Revenue on Invoice, VAT on Signature, and a Bank Covenant
Tembo Systems Ltd, a Kenyan software company with a 31 December year end, signed a contract on 1 January 2025 with a county government for KES 36 million, invoiced in full on signing and paid within 30 days. The contract covers a three-year right to use Tembo's revenue-collection platform, a four-month implementation and data-migration service, and three years of support. Standalone selling prices are KES 18 million for the licence, KES 9 million for implementation and KES 12 million for support. Separately, Tembo carries plant with a carrying amount of KES 40 million whose tax written-down value is KES 28 million, and has recognised a KES 5 million warranty provision that will be deductible only when paid. The finance director, under pressure from a bank covenant measuring revenue, wants to recognise the whole KES 36 million in 2025. Corporation tax is 30% and VAT is 16%.
1. Apply IFRS 15 and state the revenue to be recognised in 2025 and the closing contract liability.
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Step 1 - Identify the performance obligations
The licence, the implementation and the support are each capable of being distinct and distinct within the context of the contract (the platform operates without Tembo's further work; implementation could be performed by another supplier; support is a separate service). Three obligations.
Step 2 - Allocate the transaction price on relative standalone selling prices
Total SSP = 18 + 9 + 12 = KES 39m. Allocation of the KES 36m price:
- Licence: 36 × 18/39 = 16.615m
- Implementation: 36 × 9/39 = 8.308m
- Support: 36 × 12/39 = 11.077m
- Total 36.000m
Step 3 - Recognise when each obligation is satisfied
- Licence: a right to use, recognised at a point in time on delivery - 16.615m in 2025.
- Implementation: a service performed over four months, all within 2025 - 8.308m in 2025.
- Support: over 36 months - 11.077/3 = 3.692m in 2025; 3.692m in 2026 and 2027.
Answer
- 2025 revenue = 16.615 + 8.308 + 3.692 = KES 28.615m
- Closing contract liability at 31 December 2025 = 11.077 − 3.692 = KES 7.385m
Recognition is driven by transfer of control, not by invoicing or by collection. The KES 7.385m is a liability to provide support, not revenue, however the bank covenant is drafted.
2. Quantify deferred tax at 31 December 2025 and explain why the VAT is not a timing difference.
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Temporary differences
| Item | Carrying amount | Tax base | Difference | Tax @30% |
|---|---|---|---|---|
| Plant | 40.0 | 28.0 | 12.0 taxable | DTL 3.60 |
| Warranty provision | 5.0 | 0 | 5.0 deductible | DTA 1.50 |
| Net | DTL 2.10 |
- Plant: capital allowances have run ahead of accounting depreciation, so tax has been deferred - a taxable temporary difference.
- Warranty provision: a liability with a tax base of nil because the deduction arises only on payment - a deductible temporary difference. The DTA is recognised because future taxable profit is expected (the contract backlog supports it); if it were not, it would be impaired.
- Contract liability of 7.385m: this is not automatically a temporary difference. If the tax computation follows accounting revenue (accrual), both carrying amount and tax base are nil-effect. If the whole KES 36m was taxed on receipt, a deductible difference of 7.385m arises and a DTA of 2.216m should be added - the point must be resolved against the actual tax computation, not assumed.
Why VAT is different
VAT is a tax collected on behalf of the revenue authority, not an income or an expense of the company. It therefore creates no temporary difference and no deferred tax. Its issue is purely timing of payment: with the invoice issued at signing, output VAT of 36 × 16% = KES 5.76m falls due for that tax period (payable by the 20th of the following month), even though only 28.615m of revenue is recognised. That is a genuine cash-flow cost of the invoicing arrangement and should be raised with the finance director.
3. Draft the secretary's response to the finance director, addressing the covenant request and the ethical position, with a practical alternative.
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Position
The request is to recognise KES 36m in 2025 - KES 7.385m more than IFRS 15 permits - because the contract is invoiced and paid. Invoicing is not the criterion. Recognising revenue that has not been earned, in order to move a covenant test, is not an accounting judgement; it is a misstatement made with intent.
Consequences the director must weigh
- Audit. The auditor will test the three obligations; a qualification or an uncorrected misstatement reported to those charged with governance follows, and the audit committee must be told.
- Directors' duties. Approving financial statements that do not show a true and fair view is a breach of duty and potentially an offence; the CEO and FD sign, and the secretary certifies the process.
- The covenant itself. A breach obtained by misstating revenue is worse than the original breach: it is a default and a misrepresentation to the lender, which normally triggers acceleration.
- Downstream. VAT of KES 5.76m is already due; tax filings built on the inflated figure will not reconcile.
Practical alternatives
- Disclose the KES 36m contract and its backlog to the bank and seek a covenant reset or waiver, presenting the three-year cash flow - support and licence renewals are recurring revenue and the bank will value them.
- Offer the bank a different, genuinely favourable metric: cash collected, contract backlog, or net debt to EBITDA.
- Accelerate cash, not revenue: milestone billing on implementation, an advance on support, or invoice discounting.
Process: put the disagreement in writing to the audit committee and the chair, with the accounting analysis attached. If overruled, ensure the dissent is minuted - the secretary's protection, and the company's, lies in the record.