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Can you please explain this adjustment from Dec 09 paper? How should we record this transaction?
(i) Sandown’s revenue includes $16 million for goods sold to Pending on 1 October 2008. The terms of the sale
are that Sandown will incur ongoing service and support costs of $1·2 million per annum for three years after
the sale. Sandown normally makes a gross profit of 40% on such servicing and support work. Ignore the time
value of money.Thanks.
Yes, Sandown has got itself into a situation of having to supply on-going support at the rate of $1.2m per annum (at cost to Sandown)
It would be inappropriate for Sandown to recognise the profit that will be earned over the next three years on the support income. The invoice value of the three years’ support is $2m each year
Assuming that the year end in the question is 30 September, 2009 as at that date Sandown still has an obligation for 2010 and 2011.
At the moment, revenue includes an amount of $16m. This should be reduced by the two years’ worth of revenue (including profits) amounting to 2 x $2m and should be credited to a deferred income account
OK?
Almost there!
The total sales of goods to Pending is $16m. This is a revenue for current year or three years?
The total supporting cost to this sales of goods is $3.6m (1.2m x 3). From the profit margin of 40% the total revenue of such service should be $6m ($3.6m/0.6). From the answer in the book, $4m should be deducted from the total sales of $16m to account for 2 year deferred revenue. My question is, has this $6m service revenue been included in the total sales revenue of $16m?
Yes, it has. The first year of this deferred revenue has been earned by the end of the current year, so only 2 years @ $2 = $4m needs to be taken out of this year’s revenue and deferred to next year and the year after
Ok?
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