Chapter 9: Contract costs
Incremental costs of obtaining a contract
An entity capitalises the incremental costs of obtaining a contract with a customer if it expects to recover those costs. However, costs to obtain a customer do not include payments to customers.
Can an entity apply the portfolio approach to account for contract costs?
Yes. Management can apply the portfolio approach to account for costs related to contracts with similar characteristics, similar to other aspects of the revenue standard. The portfolio approach is permitted if the entity reasonably expects that the effect of applying the guidance to the portfolio would not differ materially from applying the guidance to each contract or performance obligation individually.
Example
Modification of a contract for goods (1)
An entity promises to sell 120 products to a customer for CU12,000 (CU100 per product). The products are transferred to the customer over a six-month period. The entity transfers control of each product at a point in time. After the entity has transferred control of 60 products to the customer, the contract is modified to require the delivery of an additional 30 products (a total of 150 identical products) to the customer. The additional 30 products were not included in the initial contract.
Case A – Additional products for a price that reflects the stand-alone selling price
When the contract is modified, the price of the contract modification for the additional 30 products is an additional CU2,850 or CU95 per product. The pricing for the additional products reflects the stand-alone selling price of the products at the time of the contract modification and the additional products are distinct from the original products.
In accordance with IFRS 15, the contract modification for the additional 30 products is, in effect, a new and separate contract for future products that does not affect the accounting for the existing contract. The entity recognises revenue of CU100 per product for the 120 products in the original contract and CU95 per product for the 30 products in the new contract.
Modification of a right-to-access licence agreement – example
Entity X and Customer Y enter into an agreement under which Customer Y is provided the right to access Entity X’s intellectual property (IP) for three years for CU3 million (CU1 million per annum). After one year, Entity X and Customer Y agree to extend the contract for an additional two years for CU1.8 million. Entity X has concluded that the additional two years of access to its IP are distinct from the initial period.
To determine whether the contract modification should be accounted for as a separate contract, Entity X must consider both of the criteria in IFRS 15. The criterion in IFRS 15 is met because the scope of the contract is increased by two years and the right to access Entity X’s IP over that period is considered distinct in accordance with IFRS 15.
The criterion in IFRS 15 will be met if the modification increases the price of the contract “by an amount of consideration that reflects the entity’s stand-alone selling prices of the additional promised goods or services”.
Depending on the specific facts and circumstances, Entity X might conclude that the additional price charged to the customer (CU0.9 million per annum) represents the stand-alone selling price of the additional two years, adjusted to reflect the particular circumstances of the contract. While it is lower than the CU1 million per annum charged in the original contract, the difference might reflect a discount for costs that Entity X has not incurred, because it has modified a contract with an existing customer and not incurred costs associated with finding a new customer. If Entity X concludes that the criterion in IFRS 15 is met, it will account for the modification as a separate contract, continuing to recognise revenue of CU3 million over the first three years under the initial contract, and then revenue of CU1.8 million over the remaining two years under the new contract.
If Entity X instead concludes that the additional price charged to the customer does not represent the stand-alone selling price of the additional two years, adjusted to reflect the particular circumstances of the contract, Entity X should account for the modification in accordance with IFRS 15, (i.e. as a termination of the existing contract and creation of a new contract). If this was the case then Entity X would recognise CU0.95 million per annum for the remaining four years ((CU2 million revenue not yet recognised from original contract + CU1.8 million revenue for additional two years ÷ four years remaining based on modified contract).
Example
Modification of a contract for goods (2)
An entity promises to sell 120 products to a customer for CU12,000 (CU100 per product). The products are transferred to the customer over a six-month period. The entity transfers control of each product at a point in time. After the entity has transferred control of 60 products to the customer, the contract is modified to require the delivery of an additional 30 products (a total of 150 identical products) to the customer. The additional 30 products were not included in the initial contract.
Case B – Additional products for a price that does not reflect the stand-alone selling price
During the process of negotiating the purchase of an additional 30 products, the parties initially agree on a price of CU80 per product. However, the customer discovers that the initial 60 products transferred to the customer contained minor defects that were unique to those delivered products. The entity promises a partial credit of CU15 per product to compensate the customer for the poor quality of those products. The entity and the customer agree to incorporate the credit of CU900 (CU15 credit × 60 products) into the price that the entity charges for the additional 30 products. Consequently, the contract modification specifies that the price of the additional 30 products is CU1,500 or CU50 per product. That price comprises the agreed-upon price for the additional 30 products of CU2,400, or CU80 per product, less the credit of CU900.
At the time of modification, the entity recognises the CU900 as a reduction of the transaction price and, therefore, as a reduction of revenue for the initial 60 products transferred. In accounting for the sale of the additional 30 products, the entity determines that the negotiated price of CU80 per product does not reflect the stand-alone selling price of the additional products. Consequently, the contract modification does not meet the conditions in IFRS 15 to be accounted for as a separate contract. Because the remaining products to be delivered are distinct from those already transferred, the entity applies the requirements in IFRS 15 and accounts for the modification as a termination of the original contract and the creation of a new contract.
