Morgan, Inc. is a manufacturer of microcomputer parts and components. At the beginning of its fiscal year, Morgan entered into an agreement with Lighter Technologies to manufacture microcomputer accessory boards according to Lighter’s specifications. The agreement provided that within the next 12 months Morgan was to deliver a minimum of 100,000 boards to Lighter at a stipulated price per board. If Morgan failed to perform per the terms of the agreement, financial penalties were provided. In addition, the agreement required that Lighter make royalty payments to Morgan on the basis of a predetermined schedule of units shipped. The royalty payments actually constitute a deferral of the selling price. The agreement stipulated that in no case would the royalty payments be less than $2 million. To assist Morgan with its working capital needs during the development stage of the boards, Lighter loaned Morgan $6 million, payable in 36 months with accrued interest.
Morgan encountered some technical difficulties in developing the boards according to Lighter’s satisfaction and was not able to meet the agreed-on timetable for the shipment of boards. The problem was that boards equipped with a certain manufacturer’s chip did not meet Lighter’s operating standards. Morgan was able to solve the problem by having a third-party contractor replace the chip with a different manufacturer’s chip that met Lighter’s standards. Morgan had shipped only 38,000 boards and had 41,000 boards, with the unsatisfactory chip, in its year-end inventory. No royalty payments had been paid by Lighter to Morgan. Lighter recognized that Morgan had made a good faith effort to perform under the terms of the agreement and agreed to amend the agreement, effective as of Morgan’s current year-end, as follows:
Lighter would waive its rights to impose any financial penalties under the agreement.
Morgan would cease manufacturing the accessory boards per the agreement and not fulfill the 100, 000 minimum.
Lighter would purchase the 41,000 accessory boards in Morgan’s inventory at 110 percent of Morgan’s cost.
Any Lighter purchases of boards would be paid for by reducing the $6 million loan from Lighter to Morgan.
Lighter has the right to order Morgan to replace the unsatisfactory chip in the remaining 41,000 boards. The cost of replacement is to be paid by Morgan. Any boards not ordered for chip replacement will be shipped to Lighter at some specified future date.
Lighter will pay Morgan the minimum royalty amount of $2 million specified in the original agreement. Lighter will not be liable for any additional royalties.
Concurrent with the signing of the amended agreement, Lighter ordered 20,000 of the remaining accessory boards held in Morgan’s inventory to have the chip replaced.
Required:
For Morgan’s current year-end as well as subsequent year-ends, discuss the accounting issues raised by the amendment to the agreement between Morgan and Lighter. Your discussion, at a minimum, should include a recommendation as to how Morgan should resolve issues relating to revenue recognition, inventory valuation, and liability recognition and classification.