Overview
Construction businesses tend to be a lot different because of several different reasons that mainly occur because of relative difficulty to account for several different things.
In this regard, it can be seen that contractors, alongside accountants, tend to find it confusing as to the correct treatment and categorization of these resources that can possibly help companies in achieving accurate record-keeping that can ensure that there is proper clarity regarding the financial position of the respective organization at the end of the financial year.
Additionally, since construction projects spread over a timeline of more than one year, they are classified as long-term projects.
As a result, there is a need to have a relatively different accounting setup that can ensure proper, and specific accounting standards that are solely attributable to construction contracts.
Nature
In order to account for construction contracts, there have been several different rules that have been put forth in order to ensure the proper classification of these contracts.
Generally, there are two accepted accounting methods that are utilized to account for construction contracts, and they are referred to as the percentage of completion method, and the completed contract method.
The construction contract can simply be defined as a contract that is specifically designed and negotiated upon the construction of an asset, or any specific project.
This is broadly covered in IAS (International Accounting Standards) 15, which covers several different components. The construction contracts are supposed to be accounted for based on this rationale, in order to bring uniformity across all construction businesses (or organizations that have construction projects in their domain), and make it as transparent and easy to comprehend as possible.
Revenue Recognition Principle
The revenue recognition principle requires revenue to be recorded only when it is absolutely certain that the amount would be received by the company.
In this regard, IFRS 15 sets out certain rules and regulations that provide a framework for construction revenue to be recognized if the following conditions are duly met. These conditions are as follows:
- Total Contract Revenue should be measured in a reliable way. The measurement of revenue earned from construction contracts should not be vague, or ambiguous.
- The revenue flow should suggest that the economic benefits that are associated with the contract itself are likely to pass on to the seller. This is required for contract revenue to be recognized properly in the financial statements.
- The seller’s cost that is required to complete the contract, in addition to the stage of contract completion at the end of the reporting period should be measured in a reliable manner. Since these are relatively long-term projects, the percentage of completion and the extent to which they are completed should be clear.
- The seller’s costs can also be attributable to the contract which can be clearly identified, described, as well as measured in a reliable manner. This is mainly to ensure that actual costs that are incurred can accurately be compared with the previous estimates.
Furthermore, as far as the revenue recognition part is concerned in Construction Contracts, IFRS 15 also provides three methods that can be used in order to properly classify and recognize the revenue that is earned. This includes the following:
- The extent (or proportion) of contract costs that are incurred for work that is performed to complete the project in a successful manner.
- Surveys of work performed
- The extent to which physical construction work is completed is out of the overall scope of the contract work.
Contract Assets
Contract Assets are supposed to be recognized when performance obligations are duly satisfied, but the payment has still not been made because it is contingent on several other factors, that mainly vest on other performance obligations that need to be fulfilled.
In other words, the payout of this particular item is not contingent on the completion of this particular obligation, but on some other obligation that needs to be honored too.
They are different from trade receivables because of the fact that trade receivables depict an unconditional right to receive the particular revenue from the other party. There is a greater credit risk involved in contract assets that are not available otherwise.
Contract Liabilities
On the contrary, Contract Liabilities are disclosed on the Balance Sheet when a payment from a customer has been received, even before a performance obligation is carried out.
In this regard, the treatment of contract liabilities and unearned revenue tends to be the same, because this means that the amount has been received for the work that is yet to be executed.
Example
In order to understand Contract Assets, and Contract Liabilities better, let’s take a look at the following illustration:
Illustration 1
A telecommunications company has a package where the customer gets a phone, as well as operational service charges for a cellular network that spans over a year.
The contract is structured such that the basic flat rate to subscribe to the package is $100. This is independent of any cellular network charges.
Additionally, the customer also has to pay $20 a month, for 12 months as part of the contract obligation. The customer can back out any time, but the down payment (i.e. $100 will stay fixed as it is). The entry to record this particular transaction is going to be as follows.
| Date | Account Title and Description | Debit | Credit |
| 1 July 2019 | Accounts Receivable | 100 | |
| Contract Asset | 240 | ||
| Revenue | 340 |
Illustration 2
In the same scenario as the one above, if the customer would have paid the entire amount upfront, then the following transaction would have to be made:
| Date | Account Title and Description | Debit | Credit |
| 1 July 2019 | Cash | 340 | |
| Contract Asset | 240 | ||
| Revenue | 100 |
Conclusion
Accounting for construction contracts tends to be challenging, because of different variations and factors that are involved in the overall process.
However, with revenue recognition being the main cause of concern for accountants in this regard, it is important for accountants to properly classify all transactions, in addition to having absolute clarity regarding contract assets and contract liabilities.