Revenue Recognition on a Multi-Element Contract with Variable Consideration
Meridian Fabricators Ltd signs a contract in January 20X5 with a customer to supply and install a custom production line. The contract price is BDT 12,000,000. The equipment alone sells separately for BDT 9,500,000; installation, which is a distinct service, normally sells for BDT 2,500,000. The contract also includes a performance bonus of BDT 1,000,000 payable if the line achieves a specified throughput by 30 June 20X5. At inception, management judges a 60% probability of earning the bonus, and believes a cumulative-catch-up approach best predicts the outcome. By 31 December 20X5 the equipment has been delivered and installation is 40% complete; costs incurred to date are BDT 3,200,000 against total estimated installation costs of BDT 2,000,000 for that distinct service. The customer has paid BDT 5,000,000. The finance director wants to recognise the full BDT 12,000,000 bonus-inclusive price on delivery of the equipment.
1. Explain how the transaction price should be allocated and whether the bonus may be included at inception.
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The contract contains two distinct performance obligations: the equipment and the installation service. Because both are distinct, the transaction price is allocated on relative stand-alone selling prices.
Stand-alone prices: equipment BDT 9,500,000; installation BDT 2,500,000; total BDT 12,000,000. The allocation happens to match the stated price, so equipment receives BDT 9,500,000 and installation BDT 2,500,000.
The bonus is variable consideration. It is included only to the extent that a significant reversal is not probable when the uncertainty resolves. A 60% probability is not high certainty; there is a 40% chance of reversal of the entire BDT 1,000,000. Management should constrain the bonus and include nil (or a small constrained amount) until throughput is demonstrated. The FD's proposal to recognise BDT 12,000,000 on delivery is therefore wrong on two counts: it ignores the distinct installation obligation and it ignores the constraint on variable consideration.
2. Compute the revenue to recognise by 31 December 20X5, showing the equipment and installation separately, and explain the contract liability.
Read the worked answer
Equipment: control transfers on delivery, so recognise BDT 9,500,000 in 20X5.
Installation: a distinct service recognised over time. Progress measured on costs: costs incurred BDT 3,200,000 against total estimated costs of BDT 2,000,000 implies the estimate is stale or costs are being misclassified, because progress cannot exceed 100%. Before computing, the entity must reassess total costs; assuming the correct total cost is, say, BDT 8,000,000, progress is 40%, and revenue is 40% x BDT 2,500,000 = BDT 1,000,000.
Total revenue 20X5 = BDT 9,500,000 + BDT 1,000,000 = BDT 10,500,000 (excluding the constrained bonus).
Cash received BDT 5,000,000 is less than revenue recognised, so the difference of BDT 5,500,000 is a contract asset (unbilled receivable), not a contract liability. A contract liability arises only where cash received exceeds revenue recognised. The FD should also disclose the variable consideration constraint and the method used to measure progress.