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/. Identify the performance obligations in the contract
Once an entity has identified the contract with a customer, it evaluates the contractual terms and its customary business practices to identify all the promised goods or services within the contract and determine which of those promised goods or services (or bundles of promised goods or services) will be treated as separate performance obligations.
IFRS 15 identifies several activities common to E&C entities that are considered promised goods and services, including the construction, manufacture or development of an asset on behalf of a customer and the performance of a contractually agreed-upon task for a customer (e.g., design and engineering services). Identify the performance obligations in the contract
Entities that provide engineering or project management services will need to determine if the activities comprise a series of distinct services.
The criteria in IFRS 15 for identifying performance obligations differ from the limited guidance in IAS 11, which could result in different conclusions about the separately identifiable components. For example, under IAS 11 a contractor considered an entire contract to be a single component, but under IFRS 15, it may determine that the contract contains two or more performance obligations that would be accounted for separately. These judgments may be more complex when, for example, a construction contract also includes design, engineering or procurement services.
Separate performance obligations represent promises to transfer to the customer either:
A good or service (or a bundle of goods and services) that is distinct Identify the performance obligations in the contract
or Identify the performance obligations in the contract
A series of distinct goods and services that are substantially the same and have the same pattern of transfer to the customer
Determination of distinct Identify the performance obligations in the contract
IFRS 15 outlines a two-step process for determining whether a promised good or service (or a bundle of goods and services) is distinct:
- Assessment at the level of the individual good or service (i.e., the good or service is capable of being distinct)
- Assessment of whether the good or service is separately identifiable from other promises in the contract (i.e., the good or service is distinct within the context of the contract).
Both of these criteria must be met to conclude that the good or service is distinct and, when met, the individual components must be separated. This means the transaction price will be allocated to these performance obligations and each performance obligation must be satisfied in order to recognise revenue.
In many cases, goods or services are capable of being distinct, but may not be distinct in the context of the contract. The standard provides factors to help entities determine whether goods or services in a bundle of promised goods and services would be combined as one performance obligation (i.e., are not distinct in the context of the contract). These factors, if present, would indicate that a bundle of goods and services are separately identifiable:
- The entity does not provide a significant service of integrating the good or service with other goods or services promised in the contract into a bundle that represents the combined output for which the customer has contracted.
- The good or service does not significantly modify or customise another good or service promised in the contract.
- The good or service is not highly dependent on, or highly interrelated with, other goods or services promised in the contract.
The Boards concluded that a good or service is not separable from other promises in the contract when an entity provides an integration service to incorporate individual goods and/or services into a combined output. The Boards observed that this may be relevant in many construction contracts if a contractor provides an integration service to manage and coordinate the various construction tasks and to assume the risks associated with the integration of those tasks.
If an entity determines that a promised good or service is not distinct, the entity has to combine that good or service with other promised goods or services until a distinct bundle of goods or services is formed. This distinct bundle is accounted for as a single performance obligation.
Properly identifying performance obligations within a contract is a critical component of the revenue model because revenue allocated to each performance obligation is recognised in profit or loss as the obligation is satisfied. E&C entities, particularly those with long-term construction contracts, should carefully assess whether applying the IFRS 15 requirements results in the identification of performance obligations that are different from the separately identifiable components assessed under IAS 11 or IAS 18.
E&C entities will likely find that evaluating whether a good or service is distinct within the context of the contract will be a significant aspect of using IFRS 15.
Series of distinct goods and services that are substantially the same and that have the same pattern of transfer
Goods and services that are part of a series of distinct goods and services that are substantially the same and have the same pattern of transfer to the customer must be accounted for as a single performance obligation if both of the following criteria are met: Identify the performance obligations in the contract
- Each distinct good or service in the series that the entity promises to transfer represents a performance obligation that would be satisfied over time (see ‘Performance obligations satisfied over time’ in ‘Satisfaction of performance obligations‘) if it were accounted for separately.
- The entity would measure its progress toward satisfaction of the performance obligation using the same measure of progress for each distinct good or service in the series (see ‘Measuring progress’ in ‘Satisfaction of performance obligations‘).
