From January 1, 2018, International Financial Reporting Standard (IFRS) 15 Revenue from Contracts with Customers sets out the new requirements for recognising this revenue. In this tutorial, we will be looking at what IFRS 15 requires when accounting for subscription revenue.
After writing this article and realising how long it is, if you are here just for the journal entries and not particularly interested in what the standard says, skip down to the journal entries section. But do bear in mind Step 4 in the IFRS section might be worth a quick read through.
As part of our accounting 101 tutorial series, we laid out the fundamental points in how revenue is brought to account in a firm’s books, i.e. revenue recognition. That article dealt with the straightforward situations when a good or service is provided on or about the same time as payment is made. There is no difficulty in understanding the amount, timing or obligations between the parties.
However, what IFRS 15 does is help us where these issues are not quite as clear. And in particular, when we are dealing with material sums of money, these issues can have a material impact on the fairness of the financial reporting entity. For entities with significant revenues from subscription models, the new standard is of particular importance.
The IFRS Five Step Process
Building on our previous article, we now need to get into the more technical financial reporting requirements in this recognition to understand the new IFRS 15 requirements, particularly the accounting for revenue subscription. And for us today, we will look at the five-step model that the standard requires us to follow.
Step 1: Identify the Contract
The first hurdle we need to get over is whether there is a contract in place. The standard looks at four aspects to determine if an agreement between two or more parties exists:
- is the collection of monies from the contract probable;
- does the contract have commercial substance to it;
- are the rights and obligations of each party identifiable clearly, and;
- has the agreement been approved by each party and are they committed to their respective obligations?
Step 2: Identify Performance Obligations
The standard requires a reporting entity to determine what is necessary to deliver to the other party or parties in the form of goods or services. These don’t necessarily need to be distinct or individually identifiable, but they must be identifiable at least as a group or series of obligations.
For example, where a contact may have a bundle of goods and services and be over a series of different projects, the individual goods may not be identifiable, but the contract series could well be.
In a subscription, this may involve separating the setup fee, perhaps a delivery fee, and then an ongoing monthly service fee. This would be common for internet service providers (ISP)s. They often charge a fee for the connection of the service. Perhaps there is a charge for a new broadband router and its delivery. And finally, there is a monthly service to be paid over a 12-month contract length.
Step 3: Determine the Transaction Price
We now move onto the price and how we will recognise this in the transaction. The standard sets out four criteria to help us determine these figures:
- any variable consideration needs to be carefully estimated based on history with this particular client or group of clients:
- if there are financing provisions in the contract these need to have their respective net present values of cashflows determined;
- any non-cash considerations need to be accounted for, either at their fair market value or if not available then the selling price of the good or service exchanged at the time of the contract; and
- any payments that may be required to customer and whether these are in fact a reduction in the price, for example through discounts, or separate goods or services to be provided.
Step 4: Allocate the Transaction Price
Now we know the goods and services and the transaction price, we need to allocate these prices to the goods and services. We can assign the prices on a stand-alone or a variable basis. Under certain conditions, rather than using the stand-alone price of the goods and services, the individual price can be a proportion of the overall price rather than the individual components.
Don’t worry; this is about as complicated as subscription revenue accounting calculations get. If you get through Step 4, it’s pretty much plain sailing from there.
Let’s look at a simple example to make the point better; we’ll carry on with the ISP example we mentioned in Step 2 above. We have a new contact with the following features:
- initial router has a stand-alone price of $50.00 and a delivery fee of $10 (this gives us the stand-alone selling price of $60 for the router and delivery);
- the customer is billed $30 per month, over a 12 month contract (a total price of $360; the figure that needs to be allocated);
- the ISP has an equivalent $20 plan with no free delivered router (they will use this as the stand-alone selling price for the monthly plan at $240).
We can construct our calculations for the correct apportionment of the two different performance obligations under the contract with that information. Table 1 below sets out how we would go about this.
Of course, with a simple example like this, we have not considered the time value of money of the monthly plan cashflow figures. On more material or longer contract terms, we would have to account for the time value of money.
Step 5: Recognise Revenue
And the final step is the timing of revenue recognition. The revenue is brought to account when the customer gains control of the goods or services.
The standard considers several issues here; the two pertinent ones are the transfer of control and timing. In regards to control, a customer gains control when they are able:
- to exercise an ability to use the goods;
- deploy this use as they wish or to direct someone else to do this on their behalf;
- prevent others from the benefits of those goods; and
- to receive or direct the economic flows off those goods and again either directing others on their behalf and/or preventing others from receiving those flows.
Accounting For Subscription Revenue Journal Entries
Now is time to work through the journal entries to see the debits and credits at work. With this example, we will expand out the example we used in Step 4. A quick recap; we have an ISP that offers bundled broadband and phone contracts to customers. What we have to do is work out how to bring this type of subscription contract to account. If you skipped over the above commentary, a look at Step 4 regarding allocating the contract price between its components would be helpful.
The details of the standard bundled contract that we have are:
- a 24 month contract covering a new mobile phone, monthly phone usage, a broadband router, broadband usage and telephone line rental;
- the customer pays $0 upfront and $40 per month for 24 months;
- there is an automatic roll-over at the end of 24 months if the customer chooses to do nothing.
So our job now is to determine how we are going to record the contract in the books. We must work out what revenue we will bring to account now and then record future cashflow streams.
From the information provided, we can tease out the following individual obligations under the contract:
- there is a new mobile contact; this phone sells at a normal stand-alone price (ie outside of any phone contract) for $500;
- a similar cell phone voice, text and data plan sells for a stand-alone price of approximately $15 per month;
- the broadband router sells for a stand-alone price for $40 ;
- the seller has a similar broadband un-bundled 24 month contract available for $15; and
- a normal line rental with no other services associated with it normally sells for $18 per month.
