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Chapter 8: Licences
A licence arrangement establishes a customer’s rights related to an entity’s intellectual property (‘IP’) and the obligations of the entity to provide those rights. Common licences are:
- software and technology;
- motion pictures,
- music and copyrights;
- patents and trademarks; and
- trade names and franchises.
Management should assess each arrangement where licences are sold with other goods or services, to conclude whether the licence is distinct and therefore a separate performance obligation. For licences that are bundled with other goods or services, management will apply judgement to assess the nature of the combined item and determine whether the combined performance obligation is satisfied at a point in time or over time.
Sales of goods incorporating intellectual property
In various industries, it’s customary for an entity to vend a product, such as a book, CD, or game, which comprises wholly or partially reproduced intellectual property, like the text of a novel, a song, or the mechanics of a game (referred to as a ‘copyrighted work’).
In many jurisdictions, such as under the US First Sale Doctrine, the buyer is allowed to resell their individual copy of the product but not to utilize it as a template for producing duplicate goods (i.e., selling a second-hand book is permissible, but making copies for resale would infringe copyright law).
Even though there’s a license to intellectual property included in the product, the asset conveyed to the customer and over which the customer gains control is the single copy (e.g., the individual book) purchased. This is demonstrated by the fact that the original purchaser of the goods holds no rights to the underlying intellectual property beyond those included in the purchased copy and relinquishes all such rights if they sell or otherwise transfer the associated good to another party. Consequently, such transactions should be deemed as sales of goods rather than licenses of intellectual property, and the general guidance in IFRS 15 should be applied similarly to other sales of goods.
Interaction of sales-based and usage-based royalty exception with measuring progress for an over time licence
IFRS 15 specifies that revenue for a sales- or usage-based royalty promised in exchange for a licence of intellectual property is recognised only when (or as) the later of the following events occurs:
(a) the subsequent sale or usage occurs; and
(b) the performance obligation to which some or all of the sales- or usage-based royalty has been allocated has been satisfied (or partially satisfied).
Accordingly, to the extent that sales or usage (criterion (a)) is judged to occur in advance of satisfaction of the performance obligation over time (criterion (b)), the sales- or usage-based royalty payments that have become receivable should be recognised as a contract liability (and the related revenue recognised in a later period when the performance obligation is satisfied). Whether this is the case will depend on an analysis of the specific facts and circumstances. It will often be helpful to consider whether the structure of the royalty payments appropriately depicts progress toward satisfying the entity’s performance obligation in providing access to the entity’s intellectual property throughout the licence period. If the structure of the royalty payments does appropriately reflect such progress, then the criteria set out in IFRS 15 will coincide, and revenue will be recognised as the royalties payments fall due.
Whilst satisfaction of criterion (a) and the related amount will essentially be a matter of fact (actual sales or usage multiplied by the applicable royalty rate), judgement will typically be required to determine the extent to which criterion (b) is satisfied. In particular, it will be important to identify an appropriate measure of progress toward complete satisfaction of the entity’s obligation under the agreement, in accordance with IFRS 15. Once this is established, the requirement in IFRS 15:B63 should then be applied to determine whether any revenue from royalties that have fallen due, based on sales or usage, exceeds the amount of revenue determined by applying the identified measure of progress. If so, that excess should be deferred and recognised as a contract liability.
Note that IFRS 15:B63 requires revenue to be recognised on occurrence of the later of the events described in IFRS 15:B63(a) and (b). Consequently, it is never possible to recognise revenue in an amount greater than the sales- or usage-based royalties that are owed to the entity, even if royalty rates have been back-end loaded so that royalties lag behind the measure of progress identified.
Licences that provide a right to use an entity’s IP
Licences that do not meet all three criteria to be accounted for as a right to access IP are accounted for as a right to use IP. Revenue is recognised in those circumstances at a point in time. The customer is able to direct the use of, and obtain substantially all of the benefits from, the licence at the time that control of the licence is transferred to the licensee.
Licence that provides a right to use IP
Entity F provides a fixed-term software licence to entity G. The terms of the arrangement allow entity G to download the software by using a unique digital key provided by entity F. Entity G can use the software on its own server. The software is functional when it transfers to entity G. Entity G also purchases post-contract customer support (PCS) with the software licence. There is no expectation for entity F to undertake any activities other than the PCS. The licence and PCS are distinct, as entity G can benefit from the licence on its own, and the licence is separable from the PCS.
Question
What is the nature of the licence in this arrangement?
Answer
PCS is not considered an ‘activity’ that affects the IP because it is a separate performance obligation. The IP has significant stand-alone functionality and entity F is not expected to perform any activities that affect that functionality. Therefore, entity F does not perform activities that significantly affect the IP to which the customer has rights. The three criteria required for a right to access IP over time are not met. The licence is a right to use IP. Entity F would recognise revenue at a point in time when entity G is able to use and benefit from the licence (no earlier than the beginning of the licence term). PCS is a separate performance obligation in this arrangement and does not impact the assessment of the nature of the licence.
Factors that do not impact the nature of the licence
Many contracts include specifications or restrictions on the licence that do not impact the nature of the licence. The following provisions should not be considered when assessing the nature of the licence provided:
- Restrictions of time, geographical region, or use. However, entities need to apply significant judgement to first assess whether a contract includes multiple licences that represent separate performance obligations or a single licence with contractual restriction. Contractual restrictions of time, geography, or use within a single licence are attributes of that licence. Restrictions in a single licence therefore do not impact whether the licence is a right to access or a right to use IP or the number of promised goods or services.
- Guarantees to defend a patent are also disregarded in the assessment of whether a licence is a right to use or a right to access IP. Maintaining a valid patent and defending that patent from unauthorised use are important aspects in supporting an entity’s IP. However, the guarantee is not a performance obligation or an activity for the purpose of assessing the nature of a licence. It represents assurance that the customer is utilising a licence with the contractually agreed-upon specifications.
Licences and payment terms
Licences are often long-term arrangements and payment schedules between a licensee and licensor might not coincide with the pattern of revenue recognition. Payments made over a period of time do not necessarily indicate that the licence provides a right to access the IP. Management will need to consider whether a significant financing component exists when the time between recognition of revenue and cash receipt (other than sales- or usage-based royalties) is expected to exceed one year.
Licences of IP with sales- or usage-based royalties
There is an exception for the recognition of revenue of sales or usage-based royalties promised in exchange for a licence of IP. Revenue is recognised at the later of when the performance obligation is satisfied and when the sales or usages occur. This exception applies both to licences that provide access to an entity’s IP and to licences that provide a right to use an entity’s IP.
Guaranteed minimum royalties payable for ‘right to access’ licences of intellectual property
A licence of IP which has been determined to be a ‘right-to-access’ licence in accordance with IFRS 15:B56(a) (and, consequently, for which control transfers over time) may include sales- or usage-based royalties for any sales or usage, subject to a minimum guaranteed amount which establishes a floor for the amount of consideration.
When the transaction price for such a right-to-access licence includes a minimum guarantee, an entity should determine a method that appropriately depicts its progress toward completion. Depending on the facts and circumstances, the following methods may be acceptable approaches for recognising revenue under IFRS 15 for such arrangements.
- The entity recognises revenue as the sales or usage occurs in accordance with IFRS 15:39 (see 9.3.1.1). This approach would be appropriate only if the estimated sales- or usage-based royalties are expected to exceed the minimum guarantee.
- The entity estimates the transaction price (as the fixed consideration plus expected additional royalties to be earned over the licence term) and recognises revenue over time by using an appropriate measure of progress (e.g. time elapsed) in accordance with IFRS 15:39. Under this approach, cumulative revenue recognised should be limited to the cumulative royalties once the minimum guarantee has been recognised as revenue. As with the first approach above, this approach would be appropriate only if the estimated sales- or usage-based royalties are expected to exceed the minimum guarantee. Under this approach, an entity will need to periodically revisit its estimate of the total consideration (fixed and variable) and update its measure of progress accordingly.
- The entity recognises the minimum guarantee over time by using an appropriate measure of progress over the licence period in accordance with IFRS 15:39, and recognises incremental royalties in excess of the minimum guarantee as the subsequent sales or usage related to those incremental royalties occurs. This approach is illustrated at 11.3.8-4.
Depending on facts and circumstances, other methods may be acceptable.
In addition, entities should consider providing appropriate disclosures to help users of their financial statements understand which approach is being applied. Examples of such disclosures include the key judgements the entity applied in selecting a measure of progress for recognising revenue from a right-to-access licence of IP.
This issue was discussed by the FASB Transition Resource Group for Revenue Recognition in November 2016 in the context of FASB Accounting Standards Codification (ASC) Topic 606 (the US GAAP equivalent of IFRS 15).
Guaranteed minimum royalties payable for right-to-access licences of intellectual property (method 1) – example
Entity X enters into a five-year contract with a customer to license a trademark. The licence of the trademark is determined to represent a right-to-access licence of IP and, consequently, revenue will be recognised over time. The contract requires the customer to pay sales-based royalties of 5 per cent of the customer’s gross sales associated with the trademark. The contract also includes a guarantee that Entity X will receive a minimum of CU5 million for the entire five-year period.
