Caltron Computers, Inc.
Caltron Computers is a publicly held company with a total market capitalization in excess of $450 million. Caltron manufactures minicomputer systems that are designed to achieve the power of a mainframe at a fraction of the cost. The minicomputers are Unix-based and use multiple Intel Pentium chips.
Caltron generally recognizes revenue when minicomputers are shipped. During the fourth quarter of 20x1, Caltron recognized revenue from four transactions that were questioned by its auditors, Peale, Gower & Quill. The auditors are concerned not only about the impact that these transactions will have on 20x1 reported earnings but the impact on Caltron’s proposed secondary public stock offering in early February 20x2.
The first transaction involved the recognition of $400,000 of revenue on two systems shipped to Elegant Housing, Inc. on a trial basis for six months. Elegant paid Caltron $20,000 at the time of shipment, November 15, 20x1, which would be applied to the purchase price if Elegant accept the systems or forfeited if Elegant returns the systems. Preliminary reports from Elegant are that they are quite satisfied with the systems.
The second transaction involved the recognition of $250,000 of revenue on a system not shipped as of December 31, 20x1, under a bill and hold arrangement with Alation Electronics. Alation paid $175,000 to Caltron on December 15, 20x1, and requested Caltron to hold the system for shipment until the first quarter of 20x2. Once Alation notified Caltron where to ship the system, it would pay the $75,00 balance due in 20x2.
The third transaction also involved a bill and hold arrangement with BTO Computer Leasing, a lessor of computer equipment. On November 1, 20x1, BTO ordered five systems from Caltron and paid $190,000 down, on the condition that Caltron would hold the systems at its warehouse and assist BTO in finding lessees for the systems. Caltron recognized $950,000 of revenue in 20x1 on the BTO transactions. As of December 31, 20x1, Caltron identified an end user to lease one of the systems from BTO. The lease terms were still being negotiated between BTO and the end user.
The last transaction involved the fourth quarter 20x1 recognition of $220,000 of revenue and a related $110,000 allowance for sales returns for a system shipped to Harvey Industries on a trial basis for four months. The system was shipped to Harvey on November 27, 20x1, and Harvey paid 50 percent of the purchase price at that time. If Harvey accepts the system, its down payment of $110,000 less any shipping costs would be returned. Caltron had previously entered into two similar transactions with Harvey. On one occasion Harvey purchased the system, and the other time Harvey returned the system. Based on these previous results, Caltron recorded the $110,000 allowance for sales returns.
In general, evaluate Caltron’s revenue recognition policy and the quality of Caltron’s earnings.
Discuss how and why Peale, Gower & Quill should recommend that Caltron account for and report the four transactions in the fourth quarter of 20x1. Include in your discussion specific reference to bill and hold arrangements and accounting pronouncements that you used to formulate the basis of your recommendation.