IFRS 15 Software contract modifications

IFRS 15 Software contract modifications – It is common in the software industry to change the scope or price of the contract. For example, a vendor may license software and provide post-contract customer support (PCS) to a customer in an initial transaction and then license additional software to the same customer at a later time. In general, any change to an existing contract is a modification per the guidance when the parties to the contract approve the modification either in writing, orally, or based on the parties’ customary business practices. A new contract entered into with an existing customer could also be viewed as the modification of an existing contract, depending on the circumstances.

In determining whether a contract has been modified, among other factors, company might consider whether: IFRS 15 Software contract modifications

  • the terms and conditions of the new contract were negotiated separately from the original contract, and
  • the additional goods or services were subject to a competitive bid process, and IFRS 15 Software contract modifications
  • any discount to the stand alone selling price of the additional goods or services is attributable to the original contract.

Modifications are accounted for as either a separate contract or as part of the existing contract (either prospectively or through a cumulative catch-up adjustment). This assessment is driven by whether: IFRS 15 Software contract modifications

  1. the modification adds distinct goods and services and IFRS 15 Software contract modifications
  2. the distinct goods and services are priced at their stand alone selling prices.

Modification accounted for as a separate contract

A modification is accounted for as a separate contract if the additional goods or services are distinct and the contract price increases by an amount that reflects the stand alone selling price of the additional goods or services. The guidance provides some flexibility to adjust the stand alone selling price to reflect contract-specific circumstances. For example, a company might provide a discount to a recurring customer that it would not provide to a new customer because it does not incur the same selling-related costs.

Modification accounted for prospectively

The modification is accounted for as if it were a termination of the original contract and the creation of a new contract if the additional goods or services are distinct, but the price of the added goods or services does not reflect stand alone selling price. Any unrecognised revenue from the original contract and the additional consideration from the modification is combined and allocated to all of the remaining performance obligations under the original contract and modification. IFRS 15 Software contract modifications

IFRS 15 Software contract modifications

Modification accounted for through a cumulative catch-up adjustment

If the added goods or services are not distinct and are part of a single performance obligation that is only partially satisfied when the contract is modified, the modification is accounted for through a cumulative catch-up adjustment.

CASE – Contract modifications

Facts: Cloud Co. enters into a three-year service contract with Customer for $450,000 ($150,000 per year). The stand alone selling price for one year of service at inception of the contract is $150,000 per year. Cloud Co. concludes the contract is a series of distinct services.Considerations for cloud arrangements

At the end of the second year, the parties agree to modify the contract as follows:

  • The fee for the third year is reduced to $120,000
  • Customer agrees to extend the contract for another three years for $300,000 ($100,000 per year)

The stand alone selling price for one year of service at the time of modification is $120,000, taking into account the contract-specific circumstances.

How should Cloud Co. account for the modification?

Analysis: The modification would be accounted for as part of the existing contract on a prospective basis (as if the original arrangement was terminated and a new contract created) because the additional services to be provided are distinct, but the price of the contract did not increase by an amount of consideration that reflects the stand alone selling price of the additional services.

Cloud Co. should reallocate the remaining consideration of $120,000 and the new consideration of $300,000 to all of the services to be provided (obligations remaining from the original contract and the new obligations). Cloud Co. will recognize a total of $420,000 ($120,000 + $300,000) over the remaining four-year service period (one year remaining under the original contract plus three additional years), or $105,000 per year.

IFRS 15 Software industry revenue from contracts with customers

1. Identify the contract

Under the new revenue standards, a contract may be written, oral, or implied by the vendor’s customary business practices. Generally, any agreement with a customer that creates legally enforceable rights and obligations meets the definition of a contract under the new guidance. Software companies should consider any side agreements, whether verbal or written, as these may create enforceable rights and obligations and have implications for revenue recognition.

In the software industry, a contract may take the form of formal signed contracts, purchase orders, electronic communications, or, in the case of consumer products, sales receipts. Master agreements often define all of the basic terms and conditions for transactions between the parties.

A second communication in the form of a purchase order or electronic request that specifies the software products, quantities, and requested delivery dates often supplements the master agreement. In these cases, the master agreement and the additional communication constitute the contract with the customer because the quantities specified create enforceable rights and obligations between the two parties.