Calculations – Contract Commencement
Set out in Table 2 below are our calculations for this example. The monthly cell phone and broadband plans are the per month price x 24 months; for example, for the cell phone plan, the stand-alone price is $15 x 24 months = $360. The Contract Price Allocation uses the amount the customer will pay multiplied by the number of months in the contract. So in our case it is $40 per month x 24 month contract = $960.
Make note we have ignored cash flow net present value calculations, which IFRS 15 requires us to use. Drop us a message if you would like to see this worked through, and we can prepare a separate, shorter tutorial for this.
Journal Entry – Contract Commencement
Now we have the figures, we need to prepare the journal entries and determine their timing. So at the commencement of the contract, assuming the above calculations are pretty much automated and all parts of the contract started on October 1, 20XX, we would record the following as set out in Journal Entry 1 below. You will see that all we are bringing to account initially is the cell phone and broadband router. These are the only parts of the contract that we have fulfilled through delivery and activation to the customer. The cell, broadband and line rentals are all paid in arrears, so we can only bring them to account at the end of month one.
|Cell Phone Sale||$284|
Calculation – First Subscription Payment
Surprisingly time flies when subscription revenue accounting is on the go, and we are now at the end of October. At this point, we have to start to record the monthly plan revenue and cash received and the apportionment of the debtor balance of $307.
So the old spreadsheet needs to come out again, and Table 3 below shows the new workings for October 31 and the first month into the contract. In using these calculations, we want to know how to apportion the $40 payment we receive from the customer.
Journal Entry – First Subscription Payment
Now that we have the calculations, we have to work out the debtor balance reduction and increase in revenue. The debit to the bank is the easiest, being debit $40. The complete entry would be:
|Cell Phone Monthly Plan||$8.51|
|||Broadband Monthly Plan||||$8.51|
|Telephone Line Rental||$10.21|
The debtor entry comprises $11.82 for the new cell phone and $0.95 for the new broadband router. This makes a total credit to debtors of $12.77. With the other three credits all coming directly off Table 3 “Monthly Allocation” column. So for the cell phone and broadband plans, we have $8.51 each and the line rental making up the remainder of the $40 with $10.21.
We would repeat Journal Entry 2 each month; debit $40 to the bank, credit £12.77 to debtors, and credit other revenue line items with their respective revenue allocations.
End of Contract
At the end of the 24-month contract, we collected $960 from the customer (24 months x $40). The question now arises as to what to is to be done next. Well, this depends on what the customer chooses to do. The options we would face are the customer:
- does not renew the contract and moves to a competitor;
- renews the contract with new contract under a new agreement, or;
- rolls-over the remaining contract and moves onto a rolling month-to-month agreement (assuming this is part of the orginal contract).
We’ll look at each of these cases in turn below.
As you may well have assumed, there are not further economic flows to account for in this scenario. Unless the contract had a balloon or final payment clause, however, in our case, there isn’t one, and so no accounting entries are required.
A New Contract
If the customer decides to take out a new contract, perhaps taking advantage of the sales team’s special offer, we would run through the same exercise as we did above. Starting at “Calculations – Contract Commencement”, we would do the same review of what is available to customers as stand-alone prices and perform a split between the new bundle of services the customer takes out.
Due to a special promotion or other customer retention offerings, there may be different prices to account for. But remember from our article discussing trade discounts, there are no journal entries to make for these discounts. Now a sales discount isn’t the same as a trade discount in marketing, but in accounting, we treat it in a similar manner because these discounts do not meet the definition of an expense they are not brought to account.
If you would like some more reading on this, check out the article we linked above. Or, for some “lite reading”, the link below will take you to the IFRS Conceptual Frameworks tome.
The final case is if the contract allows the customer to say roll the contract over onto a month-to-month deal. In this scenario, we’ll assume the customer is allowed to do this, and the price will remain the same. The customer will still pay $40 per month and must give one months notice if cancelling going forward. Or they upgrade or downgrade to a different bundle.
This scenario effectively takes us out of the subscription model we have been following and moves us more into normal revenue recognition. Each month, the ISP will provide a bundle of services to the customer, who is now under contract to pay for what they have used and for a month ahead if they give notice.
So at the end of the contract, we would see an ongoing series of accounting entries looking like the following.
|Cell Phone Monthly Plan||$21.28|
|||Broadband Monthly Plan||||$8.51|
|Telephone Line Rental||$10.21|
The journal entry looks very similar to what we have done before, but with a few differences. First, the debit is to the debtor account. The ISP has provided a month of bundled services to the customer and so has earned this revenue. To account for this, it credits the respective revenue accounts and debits the debtor account. The invoice is issued to the customer, who then pays by the due date. Perhaps using the same automatic payment plan already in place.
So the other change we see is there is no debtor account to credit, as this has been fully paid off by the customer. This previous balance of £307 arose from the new cell phone and the broadband router delivery charge. As we can’t credit this asset account anymore, we need to allocate this part of the $40 to something else. In our example, this ISP allocates this to the Cell phone Monthly Plan account. In substance, this reflects the additional revenue the ISP is now generating by the customer staying on the same contract but with the old cell phone.
And then, when the customer pays their monthly bill, the ISP would make the following journal entry:
The debit entry to the bank count reflects the increase in cash, while the credit reflects the reduction in the debtor account balance.
And this pair of journal entries would be repeated each month until the customer changes to one of the other two options we discussed above; cancels the contract or changes the bundled plan they are on.
That brings us to the end of our tutorial on subscription revenue and its accounting. We trust this has helped your understanding of how to use IFRS 15 in this area. If a part isn’t clear or you would like a different example worked through, please drop us a note below or get in touch through our Contact Us page.