Revised FRS 102: What Construction Firms Need to Know About Revenue and Contract Costs

The revised FRS 102 is reshaping how businesses report revenue and costs – but, for construction firms, the impact is especially significant. With long-term contracts, complex performance obligations, and high upfront costs, the sector faces unique challenges.

In our earlier article, FRS 102 Overhaul: What the New Revenue and Lease Rules Mean for Your Business, we covered the broader changes to revenue and lease accounting. Now, we take a closer look at what the revised revenue recognition and contract cost rules mean specifically for the construction industry.

Understanding the New Revenue Framework

At the heart of the revised FRS 102 is a five-step model for revenue recognition. This framework is designed to improve consistency and transparency across industries but, for construction firms, applying it correctly requires careful judgement. We explain each step below and examine how the model operates in practice for construction businesses.

Step 1: Identify the contract(s) with a customer

For most construction businesses, identifying the contract is straightforward, as written agreements are standard practice.

Step 2: Identify the performance obligations in the contract

Most construction contracts are negotiated as a complete package and typically contain a single performance obligation. Services such as site clearance, design and construction are typically interdependent and delivered as part of an integrated project. However, if certain elements within the contract are distinct and independently deliverable, they may need to be accounted for as separate performance obligations.

Step 3: Determine the transaction price

It is common for construction contracts to include variable consideration such as incentives for early completion, penalties for delays, and claims for cost overruns which must be factored into the transaction price under the revised FRS 102 revenue recognition model. Variable consideration must be estimated using either the expected value method (a probability-weighted average of possible outcomes) or the most likely amount method (the single most probable outcome). However, revenue can only be recognised to the extent that it is highly probable the entity will be entitled to the cumulative amount of revenue when the uncertainty is resolved.

Step 4: Allocate the transaction price to the performance obligations

The transaction price is allocated to the performance obligations identified in the contract. If the contract contains a single performance obligation, common in construction projects, the entire transaction price is assigned to that obligation. However, if there are multiple distinct performance obligations, the price must be allocated to each based on their estimated standalone selling prices.

Step 5: Recognise revenue when (or as) the entity satisfies a performance obligation

A key judgement under the revised FRS 102 is whether revenue should be recognised over time or at a point in time. In construction, revenue is typically recognised over time because one of the criteria for over-time recognition is usually met. Progress toward satisfying a performance obligation may be measured using either an input method, such as the proportion of costs incurred to total estimated costs, or an output method, such as certified work completed. The chosen method must faithfully reflect the transfer of control and be applied consistently across similar contracts.

New Rules for Contract Cost Accounting

Beyond the five-step model, the revised standard also changes the emphasis of how contract costs are to be treated. Previously, revenue and related costs were recognised based on project progress, resulting in smooth and predictable margins. However, under the new approach, revenue is linked to the satisfaction of performance obligations, while most contract costs are recognised as incurred unless capitalisation is required – introducing greater variability in reported margins across periods.

Transition Options

Revised FRS 102 has allowed two choices for adopting the revenue recognition requirements:

1. Full retrospective application, including restatement of prior year comparatives
2. Modified retrospective application, with a cumulative adjustment to opening retained earnings. Only contracts incomplete at the transition date need to be adjusted.

What Construction Firms Should Do Now

• Ensure contracts are in place and clearly documented.
• Identify all key performance obligations in each contract and determine whether they are separate or combined, allocating pricing and recognising revenue accordingly.
• Identify costs intrinsic to these obligations and apply the correct account treatment – margin smoothing over the contract period is less likely to occur under the revised model.
• Consider transition options from both a reporting and commercial perspective to minimise disruption.

Final Thought

The revised FRS 102 may result in more uneven margin profiles across reporting periods. This could affect how financial performance is perceived and may impact covenants tied to profitability or balance sheet metrics.

To understand how the revised FRS 102 may affect your construction business, get in touch with Simmons Gainsford team – we can explain the key updates and outline the considerations relevant to your organisation.