Liquidated damages and penalties

Liquidated damages: a delayed project

A contractor is building a CU 20 million power substation. The contract sets liquidated damages of 20,000 a day for late completion, capped at 10% of the price, 2 million. At the year end, the project is 60% complete and its programme shows completion 30 days late, with no grounds for an extension of time.

The remaining 0.24 million of the damages reduces revenue as the remaining work is done. If the delay grows, the estimate rises, up to the cap, and another catch-up follows; if the contractor recovers the lost time on its programme, revenue is restored.

Why are liquidated damages variable consideration?

Because they are amounts payable to the client under the contract that vary with the contractor's performance, much like a penalty or a price discount. IFRS 15 treats penalties and similar items as variable consideration, so they are reflected in the transaction price, not as a separate expense or provision. The estimate uses the most likely amount or an expected value, and the constraint means the contractor should not assume favourable outcomes, such as an extension of time, unless it is highly probable.

How do extensions of time affect them?

An extension of time granted by the client for delays it caused, such as late access to the site, moves the completion date and reduces the days of damages. A claim for an extension that has not been agreed is assessed like other claims: it reduces the expected damages only to the extent it is highly probable not to result in a significant reversal of revenue. See variations and claims.

What about performance damages?

Some contracts, such as for power plants or process facilities, set damages if the finished asset fails to meet output or efficiency guarantees. These are also variable consideration, estimated from test results and engineering assessments. Where the shortfall can be fixed by further work, the cost of that work is included in the cost estimate instead.

How do they interact with a loss-making contract?

Liquidated damages reduce the transaction price, which can turn a profitable contract into a loss-making one. The onerous contract test then compares the remaining costs with the reduced remaining revenue. See loss-making construction contracts.

What about damages recoverable from subcontractors?

Contractors often pass liquidated damages down to the subcontractor responsible for a delay. The contractor's own damages to the client still reduce its revenue in full. The recovery from the subcontractor is a separate matter, recognised as a reduction of contract costs only when the contractor's right to it is established and collection is expected, often once the subcontractor accepts it.

What if the client waives the damages?

Clients sometimes waive damages as part of settling a final account or agreeing further work. Once a waiver is highly probable, the expected damages are removed from the estimate and revenue rises by the catch-up. Recognising a waiver before the client has clearly indicated it, in writing or by conduct, would be optimistic.

What do contractors disclose?

The judgements in estimating variable consideration, including significant expected damages and disputes about delays, and the contingent liabilities for damages that are possible but not expected. See variable consideration and construction accounting.

This guide is general information. It is not tax or legal advice for your situation.