An example of how the new IFRS 15 may require re-examining existing practices in a common area
As we summarized here, the IASB has issued IFRS 15, Revenue from Contracts with Customers, effective for annual reporting periods beginning on or after January 1, 2017 (NB this was subsequently amended to January 1, 2018). The new standard is built around a five-step framework, including the key step of identifying the performance obligations contained in a contract with a customer: that is, the separate promises contained in the contract to transfer to a customer goods or services that are distinct. The standard’s approach to recognizing revenue from licensing intellectual property (such as software, patents etc.) to a customer provides a good example of how this might work in practice, and how it might cause changes from existing practices. The following is a high-level summary of the approach – we’ve examined many of the concepts in greater detail in previous articles:
A contract that grants a license to a customer may also contain other promises of goods or services (for example, various types of support or maintenance); if so, the entity must identify each of these obligations. These will usually be explicitly specified in the contract; however, IFRS 15 specifies that performance obligations may also include promises implied by an entity’s customary business practices, published policies or specific statements if, at the time of entering into the contract, those promises create a valid expectation of the customer that the entity will transfer a good or service to it.
The entity must then consider whether each of these promises is distinct from the others – that is, whether the customer can benefit from the good or service either on its own or together with other resources that are readily available to it, and whether the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract. For example, a licence won’t be distinct if it’s only granted in conjunction with selling a piece of machinery, and it’s inherent to the functionality of that machine.
If the promise to grant the license isn’t distinct from the other promises in the contract, the entity accounts for the promise to grant a licence and the other promised goods or services together as a single performance obligation, looking to the other guidance in the standard to determine whether this performance obligation is satisfied over time or rather at a single point in time.
If the promise to grant the licence is distinct from the other promised goods or services in the contract and, therefore constitutes a separate performance obligation, the entity determines whether the licence itself transfers to the customer either at a point in time or over time. This requires considering whether the nature of the entity’s promise in granting the licence to a customer is to provide the customer with either:
- (a) a right to access the entity’s intellectual property as it exists throughout the licence period; or
- (b) a right to use the entity’s intellectual property as it exists at the point in time at which the licence is granted.
To make the distinction, the entity considers whether the customer can direct the use of, and obtain substantially all of the remaining benefits from, the licence at the point in time at which it’s granted. A customer won’t be in this situation if the intellectual property to which it has rights will change after that point in time, throughout the licence period. Such a change happens (and thus affects the entity’s assessment of when the customer controls the licence) when the entity continues to be involved with its intellectual property and undertakes activities that significantly affect the property to which the customer has rights, exposing the customer to any positive or negative effects of these activities. Factors indicating this kind of situation again include the entity’s customary business practices, published policies or specific statements. The standard notes: “Although not determinative, the existence of a shared economic interest (for example, a sales-based royalty) between the entity and the customer related to the intellectual property to which the customer has rights may also indicate that the customer could reasonably expect that the entity will undertake such activities.”
In this situation, the entity accounts for the promise as a performance obligation satisfied over time, looking to the guidance in the standard to determine the best method of measuring its progress toward satisfying that obligation (perhaps but not necessarily based simply on the passage of time alone).
Otherwise, the nature of the entity’s promise is to provide a right to use its intellectual property as that intellectual property exists (in terms of form and functionality) at the point in time at which it grants the licence to the customer. This means that the customer can direct the use of the licence, and obtain substantially all of the remaining benefits from it, at the point in time at which it transfers. In this case, the entity accounts for the promise as a performance obligation satisfied at a point in time.
Canadian software companies and similar entities are accustomed to applying revenue recognition policies that “unbundle” the multiple elements in their contracts with customers and allocate the total contract revenue between these elements. However, the specificity of the IFRS 15 commentary summarized above will certainly require revisiting the methods currently used to recognize that element of contract revenue….
The opinions expressed are solely those of the author