Revenue Recognition on an Automotive Supply Contract
Lanka Precision Components PLC (LPC), a CSE-listed manufacturer, has signed a three-year agreement to supply machined aluminium housings to a German automotive OEM. The contract price is LKR 1.8 billion, invoiced on delivery, but the customer retains 10% of each invoice for 24 months as quality security. LPC can also earn a bonus of up to LKR 200 million if the cumulative defect rate stays below 0.5%. LPC met that threshold on two of its last five comparable contracts, but this contract requires a production line that has not yet been commissioned. A two-year repair warranty for manufacturing defects is included. In November the OEM varied the contract to add 15% volume at LPC's list price, which is 8% above the original unit price. LPC's year end is 31 March. The finance director has recognised the full LKR 200 million bonus as revenue in the current year and has treated the 10% retention as a receivable with no impairment.
1. Determine how LPC should measure the transaction price under SLFRS 15, including the bonus and the retention. Show your reasoning and state the amount you would recognise.
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Step 1 – identify the contract and the consideration. The LKR 1.8 billion fixed price and the bonus are both consideration for the housings. The 10% retention is not a separate element; it is deferred payment of the invoice price.
Step 2 – variable consideration. The bonus is variable. LPC should use the expected value method: LKR 200m x 40% (two of five comparable contracts) = LKR 80m. However, SLFRS 15 requires the amount to be constrained so that a significant reversal is not highly probable. The 40% history comes from a different production line; the new line is uncommissioned; first-year defect rates are uncertain. The bonus therefore fails the constraint test and should be recognised at nil until commissioning and defect data support it. Recognising LKR 200m is not supportable.
Step 3 – retention. Revenue is recognised gross. The 10% retention is a receivable, or a contract asset where the right is conditional on quality acceptance. Because 24 months exceeds one year, consider whether it contains a significant financing component; here the retention protects the customer against defects rather than financing the contract, so an interest adjustment is unlikely. LPC must nevertheless apply SLFRS 9 expected credit losses and consider the customer's credit quality.
Conclusion: transaction price currently LKR 1.8 billion, bonus nil with disclosure of the uncertainty, and retention as a receivable less expected credit loss.
2. Explain the accounting for the two-year repair warranty and for the November volume variation.
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Warranty. The warranty assures that the housings meet the agreed specification and is therefore an assurance-type warranty, not a separate performance obligation. It is accounted for under LKAS 37 as a provision: estimate the cost of repairs using historical defect data, adjusted for the new line, and recognise a provision and expense when the goods are sold. If the customer could separately purchase an extended warranty, that would be a service-type warranty and a separate performance obligation under SLFRS 15. The contract documents should make clear which is intended.
Volume variation. The additional 15% is at list price, which is 8% above the original unit price. LPC must first decide whether the additional goods are distinct. They are standard housings, and the price reflects LPC's standalone selling price for that volume. Under SLFRS 15, a contract modification that adds distinct goods at their standalone selling price is treated as a separate contract; no part of the original transaction price is reallocated. If the goods were not distinct, or if the price were discounted, LPC would apply a cumulative catch-up adjustment to revenue. The November documentation and pricing file should support the standalone-price conclusion.
Presentation: the retention and any unbilled amounts should be presented separately from trade receivables, and the variable consideration and warranty provision disclosed.
3. As a member of the audit committee, list the questions you would put to the finance director and the external auditor before approving the revenue note.
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The audit committee should not accept the revenue note on management's assertion alone. Useful questions include:
- What commissioning tests have been completed on the new line, and what defect data exist for the first units produced? On what evidence is the 40% probability based?
- Why has the full LKR 200 million been recognised when the constraint test appears to fail? Has the auditor concurred, and on what evidence?
- What is the ageing of the retention receivable, and what expected credit loss has been applied under SLFRS 9? Is any part past due?
- What is the estimated warranty provision, what defect rate drives it, and how does it compare with the two-year repair history?
- For the November variation, is there a signed amendment, and does the pricing file demonstrate that list price is the standalone selling price?
- Has cut-off been tested around 31 March, particularly for goods invoiced but not delivered?
- What disclosures will be made about variable consideration, the retention and the warranty, and is a key audit matter warranted?
The committee should minute the answers and require correction before approving the note.