A Termination for Convenience (TFC) clause is a contractual clause which allows one or both parties to terminate an agreement without cause. In contrast to termination clauses that may be triggered by default or breach of contract, TFC clauses can be invoked at the convenience of the triggering party, often by giving a limited period of written notice (e.g. 3 months’ written notice) to the counterparty. Such clauses are especially common in government contracts and funding agreements, and there are conflicting views as to how these should be treated from an accounting perspective.
The accounting question that arises in respect of a Termination for Convenience clause in a funding agreement is whether or not such a clause should result in a liability being recognised in the financial statements of the funding recipient.
Two main views exist as to if/when a liability should be recognised by the recipient:
View 1 – TFC clauses create a financial liability at contract inception
Proponents of this view argue that the recipient of the funds does not have an unconditional right to defer settlement. As per AASB 132 Financial Instruments: Presentation paragraph 9 “If an entity does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation, the obligation meets the definition of a financial liability”. Under view 1, funds received would be recognised as a liability on receipt, with that liability being subsequently measured and/or derecognised in accordance with the requirements of AASB 9 Financial Instruments.
View 2 – TFC clauses do not create a financial liability unless they are invoked
Supporters of this view argue that TFC clauses are protective in nature and that there is no obligation for recipients to repay funds received until such time as a TFC clause is triggered. Although TFC clauses are common, the actual triggering of them appears to be rather rare (based on anecdotal evidence at least). Under view 2, a liability would not be recognised unless a TFC clause was triggered by the counterparty to the agreement.
In mid-2020 two stakeholders wrote to the Australian Accounting Standards Board (AASB) seeking further clarification and guidance on accounting for TFC clauses. In a AASB staff paper published in late 2020, AASB staff concluded that “…the requirements of Australian Accounting Standards and available guidance provide an adequate basis to enable an entity to account for termination for convenience clauses…”.
The paper outlines the two main views and steps through the various accounting standards and associated guidance that applies.
However, the AASB do not specifically endorse either of the above views in their staff paper, instead indicating that judgment will ultimately be required by preparers based on their specific circumstances.
In the absence of clear guidance either way, diverging views will likely continue to exist. Preparers of financial statements will need to work through the detailed requirements of accounting standards such as AASB 9, AASB 15 Revenue from Contracts with Customers, AASB 132 and AASB 1058 Income of Not-for-Profit Entities, and make judgments regarding the underlying substance and economic reality of TFC clauses in the context of their specific circumstances.
The adoption of view 1 could potentially lead to an element of matching in the profit or loss statement for entities that may otherwise have been required to recognise income on receipt under AASB 1058. Given the degree of subjectivity involved, disclosure of significant judgements made may be appropriate in the financial statements.