Long-term contract accounting – common mistakes

This In brief applies to all entities that enter into long-term contracts for revenue recognition. Set out below are some of the common mistakes and challenges we see in accounting for long-term contracts.

Entities across many industries recognise revenue under IFRS 15 in long-term contracting arrangements. This could include industries such as construction and engineering, aerospace and defence, technology and software, advertising and marketing, pharmaceuticals, business process outsourcing and many other service industries. The accounting for long-term contracts can be complex, and has been an area of regulator focus and concern over recent years.

The guidance below is not intended to be a complete guide of how to account for long-term contracts, but is intended to highlight some of the key areas where entities make mistakes or find challenges in the application of IFRS 15 to long-term contracts.

Traditional construction contracts are often a single performance obligation, because they represent an entity’s overall promise to transfer a combined item to a customer. However, long-term contracts exist in many different industries and include a wide range of activities. There are a number of cases where the outcome might be different. Examples of these include the following:

• Outsourced business processes. Many of these contracts (for example, facilities management) represent a series of distinct goods or services because each individual activity is separately identifiable. A series of distinct goods or services is accounted for as a single performance obligation if the distinct goods or services are substantially the same and have the same pattern of transfer to the customer (see MoA 11.63). This is different from a single distinct service where activities are not separately identifiable because the activities transform each other (for example, in the construction of a house where materials are transformed by the construction service into a house). In both cases, there is one performance obligation but the judgements around the measure of progress might be different when assessing revenue recognition for a ‘series’ (discussed below). There are also differences in respect of accounting for contract modifications (see MoA 11.50) and allocating variable consideration (see MoA 11.148) where the performance obligation is deemed to be a series of distinct goods or services.
• Projects that are contracted for and/or bid for in stages. A separate bidding process for different components of a project might indicate that there are multiple performance obligations because each component has separable risks. In some cases, contracting is completed in stages as a result of operational matters such as budgeting. If this is the case, generally only the agreed activities will form the contract for the purposes of applying IFRS 15, and any further work agreed will be accounted for as a contract modification (see MoA 11.44–11.52). It might sometimes be necessary to combine multiple long-term arrangements with the same customer (or a related party of the customer) into a single contract for the purpose of applying IFRS 15 (see MoA 11.39–11.43).
• Contracts that include the transfer of goods or services for which the entity never takes control. In certain outsourcing arrangements (such as procurement, distribution or inventory management), an entity might purchase significant services or materials for which control is transferred immediately to the customer. In such cases, those goods and services could represent a distinct good or service for which the entity is acting as an agent, particularly if those goods and services are never integrated into other goods and services being provided by the entity. The delivery of such goods and services would be accounted for as one or more separate performance obligations, and revenue would be recognised on a net basis at the point in time when the agency service is completed.

Once the performance obligations are identified, entities need to determine whether each of those performance obligations are satisfied over time or at a point in time. For each performance obligation satisfied over time, entities should select either an input or an output method to measure progress towards satisfaction of a performance obligation. This is not a choice; an entity should select the method which best reflects the transfer of goods or services to the customer for each performance obligation. This judgement should be explained in the entity’s accounting policies.

Input methods using costs might be common in traditional construction contracts, but other methods might be more appropriate for other types of long-term contracts in particular where they meet the definition of a ‘series’. For example, time-based methods to measure progress would generally be used where a service is provided evenly over a period of time or an entity has a stand-ready obligation to perform over a period of time. A promise to provide a fixed quantity of a good or service over a period of time is typically a promise to deliver the underlying good or service rather than a promise to stand ready; therefore, in this instance, it would be more appropriate to use another output method such as quantity delivered. See MoA 11.185 & associated FAQs.

Costs related to performance obligations that are satisfied over time should be expensed as incurred, unless specific criteria are met for them to qualify for capitalisation as a cost to obtain or fulfil a contract (see MoA 11.273–283). This is because control is being transferred to the customer as the entity performs. This applies regardless of the selected measure of progress.

One common misconception is that an entity can or should defer or accrue costs in order to achieve smooth profit margins where an output measure is used to measure progress. Costs are recognised as an expense when incurred, unless such costs meet the criteria to be capitalised as intangible assets, property, plant and equipment or inventory, or the criteria under paragraph 95 of IFRS 15 to be capitalised as contract fulfilment costs. Therefore, the use of an output measure of progress can and often does result in different profit margins being recognised in each year of a contract. See EX 11.279.1 and FAQ 11.282.1.

This principle also applies where an entity uses milestones as an output method. Whilst milestones are often used as a billing mechanism in contracts, this does not always mean that they are the most appropriate measure of progress. Entities that use output measures such as milestones or units produced or delivered should not be accumulating assets on the balance sheet between milestones. Furthermore, significant levels of costs between milestones could indicate that the measure does not reflect the entity’s performance. See FAQ 11.178.1.

Costs are included in the measure of progress in the ‘cost-to-cost’ method if they depict the entity’s performance towards satisfying a performance obligation. This includes direct labour and materials, as well as allocations of costs related directly to contract activities. See EX 11.183.1.

