A Practical Guide to IFRS - Revenue Rec. - Engenering and Construction Industry Supplement

7/28/2019 A Practical Guide to IFRS - Revenue Rec. - Engenering and Construction Industry Supplement

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Practical Guide to IFRSEngineering and Construction industry supplement July 2010

Revenue recognition full speed aheadEngineering and Construction industry supplement

Overview

Entities in the engineering and construction (E&C) industry applying IFRS or US GAAP have primarily been followingeither: IAS 11, Construction contracts or Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts (SOP 81-1, as codified in Topic 605-35) to account for revenue. Thesestandards were developed to address the particular aspects of long-term construction accounting and provideguidance on a wide range of industry-specific considerations, including:

defining the contract, such as when to combine or segment contracts, and when and how to account forchange orders and other modifications;

defining the contract price, including variable consideration, customer-furnished materials and claims;

recognition methods, such as the percentage-of-completion method (and in the case of US GAAP, the

completed contract method) and input/output methods to measure performance; accounting for contract costs, such as pre-contract costs and costs to fulfil a contract; and

accounting for loss-making contracts.

Once the new revenue recognition standard becomes effective, SOP 81-1, IAS 11 and all existing revenue recognitionguidance under US GAAP and IFRS will be replaced. This includes the percentage-of-completion method and therelated construction-cost accounting guidance as a stand-alone model.

The following items common in the E&C industry may be significantly affected by the new revenue recognitionstandard. This practical guide, examples and the related assessments contained in the industry supplements arebased on the Exposure Draft, Revenue from contracts with customers, which was issued on 24 June 2010. Theseproposals are subject to change at any time until a final standard is issued. For a more comprehensive description ofthe model, refer to PricewaterhouseCoopers' (PwC) Practical Guide to IFRS Revenue recognition

(www.pwc.com/ifrs) or visit www.ifrs.org.

Defining the contract

Current guidance covers:

when two or more contracts should be combined and accounted for together;

when one contract should be segmented and accounted for separately as two or more contracts; and

when a contract modification should be recognised.

These situations and in particular, contract modifications such as change orders are commonplace in the E&Cindustry.

The proposed standard applies only to contracts with customers when such contracts:

have commercial substance;

have been approved by the parties to the contract and such parties are committed to satisfying their respectiveobligations;

have enforceable rights that can be identified regarding the goods or services to be transferred; and

have terms and manners of payment that can be identified.


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We do not expect current practice in the area of contract combinations and segmentation to be significantly affectedby the proposed standard. Construction entities currently exercise significant judgement to determine when to includechange orders and other contract modifications in contract revenue, and there is diversity in practice. We expect thatthe use of judgement will continue to be required and do not expect current practice (or existing diversity) in this areato be significantly affected by the proposed standard, including the accounting for unpriced change orders.

Proposed standard Current US GAAP Current IFRS

Combining and segmentingcontractsTwo or more contracts should becombined and accounted for as onecontract if their prices areinterdependent. A contract should besegmented into more than onecontract and accounted forseparately if prices for goods andservices within that contract areindependent.

Contracts with interdependent pricesare typically:

Entered into at or near the sametime.

Negotiated as a package with asingle commercial objective.

Performed either concurrently orcontinuously.

Prices for goods and services withina contract are independent if:

The entity (or another entity) sellsan identical or similar good orservice separately; and

The customer does not receive asignificant discount for buying abundle of goods and services.

Combining and segmenting contractsis permitted provided certain criteriaare met. However, it is not required ifthe underlying economics of thetransaction are fairly reflected.

Combining and segmenting contractsis required when certain criteria aremet.

Contract modifications (forexample, change orders)Consistent with the contractcombination and segmentationprinciple above, a contractmodification is combined with theoriginal contract, recognising thecumulative effect of the contractmodification in the period in whichthe modification occurs, if the prices

are interdependent. A contractmodification is accounted for as aseparate contract if it is pricedindependently of the original contract(consider the factors above).

A change order is generally includedin contract revenue when it isprobable that the change order willbe approved by the customer and theamount of revenue can be reliablymeasured.

US GAAP also includes detailed

revenue and cost guidance on theaccounting for unpriced changeorders (or those in which the work tobe performed is defined, but the priceis not).

