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The question reads as follows:
Verge entered into a contract with a government body on 1 April 20X1 to undertake maintenance services on a new railway line. The total revenue from the contractis $5 million over a three-year period. The contract states that $1 million will be paid at the commencement of the contract but although invoices will be subsequently sent at the end of each year, the government authority will only settle the subsequent amounts owing when the contract is completed. The invoices sent by Verge to date (including $1 million above) were as follows:
Year ended 31 March 20X2 $2.8 million
Year ended 31 March 20X3 $1.2 million
The balance will be invoiced on 31 March 20X4. Verge has only accounted for the initial payment in the financial statements to 31 March 20X2 as no subsequent amounts are to be paid until 31 March 20X4. The amounts of the invoices reflect the work undertaken in the period. Verge wishes to know how to account for the revenue on the contract in the financial statements to date. Market interest rates are currently at 6%Why in the answer is there income of 96,000 in 20X3 (i.e. 6%*1.6M). I don’t get this answer and calculation? It is known as unwinding of discount but how is that an income and also in the answer I don’t get this phrase:
Where the inflow of cash or cash equivalents is deferred,the amount of the inflow must be discounted because the fair value is less than the nominal amount. In effect, this is partly a financing transaction, with
Verge providing interest-free credit to the government body. The market rate of interest, here 6%, must be used to calculate the discounted amount, and the difference between this and the cash eventually received recognised as interest income.How is there interest income? And why is there interest free credit or rather how is there interest free credit? Because we are using market interest rate of 6% so how are we saying there is interest free credit when we are actually basing our calculations on market interest rate of 6% and actually CHARGING interest. Doesn’t make sense.
Thanks.
Because we are using present value / dcf techniques. All current assets likeq inventory and receivables are shown at lower of cost and net realizable value. The value of the receipt in one year’s time has a current value of the discounted amount. As the year passes by and we get closer to the date of settlement, we unroll the discount and add it the the previously discounted value.
But where’s the double entry?
Debit receivables and credit …….?
Interest receivable. It’s receivable because we have recorded the amount receivable at its discounted current vale. In effect, we are lending the current value to the debtor and through that period of extended credit we are eating interest on the current value.
And that’s why it’s interest receivable income
Hope that helps
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