Acc 327
Case No. 2
Spring 2012

It is January 20, 2012, and you are the senior auditor in charge of auditing the 2011 year-end financial statements for Granger Paper Company (GPC). GPC is a profitable company that has been in business for many years. It is primarily a manufacturing company that buys wood from timber growers and converts the wood into a variety of paper products. It is a publicly traded company with a reputation as a good corporate citizen. Although GPC has been audited many times in the past by external CPA firms, this is the first year your firm has conducted the audit. GPC’s total revenue for 2011 is $80 million. In examining the revenue for the year, you notice that $3 million of the revenue does not come from GPC’s primary operations (i.e., revenue from sales of paper goods). This $3 million in revenue is labeled as timber revenue in GPC’s books. This strikes you as odd because, generally, GPC buys timber. That is, timber is part of the cost of goods sold for GPC and, as such, is an expense. You ask GPC’s controller, Pat Smith, why GPC is recognizing timber revenue? Pat informs you that GPC began diversifying its operations a few years ago. A natural extension of its business seemed to be growing and selling timber. So, five years ago, GPC bought 10,000 acres of land in Alabama and Mississippi for purposes of growing timber. The land was purchased from a previous timber grower that had recently harvested its timber. Immediately after purchasing the land, GPC planted pine tree seedlings on all 10,000 acres. You ask Pat what is the typical growing time for pine trees? Pat informs you that under normal circumstances the growing time from seedling to a mature pine tree ready for harvesting is about 20 years. From this, it is clear to you that GPC did not harvest and sell any of its pine trees in 2011. You next ask Pat why GPC recognized timber revenue on the pine trees in 2011 when it will be at least 15 years before the trees can be harvested and sold? Pat notes that each year the timber grows it becomes more valuable. It is estimated that the mature timber will sell for approximately $60 million when it is harvested at the end of the 20-year growing period. Each year of the growing period, GPC recognizes 5% (i.e., one-twentieth) of the $60 million as revenue. Pat notes that recognizing revenue in this manner is completely in line with accrual accounting and the matching principle. Since work is performed and costs are incurred each year caring for the trees, revenue is earned each year of the growing period. The revenue earned each period should be matched with the costs or expense incurred that period. Pat states that waiting and recognizing all $60 million in revenue in the year the trees are harvested and sold would distort income for all years involved. During the first 19 years, income would be understated, while income would be grossly overstated in the 20th year. You next ask Pat if GPC currently has firm contracts to sell the timber when it is harvested? Pat says no but the timber market is very good and virtually no healthy timber goes unsold. This is why GPC decided to diversify into the timber industry. In addition, Pat says that GPC is in a unique position. Unlike other timber growers, even if GPC cannot sell the timber to outside parties when it is harvested the company can use every bit of the timber as raw material in its own paper manufacturing process. You now ask Pat how GPC will handle the revenue recognition if the timber sells for more or less than $60 million when it is harvested? Pat states that this presents no particular problem because the difference in the $60 million expected revenue and the actual revenue would simply be recognized as an adjustment in the year of the sale. Pat notes that this is how you handle changes in estimates (i.e., make an adjustment in the year the estimate is changed). Finally, Pat states that the procedure GPC uses for recognizing revenue on its timber operations was not questioned by the previous auditors who felt that the procedure used by GPC was very similar to the percentage completion method of revenue recognition used by construction companies with multi-year contracts. In particular, it is common practice in the construction industry to recognize revenue on a multi-year construction contract each year based on the amount of work completed that year. Pat makes some very good arguments for GPC’s method of recognizing revenue on its timber crop. However, as the auditor, you must decide if GPC’s method is appropriate.

Solution:

Case No. 2 As senior auditor in charge of auditing the 2011 financial statements of Granger Paper Company (GPC), I have found discrepancies in some of the revenue reporting procedures. My concerns deal primarily with the $3 million in timber revenue on the financial statements. I have been informed by GPC’s controller, Pat Smith, of the accounting procedures use to determine the revenue recognized for the timber and at first glance it seems logical. However, further investigation is needed. My first concern is addressed by ASC No. 605-10-25-1 (Revenue Recognition). This code addresses when revenue can be recognized by an entity. The revenue must be realized or realizable and/or must be earned. In the case of GPC, neither of these criteria has been met. There is no sales contract on the timber and the timber has an estimated 15 years before it is mature enough for harvesting. Therefore, GPC would have to correct the revenue recognized on the 2011 financial statements. My other concern is addressed by ASC No. 905-360-25-2 (Trees and Vines Recognition). I am concerned with what (if anything) GPC can recognize when accounting for the timber production. The code states that all of the costs related to readying the land for timber growth and maintain the crop can be capitalized. Also, stated in the code is that “net proceeds from sale of the timber before commercial production begins shall be applied to the capitalized costs of the timber”. Through my research on the revenue recognition, I have found that GPC is unable to recognize any of the revenue from their timber venture. GPC will be able to recognize revenue once a sales contract on the timber is established or the timber is harvested and sold. However, GPC is able to capitalize some of the costs related to the start-up and maintenance of the timber land. I suggest that GPC make the appropriate corrections to their financial statements.