Transition Resource Group for Revenue Recognition
Contract Asset Treatment in Contract Modifications
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This paper has been prepared for discussion at a public meeting of the Transition Resource Group for Revenue Recognition. It does not purport to represent the views of any individual members of the board or staff. Comments on the application of U.S. GAAP do not purport to set out acceptable or unacceptable application of U.S. GAAP. Stakeholders are strongly encouraged to listen to feedback about this staff paper from TRG members and Board members during the TRG meeting and to read the meeting summary, which will be prepared by the staff after the meeting.
1. Some stakeholders have informed the staff that there is a question about the guidance in Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606) (Update 2014-09), about the accounting for contract assets when a contract is modified and the entity determines that the modification meets the criteria in paragraph 606-10-25-13(a) to be treated as if it were a termination of the existing contract and the creation of a new contract.
2. Previous generally accepted accounting principles (GAAP) did not include an overarching framework for accounting for contract modifications. Rather, there was only limited guidance for construction contracts in Subtopic 605-35, Revenue Recognition—Construction-Type and Production-Type Contracts, that sometimes was applied by analogy to other revenue transactions. Because of the lack of guidance under previous GAAP, there is diversity in practice today in accounting for modifications, including what type of change is considered a modification.
3. Topic 606 includes an overarching framework for accounting for contract modifications for all contracts within its scope. Under Topic 606, a contract modification is a change to the scope or price (or both) of a contract that is approved by the parties to the contract. The Board’s objective in developing the contract modification guidance, as described in paragraph BC76, was to faithfully depict an entity’s rights and obligations in the modified contract. The Board provided the framework in paragraphs 606-10-25-10 through 25-13 because it concluded that to faithfully depict the rights and obligations arising from a modified contract, an entity should account for some modifications prospectively and account for others on a cumulative catch-up basis.
4. Paragraph 606-10-25-13(a) applies to a contract modification (a) that does not meet the two criteria to be accounted for as a separate contract in accordance with paragraph 606-10-25-12 and (b) for which the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification. A contract modification in paragraph 606-10-25-13(a) is treated as if it were a termination of the existing contract and the creation of a new contract with prospective accounting (that is, a cumulative catch-up adjustment is not recorded on the modification date).
5. Paragraph 606-10-25-13(a) describes how to calculate the amount of consideration to be allocated to the remaining goods or services in the modified contract. However, that paragraph does not explicitly describe the accounting for a contract asset that exists immediately before a contract modification. Consequently, some stakeholders have raised the implementation question in this paper about how contract assets should be accounted for upon a modification.
6. A contract asset is defined in Topic 606 as an “entity’s right to consideration in exchange for goods or services that the entity has transferred to a customer when that right is conditioned on something other than the passage of time (for example, the entity’s future performance).” A receivable is an entity’s right to consideration that is unconditional. A right to consideration is unconditional if only the passage of time is required before payment of that consideration is due. An entity shall present any unconditional rights to consideration separately as a receivable.
7. This issue applies to a contract for which contract assets are created as promised goods or services transfer to a customer and there is a contract modification that would be accounted for under paragraph 606-10-25-13(a). This paper does not focus on the determination of whether an entity’s contract modification should be accounted for as a separate contract or as a termination of the existing contract and creation of a new contract (that is, whether paragraph 606-10-25-12 or paragraph 606-10-25-13 applies). This paper is about the accounting after an entity has concluded that a contract termination should be accounted for under paragraph 606-10-25-13(a). This paper relates to contract assets created under Topic 606 and does not apply to assets accounted for under other Topics (such as costs that have been capitalized to obtain a contract or fulfill a contract with a customer, as described in Topic 340, Other Assets and Deferred Costs).
Excerpts from Update 2014-09
606-10-25-10 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.
606-10-25-12 An entity shall account for a contract modification as a separate contract if both of the following conditions are present:
a. The scope of the contract increases because of the addition of promised goods or services that are distinct (in accordance with paragraphs 606-10-25-18 through 25-22).
b. The price of the contract increases by an amount of consideration that reflects the entity’s standalone selling prices of the additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the particular contract. For example, an entity may adjust the standalone selling price of an additional good or service for a discount that the customer receives, because it is not necessary for the entity to incur the selling-related costs that it would incur when selling a similar good or service to a new customer.
