ABOUT ACCOUNTING CLUBS
Discover who we are and what we do
Expert Q&A’s
Read about various complex accounting concepts
PODCASTS
See the podcasts we offer to help in your respective areas
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, indeed. Management has the option to utilize the portfolio approach to handle costs associated with contracts sharing similar characteristics, akin to other facets of the revenue standard. This approach is permissible if the entity reasonably anticipates that the application of the guidance to the portfolio would yield materially similar results compared to applying the guidance to each contract or performance obligation individually.
Example
Modification of a contract for goods (1)
An entity commits to selling 120 products to a customer for CU12,000 (CU100 per product), with the products transferred over a six-month period. Control of each product is transferred at a specific point in time. Subsequently, after the entity has already transferred control of 60 products to the customer, the contract undergoes modification, necessitating the delivery of an additional 30 products (a total of 150 identical products) to the customer. These additional 30 products were not initially included in the contract.
Case A – Additional products for a price that reflects the stand-alone selling price
When the contract is modified, the price for the contract modification concerning the additional 30 products amounts to an additional CU2,850, equating to CU95 per product. This pricing for the additional products aligns with the stand-alone selling price of the products at the time of the contract modification, and it’s important to note that the additional products are distinct from the original ones.
In accordance with IFRS 15, the contract modification for the additional 30 products effectively constitutes a new and separate contract for future products, which doesn’t impact the accounting treatment for the existing contract. Consequently, the entity recognizes revenue of CU100 per product for the initial 120 products outlined in the original contract, and CU95 per product for the 30 additional products in the new contract.
Modification of a right-to-access licence agreement – example
Entity X and Customer Y enter into an agreement granting Customer Y the right to access Entity X’s intellectual property (IP) for three years for CU3 million (CU1 million per annum). Subsequently, after one year, Entity X and Customer Y decide to extend the contract for an additional two years for CU1.8 million. Entity X determines that the additional two years of access to its IP are distinct from the initial period.
In evaluating whether the contract modification should be treated as a separate contract, Entity X must consider both criteria outlined in IFRS 15. The first criterion is met as the scope of the contract expands by two years, and the right to access Entity X’s IP over that period is deemed distinct in accordance with IFRS 15.
The second criterion in IFRS 15 is met if the modification raises the contract price “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 circumstances, Entity X might conclude that the additional price charged to the customer (CU0.9 million per annum) aligns with the stand-alone selling price of the additional two years, adjusted to reflect the contract’s particular circumstances. Though lower than the CU1 million per annum initially charged, the difference might signify a discount for costs not incurred by Entity X, given that it modified an existing contract with a customer without incurring costs associated with acquiring a new customer.
Should Entity X determine that the criterion in IFRS 15 is met, it would account for the modification as a separate contract. This entails continuing to recognize revenue of CU3 million over the first three years under the initial contract, followed by revenue of CU1.8 million over the subsequent two years under the new contract.
If Entity X instead determines that the additional price charged to the customer doesn’t align with the stand-alone selling price of the additional two years, adjusted to reflect the contract’s particular circumstances, Entity X should account for the modification in accordance with IFRS 15, treating it as a termination of the existing contract and creation of a new contract. In this scenario, Entity X would recognize CU0.95 million per annum for the remaining four years (CU2 million revenue not yet recognized from the original contract + CU1.8 million revenue for the additional two years ÷ four years remaining based on the modified contract).
Example
Modification of a contract for goods (2)
An entity commits to selling 120 products to a customer for CU12,000 (CU100 per product), with the products transferred to the customer over a six-month period. Control of each product is transferred at a specific point in time. Subsequently, after the entity has already transferred control of 60 products to the customer, the contract undergoes modification, necessitating the delivery of an additional 30 products (a total of 150 identical products) to the customer. These additional 30 products were not initially included in the contract.
Case B – Additional products for a price that does not reflect the stand-alone selling price
During the negotiation process for the purchase of an additional 30 products, the parties initially settle on a price of CU80 per product. However, the customer uncovers minor defects unique to the initial 60 products received, prompting the entity to promise a partial credit of CU15 per product to compensate for the poor quality. Consequently, the entity and the customer agree to integrate the credit of CU900 (CU15 credit × 60 products) into the price charged for the additional 30 products. As a result, the contract modification specifies a price of CU1,500 or CU50 per product for the additional 30 products. This price comprises the agreed-upon price of CU2,400, or CU80 per product, reduced by the credit of CU900.