A change order (known as avariation) is generally included incontract revenue when it is probablethat the change order will beapproved by the customer and theamount of revenue can be reliablymeasured.

There is no detailed guidance on theaccounting for unpriced changeorders.


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Example 1 Unpriced change orders

Facts: A contractor has a history of executing unpriced change orders; that is, those change orders where price is notdefined until after scope changes are agreed upon. When would these change orders be included in contractrevenue?

Discussion: An entity would first assess whether the change order meets the definition of a contract as definedabove, and next assess whether such change order is priced interdependently with the original contract. Many

unpriced change orders do not specify the consideration to be exchanged for goods or services at the time ofexecution, making it difficult to assess whether the change order is priced interdependently with the original contract.This might result in delayed recognition compared to todays model under both US GAAP and IFRS. There aresituations, however, where contractors may be able to identify the amount of consideration to be received usingvarious estimation methods based on historical experience. We believe it is possible in these situations for acontractor to include unpriced change orders in contract revenue, as such modifications would: (a) typically meet thedefinition of a contract; and (b) are likely to be priced interdependently, as the modifications are often negotiatedconsidering the original contract, with a single commercial objective, and relate to activities that are performed eitherconcurrently or continuously.

Determining the transaction price

The transaction price (or contract revenue, as it is called today in the E&C industry) is the amount of consideration thecontractor expects to receive in exchange for satisfying its performance obligations. When the contract price is fixed,this determination is simple. When the contract price is not fixed, however, the determination is more complex.Common considerations in this area for the E&C industry include the accounting for awards/incentive payments,customer-furnished materials, claims and the time value of money. Revenue related to awards/incentive paymentsmight be recognised earlier under the proposed standard. We do not expect a significant change in practice as itrelates to customer furnished materials, claims or time value of money (except for contracts where payment termsmaterially vary from performance).


Awards/incentive paymentsAwards/incentive payments are

included in contract revenue using aprobability-weighted approach whensuch payments can be reasonablyestimated. Such amounts can bereasonably estimated when thecontractor has experience withsimilar types of contract and thatexperience has predictive value (thatis, experience is relevant to thecontract because the entity does notexpect significant changes incircumstances).

Awards/incentive payments should

be included in contract revenuewhen the specified performancestandards are probable of being metor exceeded and the amount can bereliably measured.

Awards/incentive payments should be

included in contract revenue whenthe specified performance standardsare probable of being met orexceeded and the amount can bereliably measured.

Customer-furnished materialsIf a customer contributes goods orservices (for example, materials,equipment or labour) to facilitate thefulfilment of the contract, the value isincluded in contract revenue if theentity controls these goods orservices.

Any non-cash consideration ismeasured at fair value unless fairvalue cannot be reasonably

The value of customer-furnishedmaterials is included in contractrevenue when the contractor has theassociated risk for these materials.

There is no explicit guidance on theaccounting for non-cashconsideration in the constructioncontracts standard. Managementwould follow general principles onnon-monetary exchanges, whichgenerally require entities to use thefair value of goods or servicesreceived in measuring the amount tobe included in contract revenue.


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estimated; in which case, it ismeasured by reference to the sellingprice of the goods or servicestransferred.

ClaimsClaims should be included in

contract revenue, using a probability-weighted approach, only when suchrevenue can be reasonablyestimated.

A claim is recorded as contractrevenue (to the extent of contract

costs incurred) only if it is probableand reliably estimable (determinedbased on specific criteria). Profits onclaims are not recorded until they arerealised.

A claim is included in contractrevenue only if negotiations have

reached an advanced stage suchthat it is probable the customer willaccept the claim and the amount canbe reliably measured.

Time value of moneyContract revenue should reflect thetime value of money whenever theeffect is material. Managementshould use a discount rate thatreflects a separate financingtransaction between the entity and

its customer and factors in creditrisk.

Revenue is discounted in only limitedsituations, including receivables withpayment terms greater than oneyear.

When discounting is required, the

interest component should becomputed based on the stated rateof interest in the instrument, or amarket rate of interest if the statedrate is considered unreasonable.