For contracts with variable consideration (e.g., performance bonuses or fees earned based on hours incurred), identifying a series of distinct services as a single performance obligation could have a significant effect because, if certain criteria are met, variable consideration will be allocated to one or more, but not all, distinct services in a performance obligation. Use the link for further discussion on allocating variable consideration. Identify the performance obligations in the contract
The Boards have provided examples of services that may represent a series of goods or services that would be accounted for as a single performance obligation such as a cleaning contract, asset management services, transaction processing services and a contract to deliver electricity. It is unclear how these requirements will be applied to a series of goods or to services that are not repetitive. Identify the performance obligations in the contract
For example, when an entity enters into a two-year contract to provide engineering services, it will need to determine whether: the services it provides are substantially the same over the term of the contract (i.e., while the specific activities that occur each day may vary slightly, the overall service of providing engineering services is substantially the same); have the same pattern of transfer; and meet both of the criteria above. If all of these requirements are met, the contract represents one performance obligation. In contrast, if the entity determines that it provides distinct services in the contract (e.g., planning, design, construction support) that are not all substantially the same, it may identify multiple performance obligations. If an entity determines that these activities represent separate performance obligations, the transaction price must be allocated to each performance obligation (see ‘Allocate the transaction price to the performance obligations‘ for further explanations).
Because the standard does not explain what is meant by the phrase “same pattern of transfer”, judgment is required (and documented) to evaluate whether project management, construction supervision or engineering services provided by E&C entities meet this criterion. E&C entities should clarify the types of services that have the same pattern of transfer, as part of the documentation for the Financial Statements.
Principal versus agent considerations
Some E&C contracts (e.g., project management, procurement arrangements) contain provisions under which an entity’s customer receives goods or services from another entity that is not a direct party to the contract. IFRS 15 states that when other parties are involved in providing goods or services to an entity’s customer, the entity must determine whether its performance obligation is to provide the good or service itself (i.e., the entity is a principal) or to arrange for another party to provide the good or service (i.e., the entity is an agent). The determination of whether the entity is acting as a principal or an agent will affect the amount of revenue the entity recognises. That is, when the entity is the principal in the arrangement, the revenue recognised is the gross amount to which the entity expects to be entitled. When the entity is the agent, the revenue recognised is the net amount the entity is entitled to retain in return for its services as the agent. The entity’s fee or commission may be the net amount of consideration that the entity retains after paying the other party the consideration received in exchange for the goods or services to be provided by that party.
A principal’s performance obligations in an arrangement differ from an agent’s performance obligations. For example, if an E&C entity obtains control of building materials from another party before it transfers (i.e., installs) those materials to the customer, the entity’s performance obligation may be to provide the goods or services itself as part of a larger performance obligation (e.g., to construct a building). Hence, the entity may be acting as a principal and would recognise revenue in the gross amount to which it is entitled. In contrast, an entity that obtains control of materials only momentarily before control is transferred to the customer is not necessarily acting as a principal. For example, if an E&C entity is acting as a project manager and facilitates materials procurement or identifies trade contractors for the customer in exchange for a fee or commission and does not control the goods or services for any length of time, the performance obligation is likely to arrange for another party to provide the goods or services to the customer and the entity is likely acting as an agent.
Because it is not always clear which party is the principal in a contract, the Boards provided the following indicators of when a performance obligation involves an agency relationship:
- Another party is primarily responsible for fulfilling the contract. Identify the performance obligations in the contract
- The entity does not have inventory risk before or after the goods have been ordered by a customer, during shipping, or on return.
- The entity does not have discretion in establishing prices for the other party’s goods or services and, therefore, the benefit that the entity can receive from those goods or services is limited.
- The entity’s consideration is in the form of a commission. Identify the performance obligations in the contract
- The entity is not exposed to credit risk for the amount receivable from a customer in exchange for the other party’s goods or services.
The Boards noted that these indicators are based on indicators that are in today’s revenue recognition requirements in IFRS and US GAAP [IFRS 15 BC382]. However, the indicators in IFRS 15 have a different purpose in that they are based on the concepts of identifying performance obligations and the transfer of control of goods or services.
E&C entities will need to carefully evaluate whether a gross or net presentation is appropriate. Although the new standard includes application guidance that is similar to existing requirements, there are some notable differences that may affect an entity’s principal-agent judgements and conclusions.
For example, the standard requires an entity to consider whether it has control of the goods and services as part of the evaluation. Entities will need to use judgement to determine which indicators are most important based on the facts and circumstances.