Once an entity has identified the contract with a customer, it evaluates the contractual terms and its customary business practices to identify all the promised goods or services within the contract and determine which of those promised goods or services (or bundles of promised goods or services) will be treated as separate performance obligations.
Promised goods and services represent separate performance obligations if they are: Performance obligations in software and cloud services
• Distinct (by themselves or as part of a bundle of goods and services) Performance obligations in software and cloud services
Or Performance obligations in software and cloud services
• Part of a series of distinct goods and services that are substantially the same and have the same pattern of transfer to the customer
A good or service (or bundle of goods and services) is distinct if the customer can benefit from the good or service on its own or together with other readily available resources (i.e., the good or service is capable of being distinct) and the good or service is separately identifiable from other promises in the contract (i.e., the good or service is distinct within the context of the contract). A promised good or service that an entity determines is not distinct is combined with other goods or services until a distinct performance obligation is formed.
Software arrangements commonly involve the delivery of multiple goods and services, such as a software licence, unspecified or specified future upgrades and enhancements, maintenance and other professional services. Goods or services promised in a contract with a customer can either be explicitly stated in the contract or implied by an entity’s customary business practice. IFRS 15 requires entities to consider whether the customer has a valid expectation that the entity will provide a good or service when it is not explicitly stated. If the customer has a valid expectation, the customer would view those promises as part of the goods or services in the contract. Performance obligations in software and cloud services
The requirements for identifying separate performance obligations have been a significant change for software entities. IAS 18 did not specifically address contracts with multiple components. IAS 18 indicated that an entity might need to apply its recognition criteria to separately identifiable components in order to reflect the substance of the transaction. However, it did not provide additional application guidance for determining those separate elements. Performance obligations in software and cloud services
Some software entities may have recognised fees from the development of their software by reference to the stage of completion of the development, which includes the completion of post-delivery service support services [IAS 18 13, IE19]. In effect, the software entities treated the development of software and post-delivery service support as a single component under IAS 18. However, software entities have sometimes reached different conclusions under IFRS 15 about which goods and services can be accounted for separately and the consideration that is allocated to them.
Software entities will need to closely assess promised goods and services in an arrangement to determine whether separate performance obligations exist.
Other IFRS preparers may have identified separate components to reflect the substance of the transaction under IAS 18 13. Furthermore, given the limited application guidance in IFRS, some entities may have developed their accounting policies by reference to the applicable US GAAP requirements (e.g., Accounting Standards Codification (ASC) 985-605 – Software Revenue Recognition). Performance obligations in software and cloud services
US GAAP’s software accounting under ASC 985-605 allowed an entity to separately account for elements in a software licensing arrangement only if vendor-specific objective evidence (VSOE) of fair value exists for the undelivered element(s). An entity that did not have VSOE of fair value for the undelivered element(s) generally must combine multiple elements in a single unit of account and recognise revenue as the delivery of the last element takes place. For those entities that look to this literature (and separately accounted for elements only when VSOE of fair value exists), this will no longer be a requirement of the model under IFRS 15. Performance obligations in software and cloud services
Software entities reach different conclusions about separate performance obligations under IFRS 15 than they did under IAS18. Software entities need to carefully consider whether the good or service is separable from other promises in the contract, which is challenging and requires significant judgement.
Licences of intellectual property Performance obligations in software and cloud services
The determination of whether a licence is distinct may require judgement. In some software arrangements, a software licence will be distinct because it is the only promise in the contract. In other arrangements, the customer will be able to benefit from the licence on its own or with readily available resources and it will be separately identifiable from the other goods or services in the contract (i.e., the other goods or services are also distinct). An example of a distinct licence is a software package that can be used on its own without customisation or modification and future upgrades are not necessary for the customer to retain continued functionality of the software for a reasonable period of time after the initial free maintenance period.
Licences that an entity determines are not distinct are combined with other promised goods or services in the contract until a separate performance obligation is identified. In some contracts, the customer can benefit from the licence only with another good or service that is promised (explicitly or implicitly) in the contract. For example, a software licence may be embedded in a software-enabled tangible good and the software significantly influences the features and functionality of the tangible good. The customer cannot benefit from the software licence on its own, nor is it separable from the tangible good.
