Option to renew a contract

Allocation of the transaction price to an option to renew a contract

a practical application of IFRS 15

Software vendors often provide customers the option to renew or extend the term of or to cancel a license. Options to acquire additional goods and services, including options to renew or extend licenses, are not included in the initial contract term. However, an option is a separate performance obligation if it provides a material right to the customer that the customer would not receive without entering into the original contract. Option to renew a contract

For example, an option to renew a contract at a discounted price may be a material right if the discount is incremental to the range of discounts typically given to other customers. A cancellation right that allows a customer to cancel a multi-year contract after each year without penalty should be accounted for the same as a one-year contract with a renewal option, since the customer makes a decision annually whether to continue under the contract. Option to renew a contract

IFRS 15 also specifies that revenue from the renewal or extension of a license cannot be recognized until the customer can use or benefit from the license renewal (that is, at the beginning of the renewal period). This is true even if the vendor provides a copy of the IP in advance of the renewal period or the customer has a copy of the IP from another transaction. This differs from current guidance in which revenue is generally recognized from a license renewal on the date the renewal is executed.

Therefore, companies may recognize revenue for renewals later under the IFRS 15 guidance as compared to IAS 18 Revenue.

IFRS does not include specific guidance on license renewals. Companies applying IFRS should evaluate whether a renewal or extension should be accounted for as a new license or a modification of an existing license. Option to renew a contract

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Case – Renewal option for a license arrangement that represents a material right

On January 1, 20X6, Software Co. enters into an agreement to provide a customer a term license and PCS for three years for an upfront, non-refundable fee of $350,000. The customer has the option to extend the term of the license and renew PCS for an additional three years for a fee of $300,000. The rest of the terms and conditions of the original agreement remain unchanged.

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Software Co. typically increases its prices by 5% each year, and the renewal price is lower than the standalone selling price for similar customers. Option to renew a contract

How should the software vendor account for the renewal option?

Analysis: The renewal option provides a material right to the customer as it will be charged a lower price for the software license and PCS than similar customers if the agreement is renewed. Software Co. will account for the option as a separate performance obligation and allocate a portion of the $350,000 transaction price to the renewal right based on its standalone selling price.

However, as a practical alternative to estimating the standalone selling price of the option, Software Co. may determine the total consideration it expects to receive (including renewals) and allocate the estimated consideration to the goods and services it expects to provide. Option to renew a contract

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Case – Post-contract customer support

Post-contract customer support (PCS) is an element included in virtually every software arrangement; it represents the right to receive services or unspecified product upgrades/enhancements, or both. PCS is often explicitly promised in the contract, but could also be implied as a result of the vendor’s past business practices. Option to renew a contract

Consideration for PCS may be included in the license fee or separately priced.

Software companies should assess individual services included in PCS to determine whether they are distinct. Generally, a software license and PCS will each be distinct, even when PCS is not optional, because the software remains functional without the PCS. In limited circumstances, however, a software license may not be distinct from the unspecified updates/upgrades if (1) those updates/upgrades are critical to the continued utility of the software, and (2) without the unspecified updates or upgrades, the customer’s ability to benefit from the software would decline significantly. In such cases, the software license and the right to the unspecified product upgrades/enhancements are accounted for as a single performance obligation.

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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.Option to renew a contract 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.

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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

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Case – Reinstating inactive Post-contract customer support (PCS)

It is not uncommon for a customer to cancel or decline PCS renewal in a given period but subsequently decide to reinstate these services. At the time of reinstatement of inactive PCS, the customer typically receives the cumulative updates, upgrades, and enhancements released during the lapsed PCS periods, and the software vendor typically charges the customer for the lapsed periods. When PCS is reinstated, commonly a software company will generally recognize revenue immediately for the fee allocated to PCS provided during the lapsed period because control of the updates released during the lapsed PCS period transfers to the customer at reinstatement.

Option to renew a contract

Option to renew a contract

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