Entity X’s expectation of the customer’s gross sales associated with the trademark and the related royalties for each year of the contract is as follows.
Year Estimated gross sales Associated royalties (5% of estimated gross sales) CU‘000 CU‘000 1 15,000 750 2 30,000 1,500 3 40,000 2,000 4 20,000 1,000 5 60,000 3,000 Total expected royalties 8,250 Entity X therefore expects that total royalties received under the contract (CU8.25 million) will exceed the guaranteed fixed minimum (CU5 million).
Entity X recognises revenue as the underlying sales occur. Entity X determines that an output method of progress based on underlying sales is an appropriate method of progress as the royalties due (and invoiced) each year correlate directly with the value to the customer of its performance to date (see 9.3.3.2). Because the expected minimum guarantee of CU5 million is expected to be exceeded, the guarantee has no impact on revenue recognition for this selected method of progress.
Entity X also determines the selected method of progress complies with the recognition constraint for sales- or usage-based royalties in IFRS 15:B63 because revenue is not recognised until the underlying sales occur.
Entity X therefore recognises revenue over the five-year contract term as follows.
Year Royalties received Cumulative royalties received Annual revenue under IFRS 15 Cumulative revenue under IFRS 15 CU‘000 CU‘000 CU‘000 CU‘000 1 750 750 750 750 2 1,500 2,250 1,500 2,250 3 2,000 4,250 2,000 4,250 4 1,000 5,250 1,000 5,250 5 3,000 8,250 3,000 8,250 Total 8,250 8,250
Guaranteed minimum royalties payable for right-to-access licences of intellectual property (method 2) – example
The facts are the same as at 11.3.8-2.
Entity X uses an estimation of the total transaction price of CU8.25 million (comprising CU5 million fixed consideration and CU3.25 million of variable consideration) and recognises revenue over the five-year term using time elapsed as its measure of progress towards complete satisfaction of its performance obligation under the contract. In doing so, the cumulative revenue recognised cannot exceed the cumulative royalties once the minimum guarantee of CU5 million has been recognised as revenue.
Entity X therefore recognises revenue over the five-year contract term as follows.
Year Royalties received Cumulative royalties received Annual revenue under IFRS 15 Cumulative revenue under IFRS 15 CU‘000 CU‘000 CU‘000 CU‘000 1 750 750 1,650 1,650 2 1,500 2,250 1,650 3,300 3 2,000 4,250 1,650 4,950 4 1,000 5,250 300 5,250 5 3,000 8,250 3,000 8,250 Total 8,250 8,250 In Years 1 to 3, annual revenue of CU1.65 million (i.e. CU8.25 million / 5 years) is recognised based on straight-line recognition of the total estimated transaction price of CU8.25 million over the five-year term. At the end of Year 3, while the cumulative royalties received are only CU4.25 million, Entity X is entitled to recognise cumulative revenue of CU4.95 million because this does not exceed the CU5 million fixed consideration.
In Year 4, Entity X is only entitled to recognise revenue of CU0.3 million because the cumulative revenue is constrained to CU5.25 million, representing the total royalties received as at the end of Year 4. This is because, once the minimum guarantee of CU5 million has been recognised as revenue, the remaining consideration received is variable and subject to the restriction in IFRS 15:B63 where sales-based royalties cannot be recognised until the subsequent sale has occurred.
Guaranteed minimum royalties payable for right-to-access licences of intellectual property (method 3) – example
The facts are the same as previous question.
Entity X determines that the recognition constraint in IFRS 15:B63 precludes the recognition of any amounts of variable consideration (i.e. the estimated CU3.25 million) until the cumulative royalties received exceed the minimum guarantee of CU5 million (i.e. the fixed consideration under the contract). Entity X therefore applies a time elapsed method of progress to the CU5 million fixed consideration (i.e. CU1 million a year) until the point that the cumulative royalties received exceed CU5 million. Entity X considers the licence to represent a series of distinct goods or services over the five years (see 6.1.1) and the variable consideration under the contract (i.e. the royalties in excess of the minimum guarantee) is therefore allocated to the distinct time periods to which it relates once cumulative royalties exceed CU5 million.
Entity X therefore recognises revenue over the five-year contract term as follows.
Year Royalties received Cumulative royalties received Annual revenue under IFRS 15 Cumulative revenue under IFRS 15 CU‘000 CU‘000 CU‘000 CU‘000 1 750 750 1,000 1,000 2 1,500 2,250 1,000 2,000 3 2,000 4,250 1,000 3,000 4 1,000 5,250 1,250 4,250 5 3,000 8,250 4,000 8,250 Total 8,250 8,250 In Years 1 to 3, Entity X only recognises the CU1 million a year which is the fixed consideration of CU5 million spread pro rata over the five years of the contract. Entity X does not recognise any of the variable consideration in Years 1 to 3 because the cumulative royalties received as at the end of Year 3 are less than the minimum guaranteed revenue of CU5 million. In Year 4, cumulative royalties received are CU5.25 million and the variable consideration of CU0.25 million (CU5.25 million less the fixed consideration of CU5 million) is allocated to Year 4 because that is the time period in which the related sales of the customer occurred. In Year 5, the entity recognises CU1 million from the minimum guarantee and the CU3 million in variable consideration representing the difference between CU8.25 million and CU5.25 million.o
Exception for licences
The ‘later of’ guidance
The ‘later of’ guidance for royalties is intended to prevent the recognition of revenue prior to an entity satisfying its performance obligation. An entity should recognise royalties as the underlying sales or usages occur, as long as this approach does not result in the acceleration of revenue ahead of the entity’s performance. As noted in paragraph 11.254 onwards, there is no prescribed method for measuring an entity’s performance for a right to access IP (that is, a licence for which revenue is recognised over time). Management should therefore apply judgement to determine whether recognising royalties due each period results in accelerating revenue recognition ahead of performance for a right to access IP. It might sometimes be appropriate to conclude that royalties due each period correlate directly with the value to the customer of the entity’s performance. In -substance sales- or usage-based royalties Management will need to consider the nature of any variable consideration promised in exchange for a licence of IP to determine if, in substance, the variable consideration is a sales- or usage-based royalty. Examples include arrangements with milestone payments based on achieving certain sales or usage targets, and arrangements with an upfront payment that is subject to ‘claw-back’ if the licensee does not meet certain sales or usage targets.
Milestone payments
Entity J licenses IP to a manufacturer that the manufacturer will utilise in products that it sells to its customers over the licence period. Entity J will receive a fixed payment of C10 million in exchange for the licence and milestone payments as follows: An additional C5 million payment if the manufacturer’s cumulative sales exceed C100 million over the licence period. An additional C10 million payment if the manufacturer’s cumulative sales exceed C200 million over the licence period. Entity J concludes that the licence is a right to use IP. There are no other promises included in the contract.
Question
Does the sales- or usage-based royalty exception apply to the milestone payments?
Answer
Yes, the exception applies to the milestone payments, which are contingent on the manufacturer’s subsequent sales. Entity J would recognise the C10 million fixed fee when control of the licence transfers to the manufacturer. Entity J would recognise the milestone payments in the period(s) that sales exceed the cumulative targets.
Claw-back of upfront payment
Entity J licenses IP to a manufacturer that the manufacturer will utilise in products that it sells to its customers over the licence period. Entity J will receive an upfront payment of C20 million, and the contract provides for clawback of C5 million in the event that the manufacturer’s cumulative sales do not exceed C100 million over the licence period. Entity J concludes that it is probable that the manufacturer’s cumulative sales will exceed the target.
Question
Does the sales- or usage-based royalty exception apply to this arrangement?
Answer
Yes, the arrangement consists of a C15 million fixed fee and a C5 million variable fee that is in the scope of the sales- or usage-based royalty exception because it is contingent on the manufacturer’s subsequent sales. Entity J would recognise the C15 million fixed fee when control of the licence transfers to the manufacturer. Entity J would recognise the C5 million contingent fee in the period sales exceed the cumulative target. The accounting would not be impacted by the likelihood that the manufacturer will reach the cumulative target because the payment is in the scope of the salesor usage-based royalty exception, which requires recognition in the period the uncertainty is resolved (that is, when the sales occur).
Is an entity permitted to recognise sales- or usagebased royalties prior to the period when the sales or usages occur if management believes that it has historical experience that is highly predictive of the amount of royalties that will be received?
No, application of the exception is not optional. An entity cannot recognise sales- or usage-based royalties in the scope of the exception prior to the period the uncertainty is resolved (that is, when the customer’s subsequent sales or usages occur).
Should an entity recognise sales-or usage-based royalties promised in exchange for a licence of IP in the period when the sales or usages occur or the period when the customer reports such sales or usages (assuming that the related performance obligation has been satisfied)?
The exception states that an entity should recognise royalties in the period the sales or usages occur (assuming the related performance obligation has been satisfied). It might therefore be necessary for management to estimate sales or usages that have occurred, but have not yet been reported by the customer.
