Revenue Recognition on a Multi-Element Software Contract
Brightline Systems signs a three-year contract with a client for a bundled package: an on-premises licence (standalone selling price BDT 4.0m), two years of maintenance (SSP BDT 1.2m), and a cloud hosting service for three years (SSP BDT 1.8m). Total consideration is BDT 6.2m, payable BDT 3.0m upfront and the balance in equal annual instalments starting in year two. The licence is delivered immediately and the client can use it without the hosting. Hosting is a series of distinct monthly services. The finance director proposes recognising the full BDT 6.2m on delivery because 'the client has signed and paid'. Separately, a BDT 0.4m sales-based royalty on hosting usage is expected but not yet earned. The company has a 31 December year-end and the contract began 1 October 20X5.
1. Advise how the BDT 6.2m transaction price should be allocated and recognised across the three performance obligations for the year ended 31 December 20X5.
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Step 1 – Identify performance obligations. Three distinct promises: (a) the on-premises licence, (b) the maintenance service, and (c) the cloud hosting series. The licence is distinct because the client can benefit from it without the hosting and it is separately identifiable in the contract.
Step 2 – Allocate the transaction price on relative SSP. Total SSP = 4.0 + 1.2 + 1.8 = BDT 7.0m. Allocation:
- Licence: 6.2 × 4.0/7.0 = BDT 3.543m
- Maintenance: 6.2 × 1.2/7.0 = BDT 1.063m
- Hosting: 6.2 × 1.8/7.0 = BDT 1.594m
Step 3 – Recognise by pattern of transfer.
- Licence: point-in-time on delivery (1 October 20X5) – recognise BDT 3.543m in 20X5.
- Maintenance: straight-line over 24 months. Three months elapsed = 1.063 × 3/24 = BDT 0.133m in 20X5.
- Hosting: series of distinct monthly services, straight-line over 36 months. Three months = 1.594 × 3/36 = BDT 0.133m in 20X5.
Total 20X5 revenue ≈ BDT 3.809m, not BDT 6.2m. The balance sits in contract liabilities. The royalty is variable consideration constrained until the usage occurs and is recognised when earned. The upfront payment timing does not drive recognition; the finance director's proposal overstates revenue and profit and misstates deferred income.
2. The client's usage of hosting in 20X6 is unexpectedly high, triggering the BDT 0.4m sales-based royalty. Explain the accounting treatment and whether the original allocation changes.
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The royalty is variable consideration that relates specifically to the hosting service. Under the allocation exception, variable consideration tied to a specific obligation is allocated entirely to that obligation rather than spread across all obligations. It is estimated using the expected-value or most-likely-amount method and included only to the extent it is highly probable that a significant reversal will not occur. Because the royalty is sales-based and contingent on actual usage, constraint applies until the triggering usage occurs.
In 20X6, once the usage threshold is met, recognise BDT 0.4m as hosting revenue in 20X6 (or accrue over the period the usage generates, depending on the pattern). The original fixed allocation of BDT 6.2m is not reallocated; the royalty is added to the hosting obligation only.
Also consider whether the contract modification rules apply if the high usage reflects a substantive change in scope. If it is merely usage under the existing contract, no modification. Disclose the variable consideration and the constraint judgement. The key exam point: do not spread the royalty across the licence and maintenance, and do not recognise it before the uncertainty resolves.