Consequently, the amount recognised as revenue for each of the remaining products is a blended price of CU93.33 {[(CU100 × 60 products not yet transferred under the original contract) + (CU80 × 30 products to be transferred under the contract modification)] ÷ 90 remaining products}.
Example
Modification of a services contract
An entity enters into a three-year contract to clean a customer’s offices on a weekly basis. The customer promises to pay CU100,000 per year. The stand-alone selling price of the services at contract inception is CU100,000 per year. The entity recognises revenue of CU100,000 per year during the first two years of providing services. At the end of the second year, the contract is modified and the fee for the third year is reduced to CU80,000. In addition, the customer agrees to extend the contract for three additional years for consideration of CU200,000 payable in three equal annual instalments of CU66,667 at the beginning of years 4, 5 and 6. After the modification, the contract has four years remaining in exchange for total consideration of CU280,000. The stand-alone selling price of the services at the beginning of the third year is CU80,000 per year. The entity’s stand-alone selling price at the beginning of the third year, multiplied by the remaining number of years to provide services, is deemed to be an appropriate estimate of the stand-alone selling price of the multi-year contract (ie the stand-alone selling price is 4 years × CU80,000 per year = CU320,000).
At contract inception, the entity assesses that each week of cleaning service is distinct in accordance with IFRS 15. Notwithstanding that each week of cleaning service is distinct, the entity accounts for the cleaning contract as a single performance obligation in accordance with IFRS 15. This is because the weekly cleaning services are a series of distinct services that are substantially the same and have the same pattern of transfer to the customer (the services transfer to the customer over time and use the same method to measure progress – that is, a time-based measure of progress).
At the date of the modification, the entity assesses the remaining services to be provided and concludes that they are distinct. However, the amount of remaining consideration to be paid (CU280,000) does not reflect the stand-alone selling price of the services to be provided (CU320,000).
Consequently, the entity accounts for the modification in accordance with IFRS 15 as a termination of the original contract and the creation of a new contract with consideration of CU280,000 for four years of cleaning service. The entity recognises revenue of CU70,000 per year (CU280,000 ÷ 4 years) as the services are provided over the remaining four years.
When should an entity recognise a liability for costs to obtain a contract?
The revenue standard does not address the timing for recognising a liability for costs to obtain a contract. Management should therefore refer to the applicable liability guidance (for example, IAS 37) to first determine if the entity has incurred a liability and then apply the revenue standard to determine whether the related costs should be capitalised or expensed.
Only incremental costs should be recognised as assets. Incremental costs of obtaining a contract are those costs that the entity would not have incurred if the contract had not been obtained (for example, sales commissions).
How should an entity account for incremental costs that relate to multiple contracts?
Incremental costs might relate to multiple contracts. For example, many sales commission plans are designed to pay commissions based on cumulative thresholds. The fact that the costs relate to multiple contracts do not preclude the costs from qualifying as incremental costs to obtain a contract. Management should apply judgement to determine a reasonable approach to allocate costs to the related contracts in these instances.
Do fringe benefits (for example, payroll taxes) related to commission payments represent incremental costs to obtain a contract?
Yes, provided the entity would not have incurred the fringe benefits if it had not obtained the contract. An entity is required to capitalise fringe benefits that are incremental costs and recoverable, unless they qualify for the practical expedient.
Should incremental costs to obtain contract renewals or modifications be capitalised?
Yes, if the costs to obtain contract renewals or modification are incremental and recoverable. An example is a commission paid to a sales agent when a customer renews a contract. Management should not, however, record an asset in anticipation of contract renewals or modifications if the entity has not yet incurred a liability related to the costs.
Should a sales commission be capitalised if it is subject to clawback in the event the customer fails to pay the contract consideration?
Yes, assuming management has concluded that the parties are committed to perform their respective obligations and collection is probable, which are requirements for identifying a contract. Management should re-assess whether a valid contract exists if circumstances change after contract inception and assess the contract asset for impairment.
How should an entity account for payments to multiple individuals for the same contract?
An entity could make payments to multiple individuals for the same contract that all qualify as incremental costs. For example, if an entity pays a sales commission to the salesperson, manager and regional manager on obtaining a new contract, all of the payments would be incremental costs. The timing of a payment does not, on its own, determine whether the costs are incremental; however, management should consider whether the payment is contingent on factors other than obtaining a contract. For example, a bonus payment that is calculated based on obtaining contracts is similar to a commission; but, if the bonus is also based on the individual’s overall performance in relation to non-sales-related goals, it is likely that it is not an incremental cost. Similarly, a payment that is contingent upon an employee providing future service in addition to obtaining a new contract would generally not be considered an incremental cost to obtain a contract. Assessing whether a payment has a substantive future service requirement might require judgement.
Is a bonus based on a revenue target an incremental cost of obtaining a contract?
An entity’s vice president of sales receives a quarterly bonus based on meeting a specified revenue target that is established at the beginning of each quarter. The entity’s revenue includes revenue from both new contracts initiated during the quarter and contracts entered into in prior quarters.
