Keywords: Mazars, Thailand, IFRS, Revenue Recognition, IASB, IFRS 15, FASB, Intellectual Property, US GAAP, IAS 11, IAS 18
16 November 2015
These proposals relate to:
- The identification of performance obligations;
- The agent versus principal distinction;
- Licences; and
- Additional practical expedients for transitional requirements.
These proposals are in essence a response to the discussions held in the Transition Resource Group. Subsequently, these subjects have been discussed either during joint meetings of the IASB and the FASB, or by each of the boards individually.
The proposed amendments eventually published by the IASB are not totally in line with those issued by the FASB following its separate call for comments. There is therefore a risk that the originally converged standards (IFRS 15 and Topic 606) will ultimately differ. Therefore, even if the major principles underlying the model of revenue recognition are not affected by these proposals, there will be some limited situations in which divergences may appear. However, the amendments proposed on either side of the Atlantic are yet to be confirmed in the light of calls for comments and further redeliberations.
i) Identification of performance obligations
The IASB proposes to add examples without amending the body of the standard.
The aim is to clarify when several goods and services promised in a contract with a customer are “distinct” in accordance with IFRS 15, which would entail the recognition of several performance obligations.
In particular, the IASB hopes to clarify the concept of “distinct in the context of the contract” (see IFRS 15.27(b) and the indicators in paragraph 29) which is difficult to grasp in practice and which requires the exercise of considerable judgment.
The examples that will be added to the standard address the following circumstances:
- Sale of multiple units of a highly complex, specialised device;
- Sale of a good with the related installation services;
- Any contractual restrictions preventing a customer from having another entity perform the installation after the sale of a good;
- Sale of equipment and the consumables necessary to its use.
In the first of these instances, the sale of multiple units of a highly complex, specialised device, the IASB’s proposal is striking, since this example concludes that this series of identical goods corresponds to a single performance obligation of goods that are not distinct, because the entity is responsible for the overall management of the contract (including the identification of suppliers, supervising production, etc.) and for integrating various goods and services (the inputs) to produce the full complement of devices (the combined output) for which the customer has contracted. This reading seems contestable because each device operates independently of the others. It should also be noted that this example does not address the question of whether the control of each device is transferred over time or at a point in time (if control is transferred over time, the guidance on series of distinct goods and services in IFRS 15 applies, and the devices correspond de facto to a single performance obligation). The IASB therefore probably needs to explain better how this example is in line with the existing principles in the standard, and what its scope will be.
The FASB instead proposes to re-word the indicators used to determine whether a good or service is distinct “in the context of the contract”, while not changing the underlying principle.
The FASB also proposes to indicate in the standard that a good or a service that is immaterial in the context of the contract may not be identified, so that it is ignored when determining what performance obligations are accounted for separately. For its part, the IASB believes that IFRS preparers are capable of implementing the principle of materiality and that such an amendment is unnecessary.
Finally, the FASB proposes that shipping and handling activities carried out for a customer in conjunction with a good sold and of which the customer has previously taken control may not be considered as separate services to which revenue should be allocated at inception. US GAAP entities would therefore have an accounting policy choice in this matter. The IASB has refused to introduce this practical expedient, so divergences could well appear in this area.
ii) Agent versus principal distinction
The provisions on whether an entity acts as an agent or principal can be found in the IFRS 15 application guidance, starting in paragraph B34. This paragraph states that when a third party engages in the provision of goods or services to an entity’s end customer, the entity must determine whether it has an obligation:
- to provide the specified goods or services itself (in which case it is acting as a principal); or
- to arrange for the third party to provide those goods or services (meaning that the entity acts as an agent).
While IFRS 15 carries over the indicators in the existing IAS 18 application guidance on the agent / principal distinction, some think that it is not clear whether the previous conclusions need to be reconsidered in the light of the general approach of IFRS 15, which is that an entity is a principal if it controls the promised good or service before its transfer to the customer. The implementation of this principle may be particularly complex in the case of transactions involving intangible goods or services.
