Proposed changes to IFRS 15 – promises, distinct promises…

As we discussed here, the IASB has issued its exposure draft of clarifications to IFRS 15, with comments to be received by October 28, 2015.

The 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.

In a previous post, we looked at the standard’s approach to recognizing revenue from licensing intellectual property to a customer (such as software, patents etc.) as a good example of how this concept might work in practice, and how it might causes changes from existing practices. Because a contract that grants a license to a customer may also contain other promises of goods or services, a license may not always constitute a distinct promise. 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 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 between the two, the entity considers whether 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’s granted. A customer isn’t in this situation if the intellectual property to which it has rights will change after that point in time, throughout the licence period. This situation exists when the entity continues to be involved with its intellectual property, and undertakes activities that significantly affect the intellectual property to which the customer has rights, exposing the customer to any positive or negative effects of these activities. This might be evidenced by the entity’s customary business practices, published policies or specific statements.

The IASB has (not surprisingly!) identified some lack of clarity on how to apply this concept – for example, on whether these “activities that significantly affect the intellectual property” include any activities that affect its value, even if they don’t affect the functionality from the customer’s perspective. To address this, the IASB now proposes deleting some of its previous language on this point, and inserting the following:

  • “An entity’s activities significantly affect the intellectual property when either: (a) those activities are expected to change the form (for example, the design) or the functionality (for example, the ability to perform a function or task) of the intellectual property to which the customer has rights; or (b) the ability of the customer to obtain benefit from the intellectual property to which the customer has rights is substantially derived from, or dependent upon, those activities. For example, the benefit from a brand is often derived from, or dependent upon, the entity’s ongoing activities that support or maintain the value of the intellectual property. Accordingly, if the intellectual property to which the customer has rights has significant stand-alone functionality, a substantial portion of the benefit of that intellectual property is derived from that functionality. Therefore, that intellectual property would not be significantly affected by the entity’s activities unless those activities change that functionality.”

This clarifies (once you get your head around it) that activities affecting the intellectual property’s value wouldn’t necessarily be relevant, if they don’t have direct relevance to how the customer uses it, or the benefits it obtains from it. Where they are relevant, then 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). The IASB proposes corresponding changes to the illustrative examples. For instance, in illustrating a licence that’s distinct (based on rights to manufacture a drug), it now states more explicitly that “the drug formula has significant stand-alone functionality (i.e. its ability to produce a drug that treats a disease or condition) and, therefore, the ability of the customer to obtain the benefits of the drug formula is not substantially derived from the entity’s ongoing activities.”

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 IFRS 15 in this respect will certainly require revisiting the methods currently used to recognize that element of contract revenue.

The opinions expressed are solely those of the author

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