Revenue Recognition Judgement Risks for Long Term Construction Contracts

Financial reporting standards have existed for decades. Yet revenue recognition errors continue to appear in financial statements, audit files, and regulatory findings under IFRS 15.

So why does revenue recognition still go wrong under IFRS 15?

In this episode, Wayne Basford and Judith Leung explore the practical judgement areas that cause recurring mistakes when applying IFRS 15 Revenue from Contracts with Customers. They discuss why the five-step model can appear straightforward in theory but becomes far more complex in real reporting environments.

The conversation examines several common problem areas under IFRS 15, including misidentifying performance obligations, allocating revenue incorrectly, recognising revenue based on invoices rather than the standard, and failing to apply the reversal constraint when estimating contract consideration.

Using real-world examples, including long-term projects and construction contracts, they explain how cost estimates, contract variations, bonuses, and penalties can distort revenue recognition and lead to overstated financial results.

If you prepare, audit, review, or oversee financial statements, this discussion will sharpen your understanding of the judgement risks within IFRS 15 revenue recognition and highlight where financial reporting most often goes wrong.

🎧 In this episode, you’ll learn:

• Why revenue recognition errors still occur under IFRS 15
•  Why recognising revenue based on invoices can be misleading
•  How the IFRS 15 reversal constraint affects bonuses, claims, and variations
•  Why cost-to-complete estimates can distort revenue recognition
•  What auditors, boards, and preparers should watch for when reviewing revenue under IFRS 15

Financial Reporting Conversations is brought to you by Basford Consulting helping professionals go beyond compliance and get financial reporting right.

For technical insights, training, and resources that make the unknowns in financial reporting known, visit basfordconsulting.com

🔗 Connect with us:
LinkedIn: Wayne Basford & Judith Leung
YouTube: @BasfordConsulting
Website: basfordconsulting.com

Transcript

SPEAKER_00 0:00

Welcome to financial reporting conversations.

SPEAKER_01 0:09

So we can avoid the blumes and financial reporting.

SPEAKER_00 0:16

Really simply one of the main privileges.

SPEAKER_01 0:24

Hello and welcome to financial reporting conversations. I'm Judith Lumber, and as usual, I'm Jumbleman Basket. I mean, um, I'm apparently working on an ice cream course and a webinar on construction contracts. The area of construction accounting has always been an area with a lot of judgment involved. From your perspective, what are some of the key risks that preparers and auditors should be thinking about?

SPEAKER_00 0:47

Almost. Construction accounting is the model of how to get IFRS 15 wrong. How to mess up the IFRS 15's five-step approach. So you miss link contracts. So construction accounting, it can have lots of contracts to build different elements of a building, people issuing contracts to design it, to install it, to put electricals in. You can just miss link contracts. A classic that we're seeing more and more is people deliberately introduce performance obligations that aren't distinct within step two. So we want to recognize early revenue early. So remember, the key aim of a preparer is to recognize as much revenue as early as possible. And unfortunately, under IFRS 15, you can't do it or you shouldn't do it. So for the board members, people signing off on the accounts of construction companies, have we complied with IFRS 15? Should we have recognized all that revenue in the first two months of the contract? For the auditors, uh, have they complied with IFRS 15? You then get overestimating consideration. I'm desperate to recognize as much revenue as I can. I don't want revenue to reverse, so I'm going to be over-optimistic about meeting targets. I'm going to ignore penalties and uh late payments, etc. The center of IFRS 15 and construction contracts is the reversal constraint. You can only recognize revenue to the extent it is highly probable it won't reverse. So it's highly probable you're not going to incur those penalties. It's highly probable you're going to receive those bonuses. Everything is designed. The aim of the person that negotiated the contract is to recognize as much revenue up front as you can. Let's front load all the early performance obligations. Let's charge massive amount of money relatively for the design element, and we will recognize revenue in accordance with the invoicing billing schedule within the contract. That's not what IFRS 15 step four says, that you have to allocate revenue on the relative standalone selling price of the entire set of performance obligations. Classically, on big construction, uninstalled materials. A lot of construction involves buying turbines, buying bits of electrical equipment, buying pipes. So you buy material, you pay for that up front, but it's not actually even been delivered to site. Your percentage of completion methodology needs to be adjusted for the costs I've incurred to date, but they've not actually arrived on site. And you know, the classic, and this is this is the world of construction under IS 11, this is the world of construction under IFRS-15. Common error, most common error you see, underestimating the cost to complete. And it gets the accounting wrong, it overstates profit, it overstates revenue, it can be avoiding onerous contracts. So base level, how much you ask the contract manager, you ask the project manager, how much is it going to fit, how much is it going to cost us to finish this? And they get it wrong. They might get it wrong because they've missed something, or they might deliberately get it wrong because they don't want to lose their job and admit they've managed the project really, really badly. So, you know, welcome to construction.

