Revenue

Here’s the question:

“On 1 October, 2011, the first day of the accounting period, the company sold one of its products for $10 million and included this amount in revenue. As part of the sale agreement, the company is committed to the ongoing servicing of this product until 30 September, 2014 (i.e. three years from the date of sale). The value of this service has been included in the selling price of $10 million. The estimated cost to the company of the servicing is $600,000 per annum and the normal gross profit margin on this type of servicing is 25%.

What adjustment, if any, is necessary to the financial statements as at 30 September 2012? Ignore discounting?”

There’s a 3 year service period involved in the contract ending on 30 September, 2014 and the cost to the company of providing that continuing service is $600,000 per annum

Gross margin on servicing is 25% so the annual revenue earned on the servicing element is $600,000 / 75% * 100% = $800,000

Before adjustment the revenue figure includes revenue from servicing for all three years

As at 30 September, 2012 two of those years are not yet earned so we need to eliminate them from revenue (Dr Revenue $2 * $800,000 = $1,600,000) and credit a new account – probably called Deferred Income (Cr Deferred Income $1,600,000)

Better?