On January 1 Edwards Consulting entered into a contract to complete a cost reduc

Question

On January 1 Edwards Consulting entered into a contract to complete a cost reduction program for Matthews Financial over a six-month period. Edwards will receive $20,000 from Matthews at the end of each month. If total cost savings reach a specific target, Edwards will receive an additional $10,000 from Matthews at the end of the contract, but if total cost savings fall short, Edwards will refund $10,000 to Matthews. Edwards estimates an 80% chance that cost savings will reach the target and calculates the contract price based on the expected value of future payments to be received Required: Prepare the following journal entries for Edwards: 1. Prepare the journal entry on January 31 to record the collection of cash and recognition of the first month's revenue. 2. Assuming total cost savings exceed target, prepare the journal entry on June 30 to record receipt of the bonus. 3. Assuming total cost savings fall short of target, prepare the journal entry on June 30 to record payment of penalty.

Explanation / Answer

1. On Jan 31: Cash/Bank A/c Dr   $ 20000

To Contract Income   $20000

(Being first month installment of cost reduction program from Matthews received)

2. On June 30: Cash/Bank A/c Dr   $ 10000

To Contract Income   $10000

(Being additional income/ bonus received from matthews on meeting the cost reduction program targets)

3. On June 30: Contract Income Dr   $ 10000

To Cash/Bank A/c $ 10000

(Being penalty charged for not meeting the targets of cost redution program)

Note: The penalty has been shown by way of reducing the income. Alternatively, the same can be shown by way of recording expense (Depends on terms and nature of the contract). In that case, entry will be as follows:

Penalty Charges A/c Dr $ 10000

To Cash/Bank A/c $ 10000

(Being penalty charged for not meeting the targets of cost redution program)

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