IFRS 9, 15 and 16
New challenges for the construction and real estate industry
In May 2014, the International Accounting Standards Board (IASB) published IFRS 15: Revenue from Contracts with Customers. The publication of IFRS 15 was followed by IFRS 9, which outlined the new accounting requirements for financial instruments and IFRS 16: Leases. IFRS 9 and IFRS 15 are applicable for financial periods beginning on or after 1 January 2018 with IFRS 16 mandatory for financial periods beginning on or after 1 January 2019. These accounting changes have created a challenging environment for real estate and construction entities.
The most significant change as a result of IFRS 9 are the new impairment rules. This will require evaluating available qualitative data, data processes used by risk teams, changes in the macro economic environment and the like. This will also require the alignment of key controls within the new processes.
IFRS 16 will mean that substantially all leases will need to be included on a balance sheet. There are two exclusions short-term lease agreement of under 12 months and low-value asset – estimated around just under a $5,000 list price. Considering the amount of equipment acquired via a lease by construction entities the standard is expected to have a significant impact. From a lessor perspective, accounting for lease revenue will essentially be unchanged under the new standard, and most real estate leases will continue to be classified as operating leases.
The revenue standard will replace substantially all revenue guidance under IFRS, including the industry-specific guidance for construction-type and production-type contracts. IFRS 15 does not change the primary unit of measure which is still a contract or specific obligation within a contract and the percentage-of-completion revenue recognition methodology is still intact. However, this does not mean that this standard does not come without some impact.
What did result from the implementation of this standard is a five-step process that will, to varying degrees, impact all participants in the construction industry. Whether it will add to comparability between participants in the construction industry and participants in other industries remains to be seen. In this article, we will highlight the impact that the new standard will have on the construction industry by process.
Step 1: Identify the Contract
The model in IFRS 15 applies to a contract with a customer when certain criteria are met. Contracts may be written, oral or implied by an entity’s customary business practices, but must be legally enforceable and meet specified criteria.
IFRS 15 requires an entity to conclude that it is probable that it will collect the consideration to determine whether a contract with a customer exists. The transaction price may differ from the stated contract price e.g., when an entity intends to offer a concession. Therefore, significant judgement is required to determine whether a contract is within the scope of IFRS 15. If an entity believes that it will receive partial payment for performance it must determine whether the amount of consideration that it does not expect to receive is a price concession or an amount that the customer does not have the ability and intention to pay.
In making this determination, an entity will have to consider its customary business practices, published policies or specific statements providing the customer with a valid expectation that the entity will accept an amount of consideration that is less than the price stated in the contract.
Step 2: Identify the Performance Obligations
A performance obligation (PO) is defined as a promise in a contract. Under the new standard, the performance obligation, rather than the contract, is the new basis of measurement for revenue recognition.
Properly identifying performance obligations is critical to the revenue model since revenue is allocated to each performance obligation is recognised as the obligation is satisfied.
Construction entities, particularly those with long-term construction contracts, should carefully assess whether applying the new requirements results in the identification of performance obligations that are different from the separately identifiable components assessed under IAS 11 or IAS 18. These differences may result in a change in the pattern of revenue recognition and associated profit.Companies will likely find that evaluating whether a good or service is distinct within the context of the contract will be a significant aspect of implementing the new standard.
Step 3: Determine the Transaction Price
The determination of the transaction price has the potential for requiring the biggest change from previous revenue recognition methodology. In determining the transaction price, the new standard requires an entity to assess the original contract price plus adjustments for variable consideration. The contract price is typically stated in the contract as a fixed price or as a calculated value from agreed upon time and materials billing rates, plus fully executed modifications.
When including variable consideration in a transaction price calculation, the new guidance stipulates that an entity should use either the estimated value approach or the most likely amount approach depending on the type of consideration. While entities may already estimate the variable consideration, they may need to change their processes. This could also possibly change their conclusions about when and how much variable consideration is to be included in the transaction price. Variable consideration should only be included in the transaction price to the extent of its probability that it will not be reversed.
