How IFRS 15 changes revenue recognition in construction contracts
New accounting standards mean that construction companies need to pay attention to when they recognize revenue. The new standard, IFRS 15, Revenue from Contracts with Customers, replaces the accounting guidance in IAS 11 Construction Contracts, and affects annual reporting periods that begin on or after 1 January 2018.
The idea behind IFRS 15 is that a company should recognize revenue in a way that reflects the payments it expects to receive. This involves five steps:
- Determine what contracts the entity has with its customers
- Determine the performance obligations covered in the contracts
- Identify the transaction price
- Allocate that transaction price
- When the performance obligation is met, recognize that revenue
While this may sound straightforward, applying these steps to construction contracts can involve some challenges. IFRS may require some changes in how your company does business.
Determine the performance obligations in contracts
Many construction projects involve distinct goods and services, such as building supplies and payments to subcontractors. The company must look through its contracts to find out what those distinct goods and services are because they must be accounted for separately.
Identify the transaction price
The transaction price is the consideration the company expects for transferring the promised goods and services to a customer – minus amounts collected for a third party, such as sales taxes. However, in construction contracts there are often variable amounts – such as the price of commodities, including fuel, aggregate and steel.
When the performance obligation is met, recognize that revenue
In some contracts, it is easy to tell when the performance obligation is satisfied – when control of the good or service passes to the customer. In construction, that transfer of control can occur over time, such as when a construction company is renovating a building that continues to be used by the customer during the project.
Under IAS 11, revenue and profits were recognized on a basis of percentage of completion. That can be done under IFRS 15 as well – but only when the enforceable contract rights and obligations meet specified criteria. Since IFRS does not allow companies to always recognize revenue on a basis of percentage of completion, this may have implications for the company’s cash flow and its ability to meet payroll and supplier invoices.
Account for pre-contract costs correctly
IFRS 15 provides guidance on contract costs, including pre-contract costs and expenditures made to fulfill a contract.
Incremental costs incurred to land a contract must be recognized as an asset if the company expects to recover those costs. The requirement for pre-contract costs to be incremental would generally prohibit internal costs (such as the wages of employees who prepared the proposal) from being capitalized, as those employees would have been paid regardless of whether there was a specific contract.
To summarize – revenue recognition for construction revenue is mostly the same under IFRS 15. However, there are significant differences, so companies need to review their contract practices to be sure they are compliant with the new regulations. Companies subject to IFRS must document how they have complied with IFRS 15, as of the start of the first quarter of 2018.
A financial advisor, who has helped other companies comply with IFRS, can be your guide in helping your business to be compliant – so you can focus on winning contracts and getting the work done.