This is an example in a small series for illustrating the concepts in What is a good or service that is distinct?
A telecoms company enters into a contract for the sale of a mobile device and connection to its mobile network. The contract, which lasts for two years, gives the customer:
- X minutes of calls per month; Identify Telecom industry performance obligations
- Y gigabytes of data per month; and Identify Telecom industry performance obligations
- Z texts per month. Identify Telecom industry performance obligations
The telecoms company frequently sells mobile devices without connecting them to the network. Although different combinations of minute, data and texts are available, it is not possible to buy only minutes, only data or only texts. Identify Telecom industry performance obligations
The telecoms company concludes that although the customer can benefit from the minutes, data and texts independently from one another (i.e. they are capable of being distinct), they are interrelated with each other because the risks associated with the promise to transfer of minutes, texts and data are not separable as part of the network connection.
Therefore, two performance obligations are identified:
- The sale of a mobile phone; and Identify Telecom industry performance obligations
- Network services. Identify Telecom industry performance obligations
Another telecoms company sells a smartphone and network services for: Identify Telecom industry performance obligations
- € 100 in advance when entering into the contract, and
- a monthly payment of € 40 for a period of 24 months. Identify Telecom industry performance obligations
The wholesale cost of the smartphone is € 400.
The first question is: is it a benefit on its own? YES
And the second: can it be used with other services in the market? YES
This means the sale of the mobile phone and the network services are two separate performance obligations. The transaction price has to be allocated to these two performance obligations.
The transaction price for the complete transaction is € 100 plus ¤ 40 * 24 = € 1,060. The stand-alone selling price for the network services is determined on the basis of other sales propositions by the company and other competitors in the telecom industry as € 30 per month and for the smartphone is € 500. As a result is becomes clear that a discount of € 160 (or almost 15%) is applied by the telecoms company [The stand-alone selling prices, € 30 * 24 = € 720 plus € 500 = €1,220, actual transaction price is € 1,060].
As a result the smartphone revenue is € 435 (= € 500 minus 15% (€ 75)) at the moment of the sale and network service of € 625 over 24 months (= € 1,060 minus € 435 or € 26.04 per month).
Example – Accounting for early renewal rights
It is common for entities to offer non-cancellable contracts that provide the customer with the option to renew the contract prior to contract expiry. This would be common in telecommunications industry and other industries where a product is sold on day 1 of the contract with ongoing services to be provided over the contract period.
Company X is in the telecommunications industry, and offers the following contract to customers:
- 24 month non-cancellable contract which includes a device and a package of services;
- Customers pay 24 equal monthly instalments. Company X allocates each instalment between the device and the services on the same basis;
- The contract states that the customer has an option to renew their contract at any time after 21 months without penalty (no recovery is made of instalments that would have been made during the period from renewal up to the end of the original 24 month contract period);
- The early renewal results in the customer obtaining a new device and the same services for a subsequent 24 months from the renewal date;
- The renewed contract is priced at the stand-alone selling price for that contract at the time that the customer exercises the early renewal right.
The issue is how the customer’s option to renew early (prior to the full contract term of 24 months ending) should be accounted for in accordance with IFRS 15.
The early renewal right was embedded in the rights and obligations agreed to by the parties at contract inception. Therefore the early renewal option is not a contract modification because it is not an amendment to the original rights and obligations of the parties. IFRS 15 18 states that:
…………….. ‘A contract modification exists when the parties to the contract approve a modification that either creates new or changes existing enforceable rights and obligations of the parties to the contract.’
The option to renew early affects the amount of consideration to which the entity expects to be entitled for the device provided to the customer on day 1. This is because the amount of consideration could vary depending on when customers exercise their option to renew. Consequently, the amount of consideration in respect of the device is variable consideration as described in IFRS 15.51.
Company X will therefore need to estimate the amount of variable consideration to which it will be entitled, in accordance with IFRS 15.56-59. This requires that variable consideration (in this case the monthly instalments between months 21 and 24) will only be recognised as revenue to the extent that it is highly probable that there will not be a significant reversal in the amount of cumulative revenue recognised when the uncertainty over the variable consideration is resolved.
In this case, the uncertainty will be resolved when it is known whether the customers will exercise their renewal rights early. This will affect the allocation of monthly instalments between the handset (for which revenue will be recognised on inception of the contract with a related receivable being settled through the partial allocation of future monthly instalments) and the services (for which revenue will be recognised over the period of the contract, being the residual amount after deduction of the amount allocated to the handset).
The amount of variable consideration that is taken into account will depend on the facts and circumstances in each case. However, for a period of more than 21 months to be taken into account for part or all of the customer base, clear evidence would be required of the expected pattern of exercise of the early renewal option.
See also: The IFRS Foundation