Construction contract modifications

Construction contract modifications – Ever heard of a constructing a major new building, large bridge, metro railway or other significant construction project without contract modifications? Especially in the large urban agglomerations in this world….. Well then look at this: Construction contract modificationsConstruction contract modifications Construction contract modifications

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How to account for variations and claims under the construction contract?

IFRS 15 does not include explicit guidance on accounting for contract variations and claims. Instead, it includes general guidance on contract modifications and other changes in the transaction price, which applies to all industries. [IFRS 15 18–21] But it works…. Construction contract modifications

In summary

Contract modifications (e.g. variations) are required to be approved to be recognised.

Approved modifications where a change in price has not been agreed are accounted for under the guidance in relation to variable consideration,

Revenue from claims is required to be accounted for as variable consideration. Claims are included in revenue only when it is highly probably that revenue will not reveres in the future.

What does it mean

IFRS 15’s requirement for a contract modification to be approved appears to be a higher threshold than under IAS 11.

This new requirement may result in revenue from contract modifications being recognised later under IFRS 15 than would have been the case under IAS 11.

This change in requirement reflects the general approach of IFRS 15 that an entity accounts for the enforceable rights and obligations arising under contracts.

In many cases, a change in scope may be approved, but the change in price may not. In these cases, measurement of revenue will be governed by the guidance on variable consideration which means that even where approval for the modification has been obtained, the price change will be included in revenue only when ir is ‘highly probable’ that there will be no significant revenue reversal in the future.

Changes in the scope and/or price of a construction contractConstruction contracts - Measuring progress Construction contracts - Measuring progress

IFRS 15 defines a contract modification as a change in the scope or price (or both) of a contract that is approved by the parties to the contract.

If there is a modification to a construction contract, then an entity applies the following steps. Construction contract modifications

  1. The entity considers whether the change is approved. A contract modification could be approved in writing, by oral agreement or implied by customary business practices. If the modification is not approved, then the parties continue to account for the existing contract under IFRS 15. If the parties to a contract have approved a change in the scope of the contract but have not yet determined the corresponding change in price (e.g. an unpriced change order), then the entity estimates the change in price in accordance with guidance on variable consideration. Construction contract modifications
  2. The entity considers whether a modification should be accounted for as a separate contract. Typically, claims and variations in a traditional construction contract context will not be accounted for as separate contracts. This is because such claims and variations do not add a distinct good or service to the contract, as additional goods or services tend to be highly inter-related with the original contract. Construction contract modifications
  3. If this is the case, and the construction contract qualifies for over time revenue recognition, then the entity re-estimates both the total contract price and the stage of the completion of the contract. This may require the entity to adjust the cumulative revenue recognised to date.
  4. The entity continues to account for the contract, by reference to the stage of completion as modified and the new contract price. Note that if the approved new contract price is variable, then the entity applies the guidance on variable consideration. Construction contract modifications

Contract modifications

A contract modification is a change in the scope or price (or both) of a contract. An entity must determine whether the modification creates a new contract or whether it will be accounted for as part of the existing contract. The determination of a new and separate contract is driven by whether the modification results in the addition of distinct goods or services, priced at their stand-alone selling prices. Construction contract modifications

Parties to E&C arrangements frequently agree to change orders that modify the scope or price (or both) of a contract. Contractors also regularly submit claims to customers when unanticipated additional costs are incurred as a result of delays, errors or changes in scope caused by the customer. IFRS 15 states that “a contract modification exists when the parties to a contract approve a modification that either creates new, or changes existing, enforceable rights and obligations of the parties to the contract”. Approvals of a modification may be written, oral or implied by the entity’s customary business practices. Construction contract modifications

Generally, if a contract modification has not been approved, IFRS 15 is not applied to the modification until the approval occurs. However, the standard also states that an entity may have to account for a contract modification prior to the parties reaching final agreement on changes in scope or pricing (or both). Construction contract modifications