Revenue is discounted when theinflow of cash or cash equivalents isdeferred. An imputed interest rateshould be used to determine theamount of revenue to be recognised,as well as the separate interest

income to be recorded over time.

Example 2 Variable consideration

Facts: A contractor enters into a contract for the expansion of an existing two-lane highway to a three-lane highway ina heavily congested area. The contract price is C65 million plus a C5 million award fee if completed before the holidaytravel season. The contract is expected to take one year to complete. The contractor has a long history of performingthis type of highway work. The award fee is binary that is, if the job is finished before the holiday travel season, the

contractor receives the full award fee. If it not finished before the holiday travel season, the contractor does notreceive any award fee. The contractor believes, based on significant past experience, that it is 95 per cent likely thatthe contract will be completed in advance of the holiday travel season.

Discussion: The contractor is likely to conclude that it can reasonably estimate the amount of expected award fee.This is because:

The contractor has a long history of performing this type of work;

It is largely within the contractor's control to complete the work before the holiday travel season;

The uncertainty will be resolved within a relatively short period of time; and

The possible outcomes are not highly variable.

The contract's transaction price is therefore C69.75 million (the fixed contract price of C65 million, plus C4.75 millionaward fee (probability-weighted amount of C5 million)). This estimate is continuously revised and adjusted as

appropriate, using a cumulative catch-up approach, which is consistent with current practice.

Example 3 Claims

Facts: Assume the same fact pattern as Example 2, except that due to reasons outside of the contractor's control (forexample, owner-caused delays), the cost of the contract far exceeds original estimates (but a profit is still expected).The contractor submits a claim against the owner to recover a portion of these costs. The claim process is in its earlystages, but the contractor has a long history of successfully negotiating claims with owners.

Discussion: Claims are highly susceptible to external factors (such as the judgement of third parties), and thepossible outcomes are highly variable. The contractor may have experience in successfully negotiating claims, but itmight be challenging to assert that such experience has predictive value in this fact pattern (because of the highly


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uncertain variables that warrant consideration). The contractor might therefore conclude that such a claim, in the earlystages, cannot be reasonably estimated. The claim is excluded from the transaction price until it can be reasonablyestimated (this is likely to be closer to the date when the claim is expected to be resolved).

Accounting for multiple performance obligations

Performance obligations are defined as promises to deliver goods or perform services. Today, contractors oftenaccount for each contract at the contract level; that is, contractors account for the macro-promise in the contract tobuild a road or build a bridge, etc. Current guidance permits this, although a contractor effectively promises to provide

a number of different goods or perform a number of different services in delivering such macro-promises. Clearing,grading and paving, for example, may qualify as separate performance obligations within the macro-promise to build aroad. Determining when to separately account for these performance obligations under the proposed model istherefore a key determination and will require a significant amount of judgement.

Under the proposed model, it is possible to account for the contract at the contract level (for example, macro-promiseto build a road), but we expect that contractors might have to separately account for more obligations within eachcontract compared to current guidance. This is an area that we expect will continue to evolve and that contractorsshould pay particular attention to. Applying the proposed separation principle will be challenging for many constructionentities. We believe the final standard should be clear about how to apply this principle to long-term contracts toensure it meets the proposed standards objectives of providing consistent, decision-useful information foreconomically similar contracts.


Performance obligations separation

An entity should separately accountfor performance obligations only ifthey are transferred at different timesand are distinct. An entity willotherwise combine goods or serviceswith other promised goods orservices until it identifies a bundle ofgoods or services that are distinct.

A good or service is distinct if either: the entity or another entity sells

an identical or similar good orservice separately; or

the entity could sell the good orservice separately because it:(a) has a distinct function (utility

on its own or together withother goods or services); and

(b) has a distinct profit margin(subject to distinct risks andthe resources needed can beseparately identified).

The basic presumption is that eachcontract is the profit centre forrevenue recognition, costaccumulation and incomemeasurement. That presumptionmay be overcome only if a contractor a series of contracts meets theconditions described above forcombining or segmenting contracts.

There is no further guidance forseparately accounting for more thanone deliverable in a constructioncontract.

