Revenue Impacting Contract Terms: Early Cancellation Rights and the Right to Refund
Our series of analyzing non-standard contract terms for revenue impact brings us to early cancellation rights. Early cancellation can come in many forms including termination for convenience which we focused on in our post on June 19th. Giving a customer the right to cancel the contract can also be fore cancellation for failure to deliver a software feature, issues with acceptance testing, or simply customer satisfaction, to name a few. In addition to the many flavors of early cancellation, the right to refund could span from no refund at all to a full refund, and anywhere in between.
Companies must assess the right to refund for early cancellation at the onset of the contract and re-assess at relevant periodic intervals such as the passing of a specified date in the contract or on a monthly / quarterly basis depending on the company’s reporting cadence. If the assessment determines that there is an impact to the transaction price in the contract, there could be both a balance sheet and income statement impact. If the assessment results in an adjustment to the term of the contract, the most likely impact is to the balance sheet alone. Given the right to cancel and the particular refund language, an assessment could be made that there is no contract until the right to cancel has expired. Here are some illustrative examples:
Contract Clause Example:
Customer may elect to terminate its subscription to the Software by delivering written notice to Seller no later than January 1, 2021 (the “Due Date”). If Seller receives such notice by the Due Date, the Software subscription fees shall be reduced by $100,000.
Given the right to cancel and the particular refund language, an assessment could be made that there is no contract until the right to cancel has expired.
Assessment Example:
The customer here has a specific date by which they have the ability to terminate the subscription to the Software. If the customer does terminate the subscription, the fees will be reduced, but there will not be a full refund. Therefore, this clause could have an impact on both the transaction price and the term of the contract. However, the company will assess that a contract exists. There is also some subjectivity in the accounting analysis. For example, how likely is the customer to terminate? Does the company offer this clause to many customers, and is the resulting cancellation high or low? If the company’s revenue accounting policy allows, this may be factored into the assessment.
For this example, let’s assume that the company’s policy is strict in that if the customer has a right to cancel early, the company will account for the customer contract as if the customer will exercise that right. Let’s also assume that the original transaction price is $200,000 for a 1 year SaaS subscription starting on July 1, 2021.
Revenue Accounting Conclusion Example:
Being that the customer has the right to cancel this contract at the 6 month mark, we consider this a 6 month contract. If the customer cancels, total fees for the contract will be $100,000, and the contract will terminate on December 31, 2020. Therefore, we will recognize $100k ratably from July 1, 2020 through December 31, 2020. $100k of the original transaction price will be reclassified from deferred revenue to a refund liability account.
If on January 1, 2021 the customer has not exercised their option to cancel, we will reclass the $100k back to deferred revenue and recognize the remaining balance over the remaining term of January 1, 2021 through June 30, 2021.
Alternative Scenario 1:
If we take the same contract clause, but change the refund to be the full $200k fee, then we will not account for this transaction until the right to a refund has expired. Therefore, there is no contract until January 1, 2021 when the customer has decided not to cancel. At this point, the contract will be assessed as if there is no remaining cancellation right.
Alternative Scenario 2:
Assuming the same facts as in the original example, but that the customer would not receive a refund if the termination right is exercised by the due date, we can account for the full contract, term, and transaction price up front. Because there is no right to refund, the customer’s cancellation will only take effect after the end of the term. Therefore, we will recognize the $200k ratably over the 1 year term as the company delivers the subscription service.
Alternative Scenario 3:
Let’s use the same contract clause, but assume that the contract is for 75 users for the annual term. Also, an additional 50 users (for a total of 125) will be added for the second half of the term if feature X is delivered in software updates by December 31st, 2020. In this instance, the term of the contract does not change, but the transaction price does. If the feature is not available on or before December 31st, the customer will still use the subscription for the full term, but the customer will receive a refund of $50k, or the contracted fee for the additional users expected from the addition of feature X. Therefore, we will recognize revenue of $150k ratably over the full contract term. If the cancellation right is exercised, there is no change to the accounting on the contract, and the customer will receive a refund of $50k. If the cancellation right is not exercised, the $50k will be recognized over the 2nd half of the contract term along with the ratable recognition of the original $150k transaction price.
Up Next
Stay tuned for our next post in the series: Variable Consideration