Question
Is the bonus an incremental cost to obtain a contract?
Answer
No. The revenue target is impacted by more than obtaining new contracts. As such, the payment would not be an incremental cost to obtain the contract. If the revenue target was based on obtaining new contracts, the substance of the payment would be the same as a sales commission. If this were the case, the bonus might be an incremental cost.
Is a payment which requires future service an incremental cost of obtaining a contract?
An internal salesperson employed by an entity earns a 5% commission on a new contract obtained in January 20X1. The commission plan requires the employee to continue providing employee service through the end of 20X2 to receive the commission payment.
Question
Is the payment an incremental cost to obtain a contract?
Answer
No. The employee has to provide future service to receive the payment; therefore, the payment is contingent upon factors other than obtaining new contracts. The entity would recognise the expense over the service period based on IAS 19.
Costs of obtaining a contract that are not incremental should be expensed as incurred, unless those costs are explicitly chargeable to the customer, even if the contract is not obtained. Amounts that relate to a contract that are explicitly chargeable to a customer are a receivable if an entity’s right to reimbursement is unconditional.
Construction industry
Entity S incurs costs in connection with winning a bid on a contract to build a bridge. The costs were incurred during the proposal and contract negotiations (for example, legal costs), and include the initial bridge design.
Question
How should entity S account for the costs?
Answer
Entity S should expense the costs incurred during the proposal and contract negotiations as incurred. The costs are not incremental, because they would have been incurred even if the contract was not obtained. The costs incurred during contract negotiations could be recognised as an asset if they are explicitly chargeable to the customer regardless of whether the contract is obtained. Even though the costs incurred for the initial design of the bridge are not incremental costs to obtain a contract, some of the costs might be costs to fulfil a contract and recognised as an asset under that guidance.
Telecommunications industry
Entity T sells wireless mobile phone and other telecom service plans from a retail store. Sales agents employed at the store signed 120 customers to two year service contracts in a particular month. Entity T pays commissions to its sales agents for the sale of service contracts in addition to their salaries. Salaries paid to sales agents during the month were C12,000, and commissions paid were C2,400. The retail store also incurred C2,000 in advertising costs during the month.
Question
How should entity T account for the costs?
Answer
The only costs that qualify as incremental costs of obtaining a contract are the commissions paid to the sales agents. The commissions are costs to obtain a contract that entity T would not have incurred if it had not obtained the contracts. Telecom should record an asset for the costs, assuming they are recoverable. All other costs are expensed as incurred. The sales agents’ salaries and the advertising expenses are expenses that entity T would have incurred whether or not it obtained the customer contracts.
Expensing these costs as they are incurred is not permitted, unless they qualify for the practical expedient discussed.
Application of IFRS 15 Illustrative Example 7 (Modification of a services contract)
In applying the guidance in example 10.3B, the first consideration is whether IFRS 15:20 applies (i.e. to determine whether the contract modification should be accounted for as a separate contract). In this example, as a result of the modification, a discount of CU20,000 is given for the outstanding third year of cleaning services (CU80,000 rather than CU100,000 as under the terms of the original contract). In addition, the contract term is extended for another three years for additional consideration of CU200,000. The contract modification therefore increases the transaction price overall by CU180,000 (CU200,000 additional consideration less the CU20,000 discount). The contract modification also requires the entity to provide six years of cleaning services in total, i.e. an increase of three years over the original contract.
To meet the requirements of IFRS 15 the scope of the contract must increase as a result of the addition of promised goods or services that are distinct, and the price of the contract must increase by an amount of consideration that reflects the stand-alone selling prices of those additional goods or services. Although the additional three years of services are distinct, the additional consideration payable as a result of the contract modification is less than the stand-alone selling price of those services (CU 180,000 additional consideration compared to a stand-alone selling price of CU240,000 (CU80,000 × 3 years)).
As the requirements of IFRS 15 are not met, the entity applies IFRS 15:21(a) to the modified contract, i.e. as if it were a termination of the existing contract and the creation of a new contract. This results in revenue of CU70,000 (CU280,000/4 years) being recognised each year for the remaining four years of the contract term.
Contract modification resulting in a reduction in the scope of a contract
IFRS 15 provides guidance on how to account for a contract modification, which is defined as “a change in the scope or price (or both) of a contract that is approved by the parties to the contract”.
Specifically, IFRS 15 notes that a contract modification must be accounted for as a separate contract if both of the following criteria are met:
- the scope of the contract increases because of the addition of promised goods or services that are distinct; and
- the price of the contract increases by an amount of consideration that reflects the entity’s stand-alone selling prices of the additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the particular contract.
If the above criteria are not met, the contract modification must be accounted for in accordance with IFRS 15 as follows:
- if the remaining goods or services (i.e. those not yet transferred at the date of the modification) are distinct from the goods or services transferred on or before the date of the contract modification, the contract modification is accounted for as if it were a termination of the existing contract and creation of a new contract; or
- if the remaining goods or services are not distinct from the goods or services transferred on or before the date of the contract modification, the contract modification is accounted for as if it were a part of the existing contract, and an adjustment (on a cumulative catch-up basis) is recognised to revenue.
