This part relates to a complete explanation of IFRS 15 Revenue from contracts with customers in respect of Engineering & Construction contracts, see Revenue from Engineering & Construction contracts.
Under IFRS 15, an entity recognises revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is considered to be transferred when the customer obtains control. Control of the good or service refers to the ability to direct its use and to obtain substantially all of its remaining benefits (i.e., right to cash inflows or reduction of cash outflows generated by the good or service). Control also means the ability to prevent other entities from directing the use of and receiving the benefit from, a good or service.
The change to a control model under IFRS 15 will require E&C entities to carefully assess when revenue can be recognised. The standard indicates that an entity has to determine at contract inception whether it will transfer control of a promised good or service over time, regardless of the length of the contract or other factors. Depending on the measure of progress the entity applies, the accounting treatment for a contract that meets the criteria for recognition of revenue over time may be similar to the method it applied under old requirements in IAS 11 (e.g., percentage-of-completion). If an entity does not satisfy a performance obligation over time, the performance obligation is satisfied at a point in time.
Performance obligations satisfied over time
An entity transfers control of a good or service over time (rather than at a point in time) when any of the following criteria are met:
- The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs.
- The entity’s performance creates or enhances an asset (e.g., work in progress) that the customer controls as the asset is created or enhanced.
- 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. [IFRS 15 35]
If an entity is unable to demonstrate that control transfers over time, the presumption is that control transfers at a point in time.
The customer simultaneously receives and consumes benefits as the entity
As discussed in the Basis for Conclusions, the Boards created this criterion to clarify that, in pure service contracts, entities generally transfer services over time. In addition, the Boards intend that this criterion only applies to services and not to goods. As a result, the Boards note that an entity does not apply this requirement to determine whether a performance obligation is satisfied over time if the entity’s performance creates an asset the customer does not consume completely as it is received. Instead, an entity assesses that performance obligation using the criteria discussed in ‘Customer controls asset as it is created or enhanced’ and ‘An asset with no alternative use and right to payment’ below.
E&C entities that provide project management, construction supervision or engineering services will need to carefully evaluate their contracts to determine whether the services performed are simultaneously received and consumed by the customer. It may be apparent that activities such as day-to-day site supervision services meet the criteria for recognition of revenue over time.
These judgements may also be affected by an entity’s conclusion about the number of performance obligations (i.e., single or multiple) within the contract.
Customer controls asset as it is created or enhanced
The second criterion in which the control of a good or service is transferred over time is where the customer controls the asset as it is being created or enhanced. For purposes of this determination, the definition of control is the same as previously discussed (i.e., the ability to direct the use of and obtain substantially all of the remaining benefits from the asset).
The Boards note that for a construction contract in which an entity is building on the customer’s land, the customer often controls any work in progress resulting from the entity’s performance. The Boards said they believe the customer’s control over the asset as it is being created or enhanced indicates that the entity’s performance transfers goods or services to a customer over time.
An asset with no alternative use and right to payment
The Boards acknowledged that the application of the first two criteria could be challenging in certain circumstances. For example, a contractor may construct an asset, but only transfer title to the customer upon completion.
Alternatively, an entity may provide services that result in a tangible deliverable (e.g., drawings, site plans, technical specifications) in the latter part of a contract. As a result, the third criterion (mentioned above) was added whereby, if both of the following requirements are met, entities must recognise revenue for a performance obligation over time:
- The entity’s performance does not create an asset with alternative use to the entity. Recognise revenue in progress or at completion?
- The entity has an enforceable right to payment for performance completed to date. Recognise revenue in progress or at completion?
An asset created by an entity has no alternative use if the entity is either restricted contractually or practically from readily directing the asset for another use (e.g., selling to a different customer). An entity has to make this assessment at contract inception and does not update its assessment unless the parties to the contract approve a contract modification that substantively changes the performance obligation.Recognise revenue in progress or at completion?
