Revenue Recognition on a Contract Modification and Service-Level Credits
Sahel Cloud Systems Ltd, a Kano-based software company, signed a three-year contract with a commercial bank to implement and host a core banking platform. The contract price is ₦180m: ₦60m for implementation and ₦40m per year for hosting. Implementation is not distinct because the bank cannot benefit from it without the hosting service, and the two are significantly integrated. Revenue has been recognised on a straight-line basis over three years. At the end of year 1, the parties modified the contract to add a fraud-analytics module and extend hosting by two years for additional consideration of ₦100m. The module cannot be used separately from the platform, and its price does not reflect standalone selling price. The contract also includes service-level credits of up to ₦12m per year if uptime falls below 99.5%; at the end of year 1, management estimates that ₦7m of credits will be payable and that no significant reversal is likely. The finance director has asked whether the modification is a separate contract and how much revenue should be recognised in year 1.
1. Assess whether the modification should be accounted for as a separate contract under IFRS 15.
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IFRS 15 treats a contract modification as a separate contract only if two conditions are met: the scope increases because of distinct goods or services, and the price increases by an amount that reflects the standalone selling price of those additional goods or services. Here the fraud-analytics module is not distinct: the bank cannot benefit from it separately from the hosting platform, and the module is significantly integrated with the existing service. In addition, the additional ₦100m does not reflect the module’s standalone selling price. The modification therefore fails the separate-contract test. Because the remaining services are not distinct from the services already transferred and the combined arrangement is a single performance obligation satisfied over time, the modification is accounted for as a termination of the original contract and the creation of a new contract. The entity must remeasure cumulative revenue using the total transaction price of ₦280m (₦180m original plus ₦100m additional) over the total five-year service period (three original years plus two extension years).
2. Calculate the revenue that should have been recognised in year 1 before considering the service-level credits, and explain the adjustment required.
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Before the modification, revenue was ₦60m per year (₦180m ÷ 3 years). After the modification, the total consideration is ₦280m and the total service period is five years. At the end of year 1, cumulative revenue should be ₦280m × 1/5 = ₦56m. Since ₦60m has already been recognised, a catch-up reduction of ₦4m is required. The year 1 revenue restated for the modification is therefore ₦56m, not ₦60m. The remaining consideration of ₦224m (₦280m − ₦56m) is recognised over the remaining four years at ₦56m per year. The adjustment is: Dr Revenue ₦4m; Cr Contract liability ₦4m. The reasoning is that the modification changes the total consideration and the total service period, so the entity must revise the measure of progress and adjust cumulative revenue in the period of modification rather than prospectively only.
3. Explain how the service-level credits should be treated and compute the final revenue for year 1 after the credits.
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Service-level credits are variable consideration because the amount payable depends on uptime performance. IFRS 15 requires the entity to estimate variable consideration using either the expected value or the most likely amount, and to include it in the transaction price only to the extent that it is highly probable that a significant reversal will not occur when the uncertainty is resolved. Management estimates ₦7m of credits and considers that no significant reversal is likely, so the credits should be included as a reduction of the transaction price. Because the credits relate specifically to year 1 service, they reduce year 1 revenue rather than being spread over the remaining contract. The adjusted total transaction price is ₦280m − ₦7m = ₦273m. Year 1 revenue is the pre-credit amount of ₦56m less ₦7m = ₦49m. Since ₦60m was originally recognised, the total catch-up adjustment is a reduction of ₦11m (₦4m for the modification plus ₦7m for the credits): Dr Revenue ₦11m; Cr Contract liability ₦11m. Future revenue is ₦224m over four years, or ₦56m per year.