IFRS 15 provides a comprehensive and robust framework with clear principles for revenue recognition, especially revenue earned under contractual obligations, for real estate and construction companies.
The introduction of the International Financial Reporting Standard (IFRS) 15/Australian Accounting Standards Board (AASB) 15, to be implemented from 1 January 2018, means that 31 December 2018/30 June 2019 financial reports will be impacted with comparatives required for 31 December 2017/30 June 2018.
This poses an administrative challenge for real estate and construction companies as it will change the timing of revenue recognition for construction contracts.
Real estate and construction companies should not underestimate the administrative requirements the new revenue recognition standard will impose. Companies need to ensure their five year forecasts are accurate and should start to consider the impact on revenue recognition policies now.
What is IFRS 15?
IFRS 15 represents a joint initiative of the International Accounting Standards Board (IASB) and the US's Financial Accounting Standards Board (FASB) to introduce new guidelines for managing revenue from customer contracts. The existing international standards has seen limited guidelines for accountants on this point - leading to considerable diversity in implementation.
At the centre of the changes introduced by IFRS 15 is a core principle which states that revenue that depicts the transfer of goods and services needs to be an amount that reflects what the entity expects to be entitled in exchange for these products.
There are five steps that underpin this core principle:
- Identifying the contract
- Recognising separate performance obligations - a promise to provide goods or services. Two or more services can be combined if they represent one overall obligation
- Determining the transaction price
- Allocating this price to a contractual performance obligation
- Recognising revenue when these obligations have been satisfied. This could be either at a specific point in time or over time, and signifies when the client receives ownership of the project.
How will IFRS 15 impact the real estate and construction sector?
While these changes will have important implications for a range of industries, real estate and construction are areas where they will have the greatest impact. The areas expected to be of significance include:
Over time versus point in time revenue recognition
- The concept of the vendor needing to assess if they have an ‘alternative use’ for the asset they are constructing is a significant change to current revenue recognition criteria. If there is no alternative use, and the vendor does not have an enforceable right to be paid for work completed to date, the vendor will be required to recognise revenue at a point in time, such as on completion of the contract rather than ‘over time’ as the contract is completed.
Measuring progress towards completion
- This is based on either an output method (based on the value of goods and services transferred) or an input method (based on resources consumed). Importantly, inputs that do not directly relate to the vendors performance are excluded when measuring performance.
Bundling and unbundling of contracts
- It may be that a number of contracts need to be bundled together to form one contract, or a single contract needs to be unbundled into separate contracts. Bundling and unbundling of contracts will be driven by the separability of certain performance obligations under the contract/s.
Contracts with variable consideration and modifications to contracts
- Variable consideration is measured based on the specific circumstances outlined in the contact and is limited to the amount for which it is highly probable that there will not be a significant reversal in the cumulative amount of revenue recognised to date.
- Modifications to contracts need to be assessed to determine whether the extent of the modification is such that a new contract has been issued. Revenue recognition needs to be adjusted to be in line with the modification, or the new contract.
Costs for obtaining a contract
- Only incremental costs of obtaining a contract are considered. Costs that would not have been incurred if the contract had not been obtained can be capitalised and amortised over the revenue recognition pattern of the contract.
Implicit and explicit financing components
- Where cash receipts do not correspond with timing of revenue recognition by longer than a year, an adjustment to revenue needs to be determined as either finance income (decrease revenue) for payment in arrears, or finance expense (increase in revenue) for payments in advance.
To better understand how IFRS 15's revenue guidelines will work in practice, we have outlined below some example’s that compare current accounting under AASB 118 Revenue and what would be required under IFRS/AASB 15.
Installing a specific piece of large equipment/machinery
While IFRS 15 allows revenue to be based on the proportion of costs incurred to date (‘costs incurred to date’ model), which is similar to the ‘percentage of completion’ method under AASB 111 Construction Contracts, it potentially differs significantly in respect of the pattern of profit recognition when the construction contract involves the installation of large pieces of specific equipment or machinery (e.g. lifts, turbines, engines, etc.), which have a significant cost.
IFRS 15 requires that the cost of the equipment/machinery be excluded from the ‘costs incurred to date’ model when determining the profit recognised, because that cost is not indicative of the progress of the construction activity. When such material is installed and control passes, revenue is only recognised to the extent of the costs of the materials installed, and no profit margin is recognised.