The basic presumption is that eachcontract is the profit centre forrevenue recognition, costaccumulation and incomemeasurement. That presumption isovercome when a contract or aseries of contracts meets theconditions described for combining osegmenting contracts.

There is no further guidance aroundseparately accounting for more thanone deliverable in a constructioncontract.

Example 4 Design/build contract

Facts: A contractor enters into a construction contract with an owner to design and build a new runway at a smallairport. The build stage primarily includes clearing, excavation, grading and paving activities. The contractor oftensells similar design and build services together but also sells them separately. How many performance obligations isthe contractor required to account for separately?

Discussion: We believe that application of the proposed separation principle remains unclear for many long-termcontracts. However, based on the principles described above, it is likely that this design/build contract has at least twoperformance obligations: that of providing design services and that of building the runway. This is because they are


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transferred at different times and are distinct, as the contractor has a history of selling similar design servicesseparate from the build. The build aspect of the contract, however, may require further separation. In making thisdetermination, the contractor may have to assess whether the clearing, excavation, grading and paving activities (oractivities at an even lower level than these) are sold (or could be sold) by the contractor or others, such assubcontractors. For example, identical or similar activities that are sold separately by subcontractors may beconsidered distinct and require separation. Construction contracts to deliver a good often also include a significantconstruction management service. Assessing whether such management services are distinct from other aspects ofthe contract (that is, the design service and construction of the good) will require significant judgement.

Example 5 Construction management contract

Facts: A contractor enters into a construction contract with an owner to provide construction management services,overseeing the construction of a new runway at a small airport. How many performance obligations is the contractorrequired to separately account for?

Discussion: The contractor might only have one performance obligation in this example: that of providing theconstruction management service to supervise and coordinate the construction activity on the project.

Allocating the transaction price to multiple performance obligations

Performance obligations are measured at the amount of consideration the contractor expects to receive (that is, the

transaction price as described above). This consideration should then be allocated to the performance obligations in acontract that requires separate accounting. We expect that contractors will have to separately account for moreperformance obligations than today, so the allocation of the transaction price (that is, contract revenue) will be new tomany E&C companies. Of particular interest will be the allocation of variable consideration (for example,award/incentive payments) associated with only one separately accounted for performance obligation, rather than thecontract as a whole. This is an area that is currently unclear in the proposed standard and we believe is an importantarea that requires further consideration.


Allocating the transaction priceFor performance obligations thatrequire separate accounting, contract

revenue is allocated to eachperformance obligation based onrelative actual or estimated sellingprices. An estimation method will notbe prescribed nor will any method beprecluded. For example, a contractormight use cost plus a reasonablemargin in estimating selling price of agood or service.

This initial measurement is notrevisited unless performanceobligations become onerous.

Except for allocation guidancerelated to contract segmentation,

there is no explicit guidance onallocating contract revenue tomultiple deliverables in aconstruction contract, given thepresumption that the contract is theprofit centre for determining revenuerecognition.

Except for allocation guidancerelated to contract segmentation,

there is no explicit guidance onallocating contract revenue tomultiple deliverables in aconstruction contract, given thepresumption that the contract is theprofit centre for determining revenuerecognition.

Example 6 Allocating contract revenue to more than one performance obligation

Facts: A contractor enters into a contract to build both a road and a bridge (assume for this example that there areonly two performance obligations: to build the road and to build the bridge). The contractor determines at inceptionthat the contract price is C150 million, which includes a C140 million fixed price and an estimated C10 million of awardfees if the contact as a whole is finished 30 days ahead of schedule.


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Discussion: In allocating the contract consideration (including both the fixed and variable amounts), a contractormust first assign a selling price to both the road and the bridge. The contractor typically constructs both roads andbridges of a similar type and nature to those required by the contract, on a stand-alone basis. The stand-alone sellingprice to build this road, based on prior experience, is C140 million. The stand-alone selling price to build this bridge,based on prior experience, is C30 million. There is therefore an inherent discount of C20 million built into the bundledcontract. Using a relative allocation model, the C150 million transaction price is allocated as follows:

Road C124m (C150m * (C140m / C170m))Bridge C26m (C150m * (C 30m / C170m))

Example 7 Allocating contract revenue to more than one performance obligation changes inthe transaction price

Facts: After contract inception, the amount of variable consideration changes from an expected C10 million to anexpected C12 million. Performance obligations are not remeasured after contract inception, so the additional C2million would be allocated to the road and bridge using the initially developed allocation percentages, as follows:

Road C1.6m (C2m * (C140m / C170m))Bridge C 0.4m (C2m * (C30m / C170m))

Discussion: Such changes are recognised using a cumulative catch-up approach. For example, if the road wascompleted before the change in estimated variable consideration, the full amount of C1.6m would be recognised as

revenue when the estimate was revised.

