Contract Costs (IFRS 15)

Last updated: 16 January 2024

IFRS 15 outlines the accounting for the incremental costs of obtaining a contract, as well as the costs incurred to fulfil a contract. These requirements, however, are only applicable in instances where no other rules within IFRS address these costs (IFRS 15.8).

Incremental costs of obtaining a contract

Incremental costs of obtaining a contract refer to those expenditures which would not have been incurred if the contract had not been secured (for instance, if any of the involved parties decided to withdraw just before signing the contract). These incremental costs should be recognised as an asset unless entities do not anticipate recovering them. Such recovery may be achieved through direct customer billing or by generating sufficient contract margins.

A typical example of incremental costs involves sales commissions. There could also be other varieties of incremental employee contract costs like bonuses which progressively increase with each contract. Technically, entities should also recognise social security charges levied on the incremental part of remuneration as assets. Other less frequent examples of incremental costs include various types of success fees paid to advisors.

Contrastingly, discretionary annual bonuses — contingent upon factors like annual sales targets, the entity’s overall profitability, and individual performance assessments — are not recognised as assets. The rationale behind this is the discretionary nature of these bonuses. They are influenced by broader considerations, including the financial success of the entity and the performance of individual employees. Consequently, such bonuses do not qualify as genuinely incremental or directly linked to specific contracts, thus differing from the aforementioned incremental costs.

If an entity incurs incremental costs on contract modification, these costs should still be recognised as an asset, even if the modification is deemed part of the existing contract. This is not explicitly mentioned in IFRS 15, but it’s widely accepted as IFRS 15 doesn’t restrict the requirements to initial costs only.

Non-incremental costs can be recognised as an asset only if they are explicitly billable to the customer, irrespective of whether the contract is obtained (IFRS 15.91-93). If not, they should be charged to P/L as incurred. Examples of non-incremental costs include due diligence costs or costs related to proposals and negotiations, such as travel and accommodation expenses.

IFRS 15 provides a practical expedient to the above rule by permitting the immediate recognition of all contract costs as an expense if the amortisation period of such costs would not exceed 12 months (IFRS 15.94).

See also Example 36 accompanying IFRS 15.

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Costs incurred to fulfil a contract

Certain costs incurred to fulfil a contract may fall under the scope of other IFRSs. In such cases, these corresponding standards should guide the accounting treatment of these costs (IFRS 15.8/96). Such costs may include:

• The cost of inventories.
• The cost of property, plant, and equipment.
• The cost of intangible assets.

If other applicable IFRSs do not permit recognition of specific costs as assets, they should be expensed in P/L when incurred, even if they meet the IFRS 15 criteria for capitalisation. However, if costs incurred to fulfil a contract are not covered by other IFRSs, they should be recognised as an asset if they (IFRS 15.95):

• Are directly related to a contract or to an anticipated contract that can be specifically identified by the entity,
• Generate or enhance resources of the entity that will be used in satisfying (or in continuing to satisfy) future performance obligations, and
• Are expected to be recovered.

Examples of costs that directly relate to a contract, given that they meet all the above criteria, include (IFRS 15.97):

• Direct labour costs: for instance, the wages of employees who provide services directly to the customer.
• Direct materials: such as supplies used in providing the promised services to a customer.
• Allocation of costs that directly relate to the contract or to contract activities: for instance, costs of contract management and supervision, insurance, and depreciation of tools, equipment and right-of-use assets utilised in fulfilling the contract.
• Costs explicitly chargeable to the customer under the contract.
• Other costs incurred solely due to the entity entering into the contract: for instance, payments to subcontractors or rent for an additional project office.

Examples of costs that should be expensed in P/L as incurred include (IFRS 15.98):

• General and administrative costs (unless these costs are explicitly chargeable to the customer under the contract).
• Training costs.
• Costs of wasted resources such as materials, labour, or other resources used to fulfil the contract that were not reflected in the contract price.
• Costs relating to satisfied performance obligations (or partially satisfied obligations) in the contract (i.e., costs related to past performance).
• Costs where an entity cannot determine whether they relate to unsatisfied or satisfied performance obligations (or partially satisfied obligations).

