IFRS 15 Revenue from contracts with customers - from a shipbuilder's point of view
Shipbuilding contracts will extend over several months and will be capital intensive for the yard. In order for the yard to comply with its financial covenants under its building loan, it is essential for the yard to have revenue recognition throughout the duration and performance of the contract. Due to the new IFRS 15 Revenue for Contracts with Customer, yards will need to be cautious in their drafting of their shipbuilding contracts, so that they do not loose the right of progressively revenue recognition. If so revenue recognition would have to wait until delivery of the vessel. The objective of this newsletter is to provide a brief overview of IFRS 15, as well as identify some key issues for the yards in the drafting future shipbuilding contracts.
IFRS 15 in a nutshell
Yards applying IFRS must implement IFRS 15 for reporting periods beginning on or after 1 January 2018. The objective of IFRS 15 is to establish principles applicable for reporting information to users of financial statements concerning timing, amount, nature and uncertainty of revenue and cash flow from customer contracts.
A key feature of IFRS 15 is the concept of defining revenue transactions based on the specific contractual performance obligations with revenue recognized either at a point in time or over time.
The cardinal principle is that an entity shall recognize revenue at a level that reflects the payment to which the entity expects to be entitled to in exchange for transferring either goods or services.
This cardinal principle is applied through the application of the following five steps in the following order:
(1) Identify the contract with the customer;
(2) Identify the performance obligation in the contract;
(3) Determine the transaction price;
(4) Allocate the transaction price; and
(5) Recognize revenue when a performance obligation is satisfied.
Due to the nature of a normal shipbuilding contract, we will limit our further comments to step 2 and 5.
Identify the performance obligation in the contract
In a contract with a customer, the seller's obligation will be to transfer (i) goods or a service; (ii) a series of distinct goods or services (substantially being the same and that has the same pattern of transfer to the customer); or (iii) a series of goods or services that are distinct.
Under IFRS 15 the key question is what the customer expects to receive as the final product under the contract.
In a contract for the construction of a vessel, the yard will provide a series of distinct goods and services over a long period. However, the buyer will only expect to receive one vessel.
As there is only one performance obligation under such a construction contract, this forces the following question: how can the yard still have running revenue recognition under IFRS 15?
Recognized revenue when a performance obligation is satisfied
The recognition framework is applied to each performance obligation separately. In an ordinary shipbuilding agreement, this would apply to the delivery of one ship. The recognition model requires that the yard's management considers whether a performance obligation is satisfied over time.
A performance obligation is satisfied over time if one of the following three conditions are met:
(1) Customer consumes simultaneously
(2) Customer controls the assets
(3) No alternative use with the right to payment
Condition (1) and (2) are not very relevant for a shipbuilding contract. Customer will not consume, nor will it usually control the hull under construction.
The third condition consists of two elements:
- The asset has no alternative use; and
- There is an enforceable right to payment for the work completed to date.
No alternative use
The asset will have no alternative use if the yard is unable to redirect it for another use or to a different customer, e.g. the construction of highly customised equipment that could not be sold to another customer – even if modified.
In a shipbuilding agreement, this could also be when a vessel's hull is identified in the agreement; as it will no longer be generic as it is assigned to one particular contract and customer.
Enforceable right to payment for the work
It is also a requirement that the contract contains a condition entitling the yard to receive payment for work completed to date – if the customer cancels the contract. It is not a requirement that this will need to be a prepayment or a progress payment. It can also be in the form of a cancellation fee.
The key consideration is whether the payment reflects the work actually being performed to date includes a reasonable profit margin. It is explicitly stated that recovery of only costs incurred to date does not meet the condition or right to payment.
Termination due to buyers default
If the parties enter into Skip 2000, the yard will be able to terminate the contract in the event where the buyer is in default of its payment obligations. The yard will then be able to claim "compensation for losses caused thereby". If the contract is subject to Norwegian law, the defaulting party should be able to claim for the full economic loss, so long as there is causation. This should also include the loss by non-performance (i.e. fortjeneste).
However, this may not be the case if the contract is subject to foreign law.
In other words, each contract must be considered specifically to ascertain the payment obligation.
Termination for convenience or take-out clauses
Particular caution should also be given to termination for convenience or take-out clauses. If the buyer can cancel the contract at any time, there is no breach of contract. In other words, Norwegian background law will be of little help if the wording of the payment terms is vague. Furthermore, the standard contract for shipbuilding under Norwegian law does not contain such clauses. Thus, an early termination or take-out clause must be carefully drafted by the parties.
Inspiration may be taken from the solution provided for in NTK 15 clause 17.2 and 17.3. While clause 17.2 provides an exhaustive list of costs to be recovered, clause 17.3 provides for an additional cancellation fee, based on the contract sum. This should provide the yard cover for both costs incurred and a reasonable element of profit.
Always make sure to carefully draft any cancellation and termination clauses, in order to secure costs incurred as well as a reasonable profit margin. Seek local legal advice before entering into a contract to ascertain whether or not the contract with cover a reasonable profit margin.
 This may be determined based on input or output methods, whatever best will reflect the transfer of control to the customer. IFRS 15 provides specific guidance on how to select an appropriate performance measurement method.
 Sales of Goods Act Section 67
Norsk totalkontrakt 2015