Upon modification, the entity recognizes the CU900 credit as a reduction of the transaction price and, thus, a reduction of revenue for the initial 60 products transferred. When 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 fails to meet the conditions in IFRS 15 to be treated as a separate contract.
Given that the remaining products to be delivered are distinct from those already transferred, the entity applies the requirements in IFRS 15 and treats the modification as a termination of the original contract and the creation of a new contract. Consequently, the amount recognized as revenue for each of the remaining products is a blended price of CU93.33, calculated as follows: {(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
The entity initially enters into a three-year contract to clean a customer’s offices on a weekly basis, with the customer agreeing to pay CU100,000 per year. At contract inception, the stand-alone selling price of the services is also determined to be CU100,000 per year. The entity recognizes revenue of CU100,000 per year during the first two years of service provision.
However, at the end of the second year, the contract undergoes modification, reducing the fee for the third year to CU80,000. Additionally, the customer agrees to extend the contract for three additional years, with consideration of CU200,000 payable in three equal annual installments of CU66,667 at the beginning of years 4, 5, and 6. With the modification, the contract now has four years remaining, with 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, and multiplying this by the remaining number of years (4) provides an estimate of the stand-alone selling price of the multi-year contract, which is CU320,000.
Although each week of cleaning service is deemed 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 represent a series of distinct services that are substantially the same, with the same pattern of transfer to the customer over time, and utilizing a time-based measure of progress.
Upon the modification, the entity assesses the remaining services to be provided as distinct. However, the remaining consideration to be paid (CU280,000) does not align with the stand-alone selling price of the services (CU320,000). Consequently, the entity accounts for the modification 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 recognizes 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 lacks specific guidance on the timing for recognizing a liability for costs to obtain a contract. Consequently, management should consult the relevant liability guidance, such as IAS 37, to ascertain whether the entity has incurred a liability. Subsequently, the revenue standard should be applied to determine whether the associated costs should be capitalized 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 may pertain to multiple contracts, as seen in scenarios where sales commission plans are structured to compensate based on cumulative thresholds. The fact that these costs are linked to multiple contracts does not automatically disqualify them from being considered incremental costs to obtain a contract. In such cases, management should exercise judgment to devise a reasonable approach to allocate costs to the associated contracts.
Do fringe benefits (for example, payroll taxes) related to commission payments represent incremental costs to obtain a contract?
Yes, provided that the entity would not have incurred the fringe benefits if it had not secured the contract, those benefits can be capitalized. An entity is mandated to capitalize fringe benefits that qualify as incremental costs and are recoverable, unless they are eligible for the practical expedient.
Should incremental costs to obtain contract renewals or modifications be capitalised?
Yes, if the costs to obtain contract renewals or modifications meet the criteria of being incremental and recoverable, they can be capitalized. For instance, a commission paid to a sales agent upon a customer’s contract renewal qualifies as such a cost. However, it’s important for management not to recognize an asset in anticipation of contract renewals or modifications if the entity has not yet incurred a liability associated with these 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 determined that the parties are committed to fulfilling their respective obligations and that collection of the consideration is probable, which are requirements for identifying a contract, a contract asset can be recognized. However, it’s crucial for management to continually reassess the existence of a valid contract if circumstances change after contract inception. Additionally, management should evaluate the contract asset for impairment in such situations.
How should an entity account for payments to multiple individuals for the same contract?
An entity may distribute payments to multiple individuals for the same contract, all of which may qualify as incremental costs. For instance, if an entity disburses a sales commission to the salesperson, manager, and regional manager upon securing a new contract, each of these payments would be considered incremental costs. The timing of a payment alone does not determine whether the costs are incremental; however, management should assess whether the payment is contingent on factors beyond securing a contract. For example, a bonus payment calculated based on contract acquisition is akin to a commission; yet, if the bonus is also tied to the individual’s overall performance concerning non-sales-related objectives, it is likely not an incremental cost. Similarly, a payment contingent on an employee providing future service in addition to securing a new contract would generally not be considered an incremental cost to obtain a contract. Determining whether a payment entails a substantive future service requirement may necessitate judgment.