Minimum royalties or other fixed-fee components
The sales- or usage-based royalty exception does not apply to fees that are fixed and are not contingent on future sales or usage. Some arrangements include both a fixed fee and a fee that is a sales- or usage-based royalty. Any fixed, non-contingent fees, including any minimum royalty payments or minimum guarantees, are not subject to the sales- or usage-based royalty exception. An entity recognises a fixed fee at the point in time when control of the licence for a right to use IP transfers to the customer. Thus, if a contract includes a sales-based royalty with a minimum royalty guarantee that is binding and not contingent on the occurrence or non-occurrence of a future event, the entity would recognise the minimum (fixed fee) as revenue when control of the licence transfers. It would recognise royalties in excess of the minimum in the period when the sales occur. An entity recognises a fixed fee over time in exchange for a licence that is a right to access IP. We believe there could be multiple acceptable approaches for recognising revenue when a licence that is a right to access IP includes a sales- or usage-based royalty and a minimum royalty guarantee.
Examples of acceptable approaches include: Recognise revenue as the royalties occur if the licensor expects the total royalties to exceed the minimum guarantee, and the royalties due each period correspond directly with the value to the customer of the entity’s performance (that is, recognising royalties as they occur is an appropriate measure of progress, using the ‘right to invoice’ practical expedient discussed in para 11.181 onwards). Estimate the total transaction price (including fixed and variable consideration) that will be earned over the term of the licence. Recognise revenue using an appropriate measure of progress; however, the sales- or usage-based royalty exception must continue to be applied to the cumulative revenue recognised. Recognise the minimum guarantee (fixed consideration) using an appropriate measure of progress, and recognise royalties only when cumulative royalties exceed the minimum guarantee. The selection of an approach could require judgement, and it should consider the nature and terms of the specific arrangement.
Minimum guarantee
Entity T licenses IP to a manufacturer that the manufacturer will utilise in products that it sells to its customers over a five-year licence period. Entity T will receive a royalty based on the manufacturer’s sales during the licence period. The contract states that the minimum royalty payment in each year is C1 million. Entity T expects actual royalties to significantly exceed the C1 million minimum each year. Entity T concludes that the licence is a right to use IP. There are no other promises included in the contract and control of the licence transfers on 1 January 20X0. There is not a significant financing component in the arrangement.
Question
When should entity T recognise revenue from the arrangement?
Answer
The minimum royalty of C5 million (C1 million × five years) is a fixed fee. Since the licence is a right to use IP, subject to point-in-time revenue recognition, entity T would recognise the C5 million fixed fee on 1 January 20X0 when control of the licence transfers to the manufacturer. Entity T would apply the sales- or usage-based royalty exception guidance for the royalty, and it would recognise the royalties earned in excess of C1 million each year in the period when sales occur. The fact that actual royalties are expected to significantly exceed the minimum does not impact the accounting conclusion.
Can an IP distribution agent apply the exception for sales- or usage-based royalties?
An entity (an agent) distributes licenses of IP on behalf of the owner of the IP (the licensor). The entity is a distribution agent and, accordingly, it performs an agency service for the licensor. The agent’s compensation is in the form of a specified percentage of the royalties that the licensor receives from its customers. Those royalties are calculated based on the licensor’s customers’ sales (that is, a sales-based royalty).
Question
Can the agent also apply the exception for sales- or usage-based royalties?
Answer
We believe it would be acceptable for the agent to apply the exception for sales- or usage-based royalties. As discussed in paragraph BC 415 of IFRS 15, applying the exception in this case is consistent with the reasons why the Boards concluded that entities should not estimate royalties from licences of IP and provided the royalty exception. Additionally, in this fact pattern, the service provided by the agent is directly related to the licence of IP. Application of the sales- or usage-based royalty exception might not be appropriate in circumstances when an entity receives a share of a royalty stream as compensation, but its performance is clearly unrelated to the licence of IP. We believe it would also be acceptable for the agent to conclude its fee is not subject to the exception for sales- or usage-based royalties. This conclusion would be based on the fact that the agent’s performance obligation is a service, not the licence of IP. An entity concluding its fee is not subject to the exception would apply the general guidance on variable consideration, which would require the entity to estimate its transaction price and apply the variable consideration constraint. The entity’s conclusion should be applied consistently to similar arrangements.
This guidance is an exception to the general principles for accounting for variable consideration The exception only applies to licences of IP and should not be applied to other fact patterns by analogy. Management should estimate sales- or usage-based royalties received in arrangements other than licences of IP as variable consideration and include them in the transaction price, subject to constraint. Entities that sell, rather than license, IP cannot apply the sales- or usage-based royalty exception.
How should entities account for sales- or usage-based royalties promised in exchange for a licence of IP that in substance is the sale of IP?
The exception for sales- or usage-based royalties applies to licences of IP and not to sales of IP. Management needs to apply judgement to determine if an entity needs to assess whether an arrangement is a licence or sale of IP.
Distinguishing usage-based royalties from additional rights
Many licence arrangements include a variable fee linked to usage of the IP. It might not be clear, particularly for software licences, whether this fee is a usage-based royalty or a fee received in exchange for the purchase of additional rights by the customer. If a licensor is entitled to additional consideration based on the usage of IP to which the customer already has rights, without providing any additional or incremental rights, the fee is generally a usage-based royalty. In contrast, if a licensor provides additional or incremental rights that the customer did not previously control for an incremental fee, the customer is likely exercising an option to acquire additional rights. Judgement might be required to distinguish between a usage-based royalty (a form of variable consideration) and an option to acquire additional goods or services. A usage-based royalty is recognised when the usage occurs or the performance obligation is satisfied, whichever is later. The usage-based royalty might need to be disclosed in the period recognised pursuant to the requirements to disclose revenue recognised in the reporting period from performance obligations satisfied in previous periods. Fees received when an option to acquire additional rights is exercised are recognised when the additional rights are transferred; however, at contract inception, management would need to assess whether the option provides a material right. If so, a portion of the transaction price would be allocated to the option and deferred until the option is exercised or expires. The following examples illustrate the assessment of whether variable fees represent a usage-based royalty or an option to acquire additional rights.
Example 1: Usage-based royalty
A software company licenses software to a customer that will be used by the customer to process transactions. The licence permits the customer to grant an unlimited number of users access to the software for no additional fee. The contract consideration includes a fixed upfront fee and a variable fee for each transaction processed using the software.
Question
How should the software company account for the variable fee?
Answer
The software company should account for the variable fee as a usage-based royalty. The incremental fees that the software company receives are based on the usage of the software rights previously transferred to the customer. There are no additional rights transferred to the customer; therefore, the software company should recognise the usage-based royalty in the period the usage occurs.
Example 2: Option to acquire additional rights
On 1 January 20X7, a software company licenses to a customer the right to use its software for five years for a fixed price of C1 million for 1,000 users (or ‘seats’). C1,000 per user is the current stand-alone selling price for the software. The contract also provides that the customer can add additional users during the term of the contract at a price of C800 per user. Management has concluded that each ‘seat’ is a separate performance obligation and, in substance, the customer obtains an additional right when a new user is added. On 1 January 20X8, the customer adds 20 users and pays to the software company an additional C16,000.
Question
How should the software company account for the variable fee?
Answer
The variable fee in this arrangement is an option to purchase additional rights to use the software, because the rights for the additional users are incremental to the rights transferred to the customer on 1 January 20X7. The software company will need to assess whether the option provides a material right and, if so, allocate a portion of the C1 million transaction price to the option. The amount allocated to the option would be deferred until the option is exercised or expires. In this fact pattern, the discounted pricing of C800 per user, compared to the current pricing of C1,000 per user, might indicate that the option provides a material right if the customer would not have received the discount without entering into the current contract. The software company would recognise the C16,000 fee for the additional rights when it transfers control of the additional licences. The software company would also recognise amounts allocated to the related material right, if any, at the time the right is exercised.
Some arrangements include sales- or usage-based royalties that relate to both a licence of IP and other goods or services. Management will either apply the exception to the royalty stream in its entirety (if the licence to IP is predominant) or apply the general variable consideration guidance (if the licence to IP is not predominant). Management should not ‘split’ the royalty and apply the exception to only a portion of the royalty stream. A licence of IP might be the predominant item to which the royalty relates, for example, when the customer would ascribe significantly more value to the licence than to the other goods or services to which the royalty relates. There is no specific definitions of ‘predominant’ and ‘significantly more value’, management needs to apply judgement when making this assessment. Example 60 of the revenue standard illustrates this concept.
Licence of IP is not predominant
Entity J and entity K enter into a multi-year agreement under which entity J licenses its IP to entity K and agrees to manufacture the commercial supply of the product as it is needed. In this agreement, the licence and the promise to manufacture are each distinct, and the value of each is determined to be about the same. The only compensation for entity J in this arrangement is a percentage of entity K’s commercial sales of the product.
Question
Do the sales- or usage-based royalty exception apply to this arrangement?