Depending on whether the remaining goods or services in the existing contract are distinct from those transferred prior to the modification, IFRS 15 requires an entity to account for a contract modification that results in a decrease in scope (i.e. the removal from the contract of promised goods or services) as either (1) the termination of the existing contract and the creation of a new contract or (2) a cumulative catch-up adjustment to the existing contract.
The modification cannot be accounted for as a separate contract because the criterion in IFRS 15 specifying an increase in scope of the contract is not met.
Practical expedient
There is a practical expedient that permits an entity to expense the costs to obtain a contract as incurred where the expected amortisation period is one year or less. Anticipated contract renewals, amendments, and follow-on contracts with the same customer are required to be considered (to the extent the costs relate to those goods or services) when determining whether the period of benefit, and therefore the period of amortisation, is one year or less. These factors might result in an amortisation period that is beyond one year, in which case the practical expedient is not available
Can an entity elect whether to apply the practical expedient to each individual contract or is it required to apply the election consistently to all similar contracts?
The practical expedient is an accounting policy election that should be applied consistently to similar contracts.
Sales commission
A salesperson for entity U earns a 5% commission on a contract that was signed in January. Entity U will deliver the purchased products throughout the year. The contract is not expected to be renewed the following year. Entity U expects to recover this cost.
Question
How should entity U account for the commission?
Answer
Entity U can either recognise the commission payment as an asset or expense the cost as incurred under the practical expedient. The commission is a cost to obtain a contract that would not have been incurred if the contract had not been obtained. Since entity U expects to recover this cost, it can recognise the cost as an asset and amortise it as revenue is recognised during the year. The commission payment can also be expensed as incurred, because the amortisation period of the asset is one year or less. The practical expedient would not be available, however, if management expects the contract to be renewed, such that products will be delivered over a period longer than one year, because the amortisation period of the asset would also be longer than one year.
Costs to fulfil a contract
Entities often incur costs to fulfil their obligations under a contract once it is obtained, but before transferring goods or services to the customer. Some costs could also be incurred in anticipation of winning a contract. The guidance in the revenue standard for costs to fulfil a contract only applies to those costs not addressed by other standards. For example, inventory costs would be covered under IAS 2. An entity cannot recognise an asset under the revenue standard if such costs are required to be expensed in accordance with other standards. Fulfilment costs not addressed by other standards should be capitalised if all of the following criteria are met:
- the costs relate directly to a contract or an anticipated contract that the entity can specifically identify;
- the costs generate or enhance resources of the entity that will be used in satisfying or continuing to satisfy performance obligations in the future; and
- the costs are expected to be recovered.
Learning curve costs
Learning curve costs are costs that an entity incurs to provide a service or produce an item in early periods before it has gained experience with the process. Over time, the entity typically becomes more efficient at performing a task or manufacturing a good that is done repeatedly and no longer incurs learning curve costs for that task or good. Such costs usually consist of labour, overhead, rework or other special costs that are required to be incurred to complete the contract, other than research and development costs. Judgement is required to determine the accounting for learning curve costs. Learning curve costs incurred for a single performance obligation that is satisfied over time are recognised in cost of sales, but they might need to be considered in the measurement of progress towards satisfying a performance obligation, depending on the nature of the cost. For example, an entity applying a cost-to-cost measure of progress might recognise more revenue in earlier periods due to the higher costs incurred earlier in the contract. Learning curve costs incurred for a performance obligation satisfied at a point in time should be assessed to determine if they are addressed by other standards (such as inventory). Learning curve costs not addressed by other standards are unlikely to meet the criteria for capitalisation under the revenue standard, as such costs generally do not relate to future performance obligations. For example, an entity might promise to transfer multiple units under a contract in which each unit is a separate performance obligation satisfied at a point in time. The costs to produce each unit would be accounted for under inventory guidance and recognised in cost of sales when control of the inventory transfers. As a result, the margin on each individual unit could differ if the costs to produce units earlier in the contract are greater than the costs to produce units later in the contract.
Set-up and mobilisation costs
Set-up and mobilisation costs are direct costs typically incurred at a contract’s inception, to enable an entity to fulfil its obligations under the contract.
For example, outsourcing entities often incur costs relating to the design, migration and testing of data centres when preparing to provide services under a new contract. Set-up costs might include labour, overhead or other specific costs. Other standards might address some of these costs, such as property, plant and equipment. Management should first assess whether costs are addressed by other standards and if so, it should apply that guidance. Mobilisation costs are a type of set-up cost incurred to move equipment or resources to prepare to provide the goods or services in an arrangement. Costs incurred to move newly acquired equipment to its intended location could meet the definition of the cost of an asset under property, plant and equipment guidance. Costs incurred subsequently, to move equipment for a future contract, that meet the criteria are costs to fulfil a contract and are therefore assessed to determine whether they qualify to be recognised as an asset. Entities in certain industries undertake pre-production activities, including efforts to design and develop products or create a new technology based on the needs of a customer. An example is an entity that designs and develops tooling prior to the production of automotive parts under an automotive supplier contract. Management should evaluate whether pre-production activities represent promised goods or service s or costs to fulfil a contract.
