How will IFRS 15 Revenue from Contracts with Customers affect you?

The International Accounting Standards Board (IASB) published IFRS 15[1] Revenue from Contracts with Customers in May 2014 effective for reporting periods commencing on or after 1 January 2018.  During the development of IFRS 15 the construction and property industry was identified as one of those most likely to be impacted upon by the new standard[2].  Given the long term nature of contracts within the construction and property industry it is vital that you understand and prepare for the impacts of IFRS 15 now.

Likely areas impacted upon include:

  1. Pre-contract costs

  2. Revenue recognition – % of completion versus a point in time

  3. Bundling of contracts and performance obligations

  4. Variable consideration – how is it measured

  5. Loss making contracts

  6. Contract modifications

  7. Financing components within contracts

  8. Warranties

 

1. Pre-contract costs

Only the incremental costs of obtaining a contract are capitalised. Costs that would have been incurred regardless of whether the contract was obtained (except those that are explicitly chargeable to the customer regardless of outcome) shall be recognised as an expense when incurred.
Example:
A construction company wins a competitive bid to build an office to a new customer. The entity incurred the following costs to obtain the contract:
 
External legal fees for due diligence             15,000
Travel costs to deliver proposal                      25,000
Commissions to sales employees                  10,000
Total costs incurred                                             50,000

In accordance with paragraph 91 of IFRS 15, the entity recognises an asset for the 10,000 incremental costs of obtaining the contract arising from the commissions to sales employees because the entity expects to recover those costs through future fees. The entity also pays discretionary annual bonuses to sales supervisors based on annual sales targets, overall profitability of the entity and individual performance evaluations. In accordance with paragraph 91 of IFRS 15, the entity does not recognise an asset for the bonuses paid to sales supervisors because the bonuses are not incremental to obtaining a contract. The amounts are discretionary and are based on other factors, including the profitability of the entity and the individuals’ performance. The bonuses are not directly attributable to identifiable contracts.
The entity observes that the external legal fees and travel costs would have been incurred regardless of whether the contract was obtained. Therefore, in accordance with paragraph 93 of IFRS 15, those costs are recognised as expenses when incurred, unless they are within the scope of another Standard, in which case, the relevant provisions of that Standard apply.
 

2. Revenue recognition – % of completion versus a point in time

In order to recognise revenue over the life of the project one of the following must be met:

a. the customer simultaneously receives and consumes the benefits provided;

b. the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced; or

c. the entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.

Example:

An entity is developing a multi-unit residential complex. A customer enters into a binding sales contract with the entity for a specified unit that is under construction.  Each unit has a similar floor plan and is of a similar size, but other attributes of the units are different (for example, the location of the unit within the complex). The customer pays a deposit upon entering into the contract and the deposit is refundable only if the entity fails to complete construction of the unit in accordance with the contract.  The remainder of the contract price is payable on completion of the contract when the customer obtains physical possession of the unit.  If the customer defaults on the contract before completion of the unit, the entity only has the right to retain the deposit.

The entity determines that it does not have an enforceable right to payment for performance completed to date because, until construction of the unit is complete, the entity only has a right to the deposit paid by the customer.

Because the entity does not have a right to payment for work completed to date, the entity’s performance obligation is not a performance obligation satisfied over time in accordance with paragraph 35(c).
Instead, the entity accounts for the sale of the unit as a performance obligation satisfied at a point in time in accordance with paragraph 38.

Let’s tweak the facts and assume:

The customer will make progress payments during construction of the unit.  The contract has substantive terms that preclude the entity from being able to direct the unit to another customer.  The customer does not have the right to terminate the contract unless the entity fails to perform as promised.  If the customer defaults on its obligations by failing to make the promised progress payments as and when they are due, the entity would have a right to all of the consideration promised in the contract if it completes the construction of the unit.

The entity determines that the asset (unit) created by the entity’s performance does not have an alternative use to the entity because the contract precludes the entity from transferring the specified unit to another customer.

The entity does not consider the possibility of a contract termination in assessing whether the entity is able to direct the asset to another customer.

The entity also has a right to payment for performance completed to date. This is because if the customer were to default on its obligations, the entity would have an enforceable right to all of the consideration promised under the contract if it continues to perform as promised.
 

3. Bundling of contracts and performance obligations

Contracts are combined where at least one of the following is met:

a. the contracts are negotiated as a package with a single commercial objective;

b. the amount of consideration to be paid in one contract depends on the price or performance of the other contract; or

c. the goods or services promised in the contracts are a single performance obligation.

Example:
An entity, a contractor, enters into a contract to build a hospital for a customer. The entity is responsible for the overall management of the project and identifies various goods and services to be provided, including engineering, site clearance, foundation, procurement, construction of the structure, piping and wiring, installation of equipment and finishing.
 
The goods and services are not distinct within the context of the contract in accordance with paragraph 27(b).  That is, the entity’s promise to transfer individual goods and services in the contract are not separately identifiable from other promises in the contract.   This is evidenced by the fact that the entity provides a significant service of integrating the goods and services (the inputs) into the hospital (the combined output) for which the customer has contracted.  Because both criteria in paragraph 27 are not met, the goods and services are not distinct.  The entity accounts for all of the goods and services in the contract as a single performance obligation.
 

4. Variable consideration – how is it measured

An entity use one of the following models depending on which best predicts the consideration the entity will receive:

a. the expected value; or

b. the most likely amount.