606-10-25-13 If a contract modification is not accounted for as a separate contract in accordance with paragraph 606-10-25-12, an entity shall account for the promised goods or services that are not yet transferred at the date of the contract modification (that is, the remaining promised goods or services) in whichever of the following ways is applicable:
a. An entity shall account for the contract modification as if it were a termination of the existing contract, and the creation of a new contract, if the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification. The amount of consideration to be allocated to the remaining performance obligations (or to the remaining distinct goods or services in a single performance obligation identified in accordance with paragraph 606-10-25-14(b)) is the sum of:
1. The consideration promised by the customer (including amounts already received from the customer) that was included in the estimate of the transaction price and that had not been recognized as revenue and
2. The consideration promised as part of the contract modification.
[Subparagraphs (b) and (c) are excluded because they are not relevant in this paper.]
BC78. The Boards also decided that a contract modification should be accounted for prospectively when the goods or services to be provided after the modification are distinct from the goods or services already provided (see paragraph 606-10-25-13(a)). The Boards decided that this should be the case regardless of whether the pricing of the additional promised goods or services reflected their standalone selling prices. This is because accounting for those types of modifications on a cumulative catch-up basis could be complex and may not necessarily faithfully depict the economics of the modification because the modification is negotiated after the original contract and is based on new facts and circumstances. Therefore, this approach avoids opening up the accounting for previously satisfied performance obligations and, thus, avoids any adjustments to revenue for satisfied performance obligations.
Implementation Question: What is the accounting for a contract asset that exists immediately before a contract modification that is treated as if it were a termination of the existing contract and creation of a new contract in accordance with paragraph 606-10-25-13(a)?
8. The staff is aware of the following views for how to account for a contract asset in a contract modification:
(a) View A—The contract asset should be written off to revenue. Stakeholders with this view observe that if a contract is terminated, then there is no longer a contract and, therefore, the related contract asset should be written off to revenue.
(b) View B—The contract asset is carried forward into the new modified contract and subsequently realized under the new modified contract as receivables are recognized. Stakeholders with this view note that this approach does not lead to revenue reversals and, therefore, results in prospective accounting.
9. The following example illustrates the accounting for a contract asset upon a contract modification that is accounted for under paragraph 606-10-25-13(a), under the two views described above.
An entity (“Vendor”) enters into a contract to provide a good and one year of service. The transaction price is $4,200. Assume the good and service are separate performance obligations and the service is considered a series under paragraph 606-10-25-14(b). The standalone selling price for the good is $3,000, and the standalone selling price for the services are $100 per month ($1,200 for one year). Therefore, Vendor allocates $3,000 to the good and $1,200 to the services.
The contract does not have an upfront payment. Customer will pay 12 equal installments of $350. Vendor will invoice Customer at the end of each month and the contract requires Customer to pay the invoice within 30 days of month end (or Vendor has the right to assess an agreed upon late payment penalty and/or exercise its enforceable rights to demand payment).
At the beginning of the first month, the good is transferred to Customer, and the revenue allocated to that performance obligation ($3,000) is recognized. Vendor also recognizes a contract asset for $3,000 because payment of that $3,000 is conditional upon Vendor performance of future services.
At the end of the first month, Vendor recognizes revenue of $100 for progress toward complete satisfaction of the performance obligation related to the services (assume the entity is using a time based measure of progress). Vendor also recognizes accounts receivable of $350 because that amount is not conditional. The contract asset, which had a balance of $3,000 at the beginning of the month, would have a balance of $2,750 at the end of the first month.
Vendor continues to make similar entries through the end of the first nine months of the contract. After nine months, $3,900 of revenue has been recognized for the contract ($900 of revenue for the services and $3,000 for the good). At the end of nine months, Vendor has a receivable for $350 (assuming Customer already paid the first eight installments). In addition, Vendor has a contract asset for $750 (equal to $3,000 – (9 x ($350 - $100))).
At the end of nine months, Vendor negotiates with Customer to change the scope and price of the contract. The contract is modified to include one additional year of service beyond the initial one-year service term. The fee for the last three months of the initial one-year contract is unchanged as a result of the modification. The agreed-upon fee for the additional one year of services is $50 per month, which is significantly below the standalone selling price of the services. Vendor determines that the additional promised services arising from the modification do not reflect the standalone selling price of the services to be provided. Because the remaining services are a series of distinct services, Vendor determines that the remaining services are distinct from the goods or services transferred prior to the modification. Therefore, the modification would be accounted for under paragraph 606-10-25-13(a).
[Note: For the purposes of illustrating this specific implementation question, the staff has not evaluated considerations about whether there is a significant financing component, as described in paragraphs 606-10-32-15 through 32-20.]
