I am working on a case study. I have attached the full case study and my response so far. I have a question about the calculation using the expected cost plus margin approach. I do not know which numbers to use to get the percentages of the obligations. Also, once I have the percentage do I multiply it by the 9.5 million? I am only working on part two. Revenue recognition steps 4 and 5. 

Memorandum To: Eye Spy, Accounting Files From: Accounting Date: 7/01/2021 RE: Accounting for Revenue by apply the last 2 steps of the Revenue Recognition guidance (Topic 606) to contract revenue from Secret Manufacturing (SM) Facts July 1, 2020, SM delivered the sign contract for $10 million (after the $100,000 credit for the old equipment) with all previously negotiated terms. SM elected to take the $500,000 discount and paid $9.5 million two days after delivering the signed the contract. In the interest of full and expanded disclosure Eye Spy, has elected to not apply the practical expedient in ASC 606-10-32-18. The system was fully functional on May 31, 2021. SM tested and accepted the system. The old equipment was decommissioned and shipped to Eye Spy by June 1. The old equipment was sold in June for $120,000. No financing component will be allocated to the maintenance contract. The forecasted cost for the equipment and integration required in the contract is $8.136 million. The forecasted cost of the maintenance service is $164,000. Issues 1. How should the transaction price be allocated to the 2 identified performance obligations? 2. When should the revenue be recognized during the time of the contract? 3. What are the implications for the financial statements? Analysis-Issue 1: How should the transaction price be allocated to the 2 identified performance obligations? FASB Accounting Standards Codification (ASC) 606-10 (Revenue from Contracts with customers) provides the following guidance for: 32-33 If a standalone selling price is not directly observable, an entity shall estimate the standalone selling price at an amount that would result in the allocation of the transaction price meeting the allocation objective in paragraph 606-10-32-28. When estimating a standalone selling price, an entity shall consider all information (including market conditions, entity-specific factors, and information about the customer or class of customer) that is reasonably available to the entity. In doing so, an entity shall maximize the use of observable inputs and apply estimation methods consistently in similar circumstances. 32-34 Suitable methods for estimating the standalone selling price of a good or service include, but are not limited to, the following: a. Adjusted market assessment approachAn entity could evaluate the market in which it sells goods or services and estimate the price that a customer in that market would be willing to pay for those goods or services. That approach also might include referring to prices from the entity's competitors for similar goods or services and adjusting those prices as necessary to reflect the entity's costs and margins. b. Expected cost plus a margin approachAn entity could forecast its expected costs of satisfying a performance obligation and then add an appropriate margin for that good or service. c. Residual approachAn entity may estimate the standalone selling price by reference to the total transaction price less the sum of the observable standalone selling prices of other goods or services promised in the contract. However, an entity may use a residual approach to estimate, in accordance with paragraph 606-10-32-33, the standalone selling price of a good or service only if one of the following criteria is met: 1. The entity sells the same good or service to different customers (at or near the same time) for a broad range of amounts (that is, the selling price is highly variable because a representative standalone selling price is not discernible from past transactions or other observable evidence). 2. The entity has not yet established a price for that good or service, and the good or service has not previously been sold on a standalone basis (that is, the selling price is uncertain). In this instance the expected cost plus a margin approach should be used. There are two performance obligations which need to have costs allocated to them. In order to calculate the cost. We start with. Analysis-Issue 2: When should the revenue be recognized during the time of the contract? FASB ASC 606-10 provides the following guidance for recognizing revenue as follows: 25-23 Satisfaction of Performance Obligations An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (that is, an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset. 25-24 For each performance obligation identified in accordance with paragraphs 606-10-2514 through 25-22, an entity shall determine at contract inception whether it satisfies the performance obligation over time (in accordance with paragraphs 606-10-25-27 through 25- 29) or satisfies the performance obligation at a point in time (in accordance with paragraph 606-10-25-30). If an entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time. Measuring Progress toward Complete Satisfaction of a Performance Obligation 25-31 For each performance obligation satisfied over time in accordance with paragraphs 606-10-25-27 through 25-29, an entity shall recognize revenue over time by measuring the progress toward complete satisfaction of that performance obligation. The objective when measuring progress is to depict an entity's performance in transferring control of goods or services promised to a customer (that is, the satisfaction of an entity's performance obligation). 25-32 An entity shall apply a single method of measuring progress for each performance obligation satisfied over time, and the entity shall apply that method consistently to similar performance obligations and in similar circumstances. At the end of each reporting period, an entity shall remeasure its progress toward complete satisfaction of a performance obligation satisfied over time. Methods for Measuring Progress 25-33 Appropriate methods of measuring progress include output methods and input methods. Paragraphs 606-10-55-16 through 55-21 provide guidance for using output methods and input methods to measure an entity's progress toward complete satisfaction of a performance obligation. In determining the appropriate method for measuring progress, an entity shall consider the nature of the good or service that the entity promised to transfer to the customer. 