The clarifications proposed by the IASB are identical to those put forward by the FASB, and relate to:
- Clarification that the analysis of the entity’s “role” (agent or principal) must be carried out for each separately recognised performance obligation (i.e. for each specified good or service);
- The nature of the specified good or service where the entity acts as principal. In practice this may be:
- a good or another asset from the other party that it then transfers to the customer;
- a right to a service to be performed by the other party, which gives the entity the ability to direct that party to provide the service to the customer on the entity’s behalf; or
- a good or service from the other party that it then combines with other goods or services in providing the specified good or service to the customer. The exposure draft therefore establishes that if an entity provides a significant service of integrating goods or services, it controls the specified good or service integrating the assets obtained from another party before that good or service is transferred to the customer. This clarification may end discussion in many situations where an entity provides a service of integrating elements which have been produced by subcontractors or co-contractors.
- Amendment of the indicators in paragraph B37 to present them from the point of view of the principal rather than the agent (this was the point of view adopted in IAS 18). Further, while these indicators still address the same issues (for example, who is exposed to the customer credit risk for the transaction price of the specified goods or services), they have been reworded to emphasise their relationship with the principle of the transfer of control. Finally, the amendment notes that these indicators may be more or less relevant depending on the nature of the specified good or service, and that different indicators may provide more persuasive evidence in different contracts.
- The addition of illustrative examples.
Distinction between right to access and right to use the entity’s intellectual property
IFRS 15 requires entities to determine whether an entity’s promise to grant a licence to a customer consists of granting a right to access the entity’s intellectual property (a “dynamic” licence) or a right of use of its intellectual property (a “static” licence). In the first case, revenue is recognised over time, as the performance obligation is satisfied. In the second case, revenue is accounted for at a point in time.
To make the distinction between dynamic and static licences, IFRS 15 as published in May 2014 identified conditions for the identification of dynamic licences:
- The contract requires or the customer reasonably expects that the entity will undertake activities that significantly affect the intellectual property to which the customer has rights;
- the rights granted by the licence directly expose the customer to any positive or negative effects of the entity’s activities;
- those activities do not transfer a good or a service to the customer as those activities occur.
It is the first of these conditions which has raised the most practical questions.
The IASB proposes to clarify this subject by indicating that an entity’s activities materially affect its intellectual property when:
- those activities are expected to change the form (for example, the design) or the functionality (for example, the ability to perform a function or task) of the intellectual property to which the customer has rights;
- the customer’s ability to obtain benefit from the intellectual property to which it has rights is substantially derived from or dependent on those activities. For example, the benefit of a brand is often derived from or dependent upon the entity’s ongoing activities that support or maintain the value of the intellectual property.
It will also be clarified that in the case of intellectual property that has significant stand-alone functionality, it can be expected that the intellectual property would not be significantly affected by the entity’s activities unless those activities change that underlying functionality.
The FASB goes much further in its amendment proposals, by introducing a distinction between “functional” intellectual property (intellectual property with significant stand-alone functionality) and “symbolic” intellectual property (which has no significant stand-alone functionality). Substantially all of the utility of symbolic intellectual property derives from the entity’s past or ongoing activities, including its ordinary business activities. The FASB has produced a decision tree showing that symbolic intellectual property corresponds to a right to access the entity’s intellectual property, so revenue will be recognised over time.
Although the application of the guidance proposed by the two boards is only likely to result in different treatment in a few cases (for example, where an entity makes available a right to use a brand even though there is no expectation that it will undertake any further activities), it must be recognised that the FASB is proposing radical changes in a complex area that was discussed at great length before the converged standard was first published. It is not impossible that further unintended consequences of this amendment will emerge in due course.
Determining when an entity should assess the nature of a licence
Under some circumstances, it may have originally been considered that the grant of a licence of intellectual property did not correspond to a performance obligation distinct from other goods or services promised in the contract. In this instance, the question is whether the nature of the licence should nevertheless be assessed in order to know how to recognise the revenue for a performance obligation including the grant of a licence of intellectual property, where this is a significant part of the performance obligation under consideration.
