HKFRS 15.31 states:
An entity shall recognise revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (ie an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset.
An entity satisfies a performance obligation when it transfers control of the promised good or service underlying that performance obligation to the customer. Consequently, assessing when control of a good or service is transferred is a critical step in applying HKFRS 15.
HKFRS 15.33 states that "control of an asset refers to the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset". It can be difficult to apply the concept of control to a promised service because in most service contracts the service asset is simultaneously created and consumed and so no asset is ever recognised by the customer. For this reason, specific criteria are given in HKFRS 15.35 to provide an objective basis for assessing when control transfers over time and thus the timing of when a performance obligation is satisfied.
HKFRS 15.35 states:
An entity transfers control of a good or service over time and, therefore, satisfies a performance obligation and recognises revenue over time, if one of the following criteria is met:
(a) the customer simultaneously receives and consumes the benefits provided by the entity's performance as the entity performs;
(b) the entity's performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced; or
(c) the entity's performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.
Following the fact pattern provided, the sponsor arrangement does not meet criterion (a) because the listing applicant does not simultaneously receive and consume the benefits provided by the sponsor's performance during the IPO process. The listing applicant only receives the benefits when the sponsor completes all of its services before the listing of the shares on the Exchange or another outcome. Applying paragraph 3A.18 of the Listing Rules, the performance obligation does not meet the condition in HKFRS 15.B4 to be considered satisfied over time because a replacement sponsor would need to substantially re-perform all of the work performed by the existing sponsor (as explained under Question 1), including reperformance of the due diligence work and coordination with other professional parties. Even if some of the work done by other professional parties (such as lawyers and auditors) has been completed, this work is not part of the role of the sponsor. The sponsor will still need to coordinate with other professional parties and perform its own due diligence on the information provided by these parties.
The sponsor arrangement also does not meet criterion (b) because there is no asset controlled by the listing applicant during the period.
Accordingly, in determining whether a sponsor should recognise sponsor fee income at a point in time or over time, the focus should be on criterion (c). In particular, a sponsor has to consider:
- whether the sponsor has a right to payment for performance completed to date at all times throughout the duration of the contract [HKFRS 15.37]; and
- whether that right to payment is enforceable.
Right to payment for performance completed to date
HKFRS 15.37 states:
… at all times throughout the duration of the contract, the entity must be entitled to an amount that at least compensates the entity for performance completed to date if the contract is terminated by the customer or another party for reasons other than the entity’s failure to perform as promised…
HKFRS 15.B9 states:
…An amount that would compensate an entity for performance completed to date would be an amount that approximates the selling price of the goods or services transferred to date (for example, recovery of the costs incurred by an entity in satisfying the performance obligation plus a reasonable profit margin) rather than compensation for only the entity's potential loss of profit if the contract were to be terminated. Compensation for a reasonable profit margin need not equal the profit margin expected if the contract was fulfilled as promised, but an entity should be entitled to compensation for either of the following amounts:
(a) a proportion of the expected profit margin in the contract that reasonably reflects the extent of the entity's performance under the contract before termination by the customer (or another party); or
(b) a reasonable return on the entity's cost of capital for similar contracts (or the entity's typical operating margin for similar contracts) if the contract-specific margin is higher than the return the entity usually generates from similar contracts.
In practice, the upfront non-refundable payment plus the cumulative milestone payments may compensate the sponsor for performance completed to date at the date each of the milestones are met. However, a sponsor will need to assess whether it is entitled to an amount that at least compensates for its performance completed to date between milestones and at all times throughout the contract, not only at the date of the milestone.
HKFRS 15 is silent on whether compensation for a reasonable profit margin is based on a constant margin over the duration of the contract. A sponsor's view of what constitutes a reasonable margin on a contract might vary between milestones depending on the nature of work performed and associated risk. Furthermore, at times during the contract, the sponsor might consider that compensation for a reasonable margin is less than the profit margin expected if the contract was fulfilled as promised. For example:
- the sponsor might determine that its risk exposure increases subsequent to the submission of the listing application document and thus a reasonable margin would be higher after submission compared to before submission. The additional payment received upon submission may be structured to compensate for the increase in risk for the sponsor caused by that event and thus increases the profit margin on the contract to date.
- even if the compensation is less than the profit margin on that particular contract, it might be higher than the profit margin on other contracts entered into by the sponsor that are similar but less profitable. The sponsor might determine that the profit margin on the less profitable contracts would constitute a reasonable margin for the contract being assessed.
