Project Accounting

Accounting for Revenue from contracts with customers

IFRS 15 – Revenue from Contracts with Customers has been effective since 1st January, 2018. It introduced the five-step model to revenue recognition and created a new category of assets called “Contract Asset”.

Definition

A contract asset is defined in IFRS 15 as “an entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer, when that right is conditioned on something other than the passage of time, for example, the entity’s future performance”.

In contrast, a trade receivable is an entity’s right to payment that is unconditional, except for the passage of time. The difference between contract assets and trade receivables is the conditionality attached to payment.

A Look at Conditionality

With a contract asset, the entity has the right to payment. However, this right to payment is subject to the entity’s future performance of an obligation.

Assume for example that you are a supplier and you have performed or delivered part of the services or goods as agreed, but under the contract you still have some services to perform or deliver before you can bill the client.

The asset created from partial performance is a contract asset. When you perform or deliver all the services or goods under the contract and bill the client, then this becomes a trade receivable.

Perhaps we could simplify this discussion by referring to completion of this future performance or obligation as “an agreed billing milestone”.

Contract accounting with milestone billing involves the tracking and management of project costs and revenues based on milestones achieved. Under this billing method, the organisation performs work on the project and submits invoices to the client based on the completion of specific milestones.

For example, imagine a company is building a custom software solution for a client using milestone billing. The direct costs would include expenses such as salaries and wages, software licenses, and hardware. Indirect costs might include rent, utilities, and marketing expenses. The agreed billing milestones are: first billing of 10% of contract value upon satisfactory completion of a technical blueprint of the software, the second billing milestone of another 20% is upon completion of satisfactory completion of functional specifications of software and third billing milestone of 30% is upon satisfactory completion of programming work and the last milestone of 30% upon acceptance of user testing. The remaining 10% is withheld by the customer for a year as a warranty.

As milestones are completed and invoices are sent to the client, the amount invoiced is recognised as revenue in the income statement and trade receivable in the balance sheet. However, depending on the terms of the contract, the amount cost incurred to that point may exceed the amount of revenue that can be recognised right away. In this case, the difference between the invoiced amount and the cost is classified as a contract asset on the balance sheet.

A contract asset represents revenue that has been invoiced but not yet earned by the organization. This asset is recognized because the organization has fulfilled its contractual obligations but has not yet earned the invoiced revenue. As milestones continue to be completed and revenue is earned, the contract asset is gradually reduced until all of the invoiced revenue has been earned and recognized in the accounting system.

In conclusion, project accounting with milestone billing involves the tracking and management of project costs and revenues based on the completion of specific milestones. Under this billing method, costs are allocated to specific milestones as they are incurred, and revenue is recognized as milestones are achieved. Any invoiced revenue that exceeds the amount of revenue recognized is classified as a contract asset on the balance sheet until revenue has been earned and recognized.