HKFRS 15 Revenue from Contracts with Customers
The Questions and Answers (Q&As) below were developed by the Financial Reporting Standards Committee ("FRSC") of the Hong Kong Institute of Certified Public Accountants (the HKICPA) and are for general reference only. The HKICPA, FRSC and their staff do not accept any responsibility or liability in respect of the Q&As and any consequences that may arise from any person acting or refraining from action as a result of any materials in the Q&As. Members of the HKICPA and other users of these Q&As should also read the original text of HKFRS 15 Revenue from Contracts with Customers, as found in the HKICPA Members’ Handbook for further reference and seek professional advice where necessary when applying the references contained in these Q&As.
The HKICPA's Standard Setting Department welcomes your comments and feedback on this paper, which should be sent to commentletters@hkicpa.org.hk.
HKFRS 15 Revenue from Contracts with Customers brought together the revenue recognition requirements in HKFRS into one standard, thereby providing the core principles for revenue recognition across all sectors. In the past, entities in the engineering and construction industries applied requirements in HKAS 11 Construction Contracts to account for their construction contracts. However, since 1 January 2018, with the withdrawal of HKAS 11, entities now follow the comprehensive revenue recognition framework in HKFRS 15.
Under HKFRS 15, the amount and pattern of revenue recognition of construction contracts could differ from those that applied under HKAS 11. This publication highlights key differences and how they might change the current accounting practices for construction contracts.
E&C entities often provide a significant service of integrating goods or services into a bundle under a single contract. Previously, HKAS 11 contained requirements for when a contract covering a number of assets was segmented and treated as separate construction contracts, which included considering if the assets had been subject to separate proposals and negotiations. HKFRS 15 introduces the new concept 'performance obligation', which refers to a promise in a contract to transfer a distinct good or service to a customer. These performance obligations are the units of the contract that are accounted for separately when applying HKFRS 15. HKFRS 15 provides specific requirements for identifying and accounting for the separate performance obligations in a contract. Revenue is recognised upon satisfaction of performance obligations rather than on completion of the whole contract. It is important to note that each performance obligation can have its own profit margin and pattern of revenue recognition.
Applying paragraph 27 of HKFRS 15 a promised good or service is distinct if both of the following are met:
i) the customer can benefit from the good or service either on its own or together with other readily available resources; and
ii) the promise to transfer the good or service is separately identifiable from other promises in the contract.
HKFRS 15 provides examples of factors that indicate an entity's promise to transfer a good or service is not separately identifiable. For example, one such factor is that the good or service is highly dependent on, or highly interrelated with, other goods or services promised in the contract (HKFRS 15.29).
The manner in which promised goods and services are bundled within a contract can affect the conclusion of whether those goods or services are distinct. That is, an E&C entity should not assume that a particular kind of good or service is distinct (or not distinct) in all instances. For example, in some contracts the engineering and construction services may be highly interdependent and need to be performed concurrently by the same contractor. However, in other contracts, the engineering services might be separately identifiable from the construction services, for instance when they are performed independently in separate phases for which the customer could award the construction work to a different contractor upon completion of the engineering phase. Judgement is therefore required when assessing whether goods and services are distinct.
Footnote:
1. IFRS 15 and Topic 606 are the result of the IASB's and the FASB's joint project to improve the financial reporting of revenue under International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP).
Q5. | Can E&C entities continue to recognise revenue using the stage of completion method under HKAS 11? |
To reflect the entity's activity for the reporting period, HKAS 11 required revenue and expenses to be recognised on uncompleted construction contracts. The underlying principle was that, once the outcome of a construction contract could be estimated reliably, associated revenue and expenses were recognised with reference to the stage of completion of the contract activity at the end of the reporting period.
HKFRS 15 retains over time revenue recognition similar to stage of completion accounting under HKAS 11. However, specific criteria must be met for it to apply, meaning that E&C entities no longer have an automatic right to over time revenue recognition. For transactions previously accounted for using the stage of completion method under HKAS 11, it will be necessary for management to evaluate contracts against HKFRS 15's criteria to establish whether revenue should be recognised over time.