Activity
Entity V enters into a contract with a customer to track and monitor payment activities for a five-year period. A prepayment is required from the customer at contract inception. Entity V incurs costs at the outset of the contract consisting of uploading data and payment information from existing systems. The ongoing tracking and monitoring is automated after customer set-up. There are no refund rights in the contract.
Question
How should entity V account for the set-up costs?
Answer
Entity V should recognise the set-up costs incurred at the outset of the contract as an asset, since they (1) relate directly to the contract, (2) enhance the resources of the entity to perform under the contract, and relate to future performance, and (3) are expected to be recovered. Entity V would recognise an asset and amortise that asset on a systematic basis in a way that is consistent with the pattern of transfer of the tracking and monitoring services to the customer. It should include the prepayment from the customer in the transaction price and allocate it to the performance obligations in the contract (that is, the tracking and monitoring services).
Contract margin over the life of a contract
For performance obligations satisfied over time, IFRS 15 requires entities to select either an input or output method to measure progress towards satisfaction of a performance obligation. This is not an accounting policy choice. The entity should select the method which best reflects the transfer of goods or services to the customer.
The use of an output measure of progress can result in different profit margins being recognised in each year of a contract. Costs to fulfil a contract are subject to the guidance in IFRS 15. Costs should be recognised as an expense when incurred and cannot be deferred to future periods or accrued in advance merely to ‘smooth’ profit margin, unless such costs meet the criteria to be capitalised as contract fulfilment costs, or the criteria to be capitalised as intangible assets, property, plant and equipment or inventory. Consider the following example: Company A is a contractor providing construction services for property developers. The contract includes a single performance obligation. The contract price is C3,000,000 and estimated total costs are C2,400,000, leading to an expected overall contract margin of 20%. The construction commences on 1 January 20X7 and is expected to last for three years. The construction work is bespoke to the customer, and company A is entitled to recover costs incurred plus a 20% margin if the customer cancels the contract during construction, so company A recognises revenue over time. Company A has determined that an output method based on the performance completed to date is the best measure of its performance in transferring control of the work in progress to the customer. Company A uses a surveyor to assess the work in progress and to determine the percentage of the contract that has been completed at the end of each year. Costs incurred by company A each year, and the percentage of contract completion as determined by the surveyor at the end of each year, are as follows:
20X7 20X8 20X9
Actual costs incurred 575,000 975,000 850,000
Percentage of contract completed, based on survey 23% 63% 100%
Revenue is recognised each year, based on the transaction price and the percentage of the contract completed. Costs are taken each year as they are incurred. The revenue and margin recognised in each year of the contract for company A would therefore be as follows:
20X7 20X8 20X9
Revenue recognised 690,000 1,200,000 1,110,000
Costs incurred (575,000) (975,000) (850,000)
Profit recognised 115,000 225,000 260,000
Margin % 17% 19% 23%
The use of an output method results in different margins being recognised in the three years, with a lower margin being recognised during the early part of the contract in this example. Company A has other contracts where it has determined that an input method based on costs incurred is the best measure of performance under the contract. Using an input method will result in those contracts having a consistent margin across their lives.
Costs that relate directly to a contract include the following:
- direct labour;
- direct materials;
- allocation of costs that relate directly to the contract or to contract activities;
- costs that are explicitly chargeable to the customer under the contract; and
- other costs that are incurred only because an entity entered into the contract.
Certain costs might relate directly to a contract, but neither generate nor enhance resources of an entity, nor relate to the satisfaction of future performance obligations. An entity should recognise the following costs as expenses when incurred:
- general and administrative costs;
- costs of wasted materials, labour or other resources to fulfil the contract that were not reflected in the price of the contract;
- costs that relate to past performance (satisfied performance obligations or partially satisfied performance obligations); and
- costs for which an entity cannot distinguish whether the costs relate to unsatisfied performance obligations or to satisfied performance obligations (or partially satisfied performance obligations).
Abnormal costs
Abnormal costs are fulfilment costs that are incurred from excessive resources, wasted or spoiled materials, and unproductive labour costs (that is, costs not otherwise anticipated in the contract price). Such costs might arise due to delays, changes in project scope or other factors. They differ from learning curve costs, which are typically reflected in the price of the contract. Abnormal costs should be expensed as incurred.
Activity
Entity W enters into a contract with a customer to build an office building. Entity W incurs directly related mobilisation costs to bring heavy equipment to the location of the site. During the build phase of the contract, entity W incurs direct costs related to supplies, equipment, material and labour. Entity W also incurs some abnormal costs related to wasted materials that were purchased in connection with the contract. Entity W expects to recover all incurred costs under the contract.
Question
How should entity W account for the costs?