25-34 When applying a method for measuring progress, an entity shall exclude from the measure of progress any goods or services for which the entity does not transfer control to a customer. Conversely, an entity shall include in the measure of progress any goods or services for which the entity does transfer control to a customer when satisfying that performance obligation. Based on the guidance from the FASB codification, revenue for each performance obligation should be recognized as the obligation is satisfied. For the equipment and integration services the revenue will be recognized once the equipment and integration is completed and SM takes control of the equipment and services. The maintenance service will be recognized over the time of the service agreement. The total cost of the service, $200,000 should be recognized as unearned revenue. The $200,000 should be allocated to the 5 years of required service and each year the portion of the payment corresponding to that year will be recognized. $200,000 (cost of maintenance service)/ 5 (years)= 40,000 per year. Analysis-Issue 3: What are the implications for the financial statements? ASC 340-40 (Other Assets and Deferred Costs -Contracts with Customers) provides the following information regarding incremental costs of Conclusion Issue 1: I How should the transaction price be allocated to the 2 identified performance obligations? In order to allocate the transaction price to the performance obligation, the expectant cost plus margin method is used. We first find the percentage of the transaction price that is representative of the amount of each cost. Multiple the percentage times the total contract price to find the amount allocated to each performance obligation. Issue 2: When should the revenue be recognized during the time of the contract? Revenue should be recognized as each performance obligation is fulfilled. The first obligation was fulfilled when the equipment was installed, integration was complete and SM took ownership of the fully integrated equipment. The performance obligation of the maintenance will be performed over a five year period. Each year the revenue earned for the service maintenance will be recognized. We calculate that amount as the full price of the service, $200,000 divided by the number of years of the agreement, in this case 5 years. Each year revenue of $40,000. Will be recognized. Issue 3: What are the implications for the financial statements? Dislosure Draft-For Discussion Purposes Only Memorandum To: Eye Spy, Accounting Files From: Brittany Ehresman, Accounting Date: 6/25/20 RE: Accounting for Revenue by apply the new 5 step Revenue Recognition guidance (Topic 606) to contract revenue from Secret Manufacturing (SM) Facts Eye Spy, sells video surveillance equipment and computer integration service. They do not sell the equipment and integration service separately. The integration service is necessary and requires significant customization. Historically Eye Spy has not sold maintenance service. Eye Spy is in the process of signing a $10.1 million cash contract with Secret Manufacturing (SM). Eye Spy anticipates a signed contract from Secret Manufacturing for equipment and the computer integration services. The equipment and integration service are expected to be ready for use in one year, or in the 12th month of the contract. SM will get control of the equipment when integration services are complete, and the full payment is made. The negotiated contract is for a total of 10.1 million. Eye spy will give SM their old surveillance equipment for $100,000.00 credit. The old equipment is believed to have a fair value of $115,000 at the inception date. The equipment will not be decommissioned until the new equipment is full functioning. The remaining amount due will be paid in cash. Eye Spy offered maintenance services as a part of the initial contract. Eye Spy originally asked for $300,000 for the five-year maintenance contract, then reduced the maintenance cost to $200,000 in order to be compete with other maintenance service providers. The $200,000 is included in the $10.1 million contract. The five-year period will begin when installation is finished. SM will receive a discount of $500,000, reducing the $10.1 million amount due to $9.6 million, if the full amount is paid in cash, within 3 days of signing the contract. The $500,000 discount was determined by 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. SM is offering a bonus to Eye Spy for early completion. Eye Spy agrees to pay a penalty if the integration is not completed by the 12 th month. The 12-month time frame is based on Eye Spy's significant historical experience with similar projects. The following table lays out the proposed bonus or penalty. Completed 10 months 11 months 12 months 13 months 14 months 15 months Total Bonus $100,000 $50,000 0 Penalty 0 -$50,000 -$100,000 -$500,000 Percentage 17% 27% 46% 7% 3% 0% 100% SM has a great credit rating and always pays bills on time. Eye Spy's sales manager will receive a 2% bonus on the $10 million (after the credit for the equipment) payable once the contract is signed. The marketing groups supports the sale manager their salaries total $400,000. The marketing group works on an average of 20 proposals each year. A 15% to 20% margin is expected on this contract. Issues 1. Does the contract satisfy the first criteria of revenue recognition related to a contract? 2. Are there one or more \"performance obligations\" that will affect the timing of revenue recognition? 3. How and when should the sales manger's bonus, and the related marketing costs, be recorded? 