CASE 6–1: Understanding Revenue Recognition

BIKE Company starts with $3,000 cash to finance its business plan of producing bike helmets using a simple assembly process. During the first month of business, the company signs sales contracts for 1,300 units (sales price of $9 per unit), produces 1,200 units (production cost of $7 per unit), ships 1,100 units, and collects in full for 900 units. Production costs are paid at the time of production. The company has only two other costs: (1) sales commissions of 10% of selling price when the company collects from the customer, and (2) shipping costs of $0.20 per unit paid at time of shipment. Selling price and all costs per unit have been constant and are likely to remain the same.

Required:

• a. Prepare comparative (side-by-side) balance sheets and income statements for the first month of BIKE Company for each of the following three alternatives:
  • (1) Revenue is recognized at the time of shipment.
  • (2) Revenue is recognized at the time of collection.
  • (3) Revenue is recognized at the time of production.

  Note: Net income for each of these three alternatives is (1) $990, (2) $810, and (3) $1,080, respectively.

• b. The method where revenue is recognized at time of collection, known as the installment method, is acceptable for financial reporting in unusual and special cases. Why is BIKE Company likely to prefer this method for tax purposes?
• c. Comment on the usefulness of the installment method for a credit analyst in using both the balance sheet and income statement.