Under AASB 118, revenue and profit margin is typically recognised when the equipment is installed as part of the percentage of completion method.
In situations where large pieces of equipment are installed early on in the construction contract, IFRS 15 will most likely delay the recognition of revenue, and therefore profit, compared with current practice under AASB 111.
Mobilisation fees, such as recruiting teams and building capacity to fulfil the contract, are also excluded from the ‘costs incurred to date’ model. As the customer has not received a benefit from 'mobilisation’, this does not represent revenue under IFRS 15. Any fees received from the customer associated with this mobilisation are not separately recognised as revenue, but are recognised as part of the total contract price and therefore recognised over the period of the contract.
Costs in relation to mobilisation activities may be capitalised and amortised over the period of the construction contract.
Performance penalties and bonuses
Penalty payments often apply when a project is not completed on time. Similarly, when a project is completed on time, or earlier than the agreed date, performance bonuses may also apply. Penalty payments and performance bonuses are variable consideration under IFRS 15.
Compared to AASB 118, IFRS 15 contains more detailed guidance on variable consideration. Under IFRS 15, variable consideration must be estimated using one of these two methods:
- Expected value method – this method involves adding up the probability-weighted amounts in the range of the total possible consideration, or
- Mostly likely value method – this method involves choosing the single most likely amount from a range of possibilities. This would be appropriate where there are say only two possible outcomes.
The method used should be the one that is expected to better predict the outcome. The estimate needs to be updated every reporting period.
When estimating variable consideration, IFRS 15 requires the application of 'constraint’ and recognise variable consideration as revenue ‘only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognised will not occur’.
Design and build’ contracts
It is not uncommon to enter into separate contracts with a customer, one for design work, and the other for construction. IFRS 15 contains significantly more guidance when accounting for contracts that are not ‘distinct’ from another contract.
‘Design and build’ contracts are likely to be accounted for as one performance obligation under IFRS 15, rather than two separate contracts. This means that ‘design’ revenue will be recognised over the period of the ‘design and build’ performance obligation, rather than on completion of the ‘design’ contract.
Contracts with significant advance payment terms
Under IFRS 15, the amount of revenue recognised on construction contracts with significant advance payment terms is likely to be higher than the agreed contract price. The advanced payment from the customer represents a borrowing cost, which has effectively been netted off the amount received from the customer. Revenue recognised under IFRS 15 would effectively be ‘grossed up’ by the amount of interest expense (the amount ‘borrowed’ from the customer to fund construction).
It is likely that the borrowing cost would qualify for capitalisation if the asset under construction is a qualifying asset under AASB 123 Borrowing Costs.
1 June 2018
- Builder Co enters into a contract to refurbish an old building and install a lift for $5,000,000
- Refurbishment work is to be completed by 30 June 2019. If the refurbishment is not completed on time there will be a $100,000 penalty for each week that Builder Co is late
- Builder Co estimates total costs for the project to be $4,000,000
- Lift cost: $1,500,000
- Other refurbishment costs, including installation costs of the lift (‘refurbishment costs’): $2,500,000.
Based on the facts above and details of progress below, how should Builder Co recognise revenue and profit at 30 June 2018, 31 December 2018, 30 June 2019, 31 December 2019 and 30 June 2020?
1 June 2018
- Builder Co enters into a contract to refurbish an old building.
- Builder Co charges the customer a mobilisation fee of $200,000 to set up site security, and bring in equipment and facilities such as a port-a-cabin and a port-a-loo for the construction workers.
- The mobilisation cost to Builder Co is $150,000.
How should Builder Co recognise the mobilisation fee and the associated costs?
1 January 2018
- Construction Co enters into two contracts, one to design, and the other to build a factory.
The design stage is completed by 30 June 2018 and the construction of the factory is completed by 30 June 2019.
How should Construction Co recognise revenue at 30 June 2018 and 2019?
The impacts of IFRS 15 are not only the significant changes in the patterns of revenue and profit recognition as the above examples have shown. Systems and processes will also have to change to deduct the costs of significant equipment/material and mobilisation costs in calculating percentage of progress to date. Entities in the construction industry will also need to think about how to account for penalties and performance bonus payments in construction contracts, as well as its policy and processes for estimating the expected or most likely value, and revising the estimate at each reporting date.