Compaq Computer Corporation, is the second largest computer company in the world and the largest global supplier of computer systems. Compaq develops and markets hardware, software, and provides various technology services. Compaq reported a 1998 loss of $2.7 billion on revenues $31 billion. From Compaq's home page you can access information about Compaq's products and services, and can order a custom made computer.

Southwest Airlines is the country's only major, low-fare, high frequency, point-to-point carrier. It is the fifth largest U.S. domestic carrier, servicing 52 cities in 26 states. Southwest reported 1998 revenues of $4.16 billion dollars and 1998 marked the airlines' 26th consecutive year of profitability. From Southwest's home page, you access information on fares, frequent flier programs, career opportunities, and you can book a flight. Southwest's 1998 annual report can be downloaded in Adobe Acrobat PDF format, or a Microsoft Word (self-extracting zip) file.

Accrual basis accounting attempts to record the effects of transactions in the period in which they occur rather than in the period in which cash is paid or received by a business. To properly determine net income under accrual basis accounting, revenues and expenses must be assigned to the appropriate accounting period. The revenue recognition and matching principles provide the basis for determining net income under accrual basis accounting.

The revenue recognition principle requires firms to recognize revenues when earned. Typically this is when a service has been provided, or when goods are delivered. The matching principle attempts to match expenses with the revenues they produce. As a result, expenses are recorded in the same period as the revenues they generated.

While the revenue recognition and matching principles are rather straight forward, their application is often subject to seemingly arbitrary rules and requires the use of estimates. In this exercise you will access the financial statements of Compaq and Southwest Airlines, and consider some of the complexities involved in applying the revenue recognition and matching principles.

1. Open Compaq's 1998 annual report, and use the notes to the financial statements to answer the following questions:

   1. What do the notes to Compaq's financial statements say about the use of estimates in preparing financial statements?

   2. When does Compaq recognize revenue on hardware sold through distributors?

   3. When are revenues recognized on products licensed to original equipment manufacturers?

   4. How does Compaq recognize maintenance and subscription revenue?

   5. When does Compaq record the cost associated with telephone support and product warranties?

   6. What types of estimates must Compaq make in recording sales?

2. The following costs and expense items appear on Compaq's income statement, and have a significant impact on Compaq's reported earnings:

   Research and development costs
   Purchased-in-process technology
   Restructuring and asset impairment charges

   Use the notes to Compaq's financial statements to evaluate the role that "arbitrary" rules and estimates had in determining these costs.

   1. How are research and development (R&D) costs accounted for?

   2. Presumably Compaq, and other firms, make R&D expenditures, because they expect to receive a future benefit. This will likely be in the form of new products and services to sell in the future. Can you reconcile the accounting treatment of R&D expenditures with the matching principle?

   3. In 1998, Compaq expensed $3.2 billion in "purchased in-process technology" related to its $9.1 billion acquisition of Digital Computer Corporation. How did Compaq arrive at the $3.2 billion dollar write-off? Were estimates used?

   4. What rational is provided for writing off approximately one-third of the $9.1 billion acquisition price?

   5. What impact would capitalizing the $3.2 billion have had on 1998 earnings and earnings in future years?

   6. In 1998 Compaq reported restructuring charges of $393 million. What types of estimates were involved in arriving at the $393 million charge (See note 3).

3. Open Southwest Airline's 1998 annual report, and use the notes to the financial statements to answer the following questions:

   1. What do the notes to Southwest's financial statements say about the use of estimates in preparing financial statements?

   2. When does Southwest Airlines record passenger revenues? When tickets are sold, or when passengers actually travel?

   3. In apply the matching rule, depreciation is used to allocate the cost of fixed assets over time, and matches their cost with the revenues that they generate. Depreciation involves the use of estimates and the application of "arbitrary" rules. Use the property and equipment footnote to identify the how Southwest uses estimates and "arbitrary" rules to determine depreciation expense.

© 2002 by Prentice-Hall, Inc.A Pearson Education Company, Upper Saddle River, New Jersey 07458

PHLIP was originally conceived and developed for Prentice Hall with the expertise of Dan W. Cooper of Active Learning Technologies, Inc.and Scott R. Lyman.

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