Accounting for lifetime memberships: The case of Travel Time Partners, Inc

Pergamon Journal of Accounting Education, Vol. 15, No. 4, pp. 577- 590, 1997

© 1997 Elsevier Science Ltd. All rights reserved Printed in Great Britain

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Case

A C C O U N T I N G F O R L I F E T I M E M E M B E R S H I P S : T H E

C A S E O F T R A V E L T I M E P A R T N E R S , INC.

Ray D. Dillon and Siva Nathan SCHOOL OF ACCOUNTANCY, COLLEGE OF BUSINESS

ADMINISTRATION, GEORGIA STATE UNIVERSITY

Abstract: Travel Time Partners, Inc. is a travel agency which offers lifetime memberships to its customers. These lifetime memberships entitle the members (among other benefits) to receive a travel magazine. The transaction described in this case offers interesting accounting possibilities for class discussion. The case can be viewed either as a revenue recognition problem or a liability measurement problem. The sliding scale refunds offered on lifetime memberships, the discounts on classified advertisements and the accumulation of points leading to travel discounts for lifetime members, add interesting accounting complexities. The case can also be used to discuss the ethical behavior of management with respect to accounting issues and the role of the auditor in the preparation of financial statements. © 1997 Elsevier Science Ltd. All rights reserved

Travel Time Partners, Inc. (TTP) is a travel agency located in Atlanta, Georgia. Max Holt, a successful travel agent himself, formed it 10 years ago in 1987. Mr. Holt had 15 years of experience in the travel and entertainment business prior to starting TTP. TTP hired some of the brightest people to staff their agent positions and formed corporate relationships with several large companies in the city. Their growth, while not meteoric, had been steady and strong and, currently, there are three locations in Atlanta, and two each in six other metropolitan areas within a 400-mile radius. While TTP had experienced growth, the industry was changing and profit margins were getting squeezed. For example, airlines were reducing the commissions paid to travel agencies for issuing tickets. Therefore, Mr. Holt was attempting to diversify into related travel areas and upgrade some systems that had become obsolete due to technology changes. Diversification and upgrading was difficult because it required capital. In late 1996, TTP had worked out a loan from Inco Capital to fund the acquisition of technology that would support the new strategy. Inco's loan covenant with TTP had several negative covenants included which limited the company's decision-making flexibility. Included in the covenant was a section noted as Negative Covenants which read in part:

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578 R.D. Dillon and S. Nathan

Current Ratio, Working Capital and Interest Coverage. The Company stipulates that it will not at any time permit:

The Current Ratio to fall below 0.75 to 1. Income (Earnings) before interest, depreciation and amortization (EBIDA) to be less than 200% of Interest Charges; Long-Term Debt to exceed 52% of capitalization (defined as long- term debt plus stockholders' equity).

The payment of the interest on the term loan from Inco had gone reasonably well from TTP's view with payments only a few days late and one about a month late. However, Inco had been firm during the loan negotiations that if the covenants were not met, the loan would be accelerated or called. This was something Mr. Holt knew would place TTP into receivership. Due to the risk Inco believed it was exposed to in the loan, Inco's loan committee required monthly meetings between Mr. Holt and Inco's loan officer to review current circumstances.

THE GLOBETREK CLUB

In the first eight years of TTP, Mr. Holt had been responsible for most of the functions related to marketing. His academic training had been a two-year program in Hospitality Management at a community college in the northeast United States. He considered himself a promoter and idea man, a description agreed to by close friends. He had attained growth in the business by personal relationships and hard work. However, he recognized that the multiple site locations and the turmoil in the industry required that he focus more of his attention on strategic issues that left little time for the 'hands-on' marketing he had enjoyed early on. He recognized his limitations in the financial and accounting functions of the business and had hired a controller in the fifth year of the business.

