Capital Quarter Spring 2020: Understanding IFRS 15 – Licences

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The implementation of IFRS 15 revolutionised how many technology companies recorded revenue from contracts with customers. But the new regulations are complicated, and we are often asked by our clients to explain how they work – particularly in relation to the treatment of licences. To simplify matters for tech businesses, we have drafted this overview of the IFRS 15 guidance in respect of licences and assembled a list of key considerations specific to technology companies.

Many tech businesses promise to grant a licence to a customer as well as promising to transfer other goods or services to the customer. Those promises may be explicitly stated in the contract or implied by your business practice, published policies or potentially specific statements.

As with all other types of contracts, when a contract with a customer includes a promise to grant a licence in addition to other promised goods or services, you must assess the performance obligations within the contract. In particular, it is important to understand if the goods or services promised are ‘distinct’ from the promise of the licence, and therefore need to be recognised individually in the accounts. For the avoidance of doubt, ‘distinct’ in this sense means both capable of being distinct and, distinct in the nature of the contract.

Key considerations: Licences / consumer assistance / warranties / updates / client customisation

What should you do if goods or services are not distinct?

Where the promise to grant a licence is not distinct from other goods or services in the contract, it should be treated as one performance obligation and recognised collectively.

Some examples of licences that are not distinct from other goods or services include:
  • a licence that forms part of the physical product and is integral to the functionality of that product; and
  • a licence that the customer can benefit from only in conjunction with a related service (such as an online service provided by you that enables, by granting a licence, the customer to access content).
You will need to assess this performance obligation against the applicable guidance within IFRS 15 for the timing of revenue recognition, whether this is satisfied either over a period of time or at a point in time.

And what happens if they are distinct?

Where goods or services are deemed to be distinct from the promise to grant a licence, separate performance obligations arise. As a result, you will need to consider whether the licence transfers to a customer either at a point in time or over time. In making this determination, you will also need to consider whether the nature of the promise in granting the licence to a customer is to provide the customer with either:
  • a right to access the intellectual property as it exists throughout the licence period; or
  • a right to use the intellectual property as it exists at the point in time at which the licence is granted
Where the licences of intellectual property are distinct, the licence guidance for revenue recognition should be applied. In theory, the question to ask is: will the software be used in its current form? If the answer is yes, revenue should be recognised at a point in time. Otherwise, revenue will be recorded over a period of time.

Key consideration: Does the software require constant updates?

Sales-based or usage-based royalties?

Sales-based or usage-based royalty promised in exchange for a licence of intellectual property is recognised as revenue only when the later of the following events occurs:
  • the subsequent sale or usage occurs; and
  • the performance obligation to which some or all of the sales-based or usages based royalty has been allocated has been satisfied (or partially satisfied).
It is important to note that the requirement for a sales-based or usage based royalty applies when the royalty relates only to a licence of intellectual property or when a licence of intellectual property is the predominant item to which the royalty relates.

In summary, where a royalty relates to, or primarily relates to, a licence for intellectual property and is either sales or usage based, revenue is recognised as the sale or usage occurs. When this is not the case, the general IFRS 15 guidance applies.

Key considerations: minimum royalty arrangements / tiered royalties

Customer options for additional goods or services, variable consideration and determining the transaction price

Are customer options or variable consideration included within your contracts?

Customer options to acquire additional goods or services for free or at a discount come in many forms – including sales incentives, customer award credit, contract renewal options or other discounts on future goods or services.

Where a customer option is included within the contract, the consideration from the exercise of the option is excluded from the transaction price.

IFRS 15 requires you to allocate the transaction price to performance obligations on a relative stand-alone selling price basis. If the stand-alone selling price for a customer’s option to acquire additional goods or services is not directly observable, an estimation technique must be used. That estimate must reflect the discount that the customer would obtain when exercising the option, adjusted for both of the following:
  • any discount that the customer could receive without exercising the option; and
  • the likelihood that the option will be exercised.

Where the transaction price is not directly observable, an estimation method is used. These methods include:

a) Adjusted market assessment approach – referring to prices from competitors for similar goods or services and adjusting those prices as necessary to reflect your costs and margins.
b) Expected cost plus a margin approach – a forecast of your expected costs of satisfying a performance obligation and then add an appropriate margin for that good or service.
c) Residual approach – estimate the stand-alone selling price by reference to the total transaction price less the sum of the observable stand-alone selling prices of other goods or services promised in the contract (note – this technique can only be used subject to certain conditions being met).

Key considerations: Discounts / refunds / incentives / transaction and processing fees / allocations of discounts

Written by Nick Joel in our London office.