Velocity, a consulting firm, enters into a contract to help Burger Boy, a fast-f

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 $78,000 at the beginning of each month. At the end of the contract, Velocity either will give Burger Boy a refund of $26,000 or will be entitled to an additional $26,000 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 $26,000 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 will earn the bonus. At the end of the contract, Velocity receives the additional consideration of $26,000.

Required:
1. to 4. Prepare the journal entries related to the contract. (If no entry is required for a transaction/event, select "No journal entry required" in the first account field.)

Explanation / Answer

1) At the inception of the contract, Velocity calculates the transaction price to be the expected value of the two possible eventual prices:-

As its consulting services are provided evenly over the eight months, velocity will recognize revenue of $79,950 ($639,600/8 months). The velocity is guaranteed to receive only $78,000 per month, it will recognize the bonus receivable of $1,950 ($79,950-$78,000) in each month to reflect the expected value of the bonus amount to be received at the end of the contract. Therefore the journal entry to record the revenue each month for the first four months is as follows:- (Amount in $)

2) By the end of fourth month the balance of bonus receivable account will have a balance of $7,800 ($1,950*4 months). After four months, the estimated likelihood of receiving the bonus is revised which is shown as follows:-

So after four months, the bonus receivable account should have a balance of $2,600, which is half of the new expected value of the bonus of $5,200 [$629,200 - ($78,000*8 months)]. Because the bonus receivable account was increased to $7,800 in the first four months, an adjustment of $5,200 is needed to reduce the bonus receivable down to $2,600.   

(Amount in $)   

3) Velocity will recognize revenue of $78,650 per month ($629,200/8 months) in each of the months five through eight. Velocity will recognize a bonus receivable of $650 per month ($78,650 - $78,000).

  Journal Entries (Amounts in $)

4) At the end of the contract, velocity receives the additional consideration of $26,000. It has already recognized revenue of $5,200 associated with bonus. Therefore when Velocity receives the cash bonus it will recognize an additional revenue of $20,800 ($26,000 - $5,200).

Journal Entries (Amounts in $)

Possible prices (A) Probabilities (B) Expected consideration (A*B) [($78,000*8 months)+$26,000] = $650,000 80% $520,000 [($78,000*8 months)-$26,000] = $598,000 20% $119,600 Expected value at contract inception $639,600

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