2. Identify performance obligations

Software arrangements are typically comprised of: IFRS 15 Software contract modifications

  • Multiple goods and services, such as software licenseSoftwares IFRS 15 Software contract modifications
  • Unspecified or specified future updates or upgrades / enhancements IFRS 15 Software contract modifications
  • Specified or unspecified additional software products IFRS 15 Software contract modifications
  • Exchange and platform transfer rights IFRS 15 Software contract modifications
  • Post-contract customer support (PCS) IFRS 15 Software contract modifications
  • Installation IFRS 15 Software contract modifications
  • Other professional services IFRS 15 Software contract modifications

The goods or services promised in a contract with a customer may be explicitly stated in the arrangement or implied by the software vendor’s customary business practices. The new revenue guidance requires companies to consider whether the customer has a valid expectation that the vendor will provide a good or service when it is not explicitly stated. If the customer has a valid expectation, the customer would view those promises as part of the goods or services in the contract. IFRS 15 Software contract modifications

A promised good or service must be distinct to be accounted for as a separate performance obligation when there are multiple promises in a contract. A good or service is distinct if (1) the customer can benefit from the good or service either on its own or together with other readily available sources (that is, it is capable of being distinct) and (2) if the good or service is separately identifiable from the other promises in the contract (that is, distinct in the context of the contract). Determining whether a good or service is distinct may require significant judgment.

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Under the new guidance, how to identify separate performance obligations is a significant change for companies in the software industry. The new guidance eliminates current software industry-specific guidance under US GAAP (which was often applied by analogy under IFRS) and thus, vendor specific objective evidence (VSOE) of fair value is no longer required to separately account for elements in a software licensing arrangement. As a result, companies that couldn’t separately account for elements due to a lack of VSOE may recognize revenue earlier.

License is not distinct
When a license is not distinct from the other goods or services, the company will need to determine whether the combined performance obligation is satisfied (1) over time or (2) at a point in time.

License is distinct
Under US GAAP, for licenses that are distinct, the licensor will need to determine if the license provides a right to use the IP or a right to access the IP, as this will determine whether revenue allocated to the license should be recognized at a point in time or over time. ASC 606 defines two categories of IP, functional and symbolic, for purposes of assessing whether a license is a right to use or a right to access IP. IFRS 15 Software contract modifications

Similarly, under IFRS, for licenses that are distinct, the licensor will need to determine whether the license is a right to use or a right to access IP. This assessment is based on whether the licensor’s activities significantly change the IP to which the customer has rights. IFRS 15 Software contract modifications

Commonly, the outcome of applying ASC 606 and IFRS 15 in determining the nature of a license will be similar; however, there may be limited instances when the conclusions could differ.

Sales- or usage-based royalties in exchange for IP will also impact revenue recognition under the new guidance for both US GAAP and IFRS reporters.

Restrictions on time, geography, or use IFRS 15 Software contract modifications
All software licenses contain provisions that specify the licensee’s rights with respect to the use of the IP. For example, a license could stipulate that the IP can only be used for a specified term or only to sell products in a specified geographical region. The new revenue guidance requires companies to distinguish between (1) contractual provisions that define the attributes of a license of IP and (2) provisions that represent additional promised goods or services to the customer. IFRS 15 Software contract modifications

Contractual provisions that are attributes of a single promised license define the scope of a customer’s rights to IP and do not affect the number of performance obligations or whether a performance obligation is satisfied at a point in time or over time. IFRS 15 Software contract modifications

ASC 606 and IFRS 15 use different words to explain how contractual restrictions may impact the number of promises in a contract. The FASB included additional examples related to license restrictions. We believe the concepts in the two standards are similar; however, companies may reach different conclusions under the two standards given that US GAAP contains more specific guidance.

3. Determine transaction price

The transaction price in a contract reflects the amount of consideration to which the software vendor expects to be entitled in exchange for goods or services transferred. The transaction price includes only those amounts to which the company has enforceable rights under the present contract. Management must take into account consideration that is variable, non-cash consideration, and amounts payable to a customer to determine the transaction price. Management also needs to assess whether a significant financing component exists.

Variable consideration IFRS 15 Software contract modifications
Determining the transaction price is more straightforward when the contract price is fixed, but is more complex when the arrangement includes a variable amount of consideration. Consideration that is variable includes, but is not limited to, discounts, rebates, price concessions, refunds, credits, incentives, performance bonuses, and royalties. Management must estimate the consideration to which it expects to be entitled to determine the transaction price and to allocate consideration to performance obligations.

