Nonrefundable Upfront Fees

In many circumstances, companies require customers to pay nonrefundable upfront fees. Examples include membership fees for a health club or an activation fee for cable, internet, or telephone services. Should revenue be recognized immediately or deferred over time? If the revenue should be deferred, over what time period should the revenue be deferred?

Considerations for Nonrefundable Upfront Fees

The revenue standard addresses this issue in Accounting Standards Codification (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 consideration received in connection with nonrefundable upfront fees should be added to the other consideration received in the contract. The total amount of consideration the entity expects to receive should then be allocated to the distinct performance obligations. In some cases, there may be a distinct performance obligation in connection with the upfront fee. If the fee is related to a distinct performance obligation, the revenue will be allocated to that performance obligation based on its relative standalone selling price. That amount may or may not be the same as the upfront fee. This can result because the timing of payments does not always correlate to the timing of goods or services delivered. This flow chart from KPMG illustrates clearly the thought process that should take place. Notice that if the fee does relate to specific goods or services transferred to a customer (a performance obligation), the amount recognized is the consideration allocated to the performance obligation rather than the amount of the fee.

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One issue relating to nonrefundable upfront fees arises when there is a contract renewal option that provides the customer with a material right. A material right is created when customers have an option to purchase additional goods or services for a material discount. For example, a material right is created when a health club charges a $100 membership fee upfront, in addition to $30 ongoing monthly payments for 1 year, but the contract allows for a renewal of the contract for additional years without another membership fee. The upfront fee does not relate to activities that transfer a good or service to the customer and does not represent a distinct performance obligation. The revenue associated with the fee would be allocated to the performance obligations within the contract, the gym service in this case, which is satisfied over the 12 months of the contract. If there is a renewal option that allows a customer to renew the one year contract without paying the additional fee, a material right may exist.

When evaluating if a material right exists, both quantitative and qualitative factors should be considered, as well as past and future transactions with the customer. If it is determined that the renewal option conveys a material right to the customer, the customer effectively pays in advance for additional goods or services, and the material right should be accounted for as a separate performance obligation. The entity should allocate revenue based on the relative standalone selling price of the option. Often, the standalone selling price of that option is not directly observable and must be estimated. See Standalone Selling Prices for additional discussion on the estimation of standalone selling prices. The associated revenue should then be recognized when that right is exercised or expires.

Although the standalone selling price of these options is often unobservable, a practical alternative to estimating the standalone selling price of the option can be found in ASC 606-10-55-45:

If a customer has a material right to acquire future goods or services and those goods or services are similar to the original goods or services in the contract and are provided in accordance with the terms of the original contract, then an entity may, as a practical alternative to estimating the standalone selling price of the option, allocate the transaction price to the optional goods or services by reference to the goods or services expected to be provided and the corresponding expected consideration. Typically, those types of options are for contract renewals.

This option is only available if the optional goods or services are similar to the goods or services being provided under the original contract. Using this approach, a company allocates the transaction price to the optional goods or services by spreading out the total amount of expected consideration over the entire period in which the entity expects to deliver those goods or services. For the example given above, the practical alternative would be available because the optional services, (the health clubs facilities and benefits), are the same as the services under the original contract. If the health club expects that the customer will renew the membership for one additional year, the company would recognize $34.17 each month for the 24 month period ((30*24 months + 100)/24 = 34.17).

Example A: Activation Fee Allocated Over The Life Of The Contract

Company A enters into a contract to provide cable television services for customer B for 1 year. Company A charges a $120 activation fee, at which point the company provides the customer with a cable box (which must be returned when the customer leaves) and sets up the customer’s account. The customer is required to make monthly payments of $50 for the continuing cable service. Customer B must pay an additional $120 fee the next year in order to obtain another year of cable service.

Even though there are activities that Company A must do associated with the upfront fee (such as set up the cable service), those activities do not transfer the service to the customer for which the customer contracted. The company should add the $120 from the fee to the monthly payments to calculate the total transaction price ($120 + 12 months * $50 = $720). All the revenue should be allocated to providing the cable service and recognized over the 12 month term, resulting in recognition of $60 per month.

