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It is common in some industries for reporting entities to charge customers a fee at or near inception of a contract. These upfront fees are often nonrefundable and could be labeled as fees for set up, access, activation, initiation, joining, or membership.
A reporting entity needs to analyze each arrangement involving upfront fees to determine whether any revenue should be recognized when the fee is received.

Excerpt from ASC 606-10-55-51

To identify performance obligations in such contracts, an entity should assess whether the fee relates to the transfer of a promised good or service. In many cases, even though a nonrefundable upfront fee relates to an activity that the entity is required to undertake at or near contract inception to fulfill the contract, that activity does not result in the transfer of a promised good or service to the customer... Instead, the upfront fee is an advance payment for future goods or services and, therefore, would be recognized as revenue when those future goods or services are provided. The revenue recognition period would extend beyond the initial contractual period if the entity grants the customer the option to renew the contract and that option provides the customer with a material right.

No revenue should be recognized upon receipt of an upfront fee, even if it is nonrefundable, if the fee does not relate to the satisfaction of a performance obligation. Nonrefundable upfront fees are included in the transaction price and allocated to the separate performance obligations in the contract. Revenue is recognized as the performance obligations are satisfied. This concept is illustrated in Example 53 of the revenue standard (ASC 606-10-55-358 through ASC 606-10-55-360).
There could be situations, as illustrated in Example RR 8-4, when an upfront fee relates to separate performance obligations satisfied at different points in time.
EXAMPLE RR 8-4
Upfront fee allocated to separate performance obligations
Biotech enters into a contract with Pharma for the license and development of a drug compound. The contract requires Biotech to perform research and development (R&D) services to get the drug compound through regulatory approval. Biotech receives an upfront fee of $50 million, fees for R&D services, and milestone-based payments upon the achievement of specified acts.
Biotech concludes that the arrangement includes two separate performance obligations: (1) license of the intellectual property and (2) R&D services. There are no other performance obligations in the arrangement.
How should Biotech allocate the consideration in the arrangement, including the $50 million upfront fee?
Analysis
Biotech needs to determine the transaction price at the inception of the contract, which will include both the fixed and variable consideration. The fixed consideration is the upfront fee. The variable consideration includes the fees for R&D services and the milestone-based payments and is estimated based on the principles discussed in RR 4. Once Biotech determines the total transaction price, it should allocate that amount to the two performance obligations. See RR 5 for further information on allocation of the transaction price to performance obligations.

Reporting entities sometimes perform set-up or mobilization activities at or near contract inception to be able to fulfill the obligations in the contract. These activities could involve system preparation, hiring of additional personnel, or mobilization of assets to where the service will take place. Nonrefundable fees charged at the inception of an arrangement are often intended to compensate the reporting entity for the cost of these activities. Set-up or mobilization efforts might be critical to the contract, but they typically do not satisfy performance obligations, as no good or service is transferred to the customer. The nonrefundable fee, therefore, is an advance payment for the future goods and services to be provided.
Set-up or mobilization costs should be disregarded in the measure of progress for performance obligations satisfied over time if they do not depict the transfer of services to the customer. Some mobilization costs might be capitalized as fulfillment costs, however, if certain criteria are met. See RR 11 for further information on capitalization of contract costs.

