Accounting for the sales of software licenses with subsequent updates
“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: Apply IFRS 15 guidance
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:
- The license and the services are capable of being distinct and
- 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:
- Software license, and
- 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:
- 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
- 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!
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Very thoughtful response. Thankyou Silvia!
Hi Silvia,
I have a question about how we recognise software term licence revenue under IFRS.
I understand that for support or subscriptions, we have to accrue the revenue, and release it over the period of support or subscription. For a perpetual licence sale, we recognise the full revenue straight away.
But what about a software term licence, which is something in the middle? It’s time-limited – so expires after a year. At which point they renew / extend or stop using. But in our case, it does include product support for that period. We don’t bill that separately. The term licence isn’t cancellable part-way through – but neither are our support agreements. For me it seems when we sell term license, license is not distinct from support. IFRS provides specific guidance for the licenses only if the license is distinct.
How should we recognize the revenue?
Many thanks for your reply in advance!
Nikoletta
Ravi Its completely depends on the control & situation. If your entity receiving total amounts from Customer & transferring to other party, yes you need to fully recognize the revenue. If not margin is fine.
Hi Silvia, if the license of intellectual property is not related to software such as childcare operator, do the above principles should apply the same? (for example, to assess if the seller required to make changes in the study materials, syllabus and training guides etc)
Superb ! Great way to explain such a compliacted topic.
Silvia- U r really genius ,,,
You mean if the financialyear 31 Dec, 2 months of 120 upgrades should be apportioned?
Hello,
Very good and professional approach here.
Quick question in relation to the above. How can we justify to recognize the income related to the 12 months services (upgrades) when the invoice is booked ?
Example : we sell in November a software for 200 USD (80 of licence + 120 of upgrades and services covering next 12 months).
We recognize the full amount of 200 in P&L in November instead of deferring 120 over subsequent 12 months. Is there a way to justify we take the full hit directly in the november P&L ?
Thanks a lot in advance
Regards
Sal
Hi Sal, I don’t think this is the correct approach, because upgrade service is provided continually over 12 months, so you should apportion somme of the revenue to this performance obligation (satisfied over time) and recognize revenue over 12 months, not at the point of time. S.
Hi Silvia,
We have a channel partner who sold software license to one of our customer. We will be charging 20% of SaaS fee to our channel partner. It will be one time fee. My question is how i should recognize revenue in this case. Should i just recognize complete 20% of SaaS fee in the same month or should i spread over 12 months like we do for other SaaS customers. Please advise.
Hi Silvia,
amazing answers from you, as usual, my question here is whether the software has considered Right to Access Or Right to use, how the selling company classifies the software and license, Inventory ? or Intangible assets?
Thank you very much
Got a job interview tomorrow with a fintech company, and i was looking for some illustration on how to recognize the revenue from a software sale, your article came to the rescue, much easier to get the picture than reading the IFRS it self, thanks a lot
Hi Bana,
oh, great, good luck!
Hello Silvia
How is revenue recognized in mobile phone companies from the sale of recharge cards (prepaid cards)?
When selling cards and receiving payment?
Over time with use?
Or is there another way to recognize revenue?
Thank you so much
No, not at time of receiving payments, but at the time of satisfying the performance obligation – i.e. as the prepaid minutes are being spent. S.
Thank you so much dear Silvia
But can I know under what standard this is mentioned?
I would say that the whole IFRS 15 is about that.
Incase
they are not distinct and are to be treated a s a single Performance obligation then how would the company recognise revenue?
Thanks for the Article Silvia.
Just small question, how to account for Trading of license for software where the entity is more of facilitator/intermediary? Whether the entity should account for full amount of license sold as a part of trading or only margin at which license have been transferred.
Would not it be better if the date of each such post/Q&A is also mentioned?
Well, no. The reason is that when people see that the post is 1 year old, it does not apply anymore – which is not true. I try to update posts as the new rules are issued so that everything is fresh, despite the original date of posting. And, if there was no change for 2 years, then there’s no need to update for 2 years and the 2-year old post is still valid. S.