Question

Toucan is a telecommunications provider. One of its products is a mobile phone service, the contract terms of which require the customers to pay 12 months’ rental charge in advance at $120 per month. Toucans policy is to record the rental as revenue on receipt of the customers' payment. Its financial statements at 30 June 2018 classify the full amount of rental received during the year as revenue. Toucan’s auditor has advised that the rental revenue is overstated and must be adjusted.

Explain how Toucan should adjust the rental revenue recorded at 30 June 2018, justifying your answer by reference to relevant Conceptual Framework definitions and recognition criteria.   

Answer 1

The rental prepaid amount at 30 June 2018 will not increase the income until Toucan has a claim against its customers for the provided rental services. This claim occurs progressively with the passage of time when the customers use the rental service. In regard to the prepaid amount prepaid at 30 June 2018, Toucan holds an equivalent liability over the remaining period of the prepayment for providing the rental service. Although there is an equivalent rise in a liability, however there is no increase in equity. Thus the prepaid amount at 30 June 2018 does not fulfil the definition of income.

The rental prepaid at 30 June 2018 need to be recognised as a liability. Thus Toucan have to record an adjusting entry at 30 June 2018 wherein it should debit the Rental revenue and credit Unearned revenue) for the amount prepaid (=$120 * 6months)