Non-refundable upfront fees

Case – Non-refundable upfront fees: Annual contract

Cable Company C enters into a one-year contract to provide cable television to Customer Z. In addition to a monthly service fee of 100, C charges a one-time upfront fee of 50. C has determined that its set-up activity does not transfer a promised good or service to Z, but is instead an administrative task.

At the end of the year, Z can renew the contract on a month-to-month basis at the then-current monthly rate or can commit to another one-year contract at the then-current annual rate. In either case, Z will not be charged another fee on renewal. The average customer life for customers entering into similar contracts is three years.

C considers both quantitative and qualitative factors to determine whether the upfront fee provides an incentive for Z to renew the contract beyond the stated contract term to avoid the upfront fee. If the incentive is important to Z’s decision to enter into the contract, then there is a material right.

First, C compares the upfront fee of 50 with the total transaction price of 1,250 (the upfront fee of 50 plus the service fee of 1,200 (12 × 100)). It concludes that the non-refundable upfront fee is not quantitatively material.

Second, C considers the qualitative reasons that Z might renew. These include, but are not limited to, the overall quality of the service provided, the services and related pricing provided by competitors and the inconvenience to Z of changing service providers (e.g. returning equipment to C, scheduling installation by the new provider).

C concludes that although avoidance of the upfront fee on renewal is a consideration to Z, this factor alone does not influence Z’s decision over whether to renew the service. C concludes based on its customer satisfaction research data that the quality of service provided and its competitive pricing are the key factors underpinning the average customer life of three years.

Overall, C concludes that the upfront fee of 50 does not convey a material right to Z.

As a result, C treats the upfront fee as an advance payment on the contracted one-year cable services and recognises it as revenue over the one-year contract term. This results in monthly revenue of 104 (1,250 / 12) for the one-year contract.

Conversely, if C determined that the upfront fee results in a contract that includes a customer option that is a material right, then it would allocate the total transaction price including the upfront fee between the one-year cable service and the material right to renew the contract (see Customer options for additional goods or services).

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Quantitative and qualitative indicators are considered when assessing upfront fees

An entity considers both quantitative and qualitative factors when assessing whether a non-refundable upfront fee results in a contract that includes a customer option that is a material right, because it would probably impact the customer’s decision on whether to exercise the option to continue buying the entity’s product or service. This is consistent with the notion that an entity considers valid expectations of the customer when identifying promised goods or services. Therefore, a customer’s perspective on what constitutes a ‘material right’ includes consideration of qualitative factors as well as quantitative factors.

The following factors may be helpful in the assessment:

• the renewal price compared with the price in the initial contract with the upfront fee;
• the availability and pricing of service alternatives; and
• the history of renewals.

Some factors that could influence a customer’s decision to renew the contract may not be determinative on their own – e.g. the quality of service or convenience of not changing providers.

An entity needs to consider all quantitative and qualitative factors and exercise judgement in determining whether a non-refundable upfront fee results in a contract that includes a customer option that is a material right.

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Determining whether a non-refundable upfront fee relates to the transfer of a promised good or service

In many cases, even though a non-refundable upfront fee relates to an activity that the entity is required to undertake at or near contract inception to fulfil the contract, that activity does not result in the transfer of a promised good or service to the customer.

When assessing whether the upfront fee relates to the transfer of a promised good or service, an entity considers all relevant facts and circumstances, including whether:

• a good or service is transferred to the customer in exchange for the upfront fee and the customer is able to realise a benefit from the good or service received. If no good or service is received by the customer or if the good or service is of little or no value to the customer without obtaining other goods or services from the entity, then the upfront fee is likely to represent an advance payment for future goods or services; and
• if the entity does not separately price and sell the initiation right or activities covered by the upfront payment, then the payment may not relate to the transfer of a promised good or service.

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Upfront fee may need to be allocated

Even when a non-refundable upfront fee relates to a promised good or service, the amount of the fee may not equal the relative stand-alone selling price of that promised good or service; therefore, some of the non-refundable upfront fee needs to be allocated to other performance obligations. For further discussion on allocation, follow this link.

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Deferral period for non-refundable upfront fee depends on whether the fee provides a material right

A non-refundable upfront fee may provide the customer with a material right if the fee is significant enough that it is likely to impact the customer’s decision on whether to reorder a product or service – e.g. to renew a membership or service contract, or order an additional product.

If the payment of an upfront fee results in a contract that includes a customer option that is a material right, then the fee is recognised over the period during which the customer consumes the good or service that gives rise to the material right. Determining that period will require significant judgement, because it may not align with the stated contractual term or other information historically maintained by the entity – e.g. the average customer relationship period.

