Contract modifications and IFRS 15


In all businesses, sales contracts are extended, adapted or modified on a regular basis as client’s needs develop. Accounting for those changes so that revenues are correctly recognised can be a challenging task.

Currently, when a construction contract is changed, companies must use the rules set out in IAS 11 to decide if the modified contract should be accounted for as a separate contract. This will change for annual reporting periods beginning on or after 1 January 2018: IFRS 15 introduces three different approaches to recognising revenue when any contracts are modified. However, let’s start with the basics.

 

Has there been a modification?

A contract modification exists when the parties to a contract approve a change that either:

  • Changes existing enforceable rights and obligations of the parties, or
  • Creates new enforceable rights and obligations of the parties.

You have to consider all relevant facts and circumstances (eg external evidence as well as the terms of the contract) to determine enforceability. A contract modification may exist even though the parties:

  • Have a dispute about the scope and/or price (or both) of the modification or
  • They have approved a change in the scope of the contract but have not yet determined the corresponding change in price.

If a change in price has not been agreed, for accounting purposes businesses must use the rules for estimating variable consideration (see – Sale with a right of return).

 

How do I account for it?

IFRS 15 sets out three different approaches to accounting for a contract modification. To determine which approach is required you have to ask:

  • Are the additional goods or services distinct from those in the original contract?  and
  • Does the modification reflect the standalone selling price of the additional goods or services?

Different combinations of answers to the question can result in the change being treated as either:

  1. A separate contract in addition to the original contract,
  2. The termination of the original contract and the creation of a new contract (which will include the unsatisfied performance obligations from the original terminated contract) or
  3. As part of the original contract.

 

IFRS 15 example – sale of a product

A company enters into a contract to sell 200 units of a product for £16,000 (£80 each) and will supply 50 units per month over a four month period (control over each unit passes to the customer on delivery). After 150 units have been delivered, the contract is modified to require the delivery of an additional 50 units (ie 250 in total). At the modification date, the stand-alone selling price of one unit of the product has fallen to £75.

The additional units are distinct from those in the original contract under IFRS 15. Consequently, the subsequent accounting will depend on whether or not the sales price for the additional units reflects the stand-alone selling price at the date of contract modification (£75). This is illustrated below.

Modified contract example

Unit Price of extra units

Stand-alone unit price at date contract changes

Accounting treatment

Seller’s recognises

revenue of

1.

50 extra units

£75

£75

Treat extra units as being sold under a new and separate contract

£80 per unit for the original contract (including the remaining 50 units to be delivered)

 

£75 per unit for extra 50 units

2.

50 extra units with discount because of faults in units already delivered

£60* (ie £65 agreed unit price less £5 per unit in respect of faults on first 50) *

£75

Recognise discount on first contract

 

 

 

 

Treat original contract as terminated at date of change

 

Treat all subsequent deliveries as under a new contract ( ie remaining 50 plus extra 50)

Recognise the £5 per unit discount (£250 in total) as an immediate reduction in revenue of £250 for the first 50 units delivered that were defective.

 

Revenue before change is a proportion of total contracts value (see below)

 

 

Use weighted average to determine deemed new contract revenue to be recognised (see below)

* This reflects an agreed price of £65 per unit less a credit of £250 for poor service as some of the first 50 units that had been delivered were faulty and the vendor had been slow in rectifying the position.

 

Revenue calculations in 2

Use a weighted average to establish the amount of revenue recognised for each of the units delivered after the contract change, calculate as:

((50 x £80) + (50 x£65)) = £7,250          (100 units weighted average £72.50 each)

Therefore, revenue to be recognised for deliveries before the contract change is calculated as:

Total revenue of £16,000 (200 x £80) + £3,000 (50 x £60) = £19,000 less £7,250 recognised after the contract change = £11,750# (150*£80-£250).

# including the £250 credit

 

Read more on revenue recognition under IFRS15: