Question

PROBLEM: ASC 606: Revenue from Contacts with Customers, Correction of Accounting Errors, Professional Research, and Accounting Theory (Conceptual Framework)

Ian Mathews is a creator of board games. Ian will be selling his most recent game, Radical Rainbows, through his newly formed company, UPR, Inc. UPR was formed in June, 2018. Ian contributed $1,000 to UPR in exchange for 100% of UPR’s voting common stock. Ian has had unprecedented success with the first two games in his most recent game trilogy: unicorns, ponies and rainbows. Ian was looking to finance UPR’s initial production run of the third game, Radical Rainbows at a rate of 7.5% or less.   The best deal offered by several banks had an APR of 8%. That was more than Ian was willing to pay and he felt there were other sources of financing that were less expensive.

As he had done for the first two games in the series: Unstable Unicorns and Perplexed Ponies, Ian turned to Kickstarter to finance the cost of the first production run of Radical Rainbows. Normally, UPR will be selling Radical Rainbows for $50 per game. UPR offered to sell Radical Rainbows to its Kickstarter backers for $45 per game.   The Kickstarter campaign was completed in two days, and on June 1, 2018 UPR received $225,000 in exchange for a promise to deliver 5000 games to its Kickstarter backers on December 1, 2019.  

At a manufacturing cost of $30 per game, UPR will be able to produce 7500 units with the $225,000 raised in the Kickstarter campaign. The 7500 games would be ready for shipment on December 1, 2019.

On June 1, 2018, UPR’s bookkeeper made the following entry to record the receipt of cash:

ELEMENT	ACCOUNT DESCRIPTION	DEBIT	CREDIT
A	Cash*	$225,000
L	Deferred Revenue		$225,000

On December 1, 2019, UPR was able to deliver the 5000 board games to its Kickstarter backers. UPR also sold and delivered the additional 2500 games to other customers for the normal retail price of $50 per game. UPR’s bookkeeper made the following entries to record these transactions:

ELEMENT*	ACCOUNT DESCRIPTION	DEBIT	CREDIT
A	Cash*	$125,000
L	Deferred Revenue	$225,000
R	Sales Revenue		$350,000
X	Cost of Goods Sold*	$225,000
A	Inventory*		$225,000

UPR used the $126,000 in cash available to UPR in December, 2019 to manufacture another 4200 board games. Those games were in finished goods inventory at December 31, 2019 and were sold in January, 2020 for $50 per game

UPR’s Financial Statements at December 31, 2019 and 2018 as prepared by UPR’s bookkeeper showed the following:

Balance Sheet
			12/31/19	12/31/18
Cash*			$0	$126,000
Inventory - Work in Process*			$0	$100,000
Inventory - Finished Goods*			$126,000
Total Assets			$126,000	$226,000
Deferred Revenue			$0	$225,000
Total Liabilities			$0	$225,000
Common Stock*			$1,000	$1,000
Retained Earnings			$125,000	$0
Total Equity			$126,000	$1,000
Total Liabilities and Equity			$126,000	$226,000
Income Statement
Revenues			$350,000	$0
Cost of Goods Sold*			$225,000	$0
Gross Profit			$125,000	$0
Expenses			$0	$0
Net Income			$125,000	$0

*You can assume that the Cash, Inventory, Common Stock and Cost of Goods Sold amounts as shown in both the journal entries and financial statements are correct.

Your analysis of this problem will involve using ASC 606 - Revenue from Contracts with Customers. UPR adopted ASC 606 when Ian formed the company in 2018. UPR has applied ASC 606 incorrectly.

You can assume that a contract is in place and that only one performance obligation exists: the delivery of the board game to the customer. Thus, determining the Transaction Price is the issue that needs to be addressed. The principles for the determining transaction prices can be found in ASC Subtopic 606-10-32-2 through 606-10-32-27. You may also want to refer to the illustrations (examples) contained in ASC 606. A list of the illustrations can be found at ASC Subtopic 606-10-55-93.

QUESTIONS TO BE ANSWERED

You must answer the following questions:

What are the additional entries or correct entries required on the following dates? If the entries made by the bookkeeper are correct, indicate “Bookkeeper made correct entry”. Otherwise use the Journal Entry template to record your answer and then paste into your answer.:

June 1, 2018

December 31, 2018 Adjusting Journal Entry

December 1, 2019

Use the attached Excel Template, show the corrected comparative Balance Sheet and Income Statement at December 31, 2019 and December 31, 2018.   Paste the template into your answer.

Using references to ASC 606 explain how your arrived at your answers in 1. And 2. Above.

From the point of view of a potential investor or lender to UPR, do the corrected financial statements or the original financial statements prepared by UPR’s bookkeeper better reflect the economics of UPR during its initial two years in business? Why?             

Answer 1

BOOK KEEPER made correct entries. In addition to the entries made by book keeper the following journal enties are required:

01.Jun.18
A	Cash*	$1,000
L	Capital A/c		$1,000
31.Dec.18
A	Inventory	$100,000
A	Cash*		$100,000
L	Deferred Revenue	$75,000
R	Revenue		$75,000
	75000
01.Dec.19
A	Inventory	$125,000
A	Cash*		$125,000
R	Revenue	$75,000
L	Deferred Revenue		$75,000

Corrected balance sheet in accordance with ASC 606 is as follows:

Balance Sheet
		12/31/19	12/31/18
Cash*		$0	$126,000
Inventory - Work in Process*		$0	$100,000
Inventory - Finished Goods*		$126,000
Total Assets		$126,000	$226,000
Deferred Revenue		$0	$150,000
Total Liabilities		$0	$150,000
Common Stock*		$1,000	$1,000
Retained Earnings		$125,000	$75,000
Total Equity		$126,000	$76,000
Total Liabilities and Equity		$126,000	$226,000
Income Statement
Revenues		$275,000	$75,000
Cost of Goods Sold*		$225,000	$0
Gross Profit		$50,000	$75,000
Expenses		$0	$0
Net Income		$50,000	$75,000

As per ASC 606, the revenue is to be recognised driven by satisfaction of the performance oligation. In the given case, the contract was for the delivery of 5000 board games which was to be fulfilled over a period of 18 months (1 jun 2018 to 1 dec 2019). We dont have any other statistics as on 31 December 2018 or any information w.r.t. the percentage of work completed since all the production was in Work in process status. Hence the only rational approach available is the time period over which the contract needs to be completed. As we can see that 7 months have passed (1 jun 2018 to 31 Dec 2018) we are considering revenue recognition to the tune of 7/18 of the contract value.

Contract Sale Revenue recognised on 31 Dec 2018 = 225000 * 7/18

From the point of view of potential investor I see the financial statements prepared by UPR's book keeper as a better reflection of the economics of UPR since there is no rational method really available to identify the proportional cost of the contractual obligation finished. Also since the risk and rewards related to the product in question is not transferred to the buyer until the goods are delivered, it is not appropriate to recognise revenue.

This method of recognising revenue is more suitable in case of sevice contract where services are rendered on a recurring basis and it can be evenly distributed over the period of contract.