4. What are the implications for the income statement and balance sheet upon receipt of the signed contract from SM? Specifically, what is the impact on revenue and expenses and assets and liabilities with the discount of $500,000 and paying $4.5 million within 3 days of signing? Analysis-Issue 1: Does the contract satisfy the first criteria of revenue recognition related to a contract? FASB Accounting Standards Codification (ASC) 606-10 (Revenue from Contracts with customers) provides the following guidance for identifying the contract: 25-1 An entity shall account for a contract with a customer that is within the scope of this Topic only when all of the following criteria are met: a. The parties to the contract have approved the contract (in writing, orally, or in accordance with other customary business practices) and are committed to perform their respective obligations. b. The entity can identify each party's rights regarding the goods or services to be transferred. c. The entity can identify the payment terms for the goods or services to be transferred. d. The contract has commercial substance (that is, the risk, timing, or amount of the entity's future cash flows is expected to change as a result of the contract). e. It is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer (see paragraphs 606-10-55-3A through 55-3C). In evaluating whether collectability of an amount of consideration is probable, an entity shall consider only the customer's ability and intention to pay that amount of consideration when it is due. The amount of consideration to which the entity will be entitled may be less than the price stated in the contract if the consideration is variable because the entity may offer the customer a price concession (see paragraph 606-10-32-7). The first criteria of revenue recognition related to a contract requires that the parties to the contract have approved in writing or orally to the contract and that the parties to the contract are committed to perform their obligations in the contract. Eye spy anticipates a signed contract but as of this date they have not received the signed contract, nor has a verbal agreement been confirmed. Both parties convey a commitment to perform the obligations in the agreement, but without a signed contract, or verbal confirmation the first criteria has not been met. Analysis-Issue 2: Are there one of more \"performance obligations\" which will affect the timing of revenue recognition. FASB ASC 606-10 provides the following guidance for identifying performance obligations: 25-14 At contract inception, an entity shall assess the goods or services promised in a contract with a customer and shall identify as a performance obligation each promise to transfer to the customer either: a. A good or service (or a bundle of goods or services) that is distinct b. A series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer (see paragraph 60610-25-15). 25-15 A series of distinct goods or services has the same pattern of transfer to the customer if both of the following criteria are met: a. Each distinct good or service in the series that the entity promises to transfer to the customer would meet the criteria in paragraph 606-10-25-27 to be a performance obligation satisfied over time. b. In accordance with paragraphs 606-10-25-31 through 25-32, the same method would be used to measure the entity's progress toward complete satisfaction of the performance obligation to transfer each distinct good or service in the series to the customer. ASC 606-10 states the following regarding distinct goods or services: 25-19 A good or service that is promised to a customer is distinct if both of the following criteria are met: a. The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct). b. The entity's promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract). 25-21 In assessing whether an entity's promises to transfer goods or services to the customer are separately identifiable in accordance with paragraph 606-10-2519(b), the objective is to determine whether the nature of the promise, within the context of the contract, is to transfer each of those goods or services individually or, instead, to transfer a combined item or items to which the promised goods or services are inputs. Factors that indicate that two or more promises to transfer goods or services to a customer are not separately identifiable include, but are not limited to, the following: a. The entity provides a significant service of integrating goods or services with other goods or services promised in the contract into a bundle of goods or services that represent the combined output or outputs for which the customer has contracted. In other words, the entity is using the goods or services as inputs to produce or deliver the combined output or outputs specified by the customer. A combined output or outputs might include more than one phase, element, or unit. b. One or more of the goods or services significantly modifies or customizes, or are significantly modified or customized by, one or more of the other goods or services promised in the contract. c. The goods or services are highly interdependent or highly interrelated. In other words, each of the goods or services is significantly affected by one or more of the other goods or services in the contract. For example, in some cases, two or more goods or services are significantly affected by each other because the entity would not be able to fulfill its promise by transferring each of the goods or services independently. 25-22 If a promised good or service is not distinct, an entity shall combine that good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. In some cases, that would result in the entity accounting for all the goods or services promised in a contract as a single performance obligation. Based on the guidance, there are 2 performance obligations in the contract. The video surveillance equipment and computer integration service are combined as the first performance obligation. The video surveillance equipment will not work without the computer integration service. Although it is feasible that another company could provide the integration service, Eye Spy does not sell the items separately. It is also important to note that the equipment cannot work without significant customization. The second performance obligation is the 5-year maintenance service agreement. The 5-year period will begin after the installation is complete. The other 2 components of the agreement, the equipment and computer integration will work without the maintenance service. The maintenance service could be performed by another company. This is an additional service that Eye Spy has decided to offer to SM and has not offered before. Analysis-Issue 3: How and when should the sales manger's bonus, and the related marketing costs, be recorded? ASC 340-40 (Other Assets and Deferred Costs -Contracts with Customers) provides the following information regarding incremental costs of obtaining a contract: 25-2 The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, a sales commission). 