How will IFRS 15 Revenue from Contracts with Customers impact the software industry?

The International Accounting Standards Board (IASB) published IFRS 15[1] Revenue from Contracts with Customers in May 2014 effective for reporting periods commencing on or after 1 January 2018[2]. Since IFRS 15 replaces all the existing guidance on revenue recognition and applies to all entities and industries, there has been considerable confusion (and debate) as to what the likely impacts are going to be across different industries when adopted. 

This article highlights what the key implications of adopting IFRS 15 are expected to be on the software licensing and development industry. It is vital that you understand and prepare for any impacts of IFRS 15 now to avoid any unintended consequences such as breaching debt covenants or missing earnings targets.
Likely areas impacted upon include:

  1. Identifying performance obligations within a contract
  2. Licences
  3. Non-refundable upfront fees
  4. Financing components within contracts
  5. Costs of obtaining a contract
1. Identifying performance obligations within a contract
It is not uncommon in the software industry for contracts to include multiple components such as:
  • the licence;
  • installation;
  • software updates; and
  • technical support.

One of the critical decisions when applying IFRS 15 will be whether goods and services to be provided are distinct and represent multiple performance obligations which will then need to be accounted for separately.
In determining whether the goods and services are distinct, it is necessary to establish if the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (i.e. from other providers).

Example:
Software Ltd licences its latest robotic software to customers for a monthly fee of $15,000 (non-cancellable 12-month contract).  Customers can also upgrade for an additional $5,000 per month and receive monthly updates to the software and 24hr technical support.

As the software remains functional without the updates and the technical support, Software Ltd concludes that the customer can benefit from the licence to use to the software on a standalone basis.

Software Ltd identifies three performance obligations in the contract:

  • the licence;
  • software updates; and
  • technical support.

Where multiple performance obligations are identified the entity must apportion the price of the contract between the different components.  This is usually based on standalone prices (allocating any discount on a pro rata basis).  Assuming monthly updates can be purchased separately for $4,000/mth and technical support for $2,000/mth, then the allocation of the price to individual performance obligations would be:

  Stand-alone Package Allocation
Licence 15,000 15,000 15,000
Updates 4,000 5,000 3,333
Support 2,000   1,667


2. Licences
Establishing whether to recognise revenue associated with a licence at a point in time or over the life of the licence will depend on whether the licence grants the customer a right to use or a right of access over the software. 

IFRS 15 establishes a principle that ‘if a customer can direct the use of, and obtain substantially all of the remaining benefits from, a licence at the point in time at which the licence is granted’ then it is a right of use over the software which will be recognised at a point in time (usually when control has passed i.e. the customer has been provided with an access code or similar).

Where an entity continues to be involved in maintaining and significantly improving the underlying software over the licence period then the licence grants a right of access to the customer and the revenue will be recognised over the licence period. Establishing whether updates to the software (in section 1. above) are a distinct good or service (and therefore a separate performance obligation) will significantly impact whether a licence grants a right of use or a right of access over software.

Critically, IFRS 15 states that restrictions of time, geographical region or use contained within the licence do not impact upon the assessment of whether a licence provides a right to access or a right to use the software.

Example:
Software Ltd offers its customers 1-year non-cancellable licences over a learn a new language app.  Customers are only permitted to use the app on one device per licence.  No updates are expected or planned as the language app is fully functional on day 1.

This licence would be treated as a right to use the app under IFRS 15 and revenue recognised at a point in time once the customer has been granted full access.

Software Ltd offers its customers 3-year non-cancellable licences over artificial intelligence software.  The software requires constant updates and revisions to work effectively.

This licence would be treated as a right of access under IFRS 15 and revenue recognised over the life of the licence.  The updates cannot be a distinct good or service as the customer’s benefit from the underlying software would be limited without the updates since they are critical to the effectiveness of the software.
 
3. Non-refundable upfront fees
Many software contracts contain up-front non-refundable fees (often described as establishment or set-up fees).  Most of these fees result in no transfer of any good or service to the customer (setting the customer up on a database is an administrative task only) but rather give a right to the customer to renew a licence each year without paying the up-front non-refundable fee again.  This creates what is known as a ‘material right’ for the customer in that they can renew the licence each year at a rate well below the overall first year cost (i.e. adding the up-front fee and cost of the 1st year licence is well above the renewal fees for subsequent years).
In these situations, entities will need to estimate the average length of a customer relationship and recognise the revenue associated with the up-front fee over that period. See the example below.

Example:
Software Ltd offers new customers the following arrangements.  An up-front non-refundable fee of $300,000 and an annual licence fee of $100,000.  Customers can renew indefinitely but Software Ltd estimates that customers renew on average 3 times.

Based on the information above the average customer of Software Ltd lasts 4 years (1st year plus 3 renewals) so using the short cut method in IFRS 15 the $300,000 up-front fee will be recognised progressively over those years $75,000 p.a.
 
4. Financing components within contracts
Where an entity recognises the revenue associated with a software contract up-front but the payments for that contract occur over time the entity must assess whether there is a financing component embedded within that contract (regardless of whether or not the contract explicitly discusses a financing component).  IFRS 15 exempts contracts of less than a year from this analysis.

Example:
Software Ltd sells a right of use licence to a new customer based on a 3-year non-cancellable contract where the customer pays $5,000 per month (in advance).  Software Ltd assesses the licence revenue is to be recognised on day 1 as per IFRS 15.  Assume a discount rate of 1% per month.

  • Nominal payments are 3 years * 12 months * $5,000 = $180,000
  • Present value of these payments is approx. = $152,043
  • Financing component = $27,957

In this situation Software Ltd recognises $152, 043 as the revenue associated with the licence on day 1 and interest revenue of $27,957 over the next 3 years.
 
5. Costs of obtaining a contract
IFRS 15 permits only the incremental costs of obtaining a contract to be capitalised.  Costs that would have arisen regardless of whether the contract was obtained must be expensed when incurred.

Therefore, salary costs of employees and consulting fees (paid regardless of success) will need to be expensed under IFRS 15.  Success fees paid to internal staff or external consultants when a new contract is secured should be capitalised[3]

Example:
Software Ltd pays an external consultant $1,000 per introduction to prospective clients.  Where the introduction leads to a new client relationship Software Ltd pays the consultant an additional $2,000.
Under IFRS 15 Software Ltd must expense the initial $1,000 per introduction as they incur this cost regardless of securing the contract.  The additional $2,000 success fee will be capitalised (when it occurs) as an asset as it is an incremental cost of obtaining a new contract[4].
 

[1] AASB 15 Revenue from Contracts with Customers in Australia.
[2] Effective for reporting periods commencing on or after 1 January 2019 for not-for-profit entities
[3] Costs that are explicitly chargeable to the customer regardless of whether the contract is obtained are recognised as assets.
[4] The information contained in this article is for general guidance only and does not represent, nor intend to be, advice.  We recommend that prior to taking any action or making any decision, that you consult with an advisor to ensure that individual circumstances are taken into account.