Marlow Industrial: Packaging Line with Holdback and Acceptance Test
Marlow Industrial Ltd signed a contract on 1 October 20X5 to supply an automated packaging line to a food manufacturer for a total price of $560,000. The contract lists three elements: the machine (stand-alone selling price $480,000), installation and commissioning (stand-alone price $45,000) and a three-year remote diagnostics service (stand-alone price $36,000 a year). The machine cannot operate until it is calibrated to the customer's conveyor heights, but installation is routine, takes eight days and is performed by several local contractors. The contract also includes a 5% holdback ($28,000) payable only if the line achieves 98% uptime during a 30-day acceptance test. Marlow has never failed a test, although two prior installations needed re-calibration. At 31 December 20X5 the machine is installed and in the customer's plant; the acceptance test is 12 days from completion and the service has run for three weeks. Marlow's year-end is 31 December.
1. Identify the performance obligations in the Marlow contract and justify whether installation is a separate performance obligation.
Read the worked answer
Answer: three performance obligations.
- Machine - a distinct good. The customer can benefit from the machine together with other readily available resources.
- Installation and commissioning - distinct. The test is whether the customer benefits from the service together with the machine and whether the service is separately identifiable. Installation is routine, takes eight days, and is performed by several local contractors, so it does not significantly modify or customise the machine and is not highly integrated with it. The fact that the machine cannot operate until calibrated does not make installation non-distinct; it simply means the customer needs the service. If installation required significant integration or bespoke engineering, the machine and installation would be combined into one obligation.
- Three-year diagnostics service - distinct. The customer receives a service over time, and the service is separately identifiable from the machine.
The 5% holdback is not a performance obligation. It is part of the consideration for the machine, contingent on the uptime test, and must be analysed as variable consideration.
2. Allocate the $560,000 transaction price and state the revenue Marlow should recognise for the year ended 31 December 20X5, explaining each judgement.
Read the worked answer
Step 1 - allocate on relative stand-alone selling prices.
Total SSP = 480,000 + 45,000 + (36,000 x 3) = 633,000.
| Obligation | SSP | Allocation | Amount |
|---|---|---|---|
| Machine | 480,000 | 480/633 | 424,645 |
| Installation | 45,000 | 45/633 | 39,810 |
| Diagnostics | 108,000 | 108/633 | 95,545 |
| Total | 633,000 | 560,000 |
The $73,000 discount is allocated proportionately because there is no observable evidence that it relates only to one element.
Step 2 - timing. Machine and installation: control passes when installation is complete (about 10 December). The customer has possession, legal title and the significant risks and rewards. The 30-day acceptance test is a payment-protection mechanism rather than a substantive acceptance clause, because Marlow has never failed a test and re-calibration is within its control. Revenue for machine and installation is therefore recognised at 10 December: 424,645 + 39,810 = 464,455.
Step 3 - diagnostics. Recognised over time, straight-line over 156 weeks. Three weeks elapsed: 95,545 x 3/156 = 1,837.
Total 20X5 revenue = 466,292.
If the acceptance test were judged substantive, no machine revenue would be recognised until the test is passed in January 20X6 - a material difference.
3. Explain how the 5% holdback should be treated and whether the constraint changes your answer to the revenue figure.
Read the worked answer
The holdback is variable consideration: the right to $28,000 is contingent on the line achieving 98% uptime. It is not a separate performance obligation and it attaches to the machine, so it is allocated to the machine obligation.
Measurement. Estimate using the expected value method: $28,000 x probability of passing. On Marlow's history the probability is high, but the outcome is not yet known and two prior installations needed re-calibration.
Constraint. Variable consideration is included only to the extent that it is highly probable that a significant reversal will not occur when the uncertainty is resolved. At 31 December the test is still 12 days from completion, a re-calibration could cause failure, and the amount is binary. The constraint should therefore reduce the recognised amount to nil at year-end.
Effect on the answer. The 20X5 revenue figure of $466,292 stands; $28,000 is excluded. When the test is passed in January 20X6, the $28,000 is recognised (subject to the same constraint test) as a cumulative catch-up, because the uncertainty is resolved and the amount becomes unconditional. The holdback is due within one year, so no financing component arises.