Instead of focusing on the finalisation of a modified agreement, these requirements focus on the enforceability of the changes to the rights and obligations in the contract. That is, once the entity determines that the revised rights and obligations are enforceable, the entity is required to account for the contract modification. Construction contract modifications

If the parties to a contract have approved a change in the scope of the contract, but have not yet determined the corresponding change in price, an entity will have to estimate the change to the transaction price arising from the modification in accordance with the requirements for estimating variable consideration. Construction contract modifications

The standard provides the following example to illustrate this point: Construction contract modifications

Contract modifications that add distinct goods or services at their stand-alone selling prices are treated as separate contracts. Construction contract modifications

Extract from IFRS 15
Example 9 — Unapproved Change in Scope and Price (IFRS 15 IE42-IE43)

An entity enters into a contract with a customer to construct a building on customer-owned land. The contract states that the customer will provide the entity with access to the land within 30 days of contract inception.

However, the entity was not provided access until 120 days after contract inception because of storm damage to the site that occurred after contract inception. The contract specifically identifies any delay (including force majeure) in the entity’s access to customer-owned land as an event that entitles the entity to compensation that is equal to actual costs incurred as a direct result of the delay. The entity is able to demonstrate that the specific direct costs were incurred as a result of the delay in accordance with the terms of the contract and prepares a claim. The customer initially
disagreed with the entity’s claim.

The entity assesses the legal basis of the claim and determines, on the basis of the underlying contractual terms, that it has enforceable rights. Consequently, it accounts for the claim as a contract modification in accordance with IFRS 15 18 – 21. The modification does not result in any additional goods and services being provided to the customer.

In addition, all of the remaining goods and services after the modification are not distinct and form part of a single performance obligation. Consequently, the entity accounts for the modification in accordance with IFRS 15 21(b) by updating the transaction price and the measure of progress towards complete satisfaction of the performance obligation. The entity considers the constraint on estimates of variable consideration in IFRS 15 56 – 58 when estimating the transaction price.

Once an entity has determined that a contract has been modified (e.g., because of a change order or claim), the entity has to determine the appropriate accounting for the modification. Certain modifications are treated as separate stand-alone contracts, while others are combined with the original contract and accounted for in that manner.

An entity is required to account for a contract modification as a separate contract, with no effect on the original contract, if:
(i) The scope of the contract increases because of the addition of promisedgoods or services that are distinct
And
(ii) The price of the contract increases by an amount of consideration that reflects the entity’s stand-alone selling prices of the additional promised goods or services

In these circumstances, the stand-alone selling prices of the additional goods or services may include adjustments that reflect the circumstances of the particular contract (e.g., a discount provided to a customer because materials and equipment needed for a change order are already on site). See Modification of a construction contract below for an example.

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If a contract modification is not accounted for as a separate contract, an entity would account for the promised goods or services not yet transferred at the date of the contract modification (including those in the original contract) in whichever of the following ways is applicable: Construction contract modifications

  • A termination of the old contract and the creation of a new contract (i.e., on a prospective basis), if the remaining goods and services after the contract modification are distinct, but the consideration does not reflect the stand-alone selling price of those goods or services. See Modification of a construction contract below.
  • A continuation of the original contract if the remaining goods and services to be provided after the contract modification are not distinct (and, therefore, form part of a single performance obligation that is partially satisfied at the date of modification). Such modifications are accounted for on a cumulative catch-up basis. See Modification of a construction contract below.
  • Finally, a change in a contract may also be treated as a combination of the two: a modification of the existing contract and the creation of a new contract. In this case, an entity would not adjust the accounting for completed performance obligations that are distinct from the modified goods or services.

However, the entity would adjust revenue previously recognised (either up or down) to reflect the effect of the contract modification on the estimated transaction price allocated to performance obligations that are not distinct from the modified portion of the contract and the measure of progress. Construction contract modifications

The requirement to determine whether to treat a change in contractual terms as a separate contract or a modification to an existing contract is generally consistent with current requirements in IAS 11. For example, IAS 11 requires that a contract modification that includes the construction of an additional asset be treated as separate construction contract when certain criteria are met (e.g., when the asset differs significantly from the assets covered by the original contract or the price of the asset is negotiated without regard to the original contract price).

