Article:

IFRS 15 for the construction industry – Contracts that have variable consideration

06 June 2018

The amount of consideration specified in a construction contract may be fixed, variable, or a combination of fixed and variable amounts.

When the consideration promised in a contract with a customer includes a variable amount, the vendor estimates the amount of consideration to which it is entitled to in exchange for the transfer of the promised goods or services. There are two possible estimation methods which can be used, namely the expected value method or the most likely amount. Once a method has been selected, it must be applied consistently throughout the term of each contract.

Expected value method

The expected value is the sum of the probability-weighted amounts in a range of possible consideration amounts. This may be an appropriate approach if the vendor has a large number of contracts which have similar characteristics.

Most likely amount

The most likely amount is the single most likely amount in a range of possible consideration amounts (i.e. the single most likely outcome of the contract). This may be an appropriate approach if a contract has two possible outcomes, such as a performance bonus which will, or will not, be received.

The method chosen is not intended to be a free choice, but rather the one which is expected to provide a better prediction of the amount of consideration to which a vendor expects to be entitled.

One of the key principles is that variable consideration can only be recognised if it is highly probable that a significant reversal in the amount of the cumulative revenue recognised will not occur. There is no specific guidance on what highly probable is but this is generally thought to be more than 75-80%.

Performance bonuses

In the construction industry it is very common for there to be performance bonuses tied to completion time to incentivise construction within a specified time frame. There can also be performance bonuses tied to warranty and defect periods.

Example (using expected value method)

Background
A customer engages Construction Co to build a warehouse for $1,000,000. If the warehouse is completed on time, Construction Co will receive a performance bonus of $100,000. This amount reduces by $10,000 for every week Construction Co is late.

Estimated completion date Probability
On time 25%
One week late 25%
Two weeks late 20%
Three weeks late 20%
Four weeks late 10%

Question
What is the transaction price?

Answer
We would use the expected value method in this example because using the most likely amount would violate the significant reversal principle (none of the above scenarios is in excess of 75-80% and hence would most likely result in a reversal). Using the expected value method, we would use the probability-weighted expected consideration to calculate the expected revenue.

Estimated completion time   Probability-weighted consideration
$
On time 25% x (1,000,000 + 100,000) 275,000
One week late 25% x (1,000,000 + 90,000) 272,500
Two weeks late 20% x (1,000,000 + 80,000) 216,000
Three weeks late 20% x (1,000,000 + 70,000) 214,000
Four weeks late 10% x (1,000,000 +60,000) 106,000
  Total transaction price 1,083,500

Current practice under IAS 11

The common practice under IAS 11 would be to account for the revenue when it is probable that it will be received, and entities would usually recognise the most likely option and not weight the probability of a number of options.

Penalties

Many construction contracts contain penalty clauses that are tied to completion date or warranty/defect periods. These form part of variable consideration and need to be factored into the transaction price.

Example – Using ‘most likely outcome’ method

Background
Construction Co enters into a contract to build an oil rig for $100,000. If the rig is not completed on time, there will be a $20,000 penalty. Build Co has built similar oil rigs before and there is a 90% chance that the oil rig will be completed on time.

Question
What is the transaction price?

Answer
There are only two possible amounts of consideration:

  • $100,000 if the build is completed on time, or
  • $80,000 if the build is not completed on time.

In this scenario, the ‘most likely amount’ method better predicts the amount of consideration. Therefore, the transaction price is $100,000. Selecting this amount would mean it is highly probable that there would not be a significant reversal in revenue because the historical compliance with the deadline is 90% (in excess of 75-80%).

Current practice under IAS 11

Current practice would be to account for the revenue as $100,000 and then $20,000 as an expense.

Practical implications on systems and processes  

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

  • Determining the probabilities of estimated completion dates tied to performance bonuses and penalties
  • Determining the probability of defects and warranties tied to penalties
  • Selecting the appropriate estimation method for calculating variable consideration.