Question

With our understanding of revenue recognition lets see how we might apply the 5 step model to the following transaction that most of us have encountered. Lets say we visit our favorite phone store and sign up for new cell service. We sign up for and receive a new phone that would normally retail for $500 (cost to manufacture $380). We commit to a three year contract where we will have to pay back an amount that starts at $600 (to pay for the phone) but drops each month until it reaches zero at the end of 3 years (kind of like financing for the phone). We pay an activation fee of $35 along with the first month of service that will be $70 each month for the next 36 months. After one year of service, we will be eligible for $100 off the latest phone if we trade in the one year old phone for a new one. That rises to $200 after two years. You can describe how to apply the 5 step model to this transaction from the phone company side. Show journal entries when necessary to make sure this gets recorded (you do not have to show all of them just enough to get the idea).

Answer 1

1. Five step model revenue recognition .

Cost price of Cell phone $ 380

Normal selling price(cash) $ 500

Profit on sale of Cell Phone $ 120(500-380)

But Instalment price $ 600

So, Financial charge $ 100(600-500)

First step revenue recognition is at the time of delivery of Cell phone is Normal selling price $ 500

Second step of revenue recognition is finance charge when instalment basis sold $ 100 for three years.

Third Step of revenue recognition is Activation charges to the customers i.e $ 35

Fourth step of revenue recognition is Monthly Service charge $ 70 per month

Firth step of revenue recognition is at the time of exchange at the end of first year or at the end of second year.

2. Instalment chart for three years

year particulars Amount    instalment amount interest cash instalment price

1 first instalment 500 200 50 (100*3/6) 150

150

2 second instalment 350 200 33 (100*2/6) 167

167

3. third instalment 183 200 17 (100*1/6) 183

183

0

Journal entries

At the point of sale of cell phone

1. Account receivable a/c Dr $ 600

To Sales a/c $ 500

To Interest receivablea/c $ 100

(Beeing Cell phone sold on instalment basis)

2. Bank a/c Dr $ 35

To service charges a/c $ 35

(Beeing activation charges collected)

3. Bank a/c Dr $ 70

To Service charge a/c $ 70

(Beeing monthly service charge received)

for three years every month above entry common.

4. Interest receivable a/c Dr $ 50

To interest a/c $ 50

(Beeing year end int accounted)

5. Bank a/c Dr $ 200

To Accounts receivable a/c $ 200

(beeing first instalment received)

6. Interest a/c Dr $ 50

To Profit & loss a/c $ 50

( Beeing int. tr to profit & loss a/c)

like this entries for every year end we must provide.