IFRS 15 adopted, modified retrospective method, software, policies, judgements, customer options, current year effects

The Sage Group plc – Annual report – 30 September 2019
Industry: software
17 IFRS 15
This note provides information on the changes resulting from the adoption of IFRS 15, quantitative information on their impact at 1 October 2018 and a reconciliation for the year ending 30 September 2019 between the primary financial statements under IFRS 15 and the financial position and performance that would have been reported in accordance with IAS 18.

Differences between IFRS 15 and previous accounting policies
There are several differences between the Group’s accounting policies under IFRS 15 and its previous accounting policies under IAS 18. The most significant of these are as follows.

– Unbundling of subscription software and related maintenance and support contracts for on-premise products
IFRS 15 introduces a new concept of performance obligations. This requires changes to the way the transaction price is allocated to separately identifiable components of a bundle within a contract, which can impact the timing of recognising revenue. As a result, the revenue recognition pattern changes for certain on-premise subscription contracts, which combine the delivery of software and support services and the obligation to deliver, in the future, unspecified software upgrades under a maintenance contract. Under IAS 18 policies, the Group recognised the entire price as revenue on a straight-line basis over the subscription term. Under IFRS 15, a portion of the transaction price is recognised upon delivery of the initial software at the outset of the arrangement with the remainder recognised over the term of the contract due to the fact that these are deemed to be separate performance obligations.

– Non-refundable contract sign-up fees
In some cases, customers pay a non-refundable contract sign-up fee when they enter into a new initial contract for a software product, and no equivalent fee is payable on subsequent renewals. As a result of paying the contract sign-up fee, the customer has an option to renew the contract and to pay a lower price on renewal than would have been the case had the contract signup fee not been paid. Under IFRS 15, the fee is considered to provide the customer with a material right that the customer would not receive without having entered into the initial contract. Therefore, the upfront fee is recognised as revenue over the anticipated period of benefit to the customer, which ranges from four to seven years and takes account of the likelihood of the customer renewing the contract. Under IAS 18 policies, the full amount of the contract sign-up fee was recognised as revenue on a straight-line basis over the initial contract term.

– Costs of obtaining customer contracts
Under IFRS 15, all incremental costs of obtaining a contract with a customer, including commission to internal sales employees, are recognised as an asset on the balance sheet, within trade and other receivables, if the Group expects to recover those costs. The costs are amortised over the period during which the related revenue is recognised, which may extend beyond the initial contract term where the Group expects to benefit from future renewals as a result of incurring the costs. The amortisation periods range from one year to ten years depending on the type of offering. Amortisation is reported within selling and administrative expenses. Under previous policies, costs to obtain a contract were recognised as assets, within trade and other receivables, and amortised only if they were payable to a third-party agent and related to a contract where revenue was recognised over time. As a result, compared to previous policies the amount recognised as an asset under IFRS 15 increases and the recognition of costs is deferred.

– Business partner arrangements
Under IFRS 15, the Group is required to assess whether it controls a good or service before it is transferred to the end customer to determine whether it is principal or agent in that transaction. This is in contrast to the previous guidance which was focused on assessing whether the Group had the risks and rewards of a principal. For Sage, the application of IFRS 15 results in a change in principal versus agent assessment for a number of business partner arrangements. The Group has therefore identified an increase in the number of business partner arrangements where Sage is considered to be the principal under IFRS 15 with respect to the end customer. As a result, there is an increase in the gross revenue recognised for these arrangements as the amounts payable to business partners are classified as a cost of sale rather than a deduction from revenue. On the balance sheet, the unamortised amounts payable to business partners which were previously netted within deferred income are now presented as part of customer acquisition costs.

– Timing of recognising a receivable
Under IFRS 15, a receivable is recognised when the right to consideration is unconditional. Typically, for a non-cancellable contract this happens when the Group starts providing the service. Under IAS 18 receivables were recognised based on the billing arrangement agreed under the contract, even where the contract was not unconditional or the group had not started providing services under the contract. As a result, compared to previous policies the amount recognised as a receivable decreased with a corresponding decrease in deferred income.

Quantitative impact of policy changes on consolidated balance sheet at 1 October 2018
The financial impact of the policy changes explained above on the Group’s consolidated balance sheet on initial application is as follows:

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Primary statements under IAS 18
The Group’s consolidated financial statements for the year ended 30 September 2019 are prepared in accordance with IFRS 15; comparative periods have not been restated. Where there are differences between the primary consolidated financial statements presented in accordance with IFRS 15 and comparable presentation under the Group’s previous revenue accounting policy (in accordance with IAS 18 “Revenue”), the effects are disclosed below. The Group’s consolidated statement of cash flows is not affected by the implementation of IFRS 15 and so is not re-presented.

