What is a modification of a contract and what is a new contract?
The way chosen in IFRS 15 Revenue from Contracts with Customers is that the general rule is that a modification is a continuation of an existing contract with some changes. To account for a change (modification) in a contract as being a new contract some hurdles have to be taken.
So, an entity must determine whether the modification creates a separate contract or whether it will be accounted for as part of the existing contract.
Two criteria must be met for a modification to be treated as a separate contract:
- the additional goods and services are distinct from the goods and services in the original arrangement; and Creating a new contract or not?
- the amount of consideration expected for the added goods and services reflects the stand-alone selling price of those goods or services.
Only modifications that meet these criteria can be treated as separate contracts. In determining the stand-alone selling price, entities have some flexibility, depending on the facts and circumstances. For example, an entity may conclude that, with additional purchases, a customer qualifies for a volume-based discount. Creating a new contract or not?
|Example: Contract modification represents a separate contract|
Hi Technology Corp. enters into an arrangement to provide subscription-based services to a customer over a 12-month period for CU1 million. After six months, Hi Technology Corp. and the customer agree to modify the contract by adding another 12 months of subscription-based services.
The price for the additional service is CU800,000.
Hi Technology Corp. determines that the additional 12 months of subscription-based services are distinct, and the pricing for the additional term of subscription-based services reflects the stand-alone selling price of the services at the time of the contract modification, adjusted for the discount frequently awarded to returning customers.
The contract modification is considered a separate contract for the additional months of services and would not affect the accounting for the existing contract.
A contract modification that does not meet the criteria to be accounted for as a separate contract is considered a change to the original contract. It is treated as either the termination of the original contract and creation of a new contract or as a continuation of the original contract (or a combination of the two), depending on whether the remaining goods or services to be provided after the contract modification are distinct. Such modifications are accounted for as follows: Creating a new contract or not?
- A termination of the original contract and creation of a new contract (i.e., on a prospective basis), if the goods and services subject to the modification are distinct from the other goods and services provided within the original contract, but the consideration does not reflect the stand-alone selling price of those goods or services. Creating a new contract or not?
- A continuation of the original contract if the goods or services added or removed are not distinct from the goods and services already provided. Such modifications are accounted for on a cumulative catch-up basis (see example below). Creating a new contract or not?
|Example: Contract modification for additional products at a price that does not reflect the stand-alone selling price|
A semi-conductor manufacturer promises to provide 1,000 micro-processors to the customer for CU100,000 (CU100 per unit). The goods are transferred to the customer over a six-month period. The entity transfers control of each product upon delivery. After the entity has transferred 300 micro-processors, the contract is modified to require the delivery of an additional 500 micro-processors to the customer (i.e., total of 1,500 micro-processors).
The price for the additional 500 micro-processors is CU25,000 (CU50 per unit).
The price for the additional micro-processors does not reflect the stand-alone selling price at the time the contract is modified and, therefore, does not meet the criteria to be accounted for as a separate contract. Since the remaining products are determined to be distinct from those already transferred, the semi-conductor manufacturer accounts for the modification as a termination of the original contract and creation of a new contract.
The deliveries under the old contract and the ‘new’ contract have to be accounted for using one price per unit for all of these units to be transferred. The amount of revenue recognised for the remaining products under the new contract is a blended price of CU79.17, calculated as follows (unit = a microprocessor):