Accounting for European Construction and Contracting businesses

The construction and contracting industry in Europe is a complex and dynamic sector that faces many challenges and opportunities. Accounting for these businesses requires a thorough understanding of the specific regulations, standards and practices that apply to this industry.

• Revenue recognition
• Contract costs and variations
• Work in progress and inventories
• Construction contracts and joint arrangements
• Taxation and VAT
• Financial reporting and disclosure

Revenue Recognition

One of the main accounting issues for construction and contracting businesses is how to recognize revenue from their contracts. Revenue recognition is the process of determining when and how much revenue to record in the financial statements. Revenue recognition depends on various factors, such as the type of contract, the stage of completion, the degree of uncertainty and the terms and conditions of the contract.

There are two main methods of revenue recognition for construction and contracting businesses: the percentage-of-completion method and the completed-contract method. The percentage-of-completion method recognizes revenue proportionally to the progress of the contract, based on the estimated total contract revenue and costs. The completed-contract method recognizes revenue only when the contract is completed or substantially completed.

The choice of revenue recognition method depends on the nature of the contract and the reliability of the estimates. Generally, the percentage-of-completion method is preferred when the outcome of the contract can be reasonably estimated and there is a high degree of certainty about the contract revenue and costs. The completed-contract method is used when the outcome of the contract cannot be reliably estimated or there is a high degree of uncertainty about the contract revenue and costs.

The International Financial Reporting Standards (IFRS) provide guidance on revenue recognition for construction contracts in IFRS 15 Revenue from Contracts with Customers. IFRS 15 applies to all contracts with customers, except for those that are within the scope of other standards, such as leases, insurance contracts or financial instruments. IFRS 15 introduces a five-step model for revenue recognition, which requires entities to:

• Identify the contract(s) with a customer
• Identify the performance obligations in the contract
• Determine the transaction price
• Allocate the transaction price to the performance obligations
• Recognize revenue when (or as) the entity satisfies a performance obligation

IFRS 15 also provides specific guidance on how to apply this model to construction contracts, such as how to identify separate performance obligations, how to measure progress towards completion, how to account for contract modifications and variable consideration, and how to recognize losses from onerous contracts.

Contract Costs and Variations

Another accounting issue for construction and contracting businesses is how to account for the costs incurred in relation to their contracts. Contract costs include direct costs, such as materials, labor and subcontractors, as well as indirect costs, such as overheads, depreciation and interest. Contract costs also include contract variations, which are changes in the scope or price of the contract agreed by both parties.

Contract costs are generally recognized as expenses in the period in which they are incurred. However, some contract costs may be recognized as assets if they meet certain criteria. For example, under IFRS 15, an entity may recognize an asset from the costs incurred to fulfill a contract if those costs:

• Relate directly to a contract or an anticipated contract that the entity can specifically identify
• Generate or enhance resources of the entity that will be used in satisfying (or in continuing to satisfy) performance obligations in the future
• Are expected to be recovered

Contract variations may affect both the revenue and the costs of a contract. Depending on the nature and timing of the variation, it may be accounted for as a separate contract, a modification of an existing contract or a change in estimate. For example, under IFRS 15, a contract modification is accounted for as a separate contract if it results in both:

• Additional goods or services that are distinct (i.e., they are not highly dependent on or interrelated with other goods or services promised in the original contract)
• An increase in the price of the contract that reflects the entity’s stand-alone selling prices of those additional goods or services

Otherwise, a contract modification is accounted for by updating the existing contract, either prospectively or retrospectively depending on whether the remaining goods or services are distinct from those delivered before the modification.

Work in Progress and Inventories

A related accounting issue for construction and contracting businesses is how to measure and present their work in progress (WIP) and inventories. WIP refers to unfinished goods or services that are still under production or delivery. Inventories refer to finished goods or services that are ready for sale or use.

WIP and inventories are generally measured at cost or net realizable value (NRV), whichever is lower. Cost includes all costs of purchase, conversion and other costs incurred in bringing them to their present location and condition. NRV is the estimated selling price in the ordinary course of business less any estimated costs necessary to make them ready for sale.

WIP and inventories are generally presented as current assets in the statement of financial position. However, some WIP may be classified as non-current assets if they relate to long-term contracts that are not expected to be completed within one year. Similarly, some inventories may be classified as non-current assets if they are held for strategic purposes or are not expected to be sold within one year.

The International Accounting Standards (IAS) provide guidance on measurement and presentation of WIP and inventories in IAS 2 Inventories. IAS 2 applies to all inventories except for those that are within the scope of other standards, such as work in progress arising under construction contracts (which is covered by IFRS 15), biological assets (which are covered by IAS 41 Agriculture) or financial instruments (which are covered by IFRS 9 Financial Instruments). IAS 2 also provides specific guidance on how to determine cost, NRV and write-downs of WIP and inventories.

Construction Contracts and Joint Arrangements

Another accounting issue for construction and contracting businesses is how to account for their involvement in construction contracts and joint arrangements with other parties. Construction contracts are agreements between two or more parties for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology or function. Joint arrangements are arrangements between two or more parties that have joint control over an economic activity.

Construction contracts may take various forms, such as fixed-price contracts, cost-plus contracts or turnkey contracts. Construction contracts may also involve multiple parties, such as main contractors, subcontractors, customers, suppliers, financiers, guarantors, regulators, etc.

Joint arrangements may take various forms, such as joint operations, joint ventures, consortia, partnerships, etc.

Joint arrangements may also involve different types of assets, such as tangible assets, intangible assets, financial assets, etc.

