Chapter 4 — Step 1: Identify the Contract

4.4 Contract Term

Determining the term of the contract is an important step in the revenue recognition process since the contract term could affect the identification of promises under the contract as well as the transaction price. ASC 606 provides guidance on determining the contract duration, including the effect of termination clauses and contract renewals. The contract term is determined on the basis of the period over which the parties to the contract have present enforceable rights and obligations. The contract term would not include optional renewal periods or the delivery of optional goods or services. However, the existence of purchase options in a contract with a customer could give rise to a material right. For further discussion of material rights, see Chapter 11.

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 this Topic to the duration of the contract (that is, the contractual period) in which the parties to the contract have present enforceable rights and obligations. In evaluating the criterion in paragraph 606-10-25-1(e), an entity shall assess the collectibility of the consideration promised in a contract for the goods or services that will be transferred to the customer rather than assessing the collectibility of the consideration promised in the contract for all of the promised goods or services (see paragraphs 606-10-55-3A through 55-3C). However, if an entity determines that all of the criteria in paragraph 606-10-25-1 are met, the remainder of the guidance in this Topic shall be applied to all of the promised goods or services in the contract.

4.4.1 Termination Clauses and Penalties

When contracts have termination clauses and penalties, the duration of a contract is predicated on the contract’s enforceable rights and obligations. Accordingly, regardless of whether one or both parties have the right to terminate the contract, an entity would need to evaluate the nature of the termination provisions, including whether any termination penalty is substantive. For example, an entity would assess factors such as (1) whether the terminating party is required to pay compensation, (2) the amount of such compensation, and (3) the reason for the compensation (i.e., whether the compensation is in addition to amounts due for goods and services already delivered). Substantive termination penalties suggest that the parties’ rights and obligations extend for the duration of the contract term.

A contract’s accounting term could be less than the contract’s stated term if a termination penalty is not substantive. For example, a 12-month stated contract term could, in effect, be a month-to-month contract if the contract could be terminated each month and the termination penalty is not substantive. An entity will need to carefully consider the effect of nonsubstantive termination penalties on the timing and amount of revenue to be recognized.

Because the assessment of termination clauses and penalties focuses on legally enforceable rights and obligations, certain economic factors such as economic compulsion should not be considered. Rather, the assessment depends on whether the terminating party is required to compensate the other party. For example, an entity may have a long-term agreement with a customer for a unique good or service that is critical to the customer’s operations. If the agreement allows the customer to terminate it at any point and there are no contractual penalties if the customer does not purchase any goods or services, a contract for the purchase of additional goods or services does not exist even if it is highly likely that the customer will not terminate the agreement.

The economic considerations related to forgoing a discount on optional purchases would not be viewed as a substantive penalty suggesting that the parties’ rights and obligations extend for a longer contract term. The discount on optional purchases should be assessed for the existence of a material right instead. Therefore, while an “economic” penalty may be incurred by a customer that elects not to purchase future but optional goods at a discount, that economic penalty would not rise to the level of a substantive penalty that lengthens the contract term.

The determination of whether a termination penalty is substantive requires judgment and would be evaluated both quantitatively and qualitatively. For example, data about the frequency of contract terminations may be useful in such a determination (i.e., a high frequency of payments made to terminate contracts may suggest that the termination penalty is not substantive). Determining the enforceable term of a contract that includes termination provisions (e.g., cancellation fees) may be challenging, particularly when only the customer has a right to terminate the contract. When a customer has a right to terminate the contract without penalty, such termination provision is substantively the same as a renewal provision, as supported by paragraph BC391 of ASU 2014-09 (as well as by Implementation Q&A 8). The example below illustrates how an entity should consider a fixed-term contract that allows a customer to terminate the contract without penalty after a certain period.

Example 4-3

Company A has a contract to deliver various goods and services to Customer B. The contract includes pricing for the goods or services for a two-year period but allows B to cancel the contract at any time after six months without paying a penalty. In this scenario, we generally believe that the enforceable rights and obligations of the contract are for six months; therefore, the contract term is six months. Since the pricing terms of the arrangement are fixed for two years, A would also need to evaluate whether a material right exists for purchases beyond six months.

