Question

You own a construction company and have recently received a contract with the local school district to refurbish one of its elementary schools. You are given an up-front payment from the school district in the amount of $5 million. The contract terms extend from years 2018 to 2020. When would you recognize revenue for this payment?

• What method of accounting would you use for this construction project and why?
• What would be the benefits and challenges with your method selection?

Answer 1

IAS 11 ( IFRS ) Construction Contracts

Revenue Recognition

Contract Revenue means the original contract amount agreed along with revenue expected from variations, claims, incentives, or escalations.

When the outcome of a construction contract can be estimated reliably, contract revenue and contract costs associated with the construction contract should be recognized as revenue and expenses respectively by reference to the stage of completion of the contract activity at the reporting date.

In the given case contract amount received by company is $ 5 million.So contract revenue shall be recognized each year as per Percentage Completion method ( i.e percentage up to which the contract is completed )

Revenue recognized shall be : Contract Amount ( i.e $ 5 M )  X % of Contract Completion in the relevant year.

Accounting Method to be used

Percentage of Completion method

In case of fixed price contracts it is advised to use Percentage Completion Method because outcome of the contract can be measured reliably.

Under the percentage of completion method, contract revenue is recognised as revenue in the statement of profit and loss in the accounting periods in which the work is performed. Contract costs are usually recognised as an expense in the statement of profit and loss in the accounting periods in which the work to which they relate is performed.

The stage of completion of a contract may be determined in a variety of ways. The enterprise uses the method that measures reliably the work performed. Depending on the nature of the contract, the methods may include:

(a) the proportion that contract costs incurred for work performed up to the reporting date bear to the estimated total contract costs; or

(b) surveys of work performed; or

(c) completion of a physical proportion of the contract work.

Benefits and challenges

Following are the advantages of the percentage of completion method:

• It allocates the cost and revenue pertaining to a particular period based on the extent of completion of the contract or project and hence there is no need to wait till the project is completed to recognize the cost and revenues incurred in the duration of the contract or project.
• It does not allocate the proportion of cost that is incurred but is not currently put to use in the project. Hence it gives a more real-time estimate of the costs and revenues associated with the project.

Following are the limitations of the percentage of completion method:

• This method can only be used for contracts which have a duration of more than one year.
• This method may show fluctuation in the estimates given by the management.