Revenue Recognition on a Long-Term Contract With a Variation
Your client, Meridian Fabrications, has a single large contract to build a bespoke production line for a customer. Total contract price is £2.4m, expected cost £1.9m, and at the year end the project is 55% complete on a cost-to-cost basis. During the year the customer requested a design change; Meridian has incurred £140,000 of additional cost on it and has verbally agreed with the customer's project manager that it will be paid 'around £160,000', but nothing is signed. The customer has also withheld a £200,000 milestone payment, citing defects, and Meridian's finance director wants to recognise the full £2.4m plus £160,000 variation as revenue, arguing 'the work is done, we'll get paid'. Separately, £90,000 of materials delivered to site are included in cost to date but have not been installed.
1. Calculate and justify the revenue and profit to recognise at the year end, dealing with the variation, the withheld milestone, and the uninstalled materials.
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Work through the components in order.
Variation: a variation is only included in the transaction price if it is highly probable that there will not be a significant reversal when it is resolved. A verbal agreement with a project manager, with no signed instruction and no fixed amount, does not meet that bar. The £160,000 should be excluded from revenue. The £140,000 of cost, however, has been incurred and is a cost of the contract; it should be included in the cost-to-date used to measure progress, which has the effect of reducing the margin rather than creating revenue. Disclose the variation as a contingent asset and pursue written confirmation.
Withheld milestone: a £200,000 withholding for alleged defects is not automatically a revenue reduction, but it is evidence about the transaction price. If the defects are likely to require remediation, the expected cost of that remediation should be added to expected costs, and if the customer has a valid right to set off a credit, the transaction price should be reduced. The FD's 'we'll get paid' is an assertion, not evidence. At minimum, treat the amount as constrained until the defect position is resolved, and reflect the expected remediation cost in the cost estimate.
Uninstalled materials: £90,000 of materials delivered but not installed should generally be excluded from the measure of progress where they are not distinctive to the contract and the entity is merely acting as an agent for them - the effect is to recognise them at cost with no margin, rather than letting them inflate percentage completion. If they are bespoke and specific to this contract, the analysis differs, but the default is to strip them from the progress measure.
Revised numbers: transaction price £2.4m; expected cost £1.9m plus £140,000 variation cost plus expected remediation (assume nil for illustration) = £2.04m. Progress on cost-to-cost excluding the £90,000 uninstalled materials: qualifying cost to date = 55% of £1.9m = £1.045m, plus £140,000 = £1.185m; qualifying total cost = £2.04m; progress = 58.1%. Revenue = £2.4m × 58.1% = £1.394m. Cost recognised = £1.185m. Gross profit = £209,000. The point is the method, not the exact figures - the FD's approach would have recognised £2.56m of revenue on a £2.4m contract.
2. The FD says the auditor will 'sign it off anyway'. What is your professional position, and what would you do if he instructs you to book his figures?
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Your position is that the figures must be supportable by evidence, not by the expectation of a signature. The auditor tests the accounts; the auditor does not indemnify the preparer. If the accounts contain revenue that cannot be supported, the auditor may qualify, may require adjustment, or may resign - and in each case the preparer who booked the figures without a basis has a problem that the audit does not solve.
If instructed to book the FD's figures: first, restate the objection in writing, with the specific amounts and the accounting basis for each, so the disagreement is documented rather than verbal. Second, offer the compliant alternative - the figures you can support, with the variation disclosed as contingent and the milestone treated as constrained - so the FD has a route to a set of accounts you can sign off on internally. Third, if the instruction is repeated, escalate within the client to the board or audit committee, and consider whether the misstatement is material enough that you cannot be associated with the accounts. That may mean declining to prepare them, or resigning from the engagement, with a letter setting out why.
The key discipline is to keep the disagreement factual. 'I think this is aggressive' is weak; 'the variation has no signed instruction, so under the constraint test it cannot be included, and here is the effect on revenue and profit' is strong. If the FD overrides you anyway, your file should show exactly what you advised, when, and what was booked instead.