IFRS 15 Contract terms with customers – The standard is applied to the duration of the contract (i.e. the contractual period) in which the parties to the contract have presently enforceable rights and obligations.
A contract does not exist if each party to the contract has the unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party (or parties). IFRS 15 Contract terms with customers
A contract is ‘wholly unperformed’ if both of the following criteria are met:
It appears that an economic incentive to renew a contract is not relevant when evaluating the term of the contract because it does not give rise to enforceable rights or obligations. IFRS 15 Contract terms with customers
Contract term – Economic incentives
Company X enters into a month-to-month wireless contract with Customer Y that includes a handset and voice and data services. Y makes no up-front payment for the handset, but will pay the stand-alone selling price of the handset through monthly instalments over a 12-month period. If Y fails to renew the monthly wireless contract, then the remaining balance for the handset becomes due immediately. IFRS 15 Contract terms with customers
In addition, Y pays a monthly service fee for the voice and data services, which represents their stand-alone selling price. The contract does not include any payments other than for the handset and the services. IFRS 15 Contract terms with customers
In assessing the enforceability of the contract, X considers the amounts due if Y decides not to renew at the end of Month 1. X observes that the requirement to repay the remaining balance for the handset when the service contract is not renewed is an economic incentive for Y to renew. We believe that this economic incentive is not a substantive termination penalty, but instead is a repayment of a loan for goods already transferred. IFRS 15 Contract terms with customers
Because X cannot enforce the service contract for a period longer than one month, X concludes that the contract term is one month.
Contract term – Cancellation without penalty after a specified period
Contractor S enters into a manufacturing contract to produce 50 specialised sensors for Customer C for a fixed price of 2,000 per sensor. C can cancel the contract without a penalty after receiving 10 sensors. IFRS 15 Contract terms with customers
S determines that because there is no substantive compensation amount payable by C on termination of the contract – i.e. no termination penalty in the contract – it is akin to a contract to produce 10 sensors that gives C an option to purchase an additional 40 sensors. IFRS 15 Contract terms with customers
Contract term – Cancellable without penalty
Company X contracts with Customer R to provide its service offering for a flat fee of 130 per month, subject to annual increases based on the lesser of 2% or changes in the consumer price index (CPI). The stand-alone selling price for this service is 130. The contract term is indefinite and it is cancellable at the end of each month by either party without penalty.
X determines that the initial contract term is only one month and that the contract term will always be one month under this arrangement. This is because each party has the unilateral, enforceable right to terminate the contract at the end of the then-current month without compensating the other party.
A new contract is deemed to exist each month once each party chooses not to use its cancellation right for that period. IFRS 15 Contract terms with customers
- Contract term affects many parts of the standard – The determination of the contract term is important because it may affect the measurement and allocation of the transaction price, the collectability assessment, the timing of revenue recognition for up-front non-refundable fees, contract modifications, and the identification of material rights.
- Consideration payable on termination can affect assessment of contract term – If a contract can be terminated by compensating the other party and the right to compensation is considered substantive, then its duration is either the specified period or the period up to the point at which the contract can be terminated without compensating the other party.However, if a contract can be terminated by either party without substantive compensation, then its term does not extend beyond the goods and services already provided.In making the assessment of whether the right to compensation is substantive, an entity considers all relevant factors, including legal enforceability of the right to compensation on termination. If an entity has a past practice of not enforcing a termination penalty and that practice changes the legally enforceable rights and obligations, then that could affect the contractual term. IFRS 15 Contract terms with customers
- Compensation is broader than only termination payments – A payment to compensate the other party on termination is any amount (or other transfer of value – e.g. equity instruments) other than a payment due as a result of goods or services transferred up to the termination date. It is not restricted only to payments explicitly characterised as termination penalties. IFRS 15 Contract terms with customers
- Ability of either party to cancel the contract at discrete points in time may limit the contract term – If an entity enters into a contract with a customer that can be renewed or cancelled by either party at discrete points in time without significant penalty, then it accounts for its rights and obligations as a separate contract for the period during which the contract cannot be cancelled by either party. On commencement of each service period (e.g. a month in a month-to-month arrangement), in which the entity has begun to perform and the customer has not cancelled the contract, the entity normally obtains enforceable rights relative to fees owed for those services and a contract exists.
- Evergreen contracts – For the purpose of assessing contract term, an evergreen contract (i.e. a contract that automatically renews) that is cancellable by either party each period (e.g. on a month-to-month basis) without penalty is no different from a similar contract structured to require the parties to actively elect to renew the contract each period (e.g. place a new order, sign a new contract). In these situations, an entity should not automatically assume a contract period that extends beyond the current period (e.g. the current month).
- Only the customer has a right to terminate the contract – If only the customer has the right to terminate the contract without penalty and the entity is otherwise obliged to continue to perform until the end of a specified period, then the initial contract term ends on the earliest date on which the customer can terminate. The contract is evaluated to determine whether the customer option to continue the contract for the specified period gives the customer a material right (see also customer options for additional goods or services).
See also: The IFRS Foundation