Contract Modification Under the New Revenue Recognition GuidanceMarch 21, 2018
David Fontes, CPA, CFE, MBA
There are many nuances under ASC No. 606, Revenue from Contracts with Customers, that are often referred to as the “new rev rec" guidance. One of those nuances worth exploring further is contract modifications. Let’s start from the beginning.
What is a contract modification?
A contract modification is a change in the scope or price (or both) of a contract that is approved by the parties to the contract. A contract modification exists when the parties to a contract approve a modification that either creates new or changes existing enforceable rights and obligations of the parties to the contract. Contract modifications can be written, executed orally or implied by customary business practices. Some common examples of contract modifications that most businesses are familiar with are claims, change orders, variations, or amendments.
What is the existing revenue guidance?
Under the existing revenue guidance, the accounting for contract modifications is limited to industry-specific guidance (construction-type and production-type contracts). Contract modification guidance does not exist for arrangements other than long-term construction-type and production-type contracts, which results in inconsistencies in accounting for modifications outside of these types of contracts. One of the advantages of ASC No. 606 is that it provides clarity and consistency on how to account for contract modification across all industries.
What is the new revenue guidance?
Contract modification falls under Step 1 – Identify the contract(s) with a customer under ASC No. 606’s five-step process. Depending on the facts and circumstances, a company should account for a contract modification as one of the following:
- a separate contract
- a termination of the existing contract and a creation of a new contract
- a part of the existing contract
- or a combination of the above
1) Separate Contract
A company should account for a contract modification as a separate contract if:
- a) The scope of the contract increases because of the addition of promised goods (or services) that are distinct; and
- b) The price of the contract increases by an amount of consideration that reflects the company’s standalone selling prices of the additional promised goods (or services) and appropriate adjustments to that price to reflect the circumstance of the contract.
Before we move on to next method, it is important to define “distinct” within the context of ASC 606. For a good (or service) to be distinct, it must have a standalone value. Can a customer benefit from the good (or service) on its own? If the answer is yes, the good (or service) is distinct. Alternatively, can a customer benefit from the good (or service) together with other goods (or services)? If the answer is yes, the good (or service) is not distinct.
For example, Ring Co. agrees to sell 120 rings to David’s Jewelers for $100 per ring for a total $12,000. The rings are transferred to David’s Jewelers over a 6-month period. Ring Co. transfers control to David’s Jewelers of each ring at a point in time. After Ring Co. has transferred control of 60 rings to David’s Jewelers, a change order is executed to deliver an additional 30 rings for $95 per ring to David’s Jewelers for a total of 150 rings over a period of 4 months from the change order date. The additional 30 rings were not included in the initial contract.
The additional rings are distinct from the original rings and the pricing for the additional rings reflects the standalone selling price of the rings at the time of the contract modification. As a result, a new and separate contract for future rings that does not affect the accounting for the existing contract has occurred.
2) Termination of the existing contract and a creation of a new contract
When a contract modification does not meet the requirements of a Separate Contract and the remaining goods (or services) are distinct from the goods (or services) transferred on or before the date of the contract modification, a company should account for a contract modification as a termination of the existing contract and a creation of a new contract. The amount of consideration to be allocated to the remaining performance obligation is the:
that was included in the estimate of the transaction price and that had not been recognized as revenue
Consideration to be allocated to the remaining performance obligation
Contract Modification Consideration
Under this scenario, a company meets requirement a) of a Separate Contract, but not requirement b).
3) Part of the existing contract
When a contract modification does not meet the requirements of a Separate Contract and the remaining goods (or services) are not distinct and, therefore, form part of a single performance obligation that is partially satisfied at the date of the contract modification, a company should account for a contract modification as an add-on to the existing contract. The contract modification is recognized as an adjustment to revenue (increase or decrease) on a cumulative catch-up basis. Under this scenario, a company doesn’t meet the requirement a) of a Separate Contract.
When a contract modification does not meet the requirements of a Separate Contract, and there are multiple performance obligations in which some performance obligations include remaining goods (or services) that are distinct from those already provided under the original contract, while other performance obligations include remaining goods (or services) that are not distinct, a company should break out the contract into two separate parts. The company should account for the performance obligations that are distinct as 2) Termination of the existing contract and a creation of a new contract, and performance obligations that are not distinct as 3) Part of the existing contract.
These changes to contract modification will be effective for private companies for annual reporting periods beginning after December 15, 2018 but can be applied as of annual reporting periods beginning after December 15, 2017.
These changes to contract modification will be effective for public companies for annual reporting periods beginning after December 15, 2017 but can be applied as of annual reporting periods beginning after December 15, 2016.
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