Revenue Impacting Contract Terms: A Series
At the core of any technical revenue accounting function is participation in deals desk activities. The deals desk is generally run by Sales Operations, but the broader deals desk also includes Legal, Revenue Accounting, and Sales. For an enterprise software company, the deals desk is charged with working together to include terms in a company’s contracts with customers that are in line with the company’s business goals and policies and exclude terms that may lead to an unfavorable result on the company’s financial statements
At the core of any technical revenue accounting function is participation in deals desk activities. The deals desk is generally run by Sales Operations, but the broader deals desk also includes Legal, Revenue Accounting, and Sales.
One such policy is the company’s Revenue Recognition policy. There are an abundance of contractual terms that may impact revenue recognition and a company’s balance sheet or income statement. Over the next few weeks, we plan on performing a deep dive into these impactful contract terms in a series of posts explaining contract clauses, how they work and how they may impact your revenue recognition. Some examples of these terms are:
- Termination for Convenience
- Rate Card / Renewal Pricing Guarantee
- Option to Purchase Additional Products or Services
- Early Cancellation Rights & Refund
- Variable Consideration
- Non-Standard Renewal Option
- Opt-Out Option
- Right of Return
- Acceptance
- Non-Standard Service Level Agreement
- Whitelisted Features / Products
- Specified Future Upgrades
- Roadmap
- Broad Refund Rights
- Non-Cash Consideration
- Ramp / Step-up Pricing
- Discounting
- Non-Standard Billing
- Platform Transfer Right
- Non-Standard Warranty
- Non-Refundable Upfront Fees
Revenue Impacting Contract Terms: Termination for Convenience
Here we will focus on Termination for Convenience. Oftentimes, customers will want to have the flexibility to cancel a contract at any time, with some notification period, for any reason whatsoever or no reason at all. However, under the guidance in ASC 606, this could result in an impact to your balance sheet. Let’s go through a simple example:
Contract Clause:
Any party may terminate this Agreement at any time in its sole discretion by giving at least thirty (30) days’ written notice.
Assessment:
On the face of it, this contract term seems fairly equitable. Either party can cancel at any time within the contract term with 30 days notice. Therefore, under ASC 606, we must assess if this contract clause has an impact on the period of enforceable rights and obligations. Given that either party can terminate with 30 days notice, at any point of assessment, the rights and obligations of the parties are only required for 30 days. Therefore, this may be considered to be a 30 day contract if neither party has provided notice.
Oftentimes, customers will want to have the flexibility to cancel a contract at any time, with some notification period, for any reason whatsoever or no reason at all.
Another factor to consider in this example is fees. Let’s assume that the contract states that the customer will receive a refund of fees for any period after the effective date of termination, and will not incur a substantive penalty for cancelling. We will have to account for the potential refund fees in our assessment of the contract.
Revenue Accounting Impact:
Let’s assume that this agreement is for a one year subscription to a SaaS platform. The customer was invoiced for $1,200 on January 1, 2020 and paid the fees in line with the contractual payment terms. With the right to cancel and receive a refund, we would account for this contract as a 30 day contract on January 1st. Therefore, we would account for $100 in deferred revenue, or the amount that the customer would not receive in a refund if they were to give notice of cancellation on the first day of the contract. The remaining $1,100 would be accounted for as a refund liability.
Similarly, if we re-assess this contract on July 1, 2020, our deferred revenue balance would remain at $100 which is still the amount that the customer would not receive in a refund if they were to give notice on July 1st. The remaining balance of $500 would be accounted for as a refund liability. In this example, the customer has not issued notice of cancellation by June 30th. Therefore, we will have recognized $600 in revenue to date on this customer contract (or $100 each month between January and June).
If the contract allows for a substantive penalty for cancellation, the company will have to assess if this impacts the accounting conclusion as this may be considered evidence of enforceable rights and obligations throughout the contract term.
Up Next
Stay tuned for our next post: Revenue Impacting Contract Terms: Rate Card / Renewal Pricing Guarantee
