5.6 Nonrefundable Up-Front Fees
ASC 606-10
55-50 In some contracts, an entity charges a customer a nonrefundable upfront fee at or near contract
inception. Examples include joining fees in health club membership contracts, activation fees in
telecommunication contracts, setup fees in some services contracts, and initial fees in some supply contracts.
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 (see paragraph 606-10-
25-17). 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 as described in paragraph 606-10-55-42.
55-52 If the nonrefundable upfront fee relates to a good or service, the entity should evaluate whether to
account for the good or service as a separate performance obligation in accordance with paragraphs 606-10-
25-14 through 25-22.
55-53 An entity may charge a nonrefundable fee in part as compensation for costs incurred in setting up a
contract (or other administrative tasks as described in paragraph 606-10-25-17). If those setup activities do
not satisfy a performance obligation, the entity should disregard those activities (and related costs) when
measuring progress in accordance with paragraph 606-10-55-21. That is because the costs of setup activities
do not depict the transfer of services to the customer. The entity should assess whether costs incurred in
setting up a contract have resulted in an asset that should be recognized in accordance with paragraph
340-40-25-5.
Nonrefundable up-front fees are payments made by customers at the start of a
contract for various reasons. The revenue standard cites health club membership
fees, activation fees in telecommunication contracts, and set-up fees as examples of
nonrefundable up-front fees. Entities need to assess nonrefundable up-front fees to
determine whether the fees (1) are for goods or services provided at contract
inception or (2) provide the customer with an option for additional goods or
services that gives rise to a material right (a performance obligation).
Example 53 in ASC 606 illustrates the application of the revenue standard’s
guidance on nonrefundable up-front fees.
ASC 606-10
Example 53 — Nonrefundable Upfront Fees
55-358 An entity enters into a contract with a customer for one year of transaction processing services. The
entity’s contracts have standard terms that are the same for all customers. The contract requires the customer
to pay an upfront fee to set up the customer on the entity’s systems and processes. The fee is a nominal
amount and is nonrefundable. The customer can renew the contract each year without paying an additional
fee.
55-359 The entity’s setup
activities do not transfer a good or service to the customer
and, therefore, do not give rise to a performance
obligation.
55-360 The entity concludes that the renewal option does not provide a material right to the customer that
it would not receive without entering into that contract (see paragraph 606-10-55-42). The upfront fee is, in
effect, an advance payment for the future transaction processing services. Consequently, the entity determines
the transaction price, which includes the nonrefundable upfront fee, and recognizes revenue for the
transaction processing services as those services are provided in accordance with paragraph 606-10-55-51.
The example below illustrates how an entity would determine the
period over which to recognize a nonrefundable up-front fee.
Example 5-15
Entity X agrees to provide a customer with
services on a monthly basis at a price of $400 per month,
payable at the start of each month. At the outset, X also
charges the customer a one-time, nonrefundable up-front fee
of $50, for which no separate goods or services are
transferred. The customer can cancel the contract at any
time without penalty, but it will not be entitled to any
refund of amounts already paid. Entity X’s average customer
life is two years.
The period over which the up-front fee
should be recognized depends on whether the up-front fee
provides the customer with a material right with respect to
renewing X’s services. In determining whether the up-front
fee provides the customer with such a material right, X
should consider both quantitative and qualitative factors
(e.g., the renewal price compared with the price a new
customer would pay or the price paid for services already
transferred, inclusive of the nonrefundable up-front
fee).
If X concludes that the up-front fee does
provide a material right, that fee should be recognized over
the service period during which the customer is expected to
benefit from not having to pay a further up-front fee upon
renewal of service.
If X concludes that the up-front fee does
not provide the customer with a material right, the entire
transaction price of $450 (which comprises the minimum
one-month service fee and the up-front fee) is viewed as
advance payment for the promised services (i.e., the first
month only) and should be recognized over the first month
during which the services are provided.
The above issue is addressed in Implementation Q&A 52 (compiled from
previously issued TRG Agenda Papers 18, 25, 32, and 34). For additional information and Deloitte’s
summary of issues discussed in the Implementation Q&As, see Appendix C.
Refer to Section 8.9.4 for
additional discussion of the accounting for nonrefundable up-front fees.
5.6.1 Termination Clauses and Nonrefundable Up-Front Fees in Software Arrangements
Under some software arrangements, the customer must pay a nonrefundable up-front
fee. ASC 606 requires entities to consider whether the fee is (1) associated
with the transfer of promised goods or services or (2) an advance payment for
future goods or services.14 In addition, some software arrangements give the customer the right to
terminate the contract at the customer’s convenience. For example, an
arrangement for a one-year term license and PCS may contain a provision that
allows the customer to terminate the contract after a 30-day notice period. If
the customer can terminate a contract without having to pay a substantive
penalty, generally only the noncancelable portion of the contract (e.g., the
initial 30 days) is accounted for under ASC 606, even if the customer is
unlikely to exercise its termination right.
