Revenue Recognition on a Construction Contract
Tembo Builders Ltd has a fixed-price contract to construct a warehouse for KES 48m over 18 months. At the end of year 1, costs incurred are KES 20m and costs to complete are reliably estimated at KES 16m. The client has paid KES 15m in progress payments, and Tembo has billed KES 18m. The finance officer has recorded revenue of KES 18m (equal to amounts billed) and a receivable of KES 18m less cash received. The auditor queries this. Separately, a variation order for extra foundation work worth KES 3m has been verbally agreed by the client's site engineer but not signed; Tembo's managing director insists it should be recognised because 'the work is done'. Tembo also has a KES 2m retention held by the client until practical completion.
1. Determine the correct revenue and profit to recognise in year 1, and explain why the finance officer's approach is wrong.
Read the worked answer
Why billing-based revenue is wrong Revenue is not the same as amounts billed. Billing reflects contractual payment milestones, which may run ahead of or behind the work performed. Recognising revenue equal to billings misstates performance and creates a receivable that may not represent an enforceable right to consideration.
Percentage-of-completion (input method, cost-to-cost)
- Total expected cost = 20m incurred + 16m to complete = 36m
- Progress = 20/36 = 55.6%
- Total expected profit = 48m − 36m = 12m
- Revenue = 55.6% × 48m = KES 26.67m
- Cost recognised = 20m
- Gross profit = KES 6.67m (55.6% × 12m)
Contract asset/liability, not a plain receivable
- Revenue recognised 26.67m vs billed 18m → Tembo has a contract asset of KES 8.67m (unbilled work), not a receivable of 18m.
- Cash received 15m against billings 18m → a separate receivable of KES 3m for billed-but-unpaid amounts.
- The two must be presented separately; netting them hides the unbilled exposure.
Retention The KES 2m retention is not a deduction from revenue. It is a receivable (or contract asset) that is released at practical completion; it affects timing of cash, not the amount of revenue.
2. Advise on the KES 3m variation order and on what the auditor should require before the financial statements are finalised.
Read the worked answer
Variation order - the judgement A verbal instruction from a site engineer is weak evidence. Recognition requires that it is probable the client will approve the variation and that the amount can be reliably measured. The site engineer may lack authority to bind the client to KES 3m.
Recommended treatment:
- Do not recognise the KES 3m in revenue unless there is documentary evidence of authority and likelihood of approval (e.g., a signed instruction, correspondence confirming scope, or a history of the client honouring such instructions).
- If evidence is marginal, disclose the variation as a contingent asset rather than recognise it.
- If the cost of the extra foundation work has already been incurred and included in the KES 20m, check that this does not inflate progress on the original contract. Strip variation costs and variation revenue consistently, or include both only when recognition criteria are met.
What the auditor should require
- A signed variation order or written confirmation from an authorised client representative.
- Management's documented assessment of the probability of recovery.
- Recalculation of the cost-to-complete estimate - a 16m estimate is a key judgement; obtain the quantity surveyor's report.
- Evidence of the client's ability to pay the contract asset.
- Confirmation that the contract shows no expected loss (if costs to complete rise, an onerous contract provision is required immediately, not spread over the contract).
- Written representations from management on the variation and on estimates to complete.