Sarah Hallam – Director
Project accounting is the practice of capturing and apportioning all costs to individual projects or engagements, assessing appropriate stages of project completion and allocating profits to the correct accounting period. It is a standard requirement under IFRS.
There are a number of construction businesses that are still failing to meet some of the key requirements of long-term project accounting and this lack of understanding can place the business at serious financial risk, potentially leading to business failure and/or wrongful trading.
Long-term project accounting is widely used by businesses in the construction industry and there are a wide variety of benefits that are offered:
- Ability to closely monitor all the costs within an individual project
- Improving management capabilities
- Prevent overruns
- Meet client expectations
- More informed decision making
- Generate bottom line savings
To bring in additional complexities, IAS 11: Construction Contracts has now been replaced by a new standard called IFRS 15 Revenue from Contracts with Customers in order to provide a more robust framework for addressing revenue issues and to improve comparability of revenue recognition practices across industries.
New revenue guidance – IFRS 15 for the construction industry
For all entities applying International Accounting Standards (IAS), this standard came into effect for annual reporting periods beginning on or after 1 January 2018.
The core principle in the new standard is to recognise revenue in a way that reflects how the goods or services are provided to the customer.
Entities will apply a five-step model to determine when to recognise revenue, and at what amount. The model specifies that revenue should be recognised as an entity transfers control of goods or services to a customer at the amount to which the entity expects to be entitled.
The standard contains specific guidance to be applied in determining when revenue is recognised:
At a point in time; or
To apply the new criteria, an entity will need to evaluate the nature of its performance obligations and review its contract terms, considering what is legally enforceable in its jurisdiction.
Revenue that is recognised over time
If revenue is recognised over time, the overall principle is that revenue is recognised to the extent that each of the performance obligations has been satisfied.
The standards permits either output or input methods to be used to calculate the amount of revenue to be recognised. Under the input method there may not be a direct relationship between the inputs being used and the transfer of services to a customer so any inputs that do not relate directly to the performance obligation should be excluded when measuring progress to date.
Sale of goods for installation
The guidance extends to cover and affect not only revenue recognition, but also profit recognition. IFRS 15 takes the view that although it is appropriate to recognise revenue from the sale of these items at the point at which control is transferred to the customer, it is not appropriate to recognise profit until these goods have been installed if the performance obligation is the installation of such items.
The new standard introduces new estimates and judgemental thresholds that will affect the amount or timing of revenue recognised.
Combination of contracts
In the construction industry it is very common for an entity to provide multiple goods or services to one customer such as being engaged to provide design and engineering services as well as the actual construction.
The construction phase itself could also be seen as comprising of many component parts such as site clearance, foundations, procurement and construction of the structure.
IFRS 15 requires construction companies to consider whether these contracts should be accounted for separately or as one combined contract.
The amount of consideration specified in a construction contract may include variable consideration. Where this exists, the vendor should estimate the amount of consideration to which it is entitled to in exchange for the transfer of services. There are possible estimation methods which can be used, namely the expected value method.
IFRS 15 contains a detailed criteria to be applied when determining whether costs associated with the acquisition of a contract, such as bid costs incurred prior to being awarded the contract, should be recognised as an asset or expensed as incurred.
The standard permits only those costs which would not have been incurred if the contract had not been obtained and are deemed recoverable through the profits to be generated from the project. These are eligible to be considered for capitalisation.
It is common for construction contracts to be modified due to changes in the scope of work or contract add ons.
IFRS 15 has detailed guidance to be applied in determining whether contract modifications result in changes to the existing contract or the issue of a new contract and whether there is an adjustment to the amount of revenue recognised to date or to revenue to be recognised in future.
The commercial effects
The adoption of IFRS 15 may lead to significant changes in the pattern of revenue and profit recognition. Careful consideration and planning will be needed for a wide range of issues, including the effect on:
- Systems used to record project costs and data
- Modification of future contract terms
- Compliance with bank covenants
- Performance-based compensation (including share-based payments)
- Internal budgeting processes including cash flow management
- Corporate tax obligations
How can we help your construction business?
The construction industry needs to pay attention to the new revenue standard now as the new standard will be difficult to apply due to the complex nature of its contracts. It is far more complex than the current accounting standard, and can significantly alter the pattern of revenue recognition and pattern of profit for the construction industry.
At Menzies we can offer assistance to businesses in applying the new standards from both the calculations and disclosure aspects. We can also advise businesses on how interrupt the revisions to their management information and the impact on their daily and future operations.