The adoption date for AASB 15 Revenue from Contracts with Customers is for financial periods beginning on or after 1 January 2018.
With 31 December 2018 year end fast approaching, have you ensured your revenue accounting is in accordance with the new standard?
This publication provides insight into he expected changes for the construction industry in Australia as a result of AASB 15.
The new revenue recognition model
The core principle of AASB 15 is that revenue recognition should reflect the pattern by which promised goods or services are transferred to customers, and the amount of consideration an entity is expected to be entitled to for transferring those goods or services. This principle is achieved by following five steps as depicted below:
- Step 1: Identify the contract(s) with a customer
- Step 2: Identify the performance obligations in the contract
- Step 3: Determine the transaction price
- Step 4: Allocate the transaction price to the performance obligations in the contract
- Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation
As a construction business typically involves long-term, multi-element contracts, we expect most potential changes arising from AASB 15 relate to identifying performance obligations, allocating the transaction price to performance obligations, and determining the timing of revenue recognition. Below we focus on identifying the major changes that construction companies are likely to experience in implementing AASB 15.
Specific Issues – Identifying performance obligations
AASB 15 introduces the notion of 'performance obligation'. 'Performance obligation' is defined as a good or service (or a bundle of goods and/or services) that is distinct; or a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.
A good or service is 'distinct' if both of the following criteria are met:
- capable of being distinct – the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer
- distinct within the context of the contract – the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract
It is essential that both criteria should be met in order for a good or service to be distinct. To meet criterion (a), a good or service should be capable of generating economic benefits, either on its own or together with other readily available resources (eg. those sold separately by this or other entity).
To help assess criterion (b) – whether a good or service is distinct within the context of the contract, AASB 15 contains a list of indicators including:
- the entity does not provide a significant service of integrating the goods or services into a combined output
- the good or service does not significantly modify or customise another good or service
- the good or service is not highly dependent or highly interrelated with other goods or services.
The below example (adapted from IFRS Illustrative Example 10) illustrates how the above criteria apply to a construction contract for purpose of identifying performance obligations:
Example A: A construction company enters into a contract to build a hospital for a customer. The entity is responsible for the overall management of the project and identifies various goods and services to be provided, including engineering, site clearance, foundation, procurement, construction of the structure, piping and wiring, installation of equipment and finishing. Many of those goods and services are regularly sold separately to other customers.
The promised goods and services are capable of being distinct in accordance with AASB 15. This is because many of them are regularly sold separately, which indicates a separate value on its own. In addition, the customer could generate economic benefit from the individual goods and services by using, consuming, selling or holding these goods or services. However, they do not meet criterion (b), because the entity provides a significant service of integrating the goods or services into a combined output (ie. the hospital). Because both criteria are not met, the goods and services are not distinct. The entity accounts for all goods and services in the contract as a single performance obligation.
We suggest entities reassess their existing construction contracts against the criteria for identifying distinct goods or services under AASB 15, to determine whether the previous segmentation applied under AASB 111 Construction Contracts is still appropriate for the purpose of identifying performance obligations under AASB 15.
Specific Issues – Allocating the transaction price to performance obligations
AASB 15 requires that the stand-alone selling price be determined for the distinct good or service underlying each performance obligation at contract inception, and then allocating the transaction price to each performance obligation in proportion to those stand-alone selling prices. The objective of the allocation is to depict the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer.
Stand-alone selling price is defined as the price at which an entity would sell a promised good or service separately to a customer. The best evidence of a stand-alone selling price is the observable price of a good or service when the entity sells that good or service separately in similar circumstances and to similar customers, eg. a contractually stated price or a list price. If a stand-alone selling price is not directly observable, an entity shall estimate the stand-alone selling price at an amount that would result in the allocation of the transaction price that meets the allocation objective (as discussed in the above paragraph).
