Question

Velocity, a consulting firm, enters into a contract to help Burger Boy, a fast-food restaurant, design a marketing strategy to compete with Burger King. The contract spans eight months. Burger Boy promises to pay $66,000 at the beginning of each month. At the end of the contract, Velocity either will give Burger Boy a refund of $22,000 or will be entitled to an additional $22,000 bonus, depending on whether sales at Burger Boy at year-end have increased to a target level. At the inception of the contract, Velocity estimates an 80% chance that it will earn the $22,000 bonus and calculates the contract price based on the expected value of future payments to be received. After four months, circumstances change, and Velocity revises to 60% its estimate of the probability that it wil earn the bonus. At the end of the contract, Velocity receives the additional consideration of $22,000. Required: 1. to 4. Prepare the journal entries related to the contract. (f no entry is required for a transaction/event, select "No Journal entry required" in the first account field.) es

Answer 1

Solution:-

1) The contract inception, the expected value of the two possible eventual prices is calculated below

Possible Prices (A)	Probabilities (B)	Expected Consideration (A*B)
[($66,000*8)+$22,000] = $550,000	80%	440,000
[($66,000*8)-$22,000] = $506,000	20%	101,200
Expected Value at Contract Inception		541,200

As consulting services are provided evenly over the eight months, velocity will recognize revenue of $67,650 ($541,200/8 months). Because Velocity is guaranteed to receive only $66,000 per month, it will recognize a bonus receivable of $1,650 each month ($67,650-$66,000) to reflect the expected value of bonus amount to be received at the end of the contract. The journal entry to record revenue each month for the first four months of the contract is shown as follows:-

Journal Entries (Amounts in $)

Account Titles	Debit	Credit
Accounts Receivable	66,000
Bonus Receivable	1,650
Service Revenue		67,650

2) By the end of the fourth month, the bonus receivable account would have a balance of $6,600 ($1,650*4). After four months, the estimated likelihood of receiving the bonus is revised so the estimated transaction price decreases:

Possible Prices (A)	Probabilities (B)	Expected Consideration (A*B)
[($66,000*8)+$22,000] = $550,000	60%	330,000
[($66,000*8)-$22,000] = $506,000	40%	202,400
Transaction price after four months		532,400

After four months, the bonus receivable account should have a balance of $2,200, which is half of the new expected value of the bonus of $4,400 [$532,400-($66,000*8)]. Because the bonus receivable account was increased to $6,600 in the first four months, an adjustment of $4,400 ($6,600-$2,200) is needed to reduce the bonus receivable down to $2,200.

  Journal Entries (Amounts in $)

Account Titles	Debit	Credit
Service Revenue	4,400
Bonus Receivable		4,400

3) As services are provided evenly over eight months, Velocity would recognize revenue of $66,550 ($532,400/8 months) in each of the fifth to eighth month. Journal Entry to record revenue each month for the second four months of the contract is shown as follows:-

Journal Entries (Amounts in $)

Account Titles	Debit	Credit
Accounts Receivable	66,000
Bonus Receivable	550
Service Revenue		66,550

4) At the end of contract, Velocity learns that it will receive the bonus of $22,000. It already has recognized revenue of $4,400 associated with the bonus. Therefore, when Velocity receives the cash bonus, it will recognize additional revenue of $17,600 ($22,000-$4,400). Journal entry to record receipt of $22,000 bonus is shown as follows:-

Journal Entries (Amounts in $)

Account Titles	Debit	Credit
Cash	22,000
Bonus Receivable		4,400
Service Revenue ($22,000-$4,400)		17,600