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IFRS Question 036: What is the difference between a contract asset and an account receivable?

What is the difference between contract asset and an account receivable? I know that contract asset is a new term under IFRS 15, but I just don’t understand when we should account for a contract asset and when to account for a trade receivable. Isn’t it the same?
 

IFRS Answer 036

The answer is – NO, it is not the same thing.

I will try to explain the definitions of both terms and try to explain in a simple human language with common sense what the difference is.

Then I will illustrate it in the example.
 

What do the rules say?

Contract asset is the term defined in IFRS 15 as an entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer, when that right is conditioned on something other than the passage of time, for example the entity’s future performance.

Trade receivable or account receivable is a financial instrument defined by IAS 32 as a contractual right to receive cash or another financial asset from another entity.

As you can see, the main difference between the contract asset and a trade receivable is conditionality.

Contract asset is a conditional right, while a trade receivable is an unconditional right.

OK, you might think, but what does that actually mean?
 

When should you account for a contract asset and when for a trade receivable?

A contract asset arises when you as a supplier have already performed something – deliver part of the services or goods as agreed – but under the contract, you still have something to do before you can bill the client.
 

Illustration: contract asset vs. account receivable

Imagine you agreed to build a hotline center for your big client. The project will take 9 months and starts 1 July.

Total contract price is CU 100 000.

In the contract you agreed that the customer would pay you for the whole project when the hotline is complete and handed over to the customer.

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OK, a bit unrealistic, but let’s keep it simple to illustrate.

At the year-end, you have been working on the project for 6 months and under IFRS 15, you need to recognize the revenue based on the progress towards completion.

You assess that the project is 70% complete, so you book 70% of the total price – that is CU 70 000.

What’s the journal entry?

The credit side is the revenue, but what’s the debit side?

Well, a contract asset.

Not a trade receivable.

The reason is that at the end of the year, after only 6 months of work, you do NOT have the unconditional right to a payment.

The condition that you must meet before you get paid is to complete the project.

At the end of the year, this condition has not been met yet, so you CANNOT recognize a trade receivable.

Instead you debit contract asset. And the journal entry is:

  • Debit Contract asset: CU 70 000
  • Credit Revenues: CU 70 000.

Then, you work for another 3 months, you complete the project and hand it over to the customer.

At that moment, you have an unconditional right to a payment and not a contract asset of any kind.

Also, you have to recognize revenue over time for these remaining 3 months.

So what is your journal entry?

  • Debit Trade receivables: CU 100 000 – because the unconditional right to a payment was created by handing the project over to the customer,
  • Credit Contract asset: CU 70 000 – because your conditional right created last year turned into trade receivable or the unconditional right, and
  • Credit Revenues: CU 30 000 – because you need to recognize the revenues for the last 3 months based on the progress towards completion.

I think that by now you should have a good understanding of the difference.

I published a nice solved full example on construction contracts on my website, so don’t forget to check it out.
 

What about impairment?

Last but not least.

Contract asset is NOT a financial instrument, so IFRS 9 does not apply here, with one exception: impairment.

So, you have to assess the contract asset for any impairment, determine the expected credit loss and recognize a loss allowance – exactly as with any trade receivables you have.

Any comments or questions?

Please let me know below. Thank you!