Applied Research in Financial Reporting: Text and Cases Chapter 3 The Case Research Approach

Chapter Issues Definition of a Case Study Case Based Research: Case Development Research Sources for case development Case Analysis Research Differences with problem/exercise approach Simple vs. complex cases

Case Study Definition A case study is a documentation of a real world situation It focuses on problem situations in need of research and resolution Can be very detailed covering various functional areas (e.g., accounting, marketing) Can be short covering only one functional area (e.g., accounting)

Case Development Research Requires field work Researcher must have the requisite knowledge and experience of the field Researcher must be a careful and unbiased listener as well as a good evidence collector Researchers must consult multiple sources, also called triangulation, for evidence A need for a detailed plan of action, or protocol Staff must be trained to conduct evidence gathering

Sources for Case Development Archives of accounting firms Supplanted with field research Archives of the SEC Other sources (e.g., the Wall Street Journal reports on companies)

Cases vs. Problems/Exercises (Exhibit 3-2) 1. Information Setup 2. Source of Information 3. Nature of Questions 4. Solution 5. Assumptions 6. Authoritative Source

Cases vs. Problems/Exercises 7. Synthesis 8. Discussion 9. Cognitive Demand 10. Justification 11. Report 12. Documentation

Models of Case Analysis Analysis of Simple Cases These cases have specific requirements similar to problems and exercises The specific requirements are designed to reduce the complexity of the case Woodside Recreation, Inc. Is an example

Woodside Recreation, Inc. Facts Campground, cabins and recreational facilities within 3-hours of major cities Membership cost of $6,000 plus $30/year Use as many times as you want up to three weeks each time, but don’t make it a year-round home Average campsites 300 to be sold to 3000 members

Woodside Recreation, Inc. Facts Average per site in operation over 3 years: 6.8 members Average for all operating sites: 5.6 members Woodside opens campground when 25-30% membership is sold Sales during first 3-years average 24%, after that 2% additional annually You can buy with 10% down and pay the rest over 72 months

Woodside Recreation, Inc. Facts During the last 3 years, 23% of new members’ fees were received in cash Woodside books the entire membership amount as revenue 85% of revenues are from new sales Marketing costs are 45% of membership sales

Woodside Recreation, Inc. Facts Land acquisition is capitalized and amortized by the ratio of membership sold/maximum sites per campground Land acquisition is reported as “Operating Real Estate” net of an “Allowance for Costs of Membership Sales” Installment Contracts Receivables are used as collateral for debt. Current debt to equity ratio = 3.5 to 1.0

Woodside Recreation, Inc. Discussion Requirement 1: Earnings quality defined as correlation of earnings to cash flows at issue is whether the reported earnings can be sustained over the longer period of time Books sales with only 10% down Over three years, only 23% have paid cash for purchases

Woodside Recreation, Inc. Discussion Requirement 1: Earnings quality This can be fine per APB No. 10 if appropriate provision for uncollectible accounts exists But aggressive marketing and liberal credit granting makes collection questionable Allocating cost of land acquisition on the basis of expected members/maximum membership underestimates amortization cost due to slow sales Installment sale (SFAS 66) may be appropriate (used by analogy to make a point)

Woodside Recreation, Inc. Discussion Requirement 2: What financials should be changed? Use installment sales Defer revenue until a certain percentage of the contract is collected Increase provision for doubtful account Increase write-off for land and improvement costs

Woodside Recreation, Inc. Discussion Requirement 2: What financials should be changed? (Dollars in thousands) As Reported As Revised Membership sales $28,000 $28,000 Dues and miscellaneous 5,000 5,000 Provision for doubtful accounts (5,600) (7,000) Net operating revenues 27,400 26,000 Marketing expenses (45%) 12,600 12,600 Land and improvement costs 12,000 15,000 24,600 27,600 Income (loss) $ 2,800 $(1,600)

Woodside Recreation, Inc. Discussion Requirement 3: Cash flows Signs of trouble: Installment sales, but 45% marketing expense Debt/equity ratio is high at 3.5 Almost all installment contracts receivable are used as collateral for debt

Woodside Recreation, Inc. Discussion Requirement 3: Cash flows (Dollars in thousands) 20X3 Cash Collected Installment contracts receivable 1/1/X3 $35,300 20X3 Membership sales 28,000 Total to collect 63,300 Accounts written-off ( 1,500)* 61,800 Less: Installment contracts receivable 12/31/X3 (45,600) Cash collected 16,200 Dues and miscellaneous (assumed collected) 5,000 $21,200 *Beginning allowance $4,200 plus provision $5,600 less ending allowance $8,300. 21.6 million is needed just to cover marketing costs (12.6) and land acquisition (9.0) Woodside has a cash flow problem!

Woodside Recreation, Inc. Discussion Requirement 4: Other issues Marketing costs are too high Lifetime campground sales may be a fad The membership fee ($6,000) is too high in comparison to public campgrounds Needs additional members to grow

Models of Case Analysis Analysis of Complex Cases: A general model is needed (Exhibit 3-3): Identify the Objectives of the Case Begin with a set of key words to search the literature Discuss the literature List Alternative Solutions Suggested Solution Provide supplements, if any Provide addendum, if any

Analysis Using the Case Analysis Model (Exhibit 3-3) Cullen Provision Corp. Analysis Using the Case Analysis Model (Exhibit 3-3)

Cullen Provision Corp. Facts Returned ham from the Army of $880,000 was written off against 20X1 income The ham was rejected by the Army, but was not returned in time, resulting in spoilage Cullen filed a claim against the the Army in 20X1, but did not disclose it in its 20X1 report

Cullen Provision Corp. Facts Early in 20X3 (before issuing its annual report to public), Cullen settled for $475,000, a material amount compared to Cullen’s income Management does not want to report it in its 20X2 income, because: it occurred in 20X3, has not been received IRS will want its share in 20X2 $600,000 will have to be paid to previous owner

Cullen Provision Corp. Identify Case Objectives Timing of recognition of the contingent gain What if the settlement involves a contingent gain or loss?

Cullen Provision Corp. Professional Literature SAS No. 1, Section 560, “Subsequent Events” SFAS No. 5, “Accounting for Contingencies” ARB No. 50, “Contingencies” for gain contingencies SFAS No. 16, “Prior Period Adjustments” CON No. 5, “Recognition and Measurement in Financial Statements of Business Enterprises”

Cullen Provision Corp. Discussion Objective 1: Timing of recognition Per SAS 1, Section 560, recognize in the period if subsequent discovery of the fact that the condition existed at the balance sheet date Otherwise SAS 1 does not require recognition at the previous balance sheet date

Cullen Provision Corp. Discussion Objective 1: Timing of recognition Contingency situation per SFAS No. 5 Gain contingency per ARB No. 50 OK per CON No. 5 to postpone to 20X3 OK per SFAS 16 to postpone to 20X3 But what about the previous owner?

Cullen Provision Corp. Discussion Objective 2: What if it was a loss contingency? Conservatism would have changed the picture.

Cullen Provision Corp. Alternative Solutions Were discussed in relation to case requirements To realize gain in 20X2 What if it was a contingent loss?

Cullen Provision Corp. Suggested Solution See Discussion of Objectives 1 & 2

Cullen Provision Corp. Supplements None

Cullen Provision Corp. Addendum None