What is the accounting issue in this event? What's accounted for incorrectly? Just need some insight. Would really appreciate some help!
In May 2018, Jones Inc. opened a large plumbing department. Because management had little expertise in plumbing but wanted to provide for customers’ plumbing needs, it contracted with LIT Plumbing Ltd. (LIT) to own and operate the plumbing department. LIT paid Jones a $200,000 non-refundable fee on July 15, 2018 and will pay 5 percent of net sales (sales after returns and bad debts) per year. LIT is getting the plumbing department ready for business. The contract between LIT and Jones is for 10 years. Jones capitalized the $200,000 fee as a long-term deposit and will recognize it as revenue over the term of the contract on a straight-line basis
The accounting issue in this event is related to the recognition of revenue from the $200,000 non-refundable fee received by Jones Inc. from LIT Plumbing Ltd. (LIT).
According to the information provided, Jones Inc. has entered into a contract with LIT to own and operate the plumbing department. LIT paid Jones a $200,000 non-refundable fee on July 15, 2018, and will also pay 5 percent of net sales per year. The contract between LIT and Jones is for a term of 10 years.
The incorrect accounting treatment in this case is that Jones Inc. has capitalized the $200,000 fee as a long-term deposit and plans to recognize it as revenue over the term of the contract on a straight-line basis. This means that Jones Inc. will recognize $20,000 ($200,000 divided by 10 years) as revenue each year for the duration of the contract.
However, the correct accounting treatment for the $200,000 fee should not be recognized as revenue over time. Instead, it should be recognized as revenue when the performance obligations outlined in the contract are satisfied. In this case, the performance obligation is to provide the plumbing department to LIT.
Since Jones Inc. has contracted with LIT to own and operate the plumbing department, the revenue recognition should occur when LIT takes control over the plumbing department and the performance obligation is fulfilled. This typically occurs at the start of the contract or when the department is ready for business.
Therefore, the correct accounting treatment would be to recognize the $200,000 fee as revenue when LIT takes control of the plumbing department, rather than recognizing it over the term of the contract on a straight-line basis.