Revenue Allocation, Service Deferral and Warranty Provision at Northbridge Instruments
Northbridge Instruments Ltd sells a laboratory analyser that it installs and supports. In the year to 31 December 20X5 it contracted 40 analysers at £25,000 each, a total of £1,000,000. Each contract includes installation and a 24-month service plan. The company normally sells the analyser alone for £21,000, installation for £2,000 and the service plan for £4,000. At the year end two analysers had been delivered but not installed, and customers had a 30-day return right on five units; historically 4% of such units are returned. The analyser carries a 12-month assurance warranty; past claims average 1.5% of sales value and no provision has been made. Inventory includes £180,000 of components for an older model whose net realisable value is £120,000. The finance director proposes recognising the full £1,000,000 on delivery, deferring the warranty cost until claims arise, and carrying inventory at cost because 'the loss is not yet realised'.
1. Allocate the transaction price to the performance obligations for one analyser and explain when revenue should be recognised for the two uninstalled units and for the five units carrying a return right.
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Step 1 - identify the promises. There are three distinct performance obligations: the analyser (equipment), installation, and the 24-month service plan. The 12-month assurance warranty is not a separate obligation; it promises that the product works as specified.
Step 2 - allocate. Total stand-alone price = £21,000 + £2,000 + £4,000 = £27,000. Allocate the £25,000 price pro rata:
- Equipment: £25,000 x 21/27 = £19,444
- Installation: £25,000 x 2/27 = £1,852
- Service: £25,000 x 4/27 = £3,704
Step 3 - timing. Equipment control passes on delivery, so £19,444 per unit is recognised then, even if installation is incomplete; installation does not prevent the customer from directing the use of the analyser. Installation revenue is recognised as installation is completed, so for the two uninstalled units £1,852 each (total £3,704) remains a contract liability. Service revenue is recognised over 24 months: £3,704 / 24 = £154 per unit per month.
Step 4 - return right. The 30-day right creates variable consideration. Using the expected-value method, 4% of 5 units = 0.2 units are expected back. Recognise revenue on 4.8 units, record a refund liability of 0.2 x £25,000 = £5,000 (allocated across the obligations), and recognise a return asset for the analyser expected back, measured at its former carrying amount less expected recovery costs.
Conclusion. Recognising £1,000,000 on delivery ignores the installation, service and return obligations, and overstates revenue and profit.
2. Evaluate the finance director's treatment of the warranty and the inventory, quantify the effect on profit of the proposed treatment, and state the adjusting entries.
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Warranty. An assurance warranty is a present obligation arising from a past event (sale of units), so a provision is required under IAS 37. Best estimate = 1.5% x £1,000,000 = £15,000, recognised as the units are sold. Waiting for claims to arise would understate the liability and the expense; the obligation exists at the reporting date even though no claim has been made.
Inventory. IAS 2 requires measurement at the lower of cost and net realisable value, applied item by item or to groups of similar items. Cost £180,000 against NRV £120,000 gives an immediate write-down of £60,000. The argument that 'the loss is not yet realised' confuses realisation with measurement: NRV is evidence available at the reporting date, and prudence requires the write-down now.
Quantified overstatement relative to the proposed treatment: service revenue deferred £148,148 (40 x £3,704, before allowing for any months already delivered); installation on the two uninstalled units £3,704; expected returns £5,000; warranty provision £15,000; inventory write-down £60,000. Total at least £231,852 before tax. If service has already been delivered for part of the period, substitute only the unrecognised portion.
Adjusting entries. Dr Revenue / Cr Contract liability for deferred installation and service; Dr Revenue / Cr Refund liability £5,000 (with a corresponding return asset); Dr Warranty expense / Cr Provision £15,000; Dr Inventory write-down expense / Cr Inventory £60,000.
The board should also document how the 4% and 1.5% estimates were derived, since both are judgements that an auditor will test.