Certain types of software, such as antivirus software, require frequent upgrades to keep the software current in order for it to be beneficial to the customer. Under IFRS 15, an entity may conclude that such software licences are not capable of being distinct because the customer cannot obtain the benefit from the software without also obtaining the subsequent upgrades. In these situations, the software licence, together with the unspecified upgrades, will form a single distinct performance obligation.
Entities may also enter into arrangements with customers that involve significant production, modification or customisation of licenced software. Under IFRS 15, entities may conclude that the software licence is not distinct within the context of the contract. That is, the software licence and professional services are generally highly interrelated and significant integration and modification is required. Therefore, the licence and services together are a single performance obligation.
Post-contract support services
Most arrangements involving software also include promises for the right to receive services or unspecified upgrades and enhancements (or both) after the licence period begins. Generally, these services include telephone support and correction of errors (bug fixes or debugging), as well as unspecified upgrades or enhancements. These activities are commonly known as post-contract support (PCS). Entities may have combined PCS with the software as a single component by reference to IAS 18 IE19. While other entities may have been separating PCS as a separate component from the software or even into multiple separate components.
PCS is not a unique service contemplated or defined in IFRS 15. As a result, entities will need to evaluate whether the individual services that comprise what is considered PCS under IAS 18 are separate performance obligations under IFRS 15. For example, a software entity may conclude that the promise to provide unspecified future upgrades and enhancements is a distinct promised good or service in the contract and, therefore, is a separate performance obligation. The entity may also determine that bug fixes and telephone support are provided to ensure that the software is functioning as promised. As a result, those services would be part of the assurance warranty coverage for the software and not a revenue element (such warranties will be accounted for under IAS 37 Provisions, Contingent Liabilities and Contingent Assets).
However, other entities may conclude that the promise to provide telephone support and bug fixes contains both an assurance-type warranty (non-revenue element) and service-type warranty (revenue element), as discussed further in ‘Construction warranties‘.
Furthermore, when the contract includes a promise to provide unspecified future upgrades and enhancements, the entity must determine the nature of that promise. For example, an entity may conclude that it has established a clear pattern of providing only one significant upgrade or enhancement per year. Therefore, the obligation to provide ‘future upgrades and enhancements’ actually is an obligation to provide this single upgrade or enhancement.
Alternatively, if the entity has a history of providing multiple upgrades each year, with no discernible pattern of when those upgrades are provided, the entity may conclude that the service is more consistent with a ‘stand-ready’ obligation. Performance obligations in software and cloud services
Software entities will need to carefully assess whether the services they accounted for as PCS udent IAS 18 are separate performance obligations under IFRS 15. Software entities may need to adjust their systems or create new ones to track and account for any additional performance obligations they may identify.
Entities may provide customers with the right to specified upgrades or enhancements as part of a software arrangement. Under IFRS 15, entities will need to evaluate whether the rights to receive specified upgrades or enhancements are promised goods or services and potentially separate performance obligations. If the specified upgrade is a separate performance obligation, a portion of the transaction price is allocated to it and revenue recognition is deferred until the specified upgrade is provided.
Some entities may have accounted for a specified upgrade or enhancement as a separate identifiable component under IAS 18 and allocate revenue to it, while others may account for it together with other components. IAS 18 did not restrict the methods that may be used to allocate consideration between components. If the specified upgrades are accounted for as a separate identifiable component, entities may use methods, such as relative fair value or a residual approach, to allocate consideration.
Unspecified additional software products Performance obligations in software and cloud services
As part of a contract with a customer, a software entity may license software today and promise to deliver unspecified additional software products in the future. For example, the software entity may agree to deliver all new products to be introduced in a family of products over the next two years.
Unspecified additional software products may have been treated as a separately identifiable component under IAS 18 by some entities. If so, the amount allocated to the component was recognised as revenue over the period that the products are provided. Other entities may have accounted for the unspecified additional software products together with the related licence as a single component. The timing of revenue recognition, in those situations, may be affected by the licence.
Under IFRS 15, software entities require to determine whether the promise to deliver unspecified additional software products is a performance obligation separate from the licence that it delivers. Software entities will also need to evaluate whether the promise to deliver unspecified additional software products is a stand-ready obligation to provide future products on a when-and-if available basis or individual promises to deliver specified future products. The standard includes the following example to illustrate the determination of whether goods and services in a software arrangement are distinct, see IFRS 15 IE 49 – IFRS 15IE IE58.
