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2.7 Determining the contract term
Publication date: 30 Nov 2023
us Revenue guide
The contract term is the period during which the parties to the contract have present and enforceable rights and obligations. Determining the contract term is important as it impacts the determination and allocation of the transaction price and recognition of revenue.
Excerpt from ASC 606-10-25-3
Some contracts with customers may have no fixed duration and can be terminated or modified by either party at any time. Other contracts may automatically renew on a periodic basis that is specified in the contract. An entity shall apply the [guidance in the revenue standard] to the duration of the contract (that is, the contractual period) in which the parties to the contract have present enforceable rights and obligations.
Reporting entities should consider termination clauses when assessing contract duration. If a contract can be terminated early for no compensation, enforceable rights and obligations would likely not exist for the entire stated term. The contract may, in substance, be a shorter-term contract with a right to renew. In contrast, a contract that can be terminated early, but requires payment of a substantive termination penalty, is likely to have a contract term equal to the stated term. This is because enforceable rights and obligations exist throughout the stated contract period. Refer to Revenue TRG Memo No. 10 and Revenue TRG Memo No. 48, and the related meeting minutes in Revenue TRG Memo Nos. 11 and Revenue TRG Memo No. 49, respectively, for further discussion of this topic.
We believe that termination penalties could take various forms, including cash payments or the transfer of an asset to the vendor (see Example RR 2-13). Additionally, a payment need not be labelled a "termination penalty" to create enforceable rights and obligations. For example, a substantive termination penalty might exist if a customer must repay a portion of an upfront discount if the customer terminates the contract.
Management should apply judgment in determining whether a termination penalty is substantive. There are no "bright lines" for making this assessment. The objective is to determine the period over which the parties have enforceable rights and obligations. Factors to consider, among others, include the business purpose for contract terms that include termination rights and related penalties and the reporting entity's past business practices.
If a customer has the right to terminate a contract early without paying a substantive penalty, the assessment of contract term should not take into account the likelihood the customer will exercise that right. In other words, the contract term would not extend beyond the period the customer has the right to terminate regardless of whether the customer is expected to terminate the contract, as the contract term only includes the period during which the parties have enforceable rights and obligations. Similarly, the reporting entity should not consider whether the customer would be economically compelled not to exercise a termination right because of costs the customer would incur to cancel the contract (e.g., costs to switch vendors).
A reporting entity should not account for termination rights that do not have substance, similar to any other non-substantive contract provision. For example, a termination right may not have substance if it allows a customer to cancel a contract that has been paid in full, but does not require the vendor to refund any consideration upon cancellation.
Example RR 2-10, Example RR 2-11, Example RR 2-12, and Example RR 2-13 illustrate the impact of termination rights and penalties on the assessment of contract term.
EXAMPLE RR 2-10
Determining the contract term – both parties can terminate without penalty
ServiceProvider enters into a contract with a customer to provide monthly services for a three-year period. Each party can terminate the contract at the end of any month for any reason without compensating the other party (that is, there is no penalty for terminating the contract early).
What is the contract term for purposes of applying the revenue standard?
Analysis
The contract should be treated as a month-to-month contract despite the three-year stated term. The parties do not have enforceable rights and obligations beyond the month (or months) of services already provided.
EXAMPLE RR 2-11
Determining the contract term – only the customer can terminate without penalty
ServiceProvider enters into a contract with a customer to provide monthly services for a three-year period. The customer can terminate the contract at the end of any month for any reason without compensating ServiceProvider to terminate the contract.
What is the contract term for purposes of applying the revenue standard?
Analysis
The contract should be accounted for as a month-to-month contract with a customer option to renew each month. This is consistent with discussion in the basis for conclusions that customer cancellation rights can be similar to a renewal option. In this fact pattern, the three-year cancellable contract is equivalent to a one-month renewable contract. Refer to RR 7.3 for further discussion on the accounting for renewal options, including the assessment of whether such options provide the customer with a material right. Additionally, refer to Revenue TRG Memo No. 48 and the related meeting minutes in Revenue TRG Memo No. 49 for further discussion of this topic.
EXAMPLE RR 2-12
Determining the contract term – impact of termination penalty
ServiceProvider enters into a contract with a customer to provide monthly services for a three-year period. The customer can terminate the contract at the end of any month for any reason. The customer must pay a termination penalty if the customer terminates the contract during the first twelve months.
What is the contract term for purposes of applying the revenue standard?
Analysis
It depends. Management should assess whether the termination penalty is substantive such that it creates enforceable rights and obligations for the first twelve months of the contract. The contract term would be one year if the termination penalty is determined to be substantive.
EXAMPLE RR 2-13
Determining the contract term – license of intellectual property
Biotech enters into a ten-year term license arrangement with Pharma under which Biotech transfers to Pharma the exclusive rights to sell product using its intellectual property in a particular territory. There are no other performance obligations in the arrangement. Pharma makes an upfront nonrefundable payment of $25 million and is obligated to pay an additional $1 million at the end of each year throughout the stated term.
Pharma can cancel the contract for convenience at any time, but must return its rights to the licensed intellectual property to Biotech upon cancellation. Pharma does not receive any refund of amounts previously paid upon cancellation.
What is the contract term for purposes of applying the revenue standard?
Analysis
Biotech would likely conclude that the contract term is ten years because Pharma cannot cancel the contract without incurring a substantive termination penalty. The substantive termination penalty in this arrangement is Pharma's obligation to transfer an asset to Biotech through the return of its exclusive rights to the licensed intellectual property without refund of amounts paid.
The assessment of whether a substantive termination penalty is incurred upon cancellation could require significant judgment for arrangements that include a license of intellectual property. Factors to consider include the nature of the license, the payment terms (for example, how much of the consideration is paid upfront), the business purpose of contract terms that include termination rights, and the impact of contract cancellation on other performance obligations, if any, in the contract. If management concludes that a termination right creates a contract term shorter than the stated term, management should assess whether the arrangement contains a renewal option that provides the customer with a material right (refer to RR 7.3).
Question RR 2-4
Do fiscal funding clauses in an arrangement with a US federal governmental entity affect the determination of the contract term?
Do fiscal funding clauses in an arrangement with a US federal governmental entity affect the determination of the contract term?
PwC response
It depends. Because of the US federal government’s annual budget process, it is common for long-term contracts with the government to include fiscal funding clauses. These clauses typically state that the government’s obligations under the contract are contingent upon the appropriation of funds to fulfill those obligations. Thus, the portion of the contract that is unfunded at contract inception could be subject to cancellation if funding is not appropriated in the future. In these cases, judgment is required to determine the contract term.
We believe management could conclude that the criteria in ASC 606-10-25-1 are met for both the funded and unfunded portions of the contract if the reporting entity has an approved enforceable contract with the US federal government that clearly states each party’s rights and obligations, and the government has the ability and intention to pay for the promised goods and services. Accordingly, both the funded and unfunded portions would be included in the contract term. The unfunded portion of the contract would be considered variable consideration, and the reporting entity will need to consider whether any variable consideration is constrained as discussed in RR 4.3.2.
While arrangements with the US federal government typically include fiscal funding clauses, there may be circumstances where a contract provides the government the right to cancel the contract for any reason (that is, the right to cancel is not limited to situations where funding is not appropriated). In these circumstances, the reporting entity should assess whether the government is required to pay a substantive termination penalty upon cancellation. If there is no substantive termination penalty, enforceable rights and obligations would only exist for the noncancellable period and accordingly, the contract term would be limited to the noncancellable period.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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