In 1996, Mr. Holt decided to hire a seasoned manager to head up the marketing function. He was willing to put together a fair compensation package for a bright, innovative, experienced manager. By early October 1996, he had struck a deal with Ms. Amy Worth, a former American Express employee, and she was hired as Vice-President of Marketing. She brought to the job a discipline that a large corporation would instill in their employees and she was interested in going from a larger firm to one the size of TTP. Shortly after her arrival she added two corporate accounts and established her presence in the local travel/entertainment/hospitality industry through her affiliation and strong participation in the local chapter of the American Society of Travel Agents. Mr. Holt was pleased with her performance even as revenues sagged in the face of industry pressures. Late in 1996, Ms. Worth presented Mr. Holt with a major proposal that she said would have comprehensive benefits. She called it the Globetrek Club.

Accounting for Lifetime Memberships 579

The Globetrek Club was designed along the exclusivity concept. For a single fee of $350, a member (who had to be a person, not a company or business) would be given a lifetime membership. The membership entitled the member to a subscription to Gobetrek-- The Magazine for Travelers of the World. Globetrek was a magazine of Mr. Holt's own design and had been mailed to the company's better clients. Basically, it was a slick-cover publication with articles of general interest to travelers. The publisher produced short runs of several thousand for customers and promotional giveaways. The publisher had a number of stringers who would write articles for the publication and Mr. Holt would contribute occasional pieces. Advertising had come from vacation spots as well as hotel, airline, and rental car companies. Currently, the magazine operated at the break- even point but Mr. Holt believed it had an image appeal and was good for public relations. The magazine had been generally well received. Members would be entitled to a discount of 20% in the cost of personal classified magazine advertising. Ms. Worth believed that the discount on personal, classified advertising would appeal to members who wanted to exchange frequent flyer mileage, sell or rent time share privileges, or rent vacation homes.

More importantly, the membership allowed members to receive "the lowest air and hotel rates possible". A member could accumulate 'Trekkerpoints' for the dollars of travel bookings done through TTP. These points could then be used for redemption in the form of discounts on airline tickets, auto rental, hotel accommodations, or package deals. In order to stimulate interest and get members, the Globetrek Club agreement specified that charter members who canceled their membership within one year were entitled to a full refund of their lifetime membership fee. When the charter membership drive ended, subsequent members would be allowed a partial refund of their 'lifetime' fee if they canceled their membership. The refund for subsequent members would be based on a sliding scale. Members who wanted to withdraw from membership within the first five years would receive a one-half refund, members who withdrew from within the period of 5-10 years would receive a one-fourth refund, and members who withdrew after 10 years would receive no refund. The Globetrek Club agreement also specified that the charter membership drive would cease at the end of six months. Charter members who canceled their membership after the one-year 'full refund' period were subject to the same sliding scale schedule as the subsequent members.

Events of Early 1997

Since the concept was new, Mr. Holt was skeptical of the potential success of the Globetrek Club. However he agreed to fund the project with a reevaluation at the two-month period to determine whether the idea had


ga ined any m o m e n t u m . Ms. W o r t h re luctant ly agreed to the tr ial pe r iod even though she said it wou ld t ake longer for the p lan to demons t r a t e success or failure. She had pro jec ted a b o u t 400 members over the next two m o n t h s t h rough a direct mai l c ampa ign to their da t abase o f 40,000 people who had done business with them in the pas t 5 years. She fur ther p ro jec t ed a m e m b e r s h i p o f 2000 peop le by the end o f the first 12 months . Mr . H o l t agreed to buy ano the r mai l ing list o f 10,000 people who were no t on T T P ' s list for $5000. Dur ing the first two months o f the member sh ip campa ign , 994 peop le jo ined the club which far exceeded their expecta- t ions. Mr . H o l t was del ighted and pro jec t ions for fu ture membersh ip were ra ised to an expected 4000 people by the end o f the next 10 months . This success b r o u g h t a b o u t a te lephone call by Mr. Ho l t to Ms. W o r t h and a d iscuss ion with the cont ro l le r , Joe Bailey.