When the upfront fee is not deemed to provide a material right and the cost amortisation period is determined to be longer than the stated contract period, the period over which a non-refundable upfront fee is recognised as revenue differs from the amortisation period for contract costs.

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Consideration of whether a non-refundable upfront fee gives rise to a significant financing component

An entity will need to consider whether the receipt of an upfront payment gives rise to a significant financing component within the contract. All relevant facts and circumstances will need to be evaluated, and an entity may need to apply significant judgement in determining whether a significant financing component exists (follow this link). (IFRS 15.60)

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Upfront fees in the funds and insurance industries

In the funds industry, there may be two separate contracts:

• the first between the investor and the fund’s manager (brokerage or sales contract, whereby the fund manager acts as an agent for the fund); and
• the second between the fund’s manager and the fund itself (investment management contract).

The fund manager assesses whether the upfront fee receivable for the sale of units of a (retail) fund relates to the transfer of a promised service (i.e. a brokerage service) or if it is an advance payment for an investment management service to be satisfied in the future.

By contrast, in the insurance industry it appears that there is generally no distinct brokerage service because insurers enter into a single contract with policyholders (investors) and the contract is sold as a net package.

Case – Non-refundable upfront fees: Activity no transfer a good or service

Stock Exchange S enters into a contract with Customer C to be listed on S’s exchange. S charges C a non-refundable upfront fee on the initial listing of 50 and an ongoing annual listing fee of 100. The initial listing fee compensates S for activities that it needs to undertake to enable admission to the exchange – e.g. due diligence and reviewing the listing application.

S determines that the performance of the activities at contract inception does not transfer a good or service to C – i.e. there is no promise in the contract other than the service of being listed on the exchange.

S concludes that the non-refundable upfront fee is an advance payment for the ongoing listing service.

Case – Non-refundable upfront fees: Investment management services

Investment Management Company U enters into a one-year contract to provide investment management services to Investor X.

In addition to a monthly fee of 1% of the managed assets, U charges a one-time subscription fee of 50. U determines that this is a set-up activity that does not transfer a service to X, but instead is an administrative task. U expects to earn a monthly fee of 10 from the contract.

At the end of the year, X can renew the contract on a month-to-month basis, at a similar monthly rate. X will not be charged another fee on renewal.

U considers both quantitative and qualitative factors when determining whether the upfront fee provides an incentive for X to renew the contract beyond the stated contract term:

• U compares the upfront fee of 50 with the total transaction price of 170 – i.e. the variable fee of 120 plus the upfront fee of 50. It concludes that the non-refundable upfront fee is quantitatively material; and
• U considers the qualitative reasons why X might renew the contract. It notes that competitors charge similar management fees and subscription fees to investors for similar contracts.

These factors are also reflected in a strong history of renewals and an average customer life that is longer than one year.

U concludes that the upfront fee results in a contract that includes a customer option that is a material right. Therefore, it allocates the upfront fee between the one-year investment management services and the material right to renew the contract. U recognises the consideration allocated to the material right over the renewal periods that give rise to the material right. This period may be shorter than the average customer life.

Case – Activation fee in a month-to-month telco wireless contract

Telco B charges a one-time activation fee of 25 when Customer D enters into a month-to-month contract for a voice and data plan that costs 50 per month.

D has no obligation to renew the contract in the subsequent month. If D does renew, then no activation fee will be charged in the second or subsequent months. B’s average customer life for month-to-month contracts is two years.

B concludes that there are no goods or services transferred to D on activation. Therefore, the upfront fee does not relate to a good or service and the only performance obligation in the arrangement is the voice and data plan. The activation is merely an administrative activity that B needs to perform to allow D to access its network. (IFRS 15.B49)

The activation fee is considered an advance payment for future goods or services and included in the transaction price in Month 1.

B then assesses whether the option to renew the contract without paying the activation fee on renewal represents a material right for D. B considers both qualitative and quantitative factors in determining whether D has a material right to renew at a discount. (IFRS 15.B40)

D pays 75 in Month 1 and would pay 50 in each subsequent month for which it renews. Therefore, the ‘discount’ on the renewal rate is quantitatively material. B also notes that D is likely to renew the contract beyond the first month based on the average customer life, and that D’s decision to renew is likely to be significantly affected by the upfront fee.

Therefore, B concludes that the activation fee is a prepayment for future goods and services and represents a material right. B recognises the activation fee over the period for which D consumes the services that give rise to the material right. This period may be shorter than the average customer life.