In estimating the stand-alone selling prices, an entity should maximise the use of observable inputs and apply estimation methods consistently in similar circumstances. Suitable estimation methods include adjusted market assessment approach (estimating the price that market is willing to pay), expected cost plus a margin approach (forecasting the expected costs of satisfying a performance obligation and adding an appropriate margin) and residual approach (total transaction price less the sum of observable stand-alone selling prices). These methods could be used in combination, provided that the resulting allocation is consistent with the allocation objective.
Where the sum of stand-alone selling prices of promised goods or services exceeds the promised consideration in a contract, the difference indicates a discount. A discount is allocated proportionately to all performance obligations on a stand-alone selling basis, unless there is observable evidence that an entire discount relates to only one or more (but not all) performance obligations. In those cases, the entire discount should be allocated to those particular performance obligations.
We suggest construction entities review their current accounting treatment of contract discount and consider whether the discount should be allocated to all performance obligations on a stand-alone selling basis, or whether it still remains appropriate to allocate the entire discount to one or more performance obligations it specifically relates to.
Specific Issues – Satisfying performance obligations
AASB 15 uses an individual performance obligation as the unit of account. The issue for recognising revenue is determined by whether a performance obligation is satisfied over time, or at a point in time. If a performance obligation is deemed to be satisfied over time under AASB 15, then an entity is able to use the percentage of completion method to measure its progress in recognising revenue. If a performance obligation is deemed to be satisfied at a point in time, then revenue is recognisable only upon contract completion when the good or service is transferred.
Two methods are deemed appropriate for determining percentage of completion under AASB 15 – input method (recognising revenue based on inputs, eg. resources consumed etc.) and output method (recognising revenue based on the value of goods or services transferred to date relative to total value, eg. milestones reached). Entities are required to choose whichever method depicts the entity’s performance in satisfying its performance obligations, reflecting the nature of goods or services transferred. In circumstances where the outcome of a performance obligation cannot be reasonably measured, the entity shall recognise revenue only to the extent of costs incurred that are recoverable, until the uncertainty is resolved.
Under AASB 15, an entity is able to recognise revenue over 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
- the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced
- 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
The below examples (adapted from Illustrative Example 17) illustrate how a construction entity determines whether it is eligible to recognise revenue over time:
Example B – An entity is developing a multi-unit residential complex. A customer enters into a binding sales contract with the entity for a specified unit that is under construction. Each unit has a similar floor plan and is of a similar size, but other attributions of the units are different (for example, the location of the unit within the complex). The customer pays a deposit on entering into the contract. The deposit is refundable only if the entity fails to complete construction of the unit in accordance with the contract. The remainder of the contract price is payable on contract completion when the customer obtains physical possession of the unit. If the customer defaults on the contract before contract completion, the entity only has the right to retain the deposit.
At contract inception, the entity applies the criteria above to determine whether the performance obligation is satisfied over time. The entity determines that it does not have a right to payment for performance completed to date, because it only has entitlement to the initial deposit, should the customer default on the contract, regardless of how much progress the entity has made. Accordingly the entity concludes that (c) is not met. Because it appears that the customer only obtains control of the unit at contract completion, and does not receive and consume benefits simultaneously, the entity also concludes that (a) and (b) are not met. As none of the criteria for performance obligation over time is met, the entity accounts for the sale of the unit as a performance obligation satisfied at a point in time. Revenue is recognised upon contract completion when the customer obtains physical possession of the unit.
Example C – The customer pays a non-refundable deposit upon entering into the contract and will make progress payments during construction of the unit. The contract has substantive terms that preclude the entity from being able to direct the unit to another customer. In addition, the customer does not have the right to terminate the contract unless the entity fails to perform as promised. If the customer defaults on its obligations by failing to make the promised progress payments as and when they are due, the entity would have a right to all of the consideration promised in the contract if it completes the construction of the unit. The courts have previously upheld similar rights that entitle developers to require the customer to perform, subject to the entity meeting its obligations under the contract.
At contract inception, the entity applies (c) above to determine whether the performance obligation is satisfied over time. The entity determines that the asset promised in the contract does not have an alternative use, because the contractual terms preclude the entity from directing the asset to another customer. In this assessment, the entity does not consider the possibility of a contract termination should the customer fail to perform.
