Revenue Recognition and Audit Risk in a Construction Contract
Your firm is auditing Zarnitsa-Stroy LLC, a Belarusian construction company reporting under IFRS for a foreign lender. The company has one fixed-price contract with a total price of 1,200,000 BYN and estimated total costs of 1,000,000 BYN. At year-end, actual costs incurred are 350,000 BYN, but the project manager's internal report shows 480,000 BYN of costs incurred, because he included 130,000 BYN of materials purchased and stored on site but not yet installed. Progress billing to the customer totals 400,000 BYN. Management proposes recognizing revenue using costs incurred (including stored materials) as the measure of progress. The CFO argues this is conservative because it accelerates revenue. The audit partner asks you to assess whether the proposed treatment is acceptable and what audit procedures address the risk.
1. Evaluate whether management's proposed input measure (costs including stored materials) is acceptable for measuring progress, and compute the revenue that should be recognized under an acceptable measure.
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Under IFRS 15, an input method based on costs incurred must reflect the entity's performance in transferring control, not merely resources purchased. Materials delivered to the site but not yet installed generally do not transfer control or represent progress toward satisfying the performance obligation, so including 130,000 BYN of stored materials overstates progress.
Acceptable measure: costs incurred that relate to work performed = 350,000 BYN. Progress = 350,000 / 1,000,000 = 35%. Revenue to recognize = 35% × 1,200,000 = 420,000 BYN.
Management's measure would give 480,000 / 1,000,000 = 48%, i.e. 576,000 BYN of revenue - an overstatement of 156,000 BYN. The treatment is not acceptable as proposed. If the stored materials are highly customized and control has genuinely transferred, that would need evidence; absent such evidence, exclude them.
2. Identify the audit risks arising from this situation and design substantive procedures to address them.
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Key risks:
- Valuation/cut-off of contract costs - risk that costs not related to progress (stored materials, prepayments) are included in the progress measure.
- Revenue overstatement - risk that progress and revenue are overstated to satisfy lender covenants.
- Management bias/override - the CFO's stated rationale suggests an incentive to accelerate revenue.
Procedures:
- Obtain the cost ledger and physically inspect stored materials; agree quantities and condition to purchase invoices and delivery notes, and confirm they are not installed.
- Test the composition of costs incurred: agree to supplier invoices, payroll records, and subcontractor certificates; exclude prepayments and non-contract costs.
- Recompute the percentage of completion and revenue independently.
- Review the contract for variable consideration, penalties, and modification clauses affecting the transaction price.
- Compare budgeted total costs to actuals and engineer's estimates; assess whether estimated total costs remain reliable (risk of loss-making contract).
- Review subsequent billings and cash receipts for evidence of customer acceptance.
- Document the discussion with management and consider whether a misstatement is material; communicate with those charged with governance.