Answer
No, the exception does not apply because the licence of IP is not predominant in this arrangement. The customer would not ascribe significantly more value to the licence than to the promise to manufacture product. Entity J would apply the general variable consideration guidance to estimate the transaction price, and allocate the transaction price between the licence and manufacturing. Entity J will recognise the portion attributed to the licence when the IP has been transferred and entity K is able to use and benefit from the licence. Entity J would allocate the remaining transaction price to the manufacturing and recognise when (or as) control of the product is transferred to entity K.
Principal versus agent considerations
Some arrangements involve two or more unrelated parties that contribute to providing a specified good or service to a customer. Management will need to determine whether the entity has promised to provide the specified good and service itself (as a principal) or to arrange for those specified good or service to be provided by another party (as an agent). A specified good or service is a distinct good or service (or a distinct bundle of goods or services) that will be transferred to the customer. Management needs to determine whether the entity is a principal or agent separately for each specified good or service promised to a customer. In contracts with multiple distinct goods or services, the entity could be the principal for some goods or services and an agent for others. Determining whether an entity is the principal or an agent is not a policy choice.
Additional consideration when customers could redeem loyalty points for goods or services from other parties
Entities that issue ‘points’ under customer loyalty programmes that are satisfied by other parties need to assess whether they are the principal or an agent for transfer and redemption of the points. See guidance in paragraph 11.198 for further discussion of the accounting for customer loyalty points.
An entity is the principal in a transaction if it obtains control of the specified goods or services before they are transferred to the customer. The entity’s control needs to be substantive. For example, obtaining legal title of a product only momentarily before it is transferred to the customer does not necessarily indicate that the entity is the principal. There is a list of indicators that an entity controls a specified good or service before it is transferred to the customer to help entities apply the concept of control to the principal versus agent assessment.
When another party is involved in providing goods or services to a customer, an entity that is a principal obtains control of any one of the following:
- a good or another asset from the other party that it then transfers to the customers;
- 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 specific good or service to the customer. For example, an entity provides a significant service of integrating the goods or services provided by another party into the specified good or service for which the customer has contracted. The entity obtains control of the inputs to the specified good or service and directs their use to create the combined output that is the specified good or service. Management should assess whether goods or services are inputs into a combined output based on the guidance for determining whether goods or services are distinct from other promises in a contract.
Significant integration service
Entity M provides its customers with a package of cloud services, including access to a software-as-a-service (SaaS) platform owned and operated by a third party. Entity M contracts directly with the third party for the right to access the SaaS platform as part of its service offering to its customers. Entity M determines that it is providing a significant service of integrating the various services into a combined package to meet the customer’s specifications. Therefore, access to the SaaS platform and the related services performed by entity M are not separately identifiable and the contract contains a single performance obligation.
Question
Is entity M the principal or agent for the package of cloud services?
Answer
Entity M is the principal and should recognise revenue for the gross fee charged to customers. Access to the SaaS platform is an input into the package of cloud services (the specified good or service). Entity M obtains control of the inputs, including access to the SaaS platform, and directs their use to create the combined output for which the customer has contracted. The conclusion could differ if entity M determines that access to the SaaS platform and the related services performed by entity M are each distinct (and therefore, separate performance obligations). In that case, entity M would determine whether it is the principal or agent separately for each distinct good or service.
Out-of-pocket expenses and other cost reimbursements
Expenses are often incurred by service providers while performing work for their customers. These can include costs for travel, meals, accommodation and miscellaneous supplies. It is common, in service arrangements, for the parties to agree that the customer will reimburse the service provider for some or all of the out-of-pocket expenses. Alternatively, such expenses might be incorporated into the price of the service instead of being charged separately. Out-of-pocket expenses often relate to activities that do not transfer a good or service to the customer.
For example, a service provider that is entitled to reimbursement for employee travel costs would generally account for the travel costs as costs to fulfil the contract with the customer. Reimbursements would be included in the transaction price for the contract. Management should consider the principal versus agent guidance if a customer reimburses the vendor for a good or service transferred to the customer as part of a contract (for example, reimbursement of subcontractor services). Management should first identify the specified good or service to be provided to the customer. This includes assessing whether the goods or services are inputs into a combined output that the entity transfers to the customer.
For example, a service provider might subcontract a portion of the service that it provides to customers and agree with the customer to be reimbursed for the subcontracted services (sometimes referred to as a ‘pass-through’ cost). The service provider would be an agent with regard to the subcontracted services if it does not control the subcontracted services before they are transferred to the customer. The service provider would recognise revenue from the reimbursement net of the amount that it pays to the subcontractor. The service provider would be the principal if it controls the subcontracted services by directing the subcontractor to perform on its behalf or combining the subcontracted services with its own services to create a combined output. If the service provider is the principal, it would include the reimbursement in the transaction price and allocate it to the separate performance obligations in the contract.
The principal recognises as revenue the ‘gross’ amount paid by the customer for the specified good or service. The principal records a corresponding expense for the commission or fee that it has to pay to any agent, in addition to the direct costs of satisfying the contract.
Estimating gross revenue as a principal
An entity that is a principal will typically recognise as revenue the amount paid by the customer for the specified good or service. If the intermediary (an agent) has pricing discretion, there could be instances when the principal is not aware of the price charged to the customer.
For example, an entity and a sales agent might agree that the agent will pay to the entity a fixed amount per good or service sold, regardless of the price charged by the agent to the customer. An entity should exercise judgement to determine the principal’s transaction price in this situation. There is no specific guidance on this topic. The entity that is a principal should apply judgement and determine the transaction price based on the relevant facts.
An entity is an agent if it does not control the specified goods or services before they are transferred to the customer. An agent records as revenue the commission or fee earned for facilitating the transfer of the specified goods or services (the ‘net’ amount retained). It records as revenue the net consideration that it retains after paying the principal for the specified goods or services that were provided to the customer.
The timing of revenue recognition can also differ depending on whether the entity is the principal or an agent. Once an entity identifies its promises in a contract and determines whether it is a principal or an agent for those promises, it recognises revenue when (or as) the performance obligations are satisfied. It is therefore critical to identify the promise in the contract in order to determine when that promise is satisfied, and therefore, the timing of revenue recognition. An agent might satisfy its performance obligation (facilitating the transfer of specified goods or services) before the end customer receives the specified good or service from the principal.
Indicators that an entity is a principal
Determining whether an entity is the principal or an agent in an arrangement can require significant judgement. Management should first obtain an understanding of the relationships and contractual arrangements between various parties. This includes identifying the specified good or service being provided to the end customer and the nature of the entity’s promise.
Indicators that an entity controls the specified good or service before it is transferred to the customer (and is therefore a principal) include, but are not limited to, the following:
- the entity is primarily responsible for fulfilling the promise to provide the specified good or service. This typically includes responsibilities for acceptability of the specified good or service (for example, primary responsibility for the good or service meeting customer specification);
- the entity has inventory risk before the specified good or service has been transferred to a customer, or after transferring the control to the customer (for example, if the customer has a right of return);
- the entity has discretion in establishing the prices for the specified goods or services.
These indicators, in the context of the principal versus agent analysis, are not intended to ‘override’ the control transfer assessment that an entity makes. Instead, they provide further guidance to help management assess whether the entity obtains control of a good or service. Management is expected to generally reach consistent conclusions based on applying the definition of control and applying the indicators.
Detail on principal versus agent indicators
Primary responsibility for fulfilling the contract
The terms of the agreement and other information communicated to the customer (for example, marketing materials) often provide evidence of which party is primarily responsible for fulfilling the obligations in the contract. Management should consider who the customer views as primarily responsible for fulfilling the contract, including which entity will be providing customer support, resolving customer complaints, and accepting responsibility for the quality or suitability of the product or service. Multiple parties in an arrangement could share responsibility for fulfilment in some circumstances.
For example, one party could be responsible for providing the underlying good or service while another party is responsible for the acceptability of the good or service. This indicator might provide less persuasive evidence in these instances. Management should consider the overall principle of control and the other indicators to make its assessment in those cases. Inventory risk Inventory risk exists when the entity bears the risk of loss due to factors such as physical damage, decline in value or obsolescence, either before the specified good or service has been transferred to the customer or upon return. An entity’s risk is reduced if it has the ability to return unsold products to the supplier. Non-cancellable purchase commitments and certain types of guarantees might expose an entity to inventory risk if the entity bears the risk of not being able to monetise the inventory. Inventory risk might exist even if no physical product is sold.
For example, an entity might have inventory risk in a service arrangement if it is committed to pay the service provider even if the entity is unable to identify a customer to purchase the service. Taking physical possession of a product and bearing risk of loss for a period of time does not, on its own, result in an entity being the principal. In order to be the principal, the entity needs to have control of the product before it is transferred to the customer. On the other hand, it is not a requirement for an entity to have inventory risk to conclude that it takes control of a product.
For example, an entity that sells a product to a customer might instruct a supplier to ship the product directly to the customer (‘dropship’ the product) and, as a result, the entity does not take physical possession and might never have substantive inventory risk related to the product. This fact, on its own, would not prevent the entity from concluding that it controls the product before it is transferred to the customer. However, the entity would have to support its conclusion based on the definition of control and the other indicators.
