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Termination Clauses

Termination clauses can impact the contract term, which has implications for all steps of the revenue model. Read about the most common issues that entities face related to termination clauses.

Josh Mortensen
Lydia Sheffield
Published:
Apr 6, 2020
Updated:

Accounting Standards Codification (ASC) 606 defines a contract as an agreement between two or more parties that creates enforceable rights and obligations. Because termination clauses frequently impact the contractual period of enforceable rights and obligations, entities should evaluate termination clauses to determine whether the contract term differs from the stated term in the contract.

How To

When two parties form a contract, the contract term under ASC 606—also called the contract duration—is often equal to the stated term in the contract. However, when one or both of the parties have a right to terminate the contract, the contract term may vary from the stated term. This difference occurs because some termination clauses grant rights that impact the period of enforceable rights and obligations. Many termination for convenience clauses fall in this category and must be carefully evaluated to determine the correct contract term. Notably, clauses that allow termination for breach of contract usually do not impact the period of enforceable rights and obligations and are not addressed in this article.

Determining the correct contract term (i.e., period of enforceable rights and obligations) is critical because it can affect the number of performance obligations identified, the transaction price, the timing of revenue recognition, and the disclosed amount in required disclosures. This article identifies how the following issues may affect the contract term:

  • Termination Without Penalty
    • Wholly Unperformed Contracts
    • Period-to-Period Contracts
  • Termination With Penalty
    • Substantive Penalties
    • Non-Substantive Penalties
  • Fiscal Funding Clauses
  • Past Practice of Non-Enforcement
  • Conflicting Termination Rights

Termination Without Penalty

Of contracts that allow termination without penalty, entities most often have questions about the contract term of wholly unperformed contracts and period-to-period contracts.

Wholly Unperformed Contracts

A contract is wholly unperformed if both parties (1) have not received consideration, (2) are not entitled to consideration, and (3) have not transferred control of any promised goods or services (ASC 606-10-25-4). If both parties have the right to terminate a wholly unperformed contract without penalty, ASC 606 specifies that a contract does not exist until performance occurs because neither party has enforceable rights and obligations. Because these contracts are initially not within the scope of ASC 606, revenue recognition must be delayed until performance occurs, even if the revenue would normally be recognized over time.

Example 1: Both Parties Can Terminate A Wholly Unperformed Contract Without Penalty
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Trucker enters into a one-month contract with Customer to provide timber delivery services. Payment, which is due at the end of the month, is based on a fixed rate per hour spent delivering timber. Either party can terminate the contract at any time without penalty, and payment is only due for services performed up to the date of termination.

In this example, the contract is initially wholly unperformed because neither party has received consideration, is entitled to consideration, or has transferred control of any promised goods or services. Because both parties can terminate at any time without compensating the other party up until Trucker provides services, no contract exists until performance occurs. Consequently, Trucker cannot recognize revenue until performance occurs and is not required to make any disclosures that would otherwise be required under ASC 606. This determination is significant because if a contract did exist, Trucker likely would recognize revenue evenly over the one-month period and be required to make certain disclosures, such as significant judgments made about variable consideration in the contract.

In contrast to Example 1, if a wholly unperformed contract can be terminated without penalty by only the customer, a contract may still exist because “the entity is obliged to stand ready to perform at the discretion of the customer” (Accounting Standards Update (ASU) 2014-09 BC50).

Example 2: Only The Customer Can Terminate A Wholly Unperformed Contract Without Penalty
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Trucker enters into a one-month contract with Customer to provide timber delivery services. Payment, which is due at the end of the month, is based on a fixed rate per hour spent delivering timber. Customer may terminate the contract at any time without penalty, and payment is only due for services performed up to the date of termination.

In this example, the contract is initially wholly unperformed because neither party has received consideration, is entitled to consideration, or has transferred control of any promised goods or services. However, because only Customer can terminate the contract without penalty, a contract still exists under ASC 606. Trucker determines that the primary performance obligation in the contract is that of standing ready, and variable consideration from the contract with Customer is estimated and recognized straight-line over the one-month period.

Period-to-Period Contracts

Some contracts may continue indefinitely unless cancelled at the end of each period. Other contracts may offer renewal options at the end of each period. Both types of period-to-period contracts should be accounted for in the same way. The Financial Accounting Standards Board (FASB) illustrated this point by comparing two contracts:

  • Contract 1 lasts one year and contains the option to renew for one additional year at the end of years one and two.
  • Contract 2 lasts three years and contains the option to cancel at the end of each year.

The following diagram shows the congruence of these two contracts:

One-year contracts include the option to renew each year and three-year contract can be cancelled each year.

