The New Revenue Recognition Standard — Step 1: Identify the Contract with a Customer (Part II)
As mentioned in our previous blog, on May 28th the Financial Accounting Standards Board (“FASB”) released Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers: Topic 606. The new standard creates a whole new codification topic (ASC 606) and ushers in a new era of revenue recognition by replacing thousands of pages of industry specific guidance with a single comprehensive standard applicable to virtually all industries, and will significantly change how we recognize revenue. ASU 2014-09 isn’t effective for private entities until reporting periods beginning after December 15, 2017, but will be effective for public entities a year earlier.
ASC 606 creates a five-step process for recognizing revenue. Step 1 is to identify the contract with the customer. In our previous blog, we discussed the basics of Step 1. We also addressed cancellation rights, subsequent accounting, consideration received when no contract exists and combining contracts. Now let’s talk about a few more complicated concepts in Step 1.
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. An entity should not account for a modification until it is approved; that is, an entity should continue to apply the revenue standard to the existing contract. Similar to contract approval, modification approval can be in writing, oral or implied by customary business practice. An entity will need to make a supportable accounting policy election when claims or unpriced change orders are deemed to be approved and consistently apply the policy to all similar customers and contracts.
Interestingly, a contract modification may exist even though the parties may have a dispute about the scope or price (or both) of the modification. If the scope of the change has been approved but the price has not yet been agreed upon, then the entity shall estimate the price no differently than it should account for variable consideration (including the guidance over variable consideration constraints) under the ASC 606, which will be discussed in depth at a later blog.
1) Accounting for Contract Modifications as a Separate Contract
Contract modifications should be accounted for as a separate contract if both of the following conditions exist:
- the scope increases because of the addition of distinct promised goods or services; and
- the price of the contract increases in an amount that reflects the entity’s standalone selling prices of the additional promised goods or services.
A good or service is distinct if both of the following criteria are met:
- The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer.
- The promise to transfer the good or service is separately identifiable from other promises in the contract.
For example, if an entity sells widget A and then enters into a change order to add widget B, then so long as widget B works without widget A and the price of the change order is equal to the standalone selling price of widget B, then the change order should be treated as the formation of a new contract.
The standalone selling price is the price at which an entity would sell a promised good or service separately to a customer and can be determined a number of different ways, which we will discuss in a later blog over Step 4: Allocating the Transaction Price.
Interestingly, ASC 606 allows for “appropriate adjustments” to the standalone selling prices to reflect circumstances of a particular contract. For example, because the modification is to an existing customer, the entity will not incur selling-related costs, and thus the entity could adjust the price accordingly. However, it is important to note that the adjustments are from the perspective of cost savings to the entity and should theoretically be no different than the standalone selling prices to other customers if those other customers presented the entity with similar cost savings.
2) Accounting for a Contract Modifications as the Formation of a New Contract Combined with the Remaining Performance Obligations from the Old Contract
If the additional goods or services in the modification are distinct, but the transaction price of the modification doesn’t reflect the standalone selling prices of the additional goods or services, and if the remaining goods or services of the “old” contract are distinct from the goods or services transferred on or before the date of the contract modification, then the contract modification should be accounted for as the formation of a “new” contract which combines the performance obligations of the modification with the remaining performance obligations from the “old” contract. Under this scenario, the remaining consideration in the original contract not yet recognized as revenue is combined with the additional consideration in the modification to create a new transaction price that is then allocated to all remaining performance obligations. For example, if a construction contractor originally contracted to build an airport and expand the connecting highway by two lanes, then after completion of the airport was requested to expand the connecting highway by an additional two lanes (four lanes total) but at a discounted price, then the contractor should account for the modification as the formation of a new contract to expand the connecting highway by four lanes, with the transaction price equal to any remaining revenue not yet recognized under the original contract plus the consideration of the modification. This treatment is called “prospective.”
3) Combined with original contract
If the additional goods or services in the modification are not distinct, the modification therefore forms part of a single performance obligation that is partially satisfied at the date of the contract modification. Thus, a new contract transaction price is created and the measurement towards completion of the performance obligation must be re-measured with a cumulative catch-up adjustment (increase or decrease) to revenue.
4) Formation of a new contract and combined with original contract
If the remaining goods or services are a combination of the preceding two paragraphs, then the entity shall account for the effects of the modification on the unsatisfied (including partially unsatisfied) performance obligations with a combination of the preceding two approaches.
Previously, there was no accounting guidance for contract modifications and as a result practice was mixed. Consistent with the overall theme of ASC 606 management will need to exercise a great deal of judgment when determining whether goods or services in a modification are distinct, and whether the prices reflect the standalone selling prices in order to determine the correct accounting. This will be particularly challenging when multiple performance obligations exists. In our next blog series, we will provide detailed examples of all steps including contract modifications under Step 1.
Once the entity has completed Step 1 and identified the contract including contract modifications, then the entity must move onto Step 2: Identifying the Performance Obligations, which will be the subject of our next in depth blog.