Background:

Scenario, Part 1: On June 20^, 2020, your public accounting firm's account manager for EYE SPY, a new client, has asked you to prepare a memo addressing the client's concerns about the new revenue recognition guidance (Topic 606). The client has a general understanding of Topic 606, but this is the first time they will need to apply these new requirements. EYE SPY believes it is about to win a lucrative contract with Secret Manufacturing (SM). Its concerns about the application of the new 5 step revenue recognition guidance appear at the end of the case.

The Case, Part 1:

EYE SPY sells sophisticated video surveillance equipment. EYE SPY sells the equipment and computer integration services together. It does not sell these separately. The equipment cannot operate without being fully integrated with a computer system. Significant customization is required during this integration. Other competitors could theoretically provide computer integration services. Historically, EYE SPY has not sold maintenance services.

The sales manager for EYE SPY anticipates receiving a signed contract from Secret Manufacturing (SM) to provide equipment and to perform computer integration services for that surveillance equipment. EYE SPY expects to have everything operational within one year, at which time full payment is due. SM will not get control of the video surveillance equipment until the integration is completed and EYE SPY turns control of the system over to SM. EYE SPY management expects to be able to have the system fully operational and available for use by SM in the 12^th month of the contract.

In the initial contract negotiation stage, the contract price with SM was $10.1 million in cash. However, as part of the final contract negotiations, SM agreed to give EYE SPY its old surveillance equipment in exchange for a credit of $100,000. It is expected that this old surveillance equipment will not be decommissioned until the new equipment is operational. Based on its extensive experience, EYE SPY's management believes it is probable that the estimated fair value of the old equipment at the contract inception date is $115,000.

For this contract, EYE SPY decided to offer maintenance services. As part of the initial contract negotiations, EYE SPY told SM they would be asking for $300,000 related to the five-year maintenance contract. SM informed EYE SPY that several competitors were offering attractive pricing to obtain this maintenance work. In order get the maintenance work, EYE SPY agreed to offer the maintenance services for $200,000. The contract price of $10.1 million includes this five-year maintenance agreement that will commence after the installation is completed.

There is also a provision in the contract that SM would receive a discount (similar to that which would be reflected in a separate financing transaction between EYE SPY and SM) from the contract price of $10.1 million if they pay the cash component within three days of when the contract is signed. EYE SPY determined a discount of $500,000 for this financing based on applying the typical credit rate for the equipment and integration services to be delivered at the end of year one and the monthly delivery of maintenance services in year two through six of the contract.

Due to deep security concerns and recent losses of proprietary information, SM also is offering a bonus to EYE SPY if the integration is completed early and EYE SPY has agreed to pay a penalty if the integration is completed late. EYE SPY has a large number of contracts with bonus characteristics similar to this proposed contract with SM. The following is the schedule of the potential bonus or penalty. While no specific outcome is probable, EYE SPY's management assessment of the likelihood of completing the integration in the specified time frame is based on significant historical experience with similar integration jobs.

Completed

Bonus

Penalty

Percentage

10 month $100,000 17%

11 months $50,000 27%

12 months 0 46%

13 months (50,000) 7%

14 months (100,000) 3%

15 months (500,000 ) 0%

Total 100%

SM has a great credit rating and always pays its bills.

EYE SPY's sales manager is very pleased because he is supposed to receive a 2% bonus based on the $10 million (after credit for equipment) contract price, payable upon receipt of a signed contract. Additional costs related to acquiring the contract include the costs of the marketing group which supports the sale manager. The total annual salaries for the marketing group are $400,000. On average, the marketing group works on 20 proposals each year. This contract is expected to have a 15% to 20% margin.

My question:

• The client wants guidance as to the implications for its income statement and balance sheet upon the receipt of the signed contract from SM. Specifically, the clients wants to understand the impact on revenue and expenses and assets and liabilities, assuming SM takes the $500,000 discount by paying $9.5 million within 3 days of signing. Journal entries should be presented.