8.4.1 Accounting for upfront fees when a renewal option exists

Contracts that include an upfront fee and a renewal option often do not require a customer to pay another upfront fee if and when the customer renews the contract. The renewal option in such a contract might provide the customer with a material right, as discussed in RR 7.3. A reporting entity that provides a customer a material right should determine its standalone selling price and allocate a portion of the transaction price to that right because it is a separate performance obligation. Alternatively, transactions that meet the requirements can apply the practical alternative for contract renewals discussed in RR 7.3 and estimate the total transaction price based on the expected number of renewals.
Management should consider both quantitative and qualitative factors to determine whether an upfront fee provides a material right when a renewal right exists. For example, management should consider the difference between the amount the customer pays upon renewal and the price a new customer would pay for the same service. An average customer life that extends beyond the initial contract period could also be an indication that the upfront fee incentivizes customers to renew the contract. Refer to Revenue TRG Memo No. 32 and the related meeting minutes in Revenue TRG Memo No. 34 for further discussion of this topic.
Example RR 8-5 illustrates the accounting for upfront fees and a renewal option.
EXAMPLE RR 8-5
Upfront fee – health club joining fees
FitCo operates health clubs. FitCo enters into contracts with customers for one year of access to any of its health clubs. The reporting entity charges an annual membership fee of $60 as well as a $150 nonrefundable joining fee. The joining fee is to compensate, in part, for the initial activities of registering the customer. Customers can renew the contract each year and are charged the annual membership fee of $60 without paying the joining fee again. If customers allow their membership to lapse, they are required to pay a new joining fee.
How should FitCo account for the nonrefundable joining fees?
Analysis
The customer does not have to pay the joining fee if the contract is renewed and has therefore received a material right. That right is the ability to renew the annual membership at a lower price than the range of prices typically charged to newly joining customers.
The joining fee is included in the transaction price and allocated to the separate performance obligations in the arrangement, which are providing access to health clubs and the option to renew the contract, based on their standalone selling prices. FitCo's activity of registering the customer is not a service to the customer and therefore does not represent satisfaction of a performance obligation. The amount allocated to the right to access the health club is recognized over the first year, and the amount allocated to the renewal right is recognized when that right is exercised or expires.
As a practical alternative to determining the standalone selling price of the renewal right, FitCo could allocate the transaction price to the renewal right by reference to the future services expected to be provided and the corresponding expected consideration. For example, if FitCo determined that a customer is expected to renew for an additional two years, then the total consideration would be $330 ($150 joining fee and $180 annual membership fees). FitCo would recognize this amount as revenue as services are provided over the three years. See RR 7.3 for further information about the practical alternative and customer options.

8.4.2 Layaway sales

Layaway sales (sometimes referred to as “will call”) involve the seller setting aside merchandise and collecting a cash deposit from the customer. The seller may specify a time period within which the customer must finalize the purchase, but there is often no fixed payment commitment. The merchandise is typically released to the customer once the purchase price is paid in full. The cash deposit and any subsequent payments are forfeited if the customer fails to pay the entire purchase price. The seller must refund the cash paid by the customer for merchandise that is lost, damaged, or destroyed before control of the merchandise transfers to the customer.
Management will first need to determine whether a contract exists in a layaway arrangement. A contract likely does not exist at the onset of a typical layaway arrangement because the customer has not committed to perform its obligation (that is, payment of the full purchase price). The reporting entity should not recognize revenue for these arrangements until the contract criteria are met (refer to RR 2.6.1) or until the events described in RR 2.6.2 have occurred.
Some layaway sales could be in substance a credit sale if management concludes that the customer is committed to the purchase and a contract exists. Management will need to determine in those circumstances when control of the goods transfers to the customer. A reporting entity that can use the selected goods to satisfy other customer orders and replace them with similar goods during the layaway period likely has not transferred control of the goods. Management should consider the bill-and-hold criteria discussed in RR 8.5 to determine when control of the goods has transferred.

8.4.3 Gift cards

Reporting entities often sell gift cards that can be redeemed for goods or services at the customer's request. A reporting entity should not record revenue at the time a gift card is sold, as the performance obligation is to provide goods or services in the future when the card is redeemed. The payment for the gift card is an upfront payment for goods or services in the future. Revenue is recognized when the card is presented for redemption and the goods or services are transferred to the customer.
Often a portion of gift certificates sold are never redeemed for goods or services. The amounts never redeemed are known as “breakage.” A reporting entity should recognize revenue for amounts not expected to be redeemed proportionately as other gift card balances are redeemed. A reporting entity should not recognize revenue, however, for consideration received from a customer that must be remitted to a governmental reporting entity if the customer never demands performance. Refer to RR 7.4 for further information on breakage and an example illustrating the accounting for gift card sales.