Recognising revenue

Revenue recognition under existing guidance is based on the activities of the contractor that is, provided reasonableestimates are available, revenue can be recognised as the contractor performs (known as the percentage-of-completion method). The boards have proposed that revenue is recognised upon the satisfaction of a contractor'sperformance obligations, which occurs when control of an asset (good or service) transfers to the customer. Controlcan transfer either at a point in time or continuously over the contract period. The change to a control transfer modelwill require careful assessment of when a contractor can recognise revenue. W e expect that many construction-typecontracts will transfer control of a good or service continuously to the owner over the contract term and mighttherefore produce similar results compared to today. This should not, however, be assumed. Contractors will not be

able to default to the method used today. Cost-to-cost may be used today for example, to measure revenue underan activities based recognition model. It might not be appropriate for the extent to which control has transferred undera continuous transfer model.


Recognising revenueRevenue is recognised on thesatisfaction of performanceobligations, which occurs whencontrol of the good or servicetransfers to the customer. Controlcan transfer at a point in time or,

perhaps most important for the E&Cindustry, continuously over thecontract period. Factors to considerin assessing control transfer include,but are not limited to:

The customer has anunconditional obligation to pay.

The customer has legal title.

The customer has physicalpossession.

The customer specifies thedesign or function of the good or

Revenue is recognised using thepercentage-of-completion methodwhen reliable estimates areavailable.

In circumstances in which reliable

estimates cannot be made, but thereis an assurance that no loss will beincurred on a contract (for example,when the scope of the contract is ill-defined but the contractor isprotected from an overall loss), thepercentage-of-completion methodbased on a zero-profit margin is useduntil more precise estimates can bemade.

Where reliable estimates cannot be

Revenue is recognised using thepercentage-of-completion methodwhen reliable estimates areavailable.

In circumstances in which reliable

estimates cannot be made, but thereis an assurance that no loss will beincurred on a contract (for example,when the scope of the contract is ill-defined but the contractor isprotected from an overall loss), thepercentage-of-completion methodbased on a zero-profit margin is useduntil more precise estimates can bemade.

The completed-contract method is


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service.

This list is not intended to be achecklist or all-inclusive. The abilityto borrow against the asset, forexample, may be another controltransfer factor to consider. No one

factor is determinative on a stand-alone basis.

made, the completed-contractmethod is required.

prohibited.

Measuring continuous transfer ofcontrolFor contracts where control transferscontinuously, a contractor can useeither an input method (for example,cost-to-cost, labour hours, labourcost, machine hours, materialquantities), an output method (forexample, physical progress, unitsproduced, units delivered, contractmilestones) or the passage of time tomeasure the extent to which controlhas transferred. The method thatbest depicts the transfer of goods orservices to the customer should beapplied consistently throughout thecontract and to similar contracts withcustomers.

Once the metric to measure theextent to which control hastransferred, it should be appliedagainst contract revenue todetermine the amount of revenue to

be recognised. This is currentlyreferred to as the revenue method.The use of the gross profit methodis prohibited.

Estimates used to measure theextent to which control hastransferred (for example, estimatedcost to complete when using a cost-to-cost calculation) should becontinually evaluated and adjustedusing a cumulative catch-up method.

A contractor can use either an inputmethod (for example, cost-to-cost,labour hours, labour cost, machinehours, material quantities), an outputmethod (for example, physicalprogress, units produced, unitsdelivered, contract milestones), orthe passage of time to measureprogress towards completion.

Once a percentage-complete isderived, there are two differentapproaches for determining revenue,cost of revenue and gross profit: therevenue method and the grossprofit method.

