Question

Exercise 18-32 (Essay) Rex's Reclaimers entered into a contract with Dan's Demolition to manage the processing of recycled materials on Dan's various demolition projects. Services for the 3-year contract include collecting, sorting, and transporting reclaimed materials to recycling centers or contractors who will reuse them. Rex's incurs selling commission costs of $2,000 to obtain the contract. Before performing the services, Rex's also designs and builds receptacles and loading equipment that interfaces with Dan's demolition equipment at a cost of $27,000. These receptacles and equipment are retained by Rex's and can be used for other projects. Dan's promises to pay a fixed fee of $12,000 per year, payable every 6 months for the services under the contract. Rex's incurs the following costs: design services for the receptacles to interface with Dan's equipment $3,000, loading equipment controllers $6,000, and special testing and OSHA inspection fees $2,000 (some of Dan's projects are on government property). Does the accounting for capitalized costs change if the contract is for 1 year rather than 3 years? Explain. Dan's Demolition is a startup company; as a result, there is more than insignificant uncertainty about Dan's ability to make the 6-month payments on time. Does this uncertainty affect the amount of revenue to be recognized under the contract? Explain.

Answer 1

Does the accounting for capitalized costs change if the contract is for 1 year rather than 3 years?

There are more or less two types of cost associated with revenue recognition of contract cost. The first one is cost to obtain the contract and second one is cost to fulfill the contract before a goods or services is provided to customer. The revenue standard does provide a guidance on cost to obtain and fulfill a contract that should be recognised as an asset. The cost which is recognised as an asset is to be ammortized over the period that the related goods or services transfers to the customer and also it is reveiwed periodically for impairment.

When cost are incurred to obtain a contract with the customer or client such as selling and marketing cost, sales commission, etc are referred to as incremental cost. Basically incremental cost are those cost of obtaining a contract that would not have incurred if the contract had not been obtained. In the above case Sales commission of $2000 is an Incremental cost. Hence as per the revenue standard it should be recognised as an asset and it is recoverable also.

There is a practical expedient which allows organisation to expense the cost to obtain the contract as incurred when the expected amortization period is less than a year.

Hence if the contract is for one year or a lesser period then Rex can make use of the practical expedient and recognize the incremental cost of obtaining the contract i.e. sales commission. as an expense when incurred. So we can conclude that accounting for capitalized cost can change if the contract is for less than a year.

Explain. Dan's Demolition is a startup company; as a result, there is more than insignificant uncertainty about Dan's ability to make the 6-month payments on time. Does this uncertainty affect the amount of revenue to be recognized under the contract? Explain.

Collectibility is nothing but a customer credit risks. It is basically a risk that cutomer would be unable to pay the amount of consideration agreed as per the terms of the contract. Whether the company would get paid for completing the performance obligation of the contract is not a consideration in determining the revenue recognition. Hence the collectibility of the contract payment would not affect the amount of revenue recognised. Which implies that the amount recognized as revenue would not be adjusted for customer credit risk.

Rather, Rex should report the revenue gross (i.e. without considering credit risk) and then should present an allowance for any impairment due to bad debts (recognized initially and subsequently as per the respective bad debts guidance). It should be promienently reported as an expense in the income statement. And if there is any significant doubt at the inception of the contract with respect to its collectibility, then it would imply that parties to the contract are not fully committed to fulfill their respective obligation towards the contract. As a result it would indicate that existence of contract is not met and therefore no revenue would be recognized unless and until the issue relating to significant doubt relating to the contract is resolved.