New FRS 102: Changes to accounting for contract costs may impact your reported contract margins
New FRS 102: Changes to accounting for contract costs may impact your reported contract margins
The amended FRS 102 may alter the accounting for contract costs (and thereby the contract margins) in long term contracts. This article spotlights how contract costs accounting may change, leading to fluctuating contract margins over the contract period.
On 27 March 2024, the FRC issued amendments to FRS 102 and other FRSs following the conclusion of its second periodic review of the standards. These amendments effectively align FRS 102 with IFRS for accounting revenue and lease transactions (though some differences remain). The amendments are effective for accounting periods beginning on or after 1 January 2026, with early application permitted. For a detailed analysis of key amendments to FRS 102, please see our latest publication.
Revenue on long term contracts is generally recognised over the contract period (rather than all at a specific point in time). The revenue to be recognised is measured by reference to the stage of completion of contract activity, which could be determined using an input method (such as the proportion of contract costs incurred to total costs) or output method (such as based on a survey of work done).
Companies following an output method for applying the percentage of completion method
Under the current FRS 102, both the contract costs and revenue are recognised in profit or loss based on stage of completion of contract activity, leading to constant margins over the contract period. However, under the revised FRS 102, only revenue will be recognised by reference to the stage of completion; contract costs will be charged to profit and loss as incurred irrespective of the stage of completion. The mismatched timing of costs and revenue will result in fluctuating contract margins over the contract period. Consider the following illustration
Illustration: Contract margins under current and amended FRS 102 over the contract period
A company earns £100 per annum on a 3-year construction contract and revenue is recognised based on output method on straight line basis at £100 every year. The contract costs are £90, £75 and £75 respectively for the years 1-3 (total cost: £240), leading to a total contract margin of £60 (or 20%, ie £60 / £300). The reported contract margins over the three-year period based on output method will be as under:
| Current FRS 102 | Y1 | Y2 | Y3 |
| Contract revenue | 100 | 100 | 100 |
| Contract costs | (80) | (80) | (80) |
| Contract margins | 20 | 20 | 20 |
| Contract margins % | 20% | 20% | 20% |
| Contract WIP (on balance sheet) | 10 | 5 | 0 |
| Amended FRS 102 | Y1 | Y2 | Y3 |
| Contract revenue | 100 | 100 | 100 |
| Contract costs | (90) | (75) | (75) |
| Contract margins | 10 | 25 | 25 |
| Contract margins % | 10% | 25% | 25% |
| Contract WIP (on balance sheet) | 0 | 0 | 0 |
As can be seen above, the reported contract margins over all three years under current FRS 102 would remain consistent across the three years, whereas they would fluctuate under amended FRS 102 over the same period (although overall contract margins may be same for the entire contract period under both approaches).
Costs to obtain or fulfil a contract
Costs to obtain a contract
Under current FRS 102, directly related costs incurred in securing a construction contract are also included as part of the contract costs if they can be separately identified and measured reliably and it is probable that the contract will be obtained.
Under the amended FRS 102, companies will recognise these costs as an expense as incurred unless:
- For incremental costs: companies have selected an accounting to capitalise such costs;
- For non-incremental costs: such costs would have been explicitly chargeable to the customers irrespective whether the contract is obtained or not.
Costs to fulfil a contract
There is no specific guidance under current FRS 102 on accounting for certain costs to fulfil a contract.
Under the amended FRS 102, in accounting for costs to fulfil a contract, an entity must first assess whether these costs fall within the scope of another FRS (eg section 13 Inventories, section 17 Property, Plant and Equipment or section 18 Intangible Assets other than goodwill) and, if so, account for them in accordance with that standard. Any other costs to fulfil a contract are recognised as an asset under amended section 23 on revenue only if they:
- relate directly to a contract, or to an anticipated contract that can be specifically identified
- generate or enhance resources to be used to satisfy performance obligations in future; and
- are expected to be recovered.
Costs relating to satisfied or partially satisfied performance obligations (past performance) must be expensed.
Illustration:
A Company enters a service contract to manage a customer’s information technology data centre for five years. Before providing the services, the entity designs and builds a technology platform for the entity’s internal use that interfaces with the customer’s systems. That platform is not transferred to the customer but will be used to deliver services to the customer. Apart from software and hardware costs, the company incurred costs to design the platform (£10,000) and costs for migration and testing of data centre (£5,000).
Under the amended FRS 102, the company will capitalise the hardware and software costs as PPE and intangible assets (consistent with current FRS 102). However, design, migration and testing activities do not constitute service to the customer; instead it enables the company to provide services to the customer in future. Such costs will be capitalised and generally amortised over the contract period.
Companies now need to identify costs to obtain or fulfil a contract that are eligible for capitalisation. All non-qualifying costs will be charged to profit and loss as incurred and may not be considered as ‘contract costs’ for the purpose of determining the stage of completion (input method based on total cost) of contract activity, leading to a relatively lower stage of completion. As such, the reported revenue as well the contract margins are adversely affected.
While the amendments to FRS 102 is effective only from financial years beginning on or after 1 January 2026, companies are advised to start preparing for these amendments early to anticipate the impacts of reporting under amended FRS 102.
For more information and to discuss how we can support you through these changes, please contact Peter Latham.