Introduction
When selling goods or services, companies usually incur costs to win the work and costs to get ready to deliver it. Most of those costs are recognised as an expense as they arise, and the cost of goods sold is dealt with by IAS 2. A narrow set of them is not, and it is that set IFRS 15 addresses.
IFRS 15 contains its own capitalisation model, distinct from the five-step revenue model, for two categories of cost: the incremental costs of obtaining a contract with a customer, and the costs of fulfilling that contract where they fall outside every other standard. Both are recognised as assets, amortised as the related goods or services transfer, and tested for impairment under a test written for them.
The model exists because of a timing mismatch. An entity often pays a commission, or performs set-up work, before it recognises any of the related revenue. Capitalising those amounts and releasing them across the period of transfer matches the cost to the revenue that carries it.
| Category | Recognised as an asset when |
|---|---|
| Costs of obtaining a contract | The cost is incremental to obtaining the contract and the entity expects to recover it |
| Costs to fulfil a contract | The cost falls outside every other standard and meets three cumulative criteria |
The two categories behave identically once recognised, diverging only on the recognition test and on one point of relief: the practical expedient below is available for costs of obtaining a contract only. Our complete guide to IFRS 15 sets out the five-step model these costs attach to.
Which Standard Captures the Cost
The fulfilment cost test is a residual one. Before IFRS 15 is considered, the entity establishes whether the expenditure is already within the scope of another standard, and if it is, that standard governs recognition and measurement in full.
| Nature of the cost | Standard applied |
|---|---|
| Materials and work in progress held for the contract | IAS 2 Inventories |
| Equipment acquired or constructed to service the contract | IAS 16 Property, Plant and Equipment |
| Software or other intangible resources created for the contract | IAS 38 Intangible Assets |
| An onerous contract | IAS 37 Provisions, Contingent Liabilities and Contingent Assets |
| An asset leased in to service the contract | IFRS 16 Leases |
| The liability for a commission payable to an employee | IAS 19 Employee Benefits measures the liability; IFRS 15 decides whether the cost is capitalised |
| None of the above, and the three criteria are met | IFRS 15 |
The ordering determines the depreciation or amortisation basis, the impairment model, and the sequence of impairment tests. A cost routed to IAS 16 is depreciated over the asset's useful life and impaired under IAS 36; the same cost routed to IFRS 15 is amortised over the period of transfer and impaired under the IFRS 15 test.
The ordinary sale of goods
A straightforward sale of goods raises no contract cost question. The goods are held as inventory under IAS 2 and their carrying amount is recognised in cost of sales when control transfers and revenue is recognised, so the IFRS 15 fulfilment test is never reached.
This is not an exemption from IFRS 15 but the residual test operating as designed: IFRS 15 deals only with what no other standard has claimed. The same reasoning removes most costs a manufacturer or retailer incurs — production labour and overheads absorbed into inventory, plant depreciated under IAS 16, and distribution costs expensed as incurred.
The residual test applies only to fulfilment costs
Costs of obtaining a contract are assessed under IFRS 15 directly. There is no equivalent scope-out step, because no other standard addresses the incremental cost of winning a customer contract.
Contract Costs and Cost of Sales
Cost of sales is a presentation caption, not a recognition concept, and neither IFRS 15 nor IAS 2 defines it. IFRS 15 decides whether a cost is an asset or an expense and when that expense arises; the caption is then an IAS 1 question of analysing expenses by function, and under IFRS 18 a question of which operating line it belongs to.
The two usually give the same answer — for a sale of goods, the inventory cost becomes cost of sales at the moment control transfers. Contract costs break that coincidence: the expense arises across the period of transfer rather than at a point, and the caption depends on the function of the original cost.
| Cost | When it reaches profit or loss | Usual caption |
|---|---|---|
| Inventory sold | On transfer of control | Cost of sales |
| Amortisation of costs to fulfil | Across the period of transfer | Cost of sales — the cost is one of delivery |
| Amortisation of costs of obtaining | Across the period of transfer | Selling or distribution — the cost is one of winning the contract |
| Bid costs, wasted materials, general overheads | As incurred | The caption matching their function |
Incremental Costs of Obtaining a Contract
An entity recognises as an asset the incremental costs of obtaining a contract where it expects to recover them. Incremental costs are those the entity would not have incurred had the contract not been obtained.
The test is counterfactual: what would have happened had the contract been lost, not how closely the cost relates to the pursuit. A commission payable only on signature passes. Legal fees for drafting a proposal, payable on submission, fail, even though incurred solely for that contract.
| Cost | Treatment | Reason |
|---|---|---|
| Commission payable to a salesperson on each contract won | Asset | Incremental — not payable had the contract been lost |
| Commission payable to an external agent on a won contract | Asset | Incremental — the identity of the recipient is irrelevant |
| Bonus to a sales manager based on annual divisional targets | Expense | Not incremental to any individual contract |
| External legal fees for drafting the proposal | Expense | Payable irrespective of the outcome |
| Due diligence and travel costs on a tender | Expense | Incurred whether or not the tender succeeds |
| Tender costs the customer must reimburse either way | Expense, with a receivable | Explicitly chargeable regardless of the outcome |
Two further points follow from the definition.
