Shawinegan Development Company (SDC) con-ducts research and development on specific projects under contract for clients; SDC also conducts basic research and attempts to market any new products or technologies it develops. In January 20X4, scientists at SDC began research to develop a new industrial cleaner. During 20X4, $ 3,160,000 of costs were incurred in this effort. Late in July 20X5, potentially promising results emerged in the form of a substance the company called Scourge. Costs incurred through the end of July 20X5 were $ 1,540,000. At this point, SDC attempted to sell the formula and rights to Scourge to Pride and Glory Industries Limited (P& G), for $ 16,000,000. P& G, however, was reluctant to sign before further testing was done. It did wish, though, to have the first option to acquire the rights and formulas to Scourge if future testing showed the product to be profitable. SDC was very confident that Scourge would pass further testing with flying colours. Accordingly, the two companies signed an option agreement that allowed P& G to acquire the formulas and rights to Scourge any time before 31 December 20X6. Testing costs on the product incurred by SDC for the remainder of 20X5 amounted to $ 1,800,000.
On 5 January 20X6, P& G exercised its option and agreed to purchase the formulas and rights to Scourge for $ 16,000,000. P& G paid $ 4,000,000 immediately with the balance pay-able on 31 December 20X7. The formula was to be completed and delivered within 18 months. The credit risk rate associated with P& G was determined to be 6%. In April 20X7, SDC delivered the formulas and samples of Scourge to P& G Industries. Additional testing costs incurred by SDC during 20X6 amounted to $ 540,000; in 20X7, $ 260,000.
1. When should revenue be recognized by SDC from its work on Scourge? Why?
2. Assume that the total costs of $ 7,300,000 actually incurred by SDC over the years 20X4 to 20X7 had been accurately estimated in 20X4. Determine the amount of revenue and expense that should be recognized each year from 20X4 to 20X7, assuming revenue is to be recognized:
a. At the time the option is signed.
b. At the time the option is exercised.
c. At the time the formulas are delivered. Note that the $ 3,160,000 research costs must be expensed in all alternatives to comply with accounting standards for research costs. Development costs may be deferred if appropriate. Do not attempt journal entries— your solution should focus on SCI presentation.