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 contingent on meeting a predefined revenue target set at the start of each quarter. The entity’s revenue comprises income from both new contracts initiated during the quarter and contracts executed in previous quarters.
Question
Is the bonus an incremental cost to obtain a contract?
Answer
No, the payment would not be considered an incremental cost to obtain the contract. This is because the revenue target encompasses more than just acquiring new contracts. If the revenue target were solely based on securing new contracts, the payment would resemble a sales commission, and in that scenario, the bonus might indeed be considered 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 payment would not be considered an incremental cost to obtain new contracts. This is because the employee must provide future services to receive the payment, indicating that the payment is contingent upon factors beyond securing new contracts. Consequently, the entity would recognize the expense over the service period in accordance with 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 accrued during the proposal and contract negotiations as they are incurred. These costs are not incremental because they would have been expended regardless of whether the contract was secured. However, costs incurred during contract negotiations could be recognized as an asset if they are explicitly chargeable to the customer irrespective of contract attainment. Although the costs incurred for the initial bridge design may not qualify as incremental costs to obtain a contract, certain expenses might be considered costs to fulfill a contract and recognized 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 deemed incremental costs of securing a contract are the commissions disbursed to the sales agents. These commissions represent costs to obtain a contract that Entity T would not have incurred if the contracts had not been obtained. Telecom should capitalize an asset for these costs, provided they are recoverable. All other expenses, such as sales agents’ salaries and advertising expenses, are expensed as incurred, as they are costs that Entity T would have incurred regardless of whether or not the customer contracts were obtained.
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 , the initial consideration is whether IFRS 15 applies, aiming to determine if the contract modification should be treated as a separate contract. In this scenario, the modification entails a discount of CU20,000 for the outstanding third year of cleaning services (reduced to CU80,000 from the original CU100,000), alongside an extension of the contract term for an additional three years, with additional consideration of CU200,000. The contract modification augments the transaction price by CU180,000 (CU200,000 additional consideration minus the CU20,000 discount). Additionally, the modification entails providing six years of cleaning services in total, an extension of three years beyond the original contract.
To adhere to IFRS 15, the contract’s scope must expand due to the addition of distinct promised goods or services, accompanied by a price increase reflecting the standalone selling prices of these additions. While the additional three years of services are distinct, the supplementary consideration payable is lower than the standalone selling price of those services (CU180,000 additional consideration versus a standalone selling price of CU240,000 for three years).
As the requirements of IFRS 15 are not satisfied, the entity applies IFRS 15 to the modified contract, treating it as a termination of the existing contract and the inception of a new one. Consequently, revenue of CU70,000 (CU280,000 divided by 4 years) is recognized annually 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 increasesbecause of the addition of promised goods or services that are distinct; and
- the price of the contract increasesby 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 terminationof 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 has the option to either capitalize the commission payment as an asset or expense it as incurred under the practical expedient. The commission qualifies as a cost to obtain a contract that wouldn’t have been incurred sans the contract. Given the expectation of cost recovery, Entity U can recognize it as an asset, amortizing it in tandem with revenue recognition throughout the year.
Alternatively, Entity U can opt for immediate expense, especially since the asset’s amortization period is within one year. However, if contract renewal is anticipated, extending product delivery beyond a year, the practical expedient wouldn’t apply. In such cases, the asset’s amortization period exceeds a year, rendering the expedient unavailable.
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 represent expenses incurred by an entity as it gains experience in providing a service or manufacturing an item over time. Initially, these costs are higher due to the learning process but tend to decrease as efficiency improves. They typically include labor, overhead, rework, or other necessary expenses incurred to fulfill a contract, excluding research and development costs. The accounting treatment for learning curve costs requires judgment.
For contracts involving a single performance obligation satisfied over time, learning curve costs are recognized in the cost of sales. However, they may also impact the measurement of progress toward fulfilling the obligation. For instance, under a cost-to-cost measure of progress, higher costs incurred initially may lead to more revenue recognition in earlier periods.
For performance obligations satisfied at a point in time, learning curve costs should be assessed to determine if they fall under other accounting standards, such as inventory. If not addressed by other standards, they are unlikely to meet the criteria for capitalization under the revenue standard since they typically do not relate to future performance obligations.
