ERP Implementation Contract: Allocating and Constraining the Transaction Price
Colombo Software Ltd (CSL) signs a three-year contract with a conglomerate to implement and host an ERP system. The total fixed consideration is LKR 54 million: LKR 18 million for the on-premise licence, LKR 27 million for implementation services, and LKR 9 million for three years of support. CSL also receives a performance bonus of LKR 6 million if go-live occurs within nine months; historical data show a 60% chance, and CSL has never achieved this timeline for a client of this size. The customer can terminate for convenience, paying costs incurred plus 10%. Implementation is highly customized and CSL cannot redirect the work. At year-end, CSL has incurred LKR 12 million of the expected LKR 24 million implementation cost. Management wants to recognize the LKR 18 million licence on contract signing, treat the bonus as probable, and use cost-to-cost progress for all deliverables. The finance director argues that support revenue should be recognized evenly over three years. The customer has withheld a LKR 4 million milestone payment, citing delays.
1. Identify the performance obligations in the contract and explain whether the licence, implementation, and support are distinct. Support your conclusion with the SLFRS 15 criteria.
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Start with the distinct-good-or-service criteria: the customer can benefit from the item on its own or with readily available resources, and the promise is separately identifiable, meaning there is no significant integration, modification, or interdependence.
- Licence: An on-premise licence is capable of being used with other software, but here implementation is highly customized to the customer. The licence and implementation are likely not distinct because the customer cannot benefit from the licence without the implementation and the two are highly interdependent. Treat them as a combined performance obligation unless evidence shows the customer could use the licence with another implementer.
- Implementation: Highly customized and not redirectable. It does not merely modify a distinct licence; it creates a combined output. The fact CSL cannot redirect the work supports over-time recognition under the 'no alternative use plus right to payment' test, but that is a separate question from distinctness.
- Support: Recurring post-go-live support is usually capable of being distinct and is separately identifiable from implementation; the customer can benefit from support with the implemented system. Treat it as a separate obligation recognized over three years.
Conclusion: two obligations are likely: a combined licence-plus-implementation obligation and a support obligation. Management's plan to recognize the licence at signing is not supportable if the licence is not distinct.
2. Determine the transaction price, including the bonus and the termination clause, and allocate it to the performance obligations. Show the constraint analysis.
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The transaction price starts at LKR 54 million fixed. Add variable consideration only to the extent that it is highly probable that no significant reversal will occur. The LKR 6 million bonus has a 60% chance, and CSL has no history of achieving the timeline for a client of this size. That is not highly probable; a 40% chance of failure and a LKR 6 million reversal are significant. Exclude the bonus unless evidence changes. The termination-for-convenience clause does not add consideration if termination is not expected; it is a contract term, not a separate promise. If termination becomes expected, estimate the amount payable.
Allocation: if licence and implementation are combined, standalone selling prices are LKR 18 million plus LKR 27 million, equal to LKR 45 million for the combined obligation, and LKR 9 million for support, total LKR 54 million. Because total standalone selling price equals consideration, allocate LKR 45 million to the combined obligation and LKR 9 million to support. If the licence were distinct, allocate 18/54, 27/54, and 9/54, but that is not the conclusion above. The LKR 4 million withheld milestone is not automatically a price concession. Assess whether the customer has the ability and intention to pay. If it is only a timing difference, no adjustment; if it is a disputed concession, reduce the transaction price.
3. Advise on the revenue to recognize at year-end and the accounting treatment of the withheld LKR 4 million. Include the progress calculation.
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Combined obligation: total expected cost is LKR 24 million; incurred cost is LKR 12 million, so progress is 50%. Recognize 50% of LKR 45 million, equal to LKR 22.5 million cumulative revenue, assuming cost-to-cost faithfully depicts progress. Because the contract is over time, recognize a cumulative catch-up; present a contract asset or contract liability in the statement of financial position. Support revenue is not recognized yet because support has not been delivered. If support starts at go-live, recognize LKR 9 million over 36 months, which is LKR 0.25 million per month. Do not recognize the LKR 18 million licence at signing. Exclude the bonus until it is highly probable, and revisit at each reporting date.
Withheld LKR 4 million: this remains a receivable if the right to consideration is unconditional. Withholding for delays may indicate a penalty or a price concession. If it is a penalty, reduce the transaction price and revenue; if it is merely timing, keep the receivable. Disclose the judgement and the contract balances. Overall, management's proposed treatment overstates revenue by at least LKR 18 million and likely by more.