Answer
Entity W should recognise an asset for the mobilisation costs, because these costs (1) relate directly to the contract, (2) enhance the resources of the entity to perform under the contract and relate to satisfying a future performance obligation, and (3) are expected to be recovered. The direct costs incurred during the build phase are accounted for in accordance with other standards if those costs are in the scope of those standards. Certain supplies and materials, for example, might be capitalised in accordance with inventory guidance. The equipment might be capitalised in accordance with property, plant and equipment guidance. Any other direct costs associated with the contract, that relate to satisfying performance obligations in the future and are expected to be recovered, are recognised as an asset. Entity W should expense the abnormal costs as incurred.
Can costs to fulfil a contract be deferred to achieve a consistent profit margin?
Activity
A contractor utilises an output method (engineering survey) to measure progress of construction services for which control transfers over time. In the first reporting period, the contractor determines that 35% of the contract has been completed based on the engineering survey and, accordingly, it recognises revenue equal to 35% of the estimated transaction price. In the same period, the contractor incurs 45% of the estimated total costs to fulfil the contract.
Question
Can the contractor defer a portion of the costs incurred to achieve a consistent profit margin throughout the contract?
Answer
No. Costs cannot be deferred solely to match costs with revenue or to achieve a consistent profit margin throughout the contract. Only costs to fulfil the contract that are capitalisable under other standards, or that meet the criteria for capitalisation in the revenue standard, should be capitalised. The use of an output method to measure progress can result in different period-to-period profit margins, unlike an input method based on costs incurred; however, the total profit margin on the contract will be the same under either method. The IFRS IC discussed a similar example in its IFRS IC agenda decision, ‘Costs to fulfil a contract’, issued in June 2019.
Amortisation and impairment
The asset recognised from capitalising the costs to obtain or fulfil a contract is amortised on a systematic basis consistent with the pattern of the transfer of the goods or services to which the asset relates. An asset related to an obligation satisfied over time should be amortised using a method consistent with the method used to measure progress and recognise revenue (that is, an input or output method). Straight-line amortisation might be appropriate if goods or services are transferred to the customer rateably throughout the contract. Management might also need to apply judgement to determine the goods or services to which the asset relates. Capitalised costs might relate to an entire contract, or could relate only to specific performance obligations within a contract.
Amortisation method
Entity X enters into a developer contract to build an oil refinery. Entity X concludes that its performance creates an asset that the customer controls and that control is transferred over time. Entity X also concludes that ‘cost-to-cost’ is a reasonable method for measuring its progress towards satisfying its performance obligation. Entity X pays commission totalling C100,000 to its sales agent for securing the oil refinery contract. Entity X concludes that the commission is an incremental cost of obtaining the contract and recognises an asset. As at the end of the first year, entity X estimates that its performance is 50% complete and recognises 50% of the transaction price as revenue.
Question
How much of the contract asset should be amortised as at the end of the first year?
Answer
The pattern of amortisation should be consistent with the method that entity X uses to measure progress towards satisfying its performance obligation for recognising revenue. Entity X should amortise 50%, or C50,000, of the commission costs as of the end of the first year.
Amortisation of contract cost assets: multiple performance obligations
Entity Y enters into a contract with a customer to sell a piece of industrial equipment for C75,000 and provide two years of maintenance services for the equipment for C25,000. Entity Y concludes that the promises to transfer equipment and perform maintenance are distinct and, therefore, represent separate performance obligations. The contract price represents stand-alone selling price of the equipment and services. Entity Y recognises revenue for the sale of equipment when control of the asset transfers to the customer upon delivery. It recognises revenue from the maintenance services rateably over two years consistent with the period during which the customer receives and consumes the maintenance services. Entity Y pays a single commission of C10,000 to its sales agent equal to 10% of the total contract price of C100,000. Entity Y concludes that the commission is an incremental cost of obtaining the contract and recognises an asset. Assume that entity Y does not expect the customer to renew the maintenance services.
Question
What pattern of amortisation should entity Y use for the capitalised costs?
Answer
Entity Y should use a reasonable method to amortise the asset consistent with the transfer of the goods or services. One acceptable approach would be to allocate the contract asset to each performance obligation based on relative stand-alone selling prices, similar to the allocation of transaction price. Applying this approach, entity Y would allocate C7,500 of the total commission to the equipment and the remaining C2,500 to the maintenance services. Entity Y would expense the commission allocated to the equipment upon transfer of control the equipment and amortise the commission allocated to the services over time consistent with the transfer of the maintenance services. Other approaches could be acceptable if they are consistent with the pattern of transfer of the goods or services related to the asset. It would not be acceptable to amortise the entire asset on a straight-line basis if the asset relates to both the equipment and the services. Entity Y could also consider whether there is evidence that would support a conclusion that the contract asset relates only to one of the performance obligations in the contract.
How should management present the amortisation of an asset arising from costs to obtain or fulfil a contract in the income statement?