"Amy, I wanted to call and let you know your Globetrek Club idea is really paying off. Joe is in the office and just told me the number of responses to the charter membership drive we've had. Cash flow is up an incredible amount from last quarter and I expect our annual profits to be outstanding based on the initial response. Great idea! We'll all benefit from it; keep up the good work. If you need another mailing list, I'll gladly spring for one". Mr. Holt hung up the telephone and turned to his controller, Joe Bailey. "That idea may save us, Joe. These are tough times and innovative ideas are hard to come by. Your financials, especially the income statement, have painted a pretty sad picture lately. This Globetrek Club idea really improves our profit picture".

Joe ' s d e m e a n o r was no t as enthusias t ic as Max ' s .

"Max, we need to talk about the overall effect of the customer response to the plan on the financial statements. None of you talked to me before the development or promotion of the idea. There's no question that it has achieved more than expected, according to estimates I received. But in this case, cash flow doesn't translate into profits on a one-to-one ratio. I don't have all the data but we need to talk about the revenue and liability recognition issues. Be careful about profit projections until we put the numbers together. The quarterly statements will be out in less than a month, and we'll know the final figures then".

" I 'm not sure what you are hinting at, Joe, but I know you'll work something out. Look, this concept has caused our cash flow to skyrocket; our banker loves the cash balance we have; and I've got to decide what to do with the excess cash. Frankly, that's the kind of problem I've never had. More importantly, I have a meeting with Inco Capital next week. I want to let them know we've turned the corner. The last time I met with them, I had to deter them from accelerating our loan payments. You were there, weren't you?"

"Sure. It was a tough meeting. We had been bumping up against our loan covenants of current and capitalization ratios. But, Max, from an accounting


point of view there are some problems with the way the club agreement is structured. We may not be able to recognize all the profits from the lifetime membership sales right away. Let me set up a meeting with our auditing firm to get their opinion".

"Look, Joe, I don' t mean to be doing your job, but 1 took last year's financials and projected the modest increase of ten percent that I expected, and factored in the effect of Globetrek. I 'm no bean counter, no offense, but it's not rocket science either. Here they are". (See the financial statements given to Joe in Appendices A-C).

"Joe, you've been with me for over four years. These last two have been tough: first with the need to streamline our operations with automation, then the growth of cut-rate airlines, and then with the airlines limiting commissions to agents. We needed some good news and we're getting it. If I don't have some positive numbers to show Inco, we're in mud swamp. With no accounting background, I've done it so I know you can do it. Listen, I've got another meeting in thirty minutes that I haven't prepared for, so please excuse me. Let me see the results as soon as you have them".

Joe went back to his office and, as he passed, his ass is tant asked how it went.

"Not so good, you know how Max is. He tends to overstate the good things. He thinks we are going to show record profits and I don't think we can. In this case, he may shoot the messenger who brings the bad news".

Meeting with the Auditor

Joe recognized tha t M a x was a bi t more enthusias t ic a b o u t the po ten t ia l results than he should be. Therefore , Joe p laced a call to T a y l o r & Gran t , L L P ( T & G ) the c o m p a n y ' s audi tors . The par tner , Sue Tay lor , who had b r o u g h t the T T P account into the firm, con t inued to be the one who oversaw the account . Joe invi ted Sue to come over and meet with M a x and him and discuss the accoun t ing and repor t ing impl ica t ions o f the G l o b e t r e k membersh ips . The meet ing was set up on the fo l lowing T h u r s d a y at 1:00 in the a f te rnoon.

"Hi, Sue. Joe tells me we need to discuss the Globetrek concept. It's one of the greatest ideas I've ever seen and it's working". Max was still fairly bubbling since another 100 memberships had been added since his call to Amy Worth last week.

Sue T a y l o r had a n u m b e r of years ' experience in publ ic account ing with a larger f irm before fo rming her own firm with one o f her former c lassmates .

