The Licence That Was Never Quite Sold
On 1 October 20X4, Halvard plc (year end 31 December) grants a five-year licence to a customer for its proprietary logistics software. The contract price is £4.0m, payable as £1.0m on signing and £3.0m on 31 December 20X6. Halvard's incremental borrowing rate is 6%. The contract also obliges Halvard to provide unspecified future upgrades to keep the software compliant with new customs regulations, and to host the software on its own servers for the whole term. The customer cannot use the software without the hosting. Halvard has no other customers for this product and cannot determine a stand-alone selling price for the hosting or the upgrades. On 1 October 20X4, Halvard incurred £0.6m of development cost that had already been capitalised as an intangible and had a carrying amount of £0.6m. The finance director has recognised £4.0m of licence revenue on 1 October 20X4 and derecognised the intangible.
1. Critically evaluate the finance director's revenue recognition. Identify the performance obligations and advise on the amount and timing of revenue.
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Identify the promises. There are three candidate promises: (i) the right to use the software (the licence), (ii) unspecified future upgrades, and (iii) hosting.
Are they distinct? Under IFRS 15, a good or service is distinct if the customer can benefit from it on its own or with readily available resources and it is separately identifiable. The customer cannot use the software without the hosting, and the hosting is not sold separately - so the licence and hosting are highly integrated and form a single combined performance obligation. The unspecified upgrades are also not distinct: they are an obligation to keep the software functioning, which is part of the same integrated service.
Conclusion on timing. The single performance obligation is satisfied over time (the customer receives and consumes the benefits of the hosting and upgrade service as Halvard performs, and the asset created has no alternative use with a right to payment for performance to date). Revenue is therefore recognised over the five-year term, not on 1 October 20X4. The FD's £4.0m up-front recognition is wrong.
Measure the transaction price. The £3.0m receivable in 20X6 must be discounted at 6% for approximately 2.25 years: PV ≈ £3.0m / 1.06^2.25 ≈ £2.63m. Transaction price ≈ £1.0m + £2.63m = £3.63m. The £0.37m difference is interest income recognised under IFRS 9 over the period, not revenue.
Allocation. There is a single performance obligation, so the whole £3.63m is allocated to it. Revenue for the three months to 31 December 20X4 ≈ £3.63m × 3/60 = £0.18m.
Intangible. The £0.6m capitalised development cost should not be derecognised. It relates to the software that Halvard continues to control and use to deliver the hosting service, so it remains an intangible asset and is amortised over its useful life. Derecognising it and recognising £4.0m revenue overstates both profit and net assets.
2. Explain how the contract asset/liability and the interest income should be presented at 31 December 20X4, and identify the key judgements an auditor would challenge.
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Presentation at 31 December 20X4.
- Contract liability. Halvard has received £1.0m cash but has performed only three months of a five-year service. The £1.0m is a contract liability (deferred revenue), reduced by the £0.18m of revenue earned: £1.0m − £0.18m = £0.82m contract liability.
- Receivable. The £3.0m due in 20X6 is a financial asset measured at amortised cost. At 31 December 20X4 it is carried at its discounted amount plus accrued interest: £2.63m × 1.06^(3/12) ≈ £2.67m, with the £0.04m unwinding recognised as finance income in profit or loss, not revenue.
- No contract asset arises because the entity has an unconditional right to consideration only for the 20X6 instalment; the up-front cash creates a liability, not an asset.
Key judgements an auditor would challenge.
- Distinct vs combined. The conclusion that hosting and licence are a single performance obligation drives the entire answer. The auditor would test whether the customer could realistically use the software without Halvard's hosting (e.g. is there an alternative host? does the licence transfer a right to use?).
- Over time vs at a point in time. The 'no alternative use plus right to payment' criterion must be evidenced; if the software has alternative use to Halvard, revenue could be at a point in time.
- Discount rate. The 6% incremental borrowing rate must reflect the customer's credit characteristics where relevant; a different rate changes the transaction price materially.
- Intangible carrying amount. Whether the £0.6m remains recoverable and its remaining useful life.
- Significant financing component. IFRS 15 provides a practical expedient where the period between transfer and payment is ≤ 1 year; here it is 2.25 years, so the expedient is unavailable and the adjustment is required.