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IFRS Standards for Construction Contracts: Percentage of Completion

The IFRS (International Financial Reporting Standards) provide comprehensive guidelines for the recognition and measurement of revenue and costs associated with long term construction contracts. Under these standards, revenues and costs are allocated to the periods in which construction work is performed, based on the percentage of completion.

This approach ensures that contract revenues and costs are recognized progressively as work advances, provided the outcome of the contract can be reliably estimated. If reliable estimates are not possible, revenue is recognized only to the extent of recoverable costs incurred. These standards clarify the accounting treatment of revenue and costs related to construction contracts.

What is a Construction Contract?

A construction contract is defined as a specifically negotiated agreement for the construction of an asset or a group of related assets. Such contracts may cover one or more assets, and the terms dictate how these assets are accounted for. If a contract:

  • Covers multiple assets,
  • Has separate bids for each asset,
  • Involves separately negotiated terms for each section,
  • Allows for distinct measurement of costs and revenues for each asset,

then each asset's construction should be accounted for separately. However, if two or more contracts are closely related and negotiated together, they should be accounted for as a single contract. Additionally, when a contract includes provisions for additional assets to be ordered:

Each new asset should be treated as a separate contract if it differs significantly from the original and has a separately negotiated price.

Construction Contract Revenues and Costs

Under IFRS, contract costs include those directly attributable to the contract, costs reasonably allocated to the contractor’s overall activities, and other costs charged under the contract terms.

Revenue and costs are recognized progressively using the percentage of completion method. This method requires reliable estimates of:

  • Total contract revenue,
  • Stage of contract completion,
  • Estimated costs to complete the contract.

If the contract’s outcome cannot be reliably estimated, revenue is recognized only to the extent of recoverable costs incurred, while additional costs are recognized as expenses.

The stage of completion can be determined by:

  • The ratio of costs incurred to date compared to total estimated costs,
  • A review of completed work, or
  • The physical progress relative to the contract's scope.

IFRS ensures that revenue and costs related to construction contracts are recognized in a manner reflecting the actual progress of the work and the economic realities of the project.

The Essence of IFRS 15: The Revenue Recognition Revolution

IFRS 15 is a revolutionary standard that reshapes how businesses recognize revenue from contracts with customers. The heart of the standard is that entities should recognize the consideration to which they are entitled in exchange for delivering promised goods or services to customers in a way that best reflects reality.

The Five Golden Steps of IFRS 15:

  • Explore the Customer Contract: The first step is to understand the details of the contract with the customer.
  • Identify Obligations: The first step is to clearly set out the obligations for each separate good or service promised in the contract.
  • Calculating the Price: Determine the total amount the customer has agreed to pay.
  • Allocating the Consideration: Distributing the total consideration fairly for each obligation.
  • Timely Revenue Recognition: Recognize revenue as each obligation is fulfilled.

This five-step approach should be applied on a contract-by-contract basis. Entities should interpret and apply these steps in the most appropriate way, taking into account the characteristics of their industry and their customers. IFRS 15 standardizes the revenue recognition process, while at the same time giving entities flexibility based on their own circumstances.

This approach makes financial statements more transparent and comparable and allows businesses to manage revenue recognition more strategically. IFRS 15 is not just an accounting standard, but a catalyst for businesses to rethink customer relationships and contract management.