"Max, Joe asked me to look over the membership agreement and to consider the accounting and reporting issues involved. My belief is that you have


established a sizable liability for yourselves. Furthermore, you could have some substantial long-term liquidity problems if you use the cash received to fund long-term initiatives. In the future, when the charter membership period is over, your flexibility in decision making is increased to some degree but not to the extent you may wish. I recommend that you not treat all of the membership fees as revenue or, at least, set up a reserve for potential refunds and the effect of the points".

Max was clearly surprised and expressed disappointment,

"Sue, you've really been helpful to us in the past. That loan application with Inco couldn't have gone through without T&G's assistance. However, I can't believe what you've just said. Furthermore, if it's your final word, well just have to get a second opinion from another auditing firm, you know just like a surgeon who has said I need to have some serious surgery. I'll want to go to someone else and see what they say. If they don't agree with you but agree with me, then they'll get our business".

Suggested Questions

1. Identify the accounting issues in this case. 2. Assuming you are the accountant of TTP, Inc., describe the

accounting methods that you would use for the accounting issues identified in (1) above. Your response should include a discussion of alternative accounting methods for each issue, a discussion of the pros and cons of each alternative and the reason(s) why you chose a particular alternative. Restate the pro forma income statement and pro forma balance sheet for 1997 based on the accounting method choices that you made.

3. With relation to (2) above, for the accounting method choices that you made, what disclosures would you make in the footnotes to the financial statements? Prepare the appropriate footnotes.

4. What other disclosures are needed in the footnotes to the financial statements? Prepare the appropriate footnotes for the disclosures.

5. Discuss the ethical issues, with respect to accounting, faced by the various parties in this case.

T E A C H I N G N O T E

Accounting for Lifetime Memberships: The Case of Travel Time Partners, Inc.

Objectives of case. The primary objective of this case is to discuss the accounting for a transaction where a business entity receives an advance payment f rom a customer and has an obligation to perform services in the future. This case is unlike traditional and more familiar transactions of


this type such as long-term magazine subscriptions and extended warranty contracts where the obligation is for a known time period. The situation described in this case is unique because the commitment to perform services is open-ended and uncertain, i.e., over the lifetime of the customer. In addition the instructor can also draw analogies to accounting by airlines for frequent-flier plans and to accounting for lifetime magazine subscriptions.

An additional complexity in the case is the refund policy. The discount on classified advertising and the accumulation of Trekkerpoints which can be used for discounts are further interesting complexities. This case can be used in an undergraduate or graduate level accounting class. Depending upon the profile of the students, the case can be discussed at different levels of complexity. Based upon the pedagogic objectives of the instructor and student profile, the required assignments listed at the end of the case can be modified, some requirements deleted, or additional requirements added. The case can be assigned either as an oral or written assignment or a combination of the two. We lay out below the accounting issues pertaining to the case.

Accounting issues. This case can be viewed either as a revenue recognition problem or a liability measurement problem. Traditionally, the accounting profession has viewed the type of transaction described in this case as a revenue recognition (and income measurement) problem [Samuelson (1993)]. In keeping with that tradition, we will focus the discussion of the accounting issues as a revenue recognition problem. Later, we discuss how the transaction can also be viewed as a liability measurement problem. We recommend that the instructor discuss the accounting issues in this case at incremental levels of complexity. Based on that recommendation, we first discuss the accounting for lifetime memberships, without considering the refund policy. We then introduce the refund policy and its implications. Finally, we introduce the discount on classified advertisements which lifetime members are entitled to, and then the accumulation of points which entitles members to travel discounts.

