2.1.1 Licences of intellectual property that are distinct

Licences are frequently capable of being distinct (i.e. the first criteria of a distinct good or service) as a customer can often obtain at least some benefit from the licence of intellectual property on its own or with other readily available resources. Consider Example 28.27, Case A, in Chapter 28 at 3.2.3, which includes a contract for a software licence that is transferred along with installation services, technical support and unspecified software updates. The installation service is routinely performed by other entities and does not significantly modify the software. The software licence is delivered before the other goods or services and remains functional without the updates and technical support. The entity concludes that the customer can benefit from each of the goods or services either on their own or together with other goods or services that are readily available. That is, each good or service, including the software licence, is capable of being distinct under paragraph 27 of IFRS 15.

If an entity determines that a licence of intellectual property and other promised goods or services are capable of being distinct, the second step in the evaluation is to determine whether they are distinct in the context of the contract. As part of this evaluation, an entity considers the indicators for whether the goods or services are not separately identifiable, including whether:

1. the entity provides a significant service of integrating the licence and other goods or services into a combined output or outputs;
2. the licence and other goods or services significantly modify or customise each other; or
3. the licence and other goods or services are highly interdependent or highly interrelated, such that the entity would not be able to fulfil its promise to transfer the licence independently of fulfilling its promise to transfer the other goods or services to the customer.

Continuing with Example 28.27, Case A, in Chapter 28 at 3.2.3, which is discussed above, the entity considers the separately identifiable principle and factors in paragraph 29 of IFRS 15 and determines that the promise to transfer each good and service, including the software licence, is separately identifiable. In reaching this determination, the entity considers that the installation services are routine and can be obtained from other providers. In addition, the entity considers that, although it integrates the software into the customer's system, the software updates do not significantly affect the customer's ability to use and benefit from the software licence during the licence period. Therefore, neither the installation services nor the software updates significantly affect the customer's ability to use and benefit from the software licence. The entity further observes that none of the promised goods or services significantly modify or customise one another and the entity is not providing a significant service of integrating the software and services into one combined output. Lastly, the software and the services are not deemed to be highly interdependent or highly interrelated because the entity would be able to fulfil its promise to transfer the initial software licence independent from its promise to subsequently provide the installation service, software updates and the technical support.

The following example from the standard also illustrates a contract for which a licence of intellectual property is determined to be distinct from other promised goods or services. [IFRS 15.IE281, IE285-IE288].

2.1.2 Licences of intellectual property that are not distinct

The licences of intellectual property included in the examples above were determined to be distinct, as they met the two criteria of paragraph 27 of IFRS 15. In other situations, a licence of intellectual property may not be distinct from other promised goods or services in a contract, either because it is not capable of being distinct and/or it is not separately identifiable.

Paragraph B54 of IFRS 15 requires that a licence that is not distinct from other promised goods or services in a contract be combined into a single performance obligation. It also identifies two examples of licences of intellectual property that are not distinct from other goods or services, as follows: [IFRS 15.B54]

1. ‘a licence that forms a component of a tangible good and that is integral to the functionality of the good; and
2. a licence that the customer can benefit from only in conjunction with a related service (such as an online service provided by the entity that enables, by granting a licence, the customer to access content).’

In both examples, a customer only benefits from the combined output of the licence of intellectual property and the related good or service. Therefore, the licence is not distinct and would be combined with those other promised goods or services in the contract.

The standard includes other examples of licences of intellectual property that are not distinct, which are combined with other promised goods or services because the customer can only benefit from the licence in conjunction with a related service (as described in paragraph B54(b) of IFRS 15). For example, Example 55 in IFRS 15 and Example 56, Case A, in IFRS 15 (included as Example 31.2 at 2.2.1 below) illustrate contracts that include licences of intellectual property that are not distinct from other goods or services promised to the customer.

When an entity is required to bundle a licence of intellectual property with other promised goods or services in a contract, it often needs to consider the licensing application guidance to help determine the nature of its promise to the customer when the licence is the predominant item in the combined performance obligation. See 2.2.1 below for further discussion on applying the licensing application guidance to such performance obligations.

2.1.3 Contractual restrictions

Some licences contain substantive contractual restrictions on how the customer may employ a licence. Paragraph B62(a) of IFRS 15 explicitly states an entity must disregard restrictions of time, geography or use when determining whether the promise to transfer a licence is satisfied over time or at a point in time; such restrictions define the attributes of the promised licence, rather than define whether the entity satisfies its performance obligation at a point in time or over time. [IFRS 15.B62(a)].

While stakeholders acknowledged that paragraph B62 of IFRS 15 is clear that restrictions of time, geographical region or use do not affect the licensor's determination about whether the promise to transfer a licence is satisfied over time or at a point in time, some stakeholders thought that the standard was unclear about whether particular types of contractual restrictions would affect the identification of the promised goods or services in the contract. For example, an arrangement might grant a customer a licence to a well-known television programme or movie for a period of time (e.g. three years), but the customer might be restricted in how often it can show that licensed content to only once per year during each of those three years. In this instance, stakeholders thought that it may be unclear whether contractual restrictions affect the entity's identification of its promises in the contract (i.e. do the airing restrictions affect whether the entity has granted one licence or three licences?). [IFRS 15.BC414O].

In considering this issue further, the IASB explained that contracts that include a promise to grant a licence to a customer require an assessment of the promises in the contract using the criteria for identifying performance obligations, as is the case with other contracts. [IFRS 15.BC405-BC406]. This assessment is done before applying the criteria to determine the nature of an entity's promise in granting a licence. [IFRS 15.BC414P].

In the Basis for Conclusions, the IASB further explained that they considered Example 59 in IFRS 15 (see Example 31.4 at 2.3.2 below) in the context of this issue. The entity concludes that its only performance obligation is to grant the customer a right to use the music recording. When, where and how the right can be used is defined by the attributes of time (i.e. two years), geographical scope (i.e. Country A) and permitted use (i.e. in commercials). If, instead, the entity had granted the customer rights to use the recording for two different time periods in two geographical locations, for example, years X1‑X3 in Country A and years X2‑X4 in Country B, the entity would need to use the criteria for identifying performance obligations in paragraphs 27‑30 of IFRS 15 to determine whether the contract included one licence that covers both countries or separate licences for each country. [IFRS 15.BC414Q].