Deciding on the capitalisation of contract costs requires careful judgement. The primary focus should be on determining which costs generate or enhance resources that will be used in satisfying (or in continuing to satisfy) performance obligations in the future. As clarified in IFRS 15.BC308, entities cannot capitalise costs merely to smooth out profit margins across the life of a contract by evenly allocating revenue and costs. For instance, if an entity has not recognised some of the transaction price due to constraining estimates of variable consideration, there may be instances where contract costs recognised in P/L exceed the revenue recognised to date. Entities are not permitted to capitalise this initial loss on a contract merely because they are awaiting the resolution of the constraining estimates of variable consideration.

See also Example 37 accompanying IFRS 15.

Amortisation of contract costs

Costs recognised as an asset should be amortised on a systematic basis consistently with the transfer of goods or services related to the asset (IFRS 15.99-100). Sales commissions for acquiring a new customer can be amortised over a period exceeding the contract term if the anticipated customer relationship duration is longer and the commissions for contract renewals are relatively less than those for acquiring new customers (IFRS 15.BC309). The same principle applies to costs incurred to fulfil a contract (refer to Example 37 accompanying IFRS 15).

Estimates concerning the amortisation of contract costs should be updated at each reporting date, with any changes accounted for prospectively (IFRS 15.100).

Example: Amortisation of contract costs

On 1 January 20X1, Entity A enters into a contract with Customer X to manage his information technology data centre. The contract is set for 5 years. At the contract inception, based on previous experiences with similar contracts, Entity A anticipates that Customer X will renew the contract for an additional 5-year term. Prior to providing the services, Entity A incurs costs of $100,000 related to data centre migration and testing. These costs are recognised as assets (costs incurred to fulfil a contract) as they primarily relate to fulfilling the contract but do not involve transferring goods or services to the customer.

Entity A elects to amortise these costs over a 10-year period, representing the expected relationship duration with Customer X. After 5 years, $50,000 of these costs have been recognised (i.e., amortised) in P/L, and the remaining $50,000 continue to be recognised as an asset. Upon the expiry of the 5-year contract, Customer X signs another contract, this time for 10 years. Entity A concludes that the contract costs will be utilised in fulfilling the new contract and adjusts the amortisation period accordingly. This represents a change in accounting estimate and is accounted for prospectively, meaning that the already recognised amortisation expense is not adjusted, and the remaining $50,000 is amortised over the following 10 years.

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Impairment of contract costs

An impairment of costs recognised as an asset should be recognised whenever the asset’s value exceeds the remaining consideration to be received, less past and future expenses unrecognised in P/L (IFRS 15.101-102). For impairment testing purposes, future cash inflows are not equivalent to the transaction price as entities do not need to consider constraining estimates of variable consideration (which increases cash flows for impairment testing purposes), and entities need to take into account the customer credit risk (which reduces cash flows for impairment testing purposes).

As noted previously, contract costs can be amortised over the expected contractual relationship period, which can exceed the current contract term. Thus, expected cash flows for impairment testing should be consistently estimated for this expected contractual relationship period as well (this point is not explicitly addressed in IFRS 15).

An impairment loss can be reversed in subsequent periods (IFRS 15.104). Like other impairment reversals, the increased carrying amount of the asset should not exceed the amount that would have been calculated (net of amortisation) if no impairment loss had been recognised in the past (IFRS 15.105).

Before performing an impairment test at the contract level, any impairment loss for assets related to the contract that are in the scope of another IFRS (e.g. IAS 2, IAS 16, and IAS 38) should be recognised. After performing an impairment test at the contract level, contract costs recognised as an asset are included in the carrying value of CGU to be tested for impairment under IAS 36 (IFRS 15.103).

Presentation of contract costs

IFRS 15 does not provide specific guidance on the presentation (classification) of contract costs. The only guidance offered is in the form of disclosure requirements, outlined in paragraphs IFRS 15.127-128.

Costs incurred to fulfil a contract have similarities with work-in-progress, but they are explicitly excluded from the scope of IAS 2 (IAS 2.8). Similarly, all contract costs are also excluded from the scope of IAS 38 (IAS 38.3(i)).

In light of these exclusions, entities face a decision regarding the presentation policy to apply for these costs. It is important to note that they should not be presented as part of a contract asset, given their fundamental differences. Contract assets represent an entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passage of time (for example, the entity’s future performance).

Another issue arises concerning their presentation in the income statement. In my view, contract costs should be presented according to their nature or function, depending on the presentation method adopted by the entity (for instance, they may be included as cost of sales). It is important to note that this issue is not explicitly addressed in IFRS 15.

More about IFRS 15

See other pages relating to IFRS 15: