AMCOG Art House

Memo
To: Leslie Smythe-Davies, Executive VP
From: Evelyn Jones, Controller
CC: Billie Day
Date: 4/23/2018
Re: Revenue Revisions

Executive Summary
Generally Accepted Accounting Principles (GAAP) require that

1. Sales made in exchange for non-interest bearing notes receivable are recorded at their discounted
present value

2. The difference between the face value and the discounted present value of such notes is
recognized as interest income over the life of the notes

3. Interest income (and receivable) is recognized once it has been earned (i.e., at the end of the
accounting period), even if cash will not be received until the next accounting period.

Revenue, Interest Income and Deferred Interest Income after Corrections

Corrected Interest Income for Deferred Interest

"Portrait in Purple and Gold" $123,900 $ 5,438 $ 20,663

"Skulptur Ohne Schatten" $186,162 $ 2,883 $ 10,955

"Flotsam/Jetsam" $300,000 ** $ 25,000

 Page 1
Total $610,062 $33,320 $31,617

** Revenue for Flotsam/Jetsam had been recorded correctly at the face value of the note

Evaluation of Revenue Recognition from Sales Made in Exchange for Notes

The evaluation of Amcog's revenue recognition practices in connection with sales made in exchange
for notes receivable has revealed problems relating to (I) sales revenue recognition and (II) recognition
of interest income. Following is a discussion of problems encountered and corrective actions taken to
ensure compliance with (GAAP).

I. Sales Revenue Recognition

Amcog's revenue recognition practices in general conform to GAAP, however, two transactions were
found to have been recorded incorrectly:

1. Sale of "Portrait in Purple and Gold"

"Portrait in Purple and Gold" was sold in exchange for a two-year, non-interest-bearing note. This sale
was recorded incorrectly in the face amount of the note for $150,000. GAAP requires that such sales
be recognized at the discounted present value of the note, rather than at its face value. Using Amcog's
required rate of return of 10% on transactions of this type, requires that sales revenue be reduced by $
26,100, resulting in (corrected) revenue of $ 123,900. The $26,100 difference is recorded as "deferred
interest income" and will be recognized as interest income over the life of the note.

2. Sale of "Skulptur Ohne Schatten"

"Skulptur Ohne Schatten" was sold in exchange for a non-interest-bearing note with a face value of
$200,000, payable in four semi-annual installments of $50,000 each. Again, compliance with GAAP
requires that revenue be recognized at the discounted present value of the payments, using Amcog's
required rate of return of 10%. This results in a required reduction of sales revenue in the amount of $
13, 838 and adjusted sales revenue of $ 186,162. The $ 13,838 difference is recorded as "deferred
interest income" and will be recognized as interest income over the life of the note.

Total income from the two transactions over the life of the notes receivable will be equal to the face
value of the notes. However, adherence to proper revenue recognition methods (Statement of Financial
Accounting Concepts # 5, para.83) requires a separation of sales revenue and interest income. At the
time of the sale, only the equivalent cash value (the present value of the note) has been earned. The
difference between the present value and the face value must be considered as deferred interest
income (discount) at that time. Interest is earned as a function of the 'creditor/debtor' relationship and
cannot be recognized until it has been earned due to the passage of time. This issue is especially
important, if more than one accounting period elapses before cash is collected. In that case (as in the
two transactions discussed here), failure to segregate sales revenue from properly recognized interest
income will not only overstate sales revenue, but will overstate total income in the period in which the
sale occurs and understate income in subsequent periods. Proper allocation of income to the period(s)
in which it has been earned is one of the fundamental principles of GAAP. For further discussion on
this subject see Chasteen, Flaherty and O'Connor (1998, pp. 41-50)

II. Recognition of Interest Income

 Page 2
GAAP requires that a distinction is made between revenue resulting from sales and interest income.
Sales made in exchange for notes always include an interest income component. Since interest
income is earned as a function of elapsed time, careful attention must be paid to ensure that the correct
amount of interest income is recorded, even if cash will not be received until a later time. Interest
income is determined using the effective interest rate of 10%.

Interest income resulting from the sale of "Portrait in Purple and Gold" and "Skulptur Ohne Schatten"
amount to $5,438 and $ 2,883 respectively.

"Flotsam/Jetsam"

Examination of Notes Receivable shows that the sale of the collage "Flotsam/Jetsam" was also mad in
exchange for a note receivable. Revenue of $300,000 was correctly recognized. However, interest
income (and receivable) of $25,000 has been earned in 1997 and must be recognized as of
12/31/1997.

III. Training of Accounting Personnel

The problems identified above appear to be the result of inadequate training of Amcog's bookkeeping
staff. The recent expansion and changes in selling practices make it imperative that the staff receive
extensive additional training to ensure that such problems will not recur. Billie Day has been a valued
employee for many years. Ms Day has enrolled in enrolled in accounting courses at CSUN to refresh
and improve her knowledge of GAAP. I am in currently evaluating the qualifications of the remainder of
the staff and will make appropriate recommendations within the next week.

References

Chasteen Lanny G., R.E. Flaherty, M.C. O'Connor, Intermediate Accounting (6th ed.) Irwin/McGraw
Hill, Inc. 1998

Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 5

 Page 3
Appendix A

Comparative Draft Income Statement and Balance Sheet Sections

The tables below show the relevant income statement and balance sheet sections before and after
required adjustments.

Income Statement Accounts

Before Adjustments After Adjustments

Sales Revenue $650,000 $610,062

Interest Income $35,820

Balance Sheet Accounts

Before Adjustments After Adjustments

Notes receivable $650,000 $650,000**

Deferred interest income $31,617

Notes receivable (net) $618,383

Interest receivable $25,000

 Page 4
 Appendix B

Calculations

Portrait in
Purple
issue date
8/1
discount 10% PV(2,
ratePPG
a. note $150,000 10%) 0.826 123900

incorrect
entry:
dr. note $150,000
receivable
cr. $150,000
Revenue
to correct:
dr. $26,100
revenue
cr. $26,100
Discount
note
adjusting
receivable
entry,
dr. $5,438 (26,100/24
12/31:
discount
cr. $5,438 *5)
Interest
income
Skulptur
Ohnedate
issue
Schatten
8/1 PV(5%, 4)
b. 4 $50,000 3.723248 $186,162
payments
@
incorrect
entry:
dr. note $200,000
receivable
cr. $200,000
Revenue
to correct:
dr. $13,838
revenue
cr. $13,838
Discount
note
adjusting
receivable
entry,
dr. $2,883 (13,883/24
12/31:
discount
cr. $2,883 *5)
Interest
income
Flotsam/J
etsam
issue date:
1/21
C. note $300,000

correctly
recorded:
dr. note $300,000
receivable
cr. $300,000
Revenue

 Page 5
adjusting
entry,
dr. interest $25,000
12/31:
receivable
cr. $25,000
Interest
income Income
statement
:Revenue $610,062
(corrected)
interest $33,320
income

Balance
Sheet
Accounts: issue date 12/31/97
Face Def. Int. N/R Def. Int. N/R
value (discount) (net) (discount) (net)
Note $150,000 $26,100 $123,900 $20,663 $129,338
receivable
Note $200,000 $13,838 $186,162 $10,955 $189,045
receivable
Note $300,000 $300,000 $300,000
receivable $650,000 $39,938 $610,062 $31,617 $618,383

interest $25,000
receivable

 Page 6