Where project value does not have a direct relationship to progress – An accountant’s response (referencing IAS 11 and IFRS 15)
Please read the above first to get some context. The below is a response to the example in the article highlighting where “value does not have a direct relationship to progress”.
Here is my accountant’s spin on the subject…
There is no simple answer, and reported revenue will ultimately be dependent on the judgement call of the project owner’s view on % completion, and the accountant’s application of the financial reporting standards.
The relevant International Financial Reporting Standards are:
- IAS 11 Construction Contracts and IAS 18 Revenue (applicable up to 31 December 2017)
- IFRS 15 Revenue from Contracts with Customers (applicable from 01 January 2018)
The old way: IAS 11
Looking at your (Kobus’) last example,
[the example of a R10M project. R9M of which is for a piece of equipment and R1M is building works spread over 10 months. In month 2 the piece of equipment is delivered and claimed. Therefore, in terms of certified value the amount is R9M and also, value related progress is 90%. Yet if we measure the effort and no building work has taken place, it may as low as 0%. On this project then, we have in month 2 a situation where value progress is 90%, man-hours spent is 0% or perhaps 0.5% and time elapsed (dare I say!) is 20%.]
the current standard to be applied, IAS 11 Construction Contracts, says (without delving into too much detail) that “when the outcome of a construction contract can be estimated reliably”, you recognise revenue and costs on a stage of completion (i.e. percentage completion) basis.
The revenue and expenses are recognised on the stage of completion of the asset being constructed, including the services directly related to its construction.
They first key factor relating to the example is whether the outcome can be estimated reliably – determining the outcome at the present time is a forecasting exercise, where one is required to estimate the likely final revenue and costs.
Assuming the project owner can reliably estimate the outcome, the revenue and associated costs are recognised “by reference to the stage of completion of the contract activity”. But what is stage of completion? If the outcome can be reliably estimated, then the stage of completion would be calculated on that same basis (using a construction programme / cost-loaded programme). These programme documents are critical in determining the revenue and costs to be recognised at the end of a reporting period.
The same question that arises for the accountant is: how does one determine stage of completion?
While the project owner or site manager may be focusing on the percent complete from a project management perspective, the accountant is focusing completion relative to value. Differences in opinion arise when the progress on the ground is measured differently to the progress in terms of value. Ideally the measurement of these two should be aligned in order for actual progress to reflect value delivered (i.e. use of a cost-loaded programme). If this is not the case, it is likely that the project milestones and payment milestones (or cost-loadings) are misaligned, and the contractor may be placing themselves at risk. It may also imply that the measurement basis used for revenue recognition is not appropriate.
The new way: IFRS 15 Revenue from Contracts with Customers
From 01 January 2018, the question of when to recognise revenue changes slightly. Under IFRS 15, an entity/contractor will be required to recognise revenue not specifically on a stage of completion basis, but “as the entity satisfies a performance obligation”. For the example used, the performance obligation could be viewed as being the final completion and delivery of the construction project. The entity/contractor satisfies a performance obligation if the entity has “an enforceable right to payment for performance completed to date”. So, the question to be asked when determining whether revenue can be recognised is: do I have an enforceable right to payment for performance completed to date?
Although, as with the previous standard, the same question will arise over how to determine stage of completion or progress. You may be able to recognise revenue based on the right to payment, but how do you measure it in order to recognise that revenue (and associated costs) over time?
IFRS 15 says “an entity shall recognise revenue for a performance obligation satisfied over time only if the entity can reasonably measure its progress towards complete satisfaction of the performance obligation.”
So, the main question to ask in relation to the example is: can I reasonably measure progress at the point where the equipment is delivered but no construction work is done?
If the answer is no, because the entity/contractor lacks reliable information, but the contractor expects to be able to recover his/her costs (assuming the R9m equipment is an expense), then they would recognise revenue equal to the costs incurred to date – i.e. revenue of R9m, equal to costs expensed of the equipment of R9m (same as IAS 11). So as mentioned in the example, the accounting method is recognising 90% of the contract value. However, the gross margin for the project at inception is 10% but the margin recognised by the accountant is zero – so the accountant and project owner are hopefully still on the same page.
If the answer is yes and the contractor judges that he/she can reasonably measure progress then we get back to the question of how do we determine stage of completion? And; what is a reasonable measure of progress?
IFRS 15 provides guidance on this, outlining input methods and output methods that can be used to measure an entity/contractor’s progress toward complete satisfaction of the performance obligation.
It requires that the progress measurement method used “faithfully” depicts the entity’s/contractor’s performance in transferring control of the [asset] to the client. The term faithful may be open to interpretation but the implication is the use of fair and reasonable judgement – i.e. a person with integrity.
There is a lot more to this subject, but in short, the accountants answer would be to use the best judgement of an expert (a knowledgeable project owner/QS/project engineer) in applying, consistently, a method of project measurement, which faithfully depicts the entity’s/contractor’s progress towards completion of the contract.