Renewable Terms, Licences, Variable Consideration and other Contract Terms in the New IFRS 15 Revenue World

This article was originally published by Wiley Insight IFRS.

  1. How will the new revenue standard apply to contracts with renewable terms?

Any contract that is renewed at the time of complete satisfaction of the contractual performance obligations would be treated as an entirely new contract for revenue recognition purposes. If a contract is renewed prior to that point then an entity needs to consider the effect of the renewal and any changes in terms in relation to the remaining deliverables under the contract.

A contract that includes renewable terms, such as a modification of either the price or quantities deliverable under the contract, may be treated as part of the existing contract if the remaining goods and services are not distinct and form part of a single performance obligation that is partially satisfied at the date the modification took place. Any adjustment to the total transaction price or the performance obligations under the modified contract is accounted for as a cumulative adjustment to revenue (IFRS 15.21(b)).

If the circumstances do not meet paragraph 21(b) then the modified contract is either an entirely new stand-alone contract to which IFRS 15 is applied (paragraph 20) or it represents the termination of the existing contract and the creation of a new contract (paragraph 21(a)).

  1. Under existing IFRSs there has been debate about the appropriate revenue recognition for the sale of residential units in multi-storey apartment developments. Will IFRS 15 change the way in which those transactions are accounted for in your jurisdiction? If so, how and why?

Revenue recognition under IFRS 15 is based on control of the asset. In accordance with paragraph 35, revenue could be recognized for the sale of residential units in an apartment development when the entity does not have an alternative use for the asset created by performance of the contract and the entity has an enforceable right to payment for performance completed to date.

As described by illustrative example 17 Case B, the two criteria could be satisfied by, respectively, a contractual restriction preventing the entity from transferring the unit under construction to another buyer and when the entity’s right to payment of all the consideration for performance can be legally enforced against the customer.

Applying the same facts in this example to international financial reporting pre-IFRS 15 requires application of IFRIC 15: the contract is for the sale of goods because the buyer is not able to specify the major structural elements of the real estate and because the supply of materials is required. Therefore all the conditions in IAS 18 paragraph 14 must be met for revenue to be recognized. For certain real estate contracts the conditions can be met continuously allowing revenue to be based on the stage of completion. However, for the sale of a residential unit it seems likely that the entity will retain the risks and rewards of ownership until ownership passes to the buyer so revenue is only recognized at closing.

It seems likely that IFRS 15 will result in revenues being recognized over time, although the application of the new standard to contracts for the sale of units will depend on the exact terms of those contracts.

  1. How does the revenue standard allocate the transaction price when a bundle of goods or services is sold at a discount?

When a bundle of goods and services is sold under a contract the transaction price is allocated based on the relative stand-alone selling prices of the goods and services to be transferred, with the objective that the amount allocated depicts the amount that the entity expects to be entitled to in exchange for transferring the promised goods or services.

When the sum of the stand-alone selling prices for a bundle of goods and services exceeds the promised consideration the default method for allocating the discount is proportionately to all performance obligations in the contract, which is consistent with the method of allocating the transaction price.

As an exception to the default method, if there is observable evidence that the entire discount relates to only one or more, but not all, performance obligations then the discount is allocated appropriately. This allocation exception can be applied only when the criteria described in paragraph 82 are met, the objective of which is that the entity needs to have sufficient information to be able to allocate the discount to specific goods or services (or bundles of goods and services) within the contract.

While the criteria in themselves may not be immediately intuitive, taken together with illustrative example 34, they are more readily understandable.

  1. There are many different types of licences of intellectual property. Under IFRS 15, for some licences, an entity recognises revenue at the time the licence transfers to a customer. For other licences, an entity recognises revenue over a period of time. What factors determine whether an entity should recognise licence revenue at a point in time or over time? Do you believe the guidance provided in IFRS 15 will be operational in practice? If not, why not?

For simplicity, consider a contract under which the promise to grant a license is distinct from other deliverable goods and services. The point in time or period over which the entity satisfies a performance obligation for a deliverable item is dealt with in paragraphs 31 to 38 of IFRS 15; this guidance is applied to a distinct license in paragraphs B56 to B62.

The revenue recognition for a license between recognition at a point in time or over time is determined by whether a customer can direct the use of, and obtain substantially all of the remaining benefits from, a license at the point in time at which it is granted. The distinction is applied by considering whether the license conveys a right to access the intellectual property as it exists throughout the licence period, or a right to use the entity’s intellectual property as it exists at the point in time at which the licence is granted.

Therefore if the intellectual property over which the customer obtains rights changes over the license term then the customer cannot obtain substantially all of the remaining benefits from the license at the grant date. This is the distinction between a right to access (changing) intellectual property and a right to use (fixed) intellectual property.

The principle described is defined by the criteria in paragraph B58, all of which must be met if the license is considered a right to access the entity’s intellectual property.

The complexity of accounting for revenues arising under licenses is perhaps indicated by the fact that the standard includes so many illustrative examples on the subject.

Despite the number of illustrative examples, the application of these rules may pose problems in practice. For example, for a license of software which includes any updates for a period of time, an entity must consider whether it will ‘undertake activities that significantly affect the intellectual property.’ The phrase ‘significantly affect’ could be read in relation to the criteria in paragraph 33, in terms of ‘the potential cash flows (inflows or savings in out flows) that can be obtained.’

It is conceivable that rolling out later versions of the software could represent enhancements to the intellectual property from the customer’s perspective which should therefore be accounted for as a right to access that property as it exists throughout the license term. It is also likely that the nature of updates to be rolled out during the term, if indeed any will be, cannot be determined. Illustrative example 54 suggests that ‘because the software is functional when it transfers to the customer, the customer does not reasonably expect the entity to undertake activities that significantly affect the intellectual property.’ This seems too simplistic a statement for this industry.

  1. Do you anticipate any difficulties in applying the new standard’s requirements relating to the estimation of variable consideration? If so, in which circumstances and why?

Where variability exists in the amount of consideration receivable under a contract, the entity is required to make an estimate. The standard allows two methods of estimation: either the expected value, being the ‘sum of the probability-weighted amounts in a range of possible consideration amounts,’ or the most likely amount, being the ‘single most likely amount in a range of possible consideration amounts.’

Practical difficulties are likely to arise in a number of circumstances. For example, in determining the probability weighted amounts for the expected value method where the entity has individually unique contracts. The standard states that the expected value method may be appropriate where the entity has a large number of contracts with similar characteristics. However, the standard apparently only allows two methods of consideration estimation. If an entity has a number of contracts with dissimilar characteristics, each with a range of possible consideration amounts, the expected value approach would still have to be applied to each contract because the other method would not be appropriate.

In addition, an entity is required to consider a “reasonable number of possible consideration amounts” but a reasonable number is not defined. If there is a continuous range of possible consideration amounts under each dissimilar contract how many possible amounts should be considered in the estimation exercise?

As is often the case, the estimation of any amount can be based on accumulated historical experience. There is considerable scope where the lack of such knowledge would mean estimation is inhibited. For example, where an entity is required to refund to a customer some or all of the consideration received a refund liability is measured as the amount of consideration recognized for which the entity does not expect to be entitled. Similarly, the transaction price includes variable consideration only up to the constraint.

A lack of historical experience is likely to occur where an entity establishes a new business or product or sells existing products or services to a new customer segment which may have different characteristics rendering past experience irrelevant.