HOW WILL IT AFFECT CONSTRUCTION MARGINS?
For companies in the construction industry, while there has been a lot of focus on whether the adoption of the new revenue standard FRS 115: Revenue from Contracts with Customers will impact the top line, there has been less focus on how FRS 115 might impact contract cost accounting and contract margin.
Such companies will often find that applying the new revenue standard to a traditional construction contract will result in a revenue accounting outcome broadly similar to the current percentage-of-completion (POC) method. However, companies may be surprised that new concepts on contract cost accounting may result in a volatile contract margin over the life cycle of a typical contract.
One notable change for contract cost accounting is that FRS 115 costs are generally expensed and there is no automatic link between revenue and cost. This means that the approach under FRS 11: Construction Contracts of using a balance sheet true-up to create a consistent margin over the life of the contract may change under the new standard.
Given that most construction contracts are long term, it is critical to start the process now as a contract signed today may still be “open” when FRS 115 becomes effective in January 2018.
FRS 11 CONSISTENT MARGIN APPROACH VERSUS FRS 115 COST INCURRED APPROACH
We illustrate the impact arising from the change with an example (Table 1).
Contract price $1,320
Contract margin 20%
Output measure POC is 28% based on survey work completed to date
Input measure POC is 30% based on cost-to-cost method
Under FRS 11, both contract revenue and contract costs that are accounted for using the POC method are recognised with reference to the stage of completion. Examples of acceptable methods are contract cost incurred to date as a percentage of forecast cost (cost-to-cost method), survey of work performed and physical completion.
Under FRS 115, revenue is recognised using a measure depicting performance using an input or an output measure (Figure 1). A contractor applying the input measure excludes the effect of inputs that do not depict its performance in transferring control of goods or services to customer (example, unexpected amounts of wasted materials, labour and any uninstalled materials).
Costs, on the other hand, are expensed as incurred unless they qualify to be capitalised as an asset under another standard (example, inventory, property, plant and equipment) or they relate to incremental cost to obtain the contract or future performance. This assessment is not affected by whether an entity chooses an input or output measure to measure progress.
Revenue is recognised using a measure depicting performance
From the above example, under FRS 115, an input measure using the cost-to-cost method will most likely result in an outcome similar to FRS 11 (using the same cost-to-cost measure) and provide a stable margin. On the other hand, if an output measure is used, it may result in a more volatile margin because there is no direct linkage between the costs being expensed and the output measure used to determine revenue (Figure 2).
Output method versus input method
If progress is based on surveys (output method), revenue may be consistent throughout the stages. However, costs may be higher in the early stages of construction and consequently, the margin in the early stages may be much lower than the later stages. Conversely, if an input measure based on cost-to-cost method is used, higher revenue will be recognised at the earlier stage when the higher costs are incurred and therefore the margin will be more stable.
Under the new standard, construction companies that previously recognised revenue and costs with reference to the stage of completion which falls under the “output” measure or other input measures (except cost-to-cost) need to carefully consider how this might impact their bottom line. Specifically, they need to consider if changing to the cost-to-cost method might result in a better reflection of their performance under the contract and the margin earned.
COST ACCOUNTING: WHAT CAN BE CAPITALISED AND WHAT CAN BE PRECLUDED?
FRS 115 also introduced the following new concepts for cost recognition which may change current accounting for pre-contract costs, work-in-progress and provision for loss-making contracts (that is, foreseeable losses):
1. Costs that cannot be capitalised are expensed as incurred. Costs can be capitalised only if they qualify to be capitalised as an asset under another standard (example, inventory, property, plant and equipment) or they relate to incremental cost to obtain a contract (example, bonus or sale commission on winning a contract) and future performance.
The main costs for construction contracts are staff costs, material costs and depreciation costs. Sophisticated systems may be required to determine how to segregate costs between those relating to “future performance” and those that need to be “expensed off directly to P&L”. In addition, it is not uncommon for costs to be incurred for variation orders before they are “approved”. The determination of whether these costs should be expensed off or if some portion of it can be capitalised depends on “future performance” or a separate performance obligation, and the ability to track capitalisable cost are key considerations under the new standard.
2. Costs that are not incurred (example, risk contingencies, warranties) are recognised if they qualify as a provision under FRS 37: Provisions, Contingent Liabilities and Contingent Assets.
3. Losses on loss-making contracts are provided for under FRS 37 only if considered onerous. The measurement of the provision may change from FRS 11.
Construction companies need to identify all costs incurred throughout the life cycle of the construction contract and review if the cost accounting is still appropriate under FRS 115 and assess the potential impact on adoption of the new standard.
Given that most construction contracts are long term, it is critical to start the process now as a contract signed today may still be “open” when FRS 115 becomes effective in January 2018. In addition, it is also important to understand that the transition options are available, including the impact on the comparative period, and ensure that open contacts are restructured in advance if required.
EFFECTIVE DATE AND TRANSITION
FRS 115 is effective for annual reporting periods beginning on or after 1 January 2018. For Singapore-incorporated companies listed on the Singapore Exchange, transition to FRS 115 will coincide with the beginning of the first reporting period under a new reporting framework identical to the IFRS. Listed companies will need to take note that the application of IFRS 1 will effectively remove one of the transition approaches in FRS 115 – the cumulative effect approach.
Consequently, these companies will have to show comparatives for 2017. In order to do so, their systems will have to be in place by 1 January 2017 (about two months away for companies with December year-ends) to ensure that the information for FY 2017 are captured appropriately under FRS 115.
Teo Han Jo is Partner, Audit, KPMG, and Chan Yen San is Partner, Professional Practice, KPMG. This article was first published in KPMG’s Financial Reporting Matters, issue 54. Reproduced with permission.