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When assessing how to account for a contract modification, an entity must consider how any revisions to promised goods or services interact with the rest of the contract. That is, although a change order may add a new good or service that would be distinct in a stand-alone transaction, the new performance obligation may not be distinct in the context of the modified contract. For example, in a building construction project, a customer may request a change order to add an additional floor. Construction contract modifications

The construction entity may commonly perform construction services to add a new floor to an existing, completed building, which would likely be considered a distinct service in those contracts. However, when that service is added to an existing contract (e.g., a contract to construct the entire building) and the entity has already determined that the entire project is a single performance obligation, the added goods and services would normally be combined with the existing bundle of goods and services. Construction contract modifications

The following example illustrates an entity’s potential analysis of the accounting treatment for a contract modification: Construction contract modifications

Modification of a construction contract

Contractor E agrees to construct a manufacturing facility on a customer’s land for CU10 million. During construction, the customer determines that a separate storage facility is needed at the location. The parties agree to modify the contract to include the construction of the storage facility, to be  completed within three months of complConstruction of a residential homeetion of the manufacturing facility, for a total price of CU11 million.

Scenario A

When the contract is modified, an additional CU1 million is added to the consideration that Contractor E will receive. Contractor E would normally charge CU1.1 million to construct a similar facility. However, much of the equipment and labour force necessary to complete construction of the storage  facility is already onsite and available for use by Contractor E. Therefore, the additional CU1 million reflects the stand-alone selling price at contract modification, adjusted for the particular circumstances of the contract.

Assuming that Contractor E determines that the construction of the separate storage facility is a distinct performance obligation, the contract modification for the additional storage facility would be, in effect, a new (separate) contract that does not affect the accounting for the existing contract.

Scenario B

As in Scenario A, the contract is modified when Contractor E agrees to build the storage facility and the customer agrees to pay an additional CU1 million. Again assume that Contractor E  determines that the construction of the separate storage facility is a distinct performance obligation. However, Contractor E determines that it would normally charge CU1.5 million to construct a similar facility.

While Contractor E can attribute some of the discount to its ability to use equipment and labour resources that are already on site, the price reduction was primarily driven by other factors (such as Contractor E’s desire to maintain the customer relationship and keep its resources deployed). Therefore, the additional CU1 million does not reflect the stand-alone selling price at contract modification.

Assume that Contractor E concludes that it transfers control of each facility over time. As a result, Contractor E accounts for the modification as a modification of the existing contract . The revised transaction price of CU11 million is allocated between the two performance obligations in the modified contract (being the original incomplete performance obligation to construct the manufacturing facility and the new performance obligation to construct the storage facility).

The transaction price is allocated based on the relative stand-alone selling prices of each performance obligation (see Section 7). Any revenue previously recognised for the manufacturing facility is adjusted on a cumulative catch-up basis to reflect the allocated transaction price. Revenue from the construction of the storage facility (i.e., a separate performance obligation) is recognised based on the appropriate measure of progress.

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In practice, a contractor that is already performing work on a project may have leverage that provides it with the ability to charge a higher price for a change order than it otherwise would if the activities were performed on a stand-alone basis. This may be because, for example, the customer does not enter into an open bidding process for each individual change order. In these circumstances, determining whether the consideration from the modification reflects the stand-alone selling price of the activities will require significant judgement.

Link between construction contract modifications and construction variable consideration

In construction contract modifications in many cases, a change in scope may be approved, but the change in price may not. In these cases, measurement of revenue will be governed by the guidance on variable consideration which means that even where approval for the modification has been obtained, the price change will be included in revenue only when it is ‘highly probable’ that there will be no significant revenue reversal in the future. Construction contract modifications

General model of measurement of insurance contracts

Construction contract modifications

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