Question

Kingdom Communication Systems signs a contract to develop and install an integrated network for a customer in five phases. Suppose that each phase is considered a performance obligation. The transaction price for the contract is $2,900,000. Each phase is fully functional at the point of delivery. If sold separately, the five phases of the total network products each have standalone values as follows:

Network Phase Selling price if sold alone Phase 1 453,000 Phase 2 710,000 Phase 3 520,000 Phase 4 460,000 Phase 5 877,000

The contract price is collected in advance from the customer and Phases 1 and 2 are completed during the current year. Kingdom expects Phase 3 and 4 to be completed in the next 12 months, and Phase 5 in the year after that. How much revenue will be recognized during the current period?

I don't understand why the contract price for the current period is just the sum of the first 2 phases: 1,163,000

Why do you have to divide this by total cost and multiply by the transaction price to get the correct answer?

Please explain and show steps for how and why to do this.

Answer 1

Contract price of only Phase 1 & 2 can be shown during current period income statement based on "Revenue Recognition Principle" - Any revenue can be recognized in income statement, only when it is earned (i.e.) only after service gets complete. Until the service gets completed, the money earned doesn't belongs to the company and it still reflects as part of balance sheet liabilities under "unearned revenue" because if service provider fails to provide service as agreed, the customer who paid in advance has all right to claim refund of advance paid. Thus it is a liability in the books of service provider. Moreover as per basic principles of accounting, revenue or expense related to any service rendered /received during the current period only, can be shown under "income statement" and future obligations cannot be shown under current period income statement.

With that said, "revenue to recognize" during current period includes "only phase 1 and 2"

In order to get the correct amount of revenue recognition, standalone price of each phase has to be divided by total standalone price and then multiplied by total contract price, because as of current period ending, only phase 1 and 2 are completed and revenue related to these phases need to be arrived at. It is said that each phase is fully functional once completed, which means it has been sold standalone. But in this case "total contract price" is less than "standalone price of all phases", which denotes they have been sold at discounted price. In order to find the discounted price of each phase, the standalone price of each phase has been divided by total standalone price and multiplied by contract price. (for example - Phase 1 standalone price = $453,000. Total standalone price = $ 3,020,000. Total contract price = $ 2,900,000 Thus discounted price or revenue to be recognized in current year for Phase 1 = $ 453000 / $ 3020000 * 2900000 = $ 435,000)

Summary as per below table:

Phase	Standalone price	Contract price
Phase 1	453,000	435,000
Phase 2	710,000	681,788
Phase 3	520,000	499,338
Phase 4	460,000	441,722
Phase 5	877,000	842,152
Total	3,020,000	2,900,000
Contract Price	2,900,000

In general, if any project has different phases, either % of each phase completion or value of each phase will be provided, in order to arrive at such revenue recognition per phase completed.

As per above clarification, revenue to be recognized in current period against phase 1 and phase 2 = $ 435,000+$681,788 = $ 1,116,788