Article:

IFRS 15 for the construction industry – Contract Modifications

06 June 2018

It is common for the scope and/or price of construction contracts to be modified due to changes in the scope of work (often termed contract variations) or because additional goods or services are added to the contract.  IFRS currently has limited guidance for the accounting consequences of these changes.  In contrast, IFRS 15 has detailed guidance to be applied in determining whether, from an accounting perspective, contract modifications result in changes to the existing contract or the issue of a new contract. This links to whether there is either an adjustment to the amount of revenue recognised to date (resulting in a ‘true up’ in the income statement) or to revenue to be recognised in future.  These new requirements may result in significant changes to the pattern of revenue and profit recognition.

Example – Modification (distinct good/service)

Background
On 1 January 2019, a customer engages Construction Co to provide construction services to build a house for $500,000 (estimated cost $300,000).

On 1 January 2020, Construction Co and the customer agree to modify the contract to include a swimming pool for an additional $50,000 (estimated cost $40,000).

Construction Co regularly builds swimming pools on a standalone basis and the standard price for this is $60,000.  Construction Co has been recognising revenue on a stage of completion basis and at 1 January 2020, 50% of the original contract value has been completed.

Question
How should this contract modification be accounted for?

Answer
The construction of the swimming pool is a distinct good that should be accounted for as a separate performance obligation. As the contract price for the swimming pool is $50,000 which is less than the standalone selling price of $60,000, the modification is treated as a termination of the original contract and a new contract is created. This means that any unperformed work on the old contract is combined with the new swimming pool contract. As such, total consideration on the ‘new contract’ is $300,000 ($250,000 + $50,000).

Revenue is then split between the two performance obligations as follows:

Contract components Contract price Standalone selling price Revenue
House $250,000 $250,000 $241,935

$250,000x($300,000/$310,000)
Swimming pool $50,000 $60,000 $58,065

$60,000x($300,000/$310,000)
Total $300,000 $310,000 $300,000

Revenue recognised prior to contract modification:                    $250,000 ($500,000 x 50%)

Revenue to be recognised based on contract modification:

• House $241,935
• Swimming pool $58,065

This means that for the remaining construction services to be performed in building the house, revenue will be $241,935 rather than $250,000, due to the swimming pool discount allocated to both performance obligations (i.e. the rest of the house and the new swimming pool).

Current practice under IAS 11

The common practice under IAS 11 would be to account for these two contracts separately and recognise the revenue on a stage of completion basis for each separate contract.

Example – Modification (not a distinct good/service)

Background
On 1 January 2019, a customer engages Construction Co to provide construction services to build a house for $500,000 (estimated cost $300,000). On 1 January 2020, Construction Co and the customer agree to modify the contract to upgrade the kitchen for an additional $100,000 (estimated cost $50,000). Construction Co has been recognising revenue on a stage of completion basis and at 1 January 2020, 50% of the original contract value has been completed.

Question
How should this contract modification be accounted for?

Answer
The modified kitchen does not represent a good or service that is distinct so Construction Co needs to continue the contract and adjust revenue recognised to date via a cumulative catch up adjustment.

  End of Year 1
Total costs incurred to date $150,000 (50% x $300,000)
Updated total expected costs $350,000 ($300,000 + $50,000)
New % of completion 42.86% ($150,000/$350,000)
Revenue recognised based on modified contract $257,143 ($600,000 x 42.86%)
Revenue recognised to date $250,000 ($500,000 x 50%)
Cumulative catch-up adjustment. $7,143 ($257,143 – $250,000)

The following journal entry will be processed by Construction Co on 1 January 2020:

Dr Trade receivable $7,143  
Cr Revenue   $7,143

Current practice under IAS 11

There is limited guidance under current accounting standards, but common practice would be to account for the changes on a prospective basis.

Practical implications on systems and processes

Some of the practical implications on systems and processes for Construction Co include:

  • Identifying whether the additional goods or services are distinct
  • Systems to determine the cumulative ‘catch up’ adjustment where additional goods or services are not distinct.