- 1 Revenue Recognition
- 2 The IFRS Five Step Process
- 3 Subscription Revenue – Accounting – Journal Entries
- 4 Conclusion
From January 1, 2018 International Financial Reporting Standard (IFRS) 15 Revenue from Contracts with Customers set out the new requirements in how this revenue was to now be recognised. In this tutorial we are in particular going to be looking at what IFRS 15 requires when we are 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 journal entries here. 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, ie revenue recognition. That article dealt with the straight forward situations of 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 the 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. As subscription billing models have grown in popularity, in particular in the online world, how
And for entities with significant revenues from subscription models the new standard is of particular importance.
The IFRS Five Step Process
Building on this we now need to get into the more technical financial reporting requirements in this recognition to be able to understand the new IFRS 15 requirements; in particular the accounting of revenue subscription. And for us today we are going to look at the five step model that the standard requires to be followed.
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:
- 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 an reporting entity to determine the what it is required to deliver to the other party or parties in the form or goods and/or services. These don’t necessarily need to be distinct, or say 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 the case of a subscription this may involve the separation between 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 that the transaction will be recognised at. 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 have what the goods and services, or group of them, are and the transaction price has been worked out, we need to allocate those prices to those goods and services. These prices are allocated on a stand-alone or on a more variable allocated basis. Under certain conditions rather than using the stand-alone price of the goods and services to be provided the price allocated to each may be as a proportion of the overall price rather than as individual components.
Don’t worry, this is about as complicated as subscription revenue accounting calculations gets. If you get through Step 4 its pretty much plain sailing from there.
Lets look at a simple example to better make the point; we’ll carry on with the ISP example we mentioned in Step 2 above. We have a new contact with the following features:
- initial route and has a stand-alone price of $50.00 and delivery fee has 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).
Now with that information we can construct our calculations for the correct apportionment of the two different performance obligations under the contact. Table 1 below sets out how we would go about this.
Of course with a simple example like this we have not taken into consideration the time value of money of the monthly plan cashflow figures. On more material and/or longer contract terms this would need to be performed.
Step 5: Recognise Revenue
And the final step is the timing of revenue recognition. The revenue is to be brought to account when the customer gains control of the goods and / or services, at specific time or over a period of time.
The standard considers a number of issues here, the two pertinent ones 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.
Subscription Revenue – Accounting – Journal Entries
Now time to work through a few journal entries to see how the debits and credits will work. With this example we will expand out a bit more the example we used in Step 4 above. For 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 we are going to bring this type of subscription contract to account. If you skipped over the above commentary, a quick look at Step 4 in regards to the allocation of a contract price between its components would be useful.
The details of the standard bundled contract that we are presented with is as follows:
- 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 it determine how this contract is going to be recorded in the books. We have to work out what, if any, revenue are we going to bring to account now and then how future cashflow streams will be recorded.
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;
- 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.
Set out in Table 2 below are our calculations for this example and are what we will use 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 is going to pay multiplied by the number of months in the contract. So in our case it is $40 per month x 24 month contract = $960.
Do note we have ignored in net present value calculations here for the cashflows. This should be brought to bear in this case. Drop us a note if you would like to see this worked through and we can prepare a separate, shorter, tutorial for this.
Now we have the figures we need to prepare the journal entries and determine when they are recorded.
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. This is because these are the only parts of the contract that we have fulfilled through delivery and activation to the customer. As the cell, broadband and line rentals are all paid in arrears we can only bring them to account at the end of month one.
|Cell Phone Sale||$284|
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 first month into the contract. What are wanting to know in using these calculations is how to apportion the $40 payment we have received from the customer.
Now that we have the calculations we have to workout what is recorded as a reduction in the debtor balance and what is recorded as revenue. The debit to bank of course is the easiest, being a debit of $40.00. The complete entry would be:
|Cell Phone Monthly Plan||$8.51|
|||Broadband Monthly Plan||||$8.51|
|Telephone Line Rental||$10.21|
The debtor entry is made up of two parts: $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.
Journal Entry 2 would then be repeated each month, $40 being debited to case, £12.77 being credited to debtors and the other revenue line items being credited with their respective revenue allocation.
That brings us to the end of our tutorial on subscription revenue and its accounting. We trust this has helped your understanding, in particular of how IFRS is brought to use in this area. If there is a part that 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.