Audit Partner at RSM Poland
We have recently written a lot about recognising revenue from construction and advisory services; today it is time for the next industry; this time, we are going to analyse the sale of non-material products.
A company (hereinafter also referred to as the entity) purchases licence ABC from their vendor and, without any further modifications, sells this right to use software ABC to their client, and concludes a contract with this client to prepare and install software ABC. Thus, owing to the purchased license, the client will be able to use the software. The delivery time for the installation, together with staff training, is about 6 months, divided into 6 stages, with an acceptance protocol required for each of them.
How should the revenue from the sale of the license and the service of software installation be recognised in the books (let us skip training here as irrelevant)?
First of all, you must analyse whether:
- the contracts were negotiated jointly and pertain to the same commercial goal?
- the price due under one contract depends on the performance of the other contract?
It seems that if not both, then at least the first criterion is met, which means that the two contracts could be treated as one.
In the next step, you must identify the performance obligation
It seems that the promised obligation involves software installation and the supply of a non-material good in the form of a license. The question is whether this good and this promised service can be considered distinct according to IFRS 15 par. 27?
According to IFRS 15 par. 27, goods or services are distinct, if they meet both criteria:
- the customer may benefit from the good or promised service either on its own or together with other resources that are readily available to the customer …
…in the discussed case it seems that the software with the license can bring benefits only once the installation has been completed, and it is not the case that another vendor could perform this software installation without substantive changes. Along the same lines, using the software without the license is not possible, but the customer could purchase the license directly from another vendor; it works the same the other way round: with the license, the customer cannot use the software until it has been implemented/installed, regardless of whether it has been supplied by the company or another vendor; thus, the license and the software seem to be inseparable, even if they are supplied to the customer by different entities …;
- the entity’s promise to transfer the good or a service is separately identifiable from other promises in the contract …
…here we must consider whether the software could be supplied independently from the installation: probably “not”; it must be “created” and implemented, i.e. the software installation involves the software + installation, tests, training, knowledge transfer to the client, etc., and the client must purchase the license at the same time.
It seems that both criteria are not met, hence not only different stages of software implementation, but also the license should be considered jointly with software implementation/installation.
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The topic appears to be very unclear; therefore, what is important is the ‘business’ approach, i.e. the overtones of cooperation with the client and not the wording of the contract, even though it would be the best solution if concluded contracts reflected the intention of the parties.
It should be noted that changing a couple of parameters in the contract/expectations of the parties may result in a totally different approach in terms of contract(s) analysis.
Factors that help determine if the goods are separately identifiable or not are listed below (IFRS 15, par. 29):
- if the entity provides a significant service of integrating the good or service with other goods or services promised in the contract into a bundle of goods or services that represent the combined output for which the customer has contracted, then the goods or services ARE NOT separately identifiable;
- if the good or service does not significantly modify or customise another good or service promised in the contract, then it is separately identifiable;
- if the good or service is not highly dependent on, or highly interrelated with, other goods or services, then it is separately identifiable.
The last case seems to be a contradiction of the situation from the above example.
Moving on, you must determine when the promised service is performed /the promised good is transferred? Does it take place once the service has been performed? If so, then when does it take place, if we transfer the license for example in January 2019, and the software will be operational in July 2019… Does it take place once the software implementation has been completed? Or maybe over the time of installation …
According to IFRS 15, par. 35 and 38, revenue can be recognised either over time or at a point in time. We discussed it extensively on our blog.
The performance obligation is satisfied over time when the company transfers the control over a good or service over time and thus satisfies the performance obligation, if one of the following conditions is met:
- the customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs;
- the entity’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced;
- the entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for the performance completed to date.
As regards the transfer of control, we may refer to paragraph 31-34, 38 and B5; control is defined as the ability to direct the use of, and obtain substantially all of the remaining benefits from, an asset. Control over the asset includes the ability to prevent other entities from directing the use of, and obtaining the benefits from, the asset; one may doubt whether the control has been transferred here, because the customer cannot obtain substantially all the benefits until the software is handed over for use; it seems that this is not the right way to go, and even if the benefits cannot be obtained “now”, the control has been transferred, because the customer has the ability to direct the use of this asset (gradually) and obtain benefits quite soon.
In any case, as long as this provision may be controversial in the case of the company from our example, the provisions of the second and third indent above seem to clearly indicate that assuming that the software and license are individual and our company could not do anything with the incurred costs in the event of contract termination with the customer (the work would be gone and would not create any asset with an alternative use or sale on the market), the control is being transferred over time, hence revenue from the contract for the license and the contract for software installation should be recognised over time, proportionately to service performance.
It seems that both the presented facts and the business approach suggest that the company should recognise revenue from the sale of the license and software installation over the time of performing the service of software installation. However, it would be a different story in the case of selling ‘ready-made’ software; also in the case of additional services, like software update or technical support, these additional performance obligations towards the customer should always be analysed on a case-by-case basis.
The above discussion was supposed to show that such an analysis is necessary for each case. As it has been mentioned, the business ‘overtones’ of the concluded contract may differ, hence it is indispensable to rely on tools, i.e. questions provided in IFRS 15, in order to reject the improper accounting approach and stick to the one that best suits the facts.
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