IFRS 15 Contract modifications Decision tree guides you through the treatment of changes in contracts under IFRS 15 Revenue from contracts with customers.
Parties to an arrangement frequently agree to modify the scope or price (or both) of their contract. If that happens, an entity must determine whether the modification is accounted for as a new contract or as part of the existing contract. Generally, it is clear when a contract modification has taken place, but in some circumstances, that determination is more difficult. [see IFRS 15 18 – 19]
Account for contract modifications timely
IFRS 15 indicates that an entity may have to account for a contract modification prior to the parties reaching final agreement on changes in scope or pricing (or both). Instead of focusing on the finalisation of a modification, IFRS 15 focuses on the enforce-ability of the changes to the rights and obligations in the contract. Once an entity determines the revised rights and obligations are enforceable, it accounts for the contract modification. [see Example 9 in IFRS 15 IE42 – IE43] IFRS 15 Contract modifications Decision tree
A contract has been modified
Once an entity has determined that a contract has been modified, the entity determines the appropriate accounting treatment for the modification. Certain modifications are treated as separate stand-alone contracts, while others are combined with the original contract and accounted for in that manner. In addition, some modifications are accounted for on a prospective basis and others on a cumulative catch-up basis. (see IFRS 15 20 – 21 for determining the appropriate accounting treatment].
Break away…. IFRS 15 Contract modifications Decision tree
The saying that contracts were made to be broken is never truer than when talking about construction contracts. Contract changes are inevitable and fairly frequent on all construction jobs – and especially on large scale projects. Any construction project (large or small) with an original contract should use a change order to manage and handle work and project changes and additional or different work which falls outside the original contract scope.
Reasons for constructions contract changes IFRS 15 Contract modifications Decision tree
Contract changes can arise for a number of reasons: IFRS 15 Contract modifications Decision tree
- The client discovers obstacles or opportunities to deviate from the original plan
- The project was simply incorrectly estimated and must be amended
- During the course of the project, the client, architect or contractor propose new features or changes
While there usually isn’t any maliciousness in declaring or proposing changes, it’s important that contractors prepare and use change orders to ensure that they get paid fairly for their work. It’s also important to address unexpected changes that put you at a loss – whether they were intended or not. You relied on a contract to organise your resources.
While many contractors and clients are highly trustworthy, it’s much safer to use a change order because it’s contractual proof that because of ‘Y’, we did ‘X’ – and everyone agreed to it and knew about it.
Change order process
Your change order process and documents should be proper and reliable. A lacklustre change order process can be inadmissible and useless if it is created, sent, signed or recorded incorrectly.
Break back….. IFRS 15 Contract modifications Decision tree
IFRS 15 Contract modifications Decision tree
The decisions to be made and documented regarding contract modifications is as follows:
Document your decisions in your financial close file to facilitate internal review and approval and external audits.
Contract modification assessment
When assessing how to account for a contract modification, an entity must consider whether any additional goods or services are distinct, often giving careful consideration to whether those goods or services are distinct within the context of the modified contract (see distinct goods or services). That is, although a contract modification may add a new good or service that would be distinct in a stand-alone transaction, that new good or service may not be distinct when considered in the context of the contract, as modified. For example, in a building renovation project, a customer may request a contract modification to add a new room.
Sale of a room addition
The construction firm may commonly sell the construction of an added room on a stand-alone basis, which would indicate that the service is capable of being distinct. However, when that service is added to an existing contract and the entity has already determined that the entire project is a single performance obligation, the added goods or services would normally be combined with the existing bundle of goods or services.
Addition of distinct goods or services
In contrast to the construction example (for which the addition of otherwise distinct goods or services are combined with the existing single performance obligation and accounted for in that manner), a contract modification that adds distinct goods or services to a single performance obligation that is a series of distinct goods or services is accounted for either as a separate contract or as the termination of the old contract and the creation of a new contract (i.e., prospectively).
Compensation to customer
As illustrated in Example 5, Case B (see IFRS 15 IE22 – IE 24), a contract modification may include compensation to a customer for performance issues (e.g., poor service by the entity, defects present in transferred goods). An entity may need to account for the compensation to the customer as a change in the transaction price separate from other modifications to the contract.
See also: The IFRS Foundation