ineffective promotion could result in slow-moving inventory and perhaps greater returns from

Dynamic. As such, Larson demanded partial responsibility in creating the demonstration script and thus agreed to split the cost

of the product demonstrations with Dynamic. Dynamic, however, was adamant that (1) the ultimate presentation still follow

Dynamic’s typical style seen for all products and (2) the demonstration only promote the accessories included in the AM300.

Larson ultimately agreed to Dynamic’s points. Because Jackson and Dynamic have an ongoing relationship with regard to

product demonstrations taking place at the warehouses, Jackson billed Dynamic for the costs associated with the demonstration

services prior to each event. In turn, Dynamic gave Larson the option to pay its share of the costs by remitting payment to

Dynamic or by directly paying Jackson. Larson indicated that the first payment would be made directly to Jackson.

The sale of the AM300 to Dynamic has the potential to significantly increase Larson’s volume, yet the company also

understands the importance of the accessories sales to its business model. Given the nature of the product demonstrations to

take place, Larson is concerned that Dynamic customers will focus extensively on the accessories included with the AM300

product and will be unaware of or will ignore the other accessories available at the company’s website and stores. To address

this issue, Dynamic agreed to sell the company’s gift cards in addition to other retailers’ gift cards offered in the kiosks at

Dynamic. In turn, though, Dynamic was worried that the gift cards would lead customers to forgo purchases of the AM300 at

Dynamic warehouses, opting in favor of buying the gift cards and ultimately purchasing the product directly from Larson. As

such, Larson agreed to pay a 3 percent commission to Dynamic on the value of gift cards sold at Dynamic. The industry

standard, and the commission rate used by both Dynamic and Larson, is typically 2 percent.

Finally, with the agreement in place and with the increase in volume of sales occurring outside of Larson’s stores and

website, the company focused on the risk of a deterioration in customer service. Larson is very popular within the industry for

its service to customers experiencing issues with its products and accessories. As such, Larson asked Dynamic to accept all

warranty claims for the AM300 at its warehouses within the first year of sale to its customers, thus providing a convenient

Larson Industries: A Case on Identifying and Researching Revenue Recognition Issues 67

Issues in Accounting Education Volume 35, Number 2, 2020

option for customers experiencing problems with the product. For claims on the main product, Larson has instructed Dynamic

to provide customers the option of a refund or an exchange for a new AM300. Dynamic will send these products back to

Larson, and Larson will reimburse Dynamic for the refund or exchange amount and shipping costs. After the first year, all

warranty claims must be made directly to Larson.

II. REQUIREMENTS

Part I

Review the specifics of the agreement between Larson and Dynamic and generate a list of the potential accounting issues

related to Larson’s recognition of revenue on the sale of the AM300 to Dynamic. For each item in the list, specify: (1) the

characteristic of the agreement that generates the revenue recognition issue, and (2) the revenue recognition issue generated.

Browsing the authoritative revenue recognition guidance (i.e., the accounting standards) should help you in determining which

characteristics of the agreement will bring about revenue recognition issues. Your instructor will provide you with the

appropriate financial reporting framework (U.S. GAAP or IFRS) through which to evaluate the agreement. In a subsequent

class meeting, be prepared to hand in and discuss your list. This discussion should help prepare you for the requirements in Part

II below.

Part II

Prepare a memo to Catherine Budge identifying and analyzing the various accounting issues in the Larson-Dynamic

contract while recommending the appropriate accounting treatment. You should prepare your memo in a format that

specifically addresses the following components for each accounting issue:

? A summary of relevant case facts; ? A description of the specific accounting issue(s); ? An identification of the appropriate authoritative guidance (i.e., accounting standards); ? An analysis of the issue, including a consideration of alternative accounting treatments, if applicable; and ? A concise conclusion including your recommendation among the accounting alternatives.

On the due date of the memo, we will hold a class discussion on the case, and your work in preparing the memo will serve

as a basis for the discussion. Following the discussion, you will be allowed to submit a second and final draft of the memo. You

should highlight each issue, as it relates to a specific topic of the authoritative guidance, as a subsection of the memo. For

example, if you think the arrangement includes a financing of payments, you should identify one of the subsections as

‘‘Significant Financing Component,’’ which is the specific topic illustrated in the authoritative guidance.

68 McNellis, Barone, and Herbold

Issues in Accounting Education Volume 35, Number 2, 2020

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