Discretion in establishing pricing
Discretion in establishing the price that the customer pays for the specified good or service might indicate that the entity has the ability to direct use of the good or service and obtain substantially all of the remaining benefits. Earning a fixed percentage of the consideration for each sale might indicate that an entity is an agent, because a fixed percentage limits the benefit that an entity can receive from the transaction. An entity could sometimes have some flexibility in setting prices and still be considered an agent.
For example, agents often have the ability to provide discounts to end customer (and effectively forgo a portion of their fee or commission) in order to incentivise purchases of the principal’s good or service. Sometimes, an entity allows another entity (such as a reseller) to sell its product or services for a range of prices instead of a single set price. The reseller has some ability to set prices (within the range), but this does not necessarily indicate that the reseller is the principal in the transaction with the end customer. If the range of prices that an intermediary can charge is narrow, this could indicate that the intermediary is an agent, because the benefit that it can derive from selling the goods or services is limited. If the range of prices is broad, this might indicate that the intermediary is the principal in the sale to the end customers. The intermediary (as opposed to the end customer) would be the entity’s customer, and the entity should recognise revenue equal to the sales price to the intermediary when control transfers to the intermediary. Management should take into account all of the indicators in this assessment, some of which could still support a conclusion that the entity is the principal in the sale to the end customer.
Entity is an agent
Entity N operates a website that sell books. Entity N enters into a contract with a bookstore to sell the bookstore’s books online. Entity N’s website facilitates payments between the bookstore and the customer. The bookstore establishes the price and entity N earns a commission equal to 5% of the sales price. The bookstore ships the books directly to the customer. However, the customer returns the books to entity N if they are dissatisfied. Entity N has the right to return books to the bookstore without penalty if they are returned by the customer.
Question
Is entity N the principal or agent for the sale of books to the customer?
Answer
Entity N is acting as the agent of the bookstore and should recognise commission revenue for the sales made on the bookstore’s behalf; that is, it should recognise revenue on a net basis. The specified good or service in this arrangement is a book purchased by the customer. Entity N does not control the books before they are transferred to the customer. Entity N does not have the ability to direct the use of the goods transferred to customers and does not control the bookstore’s inventory of goods. Entity N is also not responsible for the fulfilment of orders and does not have discretion in establishing prices of the books. Although customers return books to entity N, entity N has the right to return the books to the bookstore and therefore does not have substantive inventory risk. The indicators therefore support that entity N is not the principal for the sale of the bookstore’s books. Entity N should recognise commission revenue when it satisfies its promise to facilitate a sale (that is, when the books are purchased by a customer).
Entity is the principal
Entity O negotiates with major airlines to obtain access to airline tickets at reduced rates, and it sells the tickets to its customers through its website. Entity O contracts with the airlines to buy a specific number of tickets at agreed rates and is required to pay for those tickets regardless of whether it is able to resell them. Customers visiting entity O’s website search entity O’s available tickets. Entity O has discretion in establishing the prices for the tickets that it sells to its customers. Entity O is responsible for delivering the ticket to the customer. Entity O will also assist the customer in resolving complaints with the service provided by the airlines. The airline is responsible for fulfilling all other obligations associated with the ticket, including the air travel and related services (that is, the flight), and remedies for service dissatisfaction.
Question
Is entity O principal or agent for the sale of airline tickets to customers?
Answer
Entity O is the principal and should recognise revenue for the gross fee charged to customers. The specified good or service is a ticket that provides a customer with the right to fly on the selected flight (or another flight if the selected one is changed or cancelled). Entity O controls the tickets prior to transfer of the ticket to the customer. Entity O has the ability to direct the use of the ticket and obtains the remaining benefits from the ticket by reselling the ticket or using the ticket itself. Entity O also has inventory risk before the ticket is transferred to the customer and discretion in establishing the price of the ticket. The indicators therefore support that entity O is the principal.
Multiple specified goods or services
Entity P provides payroll processing services to customers under a service arrangement. Entity P also offers consulting services to the customer related to the customer’s payroll and compensation processes. Entity P has concluded that the payroll processing services and consulting services are distinct. The consulting services are performed by a third party, entity Q. Entity Q determines the pricing of the consulting services and coordinates directly with the customer to determine the timing and scope of work. Entity P occasionally assists customers in resolving complaints about the consulting services; however, entity Q is responsible for meeting customer specifications, including providing any refunds or re-performing work, as needed. The customer pays entity P a monthly service fee for the payroll processing services. Entity P also collects the fee for the consulting services, retains 10% of the fee paid, and remits the remaining amount to entity Q. Any losses resulting from overruns in the consulting services are fully absorbed by entity Q.
Question
Is entity P the principal or agent for the payroll processing services and consulting services?
Answer
There are two specified services in the arrangement: payroll processing services and consulting services. Entity P should assess whether it is the principal or agent separately for each specified service. Entity P concludes it is the principal for the payroll processing services and is an agent for the consulting services. Entity P controls the payroll processing services before the services are transferred to the customer because it performs the services itself and no other party is involved in providing those services to the customer. Entity P does not control the consulting services before the services are transferred to the customer because it is not directing entity Q to perform on its behalf. Entity P is not primarily responsible for fulfilment because entity P is not responsible for providing the services or meeting customer specifications. Entity P also does not have inventory risk or discretion in establishing prices for the consulting services. The indicators therefore support that entity P is not the principal for the consulting services.
Shipping and handling fees
Entities that sell products often deliver them via third-party shipping service providers. Entities sometimes charge customers a separate fee for shipping and handling costs, or shipping and handling might be included in the price of the product. Separate fees might be a direct reimbursement of costs paid to the third party, or they could include a profit element. Management needs to consider whether the entity is the principal for the shipping service, or whether it is an agent arranging for the shipping service to be provided to the customer when control of the goods transfers at shipping point. Management could conclude that the entity is the principal for both the sale of the goods and the shipping service, or that it is the principal for the sale of the goods but an agent for the service of shipping those goods. Activity Entity R operates retail stores and a website where customers can purchase toys. Customers that make online purchases can choose to collect their order from the retail store for no additional cost or have the order delivered to their home for a fee. Toys can be delivered via standard delivery or overnight delivery with a specified delivery company. The customer is charged for the cost of the delivery (as established by the delivery company) and given a tracking number, so that it can track the status of the delivery and contact the delivery company with any questions or concerns. Control of the toys transfers to the customer when the order leaves the warehouse. Entity R concludes that shipping the toys is a promise in the contract and a distinct service.
Question
Should entity R recognise the shipping fees that it charges to its customers gross (as revenue and expense) or net of the amount paid to the shipping provider?
Answer
Entity R should recognise revenue for the shipping fees net of the amount paid to the shipping providers. Entity R is an agent for the delivery company, as it is merely arranging the shipping service on behalf of its customer and does not control the shipping service. Entity R is not responsible for shipping the toys and has no inventory risk or discretion in establishing prices for the shipping service. The indicators therefore support that entity R is not the principal for the shipping services
Amounts collected from customers and remitted to a third party
Entities often collect amounts from customers that are required to be remitted to a third party (for example, collecting and remitting taxes to a governmental agency). Taxes collected from customers could include sales, use, value-added and some excise taxes. Amounts collected on behalf of third parties, such as certain sales taxes, are not included in the transaction price, as they are collected from the customer on behalf of the government. The entity is the agent for the government in these situations. Taxes that are based on production, rather than sales, are typically imposed on the seller, and not the customer. An entity that is obligated to pay taxes based on its production is the principal for those taxes, and therefore recognises the tax as an operating expense, with no effect on revenue. Management needs to assess each type of tax, on a jurisdiction-by-jurisdiction basis, to conclude whether to net these amounts against revenue or to recognise them as an operating expense. The intention of the tax, as written into the tax legislation in the particular jurisdiction, should also be considered. The name of the tax (for example, sales tax or excise tax) is not always determinative when assessing whether the entity is the principal or the agent for the tax. Whether or not the customer knows the amount of tax also does not necessarily impact the analysis. Management needs to look to the underlying characteristics of the tax and the tax laws in the relevant jurisdiction to determine whether the entity is primarily obligated to pay the tax or whether the tax is levied on the customer. This could be a significant undertaking for some entities, particularly those that operate in numerous jurisdictions with different tax regimes. Indicators that taxes are the responsibility of the entity and therefore should be recorded as an expense (as opposed to a reduction of transaction price) include but are not limited to: The triggering event to pay the tax is the production or the importation of goods.
Conversely, when the triggering event is the sale to a customer, this might indicate that the entity is collecting the tax on behalf of a governmental entity. The tax is based on the number of units or on the physical quantity (for example, number of cigarettes or volume of alcoholic content) produced by the entity, rather than the selling price to customers. The tax is due on accumulated earnings during a period of time, as opposed to each individual sale transaction. The entity cannot claim a refund of the tax in the event the related inventory is not sold or the customer fails to pay for the goods or services being sold. The entity has no legal or constructive obligation to change prices in order to reflect taxes.
