Revenue Recognition and Warranty Provision at a Custom Equipment Manufacturer
Ridgeway Fabrication builds custom conveyor systems. In November Year 1 it signs a contract with a single customer: total price 1,200,000, delivery of three identical conveyor modules over 15 months, plus a 24-month assurance-type warranty. The customer may cancel any undelivered module and pay only for completed ones. Ridgeway has never built this exact configuration, but it has built similar systems and can reliably estimate costs. By 31 December Year 1 it has incurred 180,000 of costs on Module 1, of which 30,000 relates to materials delivered to site but not yet installed; total expected cost for Module 1 is 400,000. A competitor's newer design has just been announced, and the customer has hinted it may cancel Modules 2 and 3. Management wants to recognise revenue using the percentage of costs incurred to total contract costs and to defer all warranty cost until claims arise.
1. Evaluate whether Ridgeway should treat the three modules as one performance obligation or three, and whether revenue should be recognised over time or at a point in time. Justify with the five-step model logic.
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Step 1 - Identify the contract. The contract is enforceable, has commercial substance, and collection is probable, so it qualifies. The cancellation right matters: because the customer can cancel undelivered modules and pay only for completed ones, each module is effectively a separate enforceable unit once work begins.
Step 2 - Distinct goods. Each module is capable of being distinct (the customer can benefit from one alone) and distinct within the context of the contract (Ridgeway's promise to integrate is limited; modules are identical and not highly interdependent). Therefore three performance obligations, not one.
Step 3 - Transaction price. Allocate the 1,200,000 equally at 400,000 per module, since the modules are identical and standalone prices are the same.
Step 4 - Over time or point in time? For Module 1, the asset has no alternative use to Ridgeway (custom configuration) and Ridgeway has an enforceable right to payment for performance completed to date. That points to over time. However, the 30,000 of uninstalled materials do not depict progress; a cost-to-cost measure must exclude them. Adjusted progress = (180,000 - 30,000) / (400,000 - 30,000) = 150,000/370,000 = 40.5%.
Step 5 - Revenue for Module 1 = 40.5% x 400,000 = 162,162, with cost of 150,000, giving a contract asset and margin of 12,162. Modules 2 and 3 are not yet enforceable and no revenue is recognised on them. The cancellation hint is a variable-consideration/contract-modification indicator to monitor, not a reason to abandon over-time recognition for Module 1.
2. Assess management's proposal to defer all warranty cost until claims arise, and explain the correct treatment including the effect on the Year 1 margin computed above.
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Management's proposal is incorrect. The warranty is an assurance-type warranty - it provides the customer with assurance that the modules will function as specified, not an additional service. Under the five-step model, an assurance-type warranty is not a separate performance obligation; instead it is a provision recognised when the related revenue is recognised, measured at the best estimate of the obligation.
Correct treatment:
- Estimate expected warranty cost for Module 1 based on historical claim rates, adjusted for the new configuration. Suppose the estimate is 3% of the 400,000 contract value = 12,000.
- Recognise a provision (debit warranty expense, credit provision) as Module 1 revenue is recognised. Because only 40.5% of Module 1 is complete, accrue 40.5% x 12,000 = 4,860 in Year 1.
- The provision is a liability, not a reduction of revenue; it is presented separately from the contract asset.
Effect on margin: the 12,162 margin computed earlier becomes 12,162 - 4,860 = 7,302 for Year 1. Deferring the cost would overstate profit and understate liabilities, breaching the matching principle and the accrual basis. If the warranty instead promised a service beyond assurance (for example, a separately priced extended maintenance plan), it would be a separate performance obligation and revenue would be allocated to it - but the facts describe assurance only.