Connecting the Dots

As discussed above, enforceable rights and obligations in a contract are only those for which the entity has legal rights and obligations under the contract and would not take certain economic factors into account (e.g., economic compulsion). Accordingly, the economic considerations related to forgoing a discount on optional purchases would not be viewed as a substantive penalty suggesting that the parties’ rights and obligations extend for a longer contract term. The discount on optional purchases should be assessed for the existence of a material right instead. This approach is consistent with the discussion in Implementation Q&A 8, which states that “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.” Therefore, while an “economic” penalty may be incurred by a customer that elects not to purchase future but optional goods at a discount, that economic penalty would not rise to the level of a substantive penalty that lengthens the contract term.

The above issue is addressed in Implementation Q&As 7 and 8 (compiled from previously issued TRG Agenda Papers 10, 11, 48, and 49). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

4.4.1.1 Termination Clauses in License Arrangements

As noted in Section 4.4.1, an entity needs to evaluate the nature of termination provisions, including whether any penalties are substantive (i.e., whether the transfer of any consideration, including noncash consideration, from the customer to the entity is substantive). Careful consideration is required in the evaluation of whether giving up license rights is a form of penalty.

Implementation Q&As 7 and 8 include the following factors that an entity should consider when determining whether a termination penalty is substantive:

Whether the terminating party is required to pay compensation.
The amount of such compensation.
The reason for the compensation (i.e., whether the compensation is in addition to amounts due for goods and services already delivered).

The two examples below illustrate how an entity would determine whether a license arrangement includes a substantive termination penalty.

Example 4-4

License Arrangement Includes a Substantive Termination Penalty

Company A, a pharmaceutical company in the United States, owns and maintains a portfolio of patents related to an antibiotic that treats life-threatening diseases. On February 23, 20X8, A grants Customer B (a pharmaceutical company in Ireland) the exclusive right to use its patented drug formula to commercialize and supply the antibiotic in Europe. The IP is fully developed, and regulatory approval has been obtained; therefore, B is able to commercialize the IP. Company A has determined that the patented drug formula is functional IP and that therefore, the license grants B the right to use the IP. In exchange for the exclusive right to use the patented drug formula, B agrees to pay A the following amounts:

An up-front fee of $300 million.
Annual fixed fees of $50 million payable at the end of each year in which the contract is effective.
Sales-based royalties of 5 percent of B’s sales of the antibiotic in Europe (recognized in accordance with the sales-based royalty exception in ASC 606-10-55-65).

The contract states that B has the exclusive right to use the patented drug formula through the patent term, which expires in 10 years (i.e., the contract ends when the patent expires). Notwithstanding the stated contract term, the contract states that B may terminate the contract before the expiration of the patent by providing three months’ notice to A. All amounts already paid by B are nonrefundable in the event of early termination. The contract does not include an explicit termination penalty (i.e., B is not required to pay additional cash consideration to A upon early termination); however, upon early termination, the right to the patented drug formula in Europe would revert back to A, and A would be able to relicense the patented drug formula to a different pharmaceutical company in Europe. Unless B terminates the contract before the end of the stated term, A would not be able to benefit from licensing the patented drug formula to a different pharmaceutical company in Europe (i.e., A would receive this benefit only upon B’s early termination of the contract).

Under these facts, A’s contract to license the exclusive right to use its patented drug formula to B contains a substantive termination penalty. As previously discussed in Section 4.4.1, it is important for an entity to evaluate the nature of the termination provisions in its contracts to determine the appropriate contract term for applying ASC 606.

In this example, A’s contract to license the patented drug formula to B does not include an explicit termination penalty. That is, B can terminate the contract before the end of the stated term by providing three months’ notice without paying additional cash consideration to A. Although the contract does not require B to pay additional cash consideration to A upon early termination, in the event that B terminates the contract early, the exclusive license rights related to the patented drug formula would revert back to A. Company A would then be able to license the patented drug formula to another customer in Europe for the remainder of the patent term, which it would not have been able to do if B had not terminated the contract. Therefore, although B is not paying additional cash to A upon termination, B is providing consideration (i.e., something of value) to A, and A is receiving something of value from B (i.e., the right to relicense the patented drug formula), upon termination. Although Implementation Q&As 7 and 8 focus on compensation as additional cash that an entity’s customer would pay to the entity upon termination, compensation may also include noncash consideration that is of value to the entity. The fact that B is forfeiting its rights to the patented drug formula and providing A with something of value (i.e., the ability to relicense the patented drug formula to another customer in Europe) from the forfeiture upon early termination represents a substantive termination penalty in the contract.