Recovery is part of the recognition test. The costs must be expected to be recovered, through the contract margin or by direct reimbursement, so the costs of obtaining a contract expected to be loss-making from the outset do not qualify as an asset.
Practical expedient: an amortisation period of one year or less
Incremental costs of obtaining a contract may be recognised as an expense when incurred where the amortisation period of the resulting asset would be one year or less. The relevant period is the amortisation period, not the contract term — a twelve-month contract with an expected renewal on which no further commission is payable has an amortisation period longer than a year, and the expedient is unavailable. The expedient is an accounting policy choice applied consistently to similar contracts, and its use is disclosed.
Costs to Fulfil a Contract
Where fulfilment costs fall outside every other standard, an asset is recognised only if all three of the following criteria are met.
The costs relate directly to a contract, or to a specifically identifiable anticipated contract. Direct labour, direct materials, allocations of costs that relate directly to the contract, costs explicitly chargeable to the customer, and other costs incurred only because of the contract all qualify. An anticipated contract must be specifically identifiable — a general expectation of future business does not meet the criterion.
The costs generate or enhance resources that will be used in satisfying performance obligations in the future. The expenditure must build something the entity draws on later. Work that itself transfers a service does not create a resource; it satisfies a performance obligation, and its cost is expensed as the revenue is recognised.
The costs are expected to be recovered.
Four categories are expensed as incurred.
| Category | Note |
|---|---|
| General and administrative costs | Unless explicitly chargeable to the customer under the contract |
| Costs of wasted materials, labour or other resources | To the extent not reflected in the price of the contract |
| Costs relating to performance obligations already satisfied | The resource has been consumed, not created |
| Costs that cannot be attributed to satisfied or unsatisfied obligations | Recognition requires the distinction to be made |
The second criterion carries most of the weight. Mobilisation work — migrating customer data onto the entity's platform, configuring an environment, relocating equipment to a site — transfers nothing at the point it is performed but makes the later service possible. That is a resource. Routine delivery of the contracted service is not.
A related question is whether the set-up activity is a performance obligation at all. Where the customer receives a distinct service, the activity is a performance obligation and its costs are ordinary costs of delivery. Where it is an administrative task with no transfer to the customer, any associated fee is a non-refundable upfront fee recognised over the period of service, and the cost is assessed under the fulfilment criteria.
Practical Example
An entity wins a three-year managed services contract for a fixed 1,800,000, billed evenly at 600,000 a year. Contracts of this type are renewed once, for a further two years, and no commission is payable on renewal. The following amounts are incurred before the service begins.
| Cost | Amount | Treatment |
|---|---|---|
| Commission to the salesperson, payable on signature | 60,000 | Asset — cost of obtaining |
| Share of the sales director's target-based bonus | 15,000 | Expense — not incremental |
| Legal fees for the proposal, payable on submission | 12,000 | Expense — incurred regardless |
| Data migration onto the entity's platform | 90,000 | Asset — cost to fulfil |
| Rework of migration files corrupted in transfer | 10,000 | Expense — wasted resources |
The migration transfers no service, creates the resource the three years of service will be delivered from, and is recovered through the margin, so it meets all three criteria. The rework fails the second criterion and is not reflected in the price.
| Initial recognition | Debit | Credit |
|---|---|---|
| Contract cost asset — costs of obtaining | 60,000 | |
| Contract cost asset — costs to fulfil | 90,000 | |
| Expenses (bonus, legal fees, rework) | 37,000 | |
| Bank and accruals | 187,000 |
The two assets amortise over different periods. The commission relates to the services under both the initial contract and the anticipated renewal, because no further commission arises on renewal, so it is amortised over five years at 12,000 a year. The migration supports only the platform configuration the initial contract is delivered from and is amortised over three years at 30,000 a year.
| Asset | Cost | Period | Annual charge | Carrying amount after year 1 |
|---|---|---|---|---|
| Costs of obtaining | 60,000 | 5 years | 12,000 | 48,000 |
| Costs to fulfil | 90,000 | 3 years | 30,000 | 60,000 |
Had the same commission been paid on each renewal, it would relate only to the three-year contract and would amortise at 20,000 a year.
Amortisation
Contract cost assets are amortised on a systematic basis consistent with the transfer to the customer of the goods or services to which the asset relates. The basis follows the pattern of transfer, so an asset relating to a service delivered evenly amortises evenly, while one relating to a contract measured by an input or output method follows that measure of progress.
Two features distinguish the period from an ordinary useful life.
It can extend beyond the contract. Where the asset also relates to goods or services under a specifically identifiable anticipated contract, including an expected renewal, the amortisation period covers that extension. The question is which services the asset relates to, not how long the signed contract runs.