Example:
An entity enters into a contract with a customer to build a customised asset.  The promise to transfer the asset is a performance obligation that is satisfied over time.  The promised consideration is 2.5 million, but that amount will be reduced or increased depending on the timing of completion of the asset.  Specifically, for each day after 31 March 20X7 that the asset is incomplete, the promised consideration is reduced by 10,000.  For each day before 31 March 20X7 that the asset is complete, the promised consideration increases by 10,000.

In addition, upon completion of the asset, a third party will inspect the asset and assign a rating based on metrics that are defined in the contract. If the asset receives a specified rating, the entity will be entitled to an incentive bonus of 150,000.

In determining the transaction price, the entity prepares a separate estimate for each element of variable consideration to which the entity will be entitled using the estimation methods described in paragraph 53 of IFRS 15:

  • the entity decides to use the expected value method to estimate the variable consideration associated with the daily penalty or incentive (ie 2.5 million, plus or minus 10,000 per day). This is because it is the method that the entity expects to better predict the amount of consideration to which it will be entitled.

  • the entity decides to use the most likely amount to estimate the variable consideration associated with the incentive bonus. This is because there are only two possible outcomes (150,000 or 0) and it is the method that the entity expects to better predict the amount of consideration to which it will be entitled.

5. Loss making contracts

AASB 137 applies to all contracts under IFRS 15.  Previously AASB 111 Construction contracts dealt with it.  Now accounted for under AASB 137 as an onerous contract.  Likely to result in similar practical application
 

6. Contract modifications

Depending on the nature of the contract modification it may be accounted for as either a change to the existing contract or the issue of a new contract.
An entity shall account for a contract modification as a separate contract if both of the following conditions are present:

  • the scope of the contract increases because of the addition of promised goods or services that are distinct (in accordance with paragraphs 26–30); and

  • the price of the contract increases by an amount of consideration that reflects the entity’s stand-alone selling prices of the additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the particular contract. For example, an entity may adjust the stand-alone selling price of an additional good or service for a discount that the customer receives, because it is not necessary for the entity to incur the selling-related costs that it would incur when selling a similar good or service to a new customer.

Example:
An entity, a construction company, enters into a contract to construct a commercial building for a customer on customer-owned land for promised consideration of 1 million and a bonus of 200,000 if the building is completed within 24 months.

The entity accounts for the promised bundle of goods and services as a single performance obligation satisfied over time in accordance with paragraph 35(b) of IFRS 15 because the customer controls the building during construction. At the inception of the contract, the entity expects the following:

Transaction price                               1,000,000
Expected costs                                       700,000
Expected profit (30%)                         300,000
At contract inception, the entity excludes the 200,000 bonus from the transaction price because it cannot conclude that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur.

Completion of the building is highly susceptible to factors outside the entity’s influence, including weather and regulatory approvals.

The entity determines that the input measure, on the basis of costs incurred, provides an appropriate measure of progress towards complete satisfaction of the performance obligation.
By the end of the first year, the entity has satisfied 60 per cent of its performance obligation on the basis of costs incurred to date

The entity reassesses the variable consideration and concludes that the amount is still constrained in accordance with paragraphs 56–58 of IFRS 15. Consequently, the cumulative revenue and costs recognised for the first year are as follows:
Revenue                                                   600,000
Costs                                                        420,000
Gross profit                                             180,000
Modification:
In the first quarter of the second year, the parties to the contract agree to modify the contract by changing the floor plan of the building.  As a result, the fixed consideration and expected costs increase by 150,000 and 120,000, respectively.  Total potential consideration after the modification is 1,350,000 (1,150,000 fixed consideration + 200,000 completion bonus).

In addition, the allowable time for achieving the 200,000 bonus is extended by 6 months to 30 months from the original contract inception date.

At the date of the modification, on the basis of its experience and the remaining work to be performed, which is primarily inside the building and not subject to weather conditions, the entity concludes that it is highly probable that including the bonus in the transaction price will not result in a significant reversal in the amount of cumulative revenue recognised in accordance with paragraph 56 of IFRS 15 and includes the 200,000 in the transaction price.

In assessing the contract modification, the entity evaluates paragraph 27(b) of IFRS 15 and concludes that the remaining goods and services to be provided using the modified contract are not distinct from the goods and services transferred on or before the date of contract modification; that is, the contract remains a single performance obligation.

Consequently, the entity accounts for the contract modification as if it were part of the original contract (in accordance with paragraph 21(b) of IFRS 15).

The entity updates its measure of progress and estimates that it has satisfied 51.2 per cent of its performance obligation (420,000 actual costs incurred ÷ 820,000 total expected costs).

The entity recognises additional revenue of 91,200 [(51.2 per cent complete × 1,350,000 modified transaction price) –600,000 revenue recognised to date] at the date of the modification as a cumulative catch-up adjustment.
 

7. Financing components within contracts

Where the period between the payment and provision of the good or services is greater than one year an adjustment needs to be made for the implicit financing arrangement in the contract.
 

8. Warranties

It is common for an entity to provide (in accordance with the contract, the law or the entity’s customary business practices) a warranty in connection with the sale of a product (whether a good or service).

Type I
Some warranties provide a customer with assurance that the related product will function as the parties intended because it complies with agreed-upon specifications.

Type II
Other warranties provide the customer with a service in addition to the assurance that the product complies with agreed-upon specifications.  Account for the promised warranty as a performance obligation and allocate a portion of the transaction price to that performance obligation.

 


[1] AASB 15 Revenue from Contracts with Customers in Australia.

[2] Examples in this publication are based on those in AASB 15