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Question 8: How do customer termination rights and penalties affect the identification of a contract duration?
Publication date: 31 Jan 2020
us FASB Staff Q&A Revenue 8
Reference(s): Section 606-10-25
This question relates to how to evaluate the contract term when only the customer has the right to cancel without cause the contract and how termination penalties effect that analysis. See Question 7 about when both parties have a right to terminate.
The staff does not view a customer only right to terminate differently from a contract where both the customer and entity could terminate the contract. Furthermore, the staff does not think that an entity should have different results (even if many times the results would be similar) by calling the penalty (or forgoing a discount) a material right versus concluding there is a longer contractual term. The staff thinks that paragraph BC391 of Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), clarifies that customer cancellation rights can be similar to a renewal option. The staff thinks that this would typically be the case when there are no contractual penalties that compensate the other party upon cancellation and when the customer has the unilateral right to terminate the contract for other than cause or contingent events outside the customer’s control.
TRG members highlighted that when performing an evaluation of the contract term and the effect of termination penalties, an entity should consider whether those penalties are substantive. Determining whether a penalty is substantive will require judgment and the examples provided above do not create a bright line for what is substantive. If the penalty is not substantive, an entity would still evaluate whether the termination right (which is akin to an option for additional goods or services) gives rise to a material right. That is, if the existence of a contractual penalty does not create a longer contract term, it still could affect whether a material right is present for the optional periods (that is, the period not included in the duration of the contract).
Consider the following examples:
Contract 1:
Entity A enters into a four-year service contract with Customer X with a right to cancel the contract at the end of each year. Contract 1 requires Customer X to pay an annual fee of CU 100, which is the standalone selling price for renewals after Year 3. Customer X can terminate the contract before Year 4 without cause but would incur a termination penalty. The penalty decreases annually throughout the contract term. Assume the penalty is substantive in each period. The following table illustrates the payments under the contract.
Year 1
| Year 2
| Year 3
| Year 4
| |
Annual Fee
| $ 100
| $ 100
| $ 100
| $ 100
|
Termination Penalty
| 30
| 20
| 10
| -
|
Cumulative Fee if Customer Cancels in this Year
| $130
| $220
| $310
| $400
|
In this example, Contract 1 is a four-year contract. That is, the purchases in Years 2–4 are not options for the customer to purchase additional goods or services. The substantive termination penalty is evidence of enforceable rights and obligations throughout the contract term. The termination penalty is ignored until the contract is terminated at which point it will be accounted for as a modification.
Contract 2:
An entity sells equipment and consumable parts for the equipment (both the equipment and parts are distinct goods that do not meet the overtime criteria). The stand-alone selling price of the equipment and parts is CU10,000 and CU100, respectively. The entity sells the equipment for CU6,000 (a 40% discount from standalone selling price) and provides an option to purchase each part for CU100. If the customer does not purchase at least 200 parts, it is required to pay a penalty to repay some or all of the CU4,000 discount provided on the equipment. The penalty decreases as each part is purchased at a rate of CU20 per part. A discount of CU10 would be viewed as a material right to the customer.
In this example, the penalty (or forgoing the upfront discount) is substantive and in effect creates a minimum purchase obligation such that the entity would conclude that the minimum number of parts required to avoid the penalty would be evidence of enforceable rights and obligations. As a result, the contract includes both the equipment and the minimum parts (200) required to not incur the penalty. Therefore, the transaction price is CU26,000 [(200 x 100) + 6,000], which should be allocated to the multiple performance obligations (CU8,667 [26,000 * (10,000/30,000)] to the equipment and CU17,333 [26,000 * (20,000/30,000)] to the parts [86.67 per part]). The entity would account for the failure to purchase additional parts and the resulting penalty as a contract modification.
Copyright #year# by Financial Accounting Foundation, Norwalk, Connecticut.
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