Article:

IFRS 15 for the construction industry – Timing of revenue recognition

05 June 2018

Should revenue be recognised at a point in time or over time?

IFRS 15 contains specific, and more precise guidance to be applied in determining whether revenue is recognised over time (often referred to as ‘percentage of completion’ under existing standards) or at a point in time.

The general principle is that revenue is recognised at a point in time. However, if any of the criteria in IFRS 15, paragraph 35 are met, revenue should be recognised over time. The following decision tree is a useful tool to determine whether revenue should be recognised at a point in time or over time:

IFRS 15 Timing decision tree

If revenue is recognised at a point in time, how should that point in time be determined?

If revenue is recognised at a point in time, the overall principle is that revenue should be recognised at the point in time at which it transfers control of the good or service to the customer.

The following indicators should be considered to determine whether control of an asset or service has been transferred:

  • Does the customer have a present right to payment for the asset?
  • Does the customer have legal title to the asset?
  • Has the entity transferred physical possession of the asset to the customer?
  • Does the customer have significant risks and rewards of ownership of the asset?
  • Has the customer accepted the asset?

If revenue is recognised over time, how should progress towards completion be measured and recognised?

If revenue is recognised over time, the overall principle is that revenue is recognised to the extent that each of the vendor’s performance obligations has been satisfied.

IFRS 15 permits either output or input methods to be used to calculate the amount of revenue to be recognised. An output method results in revenue being recognised on the basis of direct measurement of the value of goods or services transferred to date, while input methods result in revenue being recognised based on measures such as resources consumed, costs incurred or machine hours.

It is noted explicitly that when input methods are used, there may not be a direct relationship between the inputs being used, and the transfer of goods or services to a customer.  Consequently, any inputs that do not relate directly to the vendor’s performance in transferring those goods and services are excluded when measuring progress to date.

In addition, the guidance extends to cover and affect not only revenue recognition, but also profit recognition. For example, a construction contract might involve the vendor procuring high value items for installation, such as elevators.  IFRS 15 takes the view that although it is appropriate to recognise revenue from the sale of the elevators at the point at which control is transferred to the customer, it is not appropriate to recognise profit.  This is because the vendor’s performance obligations are in connection with the construction of the building and the installation of items such as elevators; the supply of components does not result in any part of that service being provided.  Consequently, and particularly if an input method is being used for the purposes of revenue recognition, in many cases the vendor would recognise an equal amount of revenue and cost of sales for the elevators, with profit margin only being recognised on the construction and installation services.

Example 1 – Input method

Background
Customer A engages Construction Co to build a ship for $2,000,000 (expected cost $1,500,000) on 1 January 2017. The amount is payable on completion.

The ship has been designed specifically to suit the needs of Customer A and includes a number of features that may not be useful for other customers.

Construction Co operates in a jurisdiction where if Customer A terminated the contract, Construction Co would be entitled to payment for the percentage they had completed (i.e. Construction Co would be entitled to sue for damages which would include costs incurred to date plus lost profit).

The ship was completed on 31 December 2017. Construction Co’s financial year end is 30 June 2017. At 30 June 2017, Construction Co had incurred 50% of costs and their senior project manager estimated they had completed 50% of the build.

Question
How should Construction Co account for this arrangement as at 30 June 2017?

Answer
Construction Co should recognise its revenue over time because the third criterion in IFRS 15, paragraph 35(c) is met. That is:

  • The ship has no alternative use as it has been built to Customer A’s specific requirements, and
  • Construction Co also has an enforceable right to payment under the legal system it operates within.

Construction Co should use the input method of calculating progress (costs incurred to date) because this is the most accurate method it has of estimating completion. The project manager’s estimate would not be appropriate as it is merely an estimate while the costs are actually known. Therefore, costs would be the most objective method of measuring completion.

30 June 2017

Type Budgeted
$
Incurred
$
Percentage completed
Costs 1,500,000 750,000 50% = ($750,000/$1,500,000)
Revenue 2,000,000 1,000,000
= (2,000,000 x 50%)
50%

Construction Co would have processed the following journal entry as they incurred the construction costs during the year ended 30 June 2017:

Dr   Contract costs  750,000  
  Cr Bank/Creditors   750,000

The journal entries at 30 June 2017 in relation to the revenue recognised is as follows:

Dr   Cost of goods sold 750,000  
  Cr Contract costs   750,000
Dr   Trade receivables 1,000,000  
  Cr Revenue   1,000,000

Current practice under IAS 11

There would be similar treatment under IAS 11, however, there are more specific requirements under IFRS 15. For example, if the ship could be easily sold to another customer and/or the construction company’s legal framework did not allow for it to legally enforce payment; then revenue could not be recognised over time under IFRS 15.

Example 2 – Input method (uninstalled materials)

Background
On 15 December 2018, Building Co enters into a contract to refurbish an old building and install an elevator for $5,000,000. Costs on the contract comprise:

• Elevator $1,500,000
• Other refurbishment costs $2,500,000
  $4,000,000

The elevator is delivered by Building Co to the customer’s premises on 31 December 2018.

The refurbishment work is completed by 31 December 2019.

Assume Building Co qualifies for ‘over time’ revenue recognition under IFRS 15, paragraph 35(c), and recognises revenue using an ‘input method’ to determine percentage of completion.

Question
How should Building Co account for this arrangement as at 31 December 2018?

Answer
IFRS 15, paragraph B19 notes that with the input method, depending on the timing or pattern of costs incurred, there may not be a direct relationship between an entity’s inputs and the transfer of control of goods or services to a customer. For example, Building Co incurs a significant amount of costs on the elevator up front, but these costs do not reflect transfer of control of the refurbishment works to the customer.

Building Co therefore excludes from an input method the effects of any inputs that do not depict the entity’s performance in transferring control of goods or services to the customer, i.e. the cost of the elevator. No profit margin is recognised when the elevator is delivered but revenue is recognised to the extent of the costs of the elevator incurred as follows:

  31 December 2018 31 December 2019 Total
Revenue $1,500,000 $3,500,000 $5,000,000
Costs $1,500,000 $2,500,000 $4,000,000
Net profit NIL $1,000,000 $1,000,000

Current practice under IAS 11

Profit would be recognised on the delivery of the elevator at 31 December 2018, even though it had not been installed. The cost of the elevator would be included in Building Co’s calculation of percentage of completion using the input method.  

Practical implications on systems and processes  

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

  • Processes needed to identify the appropriate revenue recognition pattern using specific fact patterns for each transaction
  • Systems to calculate ‘over time’ or ‘point in time’ revenue recognition
  • Systems to isolate significant amounts of ‘uninstalled materials’ such as elevators and other significant costs which are not proportionate to the entity’s progress in satisfying its performance obligation
  • Systems to recognise revenue and account for timing differences between payment/invoicing and revenue.