Entities will be required to adjust the transaction price if the financing component is significant to the contract. A significant financing component may exist in a contract even when this is not explicitly stated in the contract. Entities will need to evaluate the payment terms including the timing of billings to determine whether a significant financing component exists.
The standard does not include any quantitative application guidance to determine whether a financing component is significant to the contract. Entities are therefore required to use judgement to determine whether a financing components is significant.
Step 4: Allocate the Transaction Price
If there are multiple performance obligations, then the contractor must allocate the transaction price between the POs based on the stand alone selling prices of the various POs. However, in many situations, stand-alone selling prices will not be readily observable. Therefore, an entity will be required to estimate the stand-alone selling price. The standard discusses three estimation methods:
- An adjusted market assessment of the various POs
- Extended cost plus margin of the various POs
- A residual approach
If there is variable consideration included in the contract, and you can determine that it relates specifically to one PO, then it should be allocated specifically to that PO.
Step 5: Recognize Revenue
Entities will either recognise revenue as the PO is satisfied over time or at a point in time. For many construction-type contracts, it is likely that entities will determine that the control of many goods or services is transferred over time. When making the determination, entities are required to understand all contract terms as well as determine whether the asset has an alternative use and whether the entity has a right to payment for performance completed to date.
Entities previously using the percentage-of-completion revenue recognition methodology will still use it to recognise revenue on their various performance obligations.
Contract modifications impact multiple steps in the revenue recognition process above. As adjustment to the contract (Step 1), the scope of a modification may impact the identification of the performance obligations (Step 2) and the price of the modification may impact the determination of the transaction price (Step 3).
Construction entities will need to carefully evaluate performance obligations at the date of a modification to determine whether the remaining goods or services to be transferred are distinct and the prices are commensurate with their stand-alone selling prices. If it does create a distinct PO and the price of the change order reflects the pricing of a stand-alone agreement, then the modification should be accounted for as a separate contract and revenue would be recognized accordingly. This assessment is important because the accounting treatment can vary significantly depending on the conclusions reached.
If the goods/services are distinct, but the pricing is not reflective of a stand-alone sales price, the contractor should treat the transaction as if the original contract is terminated and a new contract is in place. The contractor should determine the revenue remaining from the original scope of work and add it to the revenue from the change order, then allocate accordingly between the remaining performance obligations using the appropriate allocation method identified in Step 4 above.
If goods/services are not distinct, the contractor should use a cumulative catch-up method. The contract amount and total estimated costs would be increased for the impact of the change order, and any additional profit would be recognized to the extent that performance obligations had been previously satisfied.
The new revenue recognition guidance allows for claims to be accounted as variable consideration as described in Step 3, which could allow for the earlier recognition of profit compared to previous guidance.
Even though for some entities there may be no change in the timing of revenue recognition, IFRS 15 significantly increases the volume of disclosures required. The standard does not specify precisely how revenue is required to be disaggregated, however, the application guidance suggests categories, as follows:
- Type of good or service (e.g., major product lines);
- Geographical region (e.g., country or region);
- Market or type of customer (e.g., government and non-government customers);
- Type of contract (e.g., fixed price and time-and-materials contracts);
- Contract duration (e.g., short-term and long-term contracts)
- Timing of transfer of goods or services (e.g., revenue from goods or services transferred to customers at a point in time and revenue from goods or services transferred over time); and
- Sales channels (e.g., goods sold directly to customers and goods sold through intermediaries).
This article discusses the main challenges being faced in the implementation of the new standards. However, there might also be other challenges and the adoption of the new standards cannot be merely considered as an accounting exercise. They will require new judgements, estimates, and potentially changes to systems, processes and related controls. They could also potentially also have a significant impact on key performance indicators. Accordingly, companies are encouraged to make a comprehensive assessment on the impact that the new standards will have on the financial statements. This assessment may also consider the adoption of GAPSME for companies meeting the eligibility criteria.