The IASB has decided not to modify IFRS 15 in this respect, regarding the guidance currently provided in the standard, including the basis for conclusions, as adequate.
However, the FASB has decided to clarify in Topic 606 that, in some cases, an entity would need to determine the nature of a licence that is not a separate performance obligation in order to apply satisfactorily the general principles of revenue recognition (i.e. in order to determine whether revenue is to be recognised over time or at a point in time) to a performance obligation that includes the transfer of several goods or services including the grant of a licence of intellectual property.
Sales-based or usage-based royalties
The IASB and the FASB have both decided to clarify the scope and applicability of the application guidance on sales-based or usage-based royalties received in exchange for a licence of intellectual property. This guidance is an exception to the general approach to estimating variable consideration that states that an entity must recognise such revenue only to the extent that it is ‘highly probable’ that a significant reversal in the amount of cumulative revenue recognised will not occur. An entity shall recognise revenue for a sales-based or usage-based royalty promised in exchange for a licence of intellectual property only when (or as) the later of the following events occurs:
- the sale or usage occurs; and
- the performance obligation to which the sales-based or usage-based royalty is allocated has been satisfied (or partially satisfied).
The exposure draft issued by the IASB (and by the FASB) clarifies that:
- where a contract concluded with a customer includes the grant of a licence of intellectual property and the transfer of other goods or services, an entity should not split a single royalty into a portion subject to the sales-based or usage-based royalties exception and a portion subject to the general guidance on variable consideration (including the constraint on variable consideration);
- the sales-based or usage-based royalties exception should apply whenever the predominant item to which the royalty relates is a licence of intellectual property.
iv) Additional practical expedients for transitional requirements
Two additional practical expedients have been proposed to IFRS preparers in the case of the full retrospective approach:
- Entities are allowed not to restate completed contracts as defined in IFRS 15 (i.e. contracts for which the entity has transferred all the goods or services identified in accordance with IAS 11 Construction contracts, IAS 18 Revenue and the associated interpretations) at the beginning of the first comparative period presented;
- Entities are not obliged to account retrospectively for contracts modified before the transition date (which would have involved restating these contracts from inception and accounting for the effects of each successive modification). In practice, this would mean that at the beginning of the first comparative period presented, an entity could reflect the aggregate effect of these modifications in order to:
- identify the satisfied and unsatisfied performance obligations at this date;
- determine the transaction price and allocate it to the various performance obligations identified.
The additional practical expedient for contract modifications would also be available to preparers opting for the alternative transition method (i.e. in determining the impact of transition to IFRS 15 at the beginning of the first period in which the standard is applied).
The concept of “completed contracts” was discussed in July 2015 by the TRG and disagreement arose between the US and IFRS members of the group. It has been debated since, by the FASB at the end of August and by the IASB at its September 2015 meeting. The FASB decided to propose to amend the definition of a completed contract to clarify that this is a contract for which all or almost all the associated revenue has been accounted for in accordance with the previous standards on revenue. The IASB decided not to go down that path, and has retained the existing IFRS 15 definition of a completed contract. According to the staff, the concept of “transfer” relates to the delivery of goods (or the rendering of services) under IAS 18. Thus, a contract would be completed if, under the existing standard, an entity has delivered all the goods or rendered all the services that it had identified under this same standard, even if revenue has not been recognised for reasons such as uncertainties as to collectability.
The mandatory effective date of these amendments (which will be applied retrospectively) will be based on the new mandatory application date of IFRS 15, namely 1 January 2018.
The IASB’s exposure draft can be assessed on the IFRS’s website.
The IASB hopes that the definitive IFRS 15 amendments will be finalised by the end of the year. It does not anticipate that any further amendments to IFRS 15 will be required between now and its entry into force on 1 January 2018.