IFRS 15 specifically deals with incremental costs of obtaining a contract and costs to fulfil a contract.
Incremental costs of obtaining a contract
Incremental costs of obtaining a contract are those costs that the entity would not have incurred if the contract had not been obtained (e.g. if any of the parties would back out just minutes before signing the contract). Incremental costs of obtaining a contract should be recognised as an asset, unless entities do not expect to recover them. Recovery can be effected by direct billing to customer or by earning a sufficient margin on the contract. The predominant example of incremental costs relates to sales commissions. There may be other types of incremental employee contract costs, such as bonuses that are incrementally increased with each contract. Strictly speaking, entities should recognise as assets also costs incurred on top of incremental employee costs, e.g. social security charges levied on the incremental part of remuneration.
Other, less common, examples of incremental costs include various success fee type of remuneration paid to advisors.
When an entity incurs incremental costs on contract modification, those costs still should be recognised as an asset even if the modification is considered to be a part of existing contract. This is not explicitly stated in IFRS 15, but this is commonly accepted as IFRS 15 does not limit the requirements to initial costs only.
Non-incremental costs may be recognised as an asset only if they are explicitly chargeable to the customer regardless of whether the contract is obtained (IFRS 15.91-93). Otherwise, they should be expensed in P&L as incurred. Examples of non-incremental costs are due diligence costs or proposal and negotiation costs (e.g. travel and accommodation).
IFRS 15 offers a practical expedient to the rule above and allows immediate recognition of all contract costs as an expense if the amortisation period of such costs would not have exceeded 12 months (IFRS 15.94).
See also Example 37 accompanying IFRS 15.
Costs to fulfil a contract
Some costs incurred to fulfil a contract may be within the scope of other IFRS. If this is the case, these other standards should be applied to account for these costs (IFRS 15.96). Examples of such costs include:
If other applicable IFRS do not allow recognition of particular costs as assets, they must be expensed as incurred even if they would meet the criteria for capitalisation according to IFRS 15. If the costs incurred to fulfil a contract are not covered by other IFRS, they are recognised as an asset when all of the following criteria are met (IFRS 15.95):
- the costs relate directly to a contract or to 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 in continuing to satisfy) performance obligations in the future; and
- the costs are expected to be recovered.
Examples of costs that relate directly to a contract, provided they meet all the criteria above, are as follows (IFRS 15.97):
- direct labour costs, for example: salaries and wages of employees who provide promised services directly to the customer;
- direct materials, for example: supplies used in providing the promised services to a customer;
- allocation of costs that relate directly to the contract or to contract activities, for example:
– costs of contract management and supervision,
– insurance and depreciation of tools, equipment and right-of-use assets used in fulfilling the contract;
- 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, for example:
– payments to subcontractors,
– rent of additional project office.
Examples of costs that should be expensed in P&L as incurred are (IFRS 15.98):
- general and administrative costs (unless those costs are explicitly chargeable to the customer under the contract),
- training 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 satisfied performance obligations (or partially satisfied performance obligations) in the contract (i.e. costs that relate to past performance); 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).
The decision about capitalisation of contract costs is very judgemental, the predominant focus should be put on deciding which costs generate or enhance resources that will be used in satisfying (or in continuing to satisfy) performance obligations in the future. Paragraph IFRS 15.BC308 clarifies that entities cannot capitalise costs merely to normalise profit margins throughout a contract by allocating revenue and costs evenly over the life of the contract. For example, when an entity did not recognise some of the transaction price due to constraining estimates of variable consideration, it may be possible that contract costs recognised in P&L will exceed revenue recognised to date. Entities are not allowed to capitalise this difference (i.e. initial loss on a contract) simply because they are waiting for the constraining estimates of variable consideration to be resolved.
See also Example 37 accompanying IFRS 15.
