Revenue recognition on a fixed-price IT project
Software House NV signs a fixed-price contract in March 2024 to build a custom logistics platform for a client for €1,200,000. The contract is a single performance obligation satisfied over time because the client controls the work in progress and the platform has no alternative use. At 31 December 2024 the company has incurred costs of €540,000 and estimates total costs to complete of €1,100,000. The project manager reports that the work is 55% complete based on labour hours. However, €90,000 of the incurred costs relate to a component that had to be rebuilt after a design error, and the client has not accepted that component. The company has billed €600,000 and received €520,000. The finance director proposes recognising revenue of €660,000 (55% of €1,200,000) and a profit margin of 10%.
1. Assess whether the 55% labour-hours measure is an appropriate measure of progress and calculate the revenue and profit that should be recognised at 31 December 2024.
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The labour-hours measure is not reliable here because it counts rework that does not transfer value to the client. Progress should reflect the costs incurred that contribute to satisfying the performance obligation, excluding wasted or reworked costs. Adjust the cost base: €540,000 incurred minus €90,000 rework = €450,000 of productive costs. Total expected productive costs are €1,100,000 minus the €90,000 rework (assuming it is not recoverable) = €1,010,000. Progress = 450,000 / 1,010,000 = 44.6%.
Revenue to recognise = 44.6% × €1,200,000 = €535,200. Expected total profit = €1,200,000 − €1,010,000 = €190,000. Profit recognised = 44.6% × €190,000 = €84,700. Cost of sales recognised = €450,000, so gross profit = €85,200 (rounding).
If the rework is recoverable from the client or a subcontractor, it may be included in the cost base and the calculation changes; document the basis. The finance director's €660,000 revenue overstates progress and ignores the rework. Also check the contract asset/liability: billed €600,000 versus revenue €535,200 means a contract liability of about €64,800, not a receivable.
2. The client is under pressure from its bank covenant, which requires a minimum EBITDA of €250,000. The finance director asks you to accept the 55% measure. How do you respond?
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Explain that the 55% measure is not supportable because it treats rework as progress. The difference is material: revenue of €660,000 versus about €535,200, and profit of roughly €120,000 versus €84,700 - a difference of about €35,000 in profit. If EBITDA is close to the €250,000 covenant, this difference could determine compliance.
Set out the correct treatment in a written memo: the cost-based measure, the exclusion of rework, the contract liability, and the supporting evidence (timesheets, project reports, client acceptance records). Ask the client to correct the accounts. If the client refuses, consider the effect on the audit opinion and on your association with the covenant certificate. You should not sign a covenant compliance certificate that relies on figures you believe are misstated. Escalate to the board, document the disagreement, and consider whether a qualified opinion is required. Also consider whether the bank needs to be informed; at minimum, do not provide a comfort letter based on the uncorrected figures.