[Gabriella]

Black Co. requires advance payments with special orders for machinery constructed to customer specifications. These advances are nonrefundable. Information for 20X1 is as follows:

Customer advances balance December 31, 20X0 $118,000

Advances received with orders in 20X1 184,000

Advances applied to orders shipped in 20X1 164,000

Advances applicable to orders canceled in 20X1 50,000

In Black’s December 31, 20X1, balance sheet (statement of financial position), what amount should be reported as a current liability for advances from customers?

A.

$0

B.

$88,000

C.

$138,000

D.

$148,000

Correct answer is B. I’m having trouble understanding why it is not A.

If the advance is nonrefundable why is it not a liability? I know this must be obvious.

[mperez102204]

Bumpp…. I am not sure why this wouldn't be A because the advances are non-refundable..

Thanks..

[Anonymous]

The reason why there's still a liability is because for the customers who follow through with their order (which is the vast majority of them), there's still work to be done to truly earn the money.

Pretend it's something fully paid in advance – let's say that you and I agree that you'll pay me $300,000 to build you a house, and you pay me today, but I'm going to build the house next year. Agreement is that it's nonrefundable – if you decide Jan 1 that you don't want the house anymore, I get to keep the money, but unless you decide you don't want the house, I have to build it. Presume that building this house is the only thing that I'm doing this year or next; no other work at all. Should I:
A. Report $300,000 of profit this year, and $275,000 (estimated) of loss next year when I have all the expenses, or
B. Report $300,000 liability because I haven't done the work yet this year, then next year report $25,000 (estimated) profit on the project

Given that accounting has a matching principal (report revenues and expenses that relate to them in the same period), as well as principals about reporting revenue after its earned, we don't really get a choice between A and B, but I think looking at them like this helps to understand why we'd want to do B even if we got a choice. (Note that when they decide not to fulfill the contract, the revenue is considered earned due to their decision not to complete it – basically the contract gives you 2 options to earn the deposit: make the product, or have them decide not to buy the product.)

[mperez102204]

Ahhhhhhhh.. the light bulb went off. That makes complete sense. Thank you so much for the help!!

[Author]

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