9.1 Defining a Contract Modification

9.1.1 In General

Contract modifications can frequently happen in the normal course of business. Any time an entity and its customer agree to change what the entity promises to deliver or the amount of consideration the customer will pay (i.e., creates or changes the enforceable rights or obligations in a preexisting contract), there is a contract modification.

ASC 606 defines a contract modification as follows:

ASC 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. In some industries and jurisdictions, a contract modification may be described as a change order, a variation, or an amendment. A contract modification exists when the parties to a contract approve a modification that either creates new or changes existing enforceable rights and obligations of the parties to the contract. A contract modification could be approved in writing, by oral agreement, or implied by customary business practices. If the parties to the contract have not approved a contract modification, an entity shall continue to apply the guidance in this Topic to the existing contract until the contract modification is approved.

25-11 A contract modification may exist even though the parties to the contract have a dispute about the scope or price (or both) of the modification or the parties have approved a change in the scope of the contract but have not yet determined the corresponding change in price. In determining whether the rights and obligations that are created or changed by a modification are enforceable, an entity shall consider all relevant facts and circumstances including the terms of the contract and other evidence. If the parties to a contract have approved a change in the scope of the contract but have not yet determined the corresponding change in price, an entity shall estimate the change to the transaction price arising from the modification in accordance with paragraphs 606-10-32-5 through 32-9 on estimating variable consideration and paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration.

The purpose of the contract modification guidance in the revenue standard is to create a single framework for accounting for modifications that will enable entities to account for them consistently across all industries. Therefore, claims, change orders, variations, or other terms that refer to a change in a contract should be evaluated in accordance with the revenue standard’s contract modification guidance.

9.1.2 Differentiating Changes in the Transaction Price From Contract Modifications

While contract modifications often result in a change in the transaction price, not all changes in the transaction price are related to contract modifications. An entity should consider whether a change in the price is due to (1) the resolution of variability that existed at contract inception or (2) a change in the scope or price (or both) of the contract that changes the parties’ rights and obligations after contract inception. An entity will need to use judgment to determine whether a change in price is the result of a change in the transaction price or a contract modification, especially when the entity provides the customer with a price concession. As noted in Section 7.6.2, this distinction is important because the resolution of variability that existed at contract inception is accounted for in accordance with ASC 606-10-32-43 and 32-44, whereas ASC 606-10-32-45 states that changes in the transaction price that are related to a contract modification are accounted for in accordance with the contract modification guidance in ASC 606-10-25-10 through 25-13.

9.1.3 Determining Whether a Contract Modification Is Approved

The first step in the identification of a contract modification is to assess whether, for a contract accounted for under ASC 606, there has been a change in the contract’s scope (e.g., a change in the quantity or type of goods or services to be provided or the duration of the contract) or price, or both. The second step is to determine whether the parties to the contract have agreed upon the change. As defined above, contract modifications must be agreed to by both parties (written, orally, or through customary business practices). That is, both parties must agree to change the enforceable rights and obligations of the contract.

However, the requirement that a contract modification must be agreed to by both parties does not mean that the parties must be in full agreement on all details. For example, there can be situations in which both parties agree to modify a contract but there is discrepancy about the amount of consideration to be paid. Instead of determining whether all of the terms of a contract modification have been agreed to, an entity should assess whether it has the right to be compensated for satisfying the modified contract. Making this determination will require judgment. Further, a modification can be accounted for as either a separate contract or a combined contract, as discussed below. Entities may need to use judgment when determining when a contract extension has been approved after the expiration of an existing contract, as highlighted in Section 4.3.1.

Example 9 in ASC 606, which is reproduced below, illustrates how an entity may be required to make certain judgments when determining whether a contract modification has been approved. In the example, the entity is required to assess the legal enforceability of a contract modification that the customer did not enter into voluntarily.

ASC 606-10

Example 9 — Unapproved Change in Scope and Price

55-134 An entity enters into a contract with a customer to construct a building on customer-owned land. The contract states that the customer will provide the entity with access to the land within 30 days of contract inception. However, the entity was not provided access until 120 days after contract inception because of storm damage to the site that occurred after contract inception. The contract specifically identifies any delay (including force majeure) in the entity’s access to customer-owned land as an event that entitles the entity to compensation that is equal to actual costs incurred as a direct result of the delay. The entity is able to demonstrate that the specific direct costs were incurred as a result of the delay in accordance with the terms of the contract and prepares a claim. The customer initially disagreed with the entity’s claim.

