Construction contract – How 2 best account for it in IFRS 15

Construction contract provides an overview for construction contracts previously accounted under IAS 11 Construction contracts under IFRS 15 Revenue from contracts with customers. The core accounting treatment between IAS 11 and IFRS 15 is similar, but as always the devil is in the details… – give it a shot!

Under IFRS 15 revenue recognition is handled under a (generic) 5-step model, as follows:Construction contract

  1. Identify contract with the customer;
  2. Identify the performance obligations in the contract;
  3. Determine the transaction price;
  4. Allocate the transaction price to the performance obligations in the contract;
  5. Recognize revenue when (or as) an entity satisfy a performance obligation.

A construction contract is a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependence in terms of their design, technology and function or their ultimate purpose or use.

A contract may be a single contract like construction of a bridge or dam and can be a contract for a series of contracts, which are closely interrelated or interdependent in terms of design, technology or construction. Construction contracts include contracts for rendering of services and destruction/restoration of assets.

A construction contract provides a legal binding agreement, for both the owner and the builder,  that the executed job will receive the specific amount of compensation or how the compensation will be distributed. There are several types of construction contracts used in the industry, but there are certain types of construction contracts preferred by construction professionals.

A contractor is an entity that performs construction work pursuant to a construction contract.

Lump Sum or Fixed Price Contract Type

This contract shall be used when the risk needs to be transferred to the builder and the owner wants to avoid change orders for unspecified work. However, a contractor must also include some percentage cost associated with carrying that risk. These costs will be hidden in the fixed price. On a lump sum contract, it is harder to get credit back for work not completed, so consider that when analysing your options.

Cost Plus Contracts

Cost plus contracts are used when the scope has not been clearly defined and it is the owner responsibility to establish some limits on how much the contractor will be billing. When some of the aforementioned options are used, those incentives will serve to protect the owner’s interest and avoid being charged for unnecessary changes. Be aware that cost-plus contracts are difficult or harder to track and more supervision will be needed, normally do not put a lot of risk in the contractor. The most common are:

  • Cost Plus Fixed Percentage
  • Cost Plus Fixed Fee
  • Cost Plus with Guaranteed Maximum Price Contract
  • Cost Plus with Guaranteed Maximum Price and Bonus Contract
Something else -   Contingent

Time and Material Contracts When Scope is Not Clear

Time and material contracts are usually preferred if the project scope is not clear, or has not been defined. The owner and the contractor must establish an agreed hourly or daily rate, including additional expenses that could arise in the construction process.

Unit Pricing Contracts

By providing unit prices, the owner can easily verify that he’s being charged with un-inflated prices for goods or services being acquired. Unit price can easily be adjusted up and/or down during scope changes, making it easier for the owner and the builder to reach into agreements during change orders.

Example: Construction contract under IFRS 15

Construction company ABC signs a contract in June 20X1 to refurbish a building and install new windows with window blinds (let’s call it “windows”). The total contract price is CU 12 million.

Total expected contract costs are:Construction contract

  • CU 6 million for windows (purchased from external suppliers);
  • CU 4 million for labor, materials and other costs related to the project.

As of 31 December 20X1:

  • ABC handed over windows to the client, although the installation has not been completed. However, the client obtained control of windows.
  • Other costs incurred to 31 December were CU 1 million

Just before the year-end, the client paid the first progress payment of CU 8 million

How should ABC account for this contract as of 31 December 20X1 in line with IFRS 15?

Let’s follow the 5 steps for the revenue recognition.

Step 1: Identify the contract with a customer

It is very clear now, we have the explicit contractual agreement between ABC and a customer. In the construction industry this is certainly the most easy step to take. The contracts are most of the time about significant amounts to a family, first-time owners or a business building the first, second or so factory. So it is significant to the customer but mostly also to the supplier, building one family home is not always done by larger construction companies and so on.

Step 2: Identify the performance obligations in the contract

You need to identify not only individual goods and services promised in the contract, but also determine whether they are distinct or not.

Again, I will not go into theory explanations here, you can learn about distinct non distinct here.

If the goods and services are not distinct, they can’t be provided one without the other one (this is very simplified explanation) and thus they must be treated as ONE single performance obligation.

According to ABC’s assessment, the reparation services, windows and installation of windows are ONE single performance obligation.

Most construction contracts will contain just ONE performance obligation, because the contract would be to build or construct something for the customer and is negotiated as a whole package where a customer has no choice than to get the full package from the supplier.

Sometimes it’s not true and you will have TWO or more performance obligations there.

Something else -   IFRS 15 Measuring progress to completion - Best complete explanation

In this case you must adjust your accounting accordingly as explained below.