Consequently, the entity considers all of the contractual terms to determine whether the promised rights result in the transfer to the customer of one or more licences. In making this determination, judgement is needed to distinguish between contractual provisions that create promises to transfer rights to use the entity's intellectual property from contractual provisions that establish when, where and how those rights may be used. Therefore, in the Board's view, the clarifications made to the requirements on identifying performance obligations in paragraphs 22‑30 of IFRS 15 provide sufficient guidance to entities. [IFRS 15.BC414P].

We believe a critical part of the evaluation of contractual restrictions is whether the lifting of a restriction at a future date requires an entity to grant additional rights to the customer at that future date in order to fulfil its promises under the contract. The presence of a requirement to grant additional rights to the customer indicates that there may be multiple performance obligations that need to be accounted for under Step 2 of the model.

Entities may need to use significant judgement to distinguish between a single promised licence with multiple attributes and a licence that contains multiple promises to the customer that may be separate performance obligations.

ASC 606 requires that entities distinguish between contractual provisions that define the attributes of a single promised licence (e.g. restrictions of time, geography or use) and contractual provisions that require them to transfer additional goods or services to customers (e.g. additional rights to use or access intellectual property). Contractual provisions that are attributes of a promised licence define the scope of a customer's rights to intellectual property and do not affect whether a performance obligation is satisfied at a point in time or over time. Nor do they affect the number of performance obligations in the contract.

The IASB decided not to clarify the requirements for identifying performance obligations in a contract containing one or more licences since it had clarified the general requirements for identifying performance obligations. [IFRS 15.BC414P].

As a result, ASC 606 includes guidance on contractual restrictions that differs from the requirements in IFRS 15. However, the IASB noted in the Basis for Conclusions that, consistent with the ASC 606, an entity needs to apply the requirements in Step 2 of the general model on identifying performance obligations when distinguishing between contractual provisions that create promises to transfer additional rights from those that are merely attributes of a licence that establish when, where and how the right may be used. [IFRS 15.BC414P]. Under both IFRS 15 and ASC 606, an entity may need to apply significant judgement to distinguish between a single promised licence with multiple attributes and a licence that contains multiple promises to the customer that may be separate performance obligations.

2.1.4 Guarantees to defend or maintain a patent

IFRS 15 states that a guarantee provided by an entity that it has a valid patent to intellectual property and that it will defend or maintain a patent does not represent a performance obligation in a licensing contract. This is because ‘the act of defending a patent protects the value of the entity's intellectual property assets and provides assurance to the customer that the licence transferred meets the specifications of the licence promised in the contract'. Furthermore, this type of guarantee does not affect the licensor's determination as to whether the licence provides a right to access intellectual property (satisfied over time) or a right to use intellectual property (satisfied at a point in time). [IFRS 15.B62(b)].

It is not unusual for intellectual property arrangements to include a clause that requires a licensor to defend and maintain related patents. While patent defence and maintenance is a continuing obligation, it is an obligation to ensure the licensee can continue to use the intellectual property as intended, and, as discussed above, is not a promised good or service under IFRS 15 that should be evaluated under Step 2. However, if there are questions regarding the validity of a patent at the time a licence arrangement is entered into, licensors need to consider whether that component of the arrangement meets the attributes to be considered a contract within the scope of the model (see Chapter 28 at 2.1).

Furthermore, as discussed above, because such a provision is to ensure that the licensee can continue to use the intellectual property as intended, it is similar to an assurance-type warranty discussed at 3 below (i.e. a warranty that promises the customer that the delivered product is as specified in the contract). Assurance-type warranties are not within the scope of IFRS 15 and, as stated in paragraph B30 of IFRS 15, would be accounted for in accordance with the requirements for product warranties in IAS 37 – Provisions, Contingent Liabilities and Contingent Assets.

2.1.5 Application questions on identifying performance obligations in a licensing arrangement

2.2.1 Applying the licensing application guidance to a single (bundled) performance obligation that includes a licence of intellectual property

IFRS 15 does not explicitly state that an entity needs to consider the nature of its promise in granting a licence when applying the general revenue recognition model to performance obligations that are comprised of both a licence (that is not distinct) and other goods or services. However, the Board clarified in the Basis for Conclusions that to the extent that an entity is required to combine a licence with other promised goods or services in a single performance obligation and the licence is the primary or dominant component (i.e. the predominant item) of that performance obligation, the entity needs to consider the licensing application guidance to help determine the nature of its promise to the customer. [IFRS 15.BC407].

If the licence is a predominant item of a single performance obligation, entities need to consider the licensing application guidance when:

• determining whether the performance obligation is satisfied over time or at a point in time; and
• selecting an appropriate method for measuring progress of that performance obligation if it is satisfied over time.

Considering the nature of an entity's promise in granting a licence that is part of a single combined performance obligation is not a separate step or evaluation in the revenue model. Rather, it is part of the overall requirements in Step 5 of the model to determine whether that single performance obligation is satisfied over time or at a point in time and the appropriate measure of progress toward the satisfaction, if it is satisfied over time.

The Board did not provide application guidance or bright lines for determining when a licence is the primary or dominant (i.e. the predominant) component. However, the IASB explained in the Basis for Conclusions that, in some instances, not considering the nature of the entity's promise in granting a licence that is combined with other promised goods or services in a single performance obligation would result in accounting that does not best reflect the entity's performance. For example, consider a situation where an entity grants a 10-year licence that is not distinct from a one-year service arrangement. The IASB noted that a distinct licence that provides access to an entity's intellectual property over a 10-year period could not be considered completely satisfied before the end of the access period. The IASB observed in that example that it is, therefore, inappropriate to conclude that a single performance obligation that includes that licence is satisfied over the one-year period of the service arrangement. [IFRS 15.BC414X].