Analysis under View A:
Under View A, on the modification date, Vendor would write off the contract asset of $750 with a corresponding reversal (debit) to revenue for $750. Then, Vendor would perform the analysis under paragraph 606-10-25-13(a) to determine the total consideration to be allocated to the remaining distinct services (that is, 15 months of service). Immediately after the revenue reversal, the consideration promised by the customer that was included in the transaction price that has not yet been recognized as revenue under the original contract is $1,050 ($750 that was reversed relating to the good and $300 that has not yet been recognized from the service plan [3 remaining months × $100 per month]). The additional consideration promised as part of the contract modification is $600 (equal to 12 additional months × $50 per month).
Thus, the total amount of consideration allocated to the remaining distinct services is $1,650 ($1,050 + $600). Vendor would allocate the $1,650 to the remaining performance obligations and recognize revenue for the services over the remaining contract duration of 15 months.
Analysis under View B:
Under View B, Vendor would retain the original contract asset at the modification date. That contract asset relates to revenue that was previously recognized but that has not been paid by the customer and that is not presented as a receivable. Vendor would perform the analysis under paragraph 606-10-25-13(a) to determine the total consideration to be allocated to the remaining performance obligations. The consideration promised by Customer that was included in the transaction price, but not yet recognized as revenue under the original contract, would be $300 (equal to $4,200 transaction price – $3,900 already recognized as revenue). The additional consideration promised as part of the contract modification is $600 (equal to 12 additional months × $50 per month).
Thus, the total amount of consideration allocated to the remaining distinct services is $900 ($300 + $600). Vendor would allocate the $900 to the remaining performance obligations and recognize revenue over the remaining modified contract duration. Subsequent to the contract modification, the contract asset would be evaluated and accounted in the same manner as any other contract asset.
10. As the example demonstrates, View A would result in a revenue reversal upon contract modification. Additionally, because of the revenue reversal, the entity would recognize higher revenue later in the life of the modified contract because $750 of the transaction price (that is, revenue) previously allocated to the performance obligation related to the good (which was reversed on the contract modification date) would be recognized over the remaining period as services are performed.
11. View A would avoid situations in which a contract asset might be recognized for a long period of time (potentially until termination of the contract) because the contract is modified many times to extend the contract term and the additional consideration for the additional distinct goods or services are not at their standalone selling prices.
12. Revenue recognized in the aggregate for the original contract and the modification would be the same under both views; however, the amount of revenue recognized in a reporting period could differ between the two views. This is because View A results in a reversal of revenue at the modification date and a subsequent “catch-up,” which might span multiple reporting periods.
13. Under View B, an entity carries forward the current contract asset because it relates to a right to consideration for goods and services that have been transferred. The revenue recognized after the contract modification is the remaining amount of the transaction price from the original contract plus the consideration arising from the modification.
14. In the staff’s view, View B results in a financial reporting outcome that is consistent with the new revenue standard for contract modifications accounted for under paragraph 606-10-25-13(a) and View A does not. The objective of paragraph 606-10-25-13(a)(1) through 25-13(a)(2) is to determine the transaction price that should be allocated to the remaining distinct goods or services in order to account for the modification prospectively. Paragraph 606-10-25-13(a)(1) explicitly states that the starting point for the determination is the transaction price in the original contract less what had already been recognized as revenue. In the example above, View B demonstrates that the transaction price in the original contract ($4,200) is reduced by the amount of previously recognized revenue ($3,900), which includes the $750 contract asset that exists immediately before the modification. The amount of consideration that the entity would receive after the modification (that is, the right to consideration) exceeds the transaction price allocated to the remaining performance obligations and the contract asset remains on the entity’s balance sheet at the date of modification, subject to impairment.
15. The staff also thinks its view is consistent with paragraph BC78, which indicates that the intent of paragraph 606-10-25-13(a) is to account for these types of modifications on a prospective basis and that the guidance avoids adjustments to revenue for satisfied performance obligations.
16. When an entity analyzes the specific criteria and guidance in paragraphs 606-10- 25-12 through 25-13, it should consider the overall objective of the modifications framework as it relates to the nature of its promises to the customer and the nature of the modification(s). There are many different types of contract modifications, and it is important to carefully evaluate the facts and circumstances in determining which category of modification (described in paragraphs 606-10-25-12 through 25-13) applies. For example, an entity would consider whether the additional goods or services promised are distinct and whether the additional goods or services promised reflect their standalone selling prices.
17. Although Update 2014-09 includes far more guidance on contract modifications than previous GAAP, the accounting for contract modifications sometimes will require the use of significant judgment, like previous GAAP.
Question for the TRG Members
1. Do the TRG members agree with the staff’s views in this paper?
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