Revenue Recognition Problem

Without refunds. The range of accounting method possibilities for receipt of the lifetime membership fee can be discussed. It is probably easier to discuss the two extreme possibilities and then discuss an option in-between those two extremes. At one extreme, the entire amount of the lifetime membership fee can be recognized as revenue as soon as it is received. This is what Mr. Holt wants (the pro forma income statement and balance sheet for 1997 shown in Appendices A and B are prepared under this method). It is fairly easy to dismiss this possibility quickly based


on the matching principle, principle of conservatism, or the revenue recognition criteria laid out in Statement of Financial Accounting Concepts No. 5 [FASB (1984)]. The other extreme is recognizing revenue only after the death of the lifetime member. This also can be dismissed fairly quickly using some of the same criteria described above. The discussion can now focus on accounting possibilities in-between these two extremes. It becomes quite clear at this point that theoretically one would want to recognize the revenue over the period of the membership, since the costs of supplying the magazine will be incurred over that time period. However, since this is a lifetime membership, the longevity of the membership is obviously unknown. One possibility is to pick an arbitrary number (say, 10 years) for the number of years the average lifetime member will be alive and recognize revenue over that time period. Precedence in the accounting literature for such arbitrariness (40 years for Goodwill amortization and 17 years for Patent amortization) can be cited to support this method. The next step in the discussion is to bring in actuarial science. From previous discussions of pension accounting, students are probably familiar with actuarial science and its applications to accounting. TTP can use the services of an actuary to estimate the number of years a lifetime member will be alive. Decisions regarding the required amount of precision in the actuarial estimate can be made on a cost-benefit basis. For example, how much demographic information does TTP want to collect to use in the actuarial estimate? Should actuarial estimates be done on a group basis (average lifespan of all members) or on an individual member basis? An interesting accounting issue arises when actuarial estimates are done on an individual member basis. Suppose an actuarial estimate is made that an individual lifetime member (say Mr. Smith) will live for 10 years. Therefore, 10% of his membership fee will be recognized as revenue each year. Suppose Smith dies after 8 years. What do you do with the residual balance in his account? Do you show it on the Income Statement? I f so, where? Do you offset the positive balance in Smith's account against negative balances in accounts of members who died after, or are still alive beyond, their actuarial estimate? These are very interesting accounting issues that can generate heated class discussion.

After discussion of each accounting alternative, footnote disclosures pertaining to each alternative can be brought into the discussion. Footnote disclosures are especially important if the entire membership fee is recognized as revenue immediately.

With refunds. The issue of refunds to lifetime members can be introduced as the next level of complexity in this case. Charter members are entitled to a full refund if they cancel within one year and thereafter to a sliding scale refund extending up to 10 years. Subsequent members are entitled only to a sliding scale refund. Similar to the case with no refunds,


the range of accounting possibilities can be discussed. At one extreme, revenue can be recognized ignoring the fact that some refunds may have to be given in the future (the pro forma financial statements shown in Appendices A - C are prepared under this method). When members ask for refunds, the revenue for that particular year is reduced accordingly. The pros and cons of this approach can be argued using revenue recognition criteria, cost-benefit analysis, matching principle, principle of conservatism, contingencies, etc. At the other extreme, revenue can be recognized over time only for the amount that becomes not eligible for refunds. Thus, for charter members no revenue will be recognized in the first year, 50% of the revenue will be recognized after the end of the first year (can be prorated over years 2 through 5), 25% of revenue will be recognized after the end of year 5, and the remaining 25% will be recognized after the end of year 10. A similar procedure would be followed for the subsequent members. The pros and cons of this method can be discussed using the same criteria described above. Between these two extremes the possibility of a middle ground can now be introduced. One possibility is to recognize revenue as discussed in the No Refunds section above, and then set up an Allowance (or Reserve) for Refunds account. This Allowance account will be based on an estimate of the amount of refunds that would have to be paid out in the future. The payment of refunds will be debited to this Allowance account without affecting the Income Statements of those years. The Allowance account needs to be evaluated and adjusted periodically based on past refund experiences. Footnote disclosures for each alternative described above should also be included in the discussion. Footnote disclosures (Contingencies) are especially important for the first method where refunds are ignored in accounting for the lifetime membership.