In accordance with Implementation Q&As 7 and 8, the substantive termination penalty suggests that the parties’ rights and obligations extend for the duration of the stated contract term. That is, the contract term is 10 years.

Example 4-5

License Arrangement Does Not Include a Substantive Termination Penalty

Company X, a multinational software company, is a provider of financial software that can be used to track a user’s investments. On June 29, 20X8, X grants Customer Y a nonexclusive license to use X’s financial software to track Y’s personal investments for five years. The contract also includes postcontract customer support (PCS) for the five-year term. Company X also grants other customers a similar license to use its financial software (i.e., the license is not exclusive).

In exchange for the right to use X’s financial software, Y agrees to pay X the following amounts:

An up-front fee of $500.
An annual fee of $50, payable at the beginning of each year.

The contract states that Y may terminate the contract before the expiration of the five-year stated term by providing three months’ notice to X. All amounts already paid by Y are nonrefundable in the event of early termination. The contract does not include an explicit termination penalty (i.e., Y is not required to pay additional cash consideration to X upon early termination). Upon early termination, Y must forfeit its right to use X’s financial software (and, accordingly, terminate the PCS arrangement).

Under these facts, X’s contract to license its financial software to Y does not contain a substantive termination penalty. Like the contract in Example 4-4, X’s contract with Y does not contain an explicit termination penalty (i.e., Y is not required to pay additional cash consideration to X upon early termination). However, as illustrated in that example, it is important to consider whether the licensor is receiving other forms of compensation (i.e., noncash consideration that represents value to the licensor from the licensee upon termination) to determine whether the contract includes a substantive termination penalty. Unlike the license in that example, X’s license to use its financial software is not exclusive to one customer. In addition to licensing the software to Y, X licenses the software to other customers at the same time. Although Y must forfeit its right to use X’s financial software upon termination of the contract, Y is not providing anything of value to X, and X is not receiving anything of value from Y, upon early termination. Therefore, the contract does not contain a substantive termination penalty. In a manner consistent with the discussion in Section 4.4.1, this would suggest that X and Y have enforceable rights and obligations for only the first three months of the contract because three months is the amount of time that Y would need to provide as notice to X to terminate the contract. Refer to Section 4.4.1.1.2 for further considerations related to the evaluation of termination provisions in licensing arrangements.

4.4.1.1.1 Termination Clauses That Include Refunds for Prepayments in Software Arrangements

In some software arrangements, a customer prepays for a term-based license and maintenance (i.e., PCS). If a customer prepays but can terminate at any point and receive a pro rata refund for the portion of the term-based license and PCS that is unused, the arrangement would be accounted for as a daily contract. Undelivered performance obligations associated with such arrangements would generally be excluded from deferred revenue and instead be classified as some other liability account (e.g., “refund liability” or “customer arrangements with termination rights”). They would also generally be excluded from the requirement in ASC 606 to disclose “remaining performance obligations,” although an entity would not necessarily be precluded from specifying amounts that are subject to termination in the notes to its financial statements if it properly describes these GAAP amounts.

The examples below illustrate how an entity might determine the contractual term in various software arrangements with termination clauses.

Example 4-6

Term-Based Software License With Pro Rata Refund Upon Termination

On March 1, 20X1, a vendor sells a one-year term-based license with PCS for $1,200. The vendor’s customer has the right to terminate the arrangement at its convenience at the end of each month. If the customer terminates, it is entitled to a pro rata refund and loses the right to use the software. The vendor concludes that it has two distinct performance obligations: (1) the license and (2) the PCS. If there was no termination provision, the vendor would have allocated $800 to the license and $400 to the PCS (on the basis of their stand-alone selling prices). Further, it would have recognized the license fee ($800) up front and the PCS ratably over time ($33 per month).

In this circumstance, the vendor should account for the arrangement as 12 individual monthly contracts since the term is the lesser of the contractual period or the period in which the contract cannot be terminated without substantive penalty. Accordingly, the arrangement would continue to be accounted for ratably ($100 per month).6

Example 4-7

Term-Based Software License Sold to Reseller With Pro Rata Refund Upon Termination

Assume the same facts as in Example 4-6, except that the customer is a reseller that has a committed (noncancelable) contract with its end-user customer for the duration of the arrangement (one year).

