Dunn Trading Stamp Co. records stamp service revenue and provides for the cost of redemptions in the year stamps are sold to licensees. Dunn's past experience indicateds that only 80% of the stamps sold to licensees will be redeemed. Dunn's liability for stamp redemptions was $6000k at Dec 31, 2006. Additional information for 2007 is as follows:

Stamp service revenue from stamps sold to licensees   $4000k
Cost of redemptions (stamps sold prior to Jan 1, 2007) $2750k

If all the stamps sold in 2007 were presented for redemption in 2008, the redemption cost would be $2250k. What amount should Dunn report as a liability for stamp redemptions at Dec 31, 2007?

Solution:

DR Cash 4000k
CR Stamp service revenue 4000k

DR liability for stamp redemptions 2750k
CR inventory 2750k

DR cost of future redemptions 1800k
CR liability for future stamp redemptions 1800k (2250kx80%)

Liability = 6000k - 2750k + 1800k = 5050k

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My first question is why the inventory is credited for stamp redemptions. My understanding is that inventory should be increased once the stamp is redeemed.

My second question is why the liability for future stamp redemptions is 1800k. My understanding is that 80% of the stamps sold to licensees will be redeemed, which means 80% x 4000k = 320k. Since the 2008 redemption cost (2250k) is mentioned in the topic, it should be counted directly in the liability. Total liability = 6000k - 2750k + 2250k = 5500k

Please help. 

This is a contingent liability question.  I did a quick search and found it to be Wiley Chatper 10 MCQ 98.  I also checked its solution.  I recall this question from Becker as well.  So, this could be a retired MCQ. 

This question is a bit tricky.  Please distinguish "stamp service revenue" from the physical "stamps" sold or redeemed as in "stamp redemptions".  It tries to trick you into thinking these two concepts are one the same, and in fact they aren't. 

The clearest clue is given in the beginning of the 3rd para that says "If all the stamps sold in 2007 were presented for redemption in 2008, the redemption cost would be $2250k."   It means 2.25 million worth of physical stamps were sold in 2007, and only 80% of them would be redeemed in 2008. 

You've got $6mm of redemption liability at the end of 2006, you've got 2.75mm actually redeemed in 2007; and out of $2.25mm stamps sold in 2007 80% of those would be redeemed in 2008, you'd get 6mm + 2.25mm*80% - 2.75 =5.05mm.  Th $4 million stamp service revenue is a distractor.