SPEAKER_01 4:57

Now, one of the questions and big questions under revenue is when should revenue be recognized? And 15 says step five, so you recognize it over time or at a point in time. With construction contracts and under IS 11, people typically, you know, recognize revenue as we perform the work, as the contract progresses. Is that as simple as that in under 15? Can we just carry on what we're doing?

SPEAKER_00 5:25

Can we continue what we're doing? Should we continue what we're doing? So my skepticism, certainly in Australia, is we haven't noticed IFRS 15 as happened. We recognize revenue when we raise an invoice. I've seen wonderfully auditors try to explain to me we have a three-point vouching of revenue recognition. We agree to the invoice, we agree to cash, we agree a dispatch note, we agree to an invoice, and we agree to cash being collected. That is not what 15 says. So remember, you've got 15 is over time or a point in time. To get over time, we are constantly transferring control of an asset. So when you're looking at how do we do that, if I can keep be convinced that design is a distinct performance obligation, which in most cases I take a lot of convincing for somebody to convince me design is a distinct performance obligation. Well, when do you actually give the customer the plans? You're working on it, you've got all your CAD engineers, you've got your architects, you've got everybody going on. Well, have you handed over those separate, those distinct plans? And you haven't. So when it comes to that design element, most likely it's a point in time. And when you're building on somebody else's site, you're doing construction on the customer's site, then overtime is a reasonable way to do it. Noting you have to have transferred control of an asset. So you have spent a load of money, you've spent$10 million auditing turbines from Siemens, they've not been delivered on site. Why can you recognize revenue on something that you've not transferred the control of? And then you, of course, you get the nuance of you're building it on your own site. So you're either building a building, you're building a condo, you're building an industrial estate on your own land. Well, when do you not the customer's land, your land? How do you transfer control of that? When do they get the risks and rewards of that? Then you have to do that. And when you're in you know, other elements of construction, you're constructing a ship, you're constructing an airplane, you're constructing a turbine for somebody, they haven't got control of it, they haven't got access to it. You've got big big signs and big security arrangements on your own production facility. So the strict rules as to is it possible to recognise POC percentage of completion on assets that are being constructed at your own site.

SPEAKER_01 8:46

So if we do conclude that it is revenue over time, that we can um recognise revenue over time. Many entities recognize revenue based on a cost plus margin approach. Is that correct under 15?

SPEAKER_00 9:04

It depends. You know, again, particularly in terms of uninstalled materials, with the principle I just mentioned. It must be I have transferred control of a good. I can only recognize if I've revenue if I've transferred control of a good. Just because I've incurred the cost of an undelivered, uninstalled turbine, etc., it's not as simple as just that cost plus recognition.

SPEAKER_01 9:35

That's when you talked about uninstalled materials that you touched on earlier on. So construction contracts also often include very common variations, claims, bonuses, things always run late, penalties. How do these um adjustments affect revenue? How does what does I for S15 say to do?

SPEAKER_00 9:57

No, as I mentioned, it's the reversal constraint. So you can only recognize revenue to the extent it is highly probable it won't reverse. So when you're estimating, and this is percentage of completion, when you are estimating consideration in step three of IFRIS 15, what is the probable consideration you will receive? Is it probable that you will incur costs to because you're late, costs because it doesn't work to specification? You need to put that in there. And then when we're into the mechanism of the percentage of completion, which is really the same as it we were using under IS 11. I have a formula that says this is my contractual revenue that I'm estimating, this is my estimate of costs, and this is crucial when you get construction accounting. So there's my revenue, there's the original contract. There is such a temptation to keep on increasing that revenue line, increasing it because of variances, and there's two issues with variances. So is it contractually agreed? Have I a contractual right to that variance, or am I just hoping, praying, trying to bully, negotiate with my customer, they're going to accept that variance? And the other one that is commonly missed, well, I've agreed this variance. Do costs come with it? So there's a really great temptation or mistake or deliberate mistake. I book the contractual agreed variance and ignore the fact that that variance is going to cost me a fortune and cost me additional costs. Equally, you know, everything is this driven by the reasonableness of the cost to complete. I know if I deliver this thing late, I'm going to incur penalties of$10,000 a day. And I'm going to blacken my name and reputation, etc. So in reality, I'm going to incur massive inefficiencies to get it finished on time. So those last three months of the project, I'm going to hire extra staff, I'm going to be paying overtime, I'm going to have to pay additional F fares to get those staff on site. I'm going to have to pay additional accommodation to get those staff on site. So the threat of penalties also should be considered when you're looking at the reason of the cost to complain.

