Accounting for revenue – I’ll extend it if you will!

As we’ve discussed in many previous articles, the IASB has issued IFRS 15, Revenue from Contracts with Customers, effective for annual reporting periods beginning on or after January 1, 2018.

The new standard is built around a five-step framework, the first step being to identify the contract(s) with the customer. Often of course, this step will be straightforward. However, plenty of situations exist in which an initial contractual period will be (say) automatically renewed for a defined period, unless one side or the other takes steps to terminate it. This might be an efficient way of structuring the arrangement where, for instance, the entity provides ongoing services to the customer that can’t readily be replaced by another provider, and they share a mutual interest in preserving a long-term relationship.

IFRS 15.11 acknowledges that some contracts may automatically renew on a periodic basis that is specified in the contract and goes on: “An entity shall apply this standard to the duration of the contract (i.e. the contractual period in which the parties to the contract have present enforceable rights and obligations.” IFRS 15.12 adds: “For the purpose of applying this Standard, 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).”

It’s not self-evidently clear what these passages amount to in all cases though. It’s a good illustration of the practical difficulties of dealing with this monster publication that further guidance on the renewal option question comes deep within the basis of conclusions document, at BC391 onwards:

  • “A renewal option gives a customer the right to acquire additional goods or services of the same type as those supplied under an existing contract…A renewal option could be viewed similarly to other options to provide additional goods or services. In other words, the renewal option could be a performance obligation in the contract if it provides the customer with a material right that it otherwise could not obtain without entering into that contract.
  • However, there are typically a series of options in cases in which a renewal option provides a customer with a material right. In other words, to exercise any option in the contract, the customer must have exercised all the previous options in the contract. The boards decided that determining the stand-alone selling price of a series of options would have been complex because doing so would have required an entity to identify various inputs, such as the stand-alone selling prices for the goods or services for each renewal period and the likelihood that the customers will renew for the subsequent period….
  • For that reason, the boards decided to provide an entity with a practical alternative to estimating the stand-alone selling price of the option. The practical alternative requires an entity to include the optional goods or services that it expects to provide (and corresponding expected customer consideration) in the initial measurement of the transaction price. In the boards’ view, it is simpler for an entity to view a contract with renewal options as a contract for its expected term (ie including the expected renewal periods) rather than as a contract with a series of options.
  • The boards developed two criteria to distinguish renewal options from other options to acquire additional goods or services. The first criterion specifies that the additional goods or services underlying the renewal options must be similar to those provided under the initial contract—that is, an entity continues to provide what it was already providing. Consequently, it is more intuitive to view the goods or services underlying such options as part of the initial contract…
  • The second criterion specifies that the additional goods or services in the subsequent contracts must be provided in accordance with the terms of the original contract. Consequently, the entity’s position is restricted because it cannot change those terms and conditions and, in particular, it cannot change the pricing of the additional goods or services beyond the parameters specified in the original contract…”

In its October 2014 meeting, the FASB/IASB joint revenue transition group discussed some issues relating to contract enforceability and termination clauses, concluding that such issues can generally be analyzed satisfactorily within the standard as it stands. They didn’t discuss any situations relating to renewal options, suggesting that this area isn’t generally likely to prove problematic. Still, some issues will certainly arise. For example, the IASB refers above to viewing “a contract with renewal options as a contract for its expected term (i.e. including the expected renewal periods) rather than as a contract with a series of options,” which makes sense, but the extent of the “expected renewal periods” may sometimes be subject to some judgment – for example, in situations where, if no one does anything about it, the contract might renew more than once. The second criterion above specifies that “the additional goods or services in the subsequent contracts must be provided in accordance with the terms of the original contract,” but this seems broad enough to encompass cases where, for instance, price increases occur in line with a formula laid out in the original agreement, even if the parties don’t know until later what this formula will yield. Still, as a practical matter, most parties to a contract will presumably be cautious enough about preserving their economic and strategic position that they’ll impose a limit on the number of automatic renewals that takes place under such circumstances…

The opinions expressed are solely those of the author

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