Revenue recognition for a customized machine contract with acceptance and return rights
Taraz Machine Manufacturing Co. (TMM), a Tehran Stock Exchange-listed entity reporting under IFRS, signs a contract on 1 Mordad 1402 with a domestic automaker to deliver 10 special-purpose CNC machines for a fixed price of 46,000 million rials. The contract includes installation, commissioning, and two years of maintenance. TMM normally sells the machines for 40,000, installation for 6,000, and maintenance for 4,000 (total 50,000). The machines require only standard installation that other contractors could perform; however, TMM is the only entity certified to calibrate the software, and the calibration is necessary for the machines to operate. Payment terms are 40% advance, 50% on delivery, and 10% after acceptance. The customer may return any machine within 90 days for a full refund; TMM estimates a 6% return rate based on similar contracts. At year-end, all machines are delivered and installed, acceptance is expected in 20 days, and maintenance has not started. TMM recognized the full 46,000 as revenue on delivery.
1. Identify the performance obligations in the TMM contract and allocate the 46,000 million rials transaction price. Explain the treatment of the 4,000 million discount and of the calibration service.
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Performance obligations. The machine, standard installation, and proprietary calibration must be assessed together. The machine cannot operate without TMM's calibration, and no other contractor can perform that calibration. Therefore the machine, installation, and calibration are not separately identifiable in the context of the contract; they form one combined performance obligation. Maintenance is distinct because the customer can benefit from two years of maintenance separately and it is not highly integrated with the machine sale.
Allocation. Standalone selling prices are 46,000 for the combined obligation (40,000 machine + 6,000 installation; calibration is not separately priced) and 4,000 for maintenance, totaling 50,000. The 4,000 discount is allocated proportionally because no evidence shows it relates only to one obligation:
- Combined obligation: 46,000 × (46,000 ÷ 50,000) = 42,320 million rials.
- Maintenance: 46,000 × (4,000 ÷ 50,000) = 3,680 million rials.
The discount is not expensed immediately; it reduces the allocated transaction price. If TMM had evidence that the discount related solely to the maintenance obligation, it would allocate the discount entirely to maintenance, but the facts do not support that.
2. At year-end, acceptance has not occurred. Management says acceptance is a formality. Evaluate whether TMM should recognize revenue, and compute the amount if acceptance is substantive versus if it is perfunctory. Include the return allowance.
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Acceptance is substantive unless proven perfunctory. The customer has a contractual acceptance step after installation, the machines are special-purpose, and acceptance is still 20 days away. TMM must presume acceptance is substantive unless it has objective evidence that the customer will accept without further testing. On these facts, control has not transferred at year-end, so revenue is zero for the combined obligation. The 41,400 million rials received (90% of 46,000) is a contract liability, not revenue; the remaining 4,600 million is not yet a receivable. TMM should also keep the machines in inventory or present them as goods at the customer's site without derecognition, depending on the contract's title terms.
If TMM concludes acceptance is perfunctory, revenue for the combined obligation is recognized net of expected returns: 42,320 × 94% = 39,780.8 million rials. A refund liability of 42,320 × 6% = 2,539.2 million rials is recognized, plus an asset for the right to recover returned machines at their cost. Maintenance revenue is zero because maintenance has not started; the 3,680 million allocated to maintenance remains a contract liability.
3. If acceptance is substantive, how should TMM present the contract in its 1402 financial statements, and what disclosures are required?
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TMM should present a contract liability of 41,400 million rials for cash received in advance of revenue recognition. The 4,600 million balance due only after acceptance should not be recorded as a receivable unless TMM has an unconditional right to consideration. The machines should remain in inventory, or be separately disclosed as goods held at customer sites, because control has not transferred. No revenue or cost of goods sold is recognized for the combined obligation, and no maintenance revenue is recognized.
Disclosures should explain the significant accounting policy for revenue, the judgments that acceptance is substantive, the estimate of returns (6%), the allocation of the transaction price, and the amount and timing of remaining performance obligations. TMM should also disclose the contract liability balance and the expected timing of revenue recognition. If management continues to recognize revenue, the auditor should evaluate whether the acceptance clause is a substantive condition and whether the return provision has been properly accounted for.