25-3 Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained shall be recognized as an expense when incurred, unless those costs are explicitly chargeable to the customer regardless of whether the contract is obtained. 25-4 As a practical expedient, an entity may recognize the incremental costs of obtaining a contract as an expense when incurred if the amortization period of the asset that the entity otherwise would have recognized is one year or less. The sales manager is expecting to receive a 2% bonus on the $10 million total contract. The bonus does not include the $100,000 credit Eye Spy is giving to SM for their old equipment. This bonus is a cost that will not be incurred if Eye Spy does not obtain a written contract. The contract is expected to be fulfilled within 1 year so Eye Spy can recognize the bonus as an expense. The other marketing costs would be incurred with or without the contract. The other marketing costs should be recognized and expensed as they are incurred. Analysis-Issue 4: What are the implications for the income statement and balance sheet upon receipt of the signed contract from SM? Specifically, what is the impact on revenue and expenses and assets and liabilities with the discount of $500,000 and paying $4.5 million within 3 days of signing? FASB ASC 606-10 provides Implementation Guidance and Illustrations as follows: 55-240 The entity concludes that the contract contains a significant financing component because of the length of time between when the customer pays for the asset and when the entity transfers the asset to the customer, as well as the prevailing interest rates in the market. 55-241 The entity concludes that the contract contains a significant financing component because of the length of time between when the customer pays for the asset and when the entity transfers the asset to the customer, as well as the prevailing interest rates in the market. 55-242 The interest rate implicit in the transaction is 11.8 percent, which is the interest rate necessary to make the 2 alternative payment options economically equivalent. However, the entity determines that, in accordance with paragraph 606-10-32-19, the rate that should be used in adjusting the promised consideration is 6 percent, which is the entity's incremental borrowing rate. 55-243 The following journal entries illustrate how the entity would account for the significant financing component. a. Recognize a contract liability for the $4,000 payment received at contract inception. Cash $4,000 Contract liability $4,000 b. During the 2 years from contract inception until the transfer of the asset, the entity adjusts the promised amount of consideration (in accordance with paragraph 606-10-32-20) and accretes the contract liability by recognizing interest on $4,000 at 6 percent for 2 years. Interest expense $494 Contract liability 494 (494= 4000 contract liability x 6% interest per year for 2 years) c. Recognize revenue for the transfer of the asset. Contract liability $4,494 Revenue $4494 The guidance in the codification demonstrates how an advance payment and assessment of a discount will impact the revenue, expenses, assets, and liabilities. The journal entries below will be recorded when the cash payment is received within 3 days. a. Recognize a contract liability for the $9,500,000 payment received at c contract inception. Cash $9,500,000 Contract liability $9,500,000 b. The years from contract inception until the transfer of the asset. Interest expense $500,000 Contract liability $500,000 c. Recognize revenue for the transfer of the asset. Contract liability $10,000,000 Revenue $10,000,000 Conclusion Issue 1: Identifying the Contract The first criteria of revenue recognition related to a contract requires the parties to the contract have approved the contract and are committed to perform their obligations. Eye Spy anticipates getting a signed contract, but they do not have one, as of this date. Eye Spy does not have a verbal confirmation from SM. Therefore, the first criteria of the revenue recognition related to contracts has not been met. Issue 2: Identifying Performance Obligations The video surveillance equipment and computer integration service will not work without significant customization. Eye Spy does not sell these items separately. Since these two items are highly interdependent they are combined and considered one performance obligation. The five-year maintenance service agreement is a separate service Eye Spy is offering. The five-year agreement will begin after the surveillance equipment has been installed and the computer integration service has been complete. This service could be satisfied by a competitor. This service is the second performance obligation. Issue 3: Incremental Cost of Obtaining a Contract The sales bonus to the sales manager is a cost that will not be incurred if the contract is not executed. Once the contract is returned, signed, the sales manager will be paid the bonus amount. Since the contract for the equipment and integration is for one year, the bonus will be recorded as an expense when incurred. If the contract was for a period of time longer than a year, the bonus would have been amortized over the period of the asset. The other marketing costs would be incurred with or without the contract. These costs should be recorded as an expense as they are incurred. Issue 4: Implications for the Income Statement and Balance Sheet The advanced payment with the $500,000 discount will be recorded as Cash and a contract liability. An interest expense will be recorded in the amount of the discount and a corresponding contract liability. When the assets are transferred to SM the contract liability will be debited for the full $10,000,000 and revenue will be recognized in the amount of $10,000,000