Conversely, where the tax is clearly separate from the selling price and a change in the tax would result in an equivalent change in the amount passed through to the customer, this might indicate that the entity is collecting the tax on behalf of the government. The above indicators should be considered along with the intended purpose of the tax, as written into the tax legislation in the particular jurisdiction. The existence (or non-existence) of one of the above indicators might not be determinative on its own. The following two examples illustrate the assessment of whether a tax should be presented as an expense or a reduction of transaction price.
Example 1: Presentation of taxes – entity is principal for the tax Entity A is a global producer and distributor of branded alcoholic spirits. Entity A pays an excise duty based on the value as well as the volume of products that leave a bonded warehouse. The movement of products from the bonded warehouse for customs clearance is the triggering event of the obligation to pay excise duty. In case a customer fails to make payment, or if products are not sold, entity A cannot claim a refund of the excise duty that it has paid. Entity A has no legal or constructive obligation to reflect any change of the rate of excise duty in the selling price of products. An increase in the rate of excise duty can lead the entity to increase its selling price, but such increases are a commercial decision and would not be automatic. The tax is not separately presented on the invoice.
Question
How should entity A account for the excise duty?
Answer
Entity A is the principal for the excise duty as the triggering event is the movement of products (as opposed to sales to customers), entity A makes a decision whether to adjust the selling price of products to pass the tax on to the customer, and it cannot claim a refund in case of a customer’s failure to pay. Entity A should therefore recognise the excise duty as an expense, as opposed to a reduction of transaction price.
Example 2 : Presentation of taxes – tax is collected on behalf of a governmental entity A manufacturer sells widgets to customers in various jurisdictions. In a particular jurisdiction, the manufacturer pays a sales tax calculated based on the number of widgets sold. The triggering event of the obligation is each individual sale to a customer. The tax is separately identified on the invoice to the customer, and any increase in the tax rate would result in an equivalent increase of the tax charged to the customer. The manufacturer receives a refund of the tax if the receivables are not collected. Question How should the manufacturer account for the excise duty? Answer The manufacturer is likely collecting the sales tax as an agent on behalf of a governmental agency. The triggering event is sales to customers, the tax is separately charged to customers, and the manufacturer receives a refund if the receivables are not collected. The manufacturer should therefore exclude the sales tax collected from customers from the transaction price, and no expense would be recognised for the tax. The collection and payment of the tax would only impact balance sheet accounts.
No single indicator is determinative or weighted more heavily than other indicators. Some indicators might provide stronger evidence than others.
Impact of primary responsibility on whether an entity is a principal
In some cases, it may be difficult to establish whether an entity has primary responsibility for fulfilling a promise and significant judgement will be required. Conversely, in other cases it may be clear whether or not the entity has primary responsibility.
If it is clear that an entity has primary responsibility for fulfilling a promise to provide a specified good or service to a customer, this would typically mean that the entity should account for the transaction as a principal.
Although IFRS 15:B37 only lists primary responsibility as an indicator, IFRS 15:B34 makes it clear that, when applying the principal versus agent guidance, it is key to identify which party is promising to provide the specified good or service to the customer. If an entity has primary responsibility to the customer for providing a specified good or service, it will usually follow that it is the entity promising to provide that good or service to the customer (i.e. the entity is a principal, not an agent) even if it has engaged another party (for example, a subcontractor) to satisfy some or all of the performance obligation on its behalf.
Offsetting revenue and expenses when goods and services are sold at cost
When, having considered the requirements of IFRS 15:B34 to B38, an entity determines that it acts as a principal in the sale of goods or services, or both, it should recognise revenue for the gross amount to which it is entitled. This is the case even when the entity sells some goods or services to third parties at an amount equal to the cost of the goods or services. The practice of selling goods or providing services at an amount equal to cost does not mean that the proceeds should be presented as a cost reimbursement; revenue and expenses should be presented gross.
Example
Arranging for the provision of goods or services (entity is an agent) [website operation]
An entity operates a website that enables customers to purchase goods from a range of suppliers who deliver the goods directly to the customers. Under the terms of the entity’s contracts with suppliers, when a good is purchased via the website, the entity is entitled to a commission that is equal to 10 per cent of the sales price. The entity’s website facilitates payment between the supplier and the customer at prices that are set by the supplier. The entity requires payment from customers before orders are processed and all orders are non-refundable. The entity has no further obligations to the customer after arranging for the products to be provided to the customer.
To determine whether the entity’s performance obligation is to provide the specified goods itself (ie the entity is a principal) or to arrange for those goods to be provided by the supplier (ie the entity is an agent), the entity identifies the specified good or service to be provided to the customer and assesses whether it controls that good or service before the good or service is transferred to the customer.
The website operated by the entity is the marketplace in which suppliers offer their goods and customers purchase the goods that are offered by the suppliers. Accordingly, the entity observes that the specified goods to be provided to customers that use the website are the goods provided by the suppliers, and no other goods or services are promised to customers by the entity.
The entity concludes that it does not control the specified goods before they are transferred to customers that order goods using the website. The entity does not at any time have the ability to direct the use of the goods transferred to customers. For example, it cannot direct the goods to parties other than the customer or prevent the supplier from transferring those goods to the customer. The entity does not control the suppliers’ inventory of goods used to fulfil the orders placed by customers using the website.
As part of reaching that conclusion, the entity considers the following indicators in IFRS 15. The entity concludes that these indicators provide further evidence that it does not control the specified goods before they are transferred to the customers:
1. (a) the supplier is primarily responsible for fulfilling the promise to provide the goods to the customer. The entity is neither obliged to provide the goods if the supplier fails to transfer the goods to the customer, nor responsible for the acceptability of the goods.
2. (b) the entity does not take inventory risk at any time before or after the goods are transferred to the customer. The entity does not commit itself to obtain the goods from the supplier before the goods are purchased by the customer, and does not accept responsibility for any damaged or returned goods.
3. (c) the entity does not have discretion in establishing prices for the supplier’s goods. The sales price is set by the supplier.
Consequently, the entity concludes that it is an agent and its performance obligation is to arrange for the provision of goods by the supplier. When the entity satisfies its promise to arrange for the goods to be provided by the supplier to the customer (which, in this example, is when goods are purchased by the customer), the entity recognises revenue in the amount of the commission to which it is entitled.
Example
Promise to provide goods or services (entity is a principal) [equipment with unique specifications]
An entity enters into a contract with a customer for equipment with unique specifications. The entity and the customer develop the specifications for the equipment, which the entity communicates to a supplier that the entity contracts with to manufacture the equipment. The entity also arranges to have the supplier deliver the equipment directly to the customer. Upon delivery of the equipment to the customer, the terms of the contract require the entity to pay the supplier the price agreed to by the entity and the supplier for manufacturing the equipment.
The entity and the customer negotiate the selling price and the entity invoices the customer for the agreed-upon price with 30-day payment terms. The entity’s profit is based on the difference between the sales price negotiated with the customer and the price charged by the supplier.
The contract between the entity and the customer requires the customer to seek remedies for defects in the equipment from the supplier under the supplier’s warranty. However, the entity is responsible for any corrections to the equipment required resulting from errors in specifications.
To determine whether the entity’s performance obligation is to provide the specified goods or services itself (ie the entity is a principal) or to arrange for those goods or services to be provided by another party (ie the entity is an agent), the entity identifies the specified good or service to be provided to the customer and assesses whether it controls that good or service before the good or service is transferred to the customer.
The entity concludes that it has promised to provide the customer with specialised equipment designed by the entity. Although the entity has subcontracted the manufacturing of the equipment to the supplier, the entity concludes that the design and manufacturing of the equipment are not distinct, because they are not separately identifiable (ie there is a single performance obligation). The entity is responsible for the overall management of the contract (for example, by ensuring that the manufacturing service conforms to the specifications) and, thus, provides a significant service of integrating those items into the combined output – the specialised equipment – for which the customer has contracted. In addition, those activities are highly interrelated. If necessary modifications to the specifications are identified as the equipment is manufactured, the entity is responsible for developing and communicating revisions to the supplier and for ensuring that any associated rework required conforms with the revised specifications. Accordingly, the entity identifies the specified good to be provided to the customer as the specialised equipment.
The entity concludes that it controls the specialised equipment before that equipment is transferred to the customer. The entity provides the significant integration service necessary to produce the specialised equipment and, therefore, controls the specialised equipment before it is transferred to the customer. The entity directs the use of the supplier’s manufacturing service as an input in creating the combined output that is the specialised equipment. In reaching the conclusion that it controls the specialised equipment before that equipment is transferred to the customer, the entity also observes that, even though the supplier delivers the specialised equipment to the customer, the supplier has no ability to direct its use (ie the terms of the contract between the entity and the supplier preclude the supplier from using the specialised equipment for another purpose or directing that equipment to another customer). The entity also obtains the remaining benefits from the specialised equipment by being entitled to the consideration in the contract from the customer.