The standard includes examples that illustrate how an entity applies the licensing application guidance to help determine the nature of a performance obligation that includes a licence of intellectual property and other promised goods or services.

In Example 31.2 below an entity licences the patent rights for an approved drug compound to its customer and also promises to manufacture the drug for the customer. The entity considers that no other entity can perform the manufacturing service because of the highly specialised nature of the manufacturing process. Therefore, the licence cannot be purchased separately from the manufacturing service and the customer cannot benefit from the licence on its own or with other readily available resources (i.e. the licence and the manufacturing service are not capable of being distinct). Accordingly, the entity's promises to grant the licence and to manufacture the drug are accounted for as a single performance obligation, as follows. [IFRS 15.IE281‑IE284].

Example 31.2 above illustrates the importance of applying the licensing application guidance when determining the nature of an entity's promise in granting a licence that is combined into a single performance obligation with other promised goods or services. That is because the conclusion of whether a non-distinct licence provides the customer with a right to use intellectual property or a right to access intellectual property may have a significant effect on the timing of revenue recognition for the single combined performance obligation. In Example 31.2, the entity needs to determine the nature of its promise in granting the licence within the single performance obligation (comprising the licence and the manufacturing service) to appropriately apply the general principle of recognising revenue when (or as) it satisfies its performance obligation to the customer. If the licence in this example provided a right to use the entity's intellectual property that on its own would be recognised at the point in time in which control of the licence is transferred to the customer, it is likely that the combined performance obligation would only be fully satisfied when the manufacturing service is complete. In contrast, if the licence provided a right to access the entity's intellectual property, the combined performance obligation would not be fully satisfied until the end of the 10-year licence period, which could extend the period of revenue recognition beyond the date when the manufacturing service is complete.

ASC 606 explicitly states that an entity considers the nature of its promise in granting a licence when applying the general revenue recognition model to a single performance obligation that includes a licence and other goods or services (i.e. when applying the general requirements, consistent with those in paragraphs 31‑45 of IFRS 15, to assess whether the performance obligations are satisfied at a point in time or over time). Consequently, when the licence is not the predominant item in a single performance obligation, this may result in a US GAAP preparer considering the nature of its promise in granting a licence in a greater number of circumstances than an IFRS preparer. [IFRS 15.BC414Y]. The determination of whether a licence is the predominant component may be obvious in some cases, but not in others. Therefore, entities may need to exercise significant judgement and consider both qualitative and quantitative factors.

2.3.1 Right to access

The Board concluded that a licence that provides an entity with the right to access intellectual property is satisfied over time ‘because the customer simultaneously receives and consumes the benefit from the entity's performance as the performance occurs', including the related activities undertaken by entity. [IFRS 15.B60, BC414]. This conclusion is based on the determination that when a licence is subject to change (and the customer is exposed to the positive or negative effects of that change), the customer is not able to fully gain control over the licence of intellectual property at any given point in time, but rather gains control over the licence period. Entities need to apply the general requirements in paragraphs 39‑45 of IFRS 15 to determine the appropriate method to measure progress (see Chapter 30 at 3), in addition to paragraph B61 of IFRS 15 (i.e. the use and benefit requirement), discussed in 2.3.3 below.

The standard includes the following example of a right-to-access licence. [IFRS 15.IE297‑IE302].

2.3.2 Right to use

In contrast, when the licence represents a right to use the intellectual property as it exists at a specific point in time, the customer gains control over that intellectual property at the beginning of the period for which it has the right to use the intellectual property. [IFRS 15.B61]. This timing may differ from when the licence was granted. For example, an entity may provide a customer with the right to use intellectual property, but indicate that right to use does not start until 30 days after the agreement is finalised. For the purpose of determining when control transfers for the right-to-use licence, the Board was clear that the assessment is from the customer's perspective (i.e. when the customer can use the licensed intellectual property), rather than the entity's perspective (i.e. when the entity transfers the licence). Entities need to apply the general requirements in paragraph 38 of IFRS 15 to determine the point in time that control of the licence transfers to the customer (see Chapter 30 at 4) in addition to paragraph B61 of IFRS 15 (i.e. the use and benefit requirement), discussed in 2.3.3 below.

The standard includes the following example of a right-to-use licence. [IFRS 15.IE303‑IE306].

2.3.3 Use and benefit requirement

IFRS 15 states that revenue from a right-to-use licence cannot be recognised before the beginning of the period during which ‘the customer is able to use and benefit from the licence’. [IFRS 15.B61]. The IASB explained in the Basis for Conclusions that if the customer cannot use and benefit from the licensed intellectual property then, by definition, it does not control the licence. [IFRS 15.BC414]. See 2.4 below for discussion on licence renewals.

Consider an example where an entity provides a customer with a right to use its software, but the customer requires a code before the software will function, which the entity will not provide until 30 days after the agreement is finalised. In this example, it is likely that the entity would conclude that control of the licence does not transfer until 30 days after the agreement is finalised because that is when the customer has the right to use and can benefit from the software.

2.5.1 Recognition of royalties for a licence that provides a right to access intellectual property

The IASB explained in the Basis for Conclusions that the royalty recognition constraint is intended to align the recognition of sales or usage-based royalties with the standard's key principle that revenue should be recognised when (or as) an entity satisfies a performance obligation. As discussed above, IFRS 15 requires that royalties received in exchange for licences of intellectual property are recognised at the later of when: (1) the subsequent sales or usage occurs; and (2) the performance obligation to which the sales-based or usage-based royalties relates has been satisfied (or partially satisfied). That is, an entity recognises the royalties as revenue when (or as) the customer's subsequent sales or usage occurs, unless that pattern of recognition accelerates revenue recognition ahead of the entity's satisfaction of the performance obligation to which the royalty solely or partially relates, based on an appropriate measure of progress (see Chapter 30 at 3). [IFRS 15.BC421I].

Consider the following example, which was provided by the FASB, that illustrates when revenue recognition may be inappropriately accelerated ahead of an entity's performance, if revenue was recognised under paragraph B63(a) of IFRS 15 for a right-to-access licence.