Since the vendor is not a party to the reseller’s end-user arrangement (i.e., the reseller, not the end user, is the vendor’s customer), the end-user agreement is not relevant in the performance of step 1 under ASC 606 (i.e., identifying the contract with the customer). The vendor should therefore account for the arrangement in the same manner as it does for the arrangement discussed in Example 4-6.

Example 4-8

Perpetual Software License With Pro Rata Refund Upon Termination

A vendor sells a perpetual license with one year of PCS for $6,000. The vendor’s customer has the right to terminate the arrangement at its convenience at the end of each month. The contractual prices of the license and the PCS are $5,000 and $1,000, respectively. Upon termination, the customer will be entitled to a pro rata refund for the PCS and a computed pro rata refund for the perpetual license, which has a three-year life. If the customer exercises its termination right, it loses the right to use the software. The vendor concludes that it has two distinct performance obligations: (1) the license and (2) the PCS. If there was no termination provision, the vendor would have allocated $5,000 to the license and $1,000 to the PCS on the basis of their stand-alone selling prices. Further, it would have recognized the license fee ($5,000) up front and the PCS ratably over time ($83 per month).

The vendor should account for the license as 36 individual monthly contracts and for the PCS as 12 individual monthly contracts. As a result, the license would be recognized over 36 months and the PCS would be recognized over 12 months, both ratably ($139 per month for 36 months7 and $83 per month for 12 months).

Example 4-9

Perpetual Software License With Pro Rata Refund on PCS Only Upon Termination

A vendor sells a perpetual license with one year of PCS for $6,200. The vendor’s customer has the right to terminate the PCS at its convenience at the end of each month. The contractual prices of the license and the PCS are $5,000 and $1,200, respectively. Upon termination, the customer will be entitled to a pro rata refund for the PCS and no refund for the license. Upon exercising the termination right, the customer retains the right to the perpetual license. The vendor concludes that it has two distinct performance obligations: (1) the license and (2) the PCS. If there was no termination provision, the vendor would have allocated $5,200 to the license and $1,000 to the PCS on the basis of their stand-alone selling prices. Further, it would have recognized the license fee ($5,200) up front and the PCS ratably over time ($83 per month).

The vendor should account for the PCS as 12 individual monthly contracts and for the license as part of the initial monthly contract. As a result, the license would be recognized upon delivery ($5,020) and the PCS would be recognized monthly ($80 in the first month and $100 per month thereafter).8 The total revenue recognized in the first month would be limited to an amount less than what would have been recognized on the basis of relative stand-alone selling price if the contract were to be accounted for as a one-year contract. Note that there is no material right for “renewals” of PCS since the renewals are priced at $100, which is greater than the stand-alone selling price of $83.

Example 4-10

Perpetual Software License With a Negotiated Refund Upon Termination and Separate Stock-Keeping Units (SKUs)

A vendor sells a perpetual license with one year of PCS for $6,000. The vendor’s customer has the right to terminate the arrangement at its convenience at the end of each month. The contractual prices of the license and the PCS (which have separate SKUs) are $5,000 and $1,000, respectively. The contract specifies that upon termination, the vendor and the customer will negotiate, in good faith, the amount of refund, if any, to which the customer would be entitled. The vendor concludes that it has two distinct performance obligations: (1) the license and (2) the PCS.

Generally, if the amount that would be refunded is not stated (i.e., unknown) because it is subject to negotiation and not legally enforceable, the arrangement would be accounted for as a one-year contract if a substantive termination penalty is legally enforceable.

Example 4-11

Term-Based Software License With an Uncertain Refund Upon Termination and a Combined SKU

A vendor sells a one-year term license with coterminous PCS for $6,000. The customer has the right to terminate at its convenience the PCS at the end of each month. The contractual prices of the license and PCS are not separately stated (i.e., the license and PCS do not have separate SKUs). Accordingly, the amount that would be refunded upon termination is not known. The vendor concludes that it has two distinct performance obligations: (1) the license and (2) the PCS.

4.4.1.1.2 License Keys and Termination Provisions

The example below illustrates how termination provisions in a software licensing contract requiring the delivery of a license key for the customer to use the software affect the contract term and the recognition of revenue.