Trekker points accumulation. Two accounting possibilities can be discussed for the points accumulation that entitles members to travel discounts. I f the dollar amounts involved are relatively small from a cost- benefit point of view, mere disclosure in the footnotes to the financial statements of the existence of the points accumulation plan is probably justified. Any travel discounts given in future years in exchange for points accumulation will reduce the revenue in those years. I f the dollar amounts involved are relatively large, ignoring the accumulation of points will probably result in misleading financial statements. In this case, a reserve can be set up with a balance proport ional to the amount of points accumulated. Discounts given can be offset against this reserve. Footnote disclosures pertaining to this approach should also be raised as discussion points. Discussion of the accounting for points accumulation can also be used as an opportunity to bring up the accounting concept of materiality. The pro forma financial statements shown in the Appendices do not show any expense or liability for the points accumulation.


The Trekkerpoints allow for a discussion of the difficulty the airlines faced in the latter 1980s when accounting authorities were discussing the need to account for and disclose the potential liability created by the ubiquitous use of frequent flyer plans by the airlines. The decision by accounting authorities, at that time, was not to require accounting for the miles as a liability in the annual report to shareholders. However, the SEC required a disclosure of frequent flyer mileage information in the 10-K. Illustrations from the Delta Airlines 10-K for 1996 and USAir 10-K for 1996 follow:

Delta Airlines. FREQUENT FLYER PROGRAM--The Company accrues the estimated incremental cost of providing free travel awards earned under its SkyMiles(R) frequent flyer program when free travel award levels are achieved. The accrued incremental cost is included in accounts payable and miscellaneous accrued liabilities in the Company's Consolidated Balance Sheets.

The Company also sells mileage credits to participating partners in the SkyMiles(R) program, such as hotels, car rental agencies and credit card companies. The resulting revenue, net of the estimated incremental cost of the credits sold, is recorded as other operating revenue in the Company's Consolidated Statements of Operations during the period in which the credits are sold. (p. 17)

USAir group. FREQUENT TRAVELER PROGRAM--Each major airline, including USAir, has developed a frequent traveler program that offers its passengers incentives to maximize travel on that particular carder. Participants in such programs typically earn 'mileage credits' for every trip they fly that can be redeemed for airline travel or, in some cases, for other benefits.

USAir accounts for its FTP under the incremental cost method, whereby travel awards are valued at the incremental cost of carrying one additional passenger. Such costs are accrued when FTP participants accumulate sufficient miles to be entitled to claim award certificates. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, reservations, communications, liability insurance and denied boarding compensation expenses expected to be incurred on a per passenger basis. No profit or overhead margin is included in the accrual for incremental costs. No liability is recorded for airline, hotel or car rental award certificates that are to be honored by other parties because there is no cost to USAir for these awards. P.23.

USAir's customers redeemed approximately 1,160,000, 927,000 and 841,000 awards for free travel on USAir in 1995, 1994 and 1993, respectively, representing approximately 9.0%, 7.0% and 8.0% of USAir's revenue passenger miles ('RPMs') in those years, respectively. USAir does not believe that usage of FTP awards results in any significant


displacement of revenue passengers. USAir's exposure to the displacement of revenue passengers is not significant, as the number of USAir flights that depart 100% full is minimal. In the second quarter of 1995, the quarter when the highest number of free frequent traveler trips were flown for the year, for example, fewer than 6.5% of USAir's flights departed 100% full. During this same quarterly period, approximately 5.2% of USAir's flights departed 100% full and also had one or more passengers on board who were traveling on FTP award tickets. (p. 59-60)

A similar argument might be made for disclosure of the Trekkerpoints information for the use of current and future lenders.

Discount on classified advertisements. Discussion of the accounting issues related to discount on classified advertisements can proceed along the same lines as our previous discussion on points accumulation. However, the instructor may wish to direct discussion toward management information issues associated with the discounts. Capturing the discounts for management information may be important to the firm to know how much revenue is being foregone by offering these discounts to members. Recently, a large telecommunications company signed an agreement to sell prepaid 'phone cards' in multiples of $5 denominations to a government agency for use by their employees. The company gave a percentage discount to the agency on phone card purchases and captured that information in a 'Discounts on phone cards' account. The reason, in this case, was to give management information on the amount of revenue they were foregoing and to assist them when negotiating subsequent contracts with that agency and others.

