Reporting entities often provide customers the option to renew their existing contracts. For example, a customer may be allowed to extend a two-year contract for an additional year under the same terms and conditions as the original contract. A cancellation option that allows a customer to cancel a multi-year contract after each year might effectively be the same as a renewal option, because a decision is made annually whether to continue under the contract.
Management should assess a renewal or cancellation option to determine if it provides a material right similar to other types of customer options. For example, a renewal option that is offered for an extended period of time without price increases might be a material right if prices for the product in that market are expected to increase. The amount of the transaction price for the original contract that is allocated to the material right associated with a contract renewal is initially deferred. When the customer renews the contract, the deferred amount, as well as the additional transaction price resulting from the renewal, is allocated to the goods or services transferred during the renewal period.
Determining the standalone selling price of a renewal option that provides a material right requires judgment. Factors that management might consider include:
- Historical data (adjusted to reflect current factors)
- Expected renewal rates
- Marketing studies
- Data used to set the pricing terms of the arrangement
- Discussions with customer during or after negotiations about the arrangement
- Industry data, particularly if the service is homogenous
Contracts that include multiple renewal options introduce complexity, as management would theoretically need to assess the standalone selling price of each option. The revenue standard provides the following practical alternative regarding customer renewals.
If a customer has a material right to acquire future goods or services and those goods or services are similar to the original goods or services in the contract and are provided in accordance with the terms of the original contract, then an entity may, as a practical alternative to estimating the standalone selling price of the option, allocate the transaction price to the optional goods or services by reference to the goods or services expected to be provided and the corresponding expected consideration. Typically, those types of options are for contract renewals.
Arrangements involving customer loyalty points or discount vouchers are unlikely to qualify for the practical alternative associated with contract renewals. The goods or services provided in the future in such arrangements often differ from those provided in the initial contract and/or are provided under different pricing terms (for example, a hotel chain may change the number of points a customer must redeem to receive a free stay).
Example RR 7-11 illustrates the accounting for a contract renewal option.
EXAMPLE RR 7-11
Customer options – renewal option that provides a material right
SpaMaker enters into an arrangement with Retailer to sell an unlimited number of hot tubs for $3,000 per hot tub for 12 months. Retailer has the option to renew the contract at the end of the year for an additional 12 months. The contract renewal will be for the same products and under the same terms as the original contract. SpaMaker typically increases its prices 15% each year.
How should SpaMaker account for the renewal option?
The renewal option represents a material right to Retailer as it will be charged a lower price for the hot tubs than similar customers if the contract is renewed. SpaMaker is not required to determine a standalone selling price for the renewal option as both criteria for the use of the practical expedient have been met. SpaMaker could instead elect to include the estimated total number of hot tubs to be sold at $3,000 per hot tub over 24 months (the initial period and the renewal period) in the initial measurement of the transaction price.