SPEAKER_01 12:46

If you're finding this discussion useful, please take a moment to click like, subscribe, and share. It helps others in the financial reporting community discover financial reporting conversations and keeps you up to date with every new episode. From an honest perspective, how what are the red flags that might suggest that revenue might be overstated or that the contract is onerous?

SPEAKER_00 13:10

All auditors need to understand their business. And where things go wrong, there's typically two things go wrong for the construction companies. They've gone and tended for something they've never built before, and they just don't realize how difficult it is to build it, or they're desperate to win the contract. A long time ago, I was doing a due diligence on a construction entity, and I got on I got on well with the the guys. I was actually doing the uh chatting with the vendors of this business, and I'm checking this, I'm checking that, and I'm I was a young kid when these guys were giving me the answers, and they said, You're asking me all these questions. You don't realise I there's only three operators in my business. If I've lost five tenders in a row, I will win the sixth. And he's smiling at me and saying, But and that's the one you've got to find. So there's these are th things go wrong that you you know when you look at building stadiums, very good Australian company builds a beautiful stadium in Sydney weather conditions, and then go and win a contract to build the new Wembley Stadium. And for somebody who's lived in both cities, they are different climates. And they built a stadium, tended for a stadium, two things. A it's in London, where it gets cold, windy, frost, snow, and they tended to build a roof design that had never been built anywhere in the world before. And guess what? Annoyingly, for me who loves soccer, Wembley Stadium was delayed, and that construction company incurred lots of costs and penalties because it was just those two factors. It was a new geography and it was a new design. So when people are building something new, an area that either they've never built before or they've nobody's built before, there is a high risk it will go wrong. And again, when you're trying to understand, and the climate, you know, the economic climate can change between tendering and getting your procurement sorted. That one of the things to flag and ask as an auditor, so okay, you did these, you you tendered on it, you got all these different costs, you're actually going to outsource 90% of that work. How many of those costs have you managed to lock in? How much of the total cost have you managed to go and get the subcontractor, and you've locked the subcontractor into an agreed fixed price? And occasionally it goes wrong. You your plan was you would within a month of winning the tender, you intended to place that order with these subcontractors, and something went wrong. The economy's gone wrong, the the the subcontractor you're using or intended to use is fully booked, the subcontractor that you intended to use has gone bust. So all of your best-laid plans of subcontractor A was going to do the the piping for me, and it was going to cost me 20 million dollars. Well, you can't get subcontractor A to do the piping, and whoever you're going to get to do it is going to charge you a lot more than$20 million. Yeah.

SPEAKER_01 16:58

So the costs have gone up.

SPEAKER_00 17:00

And they're there, there's a problem almost from the first month. And the auditors ACE 315, we need to understand the business. Is it all going to plan? Have we done anything risky? Have have we placed all the orders and get our subs lined up? Have we locked in costs or is anything not quite working? You know, that understand the business.

SPEAKER_01 17:26

And certainly IFRS 15 requires us to um exercise sort of conservative, be more conservative in terms of how we recognize revenue. We can't recognise revenue unless there is highly probable that you won't reverse. So that's the revenue constraint in IFRS 15. Well, so we talked about auditors. What about for preparers? Um, what are some common mistakes that you see preparers make in practice?