Amortisation of contract costs
Incurred costs recognised as an asset should be amortised on a systematic basis consistently with the transfer of the goods or services to which the asset relates (IFRS 15.99-100). Sales commissions for acquiring a new customer may be amortised over a period longer than a contract to which they relate if the expected customer relationship period is longer and commissions paid on contract renewals are relatively lower than for acquisition of a new customer (IFRS 15.BC309). The same rule applies to costs to fulfil a contract (see Example 37 accompanying IFRS 15).
Estimates relating to amortisation of contract assets should be updated at each reporting date with any changes accounted for prospectively (IFRS 15.100).
Example: Estimates relating to amortisation of contract assets
This example is based on Example 37 accompanying IFRS 15.
On 1 January 20X1 Entity A enters into a contract with Customer X to manage his information technology data centre. The contract is signed for 5 years. At the contract inception, based on experience with similar contracts, Entity A estimates that the Customer X will renew the contract for another term of 5 years. Before providing the services, Entity A incurs costs of $100,000 relating to migration and testing of data centre. These costs are recognised as assets (costs to fulfil a contract) as they relate primarily to activities to fulfil the contract but do not transfer goods or services to the customer.
Entity A decides to amortise those costs over a 10-year period, i.e. the anticipated relationship with Customer X. After 5 years, $50,000 of these costs were recognised (i.e. amortised) in P&L, and the remaining $50,000 are still recognised as an asset. When the 5-year contract expires, Customer X signs another one, but this time for 10 years. Entity A concludes that the contract assets will be used to fulfil the new contract and extends the amortisation period accordingly. This constitutes a change in accounting estimate and is accounted for prospectively, i.e. already recognised amortisation expense is not adjusted, and the remaining $50,000 is amortised over the next 10 years.
Impairment of contract costs
An impairment of incurred costs recognised as an asset should be recognised whenever the value of this asset exceeds the remaining consideration to be received less past and future expenses unrecognised in P&L (IFRS 15.101-102). Future cash inflows for the impairment testing purposes are not the same as the transaction price because entities don’t need to take into account constraining estimates of variable consideration (which increases cash flows for impairment testing purposes) and entities need to take into account customer credit risk (which decreases in cash flows for impairment testing purposes).
As mentioned earlier, contract costs can be amortised during the expected contractual relationship period that can be longer than current contract period. Therefore, expected cash flows for the purpose of impairment testing should consistently be estimated for the expected contractual relationship period as well (this point is not explicitly covered in IFRS 15).
Such an impairment loss can be reversed in subsequent periods (IFRS 15.104). As with other impairment reversals, the increased carrying amount of the asset should not exceed the amount that would have been determined (net of amortisation) if no impairment loss had been recognised previously (IFRS 15.105).
Before performing an impairment test at a contract level, entities should recognise any impairment loss for assets related to the contract that are recognised in accordance with another IFRS (e.g. IAS 2, IAS 16 and IAS 38). After performing an impairment test at a contract level, contract cost 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 is silent on presentation (classification) of incremental costs of obtaining a contract and costs to fulfil a contract. There are only disclosure requirements in paragraphs IFRS 15.127-128. Costs to fulfil a contract are similar in nature to work-in-progress, but they are specifically excluded from the scope of IAS 2 (IAS 2.8). All contract costs are also excluded from the scope of IAS 38 (IAS 38.3(i)).
An entity has therefore an accounting policy choice on how to account for them. I believe it is clear that they should not be presented as a part of a contract asset as they are very different in nature from ‘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)’.
Similar question arises when it comes to presentation in P&L. I believe that contract costs should be presented according to their nature or function depending on presentation method adopted by the entity (e.g. included as cost of sales). Again, this is not covered in IFRS 15.
More about IFRS 15
See other pages relating to IFRS 15:
Identify a Contract
Performance Obligations and Timing of Revenue Recognition
Principal vs Agent, or Reporting Revenue Gross vs Net
Revenue from Licensing of Intellectual Property
Revenue from Customers’ Unexercised Rights (Breakage)
Customer Loyalty Programmes and Other Options for Additional Goods or Services
Contract Assets and Contract Liabilities