Construction contracts can span several fiscal years/reporting periods, which makes it difficult to determine how much revenue, expense and profit/loss should be recognized. The new IFRS 15 guidelines specify when to recognize revenue associated with contracts.
For a summary of IFRS 15 Revenue recognition criteria, visit our Revenue article.
Specifically, IFRS 15, Paragraph 35 deals with Obligations that are satisfied over time.
Revenue should be recognized over a period of time, if one of the following criteria is met:
“the customer simultaneously receives and consumes the benefits provided by the entity's performance as the entity performs; OR
the entity's performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced; OR
the entity's performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.”
Construction contracts that span several years fall under the third point, where the construction of an asset would not create something that the entity could use themselves, and the entity should have enforceable right to payment (likely through a signed contract).
However, we still need clarity on how much revenue and expense to recognize. Below, we review the special rules for how construction contracts are recognized.
Let’s first review some terminology and definitions.
Definitions and Terminology
Two types of Construction Contracts:
There are two different types of Construction Contracts, and these are accounted for differently.
Fixed Price: Parties agree to a fixed price for the contract, or on a per-unit basis.
Cost Plus: Client repays costs incurred, plus either a percentage of the costs or a fixed amount to cover labor and profits.
Progress Billings:
Progress Billings is a separate account that the entity should create to keep track of Revenue that is collected for each individual project. The entity will submit bills for work completed throughout the project. These are not billed for the completed project and therefore should not be credited directly to the “Sales” or “Revenue” accounts. Instead of using the “Revenue” account, these progress billings are recorded under a separate “Progress Billing” account for each project.
Progress Billing Journal Entries in Entity’s Books:
When Cash is received:
Similarly to the Progress Billing account, the client will have a “Construction in Progress” account, that acts like a temporary asset account, in which the client will record their construction progress.
Progress Billing Journal Entries in the Client’s Books:
Contract Revenues and Expenses:
For the entity building the asset, they will need to recognize Revenues and Expenses at each reporting period.
Contract Revenue (added to Progress Billing account)
= Initial amount that has been agreed upon
+ Variations in contract (they must be probable and reliably measured)
- Penalties imposed (such as late penalties, etc..)*
Note: Penalties are netted from revenue, these are not added to Expenses
Contract Costs/Expenses includes:
Costs related to the contract directly, such as materials and labor
Direct Construction Overheads
Anything else in the terms of the contract that are meant to be paid by the client
If it is probable that the contractor will obtain the contract, costs incurred in obtaining the contract can also be included in the Costs/Expenses. Note that when this cost is expensed, it cannot be reversed.
Contract Costs/Expenses do not include:
General administrative expenses or overheads
Research and development costs
Selling and marketing costs
Depreciation on plant and equipment that are not being used in the contract (idle PPE)
Stage of Completion:
The Revenue and Expense figures may be based on stage of completion. For example:
Revenue recorded for the period = (Total Revenue expected for the project) x (% completion)
or
Expenses recorded for the period = (Total Expenses expected for the project) x (% completion)
Calculating Revenue, Expenses and COGS
The amount of Revenue, Expense, Profit and Loss recognized by the entity will depend on two factors: 1) whether the project is expected to make a profit or loss and 2) whether the estimate is reliable or not.
A summary of how the two factors influence the amount of Revenue and Expense which should be recognized can be found below. The steps/approach to calculating each element is shown in the section below.
Summary of Treatment:
Does the contract make a Profit or a Loss and are the estimates Reliable or Unreliable?
*As from the definitions above, stage of completion means:
Revenue recorded for the period = (Total Revenues expected for the project) x (% completion)
or
Expenses recorded for the period = (Total Expenses expected for the project) x (% completion)
Step 1
Calculate whether the contract will make an overall profit or loss, and percentage completion.
Overall Profit or Loss
Note - this is “overall” and should include revenues received, expected revenue to be received, costs incurred and expected costs for the remainder of the period.
Profit or Loss = (Total Revenues + Approved Variations) - Total Costs
If we are not given the Total Revenues and Approved Variations, we can calculate the % completion using the following formula:
Percentage Completion = Costs Incurred to Date / Total Estimated Project Costs
Reliable Estimate:
Oftentimes, a reliable estimate can only be obtained when the project is far enough along. If you are writing an exam case, the case might state that the estimate is reliable if the contract is at least X% complete, otherwise they will be considered unreliable. Use case facts (in an exam situation) or discuss with a project manager (in real life) to determine how far along the project is, and whether this estimate is reliable.
Outcomes can be estimated reliably when:
Total contract revenue can be assessed reliably
It is probable that the economic benefits will flow to the company
Both contract costs to complete and stage of completion can be measured reliably
Contract costs can be clearly identified and measured reliably
For Fixed Price contracts, all 4 criteria must be met to be considered reliable. For Cost Plus contracts, only 2. and 4. are required.
Step 2
Using the Summary table above, as a guide, calculate the Revenue to be recognized for the reporting period.
Journal entry in Entity’s book:
This journal entry recognizes Revenue associated with an unfinished construction Project A.
Note: the Construction in Progress account will show in the Balance Sheet under “Assets”.
Step 3
Calculate the COGS, using the table above as a guide.
For Losses:
Total Loss recognized = Total estimated Revenue for whole project - Total estimated COGS
Journal entry in Entity’s book:
Step 4
Calculate the Accounts Receivable and Amounts Due To or From the Client.
Account Receivable:
Account Receivable are amounts for which we have billed the client, but have not yet received payment.
Accounts Receivable = Progress Billings Invoiced - Progress Billings Received
Amount Due To or From the Client:
“Amounts Due To” or “Amounts Due From” the client are amounts that are owed to/from the client, but have not yet been billed. It is important to note that these are different from A/R and A/P. Since we have not yet billed the client these are not yet an A/R or A/P accounts. These accounts will still appear in the Balance Sheet under either Current Assets (“Amounts Due From”) or Current Liabilities (“Amounts Due To”).
* Recognized means this is what was calculated from the steps above.
If Gross amount is a Debit balance, the client still owes for costs incurred and/or work completed, but has not yet been invoiced. This is presented as under Current Assets category of the Balance Sheet.
If Gross amount is a Credit balance, we owe the client money, as they have been over-invoiced. This is presented under the Current Liabilities category of the Balance Sheet.
Cost Plus Contracts
Costs are recognized to the extent that they are incurred. Although estimates were initially made, it is important to use only Actual costs incurred. Revenues are recognized based on the Costs + % margin added.
Revenues = Actual Costs Incurred + % Markup on Actual Costs incurred
COGS = Actual Costs Incurred
Presentation
Excerpt from Statement of Comprehensive Income/Income Statement:
Note: Revenue from all the different contracts can be added together. Similarly, COGS can be added together.
Excerpt from Statement of Financial Position / Balance Sheet:
As shown, we can add all of the accounts within “Gross Amount Due from Clients” as well as those within “Gross Amount Due to Client”, across several contracts, to show one number on the Balance Sheet for each category. However, NEVER EVER net the two off of each other. Do not subtract “Gross Amount Due from Clients” from “Gross Amount Due to Clients.” These must be presented as separate categories.
Closing the Accounts
Upon completion of the contract, the entity should close all temporary accounts.
Example journal entry in entity’s book:
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