Thus, the entity concludes that it is a principal in the transaction. The entity does not consider the indicators in IFRS 15 because the evaluation above is conclusive without consideration of the indicators. The entity recognises revenue in the gross amount of consideration to which it is entitled from the customer in exchange for the specialised equipment.
Example
Promise to provide goods or services (entity is a principal) [maintenance services]
An entity enters into a contract with a customer to provide office maintenance services. The entity and the customer define and agree on the scope of the services and negotiate the price. The entity is responsible for ensuring that the services are performed in accordance with the terms and conditions in the contract. The entity invoices the customer for the agreed-upon price on a monthly basis with 10-day payment terms.
The entity regularly engages third-party service providers to provide office maintenance services to its customers. When the entity obtains a contract from a customer, the entity enters into a contract with one of those service providers, directing the service provider to perform office maintenance services for the customer. The payment terms in the contracts with the service providers are generally aligned with the payment terms in the entity’s contracts with customers. However, the entity is obliged to pay the service provider even if the customer fails to pay.
To determine whether the entity is a principal or an agent, the entity identifies the specified good or service to be provided to the customer and assesses whether it controls that good or service before the good or service is transferred to the customer.
The entity observes that the specified services to be provided to the customer are the office maintenance services for which the customer contracted, and that no other goods or services are promised to the customer. While the entity obtains a right to office maintenance services from the service provider after entering into the contract with the customer, that right is not transferred to the customer. That is, the entity retains the ability to direct the use of, and obtain substantially all the remaining benefits from, that right. For example, the entity can decide whether to direct the service provider to provide the office maintenance services for that customer, or for another customer, or at its own facilities. The customer does not have a right to direct the service provider to perform services that the entity has not agreed to provide. Therefore, the right to office maintenance services obtained by the entity from the service provider is not the specified good or service in its contract with the customer.
The entity concludes that it controls the specified services before they are provided to the customer. The entity obtains control of a right to office maintenance services after entering into the contract with the customer but before those services are provided to the customer. The terms of the entity’s contract with the service provider give the entity the ability to direct the service provider to provide the specified services on the entity’s behalf IFRS 15. In addition, the entity concludes that the following indicators in IFRS 15 provide further evidence that the entity controls the office maintenance services before they are provided to the customer:
1. (a) the entity is primarily responsible for fulfilling the promise to provide office maintenance services. Although the entity has hired a service provider to perform the services promised to the customer, it is the entity itself that is responsible for ensuring that the services are performed and are acceptable to the customer (ie the entity is responsible for fulfilment of the promise in the contract, regardless of whether the entity performs the services itself or engages a third-party service provider to perform the services).
2. (b) the entity has discretion in setting the price for the services to the customer.
The entity observes that it does not commit itself to obtain the services from the service provider before obtaining the contract with the customer. Thus, the entity has mitigated inventory risk with respect to the office maintenance services. Nonetheless, the entity concludes that it controls the office maintenance services before they are provided to the customer on the basis of the evidence [in the paragraph above].
Thus, the entity is a principal in the transaction and recognises revenue in the amount of consideration to which it is entitled from the customer in exchange for the office maintenance services.
Example
Promise to provide goods or services (entity is a principal) [airlines]
An entity negotiates with major airlines to purchase tickets at reduced rates compared with the price of tickets sold directly by the airlines to the public. The entity agrees to buy a specific number of tickets and must pay for those tickets regardless of whether it is able to resell them. The reduced rate paid by the entity for each ticket purchased is negotiated and agreed in advance.
The entity determines the prices at which the airline tickets will be sold to its customers. The entity sells the tickets and collects the consideration from customers when the tickets are purchased.
The entity also assists the customers in resolving complaints with the service provided by the airlines. However, each airline is responsible for fulfilling obligations associated with the ticket, including remedies to a customer for dissatisfaction with the service.
To determine whether the entity’s performance obligation is to provide the specified goods or services itself (ie the entity is a principal) or to arrange for those goods or services to be provided by another party (ie the entity is an agent), the entity identifies the specified good or service to be provided to the customer and assesses whether it controls that good or service before the good or service is transferred to the customer.
The entity concludes that, with each ticket that it commits itself to purchase from the airline, it obtains control of a right to fly on a specified flight (in the form of a ticket) that the entity then transfers to one of its customers. Consequently, the entity determines that the specified good or service to be provided to its customer is that right (to a seat on a specific flight) that the entity controls. The entity observes that no other goods or services are promised to the customer.
The entity controls the right to each flight before it transfers that specified right to one of its customers because the entity has the ability to direct the use of that right by deciding whether to use the ticket to fulfil a contract with a customer and, if so, which contract it will fulfil. The entity also has the ability to obtain the remaining benefits from that right by either reselling the ticket and obtaining all of the proceeds from the sale or, alternatively, using the ticket itself.
The indicators in paragraphs IFRS 15 also provide relevant evidence that the entity controls each specified right (ticket) before it is transferred to the customer. The entity has inventory risk with respect to the ticket because the entity committed itself to obtain the ticket from the airline before obtaining a contract with a customer to purchase the ticket. This is because the entity is obliged to pay the airline for that right regardless of whether it is able to obtain a customer to resell the ticket to or whether it can obtain a favourable price for the ticket. The entity also establishes the price that the customer will pay for the specified ticket.
Thus, the entity concludes that it is a principal in the transactions with customers. The entity recognises revenue in the gross amount of consideration to which it is entitled in exchange for the tickets transferred to the customers.
Example
Arranging for the provision of goods or services (entity is an agent) [restaurant vouchers]
An entity sells vouchers that entitle customers to future meals at specified restaurants. The sales price of the voucher provides the customer with a significant discount when compared with the normal selling prices of the meals (for example, a customer pays CU100 for a voucher that entitles the customer to a meal at a restaurant that would otherwise cost CU200). The entity does not purchase or commit itself to purchase vouchers in advance of the sale of a voucher to a customer; instead, it purchases vouchers only as they are requested by the customers. The entity sells the vouchers through its website and the vouchers are non-refundable.
The entity and the restaurants jointly determine the prices at which the vouchers will be sold to customers. Under the terms of its contracts with the restaurants, the entity is entitled to 30 per cent of the voucher price when it sells the voucher.
The entity also assists the customers in resolving complaints about the meals and has a buyer satisfaction programme. However, the restaurant is responsible for fulfilling obligations associated with the voucher, including remedies to a customer for dissatisfaction with the service.
To determine whether the entity is a principal or an agent, the entity identifies the specified good or service to be provided to the customer and assesses whether it controls the specified good or service before that good or service is transferred to the customer.
A customer obtains a voucher for the restaurant that it selects. The entity does not engage the restaurants to provide meals to customers on the entity’s behalf as described in the indicator in IFRS 15. Therefore, the entity observes that the specified good or service to be provided to the customer is the right to a meal (in the form of a voucher) at a specified restaurant or restaurants, which the customer purchases and then can use itself or transfer to another person. The entity also observes that no other goods or services (other than the vouchers) are promised to the customers.
The entity concludes that it does not control the voucher (right to a meal) at any time. In reaching this conclusion, the entity principally considers the following:
1. (a) the vouchers are created only at the time that they are transferred to the customers and, thus, do not exist before that transfer. Therefore, the entity does not at any time have the ability to direct the use of the vouchers, or obtain substantially all of the remaining benefits from the vouchers, before they are transferred to customers.
2. (b) the entity neither purchases, nor commits itself to purchase, vouchers before they are sold to customers. The entity also has no responsibility to accept any returned vouchers. Therefore, the entity does not have inventory risk with respect to the vouchers as described in the indicator in IFRS 15.
Thus, the entity concludes that it is an agent with respect to the vouchers. The entity recognises revenue in the net amount of consideration to which the entity will be entitled in exchange for arranging for the restaurants to provide vouchers to customers for the restaurants’ meals, which is the 30 per cent commission it is entitled to upon the sale of each voucher.
Example
Entity is a principal and an agent in the same contract
An entity sells services to assist its customers in more effectively targeting potential recruits for open job positions. The entity performs several services itself, such as interviewing candidates and performing background checks. As part of the contract with a customer, the customer agrees to obtain a licence to access a third party’s database of information on potential recruits. The entity arranges for this licence with the third party, but the customer contracts directly with the database provider for the licence. The entity collects payment on behalf of the third-party database provider as part of the entity’s overall invoicing to the customer. The database provider sets the price charged to the customer for the licence, and is responsible for providing technical support and credits to which the customer may be entitled for service down time or other technical issues.
To determine whether the entity is a principal or an agent, the entity identifies the specified goods or services to be provided to the customer, and assesses whether it controls those goods or services before they are transferred to the customer.
For the purpose of this example, it is assumed that the entity concludes that its recruitment services and the database access licence are each distinct on the basis of its assessment of the requirements in IFRS 15. Accordingly, there are two specified goods or services to be provided to the customer – access to the third party’s database and recruitment services.
The entity concludes that it does not control the access to the database before it is provided to the customer. The entity does not at any time have the ability to direct the use of the licence because the customer contracts for the licence directly with the database provider. The entity does not control access to the provider’s database – it cannot, for example, grant access to the database to a party other than the customer, or prevent the database provider from providing access to the customer.