Liability measurement problem. Traditionally, the accounting profession has viewed obligations to perform future services as a revenue recognition problem. However, this issue can also be viewed as a liability measurement (or financial position measurement) problem. In that case, the liability should be measured at an amount that represents the probable future sacrifices that will be incurred by the firm in satisfying the liability. Students should be familiar with the FASB definition of liability as outlined in Statement of Financial Accounting Concepts No. 6 [FASB (1985)], When viewed as a revenue recognition problem with a Deferred Revenue account shown on the liabilities side of the Balance Sheet, the balance in the Deferred Revenue account will generally overstate the probable future sacrifices required to satisfy the obligation to perform future services. This is a good argument for viewing this transaction as a liability measurement problem. If viewed in this manner, revenue, which is not recognized immediately, has to be split into two parts for presentation on the balance sheet. The first part would consist of the estimated cost of providing the service (in this case, the cost of providing the magazine to lifetime members), and the second part would consist of the estimated profit from providing that service. The former would be shown in the


liabilities section of the balance sheet, and the latter in the equity section of the balance sheet and would reflect the fact that net assets of the firm have increased as a result of the sale, even though it has not been 'earned.' When discussing the revenue recognition versus liability measurement viewpoints, the issue of emphasizing Income Statement versus Balance Sheet can also be brought into the discussion. Samuelson (1993) has an extensive discussion of viewing accounting for obligations to perform future services as a liability measurement problem.

Ethical issues. For students who have had a course in auditing, the instructor can discuss the role of the auditor in this accounting controversy. Mr. Holt is clearly putting pressure on Sue Taylor (the firm's auditor) to approve immediate recognition of the entire amount of the lifetime membership fee. Ms. Taylor clearly is against recognizing all the revenue immediately. Business ethics of managers, the role of the auditor in the financial reporting system and the AICPA's Code of Ethics Pertaining to auditors can be discussed. The pros and cons of the current auditing system where the managers hire the auditors and pay their fees, which results in pressures on auditors to approve of accounting methods favored by management, can be a useful topic for discussion. The pressures faced by auditors because of threat of job loss or loss an audit client due to accounting method or disclosure disagreements with the client can prepare students for the world of public accounting. The ethical issues faced by management with respect to opinion shopping (which Mr. Holt hints he might do) can help students see this issue from the management's viewpoint.

Violation of loan covenants. TTP is in danger of violating loan covenants. This is the main reason why Max Holt wants to recognize revenue immediately. Using Agency Theory, the instructor can discuss the reasons for existence of loan covenants, the consequences of violating loan covenants (loan being called or renegotiation of loan agreement resulting in higher interest rates, larger collateral or restriction on further borrowing), and the impact of loan covenants on management behavior with respect to accounting method choices. The instructor can go over the relevant calculations to point out that not recognizing the entire revenue from Globetrek immediately can result in violation of one or more of the negative loan covenants. For example, the 1996 Balance Sheet shows the Current Ratio at about 0.80 to 1 that is close to the covenant requirement of 0.75 to 1. A change in the Reserve for ticket returns and doubtful accounts could place the company in violation.

Furthermore, the capitalization ratio of debt to equity of 0.509 to 1 is dangerously close to the covenant requirement. A violation of either of the two mentioned covenants or the provision requiring a specified profit/ interest charge relationship could doom Travel Time Partners as a going concern.


R E F E R E N C E S

Financial Accounting Standards Board (December 1984) Statement of Financial Accounting Concepts No. 5. Recognition and Measurement in Financial Statements of Business Enterprises.

Financial Accounting Standards Board (December 1985) Statement of Financial Accounting Concepts No. 6. Elements of Financial Statements.

Samuelson, R. A. (1993). Accounting for Liabilities to Perform Services Accounting Horizons, September, 32-45.