The above example notwithstanding, for many contracts with licences that provide a right to access an entity's intellectual property, applying the royalty recognition constraint results in an entity recognising revenue from sales-based or usage-based royalties when (or as) the customer's underlying sales or usage occurs in accordance with paragraph B63(a) of IFRS 15. An output-based measure of progress that is the same as, or similar to, the application of the practical expedient in paragraph B16 of IFRS 15 (i.e. when the right to consideration corresponds directly with the value to the customer of the entity's performance to date) is appropriate because the entity's right to consideration (i.e. the sales-based or usage-based royalties earned) often corresponds directly with the value to the customer of the entity's performance completed to date. The practical expedient in paragraph B16 of IFRS 15 is discussed further in Chapter 30 at 3.1.1.

In addition, an output-based measure could also be appropriate for a licence that provides a right to access intellectual property in which the consideration is in the form of a fixed fee and royalties. The following example from the standard illustrates this. [IFRS 15.IE309-IE313].

In Example 31.7 above, the fixed consideration of CU2 million is an explicit term in the contract with the customer. In some contracts, fixed consideration may be implied, such as when a guaranteed minimum amount of royalties is part of the transaction price.

In addition, as discussed in 2.3.1.A above, many licences that provide a right to access intellectual property may constitute a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer (e.g. a series of distinct periods of access to intellectual property, such as monthly access or quarterly access). In cases where the criteria for a performance obligation to be accounted for as a series of distinct goods or services have been met, an entity needs to consider whether any variable consideration in the contract (e.g. sales-based or usage-based royalties) should be allocated directly to the distinct periods of access, if the criteria for certain allocation exceptions are met. The allocation of sales-based or usage-based royalties in this manner generally results in the recognition of royalties as revenue when (or as) the customer's underlying sales or usage occurs.

An entity may need to apply significant judgement to determine the appropriate pattern of revenue recognition for royalties received on a licence that provides a right to access intellectual property.

2.5.2 Application questions on the sales-based or usage-based royalty recognition constraint

3.1.1 Evaluating whether a product warranty is a service-type warranty (i.e. a performance obligation) when it is not separately priced

At the March 2015 TRG meeting, the TRG members generally agreed that the evaluation of whether a warranty provides a service (in addition to the assurance that the product complies with agreed specifications) requires judgement and depends on the facts and circumstances. There is no bright line in the standard on what constitutes a service-type warranty, beyond it being separately priced.

However, paragraph B31 of IFRS 15 includes three factors that need to be considered in each evaluation: (1) whether the warranty is required by law; (2) the length of the warranty coverage; and (3) the nature of the tasks that the entity promises to perform.

Consider the following example from the TRG agenda paper, which illustrates the factors an entity considers in assessing whether a product warranty is a service-type warranty:

Furthermore, the TRG agenda paper emphasised that entities need to evaluate each type of warranty offered to determine the appropriate accounting treatment.⁷

3.1.2 How would an entity account for repairs provided outside the warranty period?

An entity must consider all facts and circumstances, including the factors in paragraph B31 of IFRS 15 (e.g. the nature of the services provided, the length of the implied warranty period) to determine whether repairs provided outside the warranty period need to be accounted for as an assurance-type or service-type warranty. Sometimes, entities provide these services as part of their customary business practices, in addition to providing assurance-type warranties for specified periods of time. For example, an equipment manufacturer may give its customers a standard product warranty that provides assurance that the product complies with agreed-upon specifications for one year from the date of purchase. However, the entity may also provide an implied warranty by frequently repairing products for free after the one-year standard warranty period has ended. See Chapter 28 at 3.1 for a discussion of implied promises in a contract with a customer.

If the entity determines that the repairs made during the implied warranty period generally involve defects that existed when the product was sold and the repairs occur shortly after the assurance warranty period, the entity may conclude that the repairs are covered by an assurance-type warranty. That is, the term of the assurance-type warranty may be longer than that stated in the contract. However, all facts need to be considered to reach a conclusion.

If the entity determines that the repairs provided outside the warranty period are covered by a service-type warranty (because the entity is providing a service to the customer beyond fixing defects that existed at the time of sale), it also needs to consider whether the term of the service-type warranty is longer than that stated in the contract.

3.1.3 Customer's return of a defective item in exchange for compensation: right of return versus assurance-type warranty

Should an entity account for a customer's return of a defective item in exchange for compensation (i.e. not for a replacement item) as a right of return or an assurance-type warranty? We believe that an entity should account for the right to return a defective item in return for cash (instead of a replacement item) under the right of return application guidance in paragraphs B20-B27 of IFRS 15, rather than as an assurance-type warranty. The Basis for Conclusions states that ‘… the boards decided that an entity should recognise an assurance-type warranty as a separate liability to replace or repair a defective product’. [IFRS 15.BC376]. This description of an assurance-type warranty does not include defective products that are returned for a refund. It only contemplates defective products that are replaced or repaired. See Chapter 29 at 2.4 for a discussion of rights of return.

However, there may be limited circumstances in which the cash paid to a customer for a defective item would need to be accounted for in accordance with the warranty application guidance, instead of as a right of return. For example, an entity may pay cash to a customer as reimbursement for third-party costs incurred to repair a defective item. In this case, the cash payment to the customer was incurred to fulfil the entity's warranty obligation. This assessment requires judgement and depend on the facts and circumstances.

5.1.1 Does the timing of commission payments affect whether they are incremental costs?

At their November 2016 meeting, FASB TRG members generally agreed that the timing of commission payments does not affect whether the costs would have been incurred if the contract had not been obtained. However, there could be additional factors or contingencies that would need to be considered in different commission plans that could affect the determination of whether all (or a portion) of a cost is incremental.¹⁹ Consider the following example from a FASB TRG agenda paper:

In this fact pattern, only the passage of time is required for the entity to pay the second half of the commission. For example, in some commission plans, the employee will only be entitled to the second half of the commission payment if the employee is still employed by the entity when the commission is due. For such plans, an entity needs to carefully evaluate whether the requirement to remain employed in order to receive the commission (i.e. the service vesting condition) is substantive. We believe that the second half of the commission payment would not be incremental if the service condition is substantive because other conditions are necessary, beyond simply obtaining the contract, for the entity to incur the cost.

