Contract Costs | IFRS 15 - BDO UK

Contract Costs and IFRS 15

Although IFRS 15 is primarily a standard on revenue recognition, it also includes requirements relating to contract costs. As a result, companies may need to change their accounting for those costs on adoption of IFRS 15 for annual reporting periods beginning on or after 1 January 2018. This could affect their profit and financial position - especially for entities involved in construction and long-term service contracts. Taken together with changes in the pattern of revenue recognition under IFRS 15, this may result in increased volatility in profit margins on a contract in different reporting periods.

For example, Capita, in its recent announcement notes that some of its contract costs will be expensed as currently, while certain other costs (previously expensed) will now be capitalised as contract fulfilment assets and released over the contract life. Taken with changes in revenue timing, this may lead to potentially lower profits or losses in the early years of contracts – but with overall contract profitability unchanged.

What is changing?

As there is no specific IFRS addressing the accounting for costs, entities currently refer to a number of different standards and principles in accounting for various types of costs incurred. Existing standards IAS 18 Revenue and IAS 11 Construction Contracts contain only limited guidance, mainly on applying the percentage of completion method (under which contract revenue and costs are recognised with reference to the stage of completion).

IFRS 15 introduces new guidance on accounting for all contract costs, distinguishing between:

Incremental costs incurred in obtaining a contract, and
Costs incurred to fulfil a contract.

Subject to certain criteria, these contract costs must be capitalised, amortised and assessed for impairment under guidance in IFRS 15 (eg not IFRS 9 or IAS 36), while all other types of costs have to be expensed as incurred. Assets recognised for contract costs are a new asset category and are presented separately from contract assets and contract liabilities arising on the recognition of revenue. This could bring about a change in practice for many entities.

Incremental costs of obtaining a contract

Incremental costs are costs that would not have been incurred had that individual contract not been obtained, eg a sales commission. Currently, entities either expense the costs of obtaining a contract as incurred, include them as part of contract costs under IAS 11 Construction Contracts, or capitalise them under IAS 38 Intangible Assets as ‘directly attributable’ costs.

However, under IFRS 15, these costs are recognised as an asset if they are expected to be recovered from the customer. As a practical expedient, incremental costs of obtaining a contract can be expensed if the amortisation period would be one year or less. Any other costs of obtaining a contract are expensed when incurred, unless they are explicitly chargeable to the customer regardless of whether the contract is obtained.

Example

A company wins a competitive tender to provide consulting services to a new customer and incurs the following costs to obtain the contract:

Costs	£	IFRS 15 accounting treatment
External legal fees for due diligence	35,000	Expensed as incurred as these would have been incurred whether or not the tender was won.
Travel costs to deliver proposal	5,000	Expensed as incurred as these would have been incurred whether or not the tender was won.
Commissions to sales employees	10,000	Recognise as an asset as these are incremental costs of obtaining the contract and the company expects to recover them through future consultancy fees.
Total costs incurred	50,000

Costs to fulfil a contract

In accounting for costs to fulfil a contract, an entity must first assess whether the costs fall within the scope of another IFRS (eg IAS 2 Inventories, IAS 16 Property, Plant and Equipment and IAS 38 Intangible Assets) and, if so, account for them in accordance with that standard.

Any other costs to fulfil a contract are recognised as an asset under IFRS 15 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.

There is no practical expedient to expense costs to fulfil a contract.

Costs that relate directly to a contract could include direct labour and materials or allocations of costs such as depreciation or insurance, anything explicitly chargeable to the customer under the contract and subcontractor costs. However, general and administrative costs that are not explicitly chargeable to the customer and the costs of wasted materials, labour and other resources that were not reflected in the price of the contract do not qualify.

Costs relating to satisfied or partially satisfied performance obligations (past performance) must be expensed.