There is no specific guidance on the presentation in the income statement of the amortisation of such an asset. An entity should apply the principles in IAS 1 to determine the appropriate classification in the income statement and apply it consistently. Cost to obtain a contract might be more likely to be similar in nature to other acquired intangible assets. Cost to fulfil a contract might be more likely to be similar in nature to prepaid operating costs or inventories. Management should apply judgement to determine how the amortisation of contract costs should be presented. An entity that considers certain costs to be prepaid expenditures should present such costs based on the nature of underlying expenditures. For example, an entity might capitalise sales commission to employees. An entity that presents expenses by nature would include sales commission as part of employee benefit expenses. An entity that presents expenses by function would be likely to classify the expense as part of selling and distribution costs. An entity that considers certain costs to be similar in nature to the acquisition of intangible assets might present such costs in the same line as depreciation and amortisation or separately (if material) where it presents expenses by nature. An entity that presents expenses by function would classify such costs in categories according to their functions. For example, an entity might include amortisation of costs to obtain a contract as selling and distribution costs and costs to fulfil contract as cost of sales. IFRS 15 permits an entity to expense costs to obtain a contract if the amortisation period of the asset is one year or less. An entity that applies this practical expedient should also consider the consistency of the presentation with costs that are capitalised. An entity should disclose the total amortisation of an asset arising from costs to obtain or fulfil a contract.
Is it appropriate to exclude amortisation of contract costs from EBITDA?
EBITDA is a common alternative performance measures and it is not defined by IFRS. Management might include or exclude amortisation of contract assets when deriving EBITDA. They should disclose the definition of EBITDA and a reconciliation of the measure to the closest IFRS profit measure.
Capitalised costs could also relate to anticipated contracts, such as renewals. An entity should amortise an asset recognised for contract costs over a period longer than the initial contract term if management anticipates that a customer will renew a contract and the costs relate to the goods or services that are expected to be transferred during the renewal period. However, the amortisation period should not include anticipated renewals if the entity incurs a similar cost for renewals. The costs incurred to obtain the initial contract do not relate to the subsequent contract renewal. Assessing whether costs incurred for contract renewals are ‘commensurate with’ costs incurred for the initial contract could require judgement.
How should an entity amortise capitalised costs relating to anticipated contracts?
An appropriate amortisation period could be the average customer life or a shorter period, depending on the circumstances. For example, a period shorter than the average customer life might be appropriate if the average customer life is longer than the life cycle of the related goods or services. Management needs to exercise judgement to determine the appropriate amortisation period, similar to other tangible and intangible assets.
How should an entity evaluate whether the sales commission paid on the contract renewal is commensurate with the sales commission paid on the initial contract?
Entities often pay a higher sales commission for initial contracts as compared to renewal contracts. The assessment of whether the renewal commission is commensurate with the initial commission should not be based on the level of effort required to obtain the initial and renewal contracts. Instead, it should generally be based on whether the initial and renewal commissions are reasonably proportional to the respective contract values.
Renewal periods without additional commission
Entity Z sells prepaid wireless services to a customer. The customer purchases up to 1,000 minutes of voice services, and any unused minutes expire at the end of the month. The customer can purchase an additional 1,000 minutes of voice services at the end of the month or once all of the voice minutes are used. Entity Z pays commissions to sales agents for initial sales of prepaid wireless services, but does not pay a commission for subsequent renewals. Entity Z concludes that the commission payment is an incremental cost of obtaining the contract, and it recognises an asset. The contract is a one-month contract and entity Z expects the customer, based on the customer’s demographics (for example, geography, type of plan and age), to renew for 16 additional months.
Question
What period should entity Z use to amortise the commission costs?
Answer
Entity Z should amortise the costs to obtain the contract over 17 months (the initial contract term and expected renewal periods). Management needs to use judgement to determine the period over which the entity expects to provide services to the customer, including expected renewals, and amortise the asset over that period. In this fact pattern, entity Z cannot expense the commission payment under the practical expedient, because the amortisation period is greater than one year.
Renewal periods with separate commission
Entity Z sells prepaid wireless services to a customer. The customer purchases up to 1,000 minutes of voice services, and any unused minutes expire at the end of the month. The customer can purchase an additional 1,000 minutes of voice services at the end of the month or once all of the voice minutes are used. Entity Z pays commissions to sales agents for initial sales of prepaid wireless services and renewals. Entity Z concludes that the commission payment is an incremental cost of obtaining the contract, and it recognises an asset.
Question
What period should entity Z use to amortise the commission costs?
Answer
Entity Z should assess whether the commission paid on the initial contract relates only to the goods or services provided under the initial contract or to both the initial and renewal periods. If entity Z concludes the renewal commission is commensurate with the commission paid on the initial contract, this would indicate that the initial commission relates only to the initial contract and it should amortise over the initial contract period (unless entity Z elects to apply the practical expedient). Entity Z would amortise the renewal commission over the related renewal period.
Renewal commissions are not commensurate with initial commissions
An entity pays an internal sales employee a C500 commission for selling an initial annual service contract to a customer. The entity will also pay a C250 commission for each annual renewal. The services provided under the initial and renewal contracts are substantially the same and the annual fee is the same. The entity expects the customer to renew the contract. The entity concludes that the C500 commission is an incremental cost to obtain the contract and records an asset. The entity also concludes that a five-year average customer life is an appropriate amortisation period.
