Revenue recognition on a variable-price construction contract
Nile Delta Contracting S.A.E. signed a fixed-price contract in January 2025 to build a warehouse for North Coast Development for EGP 48,000,000. Total estimated cost is EGP 40,000,000, and the work is performed on land owned by the customer. At 31 December 2025 costs incurred are EGP 24,000,000, matching the cost-based stage of completion of 60%. Two price issues are open. First, the contract contains a steel escalation clause: if the published steel index exceeds the base by more than 12%, the contractor recovers 50% of the excess, capped at EGP 3,000,000. The index published in November 2025 is 20% above base, giving an entitlement of EGP 2,000,000, not yet certified. Second, the customer engineer instructed a mezzanine floor by email and site minutes; the cost is EGP 1,500,000 but no price has been agreed and no formal variation order signed. The engineer has certified EGP 25,000,000, the client has paid EGP 21,000,000, and 5% retention is withheld from each certificate. The CFO recognised revenue of EGP 28,800,000 and expensed the mezzanine cost.
1. Does the contract qualify for revenue recognition over time, and what is the appropriate measure of progress? Explain how the escalation clause and the mezzanine floor should affect the transaction price at 31 December 2025.
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The contract qualifies for over-time recognition. The asset is built on customer-owned land and the customer controls the work in progress; alternatively, the asset has no alternative use to Nile Delta and the contract gives an enforceable right to payment for performance completed to date, including a reasonable margin. Progress should be measured using an input method, cost-to-cost, because costs incurred correlate with the transfer of value: 24,000,000 / 40,000,000 = 60%.
Variable consideration is estimated using the expected value or most likely amount and included only to the extent that it is highly probable that a significant reversal will not occur. The escalation amount is contractual, formula-based and supported by a published index, so the EGP 2,000,000 is highly probable and should be included; the cap is respected. The mezzanine floor is a variation for which no price has been agreed. Under the revenue standard, a modification is accounted for only when the parties have approved it and it creates enforceable rights and obligations. An email instruction and site minutes may evidence that work was requested, but without an agreed price the entity should not recognise the EGP 1,500,000 in the transaction price unless it has convincing evidence of an enforceable cost-plus entitlement. Constrain the variation to zero for now. The cost of EGP 1,500,000 should be expensed unless it meets the costs-to-fulfil criteria and is probable of recovery; if recovery is not probable, expensing is correct.
2. Compute revenue, cost of sales and gross profit for 2025, and show the contract asset or liability, the receivable and the retention amount at 31 December 2025. State any assumption.
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Assuming the EGP 2,000,000 escalation is highly probable and the variation is constrained to zero, the transaction price is EGP 48,000,000 + EGP 2,000,000 = EGP 50,000,000. Revenue = 60% x 50,000,000 = EGP 30,000,000. Cost of sales = EGP 24,000,000. Gross profit = EGP 6,000,000.
The engineer has certified EGP 25,000,000. The contract asset for unbilled work is revenue less amounts certified: 30,000,000 - 25,000,000 = EGP 5,000,000. The 5% retention on certified work is 25,000,000 x 5% = EGP 1,250,000, withheld from the certificate. Cash received is EGP 21,000,000, so the net receivable is 25,000,000 - 1,250,000 - 21,000,000 = EGP 2,750,000. Present the EGP 1,250,000 retention separately if it is not yet due, and assess its recoverability. If the escalation were not considered highly probable, revenue would be EGP 28,800,000 and the contract asset EGP 3,800,000.
3. Prepare the year-end adjusting journal entries, with narrations, and assess whether the CFO treatment is acceptable. Include the treatment of the mezzanine cost.
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Adjusting entries, assuming the costs incurred and the certifications are already recorded:
To increase revenue for the probable escalation: Dr Contract asset 1,200,000; Cr Revenue 1,200,000. This adjusts revenue from 28,800,000 to 30,000,000.
To present certified amounts: Dr Receivable 25,000,000; Cr Contract asset 25,000,000. If bills were already issued, reverse the existing billing entry and present the net contract asset of 5,000,000.
To record cash and retention: Dr Cash 21,000,000; Dr Retention receivable 1,250,000; Cr Receivable 22,250,000. The remaining receivable is 2,750,000.
Mezzanine cost: if the entity concludes there is an enforceable right to recovery, Dr Contract cost asset 1,500,000; Cr Cost of sales 1,500,000, then test the asset for recoverability. If recovery is not probable, no entry; the cost remains expensed.
The CFO treatment is not acceptable if it ignores a highly probable escalation; revenue is understated by EGP 1,200,000. The treatment of the mezzanine cost depends on enforceability and recoverability. The financial statements should also disclose the variable consideration, the judgement over the unapproved variation, and the retention terms.