Kestrel Ltd: allocating a bundled price and constraining a bonus
On 1 October 20X5 Kestrel Ltd signed a contract to supply a packaging line to a customer for a stated price of $1,200,000, including installation and three years of maintenance. Kestrel regularly sells the line for $1,000,000, installation for $150,000 and three years of maintenance for $250,000. Installation is routine, takes two weeks, does not change the machine's functionality and can be performed by unrelated engineering firms. The contract also promises a $100,000 bonus if the line runs at 98% uptime during its first year of operation. Kestrel's engineers have never commissioned this configuration; management puts the chance of earning the bonus at 60%, and uptime depends heavily on operator staffing decisions the customer has not yet made. The line was delivered and installed on 20 November 20X5. Kestrel's year end is 31 December 20X5.
1. Identify the performance obligations in the Kestrel contract and allocate the $1,200,000 stated price to them. Justify your treatment of the installation.
Read the worked answer
Step 1 – Identify the promises. Equipment, installation and three years of maintenance are three separate promises.
Step 2 – Is installation distinct? It is, because:
- the customer can benefit from installation together with the machine, which it controls (a readily available resource);
- the installation does not significantly modify or customise the machine – it is routine and leaves functionality unchanged;
- unrelated engineering firms can perform it, so it is not highly integrated with the machine. The machine and installation are therefore separate performance obligations, and so is the maintenance stand-ready service.
Step 3 – Allocate on relative stand-alone selling prices (SSP).
| Obligation | SSP | Share | Allocation |
|---|---|---|---|
| Equipment | 1,000,000 | 71.43% | 857,143 |
| Installation | 150,000 | 10.71% | 128,571 |
| Maintenance | 250,000 | 17.86% | 214,286 |
| Total | 1,400,000 | 100% | 1,200,000 |
A $200,000 discount is allocated proportionately because there is no observable evidence that it relates to only one obligation (for example, that Kestrel routinely discounts maintenance alone).
The $100,000 uptime bonus is variable consideration within the transaction price, not a separate performance obligation.
2. How much revenue should Kestrel recognise for the year ended 31 December 20X5, and what liability remains at that date? Address the uptime bonus explicitly.
Read the worked answer
Variable consideration and the constraint. Management's expected value of the bonus is $60,000 (60% x $100,000), but variable consideration is included only to the extent that it is highly probable there will not be a significant reversal when the uncertainty resolves. A 60% probability is nowhere near that threshold, and the key driver – operator staffing – is controlled by the customer and still unresolved. Kestrel therefore includes nil of the bonus at contract inception and at 31 December 20X5. It reassesses at each reporting date; if uptime becomes virtually assured in 20X6, revenue is added at that point (with a corresponding contract asset or reduction of the contract liability).
Revenue recognised in 20X5.
- Equipment and installation: both transferred on 20 November 20X5 (point in time, when the customer obtains control) = 857,143 + 128,571 = 985,714.
- Maintenance: recognised over time, straight-line over 36 months from 20 November. Elapsed to 31 December is about 1.4 months: 214,286 x 1.4/36 = approx. 8,000.
- Total revenue 20X5 = approx. $994,000.
Closing contract liability. Cash of $1,200,000 has been received: 1,200,000 - 994,000 = approx. $206,000, being the unearned maintenance element. It is presented separately from receivables and disclosed as part of the remaining performance obligation.