A change to an existing contract is a modification. A contract modification could change the scope of the contract, the price of the contract, or both. A contract modification exists when the parties to the contract approve the modification either in writing, orally, or based on the parties' customary business practices. Judgment will often be needed to determine whether changes to existing rights and obligations should have been accounted for as part of the original arrangement (that is, should have been anticipated due to the reporting entity's business practices) or accounted for as a contract modification. Refer to RR 7.2.2 for discussion of whether the exercise of a customer option that provides a material right should be accounted for as a contract modification or a continuation of the existing contract.
A new agreement with an existing customer could be a modification of an existing contract even if the agreement is not structured as a modification to the terms and conditions of the existing contract. For example, a vendor may enter into a contract to provide services to a customer over a two-year period. During the contract period, the vendor could enter into a new contract to provide different goods or services to the same customer. Management should assess whether the new contract is a modification to the existing contract. Factors to consider could include whether the terms and conditions of the new contract were negotiated separately from the original contract and whether the pricing of the new contract depends on the pricing of the existing contract. If the new contract transfers distinct goods or services to the customer that are priced at their standalone selling prices, the new contract would be accounted for separately (whether or not it is viewed as a contract modification). If the goods or services are priced at a discount to standalone selling price, management will need to evaluate the reason for the discount as this may be an indicator that the new contract is a modification of the existing contract.
An agreement to modify a contract could include adjustments to the transaction price of goods or services already transferred to the customer. For example, in connection with a contract modification, a reporting entity may agree to provide a partial refund due to customer satisfaction issues related to goods already delivered. The refund should be accounted for separately because it is an adjustment to the transaction price of the previously transferred goods. Thus, the amount of the refund would be recognized immediately as a reduction of revenue and excluded from the application of the modification guidance summarized in Figure RR 2-3. Determining when a portion of a price modification should be accounted for separately could require significant judgment. This concept is illustrated in Example 5, Case B, of the revenue standard (ASC 606-10-55-114 through ASC 606-10-55-116).
Contract modifications are accounted for as either a separate contract or as part of the existing contract, depending on the nature of the modification, as summarized in Figure RR 2-3.
Figure RR 2-3Refer to RR 2.9.3 for discussion of modifications that involve both goods and services that are distinct and those that are not distinct.
Question RR 2-5
A reporting entity and its customer agree to terminate an existing contract and enter into a new contract rather than modify the existing contract. Does the contract modification guidance apply in this situation?
We believe management should apply the contract modification guidance to determine the appropriate accounting if, in substance, the parties have modified the existing contract even if it is structured as a termination of the existing contract and creation of a new contract.