If the entity's payment of a commission is only ‘contingent’ on a customer paying the amount due in the obtained contract, we do not believe this would influence the determination of whether the commission is an incremental cost, provided the contract meets the Step 1 criteria to be accounted for as a contract under the five-step model. However, if there is an extended payment term (i.e. there is a significant amount of time between contract signing and the date in which the contract consideration is due), the entity should consider whether there is a service condition or other contingency, as discussed above.

5.1.2 Commission payments subject to a threshold

In November 2016, the FASB TRG members were asked to consider if commission payments subject to a threshold could be considered incremental costs. FASB TRG members generally agreed that basing a commission on a pool of contracts, rather than paying a set percentage for each contract, would not affect the determination of whether the commissions would have been incurred if the entity did not obtain the contracts with those customers.²¹ Consider the following example from a FASB TRG agenda paper:

The FASB TRG members generally agreed that these costs are incremental costs of obtaining a contract with a customer. Therefore, the costs should be capitalised when the entity incurs a liability to pay these commissions. The costs are incremental because the entity will pay the commission under the programme terms as a result of entering into the contracts. See 5.3.4 below for discussion about the period over which an entity would amortise a sales commission that is subject to a threshold and is considered an incremental cost of obtaining a contract.

5.1.3 Would an entity capitalise commissions paid on contract modifications?

An entity would capitalise commissions paid on contract modifications if they are incremental (i.e. they would not have been incurred if there had not been a modification) and recoverable. Contract modifications are accounted for in one of three ways: (1) as a separate contract; (2) as a termination of the existing contract and the creation of a new contract; or (3) as part of the existing contract (see Chapter 28 at 2.4 for further requirements on contract modifications). In all three cases, commissions paid on contract modifications are incremental costs of obtaining a contract and should be capitalised if they are recoverable. In the first two cases, a new contract is created, so the costs of obtaining that contract would be incremental. The TRG agenda paper no. 23 noted that commissions paid on the modification of a contract that is accounted for as part of the existing contract are incremental costs even though they are not initial incremental costs.²³

5.1.4 Would fringe benefits on commission payments be included in the capitalised amounts?

Fringe benefits should be capitalised as part of the incremental cost of obtaining a contract if the additional costs are based on the amount of commissions paid and the commissions qualify as costs to obtain a contract. However, if the costs of fringe benefits would have been incurred regardless of whether the contract had been obtained (e.g. health insurance premiums), the fringe benefits should not be capitalised. That is, an entity cannot allocate fringe benefits to the commission and, therefore, capitalise a portion of the costs of benefits it would provide regardless of whether the commission was paid.²⁴

5.1.5 Must an entity apply the practical expedient to expense contract acquisition costs to all of its qualifying contracts across the entity or can it apply the practical expedient to individual contracts?

We believe the practical expedient to expense contract acquisition costs (that would, otherwise, be amortised over a period of one year or less) must be applied consistently to contracts with similar characteristics and in similar circumstances.

5.1.6 How would an entity account for capitalised commissions upon a modification of the contract that is treated as the termination of an existing contract and the creation of a new contract?

We believe an asset recognised for incremental costs to obtain a contract that exists when the related contract is modified should be carried forward into the new contract, if the modification is treated as the termination of an existing contract and the creation of a new contract and the goods or services to which the original contract cost asset relates are part of the new contract. This is because the contract cost asset relates to goods or services that have not yet been transferred and the accounting for the modification is prospective. This conclusion is similar to the one reached by the FASB TRG members in relation to the accounting for contract assets upon a contract modification, as discussed in Chapter 32 at 2.1.5.E.

The contract cost asset that remains on the entity's statement of financial position at the date of modification would continue to be evaluated for impairment in accordance with IFRS 15 (see 5.4 below). In addition, an entity should determine an appropriate amortisation period for the contract cost asset (see 5.3 below).

5.2.1 Can an entity defer costs of a transferred good or service that would otherwise generate an upfront loss because variable consideration is fully or partially constrained?

An entity should not defer the costs of a transferred good or service when the application of the constraint on variable consideration results in an upfront loss, even if the entity ultimately expects to recognise a profit on that good or service, unless other specific requirements allow or require a deferral of those costs. The criteria in IFRS 15 must be met to capitalise costs to fulfil a contract, including the criterion that the costs must generate or enhance resources of the entity that will be used in satisfying performance obligations in the future. An entity recognises such costs when control of a good or service transfers to the customer. As such, the cost of those sales would not generate or enhance resources of the entity used to satisfy future performance obligations.

Consider the following example: An entity sells goods with a cost of £500,000 for consideration of £600,000. The goods have a high risk of obsolescence, which may require the entity to provide price concessions in the future, resulting in variable consideration (see Chapter 29 at 2.2.1.A). The entity constrains the transaction price and concludes that it is highly probable that £470,000 will not result in a significant revenue reversal, even though the vendor reasonably expects the contract to ultimately be profitable. When control transfers, the entity recognises revenue of £470,000 and costs of £500,000. It would not capitalise the loss of £30,000 because the loss does not generate or enhance resources of the entity that will be used in satisfying performance obligations in the future.

5.2.2 Accounting for fulfilment costs incurred prior to the contract establishment date that are outside the scope of another standard

How should an entity account for fulfilment costs incurred prior to the contract establishment date that are outside the scope of another standard (e.g. IAS 2)? Entities sometimes begin activities on a specifically anticipated contract (e.g. before agreeing to the contract with the customer, before the contract satisfies the criteria to be accounted for under IFRS 15).

At the March 2015 TRG meeting, the TRG members generally agreed that costs in respect of pre-contract establishment date activities that relate to a good or service that will transfer to the customer at or after the contract establishment date may be capitalised as costs to fulfil a specifically anticipated contract. However, the TRG members noted that such costs would still need to meet the other criteria in the standard to be capitalised (e.g. they are expected to be recovered under the anticipated contract).

