Quick Tip #20: If a customer can terminate for convenience, can a supplier recognise revenue when the deal is done?
The current financial reporting standards (IFRS 15 & ASC 606-10-25-3 – Revenue from Contracts) state that where the customer has a termination for convenience right and the supplier is entitled to substantive termination charges, then supplier is entitled to recognise the contract revenue for the full contract term.
If no termination charges apply, the supplier can only recognise the contract revenue for the period of notice required by the customer when exercising its right but not for the full contract term. For example, if the contract has a three year term with a termination for convenience right on three months’ notice but no termination charges, the supplier will only be able to recognise the revenue of three months’ worth of charges.
If a supplier is insisting that it cannot agree to a termination for convenience right because it needs to be able to recognise the revenue, then termination charges should solve this problem provided that they are ‘substantive’ according to the financial reporting standards. The question is then what amounts to ‘substantive’ termination charges and there is little guidance on this point and in turn whether recovery of sunk costs would be sufficient or whether there is a requirement for additional sums, e.g. profit, to be included before the termination charges are substantive. From a customer’s perspective the termination charges should be limited to sunk costs to avoid paying for services supplier has not had to perform. From a supplier’s perspective, the termination charges should include amounts in addition to sunk costs as a disincentive for customer to exercise the termination for convenience right.
For a fuller discussion on revenue recognition in contracts, see our blog post Applying Revenue Recognition to Commercial Contracting and for another Quick Tip on termination for convenience charges see Quick Tip #19.