Article:

IFRS 15 for the TMT industries – Timing of revenue recognition

27 June 2018

Is revenue recognised at a point in time or over time?

IFRS 15 contains specific, and more precise guidance to be applied in determining whether revenue is recognised over time (often referred to ‘percentage of completion’ under existing standards) or at a point in time.

The general principle is that revenue is recognised at a point in time. However, if any of the criteria in IFRS 15, paragraph 35 are met, revenue should be recognised over time. The following decision tree is a useful tool to determine whether revenue should be recognised at a point in time or over time.

If revenue is recognised at a point in time, how should that point in time be determined?

If revenue is recognised at a point in time, the overall principle is that revenue should be recognised at the point in time at which it transfers control of the good or service to the customer. The following indicators should be considered to determine whether control of an asset or service has been transferred:

  • Does the customer have a present right to payment for the asset?
  • Does the customer have legal title to the asset?
  • Has the entity transferred physical possession of the asset to the customer?
  • Does the customer have significant risks and rewards of ownership of the asset?
  • Has the customer accepted the asset?

If revenue is recognised over time, how should progress towards completion be measured and recognised?

If revenue is recognised over time, the overall principle is that revenue is recognised to the extent that each of the vendor’s performance obligations has been satisfied.

IFRS 15 permits either output or input methods to be used to calculate the amount of revenue to be recognised. An output method results in revenue being recognised on the basis of direct measurement of the value of goods or services transferred to date, while input methods result in revenue being recognised based on measures such as resources consumed, costs incurred or machine hours.

It is noted explicitly that when input methods are used, there may not be a direct relationship between the inputs being used, and the transfer of goods or services to a customer.  Consequently, any inputs that do not relate directly to the vendor’s performance in transferring those goods and services are excluded when measuring progress to date.

In addition, the guidance extends to cover not only revenue recognition, but also profit recognition. For example, a contract for the design and implementation of a new software package might involve the vendor procuring high value items for installation, such as servers and other IT equipment.  IFRS 15 takes the view that although it is appropriate to recognise revenue from the sale of the equipment at the point at which control is transferred to the customer, it is not appropriate to recognise profit.  This is because the vendor’s performance obligations are in connection with the design and implementation of the new software package and not the supply of items such as servers and other IT equipment; this supply does not result in any part of the design and implementation services being provided. Consequently, in many cases the vendor would recognise an equal amount of revenue and cost of sales for the servers and IT equipment, with profit margin only being recognised on the design and implementation services.

Example 1 – Software

Background

A customer engages Software Co. to build a software program from scratch. It is highly customised to the customer and would require a significant amount of time to modify it so that it could be used by other customers. Software Co. is developing this software on its own servers, to be handed to the customer once completed.

Software Co. operates in a jurisdiction where it has a legally enforceable right to payment from the customer should the customer terminate the contract.

Question
Would Software Co. recognise revenue at a point in time or over time?

Answer
The first two criteria in the decision tree above are not relevant to this fact pattern, so the timing of revenue recognition by Software Co. depends on the third criterion in IFRS 15, paragraph 35, i.e. whether there is no alternative use for the software by Software Co., and whether Software Co. has an enforceable right to payment for performance completed to date. 

Software Co. would account for its revenue over time because:

  • It is creating an asset with no alternate use (the software is specifically customised to the customer and it could not easily be sold to another party), and
  • It also has a legally enforceable right to payment.

The assessment of whether Software Co. has a legally enforceable right to payment is highly dependent on the legal system which it operates in. There are different laws and regulations for each state within Australia, although the legal framework and principles which underpins contract law is very similar. Entities would need to assess the enforceable right to payment on a contract by contract basis because each agreement will be different, and even identical agreements may have different outcomes in different legal jurisdictions (such as states).

Example 2 – Software

Background

A customer wishes to purchase a copy of Software Co.’s software program. There is no special customisation required and Software Co. would be able to sell the software to another customer at little or no additional cost.

Question
Would Software Co. recognise revenue at a point in time or over time?

Answer
As for Example 1 above, the first two criteria in the above decision tree are not relevant to this fact pattern, so the timing of revenue recognition by Software Co. depends on the third criterion in IFRS 15, paragraph 35, i.e. whether there is no alternative use for the software by Software Co., and whether Software Co. has an enforceable right to payment for performance completed to date. 

In this case, Software Co. would recognise revenue at point in time when the software is provided to the customer because there is an alternative use for the software (i.e. Software Co. is able to sell the software to another customer for minimal additional cost). The entity would therefore fulfil their performance obligation when the software is delivered. 

Current practice under IAS 18

The current practice under IAS 18 is varied between the two options but IFRS 15 contains more guidance about when revenue should be recognised over time or at a point in time.  

Example 3 – Software – Input method to recognise revenue over time

Background

On 1 January 2018, a customer engages Software Co. to build a software program from scratch for $500,000. It is highly customised and would require significant time to modify it so that it can be used by other customers.

Software Co. operates in a jurisdiction where it has a legally enforceable right to payment. It has determined that it should recognise the sale of the software over time.

Software Co. budgets for this project by estimating the total hours the programmer will require to complete the software. At 30 June 2018, the project has not yet been finished but the programmer has spent 200 hours out of a budgeted 500 hours. 

Question
How should Software Co. recognise revenue at 30 June 2018?

Answer
Software Co. would account for its revenue over time because:

  • It is creating an asset with no alternate use (the software is specifically customised to suit the customer's needs and it could not easily be sold to another party), and
  • It also has a legally enforceable right to payment.

Software Co. then needs to use an appropriate method to recognise revenue over time. It could measure revenue in reference to the hours incurred as a % of budgeted costs or hours (input method). This is the most reliable method of measuring revenue based on the information available.

  Costs (Hours) Revenue ($)
Total 500 500,000
Incurred 200 200,000
($500,000 x (200 hours/500 hours))

 $200,000 of revenue would therefore be recognised as at 30 June 2018.

Practical implications on systems and processes 

Some of the practical implications on systems and processes for Software Co. include:

  • Processes needed to identify the appropriate revenue recognition pattern using specific fact patterns for each transaction
  • Systems to calculate ‘over time’ or ‘point in time’ revenue recognition
  • Systems to isolate significant amounts of ‘uninstalled materials’ such as servers and large pieces of IT equipment which are not proportionate to the entity’s progress in satisfying its performance obligation
  • Systems to recognise revenue and account for timing differences between payment/invoicing and revenue.