This part relates to a complete explanation of IFRS 15 Revenue from contracts with customers in respect of Engineering & Construction contracts, see https://www.faqifrs.com/revenue-from-engineering-construction-contracts/. Determine the transaction price
The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties. This amount is meant to reflect the amount to which the entity has rights under the present contract, which may differ from the contractual price (e.g., if the entity intends to offer a price concession). The consideration promised in a contract may include fixed or variable amounts. Determine the transaction price
When determining the transaction price, entities must estimate, at contract inception, the variable consideration to which they expected to be entitled. However, IFRS 15 requires that entities constrain the variable consideration included in the transaction price to the amount for which it is highly probable that a significant reversal of revenue will not occur. The transaction price will also include any non-cash consideration (e.g., customer-furnished materials for which control is transferred to the entity); consideration paid or payable to a customer; and the effect of a significant financing component (i.e., the time value of money). Refer to ‘Refund liabilities’, ‘Right of return’, ‘Significant financing component’ (2018 update) and ‘Financial statement presentation of financing component’ (2018 update) further details. Determine the transaction price
The transaction price may vary in amount and timing as a result of discounts, credits, price concessions, incentives or bonuses. In addition, consideration may be contingent on the occurrence or non-occurrence of a future event (e.g., a performance bonus).
An entity is required to estimate each type of variable consideration using either the ’expected value‘ (i.e., the sum of probability-weighted amounts – see below) or the ’most likely amount‘ (i.e., the single most likely outcome). The entity selects whichever method better predicts the amount of consideration to which the entity expects to be entitled. That is, the method selected is not meant to be a free choice. An entity is required to apply the selected method consistently throughout the contract and for similar types of contracts. The entity must update the estimated transaction price at the end of each reporting period. Determine the transaction price
The Boards indicated that the most likely amount may be the better predictor when the entity expects to be entitled to one of only two possible amounts (e.g., a contract in which an entity is entitled to receive all or none of a specified performance bonus, but not a portion of that bonus). The following example illustrates how an E&C entity may estimate variable consideration:
Estimating variable consideration Determine the transaction price
On 1 January 2017, Contractor M enters into a contract with Company B to construct a new corporate headquarters on land owned by Company B. Contractor M determines that control of the building is passed to Company B as it is constructed. Therefore, the performance obligation is satisfied over time. The contract price is CU25 million, but that amount will be reduced or increased depending on when construction of the building is completed. For each day before 30 June 2018 that the building is completed, the promised consideration will increase by CU25,000. For each day after 30 June 2018 that the building is incomplete, the promised consideration will be reduced by CU25,000.
The parties have also agreed that, when the building is complete, it will be inspected and assigned a green building certification level. If the building achieves the certification level specified in the contract, Contractor M will be entitled to an incentive bonus of CU200,000.
Analysis Determine the transaction price
Contractor M has to determine whether the ’expected value’ or ’most likely amount’ better predicts the variable consideration it will receive. Contractor M determines that the ‘expected value’ is the better predictor of the variable consideration associated with the daily incentive or penalty (i.e., CU25 million, plus or minus CU25,000 per day) since multiple outcomes are possible.
Assume for purposes of this illustration that the constraint does not limit the amount that can be included in the transaction price. Based on the current construction schedule and its experience with past projects, Contractor M estimates that it is 50% likely to complete the project 10 days ahead of schedule and receive an incentive of CU250,000, 25% likely to complete the project on time and receive no incentive and 25% likely to complete the project five days past schedule and incur a CU125,000 penalty.
Using a probability-weighted estimate, Contractor M would include CU93,750 [(CU250,000 x 50%) + (CU0 x 25%) – (CU125,000 x 25%)] in the transaction price associated with this contingent consideration. Contractor M determines that the ‘most likely amount‘ is the better predictor to estimate the variable consideration associated with the green building certification bonus because there are only two possible outcomes (CU200,000 or CU0). Based on its history of completing building projects that achieve the green building certification level specified in the contract and the absence of factors that may indicate the criteria will not be met, Contractor M includes the CU200,000 bonus in the transaction price. Therefore, Contractor M estimates the total transaction price, after consideration of the base fee, daily incentive or penalty and green building certification bonus to be CU25,293,750 (CU25,000,000 + CU93,750 + CU200,000) at contract inception.
Contractor M updates its estimate of the transaction price at the end of each subsequent reporting periods. For example, as at 31 December 2017, after evaluating construction completed to date and the remaining project schedule, Contractor M determines it is now 75% likely to complete the project 10 days ahead of schedule and receive an incentive of CU250,000 and 25% likely to complete the project on time and receive no incentive bonus. As a result, Contractor M updates its estimate of variable consideration from the daily incentive or penalty to CU187,500 [(CU250,000 x 75%) + (CU0 x 25%)] and adds CU93,750 (CU187,500 – CU93,750) to the transaction price.
Constraining estimates of variable consideration to include variable consideration in the estimated transaction price, the entity has to first conclude that it is ‘highly probable’ that a significant revenue reversal will not occur when the uncertainties related to the variability are resolved. The Boards provided factors that may indicate that revenue will be subject to a significant reversal:
- The amount of consideration is highly susceptible to factors outside the entity’s influence (e.g., market volatility, judgement or actions of third parties, weather conditions).
- The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.
- The entity’s experience (or other evidence) with similar types of contracts is limited or that experience (or other evidence) has limited predictive value.
- The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances.
- The contract has a large number and broad range of possible consideration amounts.