A contractor can use either an inputmethod (for example, cost-to-cost,labour hours, labour cost, machinehours, material quantities), an outputmethod (for example, physicalprogress, units produced, unitsdelivered, contract milestones) or thepassage of time to measure progresstowards completion.

Once a percentage-complete isderived, IFRS requires the use of therevenue method. The gross profitmethod is prohibited.

Example 8 Recognising revenue

Facts: A contractor enters into a construction contract with an owner to build an oil refinery. The contract has thefollowing characteristics:

The oil refinery is highly customised to the owner's specifications; owner changes to these specifications areexpected over the contract term.

Non-refundable, interim progress payments are required as a mechanism to finance the contract.

The owner can cancel the contract at any time (with a termination penalty); any work in process is the propertyof the owner.


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Physical possession and title do not pass until completion of the contract.

How would a contractor recognise revenue in this example (assume only for these examples that there is oneperformance obligation that of building the refinery)?

Discussion: The preponderance of evidence suggests control of the oil refinery is being transferred continuously ovethe contract term. In such cases, the contractor will have to select either an input or output method (or less likely,passage of time) to measure the extent to which control has transferred.

Example 9 Recognising revenue use of cost-to-cost

Facts: Assume the same fact pattern and assumptions as above. Additional contract characteristics are:

Contract duration is three years.

Total estimated contract revenue is C300 million.

Total estimated contract cost is C200 million.

Year one cost is C120 million (including C20 million related to contractor caused inefficiencies).

The contractor has concluded that cost-to-cost is a reasonable proxy for measuring the extent to which control hastransferred. How much revenue and cost does the contractor recognise at the end of year one?

Discussion: In determining the amount of revenue to be recognised under a cost-to-cost model, the contractor would

have to exclude any costs that do not depict the transfer of goods or services; in this case, the costs associated withcontractor caused inefficiencies. The amount of contract revenue and cost recognised at the end of year one is:

Revenue C150m (C300m * (C100m / C200m)Contract cost C100mGross contract margin C 50m

Contract inefficiencies C 20mNet contract margin C 30m

Example 10 Recognising revenue use of cost-to-cost with changes in estimates

Facts: Assume same fact pattern and assumptions as above, except that total estimated cost to complete increasesat the end of year two to C250 million due to an unexpected increase in the cost of materials. Actual cumulative costincurred at the end of year two (excluding year-one inefficiencies) is C200 million.

The contractor has concluded that cost-to-cost is a reasonable proxy for measuring the extent to which control hastransferred. How much revenue and cost does the contractor recognise at the end of year two?

Discussion: The amount of contract revenue and cost recognised at the end of year two is:

Cumulative revenue C240m (C300m * (C200m / C250m)Revenue recognised year one C150mRevenue recognised year two C90m

Cumulative costs (excluding inefficiencies) C200mCosts recognised year one (excluding inefficiencies) C100mCosts recognised year two (excluding inefficiencies) C100m

Gross contract margin year two C (10m)

Gross contract margin to date C 40m (C240m - C200m)Net contract margin to date C 20m (C240m - C200m - C20m)


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Other considerations

Warranties

The proposed standard draws a distinction between warranties that protect against latent defects and warranties thatprotect against defects that arise after the product is transferred to the customer, such as normal wear and tear. Manywarranties in the E&C industry protect against latent defects. We therefore expect practice could significantly changein this area, resulting in delayed revenue recognition and complex accounting calculations. However, contractors willneed to use significant judgement to determine whether a defect is latent or has arisen subsequent to the sale.


WarrantiesWarranties that protect against latentdefects do not give rise to a separateperformance obligation. Theyacknowledge the possibility that thecontractor has not satisfied itsperformance obligation. Managementwill need to determine the likelihoodand extent of defects in the productsit has sold to customers at eachreporting period to determine theextent of unsatisfied performanceobligations. A portion of the contractrevenue should be deferred at thetime of sale for defective productsthat will be replaced either in part orin their entirety.

A warranty that protects againstdefects that arise after the product istransferred gives rise to a separateperformance obligation. A portion of

the transaction price is allocated tothat separate performance obligationat contract inception.