SPEAKER_00 17:55

Common mistakes or deliberate mistakes. So I am still professionally, I am still professionally skeptical. The person who negotiates the contract, the person who drafts the contract, is to recognize as much revenue as we can as early as we can. So they front load the contracts. And from a commercial cash flow projection, operation, it makes perfect sense. Get as much as you can for the design, get as much as you can for the initial phases of the project. But that's not the way 15 works. Because step four says you have to allocate based on the standalone selling price. For you say preparers, whether it's the guy negotiating the contract or it's the bookkeeper. We recognize our system, no matter which system it is, we recognize revenue based on the invoice. That's not the way 15 works. We recognize revenue based on the five-step approach in 15. And remember, depending on where you sit and where you make the mistakes, the reality is the mistake is you contr you tended for a contract that you shouldn't have. And you know, that can be your engineer didn't really know what they're doing. I've had engineers that have missed whole buildings from projects that and trying to explain to me then go. We tended for this, and when we we we didn't notice it was actually to refurbish two and a half buildings. We did all the spec for two buildings, and when we got to do it, we reread the spec again and we had to do a half a building. And the and the customers not being reasonable, the customer doesn't accept that we made a mistake. Well, I I've had I've had quantity surveyors that missed concrete floors out flats. So, you know, you do tend that you do have mistakes. And talking as the financial controller, looking at these mistakes, well, did your engineer make that mistake? And then I've seen there's been just a problem with procurement. There's been a problem with procurement, we thought supplier A would do it and they're refusing to do it. We thought we could get away with this grade of material. And now when we've actually tried to put it install it, it doesn't work, it right it we we can't get it past the inspectors. So we made a mistake in the specification, and when we've reread the terms of the variances, we can't claim that variance against the customer, we're in trouble. You know, there are so many ways construction projects can go wrong. And whether you're the financial controller watching it, you need to be aware of it. Whether you're sitting on an audit committee of a construction company, be aware how it can all go wrong, and be aware of what controls have I got in place sitting at the board that would tell me if something's going wrong. Would that person who messed up the tender, would that person who's not managed the project well, who's that person that got the grade wrong in the tender? How likely are they going to put their hand up and say, I'm very sorry, I messed up? Or are they trying to hide that from the board?

SPEAKER_01 21:50

Yeah, I just want to go back to rev uh recognizing over time and point in time. You know, we talked about if we're constructing something on our own premise. It's we haven't passed control. Is there any way we can recognize still recognize revenue over time?

SPEAKER_00 22:07

It's two elements. Whether I'm building a ship, I'm building something in my own shipyard, or wonderfully, we always have to drift towards the Singaporean condominium situation. So if I'm building a ship absolutely tailored for the customer's needs, and can I force the customer to take that? And must they pay me for the half-finished ship? If those criteria are met, I can recognise revenue over time. But and the same argument, the wonderful arguments on Singaporean Malaysian condos that are sold off the plan. I sell you the penthouse on the eighth floor, number eight. You have got the rights to it. You, the customer, have got the rights to that specified asset, and I can't sell it to anybody else. You're not allowed on that site. By the way, the eighth floor isn't even constructed yet, so the asset doesn't exist. But the right to the asset exists, as we're putting the footings in and level one, level two, level. Can I recognise revenue and as a dispensation to the Singaporeans and to Malaysia? If it's a specified asset, and you can force the customer to buy that asset, come what may, you can recognise revenue. This doesn't work in Australia.

SPEAKER_01 23:49

Why is that?

SPEAKER_00 23:50

Because the way it's been debated, and it was interesting that all the accountants, including me, suddenly got very educated in the basic principles of Australian law, which to be honest, because they're based on British law, I'm very surprised it's not the same in Singapore because Singaporean law is based on British law, but that's just an observation. The way Australian law works is they rarely enforce a contract. Australian law is driven by compensating loss. So if you if the property market had collapsed and the customer was refusing to so the customers agreed to buy a penthouse for$10 million, the property price has now fallen to eight million dollars, the customer is refusing. No, I don't want it anymore. It's I'm not paying$10 million for it. My understanding is Australian law, if it's an enforceable contract, would force the customer to pay two million damages.

SPEAKER_01 25:04

Okay, not the whole$10 million.

SPEAKER_00 25:06

They would not say you need you need to buy, you must give$10 million, you must go through with the contract. The way Australian world looks is you have breached your contract. The constructor has lost two million dollars because you've breached your the contract, you must pay the constructor$2 million, and that doesn't pass the requirement under 15.

SPEAKER_01 25:35

Let's wrap it here. Um hopefully that gives people a bit of a taste of our webinar and our iceberg course. And if you'd like to explore these issues in more detail, we'll be presenting a webinar and iceberg course where we walk through the key risks, um, like things that we've talked about just then. We'll go through some practical examples and also the accounting requirements. So thanks everyone for joining this episode of Financial Reporting Conversations.

SPEAKER_00 26:01

Thanks, Julie. Thanks for listening to Financial Reporting Conversations. For guidance on applying accounting and auditing standards, or to access our online training programs, please visit BassfordConsulting.com.

SPEAKER_01 26:14

Don't forget to like, subscribe, and share this episode with your colleagues and contacts. We'll see you next time where we make the unknowns in financial reporting known.