Example 4-12

Company LEH enters into an arrangement to license its software (a right-to-use license for which revenue is recognized at a point in time) to Customer MJR for one year with coterminous PCS. The annual fee for the license and PCS is $5,000 (paid quarterly). Company LEH determines that the stand-alone selling price of the license is $4,000 and the stand-alone selling price of the PCS is $1,000. Company LEH delivers a license key to MJR at the beginning of each quarter; the license key is required for MJR to use the software. Company LEH determines that the license and PCS are distinct performance obligations.

Consider the following cases:

Case A: contract may be terminated at the end of each quarter during the one-year license term — In Case A, MJR may choose not to make the next quarterly payment, thereby alleviating LEH’s obligation to deliver the quarterly license key and provide further PCS. Customer MJR’s election not to pay the quarterly fee is not deemed to be a breach of the contract, and LEH has no recourse against MJR if payment is not received (other than to discontinue providing the license and PCS). In effect, the contract is cancelable each quarter. Upon cancellation, MJR’s rights to use the license and receive PCS for the remainder of the one-year license term are also revoked.
Case B: contract may not be terminated during the one-year license term — In Case B, LEH is required to deliver or make available the license key to MJR at the beginning of each quarter (such obligation is not contingent on MJR’s making quarterly payments). If LEH does not deliver or make available the license key at the beginning of each quarter, LEH will be in breach of its contractual obligations. Similarly, MJR will be in breach of its contractual obligations if it does not make the quarterly payments. Company LEH has agreed to deliver license keys on a quarterly basis as protection against a breach of contract by MJR. For example, if MJR fails to make payment on time at the start of the second quarter, LEH would still deliver the license key for that quarter. But if MJR has still not paid by the end of the second quarter and is therefore clearly in breach of its contractual commitments, LEH could consider whether to withhold the license key for the third quarter in response to MJR’s breach of contract. The contract may not be terminated by either LEH or MJR during the one-year license term, and LEH has a history of enforcing the contract term.

In Case A, because the contract may be canceled at the end of each quarter, LEH does not have an unconditional obligation to deliver the license key to MJR after the first quarter, nor does MJR have the unconditional obligation to continue making quarterly payments to LEH. Because the contract is cancelable by MJR each quarter, the contract term is limited to one quarter unless MJR renews the contract (by making the quarterly payment). At contract inception (i.e., when the first license key is transferred to MJR), MJR obtains a right to use a license for only a term of one quarter. If MJR elects not to cancel the contract and LEH transfers an additional key to MJR, MJR obtains the rights to use and benefit from the software and receive PCS for an additional quarter.

In this case, LEH transfers control of a license for one quarter and is required to provide one quarter of PCS each time MJR elects not to terminate the contract. Therefore, LEH should recognize revenue of $1,000 allocated to the license at the beginning of each quarter and $250 allocated to PCS over the quarterly PCS period.

In Case B, LEH should account for the arrangement as a promise to transfer a one-year term license and one year of PCS. Although a new license key is required to be delivered or made available at the beginning of each quarter, LEH and MJR have entered into a noncancelable contract that gives MJR the right to use the software for one year. Control of a license can be transferred even if the product key is not transferred to the customer as long as the key is made available to the customer (and accessing the key is within the customer’s control). In Case B, MJR has an enforceable right to demand the license key, and LEH is obligated to transfer or otherwise make available to MJR the key each quarter (regardless of whether MJR makes timely payments). Accordingly, once LEH initially transfers the license (and key) to MJR, MJR obtains control of the one-year term license. Because LEH does not have the ability to terminate the contract in the absence of a breach of contract by MJR or to prevent MJR from accessing the license key each quarter, LEH transfers all of the rights to use and benefit from the software for the entire one-year license term at contract inception. Similarly, MJR does not have the right to terminate the contract and cease making quarterly payments since the contract is noncancelable and LEH has a history of enforcing the contract term.

Accordingly, LEH should recognize revenue of $4,000 allocated to the license at contract inception (when the initial key is delivered) and $1,000 allocated to PCS over the PCS term (i.e., one year).

Footnotes

Revenue associated with the license would be recognized at the beginning of each month, which is similar to ratable recognition given the short term (i.e., monthly).

See footnote 6.

Total noncancelable consideration of $5,100 for the initial month is allocated on a relative stand-alone selling price basis — that is, approximately 98 percent to the license and 2 percent to one month of PCS.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.