Working Draft: Telecommunications Revenue Recognition Implementation Issue. Financial Reporting Center Revenue Recognition

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1 December 1, 2017 Financial Reporting Center Revenue Recognition Working Draft: Telecommunications Revenue Recognition Implementation Issue Issue #15-6 Impact of enforceable rights and obligations on contract term Expected Overall Level of Impact to Industry Accounting: Minimal Wording to be Included in the Revenue Recognition Guide: 1. FASB ASC states that an entity shall apply the guidance to the contractual period in which the parties to the contract have present enforceable rights and obligations. Further, FASB ASC states an agreement does not result in enforceable rights and obligations, and therefore a contract does not exist, if it is wholly unperformed and both parties have unilateral rights to terminate the agreement without compensating the other party. 2. The determination of the contractual period in which the parties have present enforceable rights and obligations will require a thorough review of the contract. Common types of contracts seen within the industry include monthto-month contracts, month-to-month contracts with non-refundable upfront fees (e.g., material rights) and noncancelable fixed term contracts with early termination penalties. The contractual period may be readily apparent when there is a fixed non-cancelable term (e.g., two years, which is a common fixed non-cancelable term in telecommunications contracts). However, many telecommunication companies have month-to-month contracts with their customers, either from inception or upon expiration of an initial contract term. Each month of service is automatically renewed, but either party has the ability to terminate the one-month agreement at any time without penalty or to decline the renewal option. 3. Future months for which the customer has not agreed to the renewal would not create enforceable rights and obligations as both parties have the unilateral right to terminate the agreement without penalty. In month-to-month contracts (that do not contain termination penalties if the customer does not renew beyond the current month of service being provided), FinREC believes the contractual period would be for the time period for which each party has enforceable rights and obligations (generally, the current month that has been agreed to), and future renewal

2 periods that have not been exercised by the customer would not be part of the contractual period until the renewal is exercised (i.e., each month is its own contractual period). 4. Another example is when a customer pays for a device using a wireless equipment installment plan ( EIP ) arrangement. A customer signs an EIP agreement which allows the customer to pay for the device up to a maximum payment period (e.g., 24 months) with a minimum monthly payment amount. Simultaneously, the customer enters into a separate contract for one month of service and the option to enter into subsequent monthly service contracts. For simplicity, assume that the month-to-month service plan may be renewed at the then-current standalone selling price, and that no upfront fee is required. The existence of a stated renewal rate or an upfront fee may affect the accounting conclusion related to this example, see Issue #15-7, Material Renewal Rights in Telecommunications Contracts for further discussion. The entity concludes the arrangement should be accounted for as a combined contract as the sale of the device and the one month service contract with a right to renew were negotiated as a package in accordance with FASB ASC (a). The customer may pay the unpaid balance owed for the device over any period up to the maximum term, however, the customer must continue to enter into additional monthly service contracts if they wish to extend the payment period for the device to the maximum allowable period. If the customer wishes to not enter into a subsequent monthly service contract they must pay off the remaining balance on the device, if any. 5. Because the EIP contract in this example does not require the customer to maintain service in order to keep the device, there is no legally enforceable obligation beyond the one month of service as the purchase of additional months is an option for the customer, whereby they can pay off the device and terminate service or renew service and further defer a portion of the remaining amount owed on the device. The FASB-IASB Joint Transition Resource Group for Revenue Recognition (TRG) clarified contract enforceability and termination clauses, optional purchases, customer termination rights and penalties in TRG Agenda Ref No. 48: Customer Options for Additional Goods and Services. TRG Agenda Ref. No. 49: November 2015 Meeting Summary of Issues Discussed and Next Steps, paragraph 10 states: TRG members supported the view that the legally enforceable contract period should be considered the contract period. Since that meeting, stakeholders have raised further questions (Issue 2) about evaluating a contract when only one party has the right to terminate the contract. TRG members agreed with the staff analysis that the views expressed at the October 2014 TRG meeting would be consistent regardless of whether both parties can terminate, or whether only one party can terminate. TRG members highlighted that when performing an evaluation of the contract term and the effect of termination penalties, an entity should consider whether those penalties are substantive. Determining whether a penalty is substantive will require judgment and the examples in the TRG paper do not create a bright line for what is substantive. The TRG discussion illustrates that a penalty is a form of compensation paid to the vendor for both (1) foregoing the transfer of future goods or services to the customer along with (2) the resulting amounts that otherwise would be payable to the vendor, as contractually agreed. A penalty generally is incremental to contractual payments due to the vendor for previously transferred goods and services up to the time of cancellation. 6. FinREC believes an EIP contract, when combined with the month-to-month service contract, may include a substantive termination penalty when the contract includes a significant financing component at contract inception (see Issue #15-5, Considering the effect of the time value of money for further discussion). If a customer cancels (or fails to renew) the service contract, the customer is required to pay the amount owed on the device and loses the financing discount (the benefit of the time value of money) that was provided at contract inception. TRG Agenda Ref. No. 48: Customer options for additional goods and services, paragraph 48 includes an example similar to the EIP contract example, whereby an entity considers whether a penalty (or foregoing an upfront discount) is substantive: Contract 2: An entity sells equipment and consumable parts for the equipment (both the equipment and parts are distinct goods that do not meet the overtime criteria). The standalone selling price of the equipment and parts is CU 10,000 and CU100, respectively. The entity sells the equipment for CU 6,000 (a 40% discount from standalone selling price) and provides an option to purchase each part for CU 100. If the customer does not purchase at least 200 parts, it is required to pay a penalty to repay some or all of the CU 4,000 discount