8.4.4 New guidance–franchisor pre-opening services

Franchisors entering into franchise agreements with customers often perform varying levels of pre-opening activities, such as training or assisting the customer in site selection and preparation. In many cases, franchisors will charge their customers a nonrefundable upfront fee, or initial franchise fee, related to these activities. As discussed in RR 8.4, no revenue should be recognized upon receipt of an upfront fee, even if it is nonrefundable, if the fee does not relate to the satisfaction of a performance obligation. Accordingly, a franchisor will need to assess whether pre-opening activities transfer a good or service to the franchisee and if so, whether that good or service is distinct from other goods and services in the contract, including the franchise license.
In January 2021, the FASB issued ASU 2021-02, Franchisors—Revenue from Contracts with Customers (Subtopic 952-606), which applies to nonpublic entities (that is, all entities other than public entities, as defined) that are franchisors, as defined within ASC 952, Franchisors. ASU 2021-02 includes a practical expedient that permits a nonpublic franchisor to account for certain pre-opening services identified in ASC 952-606-25-2 as distinct from the franchise license in a franchise agreement. Reporting entities outside the scope of ASU 2021-02 should not apply the guidance by analogy.

ASC 952-606-25-2

As a practical expedient, when applying the guidance in Topic 606, a franchisor that enters into a franchise agreement may account for the following pre-opening services as distinct from the franchise license:

  1. Assistance in the selection of a site
  2. Assistance in obtaining facilities and preparing the facilities for their intended use, including related financing, architectural, and engineering services, and lease negotiation
  3. Training of the franchisee’s personnel or the franchisee
  4. Preparation and distribution of manuals and similar material concerning operations, administration, and record keeping
  5. Bookkeeping, information technology, and advisory services, including setting up the franchisee’s records and advising the franchisee about income, real estate, and other taxes or about regulations affecting the franchisee’s business
  6. Inspection, testing, and other quality control programs.

The practical expedient only applies to identifying the performance obligations in a franchise agreement and does not amend other aspects of the revenue guidance. For example, a franchisor will need to determine the standalone selling price of the pre-opening services and any other distinct goods or services in the contract (including the franchise license) and allocate the transaction price in accordance with the guidance discussed in RR 5. As a result, the amount allocated to the pre-opening services could differ from the amount of the initial franchise fee. A nonpublic franchisor that elects the practical expedient will apply the guidance in the revenue standard on identifying performance obligations (RR 3) to determine whether multiple pre-opening services are distinct from one another. Alternatively, franchisors applying the practical expedient can make an accounting policy election to account for all pre-opening services as a single performance obligation.
If the franchisor performs services that are not included in the list of pre-opening services in ASC 952-606-25-2, the practical expedient cannot be applied to those services. That is, franchisors cannot apply the practical expedient to other pre-opening services by analogy. For services not subject to the practical expedient, the franchisor should apply the guidance in the revenue standard on identifying performance obligations (RR 3) to determine whether the services are distinct from other promises in the contract, including the franchise license.
The practical expedient should be applied consistently to contracts with similar characteristics and in similar circumstances. Similarly, the accounting policy to account for pre-opening activities as a single performance obligation should be applied consistently. Nonpublic franchisors must disclose the use of the practical expedient and, if elected, the accounting policy to treat certain pre-opening services as a single performance obligation.
If a nonpublic franchisor has not yet adopted ASC 606, the existing transition provisions and effective date in ASC 606-10-65-1 are applicable, which allows for a modified retrospective or a full retrospective adoption. If a nonpublic franchisor has already adopted ASC 606, the practical expedient should be applied retrospectively to the date ASC 606 was adopted. The guidance is effective in interim and annual periods beginning after December 15, 2020 and may be early adopted.
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