Example B: Renewal Option That Conveys A Material Right

Assume the same facts as example A, except a renewal option now exists that enables the customer to renew the contract without paying an additional activation fee. Based on historical data, the company expects each customer to renew for one additional year before changing service providers.

In this example, the renewal option creates a material right for additional services for customer B. The renewal option is considered a separate performance obligation. The revenue allocated to the renewal option should be based on the relative standalone selling price or the practical alternative. The company elects to use the practical alternative by estimating the total consideration to be received and the total services expected to be provided to the customer ($120 + 24 months * $50 = $1,320). The company would recognize $55 dollars per month over the 2 years.

Example C: Upfront Fee That Relates Directly To A Performance Obligation

Assume the same facts as example A, except the cable box does not need to be returned to Company A, and can be used by Customer B with any cable service provider. In this situation, Company A determines that delivery of the cable box does represent a performance obligation.

To determine the amount of revenue to be recognized upon delivery of the cable box, Company A adds the upfront-fee to the monthly payments to determine the total transaction price. Company A then allocates part of the total transaction price to the delivery of the cable box based on its relative standalone selling price, and recognizes that revenue upon transfer of control of the cable box.

Contracts that involve a nonrefundable upfront fee are often long-term contracts. In long term contracts a significant financing component may exist. See Significant Financing Component for more information.

Company Example: Qualigen Therapeutics

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Qualigen Therapeutics is a firm that focused on developing treatments for adult and pediatric cancers with potential for Orphan Drug Designation. In its 2022 10-Q , it discusses about the revenue recognition process for nonrefundable upfront fees related to licenses and emphasize the distinction between licenses considered distinct from other obligations versus those bundled with additional services.

It says “If the license to the Company’s intellectual property is determined to be distinct from the other performance obligations identified in the arrangement, the Company recognizes revenue from nonrefundable upfront fees allocated to the license when the license is transferred to the customer and the customer can benefit from the license. For licenses that are bundled with other performance obligations, management uses judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress for purposes of recognizing revenue from nonrefundable upfront fees. The Company evaluates the measure of progress each reporting period and, if necessary, adjusts the measure of progress and related revenue recognition.”

Company Example: Kirkland and Ellis LLP

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Kirkland and Ellis is an international law firm that serves a broad range of clients around the world. In its recent report, it discusses its accounting policies related to nonrefundable fees and providing the customer with a material right.

“Non-recurring service fees consist mainly of nonrefundable implementation fees. The implementation activities involve setting the client up and loading data into the Company’s cloud-based modules. The Company has determined that the nonrefundable upfront fees provide certain clients with a material right to renew the contract beyond the normal 30-day contractual period without payment of an additional upfront implementation fee. Implementation fees are deferred and recognized as revenue over the period to which the material right exists, which is the period the client is expected to benefit from not having to pay an additional nonrefundable implementation fee upon renewal of the service.”

Diversity in Thought

The Transition Resource Group (TRG) met and discussed nonrefundable upfront fees as part of its discussion of customer options for additional goods and services, due to the assessment required under ASC 606 of whether or not a material right for future goods and services exists in the contract. See the “Diversity in Thought” section of Customer Options for Additional Good or Service for a discussion on the TRG’s deliberations on issues surrounding customer options and material rights.

Conclusion

The consideration received for a nonrefundable upfront fee should be added to the total consideration and allocated to the distinct performance obligations in the contract. Companies should analyze whether the nonrefundable fee creates a material right, which would be a distinct performance obligation to which consideration needs to be allocated. There may be changes in the way companies account for nonrefundable upfront fees based on whether or not the fee relates to a distinct performance obligation and whether or not the fee creates a material right.

Resources Consulted

ASC 606-10-55-50 to 55-53
EY, Financial Reporting Developments: "Revenue from Contracts with Customers." September 2023. Section 5.6.
KPMG, Revenue Recognition Handbook: "Nonrefundable Upfront Fees." March 2024. Section 5.8.
PwC, "Nonrefundable Upfront Fees." May 2023. Section 8.4.