Contractors typically account forwarranties that protect against latentdefects outside of the contract and inaccordance with existing losscontingency guidance. A contractorrecognises revenue and concurrentlyaccrues any expected cost for thesewarranty repairs.

Revenue is deferred for warrantiesthat protect against defects arisingthrough normal usage andrecognised over the expected life ofthe contract.

Contractors are required to accountfor the estimated costs of rectificationand guarantee work, includingexpected warranty costs, as contractcosts. However, contractors typically(due to materiality considerations)account for standard warrantiesoutside of the contract and inaccordance with existing provisionsguidance. A contractor will recogniserevenue and concurrently accrue anyexpected cost for these warrantyrepairs.

Revenue is deferred for warrantiesthat protect against defects arisingthrough normal usage andrecognised over the expected life ofthe contract.

Example 11 Accounting for warranties

Facts: Assume the same fact pattern and assumptions as Example 8. The contractor also provides a 60-day warrantythat covers latent defects for certain components of the oil refinery. How would the contractor account for such awarranty?

Discussion: The contractor would have to estimate, at contract inception using all available information such ashistorical experience, the selling price of each of the oil refinery components that will require repair or replacement.

Once determined, contract revenue would be allocated at inception on a relative selling price basis to thosecomponents and revenue deferred until the owner received control of those components without defects (that is,generally the earlier of when the defects are repaired/replaced and when the warranty period expires).

Contract costs

Existing construction literature contains a substantial amount of cost capitalisation guidance, both related to pre-contract costs and costs to fulfil a contract. The proposed model includes contract cost guidance, but we expect asignificant change from today's practice, in particular around the accounting for pre-contract costs.


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Contract costsAll costs of obtaining a contract,costs relating to satisfiedperformance obligations and costsrelating to inefficiencies (that is,abnormal costs of materials, labouror other costs to fulfil) should be

expensed as incurred.

Other direct costs incurred in fulfillinga contract are expensed as incurredunless they are within the scope ofother standards (for example,inventory, intangibles, fixed assets)in which case the entity shouldaccount for such costs in accordancewith those standards. If the costs arenot within the scope of otherstandards, the entity shouldrecognise an asset only if the costsrelate directly to a contract, relate tofuture performance and are probableof recovery under a contract. Thesecosts would then be amortised ascontrol of the goods or services towhich the asset relates is transferredto the customer.

There is a significant amount ofdetailed guidance relating to theaccounting for contract costs. This isparticularly true with respect toaccounting for pre-contract costs.

Pre-contract costs that are incurredfor a specific anticipated contractgenerally may be deferred only iftheir recoverability from that contractis probable.

Other detailed guidance is alsoprescribed in the standard andshould be appropriately considered.

There is a significant amount ofdetailed guidance relating to theaccounting for contract costs.

Costs that relate directly to a contracand are incurred in securing the

contract are included as part ofcontract costs if they can beseparately identified and measuredreliably and it is probable that thecontract will be obtained.

Other detailed guidance is alsoprescribed in the standard andshould be appropriately considered.

Example 12 Accounting for contract costs

Facts: Assume the same fact pattern and assumptions as Example 9. At the beginning of the contract, the contractorincurs certain mobilisation costs amounting to C1 million. The contractor has concluded that such costs should not beaccounted for in accordance with existing asset standards (for example, inventory, fixed assets or intangible assets).How should these costs be accounted for?

Discussion: These costs to fulfil a contract would be eligible for capitalisation so long as they: (a) relate to thecontract; (b) relate to future performance; and (c) are probable of recovery. Using the fact pattern in Example 9 aboveC500,000 would be amortised at the end of year one (coinciding with 50 per cent control transfer using a cost-to-costmethod).

This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. It does not take into account any objectives,financial situation or needs of any recipient; any recipient should not act upon the information contained in this publication without obtaining independent professional advice. Norepresentation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law,PricewaterhouseCoopers LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone elseacting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

2010 PricewaterhouseCoopers. All rights reserved. PricewaterhouseCoopers refers to the network of member firms of PricewaterhouseCoopers International Limited, each ofwhich is a separate and independent legal entity.

Documents

A Practical Guide to IFRS - Revenue Rec. - Engenering and Construction Industry Supplement