Consider a scenario where an entity promises to transfer multiple units under a contract, with each unit representing a separate performance obligation satisfied at a point in time. In such cases, the costs to produce each unit would be governed by inventory guidance and recognized in cost of sales when control of the inventory transfers. This could result in varying margins on individual units if the costs to produce earlier units differ from those produced later in the contract.
Set-up and mobilisation costs
Set-up and mobilization costs encompass direct expenses incurred at the commencement of a contract to facilitate an entity’s fulfillment of its contractual obligations. These costs are diverse and may include expenses related to activities like design, migration, and testing, particularly common in outsourcing arrangements where entities prepare to deliver services under new contracts. Such costs could involve labor, overhead, or other specific expenditures.It’s essential for management to initially determine whether these costs fall under the purview of other accounting standards, such as those governing property, plant, and equipment. If so, the entity should apply the relevant guidance accordingly. Mobilization costs, a subset of set-up costs, specifically involve expenses incurred to relocate equipment or resources in preparation for providing goods or services stipulated in a contract.
For instance, expenses associated with moving newly acquired equipment to its designated location might be considered part of the cost of an asset under property, plant, and equipment guidance. Subsequent costs incurred to relocate equipment for a future contract are evaluated to ascertain whether they meet the criteria to be recognized as assets representing costs to fulfill a contract.
Certain industries undertake pre-production activities, including designing and developing products or technologies tailored to meet customer needs, before actual production commences. An example is an entity involved in designing and developing tooling before manufacturing automotive parts under a supplier contract for automotive companies. In such cases, management should assess whether these pre-production activities constitute promised goods or services under the contract or represent costs incurred to fulfill contractual obligations.
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 recognize the set-up costs incurred at the outset of the contract as an asset. These costs are directly related to the specific contract in question, as they are incurred to enhance the entity’s resources and capabilities to perform under the contract. Additionally, these costs are expected to be recovered as part of the contractual arrangement and are incurred in anticipation of fulfilling future performance obligations. Therefore, Entity V should recognize these set-up costs as an asset on its balance sheet.
Subsequently, Entity V should amortize this asset on a systematic basis consistent with the pattern of transfer of the tracking and monitoring services to the customer. Moreover, any prepayment received from the customer should be included in the transaction price and allocated to the respective performance obligations within the contract, such as the tracking and monitoring services. This ensures proper alignment between the costs incurred, revenue recognition, and the fulfillment of contractual obligations.
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 in this scenario leads to the recognition of different margins over the three years of the contract. Specifically, a lower margin is recognized during the initial stages of the contract. However, Company A has identified other contracts where an input method based on costs incurred is deemed to be the most appropriate measure of performance.
By employing an input method for these contracts, Company A ensures that a consistent margin is recognized throughout the duration of each contract. This approach allows for greater consistency in margin recognition across various contracts, offering more uniformity in financial reporting and performance evaluation.
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:
1.general and administrative costs;
1.costs of wasted materials, labour or other resources to fulfil the contract that were not reflected in the price of the contract;
2.costs that relate to past performance (satisfied performance obligations or partially satisfied performance obligations); and
1.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, in contrast to learning curve costs, arise from unforeseen circumstances such as excessive resources, wasted materials, or unproductive labor, often stemming from delays or changes in project scope. Unlike learning curve costs, which are factored into the contract price, abnormal costs are not anticipated in the original contract terms.
These costs should be expensed as they are incurred, reflecting the unexpected nature of the expenditure. By expensing abnormal costs promptly, entities accurately reflect the true financial impact of unforeseen circumstances, ensuring transparency in financial reporting and decision-making processes.
Activity
Entity W, in its contract to construct an office building, incurs various costs throughout the project lifecycle. Initially, it invests in mobilization activities, such as transporting heavy equipment to the construction site, to kickstart the project efficiently. Throughout the build phase, Entity W continues to accumulate expenses, including direct costs associated with supplies, equipment, materials, and labor.
However, unforeseen circumstances may lead to abnormal costs, such as wasted materials purchased for the project. Despite these unexpected expenses, Entity W anticipates recovering all costs incurred under the terms of the contract.
Question
How should entity W account for the costs?
Answer
Entity W should recognize an asset for the mobilization costs incurred at the outset of the contract. These costs meet the criteria for asset recognition because they directly relate to the contract, enhance the entity’s resources to fulfill its obligations under the contract, and are expected to be recoverable.
