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Question 7: How should termination clauses be evaluated in determining the duration of a contract (that is, the contractual period)?
Publication date: 31 Jan 2020
us FASB Staff Q&A Revenue 7
Reference(s): Sections 606-10-25 and 606-10-32
Some stakeholders have asked whether the contractual period should be restricted to reflect the expected termination date if each party to the contract has a unilateral enforceable right to terminate the contract. Below are some considerations about how stakeholders think that termination clauses should be considered.
In determining the contractual period in which the parties have present enforceable rights and obligations, paragraph 606-10-25-3 does not explicitly explain how termination penalties should be considered. However, some stakeholders have asserted that the guidance in paragraphs 606-10-25-3 through 25-4, together with the explanation in BC50 of Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), suggests that a contract exists if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract only by compensating the other party. Accordingly, those stakeholders think that a contract continues to exist during the specified contractual period even if each party to the contract has the unilateral enforceable right to terminate the contract at any time during the specified contractual period by compensating the other party. This is because enforceable rights and obligations exist throughout the contractual period, evidenced by the fact that compensation would be required to terminate the contract. In other words, on termination, parties to the contract waive those enforceable rights and avoid their obligations by paying compensation.
Some stakeholders also point to paragraph 606-10-32-4 that, in the context of determining the transaction price, states that the entity should assume the contract will not be cancelled. However, paragraph BC186 of Update 2014-09 clarifies that paragraph 606-10-32-4 applies in the context of having already identified the contract with the customer.
It should be noted that the guidance in paragraphs 606-10-25-3 through 25-4 refers to whether the termination requires compensating the other party. Some stakeholders have shared a narrow interpretation of this guidance, asserting that the guidance refers only to termination penalties. Other stakeholders take a broader view that compensating the other party is any amount related to something other than payments due as a result of goods delivered or services transferred up to the termination date and, therefore, that it is not restricted only to payments explicitly characterized as termination penalties.
Considering the guidance outlined above, some stakeholders think that an entity could reach the following conclusions:
(a) If a contract can be terminated by each party at any time without compensating the other party for the termination (that is, other than paying amounts due as a result of goods or services transferred up to the termination date), the duration of the contract does not extend beyond the goods or services already transferred. This is the case whether the contract has a specified contract period or not. Some stakeholders think this scenario is the intent behind the discussion in paragraph BC391 of Update 2014-09 because the right to cancel the contract is no different than a right to renew the contract. Whether it is a right to cancel the contract or a right to renew the contract, a party to the contract must elect to do, or not do, something (to renew the contract or not to cancel the contract).
Example 1
An entity enters into a service contract with a customer under which the entity continues to provide services until the contract is terminated. Each party can terminate the contract without compensating the other party for the termination (that is, there is no termination penalty).
The duration of the contract does not extend beyond the services already provided.
(b) If each party can terminate the contract without compensating the other party and the termination right can be exercised only after a specified minimum period, the duration of the contract is up to the point at which the contract can be terminated.
Example 2
An entity enters into a contract with a customer to supply services for two years. Each party can terminate the contract at any time after fifteen months from the start of the contract without compensating the other party for the termination.
The duration of the contract is fifteen months.
(c) In Examples 1 and 2, any right to consideration at the point at which the contract is terminated would be unconditional (that is, a receivable). In other words, the right to consideration would not be conditional upon any future performance. If a contract can be terminated by either party by compensating the other party, the duration of the contract is either the specified contractual period or the period up to the point at which the contract can be terminated without compensating the other party.
Example 3
An entity enters into a contract with a customer to provide services for two years. Either party can terminate the contract by compensating the other party.
The duration of the contract is the specified contractual period of two years.
Example 4
An entity enters into a contract with a customer to supply services for five years. The entity earns a fixed fee each quarter and, if specified performance metrics are met, the entity will be entitled to a performance bonus at the end of the five-year service period (which will be paid at that time). Either party can terminate the contract at any time after two years; however, if the contract is terminated, the customer must pay a fee equivalent to the performance bonus it would otherwise only pay at the end of the contract.
The duration of the contract is five years. If the contract is terminated, the customer must make a payment that it would otherwise not have to make until the end of the contract term and the payment is based on conditions that might have changed over the full term of the contract. This indicates that at contract inception enforceable rights and obligations exist beyond the first two years.
(d) If the entity has a past practice of not enforcing the collection of a termination penalty to which it is contractually entitled, some stakeholders have asked whether the past practice affects the assessment of the contract term.
Example 5
An entity enters into a contract to provide services for 24 months. Either party can terminate the contract by compensating the other party. The entity has a past practice of allowing customers to terminate the contract at the end of 12 months without enforcing collection of the termination penalty.
In this case, whether the contractual period is 24 months or 12 months depends on whether the past practice is considered by law (which may vary by jurisdiction) to restrict the parties’ enforceable rights and obligations. The entity’s past practice of allowing customers to terminate the contract at the end of month 12 without enforcing collection of the termination penalty affects the contract term in this example only if that practice changes the parties’ legally enforceable rights and obligations. If that past practice does not change the parties’ legally enforceable rights and obligations, then the contract term is the stated term of 24 months.
Stakeholders note that when an entity concludes that the contractual term is less than the stated term because of a termination clause, the following are some of the possible consequences:
(a) In contracts containing multiple performance obligations, allocation of the transaction price may be significantly affected for a contract with a specified term of two years that is determined to be of one-year duration (because of a termination clause) compared with the two-year duration (if the termination clause were not considered).
(b) The termination penalty, if any, would be considered part of the transaction price. The termination penalty may be variable, in which case the guidance on variable consideration, including the constraint, would be applied.
(c) The periods covered by the termination provisions would be assessed in the same manner as renewal options (that is, whether the renewal options provide the customer a material right).
Most TRG members agreed that the conclusions reached above were consistent with the standard and agreed with the respective views for each of those examples regarding the determination of contract duration. Some TRG members highlighted the need to consider additional factors in the assessment, such as whether the termination payment is substantive.
Copyright #year# by Financial Accounting Foundation, Norwalk, Connecticut.
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