The entity also has a right to payment for performance completed to date, because in the event of a default by the customer, the entity would be able to continue performing under the contract and have enforceable rights to all promised consideration. Such rights have also been upheld by the courts in previous cases. Therefore, both the contractual terms and legal practices in the jurisdiction indicate that there is a right to payment for performance completed to date.
In conclusion, the criterion in (c) is met and the performance obligation is satisfied over time. In recognising revenue, the entity measures its progress towards complete satisfaction of its performance obligation.
We suggest construction entities review the terms in their existing construction contracts to determine whether they meet any of the AASB 15 criteria for recognising revenue over time.
Specific Issues – Contract costs
AASB 15 only permits capitalisation of two types of contract costs:
- incremental costs of obtaining a contract, and
- contract fulfilment costs (which are not covered by another standard) that satisfy certain criteria.
They are discussed separately in more detail as below.
Incremental costs of obtaining a contract
AASB 15 permits the capitalisation of incremental costs of obtaining a contract, if the entity expects to recover those costs. The incremental costs of obtaining a contract are defined as those costs that would not have been incurred if the contract had not been obtained (eg. sales commission). Costs to obtain a contract which would have been incurred regardless of whether the contract was obtained shall be expensed. In addition, the incremental costs of obtaining a contract may be expensed if that would result in an asset with an amortisation period (discussed below) of one year or less.
Construction entities may wish to determine whether their previous capitalised costs to obtain contracts are still appropriate under this requirement. In particular, whether those costs are incremental per definition in AASB 15.
Costs to fulfil a contract
AASB 15 contains prescriptive guidance for determining whether contract fulfilment costs should be capitalised, provided they are not within the scope of another standard (eg. AASB 102 Inventories, AASB 116 Property, Plant and Equipment, AASB 138 Intangible Assets, etc). Specifically, an entity shall capitalise costs incurred to fulfil a contract, if those costs meet all of the following criteria:
- the costs relate directly to a contract or to an anticipated contract that the entity can specifically identify (for example, costs relating to services to be provided under renewal of an existing contract, or costs of designing an asset to be transferred under a specific contract that has not yet been approved)
- the costs generate or enhance resources of the entity that will be used in satisfying (or in continuing to satisfy) performance obligations in the future
- the costs are expected to be recovered
The major differences from the current cost capitalisation rules under AASB 111 include:
- AASB 15 only addresses contract costs that are not within the scope of another standard – it follows that if a contract cost item is within the scope of standard but is not eligible for capitalisation under that standard, then it cannot be capitalised under AASB 15 either
- The contract costs should relate directly to a contract (current or anticipated) –the contract costs should only relate to contract activity under a specific contract, not just contract activity in general
- AASB 15 clarifies that the contract costs can relate to an anticipated contract – it therefore includes, for example, those contract costs that would be incurred under renewal of an existing contract (if the renewal is anticipated), or under a specific anticipated contract that is yet to be approved
- The contract costs should generate or enhance resources of the entity that will be used in satisfying performance obligations, in addition to being recoverable - This would include, for example, costs incurred by a construction company to upgrade its construction machinery for purpose of constructing a building under a specific contract. These costs enhance the existing asset (construction machinery) of the entity, which may be eligible for capitalisation subject to meeting other criteria.
For all assets recognised from capitalising contract costs, AASB 15 contains specific requirements on amortisation and impairment.
Specifically,amortisation shall be done on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset relates. An entity shall also recognise impairment loss to the extent that the carrying amount of the asset exceeds:
- the remaining amount of consideration that the entity expects to receive; less
- the costs that relate directly to providing those goods or services and that have not been recognised as expenses
In determining the remaining consideration as in (a), the entity shall also consider the effects of the customer’s credit risk.
We recommend construction entities review the cost components of their current contract work-in-progress asset to determine whether it is still appropriate to capitalise them under AASB 15. Cost components which do not meet all of the criteria in paragraph 95 should be expensed immediately in the period in which they are incurred.