A sponsor may consider the profit margin on similar contracts or other contracts, with appropriate adjustments, when assessing whether compensation for a reasonable profit margin is within a sensible range. Judgement will be required in assessing what constitutes a reasonable profit margin over the contract and appropriate evidence will be required to support the conclusions made [with specific consideration of HKFRS 15.B9(a) – (b)].
The table below outlines two illustrative milestone payment schedules in sponsor arrangements in Hong Kong, and provides an analysis of whether they might provide the sponsor with a right to payment for the performance completed to date at all times throughout the contract:
| Milestone payment schedule |
Analysis |
|
Scenario 1
The total costs of the sponsor under the contract approximate one third of the total sponsor fee. Payment is as follows:
| Milestone |
Payment (% of total consideration) |
| Signing of contract |
60% |
| Submission of listing application document |
20% |
| Listing approval meeting |
10% |
| Successful listing of shares |
10% |
The contract does not specify payment termination clauses which would require payment for work performed by the sponsor subsequent to the last milestone upon termination.
|
In this scenario, the 60% initial deposit received (which is non-refundable) is more than the costs expected to be incurred by the sponsor and therefore, depending on specific facts and circumstances, it is possible that this deposit provides a reasonable margin up to submission of the listing application document.
The risk of the sponsor may be considered to increase once the listing application document is submitted and the subsequent milestone payments received by the sponsor may compensate for the increase in risk profile and sufficiently improve the profit margin of the contract to date.
If this is the case, then the sponsor might effectively have a contractual right to payment for performance completed to date at all times during the contract provided that the initial deposit and the subsequent milestone payments are non-refundable.
There are no explicit payment termination clauses to consider.
|
| Milestone payment schedule |
Analysis |
|
Scenario 2
The total costs of the sponsor under the contract approximate one third of the total sponsor fee. Payment is as follows:
| Milestone |
Payment (% of total consideration) |
| Signing of contract |
20% |
| Submission of listing application document |
50% |
| Listing approval meeting |
20% |
| Successful listing of share |
10% |
There is a specific termination clause in the contract which entitles the sponsor to receive a payment pro-rata to its performance completed to date if the contract is terminated by the applicant or another party.
|
In this scenario 2, the initial deposit is only 20% of the total contract payments and therefore may not be sufficient to cover the costs plus a reasonable margin during the period before the submission of the listing application document. If so, the sponsor is unlikely to have a contractual right to payment for the performance completed to date if the assessment is solely based on the milestone payment schedule. However, in this scenario there are explicit terms in the contract which specify that the sponsor is entitled to payment for performance completed to date upon termination of the contract. Therefore, the sponsor is likely to have a contractual right to payment for performance completed to date because of the explicit termination clause. |
A sponsor would consider all of the payment and termination terms in the contract when determining whether it has a contractual right to payment for performance completed to date. The numbers used in the above scenarios are for illustration purpose only and should not be treated as bright lines leading to the corresponding outcome. A sponsor should perform the analysis considering all relevant fact and circumstances.
Enforceability of the right to payment
HKFRS 15.B12 states:
In assessing the existence and enforceability of a right to payment for performance completed to date, an entity shall consider the contractual terms as well as any legislation or legal precedent that could supplement or override those contractual terms. This would include the assessment of whether:
(a) legislation, administrative practice or legal precedent confers upon the entity a right to payment for performance to date even though that right is not specified in the contract with the customer;
(b) relevant legal precedent indicates that similar rights to payment for performance completed to date in similar contracts have no binding legal effect; or
(c) an entity's customary business practices of choosing not to enforce a right to payment has resulted in the right being rendered as unenforceable in that legal environment. However, notwithstanding that an entity may choose to waive its right to payment in similar contracts, an entity would continue to have a right to payment to date if, in the contract with the customer, its right to payment for performance to date remains enforceable.
A sponsor has to ensure that the payment and termination terms in the contract are legally enforceable when assessing whether it has an enforceable right to payment for performance completed to date, especially if relying on termination clauses rather than on non-refundable amounts received to satisfy HKFRS 15.35(c). A sponsor is recommended to seek legal advice on the enforceability of any contractual payment and termination terms.
If the contract does not explicitly state that the sponsor has a right to payment for performance upon termination, the sponsor should not assume it has such right based on customary business practices without legal interpretation.
Summary
Ultimately the assessment of whether a sponsor meets criterion (c) in HKFRS 15.35 and recognises sponsor fee income over time will depend on the specific terms in the contract and whether those terms are enforceable considering the relevant laws and regulations in Hong Kong. Subtle differences in contractual terms could result in different assessment outcomes.