The Boards specified that a contractual restriction on an entity’s ability to direct an asset for another use must be substantive (i.e., a buyer could enforce its rights to the promised asset if the entity sought to sell the unit to a different buyer). In contrast, a contractual restriction may not be substantive if the entity could instead sell a different asset to the buyer without breaching the contract or incurring significant costs.Recognise revenue in progress or at completion?
Furthermore, the Boards believe a practical limitation exists if an entity would incur significant economic losses to direct the asset for another use. A significant economic loss may arise when significant costs are incurred to redesign or modify an asset or when the asset is sold at a significantly reduced price.Recognise revenue in progress or at completion?
A contractor may be able to determine that an asset has no alternative use because its characteristics (e.g., location, design, technical specifications, materials) would generally result in a contractual and/or practical limitation to redirect its use to another buyer. In addition, an E&C entity that provides architectural or design services may conclude that drawings and plans prepared for a specific project have no alternative use.Recognise revenue in progress or at completion?
Enforceable right to payment for performance completed to date Recognise revenue in progress or at completion?
The laws or legal precedent of a jurisdiction may affect an entity’s conclusion of whether a present right to payment is enforceable.
An entity has an enforceable right to payment for performance completed to date if, at any time during the contract term, the entity would be entitled to an amount that at least compensates it for work already performed. This right to payment must be present, even if the buyer can terminate the contract for reasons other than the entity’s failure to perform as promised.
To satisfy this criterion, the amount to which an entity is entitled must approximate the selling price of the goods or services transferred to date, including a reasonable profit margin. Compensation for a reasonable profit margin does not have to equal the profit margin expected for complete fulfilment of the contract, but it must at least reflect either of the following:
- A proportion of the expected profit margin in the contract that reasonably reflects the extent of the entity’s performance under the contract before termination by the customer (or another party) Recognise revenue in progress or at completion?
- A reasonable return on the entity’s cost of capital for similar contracts (or the entity’s typical operating margin for similar contracts) if the contract-specific margin is higher than the return the entity usually generates from similar contracts Recognise revenue in progress or at completion?
Entities are required to consider any laws, legislation or legal precedent that could supplement or override contractual terms. In addition, the standard clarifies that including a payment schedule in a contract does not, by itself, indicate that the entity has the right to payment for performance completed to date. For example, progress billings collected from a customer may not reflect a reasonable profit margin on work completed to date. The entity has to examine information that may contradict the payment schedule and may represent the entity’s actual right to payment for performance completed to date (e.g., an entity’s legal right to continue to perform and enforce payment by the buyer if a contract is terminated without cause).
The standard provides application guidance in this area. It describes a situation in which a customer has a right to terminate the contract only at certain times during the life of the contract or where the customer does not have the right to terminate the contract. If a customer seeks to terminate a contract without having a right to do so (e.g., by not performing its obligations under the contract), the entity may be entitled under the contract or relevant legislation to continue to transfer the promised goods and services to the customer and, in return, require the customer to pay the consideration promised in exchange for those promised goods or services. In such circumstances, an entity has an enforceable right to payment for performance completed to date because the entity has a right to perform its obligations in accordance with the contract and to require the customer to perform its obligations (which include paying the promised consideration).
It may be difficult to demonstrate whether a real estate developer meets this criterion in practice. Recognise revenue in progress or at completion?
E&C entities that provide design or engineering services may consider the following example from the standard when assessing these criteria, reference is made to — Assessing Alternative Use and Right to Payment [IFRS 15IE 69 – IFRS 15IE 72].
For many construction-type contracts, it is likely that E&C entities will determine that control of many goods or services is transferred over time.
However, E&C entities will be required to understand all contract terms related to control and legal ownership of work in progress, as well as whether the asset has no alternative use and the entity has a right to payment for performance completed to date, when determining whether their construction-type contracts meet the criteria to recognise revenue over time.
Continue reading: Construction contracts – Measuring progress