Contract Modifications Part I – Separate Contracts

Parties to a contract frequently change the price and/or scope of the contract. These changes are referred to as contract modifications, amendments, variations, or change orders. Depending on the circumstances, these changes are accounted for either as a modification to the existing contract or as a separate contract. These changes and the associated accounting treatment may affect the timing of revenue.

This is the first in a series on contract modifications. Part I provides an introduction to accounting for contract modifications and determining (1) whether a contract change qualifies as a contract modification; and (2) whether the modification should be treated as a separate contract. Part II discusses (3) proper accounting treatment for modifications not considered separate contracts, and also includes an explanation and analysis of the practical “hindsight” expedient.

Treatment of Contract Modifications

The process for determining proper treatment for a contract modification includes three steps:

Determine whether a change to a contract qualifies as a contract modification.
Determine whether the modification should be treated as a separate, standalone contract or as a modification of the original contract. If the contract is a separate contract, the entity follows the five-step model to determine how to recognize revenue. If the modification is not treated as a separate contract, the entity continues to Step 3.
Determine appropriate accounting treatment for contract modification not accounted for as a separate contract (see Part II).

Step 1: Determine Whether the Change Qualifies as a Contract Modification

ASC 606 defines a contract modification as a change in scope and/or price to an original contract. In other words, a contract modification is any change to the enforceable rights and obligations of the parties to the original contract. Enforceable rights and obligations are those that are approved by both parties and would thus be affirmed in a court of law. A contract modification does not need to be written; enforceable changes can be the result of oral agreements or implied through customary business practices. Proper accounting for an original contract is based on each party’s enforceable rights or obligations; unsurprisingly, when those underlying rights and obligations change, the parties must evaluate how to account for those changes. This is done either by treating changes as separate, standalone contracts (Step 2) or as modifications to the original contract (Step 3).

An entity will sometimes need to account for an approved modification before negotiations finalize. This occurs when parties have agreed to a change, but have not finalized either the change in price, scope, or both. Entities account for the non-finalized modification because a change has occurred in the enforceable rights and obligations of the original contract. To determine whether a non-finalized change qualifies as a contract modification, an entity will perform its own analysis on the enforceability of the change (see example ASC 606-10-55-135). If the non-finalized change qualifies as a contract modification, the entity will account for the contract modification by estimating the transaction price using the principles set forth on estimating variable consideration (for more information see Allocating Variable Consideration).

Once an entity determines that a change is indeed a contract modification, it determines whether to account for it as a change to the original contract or as a separate contract. The following decision map outlines the process to determine the proper treatment. While this article series divides the decision-making process into three over-arching steps, the graphic below shows the granular analysis which must be made of each contract modification.

Adapted from “Figure 2-1 Accounting for Contract Modifications” PwC: Revenue from Contracts with Customers

Example A: Waiting for Regulatory Approval May Not be Substantive

Determining whether a modification is approved and/or enforceable can be challenging. This is especially true when dealing with items subject to regulation—such as defense articles. US Defense companies are required to notify Congress of weapons sales to foreign buyers. Once Congress has been notified, it has 30 days to object to the sale. When a foreign customer clearly approves additional scope for such a sale, and the US company begins work before the end of the 30-day period, should the US company recognize revenue?

An argument could be made that because the contract is pending important regulatory approval, the company should not recognize revenue. That being said, another position might be that the US company should recognize revenue because the approval is not substantive—much like a homebuilder recognizing revenue as it begins work—even if it has not yet obtained the requisite occupancy permit from a city or town.

Step 2: Determine Whether the Modification is a Separate Contract

If the modification is determined to be a separate, standalone contract, it will be accounted for separately from the original (otherwise, the modifications are combined with the original contract as outlined in Part II). A contract is considered separate when both of the following are true:

The scope of the contract has increased with the addition of distinct goods or services.
The price of the contract increases by an amount that is comparable to the entity’s standalone selling price of the additional goods or services (including any appropriate adjustments to reflect the circumstances of the particular contract in question).

First, an entity considers the change in scope. A change in scope generally means a change to the original aims of and requirements to fulfill a contract. For the scope to increase, the change in goods and services must be both additional and distinct. If the promised goods or services remain unchanged—or decrease—the modification cannot be treated as a separate contract. Furthermore, the goods and services must be distinct (for a more detailed analysis on determining if a good or service is distinct within the context of a contract, see Distinct Within the Context of a Contract).

Second, the entity addresses the pricing of the change in scope. The logic behind this rule is that a modification is considered a separate contract only if the parties in the contract would normally enter into an arrangement based only on the changes to the contract. Common sense dictates that an entity would not ordinarily enter into a contract promising goods or services at less than their standalone selling prices; therefore, the guidance precludes treating such a modification as a separate contract.

It is important to note that an entity can include any appropriate reductions to the standalone selling price in the contract when determining whether the second element is met. For example, if the normal standalone selling price includes transaction costs or other selling-related costs that are not incurred because the entity does not have to go through the ordinary selling process, the contract is considered separate so long as the price reflects the standalone selling price less the ordinary selling costs.

Conclusion

Contract modifications are any changes in the scope or price of a contract to
which both parties agree. If the change is for additional and distinct goods or
services at prices comparable to their standalone selling prices, the modification
is accounted for as a separate contract. Contract Modifications – Part II
addresses accounting for contract modifications not treated as separate
contracts.

Resources Consulted

ASC 606-10-25-10 to 25-13
EY, Financial Reporting Developments: "Revenue from contracts with customers." September 2021. Section 3.4.
FASB TRG Memo 24: "Contract Modifications." 26 January 2015.
KPMG, Handbook: "Revenue Recognition." December 2021. Section 11.
PWC, "Revenue from contracts with customers." February 2022. Section 2.9.