Costs that do not depict the transfer of goods and services to the customer should be excluded from the measure of progress. These most commonly include:

• Mobilisation costs. Whilst mobilisation activities might be critical to the contract, these activities often do not satisfy performance obligations, because no goods or services are transferred to the customer. Certain mobilisation costs can be capitalised as fulfilment costs. However, in particular, training and other similar employee costs should generally be expensed as incurred on the basis that the entity would not usually have sufficient control over the expected benefits arising from an employee (as clarified by the IFRS IC Agenda Decision March 2020); these costs are excluded from the measure of progress if they do not relate to activities that transfer goods or services to the customer. See MoA 11.227.
• Wasted materials. Whilst these might relate directly to a contract, costs associated with wasted materials do not depict the entity’s performance in transferring control of goods or services to the customer and also do not generate or enhance resources of an entity or relate to the satisfaction of future performance obligations. Therefore, such costs should be expensed as incurred and excluded from the measure of progress. See FAQ 11.281.1. This is different from the treatment of learning curve costs (see EX 11.278.2) which are typically reflected in the price of the contract.
• Uninstalled materials. However, it might be appropriate to recognise revenue, limited to the cost of those materials, if certain criteria are met. See MoA 11.184.

Uncertainty over cost reimbursements from suppliers or other third parties should also be considered when applying a cost-based measure of progress. There is no prescriptive guidance in IFRS 15. However, entities will need to ensure that the approach results in an outcome where it is highly probable that there will not be a significant reversal in the amount of cumulative revenue recognised when the outcome of the supplier/third party reimbursement is finalised.

There are several types of asset which can arise from contracts accounted for in accordance with IFRS 15, including contract assets, assets in relation to costs to obtain or fulfil a contract, or ‘payment to customer’ assets. There is a common misconception that all of these assets represent ‘contract assets’. However, a contract asset is limited to an entity’s right to consideration in exchange for goods or services provided. Assets that do not meet the IFRS 15 App A definition of a contract asset should not be labelled as ‘contract assets’ in the financial statements, and should be considered separately for accounting purposes, in particular:

• Assets in relation to costs to obtain a contract (for example, commission paid) and costs to fulfil a contract (for example, mobilisation costs). These assets arise from the capitalisation of costs incurred in relation to obtaining and fulfilling a contract. These costs are paid to parties other than the customer and are ‘amortised’ as an expense as the related goods and services are delivered. They do not represent the right to consideration from the customer for the satisfaction of performance obligations.
• Payments to customers (for example, ‘pay to play’). An asset could arise if a payment to a customer is made before the goods and services are provided – for example, at inception of the contract (see EX 11.119.1 to EX 11.119.4). The asset does not represent a right to consideration for goods and services already provided. These payments are recognised as a reduction of revenue as the related goods and services are transferred.

IFRS 15 does not provide guidance on what assets should be presented separately on the balance sheet. Entities should consider paragraph 29 of IAS 1 which requires an entity to present separately items of a dissimilar nature or function unless they are immaterial. It could be acceptable to aggregate certain assets on the balance sheet if they are similar, and then provide further detail in the notes. In practice, the most critical factor is to provide clear labels and descriptions to explain the nature of the assets and the accounting policies being adopted.

There are also different impairment approaches for different assets. See guidance on contract assets (MoA 11.294), and costs to obtain and fulfil a contract (EX 11.290.1). There is a lack of prescriptive guidance on payments to customers, but the asset arising from the payment to a customer should only be impaired if consideration under the contract is not expected to exceed the asset. The asset might still be recoverable, even if the overall contract is onerous.

Onerous long-term contracts are not unusual, given the challenges around estimating contract profitability over a longer period. The following are some key reminders:

• Level of assessment. The assessment of whether an onerous contract exists is made at the contract level and not at individual performance obligation level (see MoA 16.71). In fact, if a performance obligation appears to be loss-making at inception, this might indicate that the method for allocating the transaction price across the different performance obligations in the contract is not the best reflection of stand-alone selling price.
• The variable consideration threshold is different. Variable consideration should be considered when assessing an onerous contract, even if that variable consideration has been constrained based on the highly probable threshold for the purpose of recognising revenue. The threshold for assessing economic benefits in the context of an onerous contract is whether it is probable that income will exceed costs. Therefore, there could be instances where such a contract would appear loss-making under IFRS 15 but would not be assessed as an onerous contract under IAS 37 (see FAQ 11.292.1).
• Unavoidable costs. In assessing whether a contract is onerous, unavoidable costs should include not only incremental costs but also an allocation of other costs that relate directly to fulfilling contracts (see FAQ 16.72.1). This was clarified by an amendment to IAS 37 which is effective for periods beginning on or after 1 January 2022.

Assurance-type warranties offered as part of a contract with a customer are accounted for under IAS 37. Some might default to measuring the provision based on the percentage completion of the contract at the reporting date (that is, percentage complete multiplied by the total expected provision at the date of completion). However, if defects that ultimately lead to warranty costs occur at certain points in the contract, the provision should reflect these costs at the balance sheet date measured in accordance with IAS 37. Further guidance on warranties can be found in MoA 11.219–11.224.

Provisions for onerous contracts and warranty provisions do not meet the definition of a contract liability under IFRS 15. Therefore, such provisions should be presented separately from contract liabilities on the balance sheet, normally alongside other provisions recognised in accordance with IAS 37 (see MoA 11.292).

There have been no recent changes to the accounting requirements of IFRS 15 or in the accounting for long-term contracts, so the guidance above is currently effective.