55-135 The entity assesses the legal basis of the claim and determines, on the basis of the underlying contractual terms, that it has enforceable rights. Consequently, it accounts for the claim as a contract modification in accordance with paragraphs 606-10-25-10 through 25-13. The modification does not result in any additional goods and services being provided to the customer. In addition, all of the remaining goods and services after the modification are not distinct and form part of a single performance obligation. Consequently, the entity accounts for the modification in accordance with paragraph 606-10-25-13(b) by updating the transaction price and the measure of progress toward complete satisfaction of the performance obligation. The entity considers the constraint on estimates of variable consideration in paragraphs 606-10-32-11 through 32-13 when estimating the transaction price.

There may be circumstances in which an entity and its customer agree on what is often referred to as an “unpriced change order” (i.e., a change in the scope of the contract before the parties have agreed on the related change in price). In this situation, the entity should estimate the change in the transaction price in a manner consistent with the guidance on estimating variable consideration (see Section 6.3.2 for a discussion of that guidance). The entity will most likely need to use judgment in this situation and consider all relevant facts and circumstances when estimating the change in the transaction price. For example, the entity’s prior history of working in a particular industry or jurisdiction and with the specific customer may provide evidence of the price that will ultimately be approved.

The example below illustrates the factors that an entity may consider in determining whether an unpriced change order has been approved by both parties.

Example 9-1

Entity SF designs, manufactures, and installs custom closets and other home organization systems. While SF is often engaged by individual homeowners to redesign closet space, SF also works frequently with one specific home builder, Entity PJ. During the installation of a closet system for a home that PJ is building, the two parties discuss additional enhancements to be made to the closet system. Because of time constraints on finishing the home, SF begins work on the enhancements immediately, before the parties have decided on the additional transaction price related to the change in scope.

In determining whether the change in scope has been approved and represents a contract modification, SF considers the following factors:

The parties have worked together in the past, in the same geographic region, approximately 50 times.
All previous contracts have been negotiated without disagreement, and the parties have a history of changing the scope of the work before negotiating an updated price. There have been no disagreements on the ultimate price change related to changes in scope.
While the entities generally document their contracts in the form of a written contract, there has been sufficient history to enable SF to be certain that it will have an enforceable right to payment for the additional work that PJ asked it to perform.
Entity SF believes that PJ will agree to pay for both the incremental costs of the change in scope and a reasonable profit margin in a manner consistent with SF’s other contracts with PJ.
The jurisdiction in which the agreement is in effect does not have additional legal precedent or regulations that would override or affect the legal enforceability of SF’s right to payment for the additional work to be performed.

On the basis of these indicators, SF concludes that the parties have agreed to a contract modification. Entity SF estimates the change in the transaction price in a manner consistent with the guidance in ASC 606 on estimating the transaction price. Entity SF will reassess this estimate of variable consideration each reporting period until SF and PJ agree on the transaction price related to the change in scope of the modified contract.

9.1.4 Entering Into a New Contract With an Existing Customer

When an entity enters into a new contract with an existing customer, the entity should consider whether the new contract should be accounted for as a contract modification. There may be no economic difference between whether an entity and its customer modify an existing contract by (1) executing a legal contract whose extant written terms explicitly amend the scope or price of the original contract or (2) executing a new and separate legal contract that meets one or more of the criteria in ASC 606-10-25-9 to be combined with one or more contracts and accounted for as a single contract. Section 4.7 describes the factors in ASC 606-10-25-9 that an entity should consider when determining whether multiple contracts with a single customer should be combined and accounted for as a single contract.

At times, the determination of whether a new contract is a modification of an existing contract may be relatively simple. For example, an entity may be able to conclude relatively easily that a new contract does not modify an existing contract if the promised goods and services in the original contract are unrelated to and priced independently of those in the new contract (i.e., the additional goods or services are distinct and priced at their stand-alone selling prices).

However, in other circumstances, even when the new agreement is not explicitly structured as a modification to the original contract, the entity may need to use judgment when making this determination. In addition to the considerations described in Section 4.7, the entity may need to assess whether and, if so, why any of the promised goods or services are priced at a discount in the newly negotiated contract (e.g., whether the favorable terms were offered solely because of the existing relationship). The entity may also need to understand the substance of the negotiations between the two parties when executing the new agreement to faithfully depict the recognition of revenue related to the goods or services promised to the customer. For example, the revenue recognition pattern of a combined, modified contract, whose combined transaction price would need to be allocated to the goods and services of the combined contract, may be different from that of a newly negotiated contract accounted for as a separate unrelated contract, whose independent transaction price would be allocated to fewer goods and services.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.