Accounting for preproduction costs related to long-term supply arrangements

3. Second 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 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 Supplier owns the tooling.

The Supplier estimated and incurred $300,000 in costs on product design and development and $1,300,000 on the tooling design and development. The Supplier knew before the project began that an additional investment of $300,000 will be needed on the Supplierís part (i.e., the amount not reimbursable by the Customer: $300,000 = $300,000 + $1,300,000 - $300,000 - $1,000,000).

Assume that the tooling design and development does not involve new technologies. The tooling canít be used on other projects and its estimated useful life is three years. The Customer fully reimburses the Supplier at the end of the project (before mass production begins).

Analysis of Accounting for Preproduction Costs

In this case, the product design and development costs are fully reimbursed while the tooling design costs are not fully reimbursed. According to the supply agreement the Supplier will own the tooling. Thus, the unreimbursed portion of tooling costs ($200,000) should be recorded in the Supplierís fixed assets and depreciated over the three year period.

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

Supplier Incurs $200,000 and $600,000 in Product and Tooling Costs, Respectively

Account Titles

Debit

Credit

Other Assets

$700,0000*

 

Construction in Progress - Tooling

$100,000

 

     Cash / Accounts Payable / Other

 

$800,000

(*) $700,000 = $200,000 in product costs plus $500,000 in tooling costs

Note that the Supplier recognized a portion of incurred costs as construction in progress. Recall that the Supplier estimated $200,000 of tooling costs to be unreimbursable. As such, a portion of this amount should be recorded in the Supplierís construction in progress (fixed assets) as tooling costs are incurred. The Supplier incurred $600,000 in tooling costs. This represents 50% of the entire estimated tooling cost amount, so $100,000 (i.e., $200,000 x 50%) is recorded in construction in progress.

Supplier Incurs $100,000 and $600,000 in Product and Tooling Costs, Respectively

Account Titles

Debit

Credit

Other Assets

$600,0000*

 

Construction in Progress - Tooling

$100,000

 

     Cash / Accounts Payable / Other

 

$700,000

(*) $600,000 = $100,000 in product costs plus $500,000 in tooling costs

At this point, the balance in the Other Assets account is $1,300,000 and the balance in the Construction in Progress account is $200,000.

Supplier Invoices Customer for $1,300,000

Account Titles

Debit

Credit

Accounts Receivable

$1,300,0000

 

     Other Assets

 

$1,300,000

The $1,300,000 includes $300,000 in product costs and $1,000,000 in tooling costs.

Supplier Starts Mass Production of Part for Customer

Account Titles

Debit

Credit

Fixed Assets - Tooling

$200,0000

 

     Construction in Progress - Tooling

 

$200,000

When the Supplier starts mass production of the part under the long-term supply agreement, the unreimbursed tooling costs are moved from the Construction in Progress account to the Fixed Assets account. Once the Supplier starts using the molds, dies, and tools in manufacturing the parts, the tooling costs start being depreciated over three years.

Supplier Records Tooling Depreciation for First Month

Account Titles

Debit

Credit

Depreciation - Tooling

$5,555.56

 

     Accum. Depreciation - Tooling

 

$5,555.56

The monthly depreciation amount is $5,555.56 (rounded) = $200,000 ų (3 years x 12 months). This entry is repeated each month until the tooling cost is fully depreciated.

At the same time the Supplier needs to evaluate the tooling cost for impairment.

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