Travel Time Partners, Inc. Balance Sheets December 3 I,

A P P E N D I X A

Pro Forma ProForma

1997 Quarter Ended March 31, 1997 1996

$1,762,934.66 $712,934.66 $329,940.60

611,447.09 555,860.99 505,328.18 14,157.18 12,870.17 11,700.15

567,290.50 515,718.64 468,835.13

47,161.32 42,873.93 38,976.30 $3,002,990.76 $1,840,258.39 $1,354,780.35

Current Assets: Cash and Equivalents Accounts Receivable, net of reserve for

ticket returns and doubtful accounts Other current assets Furniture, Fixtures, and Equipment net

of depreciation Leasehold improvements, net of

accumulated amortization Total Assets Liabilities and Stockholders' Equity Current liabilities: Accounts Payable Accrued Liabilities Loan from Inco Capital Stockholders' Equity Capital Stock, 80,000 shares authorized, $.50 par value; 20,000 issued and outstanding and held by

Mr. Max Holt Retained earnings Total Liabilities and Stockholders'

Equity

$1,171,865.64 $1,065,332.40 $968,484.00 111,392.72 101,266.11 92,060.10 100,000.00 100,000.00 100,000.00

10,000.00 l 0,000.00 10,000.00 1,609,732,40 563,659.88 184,236.25

$3,002,990.76 $1,840,258,39 $1,354,780.35

Travel Time Partners, Inc. Income Statements For the periods ended Sales Other commissions

A P P E N D I X B

Pro Forma Pro Forma Quarter Ended

1997 March 31, 1997 1996 $40,133,174.70 $10,033,293.68 $35,211,977.00

1,718,98Z83 429,745.71 1,562,711.67 41,852,157.53 10,463,039.38 36,774,688.67

590 R .D. Dillon and S. Nathan

Less: Cost of sales 36,487,383.53 9,121,845.88 Sales returns and rebates 944,437.27 236.109.32 Gross Margin 4,420,336.73 1,105,084.18 Expenses: Personnel 2,554,593.70 608,648.43 General and Administrative 154,101.57 38,525.39 Rent 175,807.13 43,951.78 Communications and data processing 71,572.60 17,893.15 Professional fees 8269.80 2067.45 Advertising and public relations 29,430.13 7357.53 Travel and entertainment 61,739.70 15,434.93 Mailing lists 10,000.00 5000.00 Income from operations 1,354,822.10 366,205.53 Other expenses: Amortization 27,508.80 6877.20 Depreciation 52,743.17 13,185.79 Interest 10,500.00 2625.00 Accelerated write-off of reservation

equipment and software 0.00 0.00 Net Income (Loss) $1,274,570.13 $346,142.53

A P P E N D I X C

Travel Time Partners, Inc. statement of Cash Flows For the year ended From Operations: Net Income (Loss) Adjustments for non cash items: Amortization Depreciation Accelerated write-off of reservation equipment and software Changes in working capital items: Accounts Receivable (decrease) Other Current Assets (decrease) Accounts Payable (decrease) Accrued Liabilities (decrease) Increase (decrease) in cash due to operations Changes in cash due to investing activities: Added computer systems and software Leasehold improvements Increase (decrease) in cash due to investing activities: Changes in cash due to financing activities: Loan from Imco Capital (8 year term loan 10.50% interest Repayment of loan to Morgan Bank Increase (decrease) in cash due to financing activities: Net increase (decrease) in Cash

33,170,348.67 858,579.33

2,745,760.67

2,213,267.00 140,092.33 159,824.67 65,066.00

7518.00 26,754.67 56,127.00

0.00 77,111.00

25,008.00 47,948.33

1425.00

143,467.00 $(140,737.33)

1996

$(140,737.33)

25,008.00 47,948.33

143,467.00 150,432.00 150,432.00

2453.00 (59,645.00) (14,574.00)

$154,352.00

(86,095.00) (3972.00)

(90,067.00)

100,000.00 (4300.00) 95,700.00

$159,985.00

Documents

Accounting for lifetime memberships: The case of Travel Time Partners, Inc