Furthermore, period-to-period contracts are usually accounted for in the same way regardless of whether both parties or only the customer can terminate the contract without penalty. In either case, the contract term of a period-to-period contract extends until the earliest date at which termination can occur without penalty. For example, the contract term of a one-year contract that allows for termination without penalty at the end of each month would extend to the end of the current month. If a contract requires advance notice of termination, the contract term is equal to the period of advance notice because enforceable rights and obligations are guaranteed during this period. In all period-to-period contracts, an option for a customer to terminate (or renew) a contract should be accounted for as a performance obligation only if it provides the customer with a material right. If the option provides the customer with a material right, the entity would need to adjust its disclosures to reflect the transaction price amount allocated to the additional outstanding performance obligation (i.e., material right) and include any significant judgments in determining the standalone selling price (SSP) of the option.

Example 3: Customer Can Terminate Without Penalty At The End Of Each Year
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Trucker enters into a three-year contract with Customer to provide timber delivery services. At the end of each year, Customer can terminate the contract without penalty. Payment is due at the beginning of each year in the following amounts:

  • Year 1: $100,000 (equal to the SSP of the timber delivery services for Year 1)
  • Year 2: $75,000
  • Year 3: $50,000

In this example, because no penalty is assessed for cancellation at the end of each year, the contract term is one year even though the stated term is three years. Years 2 and 3 are considered an option to Customer. Because Customer receives a discount in Years 2 and 3 (assuming the SSP of the services remains constant), the option to purchase additional timber delivery services must be evaluated for a material right. If the right is material, the option is a performance obligation, and the transaction price of the contract must be allocated to the option based on an estimate of the option’s SSP. If the option expires unexercised, consideration allocated to the material right is recognized immediately. If the option is exercised, the exercise is accounted for as a contract modification or as an adjustment to the transaction price of the current contract, after which revenue is recognized upon transfer of the promised goods or services. For more information, see the RevenueHub article Customer Options for Additional Goods or Services.

Termination With Penalty

When identifying termination penalties, entities should remember that termination penalties may not always take the form of a cash payment, and a penalty may not be labeled as such in a contract. For example, entities may be subject to implicit termination penalties upon cancellation, such as the forced transfer of an asset to the vendor, the repayment of an up-front discount, or the forfeiture of an up-front fee. Notably, forfeiting an up-front fee may also be considered a termination penalty even when it is not otherwise refundable, such as when an entity forfeits an up-front fee paid for services to be provided.

The accounting for termination penalties depends on whether the penalty is considered substantive. Determining whether a penalty is substantive requires judgment, and entities should evaluate both quantitative and qualitative factors. For example, if a penalty significantly influences a customer’s decision of whether to cancel the contract, the penalty is likely to be substantive. Conversely, if contracts are routinely cancelled and termination penalties are regularly paid, these penalties are likely non-substantive. The following sections explain the difference in accounting treatment for substantive and non-substantive termination penalties.

Substantive Termination Penalties

Some entities initially suggested that a substantive termination penalty should be treated as a material right because such penalties represent an upfront fee that is waived if the customer chooses to renew (or not cancel) the contract. The TRG disagreed with this view, stating that a substantive termination penalty should instead be taken as evidence of enforceable rights and obligations throughout the contract term. TRG members recognized that calling a termination penalty a material right or concluding that a contract’s term is longer may have similar accounting results, but they wished to eliminate any diversity in practice by specifying the correct treatment. The TRG’s decision results in the following accounting treatment:

  • The penalty amount is ignored unless the contract is terminated, at which point the entity should follow guidance on contract modifications (for more information, see the RevenueHub article Contract Modifications Part I – Separate Contracts).
  • The contract term is equal to the period over which the termination penalty remains in effect.
Example 4: Substantive Termination Penalty
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Trucker enters into a three-year contract with Customer to provide timber delivery services. At the end of each year, Customer may cancel the contract by paying a $25,000 termination penalty. Payment is due at the beginning of each year in the following amounts:

  • Year 1: $100,000 (equal to the SSP of the timber delivery services)
  • Year 2: $75,000
  • Year 3: $50,000

If Trucker determines that the $25,000 penalty is substantive, the contract term is three years and the penalty amount is ignored unless the contract is terminated. Because the contract term encompasses all three years, Trucker does not need to assess whether the cancellation option provides a material right.

Non-Substantive Termination Penalties

If a termination penalty is non-substantive, enforceable rights and obligations may not exist for the entire contract. Consequently, the contract term is determined in the same way as cancellable contracts with no penalty. The penalty amount is included in the transaction price, and any cancellation or renewal options should be evaluated for a potential material right.

