Contract enforceability and termination clauses – The best complete 1 read

Contract enforceability and termination clauses is about those troubles, get your money as entitled or end a contract before you lose too much money. Contract enforceability of rights (AND obligations) in a contract is a matter of law. An entity has to determine the duration of the contract (i.e., the stated contractual term or a shorter period) before applying certain aspects of the revenue model (e.g., identifying performance obligations, determining the transaction price).

The contract duration under IFRS 15 is the period in which parties to the contract have present enforceable rights and obligations. An entity cannot Prohibitedassume that there are present enforceable rights and obligations for the entire term stated in the contract and it is likely that an entity will have to consider enforceable rights and obligations in individual contracts, as described in IFRS 15 11.

The period in which enforceable rights and obligations exist may be affected by termination provisions in the contract. Significant judgement will be required to determine the effect of termination provisions on the contract duration. Under the standard, this determination is critical because the contract duration to which the standard is applied may affect the number of performance obligations identified and the determination of the transaction price. It may also affect the amounts disclosed in some of the required disclosures.

Oral contract and contract enforceability

IT Support Co. provides online technology support for customers remotely via the internet. For a flat fee, IT Support Co. will scan a customer’s personal computer (PC) for viruses, optimise the PC’s performance and solve any connectivity problems. When a customer calls to obtain the scan services, IT Support Co. describes the services it can provide and states the price for those services.

When the customer agrees to the terms stated by the representative, payment is made over the telephone. IT Support Co. then gives the customer the information it needs to obtain the scan services (e.g. an access code for the website). It provides the services when the customer connects to the internet and logs onto the entity’s website (which may be that day or a future date).

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In this example, IT Support Co. and its customer are entering into an oral agreement, which is legally enforceable in this jurisdiction, for IT Support Co. to repair the customer’s PC and for the customer to provide consideration by transmitting a valid credit card number and authorisation over the telephone.

The required criteria for a contract with a customer (see step 1 identify the contract with the customer) are all met. As such, this agreement would be within the scope of IFRS 15 at the time of the telephone conversation, even if the entity has not yet performed the scanning services.

Termination clauses and termination payments affecting the duration of a contract

Entities need to carefully evaluate termination clauses and any related termination payments to determine how they affect contract duration (i.e., the period in which there are enforceable rights and obligations).

In general enforceable rights and obligations are considered to exist throughout the term in which each party has the unilateral enforceable right to terminate the contract by compensating the other party. For example, if a contract includes a substantive termination payment, the duration of the contract would equal the period through which a termination penalty would be due. This could be the stated contractual term or a shorter duration if the termination penalty did not extend to the end of the contract.

However, the determination of whether a termination penalty is substantive, and what constitutes enforceable rights and obligations under a contract, requires judgement and consideration of the facts and circumstances. Also it should be noted that if an entity concludes that the duration of the contract is less than the stated term because of a termination clause, any termination penalty should be included in the transaction price. If the termination penalty is variable, the requirements for variable consideration, including the constraint, would be applied.

Contract enforceabilityIf each party has the unilateral right to terminate a ’wholly unperformed’ contract (as defined in IFRS 15 12) without compensating the counterparty, IFRS 15 states that, for purposes of the standard, a contract does not exist and its accounting and disclosure requirements would not apply.

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This is because the contracts would not affect an entity’s financial position or performance until either party performs. Any arrangement in which the entity has not provided any of the contracted goods or services and has not received or is not entitled to receive any of the contracted consideration is considered to be a ‘wholly unperformed’ contract.

The requirements for ’wholly unperformed’ contracts do not apply if the parties to the contract have to compensate the other party if they exercise their right to terminate the contract and that termination payment is considered substantive. Significant judgement will be required to determine whether a termination payment is substantive and all facts and circumstances related to the contract should be considered.

Contract modification and Contract enforceability

IFRS 15 indicates that an entity may have to account for a contract modification prior to the parties reaching final agreement on changes in scope or pricing (or both). Instead of focusing on the finalisation of a modification, IFRS 15 focuses on the enforceability of the changes to the rights and obligations in the arrangement. Once the entity determines the revised rights and obligations are enforceable, the entity accounts for the contract modification.

The standard provides the following example to illustrate this point, IFRS 15 example 9: Unapproved change in scope and price [IFRS 15.IE42-IE43]

An entity enters into a contract with a customer to construct a building on customer-owned land. The contract states that the customer will provide the entity with access to the land within 30 days of contract inception. However, the entity was not provided access until 120 days after contract inception because of storm damage to the site that occurred after contract inception.

The contract specifically identifies any delay (including force majeure) in the entity’s access to customer-owned land as an event that entitles the entity to compensation that is equal to actual costs incurred as a direct result of the delay. The entity is able to demonstrate that the specific direct costs were incurred as a result of the delay in accordance with the terms of the contract and prepares a claim. The customer initially disagreed with the entity’s claim.

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The entity assesses the legal basis of the claim and determines, on the basis of the underlying contractual terms, that it has enforceable rights.

Consequently, it accounts for the claim as a contract modification in accordance with paragraphs 18-21 of IFRS 15. The modification does not result in any additional goods and services being provided to the customer. In addition, all of the remaining goods and services after the modification are not distinct and form part of a single performance obligation.

Consequently, the entity accounts for the modification in accordance with paragraph 21(b) of IFRS 15 by updating the transaction price and the measure of progress towards complete satisfaction of the performance obligation. The entity considers the constraint on estimates of variable consideration in paragraphs 56-58 of IFRS 15 when estimating the transaction price.

Once an entity has determined that a contract has been modified, the entity determines the appropriate accounting treatment for the modification.

Certain modifications are treated as separate stand-alone contracts, while others are combined with the original contract.

The requirement to determine whether to treat a change in contractual terms as a separate contract or a modification to an existing contract is relatively consistent with the requirements in IAS 11 for construction contracts. [IAS 11.13].

Also read: Contract enforceability

Contract enforceability

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