The accounting for construction contracts and joint arrangements depends on various factors, such as:

• The nature and terms of the contract or arrangement
• The rights and obligations of each party
• The risks and rewards of each party
• The degree of integration and interdependence of each party

The International Financial Reporting Standards (IFRS) provide guidance on accounting for construction contracts and joint arrangements in IFRS 15 Revenue from Contracts with Customers (for construction contracts) and IFRS 11 Joint Arrangements (for joint arrangements). IFRS 15 applies to all contracts with customers except for those that are within the scope of other standards such as leases insurance contracts or financial instruments.

IFRS 11 applies to all joint arrangements except for those that are within the scope of other standards such as associates (which are covered by IAS 28 Investments in Associates) or financial instruments (which are covered by IFRS 9 Financial Instruments). IFRS 15 also provides specific guidance on how to apply its model to construction contracts such as how to identify separate performance obligations how to measure progress towards completion how to account for contract modifications variable consideration losses from onerous contracts etc.

IFRS 11 also provides specific guidance on how to classify account for disclose joint operations joint ventures etc.

Taxation and VAT

Another accounting issue for construction contracting businesses is how to account for taxation value-added tax VAT etc.

Taxation refers to income taxes corporate taxes withholding taxes etc. that are levied by governments on entities’ income profits gains etc.

VAT refers to indirect taxes that are levied by governments on entities’ sales purchases imports exports etc. of goods services etc.

Taxation VAT etc. may affect both income statement statement financial position cash flows etc. of entities involved in construction contracting businesses. Taxation VAT etc. may also vary depending on various factors such as:

• The jurisdiction country region etc. where entities operate reside etc.
• The type nature form etc. of entities involved such sole proprietorship partnership corporation etc.
• The type nature form etc. of transactions activities events etc. involved such sales purchases imports exports etc. of goods services etc.
• The type nature form etc. of income profits gains etc. involved such operating income non-operating income capital gains etc.

The International Accounting Standards (IAS) provide guidance on accounting taxation VAT etc. in IAS 12 Income Taxes (for taxation) IAS 20 Accounting Government Grants Disclosure Government Assistance (for government grants subsidies incentives etc.)

IAS 37 Provisions Contingent Liabilities Contingent Assets (for provisions contingent liabilities contingent assets etc.) etc.

IAS 12 applies all income taxes except those that relate equity transactions which covered by IAS 32 Financial.

Financial Reporting and Disclosure

Financial reporting and disclosure in Accounting for European Construction and Contracting businesses

Financial reporting and disclosure are essential for providing relevant and reliable information to investors, creditors, regulators and other stakeholders about the financial performance and position of a business. In the European Union (EU), financial reporting and disclosure requirements vary depending on the type and size of the business, as well as the market where its securities are traded.

For listed companies (those whose securities are traded on a regulated market), EU rules require them to prepare their consolidated financial statements in accordance with a single set of international standards called IFRS (international financial reporting standards). IFRS are developed by the International Accounting Standards Board (IASB), an independent body that sets high-quality and globally accepted accounting standards. IFRS aim to enhance comparability, transparency and consistency of financial information across different jurisdictions.

In addition to IFRS, listed companies must also comply with other EU rules on financial information disclosure, such as:

• The Transparency Directive, which sets out the minimum requirements for periodic and ongoing disclosure of information by issuers of securities admitted to trading on a regulated market.
• The Market Abuse Regulation, which aims to prevent insider dealing, unlawful disclosure of inside information and market manipulation.
• The Non-Financial Reporting Directive, which requires large companies and listed companies to publish regular reports on the social and environmental risks they face, and on how their activities impact people and the environment.
• The Public Country-by-Country Reporting Directive, which requires companies in the extractive and logging industries to report on their payments to governments.

For non-listed companies and small businesses, EU rules allow more flexibility in financial reporting and disclosure. Non-listed companies can choose to apply IFRS or national accounting standards for their consolidated financial statements, while small businesses can use simplified accounting rules under the Accounting Directive. However, non-listed companies and small businesses must still comply with national laws and regulations on financial reporting and disclosure in their respective countries.

One of the challenges for European construction and contracting businesses is to adapt to the changing accounting standards that affect their revenue recognition. In 2018, a new standard called IFRS 15 – “Revenues from Contracts with Customers” became effective, introducing a single comprehensive model of accounting for revenues arising from contracts with customers. IFRS 15 requires construction and contracting businesses to identify the performance obligations in their contracts, allocate the transaction price to each performance obligation, and recognize revenue when (or as) each performance obligation is satisfied. This may result in significant changes in the timing and amount of revenue recognition for some contracts, as well as increased disclosures on the nature, amount, timing and uncertainty of revenue and cash flows from contracts with customers.

The implementation of IFRS 15 poses significant challenges for construction and contracting businesses, as they need to collect and present new information, update their accounting policies and systems, train their staff, and communicate with their stakeholders. A study by Quagli et al. (2021) provides evidence on the preparedness of European companies to adopt IFRS 15 by analyzing information on the expected impact disclosed in the pre-adoption phase. The study finds that several firm-level factors influence the quality of disclosure on expected impact, such as profitability, company size, complexity of business, industry sector, auditor type and country legal system.

In conclusion, financial reporting and disclosure in accounting for European construction and contracting businesses are subject to various EU rules that aim to ensure transparency, comparability and reliability of financial information for investors and other stakeholders. However, these rules also entail costs and challenges for businesses that need to adapt to new or revised accounting standards, such as IFRS 15 on revenue recognition. Therefore, it is important for construction and contracting businesses to keep abreast of the latest developments in accounting standards and regulations, and to prepare adequately for their implementation.