Identifying performance obligations under IFRS 15 will require software entities to exercise greater judgement. The performance obligations identified under IFRS 15 may differ from the components identified under IAS 18 (whether the software entity looked to US GAAP or not) and this may mean a change to how revenue is being recognised for some software entities.
Customer options for additional goods or services Performance obligations in software and cloud services
Customer options for additional goods or services are separate performance obligations if they provide a material right to the customer.
Software arrangements often include options to purchase additional goods or services that may be priced at a discount, such as sales incentives, contract renewal options (e.g., waiver of certain fees, reduced future rates) or other discounts on future goods or services. IAS 18 did not provide application guidance on how to distinguish between an option and a marketing offer. Nor did it address how to account for options that provide a material right. As a result, some entities may have effectively accounted for such options as marketing offers, even if the option was substantive (i.e., the customer makes a separate buying decision and has the ability to exercise or not exercise its right).
Careful assessment of contractual terms is important to distinguish between options that are accounted for as separate performance obligations under IFRS 15 and marketing offers. See also the discussion on ‘Construction warranties’.
Considerations for cloud arrangements Performance obligations in software and cloud services
Cloud services arrangements may include the cloud services (such as software-as-a-service (SaaS)) or other products or services. These arrangements also frequently include a licence of the software, for which the customer may (or may not) have the right to take possession. Cloud services entities also frequently offer professional services, such as implementation, data migration, business process mapping, training and project management services, in addition to the cloud service itself. These professional services may be required for a customer to begin using the cloud services in the manner described in the contract.
IFRS 15 provides a framework for identifying the performance obligations in a contract. When an entity determines that the promised goods or services are distinct, it will need to determine whether it is providing a software licence (as a separate performance obligation from the hosting service) or a service (a licence and hosting services that, together, are a single performance obligation because the two promises are not distinct from one another).
In some contracts, the assessment of whether the licence is distinct will be relatively straight-forward. For example, an entity may provide a customer with a software licence, but only in conjunction with a hosting service. In addition, the customer cannot take control of the licence or use the software without the hosting service. In this example, the customer cannot benefit from the licence on its own and the licence is not separable from the hosting services. Therefore, the licence is not distinct and would be combined with the hosting service.
However, many arrangements are more complex. For example, in some contracts, some of the software (enabling certain functionality) resides on the customer’s premises, and the customer has the ability to take control of that software. However, other functionality is provided by the hosting service and the customer cannot take control of that software. As a result, this determination may require significant judgement, depending on the terms of the contract.
In many transactions, customers may pay an upfront fee at contract inception, which may relate to the initiation, activation or set-up of a good to be used or a service to be provided in the future. Under IFRS 15, entities must evaluate whether non-refundable upfront fees relate to the transfer of a good or service.
In addition, the existence of such fees may indicate that there are other implied elements in the contract, such as the option to renew a service at a discounted rate because the upfront fee would not be charged for the renewal period. In such situations, the identified promised goods and services would also include those implied items.
Under IFRS 15, the non-refundable fee is allocated to the identified performance obligations in the contract (which may include some implied performance obligations) and it is recognised as revenue as the performance obligations are satisfied. By requiring allocation of the upfront fees to the future goods or services or renewal options, the adoption of IFRS 15 many times results in a change in practice for some entities. See the illustrative example below: Performance obligations in software and cloud services
Non-refundable upfront fees
Cloud Co. enters into a contract with a customer for a licence of its software and a non-cancellable one-year subscription to access the licensed application (the cloud services). The contract amount for the software licence is an upfront, non-refundable fee of CU1 million. The fee for the cloud services is CU500,000 for one year. The customer has the right to renew the cloud services each year for CU500,000.
Assume that Cloud Co. determines the software licence and cloud services are a single performance obligation. There are no other promised goods and services in the contract. Therefore, the upfront fee is not associated with the transfer of any other good or service to the customer. However, Cloud Co. determines there is an implied performance obligation. That is, the right to renew the cloud services each year for CU500,000 is a material right to the customer because that renewal rate is significantly below the rate the customer paid for the first year of service (CU1.5 million in total).
Based on its experience, Cloud Co. determines that its average customer relationship is three years. As a result, Cloud Co. determines that the performance obligations in the contract include the right to a discounted annual contract renewal and that the customer is likely to exercise twice.