Under HKFRS 15, revenue is recognised when, or as, performance obligations are satisfied through the transfer of control of a good or service to a customer. Control of an asset is defined in HKFRS 15 as the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset (HKFRS 15.33). An E&C entity will need to consider whether the performance obligations in its contracts meet any of the following three criteria necessary for recognition of revenue over time:
(a) the customer simultaneously receives and consumes the benefits provided by the entity’s performance;
(b) the entity's performance creates or enhances an asset controlled by the customer; or
(c) the entity's performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date (HKFRS 15.35).
The Boards2 developed the criteria in IFRS 15.35 (equivalent to HKFRS 15.35) to provide an objective basis for assessing when control transfers over time and, thus, when a performance obligation is satisfied over time. In particular, the Boards observed that the third criterion (paragraph 35(c) of IFRS 15) may be necessary for services that may be specific to a customer but also for the creation of tangible (or intangible) goods (HKFRS 15.BC132).
E&C entities often enter into contracts designed specifically to the customers' requirements with the creation of an asset and so HKFRS 15.35(c) will often be relevant to E&C entities. When an entity creates an asset that is highly customised for a particular customer, the asset would be less likely to have an alternative use. This is because the entity would incur significant costs to reconfigure the asset for sale to another customer (or would need to sell the asset for a significantly reduced price). In that case, the customer could be regarded as receiving the benefit of the entity's performance and, consequently, as having control of the goods or services (i.e. the asset being created) as the performance occurs, provided that the second part of the criterion in HKFRS 15.35(c) about enforceable right to payment is also met.
If an asset that an entity is creating at the direction of the customer has no alternative use to the entity, the entity will want to be economically protected from the risk of the customer terminating the contract and leaving the entity with no asset or an asset that has little value to the entity. That protection will be established by requiring that if the contract is terminated, the customer must pay for the entity's performance completed to date, which would suggest that the customer has obtained the benefits from the entity's performance. Rationally, the entity would only agree to transfer control of the goods or services to the customer if the entity is compensated for the costs associated with fulfilling the contract and it receives a profit margin that includes a return on those costs. The Boards also clarified that an entity must have an enforceable right to demand and/or retain payment for performance completed to date if the customer were to terminate the contract because the contractual payment terms might not always align with the entity's enforceable rights to payment for performance completed to date (HKFRS 15.BC142-145).
In order to determine whether their contracts meet the over time revenue recognition criteria under HKFRS 15, E&C entities should have a full understanding of the construction process, including the nature of the promised goods and services and all contract terms related to the transfer of control of those goods or services. Subtle differences in contract terms could affect whether the contract meets the criteria in HKFRS 15.35 – and therefore result in differences in the timing of revenue recognition.
Consider the following example that covers application of the criteria in HKFRS15.35:
Contract to build a ship
A contractor enters into a contract to build a ship. The contract has the following characteristics:
The contractor determines that the contract has a single performance obligation to build the ship.
How should the contractor recognise revenue?
In this example, the asset in question is the ship specified in the contract. Accordingly, the assessment of HKFRS 15.35 focuses on whether the customer controls that ship as it is being constructed. The performance obligation to build the ship is satisfied at a point in time because:
Given that none of the over-time revenue recognition criteria are met, the revenue would be recognised at a point in time – when control of the ship is passed to the customer.
The outcome could be different if the facts and circumstances are varied slightly. For example, the contractor would recognise revenue over time for the performance obligation to build the ship if:
|
Footnote:
2 the IASB and the FASB.
Q6. | If revenue is required to be recognised over time, how should progress towards completion be measured? |
HKFRS 15 requires that revenue is recognised over time by measuring an entity's progress towards complete satisfaction of the performance obligation. The objective is to depict an entity's performance in transferring control of goods or services promised to a customer (HKFRS 15.39).