As for the direct costs incurred during the construction phase, Entity W should account for them according to other applicable standards. For instance, certain supplies and materials might be capitalized following inventory guidance, while equipment may be capitalized under property, plant, and equipment standards. Any other direct costs associated with the contract, which contribute to fulfilling future performance obligations and are expected to be recoverable, should also be recognized as assets.
However, abnormal costs, such as those stemming from wasted materials, should be expensed as they are incurred, as they do not align with the normal course of business for the contract.
Can costs to fulfil a contract be deferred to achieve a consistent profit margin?
Activity
The contractor employs an output method, specifically an engineering survey, to gauge the progress of construction services, whereby control is transferred over time. In the initial reporting period, the contractor assesses that 35% of the contract has been completed based on the engineering survey. Consequently, revenue recognized equals 35% of the estimated transaction price. However, during the same period, the contractor incurs costs amounting to 45% of the estimated total costs to fulfill 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 shouldn’t be deferred solely to align them with revenue or maintain a consistent profit margin across the contract. Only costs to fulfill the contract that meet the criteria for capitalization under applicable standards, including the revenue standard, should be capitalized. While using an output method for progress measurement may yield varying profit margins from period to period, unlike an input method based on costs incurred, the total profit margin over the contract’s duration remains unchanged regardless of the method used. The IFRS Interpretations Committee addressed a similar scenario in its agenda decision ‘Costs to fulfill a contract,’ released 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 engages in a developer contract to construct an oil refinery, determining that its performance yields an asset controlled by the customer, with control transferred over time. It adopts the ‘cost-to-cost’ method to gauge progress toward fulfilling its obligation. A commission of C100,000 is disbursed to its sales agent for securing the contract, deemed an incremental cost of contract acquisition, thus recognized as an asset. At the end of the initial year, Entity X estimates 50% completion of its performance and records 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
Entity X’s amortization pattern must align with its method for measuring progress toward fulfilling its performance obligation. Since Entity X employs the ‘cost-to-cost’ method to recognize revenue, it should amortize 50%, or C50,000, of the commission costs by the end of the initial year.
Amortisation of contract cost assets: multiple performance obligations
Entity Y’s contract involves selling industrial equipment and providing maintenance services, which are deemed distinct performance obligations. Revenue for the equipment sale is recognized upon transfer of control at delivery, while revenue from maintenance services is recognized evenly over two years, aligning with the period of service consumption. Entity Y pays a commission of C10,000 to its sales agent, constituting 10% of the total contract price. This commission is considered an incremental cost of obtaining the contract, leading Entity Y to recognize it as an asset. Given that Entity Y doesn’t anticipate service renewal by the customer, it does not expect the commission cost to be recoverable beyond the contract term.
Question
What pattern of amortisation should entity Y use for the capitalised costs?
Answer
Entity Y should employ a reasonable method to amortize the asset, ensuring consistency with the transfer of goods or services. A suitable approach involves allocating the contract asset to each performance obligation based on relative stand-alone selling prices, akin to the allocation of transaction price. Under this method, Entity Y would assign C7,500 of the total commission to the equipment and the remaining C2,500 to the maintenance services. The commission allocated to the equipment would be expensed upon the equipment’s control transfer, while the portion allocated to services would be amortized over time, aligning with the services’ transfer. Alternatively, other acceptable approaches could be considered, provided they mirror the pattern of goods or services transfer. However, amortizing the entire asset on a straight-line basis wouldn’t be acceptable if it pertains to both equipment and services. Entity Y might explore evidence supporting a conclusion that the contract asset relates solely to one performance obligation
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 income statement presentation of amortization for such assets. An entity should apply IAS 1 principles to determine appropriate classification consistently. Costs to obtain a contract might resemble acquired intangible assets, while costs to fulfill a contract may resemble prepaid operating costs or inventories. Management should use judgment to decide presentation. If costs are considered prepaid, present based on underlying expenditure nature; for example, capitalizing sales commissions may classify them as employee benefits or selling/distribution costs. If costs resemble intangible asset acquisition, present with depreciation/amortization or separately. For costs expensed under the one-year practical expedient, ensure consistency with capitalized costs. Disclose total amortization of assets from contract costs.
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?
Determining the appropriate amortization period for contract-related assets requires judgment. It could align with the average customer life or a shorter period, depending on circumstances. A shorter period may be suitable if the average customer life exceeds the related goods or services’ life cycle. Management should exercise judgment akin to 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?
