Chapter 17, Problem 2P

JustKitchens Inc. provides services to restaurants and hotels. The company supplies paper products, tableware, cookware, restaurant and kitchen equipment, and cleaning supplies. On January 2, 2019, Just-Kitchens enters into a contract with a local restaurant chain to provide its services for 3 years at a cost of $10,000 per year. The restaurant chain pays the total contract fee on January 2, 2019. JustKitchens’s stand-alone selling price is also $10,000 per year.

After 2 years, the restaurant asks to modify the contract. On January 2, 2021, the companies agree to reduce the fee for the third year to $9,000 in exchange for extending the contract for 2 additional years at a fee of $11,000 per year. This modification is agreed to by both parties, and on that date the restaurant chain pays for the additional 2 years of service. The $11,000 fee for the additional years is the same as JustKitchens’s stand-alone price.

Required:

1. 1. How should JustKitchens account for the contract modification?
2. 2. Prepare the journal entry that JustKitchens would make over the life of the contract.

To determine

State the manner in which the Company J should account for the contract modification.

Explanation of Solution

Contract modification:

In a contract, Companies generally modify the respective rights and performance obligations. An agreed-upon change in the goods or services that must be delivered or the contract’s price is known as a contract modification and it is also referred as contract amendment or change order.

The price and length of the contract is affected by contract modification. Furthermore, the contract modification enhances distinctive services. Though, the price does not increase by an amount equal to the stand-alone selling price on the date of the contract modification [new 3-year price is $31,000 versus stand-alone price of $33,000$\left(\$11,000\times 3\right)$] the contract modification must be accounted for prospectively.

To determine

Journalize entry over the life of the contract.

Explanation of Solution

Contract:

Contract is an agreement among two parties or more parties which includes enforceable obligations and rights. A contract can be written, oral or implied by ordinary business practices.

Journal entry:

Journal entry is a set of economic events which can be measured in monetary terms. These are recorded chronologically and systematically.

Accounting rules for Journal entries:

• To record increase balance of account: Debit assets, expenses, losses and credit liabilities, capital, revenue and gains.
• To record decrease balance of account: Credit assets, expenses, losses and debit liabilities, capital, revenue and gains.

Prepare journal entries:

Date	Account title and explanation	Debit ($)	Credit ($)
January 2,2019	Cash (1)	30,000
	Unearned Service Revenue		30,000
	( To record the cash collected for the three years of contract)
December 31,2019	Unearned Service Revenue	10,000
	Service Revenue		10,000
	(To record the unearned service revenue)
December 31,2020	Unearned Service Revenue	10,000
	Service Revenue		10,000
	(To record the unearned service revenue)
January 2,2021	Cash (2)	21,000
	Unearned Service Revenue		21,000
	(To record the contract price for one year and fees for additional two years)
December 31,2021	Unearned Service Revenue (3)	10,333.33
	Service Revenue		10,333.33
	(To record the unearned service revenue)
December 31,2022	Unearned Service Revenue (4)	10,333.33
	Service Revenue		10,333.33
	(To record the unearned service revenue)
December 31,2023	Unearned Service Revenue (5)	10,333.33
	Service Revenue		10,333.33
	(To record the unearned service revenue)

Table (1)

Working notes:

(1)Calculate the amount of cash on January 2, 2019:

$\begin{array}{c}\text{Cash}\text{=}\left(\begin{array}{l}\text{contract}\text{price}\text{per}\text{year}\text{×}\\ \text{Number}\text{of}\text{service}\text{years}\end{array}\right)\\ \text{=\$10,000}\text{×}\text{3}\text{years}\\ \text{=\$30,000}\end{array}$

(2)Calculate the amount of cash on January 2, 2021:

$\begin{array}{c}\text{Cash}\text{=}\left(\begin{array}{l}\text{contract price}\text{per}\text{year}\text{+}\\ \text{Amount}\text{of}\text{fees}\text{for}\text{additonal}\text{years}\end{array}\right)\\ \text{=\$10,000}\text{×}\text{\$11,000}\\ \text{=\$21,000}\end{array}$

(3)Calculate the amount of unearned service revenue on December 31, 2021:

$\begin{array}{c}\text{Unearned}\text{Service}\text{revenue}\text{=}\left(\begin{array}{l}\text{Contract}\text{price}\text{per}\text{year}\text{+}\text{Difference}\text{of}\text{amount}\text{between}\\ \text{existing}\text{contract}\text{price}\text{and}\text{modified}\text{contract}\text{price}\text{for}\text{each}\text{year}\end{array}\right)\\ \text{=\$10,000 + \$333}\text{.33}\text{(6)}\\ \text{=\$10,333}\text{.33}\end{array}$

(4)Calculate the amount of unearned service revenue on December 31, 2022:

$\begin{array}{c}\text{Unearned}\text{Service}\text{revenue}\text{=}\left(\begin{array}{l}\text{Contract}\text{price}\text{per}\text{year}\text{+}\text{Difference}\text{of}\text{amount}\text{between}\\ \text{existing}\text{contract}\text{price}\text{and}\text{modified}\text{contract}\text{price}\text{for}\text{each}\text{year}\end{array}\right)\\ \text{=\$10,000 + \$333}\text{.33}\text{(6)}\\ \text{=\$10,333}\text{.33}\end{array}$

(5)Calculate the amount of unearned service revenue on December 31, 2023:

$\begin{array}{c}\text{Unearned}\text{Service}\text{revenue}\text{=}\left(\begin{array}{l}\text{Contract price}\text{per}\text{year}\text{+}\text{Difference}\text{of}\text{amount}\text{between}\\ \text{existing}\text{contract}\text{price}\text{and}\text{modified}\text{contract}\text{price}\text{for}\text{each}\text{year}\end{array}\right)\\ \text{=\$10,000 + \$333}\text{.33}\text{(6)}\\ \text{=\$10,333}\text{.33}\end{array}$

(6)Calculate the amount of difference between existing contract price and modified contract price for each year:

$\begin{array}{c}\begin{array}{l}\text{Amount of difference between}\\ \text{existing contract}\text{price and modified }\\ \text{contract price for each year}\end{array}\}\text{=}\frac{\text{Existing}\text{contract}\text{price}-\text{Modified}\text{contract}\text{price}}{\text{Number}\text{of}\text{years}}\\ \text{=}\frac{\text{\$10,000}-\text{\$9,000}}{\text{3}\text{years}}\\ \text{=}\frac{\text{\$1,000}}{\text{3years}}\\ \text{=\$333}\text{.33}\end{array}$

Note: 3 years is taken from 2021 to January 2023 (additional two years).