Example 5: Non-Substantive Termination Penalty
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Trucker enters into a three-year contract with Customer to provide timber delivery services. At the end of each year, Customer may cancel the contract by paying a $25,000 termination penalty. Payment is due at the beginning of each year in the following amounts:

  • Year 1: $100,000 (equal to the SSP of the timber delivery services)
  • Year 2: $75,000
  • Year 3: $50,000

If Trucker determines that the $25,000 penalty is non-substantive, the contract term is one year. The penalty amount is included in the transaction price, and the option to not cancel the contract is evaluated for a material right.

Fiscal Funding Clauses

Some contracts, particularly those in which the customer is a governmental entity, include a fiscal funding clause that allows the customer to cancel the contract if the respective funding authority does not approve further funding. The customer may fully intend to complete the contract in its entirety yet be forced to terminate in accordance with the funding authority’s decision. Depending on the legal jurisdiction, a funding contingency may cause the contract to be unenforceable and thus not a contract under ASC 606. Therefore, entities should consult with their respective legal department in determining to what extent enforceable rights and obligations exist. If a contract is deemed to exist despite the funding contingency, the contract term may be limited to the period in which funding has already been authorized. Alternatively, entities could treat the unfunded portion as variable consideration, subject to the constraint, and include an estimate of the amount to be received in the transaction price. For more information, see the RevenueHub article Variable Consideration and the Constraint.

Exmaple 6: Fiscal Funding Clause
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Trucker enters into a three-year contract with University to deliver construction materials. The contract contains a fiscal funding clause that allows University to cancel the contract at the beginning of each year if additional funding is not approved by the state legislature. Funding for Year 1 has already been approved.

After consulting with its legal department, Trucker determines that enforceable rights and obligations exist for Year 1 because funding has already been approved. However, enforceable rights and obligations do not exist for Years 2 and 3 due to the funding contingency. Therefore, the contract term is only one year.

Past Practice of Non-Enforcement

When an entity has a history of not enforcing a substantive termination penalty, the contract term depends on the applicable jurisdiction’s legal framework. If a past practice of non-enforcement legally restricts an entity’s enforceable rights and obligations, the contract term is limited to the period over which the substantive termination right is legally enforceable. If a past practice of non-enforcement does not change the legal enforceability of a termination penalty, the contract term is unaffected by past practice.

Example 7: Past Practice Of Non-Enforcement
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Trucker enters into a three-year contract with Customer to provide timber delivery services. At the end of each year, Customer may cancel the contract by paying a $25,000 termination penalty. Payment is due at the beginning of each year in the following amounts:

  • Year 1: $100,000 (equal to the SSP of the timber delivery services)
  • Year 2: $75,000
  • Year 3: $50,000

Assume the $25,000 is deemed to be substantive, and a history of non-enforcement legally restricts Trucker’s ability to enforce the penalty. If Trucker has no history of enforcing the $25,000 penalty at any time, the contract term is one year. If Trucker has a history of enforcing the $25,000 penalty at the end of Year 1 but not at the end of Year 2, the contract term is two years. If Trucker always enforces the penalty, the contract term is three years.

Conflicting Termination Rights

Master Service Agreements (MSAs) are commonly used in practice to govern the working relationship of two or more parties. A statement of work (SOW), which establishes the details for a specific project, will often be governed by the terms and conditions (T&Cs) of an MSA. This arrangement enables multiple SOWs to fall under an MSA, which reduces time spent negotiating legal terms. Entities in the software or SaaS industries often add another layer of complexity by including a professional services agreement (PSA), under an SOW, with unique T&Cs that apply only to implementation services.

When using multiple sets of T&Cs, entities may find that the termination clauses of an MSA, SOW, and/or PSA conflict with each other. In these situations, entities should first determine which document takes precedence by consulting with their legal department. The termination clause of the prevailing document should then be used in applying ASC 606.

Conclusion

Termination clauses and renewal options frequently affect the contract term by changing the contractual period of enforceable rights and obligations. In determining the contract term, entities must consider many factors, such as the nature of cancellation or renewal options, the substantiveness of any termination penalty, the enforceability of contracts with contingency funding, and any past practice of non-enforcement. Consulting with legal experts may also be necessary to determine legal enforceability or resolve conflicting termination rights. By identifying the proper contract term, entities will then be able to identify the appropriate performance obligations, determine the correct transaction price, and create the required disclosures in accordance with ASC 606.

Resources Consulted

Footnotes
Josh Mortensen
Lydia Sheffield
Apr 6, 2020