When evaluating whether renewal commissions are commensurate with initial commissions, it’s crucial not to solely consider the effort needed to secure each contract. Instead, the assessment should primarily focus on whether both initial and renewal commissions reasonably align with the respective contract values.
Renewal periods without additional commission
Entity Z recognizes that the commission payment for initial sales of prepaid wireless services constitutes an incremental cost of obtaining the contract, leading to the recognition of an asset. Since the contract spans one month, Entity Z anticipates that, based on customer demographics, the customer will likely renew for 16 additional months.
Question
What period should entity Z use to amortise the commission costs?
Answer
Entity Z should amortize the costs to obtain the contract over a period of 17 months, which includes the initial contract term and the expected renewal periods. Since this period exceeds one year, Entity Z cannot expense the commission payment under the practical expedient.
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 must evaluate if the commission paid pertains solely to the goods or services rendered during the initial contract or encompasses both the initial and renewal phases. If Entity Z determines that the renewal commission aligns with the initial commission, it suggests that the initial commission solely pertains to the initial contract. In such a scenario, Entity Z would amortize the initial commission over the initial contract period, unless it opts for the practical expedient. The renewal commission would then be amortized over the subsequent renewal period.
Renewal commissions are not commensurate with initial commissions
The entity recognizes a C500 commission as an incremental cost for securing the initial annual service contract with a customer. Additionally, it anticipates paying a C250 commission for each subsequent annual renewal, with both contracts offering similar services at identical annual fees. Expecting the customer to renew, the entity records the C500 commission as an asset, deeming it essential for contract acquisition. Moreover, it determines a five-year average customer life as suitable for amortizing this asset.
Question
What pattern of amortisation should the entity use for the capitalised costs?
Answer
The initial commission of C500 should be amortized over a period exceeding the initial contract term, given the dissimilarity between the renewal and initial commissions, suggesting that a portion of the initial commission pertains to services rendered during renewal periods. To ensure compliance, the entity could systematically amortize the C500 commission over the five-year average customer life. Alternatively, it could split the C500 commission into two parts, amortizing C250 over the initial annual contract term and the remaining C250 over the same five-year period. Other approaches aligning with the service transfer pattern may also be acceptable.
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 recognize an impairment loss amounting to C100,000. This calculation is based on the fact that the carrying value of the asset recognized for the contract costs (C600,000) surpasses the remaining consideration to which the entity anticipates entitlement, less the costs directly associated with providing the data center (C650,000 minus C150,000). Therefore, recognizing an impairment loss of that magnitude is appropriate. This assessment assumes that the entity previously acknowledged any requisite impairment loss for inventory or other assets linked to the contract before recognizing an impairment loss under the revenue standard. It’s worth noting that impairment of other assets could influence the remaining costs necessary for completing the data center.
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 conduct an assessment of the recoverability of the incremental costs incurred to obtain a contract. This evaluation can be performed either on a contract-by-contract basis or for a group of contracts if those costs are related to the group. If management finds similarities between the current contract and past transactions, they may be able to justify the recoverability of costs based on prior experience. As part of this assessment, management should factor in estimates of expected consideration from potential renewals and extensions, encompassing both recognized and anticipated future revenue. Additionally, variable consideration that is restricted for revenue recognition purposes should be taken into account when assessing recoverability. Any costs that are deemed unlikely to be recovered should be expensed as they are 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 offers guidance on identifying and measuring onerous contracts, which applies to all contracts within the scope of the revenue standard. An onerous contract is one where the unavoidable costs of fulfilling its obligations exceed the economic benefits expected from it. While IAS 37 doesn’t precisely define “unavoidable costs,” it mandates measuring the liability for such contracts at the lower of the cost to exit or the cost to fulfil the remaining obligations. Unlike US GAAP, IAS 37 doesn’t allow an accounting election to determine provision for losses at the performance obligation level; instead, it requires assessing losses at the contract level. Furthermore, assets dedicated to a contract must undergo impairment testing before recognizing a liability for an onerous contract. Proposed amendments to IAS 37 include clarifying that the costs of fulfilling a contract encompass both incremental costs and an allocation of other directly related expenses. Financial statement preparers are advised to stay updated on developments regarding this project.