Subsequent to capitalisation, costs that relate to goods or services that are transferred to the customer at the contract establishment date would be expensed immediately. Any remaining capitalised contract costs would be amortised over the period that the related goods or services are transferred to the customer.²⁷

For requirements on recognising revenue for a performance obligation satisfied over time when activities are completed before the contract establishment date, see Chapter 30 at 3.4.6.

5.2.3 Learning curve costs

As discussed in the Basis for Conclusions on IFRS 15, ‘a “learning curve” is the effect of efficiencies realised over time when an entity's costs of performing a task (or producing a unit) decline in relation to how many times the entity performs that task (or produces that unit)'. [IFRS 15.BC312]. Learning curve costs usually consist of materials, labour, overhead, rework or other costs that must be incurred to complete the contract (but do not include research and development costs). These types of efficiencies generally can be predicted at inception of an arrangement and are often considered in the pricing of a contract between an entity and a customer.

The IASB noted that in situations where learning curve costs are incurred in relation to a contract with a customer accounted for as a single performance obligation that is satisfied over time to deliver a specified number of units, IFRS 15 requires an entity to select a method of progress that depicts the transfer over time of the good or service to the customer (see Chapter 30 at 3). [IFRS 15.BC313]. The IASB further noted that an entity would probably select a method (such as a costs incurred measure of progress) for these types of contracts, which would result in the entity recognising more revenue and expense at the beginning of the contract relative to the end. The IASB clarified that this would be appropriate as an entity would charge a higher price to a customer only purchasing one unit (rather than multiple units) in order to recover its learning curve costs.

Conversely, when learning curve costs are incurred for a performance obligation satisfied at a point in time (rather than over time), an entity needs to assess whether those costs are within the scope of another standard. The IASB noted that in situations in which an entity incurs cost to fulfil a contract without also satisfying a performance obligation over time, the entity is probably creating an asset that is within the scope of another standard (e.g. IAS 2). [IFRS 15.BC315]. For example, if within the scope of IAS 2, the costs of producing the components would accumulate as inventory in accordance with the requirements in IAS 2. The entity would then recognise revenue when control of the inventory transfers to the customer. In that situation, no learning curve costs would be capitalised under IFRS 15 as the costs would be in the scope of another standard.

If the learning curve costs are not within the scope of another standard, we believe they generally will not be eligible for capitalisation under IFRS 15 (e.g. because the costs relate to past (and not future) performance).

5.2.4 Accounting for pre-contract or setup costs

Pre-contract costs are often incurred in anticipation of a contract and will result in no future benefit unless the contract is obtained. Examples include: (1) engineering, design or other activities performed on the basis of commitments, or other indications of interest, by a customer; (2) costs for production equipment and materials relating to specifically anticipated contracts (e.g. costs for the purchase of production equipment, materials or supplies); and (3) costs incurred to acquire or produce goods in excess of contractual requirements in anticipation of subsequent orders for the same item.

Pre-contract costs that are incurred in anticipation of a specific contract should first be evaluated for capitalisation under other standards (e.g. IAS 2, IAS 16, IAS 38). For example, pre-contract costs incurred to acquire or produce goods in excess of contractual requirements for an existing contract in anticipation of subsequent orders for the same item would likely be evaluated under IAS 2. Some other examples include costs incurred to move newly acquired equipment to its intended location, which could be required to be capitalised under IAS 16 (see 5.2.5 below), and employee training costs that are expensed in accordance with IAS 38.

Pre-contract costs incurred in anticipation of a specific contract that are not addressed under other standards are capitalised under IFRS 15 only if they meet all of the criteria of a cost incurred to fulfil a contract. Pre-contract costs that do not meet the criteria under IFRS 15 are expensed as incurred.

5.2.5 Capitalisation of mobilisation costs as costs to fulfil a contract with a customer under IFRS 15

Entities incur mobilisation costs when moving personnel, equipment and supplies to a project site either before, at or after inception of a contract with a customer. They are incurred in order to ensure that the entity is in a position to fulfil its promise(s) in a contract (or specifically anticipated contract) with a customer, rather than transferring a good or service to a customer (i.e. they are not a promised good or service).

The assessment of whether mobilisation costs can be capitalised depends on the specific facts and circumstances and may require significant judgement. Entities need to ensure that the costs are: (1) within the scope of IFRS 15; and (2) meet all of the criteria in paragraph 95 of IFRS 15 to be capitalised.

Are the costs within the scope of IFRS 15?

If the asset being moved (e.g. equipment in the scope of IAS 16, inventory in the scope of IAS 2) is in the scope of another standard, an entity should determine whether the mobilisation costs are specifically addressed by the other standard. If so, the cost is outside the scope of IFRS 15.

If the mobilisation costs are not specifically addressed in another standard, or it is not clear whether these are within the scope of another standard, an entity further analyses whether the mobilisation costs are:

• specific to the asset being moved or applicable to more than one customer under unrelated contracts; in the latter case it is likely that they would not be within the scope of IFRS 15. For example, moving an asset between different premises of the entity to better utilise the asset in preparation for future contracts with many customers; or
• specific to the contract with the customer, in which case, it would be within the scope of IFRS 15. For example, moving an asset to a remote location at the customer's request, which does not provide a benefit to the entity beyond ensuring it is in a position to fulfil its obligation(s) to the customer under the contract.

Do the costs meet the criteria in paragraph 95 of IFRS 15 to be capitalised?

As discussed above, IFRS 15 includes three criteria that must be met for costs to fulfil a contract within its scope can be capitalised:

1. Entities may need to use judgement to determine if costs relate directly to a contract (or a specifically anticipated contract) as required in paragraph 95(a) of IFRS 15. Indicators that a cost, by function rather than by nature, may be directly related include, but are not limited to, the following:
   • the costs are explicitly or implicitly chargeable to the customer under the contract;
   • the costs are incurred only because the entity entered into the contract;
   • the contract explicitly or implicitly refers to mobilisation activities (e.g. that the entity must move equipment to a specific location); or
   • the location in which the entity must perform is explicitly or implicitly specified in the contract and the mobilisation costs are incurred in order for the entity to fulfil its promise(s) to the customer.
2. Significant judgement may also be required to determine whether costs generate or enhance resources of the entity that will be used in satisfying performance obligations in the future as required by paragraph 95(b) of IFRS 15. This determination would include (but not be limited to) considering whether:
   • the costs are incurred in order for the entity to be able to fulfil the contract; and
   • location is implicitly or explicitly an attribute of the contract.