Similar to stage of completion accounting under HKAS 11, there are various methods that an entity might use to measure progress under HKFRS 15, generally categorised as output methods and input methods (HKFRS 15.41). An output method results in revenue being recognised on the basis of direct measurements of the value to the customer of goods or services transferred to date (such as surveys of performance completed to date, milestones achieved and units produced) (HKFRS 15.B15), while an input method results in revenue being recognised based on the entity’s efforts or inputs, such as resources consumed, costs incurred or machine hours used (HKFRS 15.B18).
The methods used for determining the amount of work completed to date are similar between HKAS 11 and HKFRS 15. However, HKFRS 15 requires an entity to consider the nature of the good or service being transferred to the customer in determining the appropriate method for measuring progress (HKFRS 15.41). Hence, HKFRS 15 does not provide a free choice of method for measuring progress (HKFRS 15.BC159). For example, an entity would not be able to select the input method solely on the basis that it provides a more stable profit margin over the contract period.
The use of input and output methods when applying HKFRS 15 are both seen in practice in the E&C industries. When selecting an appropriate method, judgement is required. An E&C entity should consider whether the related information that would be required to apply its chosen method is reliable and supportable, and whether the method would appropriately reflect the performance of the E&C entity to date.
An E&C entity should also apply the selected method for measuring the progress consistently for similar performance obligations. Some E&C entities may need to change their revenue recognition methods used under HKFRS 15.
Q7. | How to account for costs incurred that are not indicative of an entity's progress towards satisfying a performance obligation? |
Application of input methods
E&C entities applying an input method that uses costs incurred to measure progress towards satisfaction of a performance obligation may find that certain costs incurred do not contribute to such progress, for example, costs of unexpected amounts of wasted materials incurred to satisfy the performance obligation, under these circumstances, an adjustment to the measure of progress will be required. HKAS 11 only provided a general principle that costs that did not reflect work performed should not be included in the contract costs. Compared with HKAS 11, HKFRS 15 provides more detailed guidance in this respect.
Consideration of significant inefficiencies in performance
Paragraph B19(a) of HKFRS 15 requires that, under an input method, an entity excludes costs related to significant inefficiencies, wasted materials and required rework from the measure of progress, unless such costs were reflected in the price of the contract. E&C projects normally have some areas of expected inefficiencies, and contingencies are included in the original pricing of the contract. There are circumstances, however, where unexpected inefficiencies may occur that were not considered a risk at the time of entering into the contract, such as design or construction execution errors that result in significant wasted resources that may require adjustment to a cost-based input method for measuring progress. These wasted materials should be excluded from the measure of progress and the costs should be expensed as incurred.
Consideration of uninstalled materials
There may also be circumstances in which the cost incurred to acquire goods for satisfying the performance obligations is not proportionate to the entity's progress. For example, this could be the case if goods are delivered to the customer site significantly earlier than the E&C entity integrates the goods into the overall project (i.e. uninstalled materials) and those delivered goods are not distinct from other promised goods and services in the contract.
As a first step, the E&C entity should determine whether control of these goods have been transferred to the customer. If not, the E&C entity should continue to recognise the goods as inventory under HKAS 2 Inventories. If the customer obtains control of these goods before they are installed, the E&C entity should recognise revenue for the transferred goods in accordance with the principles of HKFRS 15.
If an E&C entity is using an input method based on costs incurred (i.e. cost-to-cost method), the measure of progress may be inappropriately affected by the delivery of uninstalled goods. If so, application of such a measure of progress without adjustment would result in overstated revenue (HKFRS 15.BC171). HKFRS 15 states that, in such circumstances, the best depiction of the entity's performance may be to recognise revenue at an amount equal to the cost of the goods (i.e. at zero margin) and exclude the costs of the goods from the cost-to-cost calculation (HKFRS 15.B19(b)).
