This part relates to a complete explanation of IFRS 15 Revenue from contracts with customers in respect of Engineering & Construction contracts, see https://annualreporting.info/revenue-from-engineering-construction-contracts/.
Once the performance obligations are identified and the transaction price has been determined, IFRS 15 requires (with some exceptions, as discussed below) an entity to allocate the transaction price to the performance obligations in proportion to their stand-alone selling prices (i.e., on a relative stand-alone selling price basis).
To allocate the transaction price on a relative stand-alone selling price basis, an entity must first determine the stand-alone selling price (i.e., the price at which an entity would sell a good or service on a stand-alone basis at contract inception) for each performance obligation. The observable price of a good or service sold separately provides the best evidence of stand-alone selling price.
However, in many situations, stand-alone selling prices will not be readily observable. In those cases, the entity estimates the stand-alone selling price.
The standard discusses three estimation methods: (1) the adjusted market assessment method; (2) the expected cost plus a margin method; and (3) the residual method. However, these are not the only estimation methods permitted.
The standard allows an entity to use any reasonable estimation method (or combination of methods), as long as it is consistent with the notion of a stand-alone selling price, maximises the use of observable inputs and is applied consistently in similar circumstances.
Under the relative stand-alone selling price method, once an entity determines the stand-alone selling price for the performance obligations in a contract, the entity allocates the transaction price to those performance obligations, based on the proportion of the stand-alone selling price of each performance obligation, to the sum of the stand-alone selling prices of all of the performance obligations in the contract. The following example illustrates this allocation:
|Allocating revenue to performance obligations|
Contractor Z enters into an arrangement to build a retail shopping centre and detached car park for CU60 million. Assume that Contractor Z determines that the building and car park each represent performance obligations.
To allocate the transaction price to the two performance obligations, Contractor Z must first determine the stand-alone selling price of the shopping centre and car park. Contractor Z builds similar structures on a regular basis and determines that the stand-alone selling prices of the shopping centre and car park are CU54 million and CU10 million, respectively. Contractor Z allocates the CU60 million transaction price on a relative basis as follows:
Shopping centre: CU50.63 million [(CU54 million / CU64 million) x CU60 million]
Car park: CU9.37 million [(CU10 million / CU64 million) x CU60 million]
Contractor Z recognises revenue allocated to each performance obligation based on the selected measure of progress for each.
Exceptions to the relative stand-alone selling price method
IFRS 15 requires an entity to use the relative stand-alone selling price method to allocate the transaction price, with two specific exceptions. The first exception requires an entity to allocate a discount in a contract only to the specific goods or services to which it relates, rather than proportionately to all of the separate performance obligations if certain criteria are met.
The second exception requires variable consideration to be allocated entirely to a specific part of a contract (such as one or more (but not all) performance obligations or one or more (but not all) distinct goods or services promised in a series of distinct goods or services that forms part of a single performance obligation), if both of the following criteria are met:
The terms of a variable payment relate specifically to the entity’s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service).
Entities that provide project management or engineering services may be able to allocate variable consideration to the period in which the related services were performed if certain criteria are met.
Allocating the variable amount of consideration entirely to the performance obligation or the distinct good or service is consistent with the standard’s overall objective of allocating revenue in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer.
An E&C entity that determines that a contract contains multiple performance obligations may use this exception if it concludes that variable consideration relates only to one performance obligation (or more than one, but not all performance obligations). For example, ‘Modification of a construction contract‘ describes a contract in which the contractor determined that the construction of manufacturing and storage facilities represented separate performance obligations. If the contract included an incentive fee for completing construction of the manufacturing facility ahead of schedule, the entity would allocate consideration from that incentive fee to the performance obligation representing the construction of the manufacturing facility alone (provided the contractor determined the total consideration allocated to this performance obligation depicts the amount to which it is entitled).
In addition, E&C entities that provide project management, construction supervision or engineering services that are a series of distinct services that form part of a single performance obligation may be able to use this exception and, thereby, allocate variable consideration to distinct services within the series, if the above criteria are met. That is, an entity may receive variable consideration that relates specifically to an entity’s efforts to transfer services for a certain period within a single performance obligation (e.g., a day, a month or a quarter) that are distinct from the services provided in other periods within the performance obligation. If the criteria are met, the entity will be required to allocate that variable consideration only to those distinct periods, instead of allocating it to all distinct services within the series.
The following example illustrates the application of the second exception related to variable consideration by an engineering services entity that determines that the services it is providing represent a single performance obligation:
Engineering services with variable consideration
On 1 January 2018, Engineer Co. X enters into a one-year contract with a government agency to provide engineering consultation services for a sewer project. Engineer Co. X receives a fee of CU100 for each hour incurred (i.e., variable consideration based on effort expended).
Assume that Engineer Co. X concludes that the management services are a single performance obligation recognised over time because they are determined to be a series of distinct services that are substantially the same and that have the same pattern of transfer to the customer.
Engineer Co. X determines that the transaction price is allocated to the services provided within each reporting period because the hours incurred during the period relate specifically to the entity’s efforts to satisfy the performance obligation and the allocation is consistent with the objective of allocating an amount that depicts the consideration to which the entity expects to be entitled in exchange for transferring the promised services.
For example, if Engineer Co. X provided 800 hours of services during the first quarter of 2018, revenue of CU80,000 (800 hours x CU100 per hour) would be recognised in the quarter ending 31 March 2018.
E&C entities will need to evaluate their contracts to determine whether this allocation exception will apply to contracts that are based on an hourly rate, including contracts that an entity concludes contain only one performance obligation. Some entities may find that applying the exception (and,
However, certain contracts may contain multiple forms of consideration that relate to a single performance obligation. For example, a contract could also include a fixed fee that would generally be recognised over the term of the contract using the entity’s selected measure of progress (e.g., time elapsed, hours incurred), which may differ from the pattern in which the variable consideration is earned and therefore recognised under the contract.
Changes in transaction price after contract inception
Changes in the total transaction price are allocated to the separate performance obligations on the same basis as the initial allocation. Stand-alone selling prices are not updated after contract inception.
However, if the contract is modified, the contract modification requirements discussed in Identify the contract with the customer must be followed. Depending on the facts and circumstances, the application of modification requirements could result in a need to update the stand-alone selling prices. Changes in the transaction price resulting from the modification would also be subject to those requirements.
When contracts include variable consideration, it is possible that changes in the transaction price that arise after a modification may (or may not) be related to performance obligations that existed before the modification. For changes in the transaction price arising after a contract modification, when contract modification was not treated as a separate contract, an entity must apply one of the following approaches:
- If the change in transaction price is attributable to an amount of variable consideration promised before the modification, and the modification was considered a termination of the existing contract and the creation of a new contract, the entity allocates the change in transaction price to the performance obligations that existed before the modification.
- In all other cases, the change in the transaction price is required to be allocated to the performance obligations in the modified contract (i.e., the performance obligations that were unsatisfied and partially unsatisfied immediately after the modification).