Revenue Recognition on a Multi-Year Contract with a Financing Component
Ridgeway Fabrication signs a three-year contract with a customer on 1 January to build and maintain a specialised conveyor system. Total consideration is $1,200,000, payable as $500,000 on signing and $700,000 at the end of year three. The system is a single performance obligation satisfied over time; engineers estimate costs to complete using an input measure. Year-one costs incurred are $360,000 against total estimated costs of $900,000. The finance director has already recorded $400,000 of revenue for year one by simply spreading the cash receipts evenly, and argues that no adjustment is needed because the customer is a long-standing partner. The company's borrowing rate is 8% and the present value of $700,000 due in three years is approximately $555,700.
1. Quantify the revenue that should be recognised in year one, and explain why the finance director's even-spread figure is wrong.
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Two adjustments are needed. First, strip out the significant financing component: the transaction price is the present value of the consideration, roughly $500,000 + $555,700 = $1,055,700, not $1,200,000. The $144,300 difference is interest income recognised over three years, not revenue. Second, apply the input measure: costs incurred of $360,000 against total costs of $900,000 gives 40% completion, so revenue is 40% x $1,055,700 = $422,280. The even-spread figure of $400,000 ignores both the financing element and the actual progress on the contract, and 'long-standing partner' is not a basis for departing from the standard. The correcting entry increases revenue by about $22,280 and removes the premature interest.
2. The customer's credit rating deteriorates sharply at the end of year one. How does this affect the measurement, and what judgement must be documented?
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Credit risk affects the financing component and collectability, not the progress measure. If the receivable is no longer expected to be collected in full, the expected credit loss on the contract asset/receivable must be recognised separately as an impairment, not netted against revenue. The financing rate used should reflect the rate that would be charged in a separate financing transaction between the parties at inception, so a later deterioration does not retrospectively change the discount rate. The judgement to document is the evidence supporting the revised expected cash flows and the impairment amount, plus whether the contract remains probable of collection; if not, revenue recognition may need to be constrained.