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/.
The model in IFRS 15 applies to each contract with a customer. Contracts may be written, oral or implied by an entity’s customary business practices, but must be legally enforceable and meet specified attributes.
Attributes of a contract Identify the construction contract with the customer
To help entities determine whether (and when) their arrangements with customers are contracts within the scope of the model in the standard, the Board identified certain attributes that must be present, as follows [IFRS 15.9]:
- The parties have approved the contract and are committed to perform their respective obligations.
- Each party’s rights regarding the goods or services to be transferred can be identified.
- Payment terms can be identified.
- The contract has commercial substance.
- It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
An entity is required to combine two or more contracts that it enters into at, or near, the same time with the same customer and account for them as a single contract, if they meet specified criteria (see ‘Combining E&C contracts‘ below).
An assessment of collectability is one of the criteria for determining whether a contract with a customer exists, i.e., an entity must conclude that it is probable that it will collect the consideration to which it expects to be entitled. The amount of consideration to which an entity expects to be entitled (i.e., the transaction price) may differ from the stated contract price (e.g., if an entity intends to offer a concession and accept an amount less than the contractual amount). When performing the collectability assessment, an entity only considers the customer’s ability and intention to pay the expected consideration when due. Identify the construction contract with the customer
Significant judgement will be required to determine whether a contract is within the scope of IFRS 15 if an entity believes it will receive partial payment for performance. The entity will be required to determine whether the amount of consideration that it does not expect to receive is a price concession or an amount that the customer does not have the ability and intention to pay.
In making this determination, an entity will have to consider whether its customary business practices, published policies or specific statements provide the customer with a valid expectation that the entity will accept an amount of consideration that is less than the price stated in the contract.
If an entity concludes that it has met all of the criteria for a contract under IFRS 15, it will not reassess the criteria unless there is an indication of a significant change in facts and circumstances. An example of this scenario is included in the standard relating to the significant deterioration in a customer’s ability to pay the consideration when due. Entities in this situation will need to determine whether it is still probable that they will be able to collect the amount of consideration to which they are entitled, or the contract may no longer be a contract under IFRS 15. E&C entities will need to apply significant judgement in these circumstances. Identify the construction contract with the customer
IFRS 15 provides requirements for entities to follow when an arrangement does not meet the criteria of a contract under the standard . Any consideration received from a customer (e.g., an advance payment) before the contract criteria have been satisfied is initially accounted for as a liability (not revenue).
If an entity enters into an arrangement that does not meet the criteria for a contract under IFRS 15, revenue can only be recognised when either:
- the entity has no remaining obligations to transfer goods or services and substantially all of the consideration has been received by the entity and is non-refundable; or
- the contract has been terminated and the consideration received is non-refundable. Identify the construction contract with the customer
Combining E&C contracts Identify the construction contract with the customer
Under IFRS 15, an entity will generally apply the model to an individual contract with a customer. However, IFRS 15 requires entities to combine contracts entered into at or near the same time with the same customer if they meet one or more of the following criteria:
- The contracts are negotiated as a package with a single commercial objective. Identify the construction contract with the customer
- The amount of consideration to be paid in one contract depends on the price or performance of the other contract. Identify the construction contract with the customer
- The goods or services promised in the contracts (or some goods or services promised in each of the contracts) are a single performance obligation (see Section 5 for a discussion on identifying performance obligations). Identify the construction contract with the customer
The Boards clarified that negotiating multiple contracts at the same time is not sufficient evidence to demonstrate that the contracts represent a single arrangement [IFRS 15 BC73].
Overall, the criteria for combining contracts are generally consistent with the underlying principles in the existing revenue standards. However, IFRS 15 provides more application guidance on when to combine contracts than IAS 18 and, unlike IAS 18, the new standard explicitly requires an entity to combine contracts if the criteria are met. Therefore, some entities that do not currently combine contracts may need to do so.
