Marshall Manufacturing Ltd is a manufacturer of fuel injection systems for the automotive industry. At the beginning of the current financial year, Marshall Manufacturing Ltd entered an agreement with Auto Essentials Ltd to manufacture and to supply to Auto Essentials Ltd 10 000 fuel injection systems at a stipulated price before the end of the financial year. The systems were to be made to the exact specifications required by Auto Essentials Ltd. If Marshall Manufac¬turing Ltd failed to perform as per the agreement, severe financial penalties were included as part of the contractual arrangements.

The agreement also provided that Auto Essentials Ltd would make royalty payments to Marshall Manufacturing Ltd after each batch of 2000 systems was delivered. Each royalty payment was to be $100 000, and was to be paid by Auto Essentials Ltd for the use of Marshall Manufacturing Ltd’s patent rights attached to the fuel injection systems, and to help in supplying working capital to Marshall Manufacturing Ltd during the manufacturing process. The royalty payments were con¬sidered to be a part payment of the ultimate selling price, which was receivable in full immediately on delivery of the final batch.

On delivery of the first batch of 2000 systems to Auto Essentials Ltd, the batch was found not to comply with the exact specifications required, and the batch was returned to Marshall Manufac¬turing Ltd. Auto Essentials Ltd refused to pay the royalty payment attached to that batch until the appropriate modifications had been carried out. Furthermore, Auto Essentials Ltd indicated that, unless the modifications were completed promptly, financial penalties under the contract would be instigated. Marshall Manufacturing Ltd assessed that the modifications would delay completion of all batches by 6 months. Auto Essentials Ltd was prepared to accept this delay without imposing penalties, but indicated that no further delays would be tolerated. If further delays occur, the con¬tract would be cancelled.

Required

Discuss, with reference to the Conceptual Framework, the appropriate accounting treatment in the accounting records of Marshall Manufacturing Ltd for its contract with Auto Essentials Ltd. Pay particular attention to the timing of recognition of the appropriate financial statement elements.