3 provided on the equipment. The penalty decreases as each part is purchased at a rate of CU 20 per part. A discount of CU 10 would be viewed as a material right to the customer. For this example, the FASB staff concluded, and the TRG agreed, that the requirement to forego the discount should be viewed as a termination penalty that needs to be evaluated as to whether it is substantive. In the case of an EIP contract, the telecommunications entity would consider the quantitative amount of the penalty (i.e., the loss of the financing discount), as well as other qualitative factors that may be relevant to the assessment of whether the penalty is substantive and provide evidence of enforceable rights and obligations beyond the one month service contract. If the termination penalty is substantive, the telecommunications entity s identification of performance obligations would include additional months of service to be provided after the contractual minimum one month (the number of periods over which foregoing the financing discount would be considered a substantive penalty, which may be up to the end of the maximum payment period of the EIP). 7. Generally, if a significant financing component does not exist in the contract, the loss of the financing discount upon a customer s termination of the installment plan would not likely be considered a substantive penalty, and the service contract would be accounted for as a monthly contract with a renewal option that should be evaluated to determine if the option is a material right. 8. Telecommunications entities may include other incentives (e.g., options for free future goods and services) within contracts, which may be material rights. The revenue that is deferred for an incentive deemed to be a material right should be recognized when the future goods or services are transferred or when the option expires. Refer to Issue #15-7, Material Renewal Rights in Telecommunications Contracts for additional information. 9. Consideration should be given as to whether the ability of the customer to renew at the end of the contract s stated term is a stand ready obligation. Stand ready obligations are discussed in BC50 of FASB ASU BC50 discusses when there is a stand ready obligation on the part of an entity, when the entity must perform at the discretion of the customer and only the customer can terminate the contract. As noted earlier, in month-to-month contracts (that do not contain termination penalties for beyond the current month of service being provided), FinREC believes the contractual period would be for the time period for which each party has enforceable rights and obligations (generally, the current month that has been agreed to), and future renewal periods that have not been exercised by the customer would not be part of the contractual period until the renewal is exercised (i.e., each month is its own contractual period). Further, telecommunications entities typically have the right to terminate the contract; that is, the nature of these month-to-month contracts is such that the customer is not the only party with the right to terminate the contract. As a result, FinREC believes the customer s ability to renew a monthly contract at the then current standalone selling price does not contain a stand ready obligation as contemplated by the FASB. 10. A telecommunications company would also consider whether the monthly price for service is at a then current standalone selling price or if it is a rate stated at contract inception with no ability to re-price. A month-to-month contract that provides a fixed renewal price may provide the customer with the right to renew the contract at a rate different (presumably, lower) than the standalone selling price (i.e., the price charged to other customers). In these circumstances, a telecommunications company would evaluate whether a material right exists as a result of the difference in pricing. Refer to Issue #15-7, Material Renewal Rights in Telecommunications Contracts, for further discussion regarding material rights. 11. The determination of whether the parties to a contract have a unilateral enforceable right to terminate a wholly unperformed contract without compensating the other party (or parties) will require a thorough review of the contract. Telecommunication companies may have clauses in customer agreements that give the company the unilateral right to modify or cancel the contract without compensating the customer. For example, at contract inception, a telecommunications company may have the unilateral right to change the channel line-up for its television service contracts. However, the customer may not have the unilateral right to cancel service due to this change in channel line-up (i.e., the customer may cancel but subject to penalty). BC50 of FASB ASU explains that when only the entity (e.g., the telecommunications company) can terminate the wholly unperformed contract without penalty, and not the customer, the telecommunication company has an enforceable right to payment from the customer if it chooses to perform.