The criteria in IAS 11 and IFRS 15 are similar. However, unlike IAS 11, IFRS 15 does not require concurrent or sequential performance [IAS 11 9(c)]. Furthermore, IAS 11 required that all criteria be met before combining contracts. Whereas, IFRS 15 only requires that one or more of the criteria be met.
Contract modifications Identify the construction contract with the customer
A contract modification is a change in the scope or price (or both) of a contract. An entity must determine whether the modification creates a new contract or whether it will be accounted for as part of the existing contract. The determination of a new and separate contract is driven by whether the modification results in the addition of distinct goods or services, priced at their stand-alone selling prices (see ‘Allocate the transaction price to the performance obligations‘).
Parties to E&C arrangements frequently agree to change orders that modify the scope or price (or both) of a contract. Contractors also regularly submit claims to customers when unanticipated additional costs are incurred as a result of delays, errors or changes in scope caused by the customer. IFRS 15 states that “a contract modification exists when the parties to a contract approve a modification that either creates new, or changes existing, enforceable rights and obligations of the parties to the contract” [IFRS 15 18]. Approvals of a modification may be written, oral or implied by the entity’s customary business practices. Identify the construction contract with the customer
Generally, if a contract modification has not been approved, IFRS 15 is not applied to the modification until the approval occurs. However, the standard also states that an entity may have to account for a contract modification prior to the parties reaching final agreement on changes in scope or pricing (or both).
Instead of focusing on the finalisation of a modified agreement, these requirements focus on the enforceability of the changes to the rights and obligations in the contract. That is, once the entity determines that the revised rights and obligations are enforceable, the entity is required to account for the contract modification. If the parties to a contract have approved a change in the scope of the contract, but have not yet determined the corresponding change in price, an entity will have to estimate the change to the transaction price arising from the modification in accordance with the requirements for estimating variable consideration. Identify the construction contract with the customer
The standard provides the following example to illustrate this point, refer to [IFRS 15IE 42 – IFRS 15IE 43] – Contract modifications that add distinct goods or services at their stand-alone selling prices are treated as separate contracts.
Once an entity has determined that a contract has been modified (e.g., because of a change order or claim), the entity has to determine the appropriate accounting for the modification. Certain modifications are treated as separate stand-alone contracts, while others are combined with the original contract and accounted for in that manner.
An entity is required to account for a contract modification as a separate contract, with no effect on the original contract, if:
(i) The scope of the contract increases because of the addition of promised goods or services that are distinct (see ‘Identify the performance obligations in the contract‘)
And Identify the construction contract with the customer
(ii) 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.
In these circumstances, the stand-alone selling prices of the additional goods or services may include adjustments that reflect the circumstances of the particular contract (e.g., a discount provided to a customer because materials and equipment needed for a change order are already on site). See below for an example.
Contractor E agrees to construct a manufacturing facility on a customer’s land for CU10 million. During construction, the customer determines that a separate storage facility is needed at the location. The parties agree to modify the contract to include the construction of the storage facility, to be completed within three months of completion of the manufacturing facility, for a total price of CU11 million.
Scenario A Identify the construction contract with the customer
When the contract is modified, an additional CU1 million is added to the consideration that Contractor E will receive. Contractor E would normally charge CU1.1 million to construct a similar facility. However, much of the equipment and labour force necessary to complete construction of the storage facility is already onsite and available for use by Contractor E. Therefore, the additional CU1 million reflects the stand-alone selling price at contract modification, adjusted for the particular circumstances of the contract.
Assuming that Contractor E determines that the construction of the separate storage facility is a distinct performance obligation, the contract modification for the additional storage facility would be, in effect, a new (separate) contract that does not affect the accounting for the existing contract.