Under the new guidance, variable consideration is only included in the estimate of transaction price up to an amount that is probable (US GAAP) or highly probable (IFRS) of not resulting in a significant reversal of cumulative revenue in the future. While different terminology is used under IFRS, it is intended in this situation to have the same meaning as in US GAAP.

Extended payment terms IFRS 15 Software contract modifications
Software companies may offer payment terms that extend over a substantial portion of the period during which the customer is expected to use or market the software. Extended payment terms should be considered when assessing the customer’s ability and intent to pay the consideration when due, and may impact the vendor’s assessment of whether the collectibility criteria is met in Step 1 (discussed on page 2), and therefore, whether a contract exists. Software vendors should also determine if there is a possibility of a future price concession, which may lead to the conclusion that the transaction price is variable. IFRS 15 Software contract modifications

The new guidance differs from current US GAAP guidance in which payment terms beyond one year typically preclude revenue from being recognized because there is a presumption that the fee is not fixed or determinable. Although there is no similar guidance under current IFRS, companies are required to evaluate whether the inflow of benefits was probable. As a result, companies that provide extended payment terms might recognize revenue earlier under the new guidance. IFRS 15 Software contract modifications

Extended payment terms could also indicate that the arrangement includes a significant financing component that would need to be accounted for separately. A significant financing component does not exist, however, when the difference between the promised consideration and the cash selling price arises for reasons other than financing. This may occur, for example, when the intent of extended payment terms was to ensure that the vendor performs as specified under the arrangement rather than to provide financing to the customer.

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Service level agreements IFRS 15 Software contract modifications
Service level agreements (SLAs) are a form of guarantee frequently found in contracts with customers. SLA is a generic description often used to describe promises by a vendor that could include a guarantee of a product’s or service’s performance or a guarantee of warranty service response rates. SLAs are commonly used by companies that sell products or services that are critical to the customer’s operations in which the customer cannot afford to have product failures, service outages, or service interruptions.

For example, a vendor might guarantee a certain level of “uptime” for a network, say 99.999%, or guarantee that service call response times will be within a defined time limit. SLAs might also include penalty clauses triggered by breach of the guarantees. IFRS 15 Software contract modifications

The terms and conditions of the SLA determine the accounting model. SLAs that are warranties should be accounted for under the warranty guidance of IFRS 15. SLAs that could result in payments to a customer (e.g., refunds or penalties) should generally be accounted for as variable consideration. IFRS 15 Software contract modifications

4. Allocate transaction price

Many contracts involve the sale of more than one good or service. For example, they might involve the sale of multiple goods, goods followed by related services, or multiple services. The transaction price in an arrangement must be allocated to each separate performance obligation based on the relative standalone selling prices (SSP) of the goods or services being provided to the customer. The allocation could be affected by variable consideration or discounts. IFRS 15 Software contract modifications

The best evidence of SSP is the price a company charges for that good or service when the company sells it separately in similar circumstances to similar customers. However, goods or services are not always sold separately. The SSP needs to be estimated or derived by other means if the good or service is not sold separately. This estimate often requires judgment, such as when specialized goods or services are sold only as part of a bundled arrangement. IFRS 15 Software contract modifications

The new standards do not prescribe or prohibit any method for estimating SSP as long as the method results in an estimate that faithfully represents the price a company would charge for good or services sold separately. The standards provide three examples of methods a company might use to estimate SSP: (1) adjusted market assessment approach, (2) expected cost plus a margin approach, and (3) residual approach. IFRS 15 Software contract modifications

Companies who do not separately account for elements in a software arrangement due to a lack of VSOE of fair value under current US GAAP software guidance may need to develop new processes for estimating SSP under the new standards. IFRS 15 Software contract modifications

Standalone selling price for software licenses and post-contract customer support IFRS 15 Software contract modifications
SSP for certain software products or services may not be directly observable and may need to be estimated because it is common practice in the software industry for vendors to bundle their software licenses together with other products and services. For example, some vendors may often, or even always, license software bundled together with post-contract customer support (PCS), professional services, or hosting.

