Revenue recognition on construction contracts

When should a contractor record revenue on a job that takes eighteen months to build? Not when it signs the contract, because no work has been done; not only when the building is handed over, because that would show nothing for a year and a half and then a large jump. The accounting standards require most construction contractors to recognize revenue as the work is performed, in proportion to progress. This lesson explains how the standards reach that answer, how progress is measured, how changes, claims and penalties are handled, and why a job that is expected to lose money must show its whole loss as soon as the loss is foreseen.

Three frameworks matter in Canada. Publicly accountable enterprises use IFRS 15, Revenue from Contracts with Customers. Private enterprises can choose IFRS or ASPE; under ASPE, Section 3400 Revenue applies. Kestrel, as a private company, uses ASPE. Because many lenders and sureties are familiar with IFRS concepts, and because ASPE's own guidance on long-term contracts is brief, this lesson explains the IFRS 15 model and then shows how ASPE differs.

The five-step model

IFRS 15 sets out five steps for recognizing revenue. Applied to a construction contract, they look like this.

Step 2 deserves a comment. A building contract includes many tasks: excavation, concrete, framing, mechanical and electrical systems. These are not separate performance obligations because the contractor's promise is to combine them into a single building; the owner is buying the building, not a list of activities. Contracts that include genuinely separate promises, such as a design-build contract with a long-term maintenance service, or a contract to build two unrelated structures, may have more than one obligation, with the price allocated between them.

Why construction revenue is recognized over time

Revenue is recognized over time if any one of three criteria is met. The customer receives and consumes the benefit as the work is performed (common for services); the contractor's work creates or enhances an asset that the customer controls as it is created; or the work creates an asset with no alternative use to the contractor and the contractor has an enforceable right to payment for work completed to date. Most construction on an owner's land meets the second criterion, because the owner controls the land and everything built on it. Specialized fabrication, such as custom steel or precast for a particular project, often meets the third.

Speculative building is different. A developer that builds condominiums or houses for sale, without a buyer who controls the work as it proceeds, usually recognizes revenue when each unit is delivered. Some jurisdictions have interpreted condominium presale contracts in different ways, so developers need specialist advice; this course deals with contractors building for owners.

Measuring progress: input and output methods

Once revenue is to be recognized over time, the contractor needs a measure of progress that faithfully depicts its performance. The standards allow output methods, based on the value delivered to the customer (surveys of work performed, milestones reached, units produced), and input methods, based on the contractor's efforts (costs incurred, labour hours, machine hours). Most contractors use the cost-to-cost input method because cost data is available monthly from the job cost ledger and ties directly to the estimate.

Revenue for the current period is the revenue to date less revenue recognized in earlier periods. Because the estimated total cost changes as the job proceeds, the percent complete and revenue to date change too; the effect of a change in estimate is recognized in the period of the change, not by restating earlier periods. That is a cumulative catch-up, and it is the mechanism by which profit fade, discussed in Lesson 5, appears in the statements.

# Cost-to-cost revenue on a contract spanning three fiscal years (illustrative)
price = 12_000_000
periods = [  # (label, cost to date, estimated total cost)
    ("Year 1", 4_350_000, 10_900_000),
    ("Year 2", 9_600_000, 11_150_000),
    ("Year 3", 11_200_000, 11_200_000),
]
prev_rev = prev_cost = 0
for label, ctd, etc in periods:
    pct = ctd / etc
    rev_to_date = pct * price
    rev = rev_to_date - prev_rev
    cost = ctd - prev_cost
    print(f"{label}: {pct:6.1%} complete, revenue {rev:>11,.0f}, "
          f"cost {cost:>11,.0f}, gross profit {rev - cost:>9,.0f}")
    prev_rev, prev_cost = rev_to_date, ctd
print(f"Total gross profit {price - 11_200_000:,.0f}")

Year 1:  39.9% complete, revenue   4,788,991, cost   4,350,000, gross profit   438,991
Year 2:  86.1% complete, revenue   5,542,848, cost   5,250,000, gross profit   292,848
Year 3: 100.0% complete, revenue   1,668,161, cost   1,600,000, gross profit    68,161
Total gross profit 800,000

In year 1 the job was expected to earn $1.1 million and showed a gross profit in proportion. In year 2 the estimated total cost rose by $250,000, so the year's profit is lower: the catch-up takes the effect of the higher estimate on all the work done so far in year 2. Year 3 completes the job at the final estimate. The total gross profit over the three years is fixed by the final result; revenue recognition only decides which period shows it.