Questions have arisen in practice regarding how to account for nonrefundable
up-front fees associated with a software arrangement that contains a termination
provision. The examples below illustrate this scenario and discuss the
accounting considerations.
Example 5-16
All Fees Are Nonrefundable
A vendor sells a one-year term-based license with PCS for
an up-front nonrefundable fee of $1.25 million. The
stand-alone selling prices of the license and PCS are $1
million and $250,000, respectively. The vendor’s
customer has the right to terminate the arrangement at
its convenience at the end of each month without paying
any penalty. If the customer terminates, it loses the
right to use the software and receive support. The
customer also has the right to renew the contract
annually for the same fee.
Under the assumption that the license is distinct from
the PCS, the vendor has two performance obligations: (1)
a one-year term license and (2) one year of PCS. While
the customer has the right to terminate the contract at
the end of each month without paying the vendor a
penalty, the customer has, in substance, paid up front
for all the goods and services in the contract — the
one-year term license and one year of PCS. That is,
while a termination provision is treated similarly to a
renewal option, there is no incremental fee to “renew”
(i.e., not terminate) the contract each month, nor is
there a refundable payment for termination. Therefore,
the nonrefundable up-front fee is payment for the term
license and PCS for the full year. In addition, the
contract does not give the customer a material right
since the annual renewal provision is priced at the
stand-alone selling prices of the term license and
PCS.
Example 5-17
Nonrefundable License Fees and Pro Rata Refund for
PCS
A vendor sells a one-year term-based license with PCS for
an up-front fee of $1.25 million. The stand-alone
selling prices of the license and PCS are $1 million and
$250,000, respectively. The vendor’s customer has the
right to terminate the arrangement at its convenience at
the end of each month without paying any penalty. If the
customer terminates, it loses the right to receive
support and $1 million of the up-front fee. However, the
customer receives a pro rata refund for the PCS
($250,000) and retains the software license for the
remainder of the year. The customer also has the right
to renew the contract annually for the same fee.
Under the assumption that the license is distinct from
the PCS, the vendor has two performance obligations: (1)
a one-year term license and (2) one month of PCS. The
contract terms are one year for the license and one
month for the PCS. While the customer has the right to
terminate the contract at the end of each month without
paying the vendor a penalty, the customer has, in
substance, paid up front for the one-year term license
since the fee for the license is nonrefundable and the
customer retains the right to use the license for the
entire year, even if the contract is terminated.
However, the termination provision is treated similarly
to a renewal option for PCS since there is a pro rata
refund for PCS. Therefore, the incremental fee to renew
the contract each month is for optional renewals of PCS
only. In addition, the contract does not give the
customer a material right since (1) the annual renewal
provision is priced at the stand-alone selling prices of
the term license and PCS and (2) the monthly renewal of
PCS is priced at the stand-alone selling price of
PCS.
Example 5-18
Nonrefundable License Fees and Pro Rata Refund for
Mandatory PCS
A vendor sells a one-year term-based license with PCS for
an up-front fee of $1.25 million. The stand-alone
selling prices of the license and PCS are $1 million and
$250,000, respectively. The vendor’s customer has the
right to terminate the arrangement at its convenience at
the end of each month without paying any penalty. If the
customer terminates, it loses the right to use the
software and receive support, but it receives a pro rata
refund that is based on the PCS fee stated in the
contract. The vendor intends to enforce compliance with
the requirement to relinquish the use of the term
license if PCS is not renewed. The stated fee for PCS
($250,000) is refundable, and the remainder of the
up-front payment for the license ($1 million) is
nonrefundable. The customer also has the right to renew
the contract annually for the same fee.
Under the assumption that the license is distinct from
the PCS, we believe that it may be reasonable to
conclude that the vendor has three performance
obligations: (1) a one-month term license, (2) one month
of PCS, and (3) a material right. If the termination
provision is substantive, the contract term is likely to
be one month (i.e., the enforceable rights and
obligations are likely to be limited to one month). The
customer has the right to terminate the contract at the
end of each month without paying the vendor a penalty.
While the customer does not receive a refund of the
up-front payment of $1 million and also loses the right
to use the software license in the event of a
termination, neither loss is considered a substantive
termination penalty. ASC 606 specifies that a
termination penalty compensates the other party. We do
not believe that the relinquishment of the software
would be considered a termination penalty because the
customer is not compensating the vendor for terminating
the contract. Because software licenses are typically
sold on a nonexclusive basis and can be replicated an
unlimited number of times at minimal or no cost, no
substantive asset is returned to the vendor (i.e., the
vendor does not receive a returned product that it can
resell or otherwise obtain economic value from). Such
licenses can be contrasted with exclusive licenses to
IP, which may have value if returned to a vendor. In
addition, we do not believe that the loss of the
up-front, nonrefundable payment is compensation to the
vendor because the initial contract already gave the
vendor the right to that payment (i.e., the vendor
retains the payment irrespective of whether the customer
cancels or renews the contract). Rather, the up-front
nonrefundable fee should be assessed under ASC
606-10-55-50 and 55-51.