There is no hierarchy for how to estimate SSP for goods or services that are not sold separately. A vendor should not presume that a contract price or list price for a product or service represents SSP although these prices may be a factor to consider in determining SSP.

Both term licenses and perpetual licenses are typically bundled with PCS. To determine the SSP of PCS bundled with a term license, a company should consider all observable evidence, which may include the SSP of PCS related to a perpetual license (i.e., the renewal price for PCS in a perpetual license arrangement). IFRS 15 Software contract modifications

The company should consider whether any adjustments are required to reflect the differences between the pricing of PCS with term licenses versus perpetual licenses. SSP could be based on a percentage of the license fee rather than a dollar amount, if the use of a percentage best reflects the company’s pricing practices.

Range of prices for determining SSP IFRS 15 Software contract modifications
Consistent with practice today, commonly a company may use a range of prices when determining SSP, provided that the range reflects reasonable pricing of each product or service as if it were priced on a standalone basis for similar customers. When the contractual price of a good or service falls outside of the range, companies should apply a consistent method to determine the standalone selling price within that range for that good or service (e.g., the midpoint of the range or the outer limit closest to the stated contractual price).

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Residual approach IFRS 15 Software contract modifications
The residual approach involves deducting from the total transaction price the sum of the observable SSPs of other goods and services in the contract to estimate SSP for the remaining goods and services. This approach is an estimation methodology, not an allocation methodology like the residual method applied under current US GAAP and IFRS guidance.

Under the new guidance, the residual approach is only permitted if the selling price of a good or service is highly variable or uncertain. Before utilizing this approach, management should first consider the overall principle that a company should maximize the use of observable data and should assess whether another method provides a reasonable method for estimating SSP.

Even when the residual approach is used, management still needs to consider whether the results achieve the objective of allocating the transaction price based on standalone selling prices. For example, if the residual method results in allocating little or no consideration to a performance obligation, this method would not be appropriate.

Allocating discounts and variable consideration IFRS 15 Software contract modifications
The transaction price should be allocated to each performance obligation based on the relative standalone selling prices of the goods or services provided to the customer. Discounts and variable consideration are typically allocated to all of the performance obligations in an arrangement based on their relative standalone selling prices. However, if certain criteria are met, a discount or variable consideration is allocated to only one or more performance obligations in the contract rather than to all performance obligations.

5. Recognize revenueRevenue from maintenance services

A performance obligation is satisfied and revenue recognized when control of the promised good or service is transferred to the customer. A customer obtains control of a good or service if it has the ability to (1) direct the use of and (2) obtain substantially all of the remaining benefits from that good or service.

Directing the use of an asset refers to a customer’s right to deploy that asset, allows another company to deploy it, or restrict another company from using it.

Management should evaluate transfer of control primarily from the customer’s perspective, which reduces the risk that revenue is recognized for activities that do not transfer control of a good or service to the customer. IFRS 15 Software contract modifications

As discussed, a software license generally represents a right to use IP for which revenue is recognized at the point in time that control of the license transfers to the customer. This occurs when a customer is able to use and benefit from the license, but not before the beginning of the stated license period. IFRS 15 Software contract modifications

There are various ways a customer may take control of a software license. Control may transfer when the customer takes possession of the software by physical receipt, download, or receipt of an access code or license key that provides the customer the ability to immediately take possession of the software. IFRS 15 Software contract modifications

Temporary keys IFRS 15 Software contract modifications
Sometimes vendors deliver temporary keys that can be turned off by the vendor or that automatically expire if the customer does not pay the vendor.

The vendor would likely be able to recognize revenue when the temporary key is provided if the vendor has a customary business practice of using temporary keys for this purpose; however, selective issuance of temporary keys might indicate software is being used only for demonstration purposes or on a trial basis. In these cases, the customer does not have control over the software and revenue recognition would be precluded. IFRS 15 Software contract modifications

Software license combined with other goods or services IFRS 15 Software contract modifications
When a software license is not distinct and is combined with other goods or services (such as implementation services or PCS) in a contract, the company needs to assess whether control of the combined performance obligation transfers to the customer at a point in time or over time. IFRS 15 Software contract modifications

If the combined performance obligation qualifies for over time recognition, the company will measure its progress toward completion by selecting a single input or output method that best reflects the transfer of control of the goods or services.

IFRS 15 Software contract modifications

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