   If a performance obligation (or a portion of a performance obligation that is satisfied over time) has been satisfied, fulfilment costs related to that performance obligation (or portion thereof) can no longer be capitalised (see 5.2 above for further discussion).

3. For costs to meet the ‘expected to be recovered’ criterion as required by paragraph 95(c) of IFRS 15, they need to be either explicitly reimbursable under the contract or reflected through the pricing on the contract and recoverable through margin.

5.2.6 Accounting for loss leader contracts

Certain contracts may be executed as part of a loss leader strategy in which a good is sold at a loss with an expectation that future sales contracts will result in higher sales and/or profits. In determining whether these anticipated contracts should be part of the accounting for the existing loss leader contract, entities need to refer to the definition of a contract in IFRS 15, which is based on enforceable rights and obligations in the existing contract (see Chapter 28 at 2.1). While it may be probable that the customer will enter into a future contract or the customer may even be economically compelled, or compelled by regulation to do so, it would not be appropriate to account for an anticipated contract when there is an absence of enforceable rights and obligations.

In addition, if the fulfilment costs incurred during satisfying the initial contract are within the scope of other accounting standards (e.g. IAS 2), the entity must account for those costs under that relevant standard. Even if the costs are not within the scope of another standard, the costs would relate to a satisfied or partially satisfied performance obligation (i.e. the original contract priced at a loss) and, therefore, must be expensed as incurred. IFRS 15 does not permit an entity to defer fulfilment costs or losses incurred based on the expectation of profits in a future contract.

5.3.1 Determining whether a commission on a renewal contract is commensurate with the commission on the initial contract

At their November 2016 meeting, FASB TRG members generally agreed that the commissions would have to be reasonably proportional to the contract values (e.g. 5% of both the initial and renewal contract values) to be considered commensurate. The FASB TRG members also generally agreed that it would not be reasonable for an entity to use a ‘level of effort’ analysis to determine whether a commission is commensurate. For example, a 6% commission on an initial contract and a 2% commission on a renewal would not be commensurate even if the declining commission rate corresponds to the level of effort required to obtain the contracts.²⁸

As discussed at 5.3 above, if the renewal commission is considered to be commensurate with the commission on the initial contract, it would not be appropriate to amortise any asset for the initial commission over a longer period than the initial contract. In contrast, it is likely that it would be appropriate to amortise the asset over a longer period than the initial contract if the commissions are not considered to be commensurate (such as in the example above). See 5.3.2 below for discussion of how an entity determines this longer amortisation period.

Although the TRG did not discuss this, entities would also need to evaluate whether any expected subsequent renewal commissions are commensurate with prior renewal commissions to determine the appropriate amortisation period for any renewal commissions that are required to be capitalised under IFRS 15. Continuing the above example, assume the original three-year contract (for which a 6% commission is paid) and each subsequent renewal contract (for which a 2% renewal commission is paid) is for a one-year term. If the entity expects to renew the contract in years two through four and continue to pay a constant 2% commission upon each renewal, each renewal commission would be considered commensurate. As a result, it is likely that the appropriate amortisation period for each renewal required to be capitalised would be one year. See 5.3.5 below for discussion of when an entity would begin to amortise an asset recognised for the incremental cost of obtaining a renewal contract.

5.3.2 Determining the amortisation period of an asset recognised for the incremental costs of obtaining a contract with a customer

The FASB TRG members generally agreed that when an entity determines an amortisation period that is consistent with the transfer to the customer of the goods or services to which the asset relates, it must determine whether the capitalised contract costs relate only to goods or services that will be transferred under the initial contract, or whether the costs also relate to goods or services that will be transferred under a specifically anticipated contract. For example, if an entity only pays a commission based on the initial contract and does not expect the customer to renew the contract (e.g. based on its past experience or other relevant information), amortising the asset over the initial term would be appropriate.

However, if the entity's past experience indicates that the customer is likely to renew the contract, the amortisation period would be longer than the initial term if the renewal commission is not ‘commensurate’ with the initial commission. See 5.3.1 above for a discussion of commensurate.

The FASB TRG members generally agreed that an entity needs to evaluate its facts and circumstances to determine an appropriate amortisation period if it determines that the period should extend beyond the initial contract term, because the commission on the renewal contract is not commensurate with the commission on the initial contract. An entity might reasonably conclude that its average customer life is the best estimate of the amortisation period that is consistent with the transfer of the goods or services to which the asset relates (e.g. if the good or service does not change over time, such as a health club membership). However, FASB TRG members generally agreed that this approach is not required and that entities should not use this as a default. The FASB TRG members noted that entities would use judgement that is similar to judgement used when estimating the amortisation period for intangible assets (e.g. a customer relationship intangible acquired in a business combination) and could consider factors such as customer loyalty and how quickly their products and services change.²⁹

Consider a technology entity that capitalises a commission earned on the sale of software, which the entity estimates it will maintain and support for only the next five years, and the estimated customer life is seven years. In evaluating the period of benefit, the entity may reasonably conclude the capitalised commission should be amortised over the five-year life of the software to which the commission relates.

However, in a TRG agenda paper the staff discussed two acceptable methods for amortising capitalised contract costs that relate to both the original contract and the renewals in cases in which the renewal commission is not commensurate with the initial commission:³⁰

• The initial capitalised amount is amortised over the period of benefit that includes expected renewals, while amounts capitalised that relate to renewals are amortised over the renewal period.
• The portion of the initial capitalised amount that is commensurate is amortised over the original contract term and the additional amount that is not commensurate is amortised over the period of benefit that includes expected renewals. Capitalised amounts that relate to renewals are amortised over the renewal period.

