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IFRS Question 037: How to account for the sales of software licenses with subsequent updates?

Hi Silvia, we are a software company.

We develop various technical software programs and sell them to the clients together with 1-year of updates.

How to account for the sale of these programs?

We sell only the right to use our software for certain period of time, and we do not permit our clients to modify or alter the software.
 

IFRS Answer 037

This is a very broad question, but let me try to highlight the main points.

Besides 5-step model, IFRS 15 gives us guidance about specific items and one of them is the sale of license to intellectual property.

Here, you still apply the 5-step model, but with some additional considerations.
 

5-step model applied to the sale of licenses

IFRS 15 says that a license of intellectual property establishes a customer’s right to the intellectual property of the entity.

Your software programs that you develop and sell, perfectly meet the definition of such a license.

But let’s go step by step and I’ll tell you about the specifics when we get there:
 

Step #1: Identify the contract

Step n. 1 is to identify the contract with the customer – nothing to be worried about, that’s clear in this case.

 

Step #2: Identify the performance obligations

Step n. 2 is to identify the performance obligations in the contract that are distinct.

You must first assess whether your license that you sell is distinct from 1-year support and updates.

You should use the 2-step process to identify whether the license is distinct or not:

  1. The license and the services are capable of being distinct and
  2. The license and the services are separately identifiable, or better said – they are distinct in the context of the contract.

I can write a whole article about what is distinct and what’s not distinct, just not here to keep this Q&A session sweet and short.

In general, a software license and post-sale customer support will each be distinct in most cases, even when the customer support and updates are not optional and customer must buy them.

Why?

Well, because the software remains functional also without the support.

Most users can work without updates and frankly speaking, that’s what I often do on my website ifrsbox.com. I pay for updates, I just don’t install them frequently and use older versions, because updates often mess up with some other elements on the website.

So if this is the case, then the license is distinct.

However, if the customer cannot continue working without updates anymore, or the functionality of the product goes down, then the license is NOT distinct.

Similarly, if you sell software with significant customization and installation services, well, again – can the customer use the software without it? If not, then it is not distinct.

To sum this step up – in this particular case, we have 2 individual performance obligations:

  1. Software license, and
  2. Updates.

 

Step #3: Determine the transaction price

Step n. 3 is to determine the transaction price.

No problem, you have the contract and you quote your selling price clearly.

Let’s just say, for the sake of illustration, that you sell your software with 1 year-updates for CU 200.
 

Step #4: Allocate the transaction price

Step n. 4 is to allocate the transaction price to the individual performance obligations.

You should do that based on their stand-alone selling prices.

In other words, you should split the total selling price into the price for the software license alone and the price for the updates alone.

It is challenging, especially if you do not sell licenses and updates separately.

What to do in this case?

You should consider all observable evidence that is available to you, for example the renewal price of the license could be a good evidence of the stand-alone selling price for updates.

Or you can use other approaches, for example residual approach.

Well, this is exactly the area in which the IFRS consultant would help you because each company and situation is different and you need tailor-made advice.

We have our IFRS Helpline service where we can help you immediately online.

Let’s assume here that you allocated CU 150 to the license and CU 50 to the 1-year support services.

 

Step #5: Recognize revenue

Step n. 5 is to recognize revenue when or as the performance obligation is satisfied.

Here, IFRS 15 provides the specific guidance for the licenses, but only if the license is distinct.

It says that you can sell two types of licenses:

  1. Right to access the entity’s intellectual property throughout the license period – in this case, the revenue is recognized over time based on the progress towards completion, and
  2. Right to use the entity’s intellectual property as it exists at the point of time in which the license is granted – here, the revenue is recognized at the point of time, when you make the software available to the client.

IFRS 15 provides a clear guidance on whether you deal with one or another type.

I would say that for software licenses, you should ask:

Are you, as a supplier or a seller, required to make changes in the software (except for future updates that are separate performance obligation)?

Is your customer exposed to positive or negative effects resulting from these changes?

If you sell technical software without customization, then well, in most cases, the answer would be NO to both questions and thus the license is the right to use, not the right to access.

So, you would recognize the revenue at the point of time for that license.

We allocated 150 to the license, so at the moment of sale, you book:

  • Debit Receivable (or cash): CU 150
  • Credit Revenue: CU 150.

What about 1-year updates?

This is a service, it seems that this performance obligation is satisfied over time based on progress towards completion, so at the time of the sale you would just book:

  • Debit Receivable (or cash): CU 50
  • Credit Contract liability: CU 50.

Then as you recognize revenue over time, you book:

  • Debit Contract liability,
  • Credit Revenue.

The amount depends on the percentage of completion of 1-year support service.

That was very general and very short, I know that it requires far more discussion and assessment and judgment, but I am sure that now you are not lost and at least now where to go.

Any questions or comments? Let me know below, thank you!