Question
What pattern of amortisation should the entity use for the capitalised costs?
Answer
The initial commission should be amortised over a period longer than the initial contract term, because the renewal commission is not commensurate with the initial commission, indicating that a portion of the initial commission relates to services provided during renewal periods. The asset should be amortised on a systematic basis that is consistent with the transfer of the related services. To comply with this objective, the entity could amortise the initial C500 commission over the average customer life of five years, or it could separate the initial commission of C500 into two components, and amortise C250 over the initial annual contract term and the remaining C250 over the average customer life of five years. Other approaches could be acceptable if they are consistent with the pattern of transfer of the services related to the asset.
An entity should update the amortisation of a contract asset if there is a significant change in the expected pattern of transfer of the goods or services. The change is accounted for as a change in accounting estimate, in accordance with IAS 8.
Assets recognised from the costs to obtain or fulfil a contract are subject to impairment testing. Prior to recognising an impairment loss on the asset, management should first apply impairment guidance for specific assets (for example, inventory). Management then apply the impairment guidance for contract costs under the revenue standard.
An entity applies the impairment guidance for cash generating units under IAS 36 after recording any asset impairment from applying other standards.
An entity recognises an impairment loss to the extent that the carrying amount of an asset exceeds the remaining amount of consideration that the entity expects to receive, less the costs that relate directly to providing those goods or services that have not been recognised as expenses.
Impairment of contract cost assets
Entity A enters into a two-year contract with a customer to build a data centre in exchange for consideration of C1,000,000. Entity A incurs incremental costs to obtain the contract and costs to fulfil the contract that are recognised as assets and amortised over the expected period of benefit. The economy subsequently deteriorates, and the parties agree to renegotiate the pricing in the contract, resulting in a modification of the contract terms. The remaining amount of consideration to which entity A expects to be entitled is C650,000. The carrying value of the asset recognised for contract costs is C600,000. An expected cost of C150,000 would be required to complete the data centre.
Question
How should entity A account for the asset after the contract modification?
Answer
Entity A should recognise an impairment loss of C100,000. The carrying value of the asset recognised for the contract costs (C600,000) exceeds the remaining amount of consideration to which the entity expects to be entitled less the costs that relate directly to providing the data centre (C650,000 less C150,000). Therefore, an impairment loss of that amount is recognised. This conclusion assumes that the entity previously recognised any necessary impairment loss for inventory or other assets related to the contract prior to recognising an impairment loss under the revenue standard. Impairment of other assets could impact the remaining costs required to complete the data centre.
The amount of consideration that the entity expects to receive (and has received but not yet recognised as revenue) should be determined based on the transaction price and adjusted for the effects of the customer’s credit risk. Management should also consider expected contract renewals and extensions (with the same customer) in addition to any variable consideration that has not been included in the transaction price due to the constraint.
Assessing recoverability of capitalised costs
Management should assess recoverability of the incremental costs of obtaining a contract, either on a contract-by-contract basis, or for a group of contracts if those costs are associated with the group of contracts. Management might be able to support the recoverability of costs for a particular contract, based on its experience with other transactions, if those transactions are similar in nature. Management should consider, as part of its recoverability assessment, estimates of expected consideration from potential renewals and extensions. This should include both consideration received but not yet recognised as revenue, and consideration that the entity is expected to receive in the future. Variable consideration that is constrained for revenue recognition purposes should also be included in assessing recoverability. Costs that are not expected to be recoverable should be expensed as incurred.
Entities will reverse previously recognised impairment losses when the conditions that caused the impairment cease to exist. Any reversal should not result in the asset exceeding the amortised balance of the asset that would have been recognised if no impairment loss had been recognised previously.
Onerous contracts
Onerous contracts are those in which the unavoidable costs of meeting the obligation under the contract exceed the economic benefits expected to be received under it. There is no new guidance on the accounting for onerous contracts as a result of IFRS 15. Existing guidance in IAS 37 on the accounting for onerous contracts should continue to be used to identify and measure onerous contracts.
Onerous contract guidance under IFRS
IAS 37 provides guidance on identifying and measuring onerous contracts, and it applies to all contracts in the scope of the revenue standard. An onerous contract exists where the unavoidable cost of meeting the obligations under a contract exceeds the economic benefits to be received under that contract. IAS 37 does not define unavoidable cost. IAS 37 requires an entity to measure the liability for an onerous contract at the lower of the cost to exit and the cost to fulfil the remaining obligations under the contract. IAS 37 requires the determination of whether a loss exists to be performed at the contract level, and it does not include the same accounting election that exists under US GAAP to determine the provision for losses at the performance obligation level. IAS 37 also requires assets dedicated to a contract to be tested for impairment before a liability for an onerous contract is recognised. The IASB has proposed to amend IAS 37 to specify that the costs of fulfilling a contract include both incremental costs and an allocation of other costs directly related to the contract. Financial statement preparers are encouraged to monitor the status of the project.
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