Consolidated income statement (reconciliation to IAS 18)

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Under IFRS 15 basis revenue from software licence and support showed a net increase of £8m, with most of the difference resulting from an increase in the number of business partner arrangements where the end user is considered to be the customer for the Group and by upfront recognition of software for certain on-premise subscription contracts. This is mitigated by a revised revenue pattern for non-refundable contract sign-up fees which are spread over the anticipated period of benefit to the customer.

Cost of sales showed a net decrease of £6m, with most of the difference resulting from business partner arrangements where there is a change in principal versus agent assessment for third-party products.

Selling and administrative expenses showed a net increase of £7m, with most of the difference resulting from an increase in the number of business partner arrangements where the end user is considered to be the customer under IFRS 15. This is mitigated by higher capitalisation of sales commissions offset by the related amortisation charge.

Consolidated balance sheet (reconciliation to IAS 18)

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Under IFRS 15 basis non-current trade and other receivables are higher by £65m (FY18: higher by £34m) due to the higher capitalisation of sales commissions.

Current trade and other receivables are lower by £11m (FY18: £23m) resulting from changes in the timing of and amounts recognised as receivables and the capitalisation of business partner commissions where the end user is considered to be the customer under IFRS 15, with corresponding impact in current deferred income.

Current deferred income is higher by £16m (FY18: £21m), resulting from revised revenue pattern for non-refundable contract sign-up fees which are spread over the anticipated period of benefit to the customer and the capitalisation of business partner commissions where the end user is considered to be the customer under IFRS 15, with corresponding impact in current deferred income. This is mitigated by changes in the timing of and amounts recognised as receivables and by upfront recognition of
software for certain on-premise subscription contracts.

Deferred income tax assets are lower by £1m (FY18: £4m), current income tax liabilities and deferred income tax liabilities are higher by £2m and £7m (FY18: £nil and £4m respectively) due to the tax impact of the above adjustments.

3.1 Revenue
Accounting policy
The Group’s new IFRS 15 accounting policy is disclosed below. Differences from policies applied to 2018 comparatives are disclosed in note 17, and full revenue policies applied to 2018 figures can be found in the Annual Report and Accounts 2018. The Group reports revenue under three revenue categories and the basis of recognition for each category is described below:

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Identification of performance obligations
When the Group enters into an agreement with a customer, goods and services deliverable under the contract are identified as separate performance obligations (“obligations”) to the extent that the customer can benefit from the goods or services on their own and that the separate goods and services are considered distinct from other goods and services in the agreement. Where individual goods and services do not meet the criteria to be identified as separate obligations they are aggregated with
other goods and/or services in the agreement until a separate obligation is identified.

Typically, the products and services outlined in the categories of revenue section qualify as separate performance obligations and the portion of the contractual fee allocated to them is recognised separately. However, certain on-premise subscription contracts, which combine the delivery of on-premise software and maintenance and support services, require unbundling. Sage native cloud services usually do not require unbundling as the terms usually do not provide the customer with a right to
terminate the hosting contract and take possession of the software.

When selling goods or services, in certain instances, customers pay a non-refundable contract sign-up fee when they enter into a new initial contract for a software product, and no equivalent fee is payable on subsequent renewals. The Group applies judgement in determining whether such sign-up fees provide a material right to the customer that the customer would not receive without entering into that contract. In applying this judgement, the Group considers whether the options entitle the customer to a discount that exceeds the discount that would normally be granted for the respective goods or services if they were to be sold without the option. Where this is the case, the non-refundable contract sign-up fee is treated as a separate performance obligation.

Determination of transaction price and standalone selling prices
The Group determines the transaction price it is entitled to in return for providing the promised obligations to the customer based on the committed contractual amounts, net of sales taxes and discounts. Contract terms generally are monthly or annual and customers either pay up-front or over the term of the related service agreement.

The transaction price is allocated between the identified obligations according to the relative standalone selling prices (SSPs) of the obligations. The SSP of each obligation deliverable in the contract is determined according to the prices that the Group would obtain by selling the same goods and/or services included in the obligation to a similar customer on a standalone basis. See “Critical accounting estimates and judgements” in note 1 for details.

