Revenue Recognition and Warranty Provision at a Custom Equipment Maker
Kauri Fabrication Ltd builds custom stainless-steel process equipment for food manufacturers. In March it signed a $480,000 contract to design, build and install a pasteurisation line for a dairy client. The contract specifies three milestones: design sign-off ($60,000), factory acceptance testing ($300,000), and on-site commissioning ($120,000). Installation requires Kauri to integrate the line with the client's existing control system, a service only Kauri can perform because the design is bespoke and the equipment has no alternative use. At year-end, design is complete and accepted, fabrication is 70% complete but factory acceptance testing has not occurred, and no cash has been received. Kauri's CFO wants to recognise the $60,000 design milestone now and defer the rest, arguing that each milestone is a separate performance obligation. Separately, Kauri offers a two-year warranty on all equipment; historically 4% of units require major rectification at an average cost of $18,000, and 10% require minor fixes averaging $1,500. Twenty units were sold this year.
1. Advise whether Kauri should recognise revenue by milestone or by progress toward completion, and quantify revenue recognisable at year-end under your preferred approach.
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The milestone-by-milestone view is not supportable. The design, fabrication and installation are highly interdependent and the equipment is bespoke with no alternative use to Kauri, and Kauri has an enforceable right to payment for performance completed to date. Together these indicate a single performance obligation satisfied over time, not three separate obligations. Allocating revenue to the design milestone simply because it was invoiced would misstate the pattern of transfer.
Revenue should therefore be recognised using an input or output measure of progress that faithfully depicts completion. Using costs incurred (or labour hours) as the input measure, and assuming the 70% fabrication figure reasonably approximates physical completion across the whole contract, cumulative revenue is approximately:
- Design and fabrication progress: the design is complete and fabrication is 70% done. If design represents roughly 12.5% of total effort (60/480) and fabrication 62.5% (300/480), completion to date is 12.5% + 0.70 × 62.5% = 56.25%.
- Revenue = 56.25% × $480,000 = $270,000.
The $60,000 cash-neutral milestone is irrelevant to the recognition decision. The key judgement the examiner is testing is that invoicing milestones do not drive revenue recognition; progress toward satisfying the single obligation does. The CFO's approach would also create a misleading front-loaded margin because design costs are largely incurred already.
2. Calculate the warranty provision and explain how the assurance-type and service-type components should be treated.
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The warranty has two possible components and they are accounted for differently.
Assurance-type (standard) warranty - that the equipment meets agreed specification - is a provision under IAS 37 / AASB 137, not a separate performance obligation. Expected cost:
- Major rectification: 4% × 20 units = 0.8 units × $18,000 = $14,400
- Minor fixes: 10% × 20 units = 2 units × $1,500 = $3,000
- Total expected warranty cost = $17,400
This is recognised as a provision (with a corresponding expense or, if capitalised into contract cost, expensed as incurred) because a present obligation exists from the sale, outflow is probable, and the amount can be reliably estimated. It is measured at the best estimate of the expenditure required to settle the obligation.
Service-type warranty - any promise to provide a service beyond assuring specification - would be a separate performance obligation and revenue would be deferred and recognised over the warranty period. The facts describe only a standard rectification warranty, so on these facts the whole $17,400 is an assurance-type provision.
The judgement point: the label 'two-year warranty' does not determine treatment; the nature of the promise does. A common error is to defer revenue for the whole warranty.