The termination provision is treated similarly to a
renewal option since there is a pro rata refund for PCS
if the contract is terminated (which can also be viewed
as an incremental fee to renew). In deciding not to
terminate the contract (i.e., by renewing the contract),
the customer renews both the term license and PCS,
because if PCS is not renewed, the customer loses the
right to the license. Therefore, because of the
termination provision, the vendor might conclude that
present enforceable rights and obligations only exist
for a term license and PCS for one month.
In evaluating whether the up-front, nonrefundable fee is
either (1) a payment for the transfer of promised goods
or services in the initial contract or (2) an advance
payment for future goods or services, the vendor should
determine whether a material right has been provided for
the monthly renewals.15 If the contract is renewed, the incremental fee
(i.e., the refundable portion) is only associated with
the stated PCS fee. In effect, the customer obtains
control of both a term license and PCS by only paying
the fee for PCS. Since the monthly renewal is priced at
a significant and incremental discount to the price that
would be charged to similarly situated customers (i.e.,
the term license and PCS are not renewed at their
stand-alone selling prices), the customer receives a
material right. That material right would be accounted
for as a performance obligation that is recognized with
the renewals of the term license and PCS. If the
practical alternative in ASC 606-10-55-45 is elected,
the transaction price would be allocated to the renewals
of the term license and PCS by reference to the renewals
expected to be provided and the corresponding expected
consideration. If renewals are expected over the entire
stated term (i.e., one year), the entire contractually
stated fee (i.e., $1.25 million) would be allocated
evenly to each monthly term license and PCS. The amount
associated with each month (approximately $104,000)
would then be allocated to the one-month term license
and PCS and recognized when the customer obtains control
of the term license (at a point in time at the beginning
of each month) and as PCS is provided (ratably over the
month) on the basis of their relative stand-alone
selling prices.
For a vendor to conclude that a termination provision
affects the contract term, the provision must be
substantive (i.e., the customer is making a purchasing
decision to renew or terminate the contract). In
determining whether the termination/renewal provision is
substantive, the vendor should consider quantitative and
qualitative factors. For example, the amount subject to
refund must be substantive relative to the total
contract fee. Further, there should be a business
purpose for the provision, and the vendor must intend to
enforce the requirement to relinquish the use of the
term license if PCS is not renewed. The factors to
consider and the relevance of those factors will depend
on the specific facts and circumstances of each
arrangement, and the use of significant judgment may be
required. Companies are therefore encouraged to consult
with their accounting advisers and auditors.
Example 5-19
Nonrefundable License Fees and Nonsubstantive Pro Rata
Refund for Mandatory PCS
A vendor sells a one-year term-based license with PCS for
an up-front fee of $1.25 million. The stand-alone
selling prices of the license and PCS are $1 million and
$250,000, respectively. The vendor’s customer has the
right to terminate the arrangement at its convenience at
the end of each month without paying any penalty. If the
customer terminates, it loses the right to use the
software and receive support, but it receives a pro rata
refund for PCS. The vendor intends to enforce compliance
with the requirement to relinquish the use of the term
license if PCS is not renewed. The stated fee for PCS is
$50,000, and the remainder of the up-front payment ($1.2
million) is nonrefundable. The customer also has the
right to renew the contract annually for the same
fee.
Under the assumption that the license is distinct from
the PCS, we believe that it is reasonable to conclude
that the vendor has two performance obligations: (1) a
one-year license and (2) one year of PCS. The contract
term is likely to be one year (i.e., the enforceable
rights and obligations are likely to be for the full
stated term). The customer has the right to terminate
the contract at the end of each month without paying the
vendor a penalty. While the customer does not receive a
refund related to the up-front payment of $1.2 million
and also loses the right to use the software license in
the event of a termination, neither loss is a
substantive termination penalty. However, unlike the
termination provision in Example 5-18, the provision in this
scenario is not likely to be considered substantive
since the amount subject to refund is only $50,000.
In evaluating whether the up-front nonrefundable fee is
either (1) a payment for the transfer of promised goods
or services in the initial contract or (2) an advance
payment for future goods or services, the vendor would
consider that substantially all of the total contract
fee is the up-front nonrefundable fee. The customer has
the right to terminate the contract at the end of each
month without paying the vendor a penalty; however, the
customer has, in substance, substantially paid up front
for all the stated goods and services in the contract —
the one-year term license and one year of PCS. That is,
while a termination provision is treated similarly to a
renewal option, there is no substantive incremental fee
to “renew” the contract (i.e., there is no substantive
refundable payment for terminating the contract).
Therefore, as in Example
5-16, the nonrefundable up-front fee (in
addition to the nonsubstantive refundable payment) is
considered an up-front payment for the term license and
PCS for the full year. In addition, the contract does
not give the customer a material right since the annual
renewal provision is priced at the stand-alone selling
prices of the term license and PCS.