Revenue allocation, warranties and a slow-moving inventory line
Mwangi & Sons Ltd, a dealer in agricultural machinery, signed a contract on 1 March 2025 to supply three threshers to a cooperative for total consideration of KSh 12,000,000, payable 40% on delivery with the balance in equal monthly instalments over the following twelve months. The contract includes installation, which the engineering team confirms cannot be performed by any other party and without which the machines will not operate, plus a two-year maintenance service. Standalone selling prices are KSh 4,200,000 per thresher, KSh 500,000 for installation and KSh 1,000,000 for the service. Separately, the warehouse holds 200 spare-part kits bought at KSh 45,000 each. The current list price is KSh 52,000, but each kit needs KSh 3,000 of rework and KSh 9,000 of selling costs before it can be moved. The finance manager has recognised the full KSh 12,000,000 as revenue on delivery of the machines and has made no inventory adjustment.
1. Allocate the KSh 12,000,000 transaction price across the performance obligations and state when each element should be recognised. Justify your treatment of the installation.
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Step 1 - Identify the performance obligations. The machines and the installation are not separately identifiable: the cooperative cannot obtain the benefit of the threshers without the installation, and no other party can perform it. They therefore form a single combined obligation. The two-year maintenance service is capable of being provided by others and is distinct from the machines.
Step 2 - Establish the relative standalone selling prices.
| Element | SSP (KSh) |
|---|---|
| 3 threshers (3 × 4,200,000) | 12,600,000 |
| Installation | 500,000 |
| Combined machines + installation | 13,100,000 |
| Maintenance service | 1,000,000 |
| Total | 14,100,000 |
Consideration of KSh 12,000,000 is KSh 2,100,000 below total SSP. There is no evidence the discount relates to one specific element, so it is allocated pro rata to all obligations.
Step 3 - Allocation.
- Machines + installation: 12,000,000 × (13,100,000 ÷ 14,100,000) = KSh 11,148,936 (KSh 3,716,312 per machine).
- Maintenance service: 12,000,000 × (1,000,000 ÷ 14,100,000) = KSh 851,064 (KSh 425,532 per year).
- Check: 11,148,936 + 851,064 = 12,000,000. ✓
Step 4 - Timing.
- Machines: control passes when the installation is complete, not when the goods are unloaded at site, because installation is part of the single combined obligation. If installation is unfinished at the reporting date, no machine revenue is recognised.
- Service: recognised over time on a straight-line basis over 24 months, as the customer receives and consumes the benefit as it is provided.
Consequence of the current treatment: recognising KSh 12,000,000 on delivery overstates revenue by KSh 851,064, brings forward machine revenue before the obligation is satisfied, and leaves a contract liability that must be presented. The error is material against a KSh 400m turnover only if aggregated across contracts - the point is that it is a systematic policy failure, not a one-off.
2. Compute the required inventory adjustment and explain the principle applied.
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Net realisable value per kit:
NRV = estimated selling price − costs to complete − costs to sell NRV = 52,000 − 3,000 (rework) − 9,000 (selling costs) = KSh 40,000
Cost is KSh 45,000, so NRV is below cost by KSh 5,000 per kit.
Write-down = 200 kits × KSh 5,000 = KSh 1,000,000
Journal: Dr Cost of sales (inventory write-down) 1,000,000 / Cr Inventory 1,000,000.
Reasoning points that carry the marks:
- The list price of KSh 52,000 is not NRV. IAS 2 requires the deduction of the costs necessary to make the sale - both the rework (costs to complete) and the selling costs.
- The comparison is made item by item (or by class of similar items). It is not acceptable to offset the write-down against the profit on the thresher contract; that would conceal a loss on one class of inventory behind a gain on another.
- The 200 kits are a separate class of asset from the contract with the cooperative. Mixing the two is the classic error this scenario tests.
- If the kits are genuinely obsolete rather than merely slow-moving, the write-down should be to NRV as computed; if NRV is expected to recover before the next reporting date because of a confirmed order, the write-down may still be required now - NRV is assessed at each reporting date on the position then existing.
- Disclose the write-down amount and the circumstances if material.
3. Does the twelve-month payment profile create a significant financing component? Advise the finance manager.
Read the worked answer
The test. IFRS 15 requires adjustment where the timing of payments gives either party a financing benefit. A practical expedient allows the entity to ignore the financing component where, at contract inception, the period between transfer of the goods or services and payment is not more than one year.
Applying it here.
- KSh 4,800,000 (40%) is paid on delivery - no financing element.
- KSh 7,200,000 is settled in equal monthly instalments across the twelve months following delivery - a period of, at most, twelve months from transfer.
- The expedient is therefore available, and no financing component need be recognised. This is a policy election, applied consistently and disclosed.
Where the judgement bites.
- If the terms include any grace period - for example a three-month moratorium before instalments begin - the period from transfer to final payment exceeds twelve months and the expedient is not available. The entity must then discount the KSh 7,200,000 at a rate that would apply in a separate financing transaction between the parties (reflecting the customer's credit standing, not Mwangi's own borrowing rate), recognise interest income over the period, and increase revenue by the same amount.
- A rough quantification at a 16% customer rate would reduce the recognised consideration by roughly KSh 500,000–550,000, recognised as interest income over the year.
- The assessment must be documented at contract inception and not revisited for convenience. The finance manager should also confirm the receivable is not credit-impaired: a cooperative paying over twelve months carries collection risk that belongs in the expected credit loss model, not in the revenue figure.