4 12. Some telecommunications companies include language in their customer contracts that require the customer to pay a penalty for terminating the contract earlier than the contractual period. A substantive termination penalty that compensates the other party is evidence of the enforceable rights and obligations for both parties throughout the period covered by the termination penalty. Determining whether a termination penalty is substantive requires judgment. Some of the factors a telecommunications entity may consider include: a. The nature and purpose of the termination penalty (i.e., is it designed to compel customers to stay? Is it meant to recoup upfront costs?) b. The amount of the penalty c. The specific laws and regulations in the given jurisdiction (i.e., certain jurisdictions may limit the amount of or not permit an entity to charge termination penalties) 13. No one factor is determinative, and a telecommunications entity may reach different conclusions for different types of contracts depending on their facts and circumstances. If a contract does not include a substantive termination payment, the duration of the contract may be shorter than the stated contractual term. 14. There is diversity in the telecommunications industry on enforcement of the termination penalties. If the telecommunications company has legal and contractual rights to that substantive termination penalty (regardless of whether it is actively enforced), then FinREC believes a contract exists pursuant to the stated contractual period (i.e., the period for which there are present enforceable rights and obligations). The Board decided in BC32 of FASB ASU that the determination of whether an agreement creates enforceable rights and obligations is a question to be considered within the relevant legal framework. Therefore, FinREC believes that the question of whether the substantive termination penalty is actively enforced does not affect the conclusion of what the contractual period is unless the entity s lack of enforcement changes the entity s enforceable rights and obligations in the relevant legal jurisdiction. Rather, it is the stated contractual period in the contract for which there are present enforceable rights and obligations that establishes the contractual period. 15. The following example is illustrative, and the actual determination of the contract term should be based on the facts and circumstances of an entity s specific situation. Example 1: A new customer is offered telephone service for a two-year period for $20 per month, which represents the standalone selling price of this particular plan. At the end of the two-year period, the customer has the right to renew the contract on a month-to-month basis at the then current standalone selling price. The contract includes a significant termination penalty if the customer elects to terminate the agreement prior to the end of the two-year period. The company determines the termination penalty is substantive. The company has a poor history of billing and attempting to collect termination penalties. The company s past practice of allowing customers to terminate the contract without enforcing collection of the termination penalty does not change the parties enforceable rights and obligations in the contract. That is, regardless of the company s intention or ability to enforce it, the present rights and obligations within the contract are for the company to provide two years of telephone service for which it has right to payment from the customer. Therefore, the agreement constitutes a contract with a two-year contractual period. 16. Certain foreign jurisdictions have consumer-friendly laws that may invalidate a company s contracts with its customers if challenged in a court of law. Therefore, careful consideration will be needed for contracts that have been approved and committed to by the entity and its customers, but may not be enforceable in a court of law in a specific jurisdiction. This evaluation may be more complex in situations where contracts are entered into across multiple jurisdictions.

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