It is revisited, not fixed. A significant change in the expected timing of transfer is a change in accounting estimate under IAS 8, accounted for prospectively. If the customer in the example above is expected after two years to renew for four further years rather than two, the remaining commission balance is spread over the revised remaining period from that point; the amortisation already recognised is not restated.
Impairment
IFRS 15 applies its own impairment test rather than IAS 36. An impairment loss is recognised in profit or loss to the extent that the carrying amount of the asset exceeds:
- the remaining amount of consideration the entity expects to receive in exchange for the goods or services to which the asset relates, less
- the costs that relate directly to providing those goods or services and have not yet been recognised as expenses.
The consideration is determined using the principles for the transaction price, including variable consideration and any constraint on it, and is then adjusted for the effects of the customer's credit risk. Where the asset relates to an anticipated contract, the consideration expected under that contract is included in the test, consistent with the amortisation period.
Continuing the example: at the end of year 1 the two assets carry 48,000 and 60,000. The customer's circumstances deteriorate and the parties renegotiate, so the entity now expects consideration of 700,000 over the remaining two years, no renewal, and direct costs of 620,000.
| Impairment test at the end of year 1 | Amount |
|---|---|
| Remaining consideration expected | 700,000 |
| Direct costs of providing the remaining services | (620,000) |
| Recoverable amount | 80,000 |
| Carrying amount of the contract cost assets | (108,000) |
| Impairment loss | 28,000 |
Two procedural rules govern the interaction with other standards.
Order of testing. Impairment losses under other standards — IAS 2, IAS 16, IAS 38 — are recognised first, and the IFRS 15 test is then applied to the remaining contract cost asset. Where the asset forms part of a cash-generating unit, the carrying amount taken into the IAS 36 test is the amount after the IFRS 15 impairment, so the same loss is not counted twice.
Reversal is required, not prohibited. Where the impairment conditions improve or cease to exist, the loss is reversed in profit or loss. The reversal is capped at the carrying amount, net of amortisation, that would have been determined had no impairment loss been recognised previously.
Presentation and Disclosure
A contract cost asset is not a contract asset
The two share a name and nothing else. A contract asset is a right to consideration the customer owes for performance already delivered, conditional on something beyond the passage of time; it is recovered in cash and impaired under IFRS 9. A contract cost asset is the entity's own expenditure, owed by nobody; it is recovered by being amortised against future revenue and impaired under the IFRS 15 test. One is a receivable in waiting, the other a prepayment of cost. Our guide to contract assets and contract liabilities covers the balances on the other side of that line.
The distinction carries through to the notes. Contract cost assets are presented separately and are excluded from the contract balance disclosure and from the reconciliation of revenue to contract balances.
The disclosure requirements for contract costs are short and specific:
- the closing balances of assets recognised from the costs to obtain or fulfil contracts, by main category of asset — costs to obtain, pre-contract costs, and set-up costs are typical categories;
- the method of amortisation used for each reporting period;
- the amortisation and any impairment losses recognised in the period; and
- where the practical expedient for costs of obtaining a contract is applied, the fact that it has been used.
On the face of the statement of financial position, the assets are split between current and non-current on the ordinary IAS 1 basis, by reference to when the amortisation will fall.
Interaction with Other Standards
IFRS 16. Leases have a parallel concept. Initial direct costs are incremental costs of obtaining a lease that would not have been incurred had the lease not been obtained — the same counterfactual test — but they are capitalised into the right-of-use asset and depreciated, not held as a separate cost asset. Our article on initial direct costs under IFRS 16 sets out the lessee and lessor treatment. Where a single arrangement contains both a lease and a service, the costs follow the component they relate to, which requires the separation of lease and non-lease components to be settled first.
IAS 38. An intangible asset is amortised over its useful life and impaired under IAS 36; the same expenditure treated as a fulfilment cost is amortised over the period of transfer and impaired under the IFRS 15 test. IAS 38 is applied first where it captures the cost.
IAS 37. The contract cost model addresses the asset side only. A loss-making contract is dealt with as an onerous contract under IAS 37, and the related contract cost assets are impaired before any onerous contract provision is measured.
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Conclusion
Contract costs resolve through a short sequence of questions. Was the cost incurred to win the contract, and would it have been avoided had the contract been lost? If so, and recovery is expected, it is an asset, subject to the one-year expedient. Was it incurred to deliver the contract? Then the scope of every other standard is tested first, and only what falls outside is assessed against the three fulfilment criteria.
After recognition the two behave alike. Amortisation follows the transfer of the goods or services the asset relates to, may extend into an anticipated renewal, and is revised prospectively. Impairment compares the carrying amount with the remaining consideration expected less the direct costs still to be incurred, is applied after the tests of other standards, and is reversed when conditions improve.
Where an arrangement also conveys the right to use an asset, our guides to right-of-use assets and manufacturer and dealer lessors cover the cases where one transaction produces both revenue and a lease.
For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.