Question

Shawinegan Development Co. (SDC) conducts research and development on specific projects under contract for clients; SDC also conducts basic research and attempts to market any new products or technologies it develops.
In January 20X4, scientists at SDC began research to develop a new industrial cleaner. During 20X4, $3,160,000 of costs were incurred in this effort. Late in July 20X5, potentially promising results emerged in the form of a substance the company called Scourge. Costs incurred through the end of July 20X5 were $1,540,000. At this point, SDC attempted to sell the formula and rights to Scourge to Pride and Glory Industries Ltd. (PGIL), for $16,000,000. PGIL, however, was reluctant to sign before further testing was done. It did wish to have the first option to acquire the rights and formulas to Scourge if future testing showed the product to be profitable. SDC was very confident that Scourge would pass further testing with flying colours. Accordingly, the two companies signed an option agreement that allowed PGIL to acquire the formulas and rights to Scourge any time before 31 December 20X6. Testing costs on the product incurred by SDC for the remainder of 20X5 amounted to $1,800,000.

On 6 March 20X6, PGILG exercised its option and agreed to purchase the formulas and rights to Scourge for
$16,000,000. The formula was to be completed and delivered within 18 months.
On 2 January 20X7, SDC delivered the formulas and samples of Scourge to PGIL. On that date, PGIL paid $6,400,000 immediately with the balance payable in four equal annual instalments on 31 December 20X7 to 20X10. Additional testing costs incurred by SDC during 20X6 amounted to $540,000; in 20X7, $260,000.

 

Required:

1. When should revenue be recognized by SDC from its work on Scourge? Why? Apply the five steps for revenue recognition.

2. Assume that the total costs of $7,300,000 actually incurred by SDC over the years 20X4 to 20X7 had been accurately estimated in 20X4. Determine the amount of revenue and expense that should be recognized each year from 20X7 to 20X10. The appropriate discount rate for the credit risk associated with this customer is 6%. Prepare journal entries related to revenue recognition for 20X6 to 20X10 assuming revenue is recognized at the point of delivery.

 

Note that the $3,160,000 research costs must be expensed in all alternatives to comply with accounting standards for research costs. Development costs may be deferred if appropriate.

Answer 1

Requirement 1

The five steps to revenue recognition are outlined below.

 

1. Identify the contract with the customer. An agreement has been signed but only outlines that PGIL will acquire the rights and formulas any time before December 31 20X6.

 

2. Identify separate performance obligations, if they exist. There is only one performance obligation and that is the transfer of control of the formulas and rights to Scourge. 

 

3. Determine the overall contract price. The consideration is $16 million which was agreed to in early 20X6. However, since payments are received in five equal installments from 20X6 to 20X10, the consideration is the present value of these payments. In addition, depending on when revenue is actually recognized, SDC may have an interest expense on advance payments and interest income on delayed payments.

 

4. Allocate the contract price to the separate performance obligations. As outline earlier, there is only one performance obligation.

 

5. Determine when the performance obligation is satisfied and revenue can be recognized. This will occur once control of the formula and rights are transferred to PGIL. Does this happen when the option is exercised on March 6, 20X6 or on delivery in January 20X7. Until January 20X7 there is no item that is actually functional. The formulas are delivered in January 20X7 once they are fully completed. Prior to this date, SDC still has the obligation to finish the formulas that can actually be used. So the performance obligation is not completed until delivery to PGIL in January 20X7.

 

 

Requirement 2

 

Costs

The research costs of $3.16 million incurred in 20x4 must be charged to expense in 20x4 because there is no reason to believe in 20x4 that a commercially saleable product has been created. Accounting standards require that research be expensed for this reason. 20x5 expenditures, which are on an established product with an obvious market, can be capitalized as development costs. Costs will be accumulated to development costs as follows:20X5 1,540,000 + 1,800,000 = 3,340,000

20X6     540,000

20X7     260,000

 

In January 20X7 when revenue is recognized, the total capitalized costs of $4,140,000 will be expensed.

 

Revenue

SDC received $6,400,000 at the time of the sale and delayed payments of $2,400,000 for the next five years. To determine the contract consideration, interest income must be determined from the point of sale which is January 20X7 as follows:

 

 

Payment date	Amount	Contract Consideration
January 2, 20X7	6,400,000	6,400,000
December 31, 20X7	2,400,000	2,400,000 / (1.06)= 2,264,151
December 31, 20X8	2,400,000	2,400,000 / (1.06)2= 2,135,991
December 31, 20X9	2,400,000	2,400,000 / (1.06)3= 2,015,086
December 31, 20X10	2,400,000	2,400,000 / (1.06)4= 1,901,025
Total	16,000,000	14,716,253

 

The interest income for each year is determined in the table below using the effective interest rate:

 

	Revenue recognized	Payments	Interest income (expense)	(Contract liability)/Receivable Balance
January 1, 20X7	14,956,253			14,716,253
January 1, 20X7		6,400,000		8,316,253
December 31, 20X7		2,400,000	8,316,253 x 6% = 498,975	6,415,228
December 31, 20X8		2,400,000	6,415,228 x 6% = 384,914	4,400,142
December 31, 20X9		2,400,000	4,400,142 x 6% = 264,009	2,264,151
December 31, 20X10		2,400,000	2,264,151 x 6% = 135849	0

 

 

January 20X7

Dr. Cash........................................................        6,400,000

Dr. Long-term receivable..............................      8,316,253

 Cr. Revenue.............................................                            14,716,253

 

December 31, 20X7

Dr. Cash........................................................      2,400,000

 Cr Interest income..................................                                 498,975

  Cr. Long-term receivable.......................                              1,901,025

 

 

December 31, 20X8

Dr. Cash........................................................      2,400,000

 Cr Interest income..................................                                 384,914

 Cr. Long-term receivable.......................                              2,015,086

 

December 31, 20X9

Dr. Cash........................................................      2,400,000

 Cr Interest income..................................                                 264,009

 Cr. Long-term receivable.......................                              2,135,991

 

December 31, 20X10

Dr. Cash........................................................      2,400,000

 Cr Interest income..................................                                 135,849

 Cr. Long-term receivable.......................                              2,264,151