Costs that do not depict progress

The cost-to-cost method assumes that each dollar of cost represents the same amount of progress. Some costs break that link, and the standards require them to be excluded from the measure of progress or adjusted.

Change orders and contract modifications

Construction contracts change constantly. Under the standards, a change order is a contract modification. When it is approved for both scope and price, it is added to the transaction price and the estimated cost, and it usually forms part of the single existing performance obligation, so the change is accounted for prospectively with a cumulative catch-up. When the scope is approved but the price is not yet agreed, the contractor may include its estimate of the price as variable consideration, subject to the constraint described below. When the change is still only claimed, it is treated as a claim.

The asymmetry in the last two rows is important: the costs of disputed work go into the estimate immediately, but the revenue goes in only when its recovery is highly probable. That conservatism protects readers from contractors who book optimistic claims as revenue, a common feature of past contractor failures.

Variable consideration and the constraint

Contract prices often include amounts that depend on future events: incentive bonuses for early completion, liquidated damages for late completion, award fees, claims and unpriced changes. These are variable consideration. The contractor estimates them using either the expected value (probability-weighted) or the most likely amount, whichever better predicts the outcome, and then constrains the estimate: it includes variable consideration only to the extent that it is highly probable, in IFRS 15's words, or probable, in ASC 606's, that a significant reversal of cumulative revenue will not occur when the uncertainty is resolved.

Loss contracts

If a contract is expected to lose money, the full expected loss must be recognized as soon as it becomes evident, not spread over the remaining work. Under IFRS, this follows IAS 37's treatment of onerous contracts. Under US GAAP, ASC 605-35 continues to require a provision for the entire anticipated loss in the period it is identified. ASPE practice follows the same principle. The effect is that a loss job hits the income statement hard in the month the loss is foreseen, and then shows zero gross profit for the rest of its life.

price, etc_new = 8_000_000, 8_400_000      # job now expected to lose 400,000
ctd = 3_150_000
pct = ctd / etc_new
rev_to_date = pct * price
gp_to_date_without_provision = rev_to_date - ctd
provision = (etc_new - price) + gp_to_date_without_provision
print(f"Percent complete {pct:.1%}")
print(f"Revenue to date {rev_to_date:,.0f}; cost to date {ctd:,}")
print(f"Gross loss to date before provision {gp_to_date_without_provision:,.0f}")
print(f"Additional provision for remaining loss {provision:,.0f}")
print(f"Total loss recognized now {gp_to_date_without_provision - provision:,.0f}")

Percent complete 37.5%
Revenue to date 3,000,000; cost to date 3,150,000
Gross loss to date before provision -150,000
Additional provision for remaining loss 250,000
Total loss recognized now -400,000

At 37.5 % complete the job has recognized only part of its loss through percentage of completion. A provision for the rest brings the total recognized loss to the full $400,000 now. If the firm had previously recognized profit on this job, the reversal of that profit is added to the hit. On a WIP schedule, the provision usually appears as an addition to contract liabilities or a separate accrued loss.

Combining and segmenting contracts

Occasionally, separate contracts with the same customer must be combined, for example when they are negotiated as a package with a single commercial objective, or when the price of one depends on the other. Conversely, a single contract with genuinely distinct obligations is split. Combining matters because it can prevent a contractor from showing profit on a profitable phase while deferring the loss on a related phase. Most building contracts do not raise this issue, but design-build-operate contracts, framework agreements and phased contracts may.

ASPE and the completed contract method

Section 3400 of ASPE permits either the percentage-of-completion method or the completed contract method for contracts for services, choosing the one that relates revenue to the work accomplished. The completed contract method, which recognizes revenue only when the work is substantially complete, is appropriate only when performance consists of a single act or when the contractor cannot reasonably estimate the extent of progress. Most construction contractors therefore use percentage of completion, and sureties generally expect it. Because ASPE's guidance is brief, many private contractors and their accountants look to IFRS 15 concepts for matters such as uninstalled materials and variable consideration.

Disclosures that readers rely on

The standards require contractors to disclose how revenue is recognized, the significant judgements involved, contract balances and their changes, and the transaction price allocated to remaining performance obligations, which is close to the industry's idea of backlog. For sureties and lenders, the key judgement is the estimated total cost of each job, because it drives percent complete and therefore revenue and profit. That is why they ask for the WIP schedule in Lesson 5 and compare it with completed contract results.