As part of reaching that conclusion, the entity also considers the indicators in IFRS 15. The entity concludes that these indicators provide further evidence that it does not control access to the database before that access is provided to the customer:
1. (a) the entity is not responsible for fulfilling the promise to provide the database access service. The customer contracts for the licence directly with the third-party database provider and the database provider is responsible for the acceptability of the database access (for example, by providing technical support or service credits).
2. (b) the entity does not have inventory risk because it does not purchase, or commit itself to purchase, the database access before the customer contracts for database access directly with the database provider.
3. (c) the entity does not have discretion in setting the price for the database access with the customer because the database provider sets that price.
Thus, the entity concludes that it is an agent in relation to the third party’s database service. In contrast, the entity concludes that it is the principal in relation to the recruitment services because the entity performs those services itself and no other party is involved in providing those services to the customer.
Royalty payments – example
Entity A has agreed to pay a royalty to Entity B for the use of intellectual property rights that Entity A requires to make sales to its customers. The royalty is specified as a percentage of gross proceeds from Entity A’s sales to its customers less contractually defined costs. Entity A is the principal in the sales transactions with its customers (i.e. it must provide the goods and services itself and does not act as an agent for Entity B).
Because Entity A is the principal in respect of the sales to its customers, it should recognise its revenue on a gross basis and the royalty as a cost of fulfilling the contract (i.e. the royalty payments should not be netted against revenue). Guidance on the appropriate accounting for the costs of fulfilling a contract, including whether such costs should be capitalised or expensed, is provided in IFRS 15.
Offsetting revenue and expenses for shared commissions – example
Company A has signed a contract with an insurance company under which it receives a commission for every policy it sells on behalf of the insurance company. Company A contracts with individual financial advisers to sell these insurance policies and agrees to split the commission evenly with the financial advisers. Company A provides administrative facilities and office space to the financial advisers. The insurance company is aware of the arrangements between Company A and the financial advisers, but its contractual relationship is with Company A and Company A is responsible for providing the service to the insurance company. The insurance company pays the full commission to Company A, which then pays half of the commission to the financial adviser who sold the policy.
Company A has determined that it is acting as a principal in this arrangement, in accordance with IFRS 15:B34 to B38, as it is providing services to the insurance company and is not acting as an agent for the financial advisers. Accordingly, it is required to present the revenue it receives for those services as a gross amount and cannot offset the amount it pays to the financial advisers against the commission revenue it receives from the insurance company.
Income tax withheld in a different country – example
Company X performs consulting services for Company C, which is located in a different country from Company X. Company C withholds 20 per cent of Company X’s fee as a local income tax withholding and transmits this amount to its local government on behalf of Company X (Company X retains the primary responsibility to pay the tax in Company C’s tax jurisdiction). Company C pays the remaining 80 per cent to Company X. The countries do not have a tax treaty, and Company X is not required to file a tax return in Company C’s country. Company X was fully aware that the 20 per cent income tax would be withheld in Company C’s country when it agreed to perform the consulting services for Company C.
In this scenario Company X is the principal in providing the consulting services to Company C. Company X also has the primary responsibility to pay the tax in Company C’s tax jurisdiction, and Company C is simply paying the tax on Company X’s behalf (acting as a collection agent). Consequently, Company X should recognise revenue in the gross amount of consideration to which it expects to be entitled in exchange for those services and should therefore report revenue of CU100 and income tax expense of CU20.
Presentation of shipping and handling costs charged to customers
Many vendors charge customers for shipping and handling of goods. Shipping costs include costs incurred to move the product from the seller’s place of business to the buyer’s designated location and include payments to third-party shippers. But they may also include costs incurred directly by the seller (e.g. salaries and overheads related to the activities to prepare the goods for shipment).
Handling costs include costs incurred to store, move and prepare the products for shipment. Generally, handling costs are incurred from when the product is removed from finished goods inventories to when the product is provided to the shipper and may include an allocation of internal overheads.
Shipping and handling costs may be included in the price of the product. Alternatively, the vendor may charge its customers a separate fee for shipping and handling costs. In some cases, the separate fee may be a standard amount that does not necessarily correlate directly with the costs incurred for the specific shipment. In other cases, the separate fee may be a direct reimbursement for shipping and any direct incremental handling costs incurred or may include a margin on top of those costs.
For example, Company S sells goods to a customer and bills the customer for shipping and handling costs. Company S needs to consider how to present the amounts billed for shipping and handling in profit or loss.
The appropriate presentation of amounts billed to a customer for shipping and handling will depend on an analysis of the principal versus agent considerations in IFRS 15 related to shipping and handling services. If control of the goods transfers on receipt by the customer (e.g. FOB destination), the vendor will generally be considered to be the principal in the shipping and handling service. If, however, control of the goods transfers when the goods are shipped, the vendor will need to determine whether it is principal or agent with respect to the shipping service.
If, after consideration of the requirements of IFRS 15, Company S determines that it is responsible for shipping and handling as a principal, then all amounts related to shipping and handling billed to a customer in a sale transaction represent revenues earned for the goods provided (and the shipping services rendered, if the shipping service represents a distinct performance obligation) and should be presented as revenue.
However, if Company S considers the requirements of IFRS 15 and determines that it is not responsible to the customer for shipping but is instead acting merely as the buyer’s agent in arranging for a third party to provide shipping services to the buyer, then Company S should not report the amount charged by that third party for shipping as its own revenue. Instead, Company S should report as revenue only the commission it receives (if any) for arranging shipping, which is the excess of any amounts charged to the customer for shipping by Company S over any amounts paid to the third party for those services.
Classification of shipping costs incurred on products sold – example
Company A sells and ships goods to a customer and has concluded that it is the principal on the sale of goods and associated shipping. Company A analyses expenses by function in its statement of comprehensive income.
Company A may adopt a policy of including shipping and handling costs in cost of sales. This treatment is permitted by IAS 2:38, which states that the circumstances of the entity may warrant the inclusion of distribution costs in cost of sales.
Alternatively, shipping and handling costs may be included in a separate ‘distribution costs’ classification or, if insignificant, in ‘other operating expenses’. Company A should ensure that:
- the classification is appropriate to the entity’s circumstances;
- the classification is consistent from year to year; and
- material items are separately identified, as required by IAS 1.
Value added tax rebate – example
In Country C, when software is sold to distributors or end users, software developers are required to collect 17 per cent value added tax (VAT) as agents for the government (this rate is consistent with VAT on other similar items). As a measure to subsidise the software development industry, 14 per cent is rebated by the government to the developer almost immediately.
Assume software is sold by Entity S for CU117 inclusive of VAT. The sales invoice indicates a sales price of CU100 before VAT, with VAT of CU17 corresponding to the 17 per cent VAT rate. As a result of the sale, Entity S receives a rebate of CU14 from the government.
In accordance with IFRS 15:47 (see 7.1), CU17 is excluded from revenue because it is being collected on behalf of a third party. Therefore, Entity S should recognise a total of CU100 as revenue. IAS 20:3 defines a government grant as “assistance by government in the form of transfers of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity” (see section 3 of chapter A36). The 14 per cent VAT rebate is regarded as a government grant to encourage the software development industry. Therefore, Entity S should recognise revenue of CU100 and government grant income of CU14. In accordance with IAS 20:29, the CU14 may be presented separately or as ‘other income’.
Accounting by an ‘undisclosed agent’ – example
Entity A has agreed to arrange for the sale of goods to end customers as an agent for a third party, Entity B. However, the agreement between the two entities requires Entity A not to disclose to the end customer that it has agreed to act as an agent.
Accordingly, the contract between Entity A and the end customer does not refer to Entity B and, in that contract, Entity A promises that it will provide the specified goods. Moreover, the end customer is unaware of the agreement between Entity A and Entity B and considers that Entity A is promising to provide the specified goods.
In the legal environment in which Entity A operates, this contract results in Entity A having the same legal responsibilities to the end customer in respect of those goods as if it were supplying them as a principal.
In this fact pattern, the agreement between Entity A and Entity B does not, in itself, affect the analysis of whether Entity A is a principal or an agent in its contract with the end customer. Entity A needs to determine whether it is an agent or principal by reference to its contract with the end customer. This analysis is not affected by the existence of a separate contract to which the end customer is not party and of which it has no knowledge.
Entity A should assess, by reference to its contract with the end customer, whether it is promising to provide the specified goods itself or promising to arrange for those goods to be provided by another party. In this particular scenario, the contract indicates that Entity A is promising to provide the specified goods itself, and the legal requirements are such that it has primary responsibility to the end customer for those goods. Accordingly, Entity A would typically account for the transaction as a principal. In some jurisdictions, the term ‘undisclosed agent’ may be used to describe Entity A’s role in these transactions.
Note that, in other scenarios, despite a contract not explicitly stating that a third party is involved, other factors or information may mean the customer is aware that the promise of goods or services is being made to it by that third party and this should be assessed as part of the accounting analysis performed.