Article:

IFRS 15 for the construction industry – Long-term contracts

06 June 2018

Long-term contracts where the customer pays a deposit

In the construction industry, it is very common for a customer to be required to pay a deposit or portion of the contract price upfront. There can also be cash receipts from customers which do not correspond with the timing of the recognition of revenue. IFRS 15 requires the entity to consider if this represents a financing arrangement.  If a financing component is significant, IFRS 15 requires an adjustment to be made for the effect of implicit financing.

Example – Customer pays a deposit

Background
Construction Co enters into a contract with a customer to supply a new building. Control over the completed building will pass to the customer in two years’ time (assuming the vendor’s performance obligation will be satisfied at a point in time). The contract contains two payment options:

  • The customer can pay $5 million in two years’ time when it obtains control of the building, or
  • The customer can pay $4 million on inception of the contract.

The customer decides to pay $4 million on inception. Construction Co’s incremental borrowing rate is determined to be 6%.

Question
Does the upfront deposit represent a financing arrangement?

Answer
Because of the significant period of time between the date of payment by the customer and the transfer of the asset (the completed building) to the customer, together with the effect of prevailing market rates of interest, there is a significant financing component in this arrangement.

The following journal entry is recognised at contract inception:

Dr Cash       $4,000,000  
Cr Contract Liability   $4,000,000
Recognition of a contract liability for the payment received in advance

The following journal is recognised over the two-year construction period:

Dr Interest expense $494,400  
Cr Contract Liability   $494,400
Accretion of the contract liability at a rate of 6% (6% compound interest X $4 million for 2 years)

The following journal is recognised at the date of the transfer of the asset to the customer:

Dr Contract Liability $4,494,400  
Cr Revenue   $4,494,400
Recognition of contract revenue after performance obligation has been satisfied

Current practice under IAS 11

The common practice under IAS 11 would be to recognise the $4 million as revenue in two years’ time when control passes to the buyer, and not account for the financing component.

Example – Customer pays in arrears

Background
Construction Co enters into a contract with a customer to supply a new building. Control over the completed building will pass to the customer in 12 months’ time (assuming the vendor’s performance obligation will be satisfied at a point in time). The contract contains two payment options:

  • The customer can pay $4.5 million in 12 months’ time when it obtains control of the building, or
  • The customer can pay $5 million one year after control passes to the customer.

The customer decides to use the second payment option. Construction Co’s incremental borrowing rate is determined to be 6%.

Question
Does the upfront deposit represent a financing arrangement?

Answer
Because of the significant period of time between the date of payment by the customer and the transfer of the asset (the completed building) to the customer, together with the effect of prevailing market rates of interest, there is a significant financing component in this arrangement.

The following journal entry is recognised at the date the building is transferred to the customer:

Dr Trade receivable $4,716,981  
Cr Revenue from sale of building   $4,716,981
Recognition of revenue from sale of building at net present value of $5 million payable in 12 months’ time at incremental borrowing rate of 6%.

The following journal entry is recognised over the one year until payment is received from the customer:

Dr Trade receivable $283,019  
Cr Interest revenue   $283,019
Accretion of the interest on the trade receivable at a rate of 6% compound interest for 1 year

The following journal is recognised when the customer settles the debt 12 months after the delivery of the building:

Dr Cash $5,000,000  
Cr Trade receivable   $5,000,000
Recognition of cash received from customer.

Current practice under IAS 11

It is likely that there is divergent current practice regarding the treatment of the additional $500,000 deferred consideration. Some entities may recognise this as a financing component but it is likely that many may not.

BDO Comment

For the purposes of identifying whether there is a significant financing component, the comparison made is between the timing of payment and the timing of transfer (of control) of the related goods or services. For those entities that provide goods or services (such as those in the construction sector) where revenue is not recognised until a point in time (on transfer of the completed item to the customer), an adjustment for financing may be required even if construction services are being carried out over a period of time.
When a significant financing component is recognised, consideration is required of whether the interest income or expense is required to be capitalised by IAS 23 Borrowing Costs.

Practical implications on systems and processes

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

  • Identifying that there is a financing component
  • Working out the incremental borrowing rate of the entity
  • Systems to split out the transaction into its two components
  • Systems to recognise the impact of the financing component.