Option to renew a contract

Allocation of the transaction price to an option to renew a contract (application of IFRS 15)

Cloud Co. enters into a contract with a customer for a licence of its software and a non-cancellable one-year subscription to access the licensed application (the cloud services). The contract amount for the software licence is an upfront, non-refundable fee of CU1 million. The fee for the cloud services is CU500,000 for one year. The customer has the right to renew the cloud services each year for CU500,000. Option to renew a contract

Assume that Cloud Co. determines the software licence and cloud services are a single performance obligation. There are no other promised goods and services in the contract. Therefore, the upfront fee is not associated with the transfer of any other good or service to the customer. However, Cloud Co. determines there is an implied performance obligation. That is, the right to renew the cloud services each year for CU500,000 is a material right to the customer because that renewal rate is significantly below the rate the customer paid for the first year of service (CU1.5 million in total). Option to renew a contract

Based on its experience, Cloud Co. determines that its average customer relationship is three years. As a result, Cloud Co. determines that the performance obligations in the contract include the right to a discounted annual contract renewal and that the customer is likely to exercise twice. Option to renew a contract

If Cloud Co. determines there is an implied performance obligation to renew the cloud services each year for CU500,000, the option would be a material right to the customer because that renewal rate is significantly below the rate the customer paid for the first year of service (CU1.5 million in total). Option to renew a contract

Consequently, the renewal options would be separate performance obligations. Therefore, Cloud Co. would allocate the CU1.5 million transaction price to the identified performance obligations (i.e., the cloud services and the renewal options). The amount allocated to the renewal options would be recognised over the renewal periods. Note, the amount allocated to the renewal options will likely differ from the stated upfront fee because a portion will be allocated to the services performed in the first year. The remainder will be allocated to the renewal options.

Assuming the criteria to use the practical expedient are met, Cloud Co. could value the renewal option by ‘looking through’ to the optional services. Cloud Co. would determine that the total transaction price is the sum of the upfront fee of CU1 million and the three years’ cloud service fees of CU1.5 million, which gives a total transaction price of CU2.5 million. Cloud Co. would then allocate the total transaction price to all of the services expected to be delivered, or three years of cloud services. Option to renew a contract

Under current IFRS, entities often recognise non-refundable upfront fees systematically over the periods in which the related services are provided. Therefore, Cloud Co. would recognise the CU1 million upfront fee over the period of benefit (generally the longer of the contractual relationship or the contract period). Option to renew a contract

Option to renew a contract

Option to renew a contract

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