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Case 03-05 Trademark, Inc. Part 1Accounting Issues This case study is the first of a two-part Earnings Management Case. The purpose of Part 1 is to...

Based on Trademark Inc - Part 1,
What revenue recognition issues should Nancy consider?
Evaluate the propriety of the company's accounting treatment for each of the issues identified should Nancy consider?

Case 03-05 Trademark, Inc. Part 1—Accounting Issues This case study is the first of a two-part Earnings Management Case. The purpose of Part 1 is to provide you with background information relating to Trademark, Inc. and raise several accounting and auditing issues affecting Trademark during the current fiscal year. The conclusions reached in this case study will be used in Part 2 — Misstatements & Materiality. Trademark, Inc., a public company, designs, manufactures, and distributes greeting cards, calendars, stationery, party goods, and specialty gift merchandise. Trademark operates through four divisions: Greeting Cards and Stationery, Calendars, Party Goods, and Specialty Gifts. In 1994, Trademark acquired a 100 percent interest in a Swiss company that manufactures and distributes similar products in Western Europe. Trademark has not integrated its operations on a global basis, and through fiscal year 1999, the Swiss company operated as a separate, wholly-owned subsidiary. Trademark operates five manufacturing plants in the U.S. Trademark’s primary customer base in both the U.S. and Europe consists of drug store and supermarket chains as well as specialty gift retailers. For its U.S. operations, Trademark maintains its inventory in both company-owned and public warehouses. Typically, Trademark’s shipping terms are FOB shipping point, and orders are shipped, if stock levels permit, to customers within 48 hours or upon completion of production. Trademark’s return policy allows customers to return damaged goods for a refund or credit within 30 days of shipment. The company began operations in 1981 and, after experiencing significant growth from fiscal years 1989 through 1991, offered its stock to the public in 1992. Trademark’s growth continued through fiscal year 1993. However, revenues were flat from fiscal years 1994 through 1997 (ignoring the acquisition of the Swiss company). In fiscal year 1998, Trademark’s revenues decreased. The schedule included as Exhibit 5-1-1 shows Trademark’s revenues for each of the past five fiscal years ending on June 30, along with other financial data. Trademark’s CFO, Rob Arnold, attributes the company’s growth rate through 1993 to its successful magazine and in-store marketing campaign led by Maxine Hartman, Vice President of Marketing. Mr. Arnold attributes the flat growth rate, beginning in fiscal year 1994, to increased competition from specialty companies and entertainment companies who began providing similar merchandise. Mr. Arnold cites the popularity of “electronic” greeting cards offered on the Internet for the decrease in revenues in 1998. Copyright 2001 Deloitte Development LLC All Rights Reserved.
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Case 03-05: Trademark, Inc.—Part 1 Page 2 Mr. Arnold recently engaged Munney, Groughs, & Treez, an investment banking company, to evaluate Trademark’s financing options. The company and its advisors are currently exploring the possibility of a public debt offering in the near future. Trademark plans to use the funds on new equipment for three of its manufacturing plants and possibly an e-commerce endeavor. Nancy Drew, a senior auditor with four years of experience, is the in-charge accountant on the Trademark audit for the year ending June 30, 1999. In addition to her supervisory and administrative responsibilities, including the coordination of the audit of the Swiss subsidiary, Nancy is responsible for auditing Trademark’s revenue accounts for its U.S. operations. Based on her work during the first week of final audit fieldwork, Nancy has learned the following: Returns of Damaged Goods Trademark records a reserve for returns of damaged goods at the time of sale based on an estimated return rate of 0.25 percent. In fiscal year 1999, Trademark accrued $5.025 million for returns based on 0.25 percent of sales. Warehouse management has informed Nancy that actual return rates during the past two years have declined. Trademark switched packaging material vendors in early fiscal year 1998 and has been using more durable packaging materials. The new boxes and packing materials appear to have substantially decreased the damage to Trademark’s products during the shipping process. Warehouse management estimates that in fiscal year 1998, returns averaged 0.23 percent, and in fiscal year 1999, returns averaged 0.22 percent. The return rate in 1999 was lower than 1998 because the company was still in the process of using up its stock of old packaging materials in 1998. Warehouse management believes that damage levels will remain at the 0.22 percent level going forward. Recognizing that the company may have over-accrued in fiscal year 1999 for future returns of damaged goods, Nancy requested audit evidence to support warehouse management’s claims that return rates had decreased. Based on the evidence examined, Nancy concluded that the 0.22% return rate was accurate for fiscal year 1999 and appeared sustainable. To assess the reasonableness of management’s estimate for the reserve at June 30, 1999, Nancy developed an independent estimate of the reserve, factoring in the impact of the new packaging materials. Nancy developed a range of acceptable estimates and determined that management’s estimate was outside that range. The difference between management’s estimate and the high-end of the range was $923,077. This amount represents the estimated gross sales amount for the related returns. The average gross margin for the year was 65%. Other Returns In addition to returns of damaged goods, over the years Trademark has periodically permitted certain specific large customers to return slow-moving merchandise for full credit so that Trademark may sell new merchandise in the space previously occupied by the old merchandise. Since customers do not have the legal right to return the merchandise, these returns have been permitted only when negotiated with Trademark. Copyright 2001 Deloitte Development LLC All Rights Reserved.
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