Example: Construction contracts under IFRS 15
Ever since the new revenue standard IFRS 15 Revenue from Contracts with Customers was issued, I get one and the same question:
What happened to construction contracts?
They were guided by IAS 11 Construction Contracts, but you might well know that after 1 January 2018, IAS 11 became superseded – it does NOT apply anymore.
Under the new IFRS 15, construction contract is treated exactly the same way as any other contract with customers.
I know I know.
Sometimes it’s hard to apply and imagine what it looks like.
Therefore in today’s article, I would like to show you HOW you should account for construction contracts under IFRS 15.
Plus, I will illustrate everything on an example with journal entries and calculations.
What do the rules say?
IFRS 15 prescribers the 5-step model for the revenue recognition.
I wrote about this model many times, for example here and here.
You can also check out my IFRS Kit with detailed video tutorials about IFRS 15.
To sum up, here are the 5 steps:
- Identify contract with the customer;
- Identify the performance obligations in the contract;
- Determine the transaction price;
- Allocate the transaction price to the performance obligations in the contract;
- Recognize revenue when (or as) an entity satisfy a performance obligation.
If you enter into the construction contracts with your customers and you previously applied IAS 11, then you need to follow exactly these 5 steps under IFRS 15.
Let me show you straight on an example.
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”). Total contract price is CU 12 million.
Total expected contract costs are:
- CU 6 mil. for windows (purchased from external suppliers);
- CU 4 mil. 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 mil.
Just before the year-end, the client paid the first progress payment of CU 8 mil.
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.
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.
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.
You can revise the short example in this article to make it totally clear.
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 mil.
- Total incurred costs to date excluding windows: CU 1 mil.
- Progress to completion: CU 1/CU 4 = 25%
- Total contract revenue excluding windows: CU 6 mil. (CU 12 – CU 6)
- Total revenue to 31 December 20X1 excluding windows: CU 6 mil. x 25% = CU 1.5 mil.
Journal entries at 31 December 20X1
As we excluded windows from measuring progress towards completion, we will draft the journal entries separately for windows and for the remaining services.
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):
- Debit Inventories: CU 6 mil.
- Credit Suppliers: CU 6 mil.
ABC recognizes the revenue for windows at zero profit margin (equal to their cost – in line with par. B19(b) of IFRS 15):
- Debit Contract Asset: CU 6 mil.
- Credit Revenue from construction project***: CU 6 mil.
***Not the revenue from sale of windows – remember, the whole project is one performance obligation and we recognize the revenue under 1 caption in this case.
Cost of windows:
- Debit Costs of construction in profit or loss: CU 6 mil.
- Credit Inventories: CU 6 mil.
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 (or suppliers or whatever is 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:
- Debit Cost of construction in profit or loss: CU 1 mil.
- Credit Contract costs: CU 1 mil.
Let’s recognize the revenue from “remaining” services (all except for windows).
We measured these revenues at CU 1.5 mil. using the progress towards completion (please see above).
Journal entry is:
- Debit Contract asset: CU 1.5 mil.
- Credit Revenue from construction project: CU 1.5 mil.
Finally, we need to account for the progress payment of CU 8 mil. made by the customer at the year-end:
- Debit Trade receivables (bank account, cash…): CU 8 mil.
- Credit Contract assets: 8 mil.
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 mil.
- Less progress payment by the customer: CU 8 mil.
- The balance: CU -0.5 mil..
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.
I personally prefer to see contract liabilities at the year-end, not contract assets, because:
- We have no credit risk as we have no performance completed to date which is not paid by the customer, and
- We don’t have to calculate expected credit loss and measure the impairment on contract assets – hurray!
This is basically the method you should follow when accounting for your construction contracts.
I tried to make this simple as possible, but I can’t cover every single situation here.
If you have any questions, please ask them in the comments or you can even consider subscribing to our IFRS Helpline where I and my amazing team answer to your very specific question, issues, help you apply IFRS or even implemented for the first time. Just write me an e-mail if you’d like to get more information.
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