Step 3: Determine the transaction price

The transaction price in ABC’s contract is CU 12 million.

This is clear, but in reality, you can have some variability involved, like progress or performance bonuses.

You should take these estimates into account, too based on their probability.

Step 4: Allocate the transaction price to the individual performance obligations

This is very easy here, because as ABC assessed in the step 2, there is just ONE single performance obligation and thus the whole transaction price is allocated to this ONE obligation.

If there would had been more than one performance obligations, then ABC would need to allocate the transaction price to them based on their relative stand-alone selling prices.

Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation

You should remember that the performance obligation can be satisfied either:

  • At the point of time; or
  • Over time.

The standard IFRS 15 lists a few criteria when a performance obligation is satisfied over time:

If you meet just one of these criteria, then the performance obligation is satisfied over time.

In most construction contracts, the performance obligations are satisfied over time and NOT at the point of time (although exceptions might exist).

In this case, you need to recognize revenue based on the progress towards completion.

How to measure progress towards completion?

You can use either input or output methods to measure the progress towards completion.

ABC uses input method, i.e. based on costs incurred to date.

Also, let me warn you about one significant factor specific especially for construction contracts:

There may be no direct relationship between your inputs and the transfer of control of goods or services to a customer.

Therefore, you should exclude the effects of any inputs from input method that do not depict your performance in transferring control of goods or services to the customer (par. B19 of IFRS 15).

Translated to human language and applied to this example:

ABC believes that costs of windows are significant item within total costs and including these costs to measure the progress to completion would not be appropriate, because it would certainly overstate ABC’s performance.

The reason is that the windows are purchased from the third party and the transfer of windows to the customer has no direct relationship with the other ABC’s work.

Therefore, progress towards completion will be measured excluding the cost of windows.

Carefully, because you should apply the resulting percentage of completion to the revenues excluding windows, too – just for the consistency!

Let’s measure the progress towards completion:

  • Total costs excluding windows: CU 4 million
  • Total incurred costs to date excluding windows: CU 1 million
  • Progress to completion: CU 1/CU 4 = 25%
  • Total contract revenue excluding windows: CU 6 million (CU 12 – CU 6)
  • Total revenue to 31 December 20X1 excluding windows: CU 6 million x 25% = CU 1.5 million

Journal entries at 31 December 20X1

As ABC handed over windows and excluded them from measurement of progress towards completion due to potential overstatement, the revenue from sale of windows is recognized at the time of their delivery.

Something else -   IFRS 15 Revenue aggregation and disaggregation at best

Purchase of windows by ABC (at the time of delivery from the supplier) (Amounts in CU):

Inventory – windows project 6,000,000
Trade creditors 6,000,000

ABC recognizes the revenue for windows at zero profit margin (equal to their cost – in line with IFRS 15 B19(b)):

Contract asset – windows project 6,000,000
Revenue from construction project 6,000,000

Not the revenue from sale of windows – remember, the whole project is one performance obligation and we recognize the revenue under 1 performance obligation in this case.

Cost of construction in profit or loss 6,000,000
Inventory – windows project 6,000,000
The remaining cost/revenues:

Labor costs, materials, etc. to complete the contracts are accounted for as contract costs (at the time when they are actually incurred):

  • Costs to paint the building:
    • Debit Contract costs (asset in balance sheet);
    • Credit Employees
    • Credit Suppliers or
    • Credit whatever is also relevant
  • Use of paints:

At 31 December 20X1, ABC needs to amortize the contract costs based on progress towards completion.

As the progress is measured by input method (incurred costs), all costs incurred to date are amortized.

However if different method is used to measure the progress to completion, then the company can amortize the cost based on the progress percentage.

In this case, at 31 December 20X1:

Cost of construction in profit or loss 1,000,000
Contract costs 1,000,000

Let’s recognize the revenue from “remaining” services (all except for windows).

We measured these revenues at CU 1.5 million using the progress towards completion (see above).

Journal entry is:

Contract asset 1,500,000
Revenue from construction project 1,500,000

Finally, we need to account for the progress payment of CU 8 million made by the customer at the year-end:

Trade receivables ( followed by receipt in bank account, cash…) 8,000,000
Contract assets 8,000,000

Let’s check the contract asset now. Its balance at 31 December 20X1 is:

As the contract asset is negative at the end of 31 December 20X1, it became a contract liability and it should be presented within liabilities in the statement of financial position.

See also:

Construction contract

Construction contract

Construction contract

Construction contract Construction contract Construction contract Construction contract Construction contract Construction contract

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