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:

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.

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.

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:

• Customer simultaneously receives and consumes as the entity performs;
• Customer controls the asset enhanced or created by the entity;
• Entity does NOT create an asset with an alternative use and has an enforceable right to payment for performance completed to date.

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.

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:
  • Debit Contract costs (asset in balance sheet)
  • Credit Inventories

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:

• Contract asset that arose at revenue recognition (6+1.5): CU 7.5 million
• Less progress payment by the customer: CU 8 million
• The balance: CU -0.5 million.

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: https://en.wikipedia.org/wiki/Construction_contract

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Construction contract

Construction contract

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