Recognition of Revenue Over Time with Cancellation Clause in Agreement

Lucky Company is a construction company that manufactures residential buildings.  On March 1, 2021, Lucky entered into an agreement with a customer, High Rise Apartments, to construct a residential apartment building for a fixed price of $1,500,000.  Lucky estimates that it will incur costs of $1,000,000 to complete construction of the apartment building.  The apartment building will only transfer to High Rise Apartments once the construction of the entire building is complete.  In addition, High Rise Apartments has various design requirements that would require Lucky to incur significant costs to rework the building prior to selling it to a customer other than High Rise Apartments. 

To construct the apartment building, Lucky acquires standard materials that it regularly uses in construction contracts for residential and commercial buildings.  These materials are used to manufacture generic component parts for inclusion in High Rise Apartments’ residential buildings.  These standard materials remain interchangeable with other items until they are deployed in a High Rise Apartments building.  Lucky has made the following purchases and incurred the following costs throughout the construction process:

• As of June 30, 2021, in total, Lucky has purchased $75,000 of component parts.  As of June 30, 2021, $25,000 of component parts remain in inventory and $50,000 have been integrated into the project.  Further, Lucky has incurred $12,500 of direct costs to integrate the component parts into the High Rise Apartments construction project during the three months ended June 30, 2021.
• During the three months ended September 30, 2021, Lucky purchased an additional $500,000 of component parts ($575,000 in total).  Of the $575,000 of component parts, $325,000 remain in inventory and $200,000 have been integrated into the project during the three months ended September 30, 2021.  During the three months ended September 30, 2021, Lucky incurred an additional $50,000 of direct costs to integrate the component parts into the High Rise Apartments construction project.
• As of September 30, 2021, Lucky determined that the project was over budget and revised its cost estimate from $1 million to $1.25 million.
• As of December 31, 2021, the construction project was completed.  During the three months ended December 31, 2021, Lucky purchased an additional $425,000 of generic component parts ($1,000,000 in total).  Of the $1 million component parts, $0 remain in inventory and $750,000 were integrated into the project during the three months ended December 31, 2021.  Lucky has incurred $187,500 of direct costs to integrate the component parts into the High Rise Apartments construction project during the three months ended December 31, 2021.

If High Rise Apartments cancels the contract, Lucky will be entitled to reimbursement for costs incurred for work completed to date plus a margin of 20%, which is considered to be a reasonable margin.  Lucky will not be reimbursed for any materials that have been purchased for use in the contract but have not yet been used and are still controlled by Lucky.

1. Assume that for this question that the criteria for recognition over time has been met.  How should the entity recognize revenue for the satisfaction of its performance obligation?  What amount of revenue should be recognized for the following periods:
   1. The three months ended June 30, 2021?
   2. The three months ended September 30, 2021?
   3. The three months ended December 31, 2021?

My concern with the question is the cancellation clause. Typically for revenue recognition over time you would take the total cost incurred to date divided by the total estimated cost for the project. This yields a percentage. The contract price is multiplied by that rate and that gives the revenue that will be recognized for the period. With the cancellation and 20% margin if the customer cancels, does this change the amount of revenue recorded? This same problem has been posted on Chegg many times and the answers are actually different from expert to expert. Some use the method I mentioned above like in the answer below:

          June 30 Revenue Recorded:

    Cost of Materials used -      $ 50,000.

              Other Costs incurred -         $ 12,500.

                                                            --------------

               Total costs to date- $ 62,500.

                                                             -------------

% of work completion = Total costs to date/ Total estimated costs.

                                        = $ 62,500/$ 1,000,000

                                        =6.25%

Revenue to be recognised in June = Total revenue x % of work completion

                                                             = $ 1,500,000 x 6.25%

                                                             = $ 93,750.

 

Others use a different method, which I have not learnt before (see below): 

Revenue for three months ended 30th june 20x1 :

	Amount ($)
Used Component parts cost	$50,000
Direct cost	$12,500
If contract cancelled recovery cost	$12,500
Total revenue / Income	$75,000

You can see that both methods yield 2 different answers so I am not sure which one is correct. 

Which is the correct method??? Can you also provide the FASB guidance? I am aware of ASC 2014-09 (TOPIC 606 in the codification) but could not find any specifics around how the cancellation clause affects how the entity recognizes revenue. 

Answer rating: 100% (QA)

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