Article:

IFRS 15 for the construction industry – Multiple contracts that should be combined

05 June 2018

Combination of contracts

In the construction industry it is very common for an entity to provide multiple goods or services to one customer or related parties of a customer. For example, a construction company can be engaged to provide design and engineering services as well as the actual construction. Even the construction itself could be seen as comprising many component services such as site clearance, foundations, procurement, construction of the structure, piping and wiring, etc. These activities can be dealt with under one contract or be separated into various sub-contracts. IFRS 15 will require construction companies to consider whether these contracts should be accounted for separately or as one combined contract. 

The following decision should be used to determine whether multiple contracts should be combined or not:

Example – Combination of contracts

Question
A customer engages Construction Co to provide construction services to build a house (contract price of $500,000) and a garage (contract price of $50,000). There are separate contracts for each of these two activities. They were negotiated together and a discount was given on the garage build as Construction Co would already have the necessary equipment on site from the house construction, and could also build the foundations simultaneously with the house. However, Construction Co has agreed with the customer to first build and complete the house and then finish the garage within the next three months.

The standalone selling prices of the house and garage are $500,000 and $80,000 respectively.

The expected cost to construct the land and garage are $400,000 and $64,000 respectively. At 30 June 2019, the entity has incurred costs of $200,000 in relation to the house and $5,000 in relation to the garage.

Question
Should the revenue from each of these contracts be kept separate and accounted for separately, or should the contracts be combined? How would the timing of the revenue recognised differ if the contracts were accounted for separated and combined?

Answer
If the contracts were accounted for separately, revenue would be recognised as follows:

Contract components Contract price Standalone selling price Estimated contract costs Costs incurred to 30 June 2019 Revenue recognised to 30 June 2019
House $500,000 $500,000 $400,000 $200,000 $250,000

$500,000 x($200,000/$400,000)
Garage $50,000 $80,000 $64,000 $5,000 $3906

$50,000x($5,000/$64,000)
Total $550,000 $580,000 $464,000 $205,000 $253,906

However, the entity needs to determine if the contracts for the building of the house and garage should be accounted for separately or as one combined contract.  The contracts were negotiated with the same customer, at the same time and pricing on one contract is dependent on the other. Construction Co also assesses that they have two separate performance obligations, because they will complete and handover the house 3 months before the completion of the garage. Revenue on both performance obligations is recognised over time, as construction is taking place on the customer’s land.

Therefore, the contracts should be combined and accounted for as one contract for the purposes of IFRS 15. Revenue would be recognised as follows:

Contract components Contract price Standalone selling price Relative standalone selling price Estimated contract costs Costs incurred to 30 June 2019 Revenue recognised to 30 June 2019
House $500,000 $500,000 $474,137
($500,000/$580,000 x $550,000)
$400,000 $200,000 $237,068

$474,137 x ($200,000/$400,000)
Garage $50,000 $80,000 $75,863
($80,000/$580,000 x $550,000)
$64,000 $5,000 $5,927

$75,863  ($5,000/$64,000)
Total $550,000 $580,000 $550,000 $464,000 $205,000 $242,965

Current practice under IAS 11

The common practice under IAS 11 would be to account for these two contracts separately and recognise the revenue for both the house and garage on a percentage of completion basis. However, timing of revenue recognition for both parts is not necessarily the same. For example, if the garage is completed first, revenue would be recognised earlier than for the house.

Practical implications on systems and processes  

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

  • Identifying that there are two related contracts
  • Determining whether related contracts should be combined
  • Identifying the number of performance obligations.