E&C entities should apply judgement when evaluating whether to make an adjustment to measure progress in their specific circumstances. For example, if the E&C entity is significantly involved in the design of the equipment, this may indicate that the cost incurred on the equipment is proportionate to the entity's progress. As such, it may not be necessary for the E&C entity to exclude the cost of the uninstalled equipment from the measure of progress. If the E&C entity is only providing a simple procurement service to the customer for the equipment, then an adjustment to measure progress may be necessary. HKFRS 15 provides an example illustrating the treatment of uninstalled materials when applying an input method that uses costs incurred to measure progress towards completion (HKFRS 15.IE95 to IE100).
Application of output methods
If an E&C entity concludes the output method is an appropriate method for the measurement of progress, costs relate to construction work performed on a partly-constructed asset which has been transferred to the customer, relate to the E&C entity's past performance (i.e. relate to satisfied or partially satisfied performance obligations). Accordingly, those costs are recognised as expenses when incurred (HKFRS 15.98(c)).
In order to obtain a contract, most E&C entities participate in a competitive tendering process. Developing a tender, or bid, involves a variety of costs including costs of gaining an understanding of a project’s requirements, the building of models, travelling costs of technicians to survey sites, and obtaining cost estimates from potential trade subcontractors.
HKAS 11 allowed pre-contract costs to be capitalised if they could be separately identified, measured reliably and it was probable that the contract would be obtained. However, HKFRS 15 has more specific requirements than HKAS 11 for accounting for contract costs, including the costs of obtaining a contract. Applying HKFRS 15, pre-contract costs are only capitalised if they are recoverable and they are incremental costs that are directly related to obtaining a contract (HKFRS 15.91) (or they are costs to fulfil the anticipated contract that meet the criteria for capitalisation in HKFRS 15.95). Costs incurred during the bid process that would have been incurred regardless of whether the contract is obtained (e.g. due diligence costs), are recognised as an expense when incurred, unless they are explicitly chargeable to the customer (HKFRS 15.93). As a practical expedient, HKFRS 15 allows such incremental costs of obtaining a contract to be recognised as expense when incurred if the amortisation period of the asset that would have otherwise been recognised is one year or less (HKFRS 15.94).
HKFRS 15 provides an example regarding the determination of incremental costs of obtaining a contract (HKFRS 15.IE189 to IE191).
Under HKAS 11, borrowing costs were capitalised as part of the construction costs of an asset if they could be allocated to specific contracts and the construction of the asset took a substantial period of time (it was a qualifying asset under HKAS 23 Borrowing Costs). However, under HKFRS 15, the pattern of revenue recognition for the contract (over time or point in time – see Q5) may affect whether an entity has a qualifying asset for the purposes of applying HKAS 23 and hence the eligibility for capitalisation of borrowing costs.
In November 2018, the IFRS Interpretations Committee discussed a request about the capitalisation of borrowing costs in relation to the construction of a residential multi-unit real estate development. In the request, the developer recognises revenue for sales of individual units over time applying IFRS 15. The Interpretations Committee concluded that, in the specific fact pattern provided in the request, the developer does not have a qualifying asset and does not capitalise borrowing costs. The Interpretations Committee's conclusion, which was published as an agenda decision in March 2019, is based on a specific fact pattern. Nevertheless, it is clear from the Interpretations Committee's analysis that, in some situations, the assessment of whether an entity has a qualifying asset to capitalise borrowing costs can differ between contracts that recognise revenue 'over-time' (i.e. transfer of control of goods or services over time) versus contracts that recognise revenue at a 'point-in-time' (i.e. transfer of control of goods or services at a point in time).
E&C entities should have a full understanding of the nature of the promised goods and services and all contract terms related to the transfer of control of those goods or services, when determining whether any work in progress asset under the contract would constitute a qualifying asset.
E&C entities should be aware that HKFRS 15 includes additional qualitative and quantitative disclosure requirements that were not included within HKAS 11. The new standard has extensive disclosure requirements that are intended to help users better understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. E&C entities should not overlook the time and effort to collect the required information.