Timing of recognition
Revenue is recognised when the respective obligations in the contract are delivered to the customer and payment remains probable.

– Licences for standard on-premise software products are typically delivered by providing the customer with access to download the software. The licence period starts when such access is granted. Licence revenue is recognised at a point in time or over time depending on whether the Group delivers software with significant standalone functionality or software which is dependent on updates for ongoing functionality. The Group recognises revenue for these licenses which have significant standalone functionality at the point in time when the customer has access to and thus control over the software. For licences which are dependent on updates for ongoing functionality the Group recognises revenue based on time elapsed and thus rateably over the term of the contract. Typically, this includes our payroll and tax compliance software.

– Where the Group’s performance obligation is the grant of a right to continuously access a cloud offering for a certain term, revenue is recognised based on time elapsed and thus rateably over the term.

– Maintenance and support revenue is typically recognised based on time elapsed and thus rateably over the term of the support arrangement. Under the standardised maintenance and support services, the Group’s performance obligation is to stand ready to provide technical product support and unspecified updates, upgrades and enhancements on a when-and-if-available basis. The customers simultaneously receive and consume the benefits of these services.

– Professional services and training revenue are typically recognised over time. Where the Group stands ready to provide the service (such as access to learning content), revenue is recognised based on time elapsed and thus rateably over the service period. Consumption-based services (such as separately identifiable professional services and premium support services, messaging services, and classroom training services) are recognised over time as the services are utilised, typically following the percentage-of-completion method or rateably.

– Non-refundable contract sign-up fees that qualify as separate performance obligations are recognised as revenue over the anticipated period of benefit to the customer, which takes account of the likelihood of the customer renewing the contract.

Identification of contract with the customer
When the Group sells goods or services through a business partner, a key consideration is determining whether the business partner or the end user is Sage’s customer. The key criteria in this determination is whether the business partner has taken control of the product. This is usually assessed based on whether the business partner has responsibility for payment and takes on the risks and rewards of the product from Sage. See “Critical accounting estimates and judgements” in note 1 for details.

Principal versus agent considerations
When the Group has control of third-party goods or services prior to delivery to a customer, then the Group is the principal in the sale to the customer. As a principal, receipts from customers and payments to suppliers are reported on a gross basis in revenue and cost of sales. If the Group does not have control of third-party goods or services prior to transfer to a customer, then the Group is acting as an agent for the other party and revenue in respect of the relevant obligations is recognised net of any related payments to the supplier and reported revenue represents the margin earned by the Group. Whether the Group is considered to be the principal or an agent in the transaction depends on analysis by management of both the legal form and substance of the agreement between the Group and its supplier. This takes into account whether Sage bears the price, inventory and performance risks associated with the transaction.

Practical expedients
As the majority of contracts have a term of one year or less, the Group has applied the following practical expedients.

– The aggregate transaction price allocated to the unsatisfied or partially unsatisfied performance obligations at the end of the reporting period is not disclosed.
– Any financing component is not considered when determining the transaction price.

1 Basis of preparation and critical accounting estimates and judgements (extract)
Critical accounting estimates and judgements (extract)
Revenue recognition
Approximately 35% of the Company’s revenue is generated from sales to partners rather than end users. The key judgement is determining whether the business partner is a customer of the Group. The key criteria in this determination is whether the business partner has taken control of the product, which is usually assessed based on whether the business partner has responsibility for payment and takes on the risks and rewards of the product from Sage.

Where the business partner is a customer of Sage, discounts are recognised as a deduction from revenue.

Where the business partner is not a customer of Sage and their part in the sale has simply been in the form of a referral, they are remunerated in the form of a commission payment. These payments are treated as contract acquisition costs.

An additional area of judgement is the recognition and deferral of revenue on on-premise subscription offerings, for example the sale of a term licence with an annual maintenance and support contract as part of a subscription contract. In such instances, the transaction price is allocated between the constituent performance obligations on the basis of standalone selling prices (SSPs). Judgement is required when estimating SSPs. The Group has established a hierarchy to identify the SSPs that are used to allocate the transaction price of a customer contract to the performance obligations in the contract. Where SSPs for on-premise offerings are observable and consistent across the customer base, SSP estimates are derived from pricing history. Where there are no directly observable estimates available, comparable products are utilised as a basis of assessment or residual approach is used. Under the residual approach, the SSP for the offering is estimated to be the total transaction price less the sum of the observable SSPs of other goods or services in the contract. The Group uses this technique in particular for its on-premise subscription offerings.