Scenario B Identify the construction contract with the customer
As in Scenario A, the contract is modified when Contractor E agrees to build the storage facility and the customer agrees to pay an additional CU1 million. Again assume that Contractor E determines that the construction of the separate storage facility is a distinct performance obligation. However, Contractor E determines that it would normally charge CU1.5 million to construct a similar facility. While Contractor E can attribute some of the discount to its ability to use equipment and labour resources that are already on site, the price reduction was primarily driven by other factors (such as Contractor E’s desire to maintain the customer relationship and keep its resources deployed). Therefore, the additional CU1 million does not reflect the stand-alone selling price at contract modification.
Assume that Contractor E concludes that it transfers control of each facility over time. As a result, Contractor E accounts for the modification as a modification of the existing contract. The revised transaction price of CU11 million is allocated between the two performance obligations in the modified contract (being the original incomplete performance obligation to construct the manufacturing facility and the new performance obligation to construct the storage facility). The transaction price is allocated based on the relative stand-alone selling prices of each performance obligation. Any revenue previously recognised for the manufacturing facility is adjusted on a cumulative catch-up basis to reflect the allocated transaction price. Revenue from the construction of the storage facility (i.e., a separate performance obligation) is recognised based on the appropriate measure of progress.
If a contract modification is not accounted for as a separate contract, an entity would account for the promised goods or services not yet transferred at the date of the contract modification (including those in the original contract) in whichever of the following ways is applicable: Identify the construction contract with the customer
- A termination of the old contract and the creation of a new contract (i.e., on a prospective basis), if the remaining goods and services after the contract modification are distinct, but the consideration does not reflect the stand-alone selling price of those goods or services. See example above.
- A continuation of the original contract if the remaining goods and services to be provided after the contract modification are not distinct (and, therefore, form part of a single performance obligation that is partially satisfied at the date of modification). Such modifications are accounted for on a cumulative catch-up basis. See example above.
- Finally, a change in a contract may also be treated as a combination of the two: a modification of the existing contract and the creation of a new contract. In this case, an entity would not adjust the accounting for completed performance obligations that are distinct from the modified goods or services. However, the entity would adjust revenue previously recognised (either up or down) to reflect the effect of the contract modification on the estimated transaction price allocated to performance obligations that are not distinct from the modified portion of the contract and the measure of progress. Identify the construction contract with the customer
The requirement to determine whether to treat a change in contractual terms as a separate contract or a modification to an existing contract is generally consistent with old requirements in IAS 11. For example, IAS 11 required that a contract modification that included the construction of an additional asset was treated as separate construction contract when certain criteria are met (e.g., when the asset differed significantly from the assets covered by the original contract or the price of the asset was negotiated without regard to the original contract price).
When assessing how to account for a contract modification, an entity must consider how any revisions to promised goods or services interact with the rest of the contract. That is, although a change order may add a new good or service that would be distinct in a stand-alone transaction, the new performance obligation may not be distinct in the context of the modified contract. For example, in a building construction project, a customer may request a change order to add an additional floor. The construction entity may commonly perform construction services to add a new floor to an existing, completed building, which would likely be considered a distinct service in those contracts. However, when that service is added to an existing contract (e.g., a contract to construct the entire building) and the entity has already determined that the entire project is a single performance obligation, the added goods and services would normally be combined with the existing bundle of goods and services. Identify the construction contract with the customer
In practice, a contractor that is already performing work on a project may have leverage that provides it with the ability to charge a higher price for a change order than it otherwise would if the activities were performed on a stand-alone basis. This may be because, for example, the customer does not enter into an open bidding process for each individual change order. In these circumstances, determining whether the consideration from the modification reflects the stand-alone selling price of the activities will require significant judgement.
Refer to IFRS 15 IE37 – IFRS 15IE 41 as an example which illustrates a contract modification that is accounted for as part of the original contract:
E&C entities will need to carefully evaluate performance obligations at the date of a modification to determine whether the remaining goods or services to be transferred are distinct and the prices are commensurate with their stand-alone selling prices. This assessment is important because the accounting treatment can vary significantly depending on the conclusions reached. See also ‘Identify the performance obligations in the contract‘ for considerations relating to this assessment.