Accounting for preproduction costs related to long-term supply arrangements

2. First example of accounting for preproduction costs

Supplier entered in a long-term supply agreement with Customer. Both the Supplier and Customer are in the automotive industry. Under the agreement, the Supplier will create a prototype of a part for the Customer (product design and development) as well as build molds, dies, and tools (tooling design and development) to mass produce the part for the Customer over a period of three years.

The Customer agreed to reimburse the Supplier for the product design and development costs in the amount of $300,000 and for the tooling design and development in the amount of $1,000,000. According to the agreement, the Customer owns the tooling.

The Supplier estimated and incurred $300,000 in costs on product design and development and $1,000,000 on tooling design and development.

The Customer fully reimburses the Supplier in two installments of equal amount each once the first and second (final) milestones are reached by the Supplier.

Analysis of Accounting for Preproduction Costs

The product design and development costs are fully reimbursed. The tooling design and development costs are also fully reimbursed. Therefore, after the Customer reimburses the Supplier, there wonít be any assets or expenses recorded by the Supplier.

Letís look at how these items can be recorded in the general ledger.

Supplier Incurs $200,000 and $500,000 in Product and Tooling Costs, Respectively

Account Titles

Debit

Credit

Other Assets

$700,0000

 

     Cash / Accounts Payable / Other

 

$700,000

The Other Assets account is used to record the incurred costs because these costs are reimbursable according to the supply agreement. When costs are incurred, they can be credited to various accounts. For example, the Supplier may pay cash in which case the Cash account is credited; the Supplier may incur costs on account (e.g., services) in which case the Accounts Payable account is credited; the Supplier may incur internal costs directly related to the design and development of the product or tooling in which case other accounts (e.g., Payroll Liability) can be credited. Note that in practice the bookkeeping side of these transactions may vary.

Supplier Reaches First Milestone and Invoices Customer for $650,000 (50% of $1,300,000)

Account Titles

Debit

Credit

Accounts Receivable

$650,0000

 

     Other Assets

 

$650,000

At this point $650,000 becomes part of accounts receivable because the Supplier has a right to invoice the Customer when the first milestone is reached. There is still $50,000 left in the Other Assets account which will be invoiced when the second (final) milestone is reached.

Supplier Incurs $100,000 and $500,000 in Product and Tooling Costs, Respectively

Account Titles

Debit

Credit

Other Assets

$600,0000

 

     Cash / Accounts Payable / Other

 

$600,000

Supplier Reaches Second Milestone and Invoices Customer for $650,000 (50% of $1,300,000)

Account Titles

Debit

Credit

Accounts Receivable

$650,0000

 

     Other Assets

 

$650,000

After this transaction the balance in the Other Assets account related to this project is zero. This is correct according to the supply agreement because the Customer fully reimbursed the Supplier for the incurred costs.

Next, letís modify this situation and see how accounting will change.

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