Costs to fulfill a contract under IFRS 15 – sufficient foundation?

IFRIC has issued for comment a draft agenda decision on costs to fulfill a contract under IFRS 15, with comments requested by May 15

I’ll post the entire text here:

  • The Committee received a request about the recognition of costs incurred to fulfill a contract as an entity satisfies a performance obligation in the contract over time. In the fact pattern described in the request, the entity (a) transfers control of a good over time (ie one (or more) of the criteria in paragraph 35 of IFRS 15 is met) and, therefore, satisfies a performance obligation and recognises revenue over time; and (b) measures progress towards complete satisfaction of the performance obligation using an output method applying paragraphs 39–43 of IFRS 15. The entity incurs costs in constructing the good. At the reporting date, the costs incurred relate to construction work performed on the good that is transferring to the customer as the good is being constructed.
  • In considering the request, the Committee first noted the principles and requirements in IFRS 15 relating to the measurement of progress towards complete satisfaction of a performance obligation satisfied over time. Paragraph 39 states that ‘the objective when measuring progress is to depict an entity’s performance in transferring control of goods or services promised to a customer.’ The Committee also observed that when evaluating whether to apply an output method to measure progress, paragraph B15 requires an entity to ‘consider whether the output selected would faithfully depict the entity’s performance towards complete satisfaction of the performance obligation.’
  • In considering the recognition of costs, the Committee noted that paragraph 98(c) of IFRS 15 requires an entity to recognize as expenses when incurred costs that relate to satisfied performance obligations (or partially satisfied performance obligations) in a contract—ie costs that relate to past performance.
  • The Committee observed that the costs of construction described in the request are costs that relate to the partially satisfied performance obligation in the contract—ie they are costs that relate to the entity’s past performance. Those costs do not meet the criteria in paragraph 95 of IFRS 15 to be recognized as an asset.
  • The Committee concluded that the principles and requirements in IFRS Standards provide an adequate basis for an entity to determine how to recognize costs incurred in fulfilling a contract in the fact pattern described in the request. Consequently, the Committee [decided] not to add this matter to its standard-setting agenda.

That may sound sufficiently straightforward and obvious to raise the question of whether the original request had any merit at all to it. It probably helps a bit to know that the illustration in the request was based on a contract to construct a house for which the foundation has been completed, and related revenue is recognized. The possible premise for recognizing a portion of those costs as an asset is that the foundation:

  • …is necessary for the continuing delivery of the different components (i.e. walls and columns, windows/doors, roof). Hence, some of the cost of (the foundation) should be allocated to the other components that are yet to be completed. This reflects more representatively the economics of the contract as the contract involves the delivery of one performance obligation (the house) to the customer. Some of the cost incurred for (the foundation) is a resource that will be used to satisfy the construction of future components. The method to allocate cost to partially completed performance obligation and future obligation may be by using the overall margin of the contract.

At the very least, the premise doesn’t seem frivolous. As I write this post, IFRIC has only received one comment on the draft decision. It’s hampered a bit by shaky articulation, but the basic meaning is clear:

  • …a construction company cannot confidently assert that all costs incurred are related to work transferred to the client at the reporting date.
  • Many different revenue recognition mechanisms are used in construction. Output methods can be based on various milestones. In addition, an important role can play design features of the building under construction.
  • Therefore, conclusion of the tentative agenda decision that «the costs of construction described in the request are costs that relate to the partially satisfied performance obligation in the contract» is not quite obvious.

I suppose though that the Committee’s decision not to provide any further guidance doesn’t necessarily mean preparers have no room for manoeuvre (obviously I am not a construction industry expert and these remarks may be overly generic). The request set out a scenario where the cost of the foundation is asserted as being $2 million, but maybe it’s not always so black and white. That is, perhaps a portion of that $2 million could be legitimately analyzed in the first instance as being primarily attributable to those other components, thus ducking the reallocation question. Or if the bottom line resulting from the company’s methodology appears unrepresentative, then maybe the company needs to reconsider its method of measuring progress. Or perhaps it’s not always so self-evident when a foundation is completed anyway, given that it’s not much use on its own. In other words, this kind of IFRIC agenda decision isn’t necessarily saying there’s no room for flexibility and reassessment, only that practitioners don’t need any more help in identifying and testing the limits of that space for themselves…

The opinions expressed are solely those of the author

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