FRS 102 revenue recognition: should construction businesses use an input or output method?
With the revised FRS 102 revenue recognition requirements now in effect, construction businesses should ask whether their current method of measuring contract progress still best reflects the work delivered to customers.
Many construction businesses will continue to recognise revenue over time. However, the revised requirements place greater emphasis on selecting a method that faithfully reflects the transfer of goods or services to the customer. Businesses must therefore determine whether an input or output method best represents performance.
Input or output: what is the difference?
An input method measures resources used to satisfy a performance obligation. Under the common cost-to-cost approach, revenue is recognised by comparing costs incurred as a proportion of total expected costs.
An output method measures progress by reference to the value transferred to the customer, using measures such as milestones, units delivered, completed sections or another measurable output.
Neither is inherently better. The appropriate method is the one that faithfully reflects progress towards satisfying the performance obligation.
When might an output method be more appropriate?
For many construction contracts, costs incurred are a reasonable proxy for progress because labour, subcontractor and other construction costs broadly track the work performed. But this is not always the case.
An output method may be more appropriate where clearly identifiable outputs or milestones better reflect the value transferred to the customer. For example, where a project comprises distinct phases or units, completing and handing over each element may be a more meaningful measure of performance than costs incurred to date.
Significant early costs do not, by themselves, make an output method more appropriate. Under a cost-based input method, costs that do not depict performance, such as materials purchased but not yet installed, should be excluded or adjusted when measuring progress. An output method may still be preferable where observable milestones or completed units provide a more faithful measure of value transferred.
The measure of progress should therefore be selected on its merits, rather than simply carrying forward the calculation historically used.
How to choose between the two
When selecting a method, businesses should consider:
- how value transfers to the customer;
- whether costs reliably measure performance, particularly where significant costs arise early in the contract;
- whether milestones, units or phases provide reliable evidence of progress;
- how variations, claims and contract modifications affect the measure of progress; and
- whether the resulting pattern of revenue recognition reflects actual performance.
Finance, commercial and project teams should work together to document why the selected method is appropriate.
The choice could affect reported margins
The measure of progress can significantly affect the timing of reported revenue and profit.
Under a cost-to-cost input method, revenue will generally track costs where those costs appropriately represent progress. Under an output method, revenue may not be recognised until a specified milestone or output is achieved, even though costs continue to arise.
This may create periods in which costs are recognised ahead of the related revenue, or vice versa. For example, a business may incur substantial costs in preparing for a contractual milestone but defer the related revenue until that milestone is achieved.
The contract’s underlying economics may be unchanged, but reported margins could be lower initially and higher once the milestone is reached. Finance teams should consider how this may affect management information and the expectations of lenders, shareholders and investors.
Look beyond the accounting
The effects extend beyond the financial statements.
A change in the timing of reported revenue and profit could affect:
- performance reporting, budgeting and forecasts;
- banking covenants and incentive arrangements;
- dividend and tax planning; and
- communications with lenders, shareholders and other stakeholders.
Businesses should assess these effects before processes and expectations become embedded.
What should construction businesses do now?
The revised FRS 102 requirements are an opportunity to reassess whether the current method remains appropriate. This does not necessarily mean switching from an input to an output method. For many businesses, cost-to-cost may continue to provide the most faithful measure of performance.
Businesses should:
- review a representative sample of contracts, particularly those with significant upfront costs, complex milestones, variations or unusual payment terms;
- document why the selected method reflects the way goods or services are transferred to customers;
- confirm that systems capture the information needed to apply the method consistently;
- assess the potential effect on reported margins, forecasts and stakeholder communications; and
- ensure management understands any change in the timing of reported revenue and profit.
The method selected should reflect how the business delivers its contracts, be supported by robust evidence and be applied consistently. For construction businesses, this is more than a compliance matter: the measure of progress can affect the timing of reported revenue and profit, the pattern of margins over a contract’s life and how stakeholders understand financial performance.
How Moore Kingston Smith can help you
If you would like to discuss whether your current approach to measuring contract progress remains appropriate under revised FRS 102, or how a change could affect reported margins, contact our team for a no-obligation discussion.