Both methods are acceptable because they each meet the objective of amortising the costs on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset relates. However, an entity needs to select one method and apply it consistently in similar circumstances. Other amortisation methods may also be acceptable if they are consistent with the pattern of transfer to the customer of the goods or services to which the asset relates.

The following example illustrates the two methods described in the TRG agenda paper:

5.3.3 Can an entity attribute the capitalised contract costs to the individual performance obligations in the contract to determine the appropriate amortisation period?

We believe an entity can attribute the capitalised contract costs to individual performance obligations in the contract to determine the appropriate amortisation period, but it is not required to do so. Paragraph 99 of IFRS 15 states that the asset recognised is amortised on a systematic basis ‘that is consistent with the transfer to the customer of the goods or services to which the asset relates’. [IFRS 15.99]. An entity may meet this objective by allocating the capitalised contract costs to performance obligations on a relative basis (i.e. in proportion to the transaction price allocated to each performance obligation) to determine the period of amortisation.³¹

Other methods for allocating capitalised contract costs may be appropriate. For example, an entity may also meet the objective by allocating specific capitalised contract costs to individual performance obligations when the costs relate specifically to certain goods or services.

An entity needs to have objective evidence to support a conclusion that a specified amount of the costs relates to a specific performance obligation and consistently apply any methods used for allocating capitalised contract costs to performance obligations.

In addition, as discussed above, an entity that attributes capitalised contract costs to individual performance obligations needs to consider whether the amortisation period for some or all of the performance obligations should extend beyond the original contract (see 5.3 above).

5.3.4 Over what period would an entity amortise a sales commission (that is only paid once a threshold is met) that is determined to be an incremental cost to obtain a contract?

The January 2015 TRG agenda paper indicated that two of the alternatives discussed might meet the objective of amortising the costs on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset relates. However, either alternative must be applied consistently to similar circumstances. In one alternative, an entity allocated the capitalised costs to all of the contracts that cumulatively resulted in the threshold being met and amortised the costs over the expected customer relationship period of each of those contracts. In the other alternative, an entity allocated the capitalised costs to the contract that resulted in the threshold being met and amortised the costs over the expected customer relationship period of that contract. The TRG agenda paper noted that the second alternative may result in a counterintuitive answer if the commission paid upon obtaining the contract that resulted in the threshold being met was large in relation to the transaction price for only that contract. While the first alternative may be easier to apply and result in a more intuitive answer than the second alternative in some situations, the TRG agenda paper noted that either approach is acceptable. The TRG agenda paper did not contemplate all possible alternatives. Consider the following example in the TRG agenda paper:³²

5.3.5 Determining when to begin to amortise an asset recognised for the incremental cost of obtaining a renewal contract

As discussed in 5.3.1 above, assets recognised for commensurate renewal commissions paid are amortised over the term of the contract renewal, with the expense recognised as the entity transfers the related goods or services to the customer.

We believe that the amortisation of the renewal commission should not begin earlier than the beginning of the renewal period. Consider the following illustration:

5.3.6 Presentation of capitalised contract costs and related amortisation in the statement of financial position and statement of profit and loss and other comprehensive income

As discussed at 5.1 – 5.3 above, IFRS 15 requires incremental costs of obtaining a contract and certain costs to fulfil a contract to be recognised as an asset and that asset to be amortised on a systematic basis. Paragraph 128 of IFRS 15 requires separate disclosure of closing balances and the amount of amortisation and impairment losses recognised during the period (see Chapter 32 at 3.2.3). However, the standard is silent on the classification of that asset and the related amortisation.

Under legacy IFRS, IAS 2 included the notion of work in progress (or ‘inventory’) of a service provider. However, this was consequentially removed from IAS 2 and replaced with the relevant requirements in IFRS 15. Furthermore, while these capitalised contract cost assets are intangible, in nature, IAS 38 specifically excludes from its scope intangible assets arising from contracts with customers that are recognised in accordance with IFRS 15. [IAS 38.3(i)]. In the absence of a standard that specifically deals with classification and presentation of contract costs, management would need to apply the requirements in IAS 8 to select an appropriate accounting policy. [IAS 8.10‑12].

In developing such an accounting policy, we believe that costs to obtain a contract and costs to fulfil a contract need to be considered separately for the purpose of presentation in financial statements.

• Considering the nature of costs to obtain a contract and the lack of guidance in IFRS, we believe that an entity may choose to present these costs as either:
  • a separate class of asset (similar in nature to work in progress, or ‘inventory’) in the statement of financial position and its amortisation within cost of goods sold, changes in contract costs or similar; or
  • a separate class of intangible assets in the statement of financial position and its amortisation in the same line item as amortisation of intangible assets within the scope of IAS 38 – this accounting treatment would be similar to the previous practice of accounting for certain subscriber acquisitions costs in the telecommunications industry.

    In addition, the entity needs to consider the requirements in IAS 7 – Statement of Cash Flows, in particular paragraph 16(a) of IAS 7, when determining the classification of cash flows arising from costs to obtain a contract (i.e. either as cash flow from operating activities or investing activities).

• In contrast, the nature of costs to fulfil a contract is such that they directly impact the entity's performance under the contract. Therefore, costs to fulfil a contract should be presented as a separate class of asset in the statement of financial position and its amortisation within cost of goods sold, changes in contract costs or similar.

We do not believe it would be appropriate to analogise to the requirements for intangible assets in IAS 38. Instead, such costs are consistent in nature to costs incurred in the process of production, as is contemplated in IAS 2. That is, in nature, they are consistent with work in progress, or ‘inventory’, of a service provider. Therefore, whether costs to fulfil a contract meet the criteria for capitalisation in paragraph 95 of IFRS 15 or are expensed as incurred, we believe that presentation of such costs in the statement of profit and loss and other comprehensive income and the presentation of related cash flows in the statement of cash flows needs to be consistent.

Capitalised contract costs are subject to impairment assessments (see 5.4 below). Impairment losses are recognised in profit or loss, but the standard is silent on where to present such amounts within the primary financial statements. We believe it would be appropriate for the presentation of any impairment losses to be consistent with the presentation of the amortisation expense.