The indicators are not meant to be all-inclusive and entities may note additional factors that are relevant in their evaluations. In addition, the presence of any one of these indicators does not necessarily mean that it is highly probable that a change in the estimate of variable consideration will result in a significant revenue reversal.
For example, when determining whether variable consideration is constrained, E&C entities will need to consider a variety of factors. This may include the extent of their experiences with similar arrangements, uncertainties that may exist in the latter periods of a long-term contract and market and other factors that may be outside of their control (e.g., weather). E&C entities may find this evaluation to be especially difficult when determining whether variable consideration from contract claims will be included in the transaction price because one or more of the above indicators may be present. E&C entities will need to determine how the existence of such indicators affects their assessment of the constraint, which may be different for each individual claim since the risks associated with each claim could vary. All entities will want to make sure they sufficiently and contemporaneously document the reasons for their conclusions, including conclusions about both corroborating and contrary evidence. Determine the transaction price
When an entity is unable to conclude that it is highly probable that a change in the estimate of variable consideration that would result in a significant revenue reversal will not occur, the amount of variable consideration is limited. In addition, when a contract includes variable consideration, an entity will update both its estimate of the transaction price and its evaluation of the constraint throughout the term of the contract to depict conditions that exist at the end of each reporting period.
While E&C entities may already estimate the variable consideration they expect to earn, they may need to change their processes for making those estimates and possibly their conclusions about when and how much variable consideration to include in the transaction price due to the constraint, when applying IFRS 15.
Furthermore, while the Boards noted that entities are required to evaluate the magnitude of a potential reversal relative to the total consideration (i.e., fixed and variable), they did not include any quantitative application guidance for evaluating ‘significance’. This will require entities to use judgement when making this assessment.
Customer-furnished materials Determine the transaction price
In many E&C arrangements, the customer may choose to procure and provide to the contractor certain materials that are necessary for the entity to complete a project. In other circumstances, the contractor may purchase and pay for the required materials using the customer’s procurement and purchase functions.
The new standard states that a customer’s contribution of goods or services (e.g., materials, equipment, labour) that are used in the fulfilment of a contract is a form of non-cash consideration if the contractor obtains control of the goods or services. The contractor has to evaluate whether it obtains control of the goods or services using the transfer of control requirements (see Section 8) in IFRS 15 and consider whether it is serving in the capacity of a principal or an agent (see Section 5.3).
When an entity receives, or expects to receive, non-cash consideration, the fair value of the non-cash consideration is included in the transaction price. The entity applies IFRS 13 Fair Value Measurement to measure the fair value of the non-cash consideration. If the entity cannot reasonably estimate the fair value of non-cash consideration, it is required to measure the non-cash consideration indirectly by reference to the estimated stand-alone selling price of the promised goods or services.
Significant financing component Determine the transaction price
The requirement to consider whether a significant financing component is present in a contract represents a significant change for E&C entities.
A significant financing component may exist when the receipt of consideration does not match the timing of the transfer of goods or services to the customer (i.e., the consideration is prepaid or is paid well after the goods or services are provided). Entities will be required to adjust the transaction price for this component if the financing is significant to the contract. Entities will need to evaluate all relevant facts and circumstances when making this evaluation, including the difference between the promised consideration and the cash selling price of the promised goods or services and the combination of the expected length of time between the transfer of the goods and services and receipt of consideration and the prevailing interest rates in the relevant market.
To reduce the burden of this requirement, the Boards included a practical expedient in the standard that allows entities to ignore a significant financing component when the period between the customer’s payment and the entity’s transfer of the goods or services is expected to be one year or less at contract inception.16 For example, billings in excess of costs that will be resolved within one year generally would not constitute a significant financing component. Determine the transaction price
The standard also states that a contract would not contain a significant financing component if the difference between the promised consideration and the cash selling price of the good or the service is due to reasons other than the provision of financing to either the entity or the customer (e.g., retainage). In addition, a significant financing component is not present if: (1) the customer pays for the goods or services in advance and the timing of the transfer of those goods or services is at the discretion of the customer; or (2) a substantial amount of the consideration promised by the customer is variable and the amount or timing depends on the occurrence (or non-occurrence) of an event that is not substantially within the control of the customer or the entity.
When an entity concludes that a financing component is significant to a contract, it determines the transaction price by discounting the amount of promised consideration. The entity uses the same discount rate that it would use if it were to enter into a separate financing transaction with the customer. The discount rate has to reflect the credit characteristics of the borrower. The use of a rate that is explicitly stated in the contract, that does not correspond with market terms in a separate financing arrangement, would not be acceptable. Subject to certain limitations, the transaction price will need to be adjusted when there is a prepayment (e.g., an advanced payment) that is determined to be a significant financing component.
The standard provides the following illustration to assist entities in determining whether a significant financing component is present in a long-term contract:
Refer to IFRS 15IE 141 – IFRS 15 IE 142 Withheld Payments on a Long-Term Contract Determine the transaction price
A significant financing component may exist in a contract even when there is no explicit purpose to finance between the parties (i.e., a significant financing component may be implicit). Entities will need to carefully evaluate certain payment terms common in E&C contracts (e.g., retainage, milestones, progress payments, award/incentive fees) and the timing of billings relative to when they expect to perform under the contract to determine whether a significant financing component exists.
Furthermore, the standard does not include any quantitative application guidance for evaluating whether a financing component is significant to the contract. This will require entities to use judgement when making this assessment. Entities will need to sufficiently document their analyses to support their conclusions.