Revenue Recognition — Contract Modifications (June 29, 2020)

Pepper’s Fit Friends (“Pepper”), the owner and operator of a health and fitness club in Chicago, enters into contracts with customers to provide one year of access to its club. Each customer has unlimited use of the club during the club’s hours of operations and, in exchange, pays $1,200 at contract inception. The customer is not obligated to pay an ongoing monthly fee. Pepper determines that the nature of its performance obligation is to stand ready to provide the customer with access to its club on an as-needed basis throughout the year. Further, Pepper determines that its performance obligation is satisfied over time because the customer simultaneously receives and consumes the benefits of Pepper’s performance as Pepper provides access to its club. Because Pepper’s obligation is the same throughout the one-year contract, Pepper concludes that its performance obligation meets the criteria to be accounted for as a series under ASC 606-10-25-15. Pepper recognizes revenue on a straight-line basis over the one-year contract term (i.e., $100 per month).

On January 1, 20X8, Pepper enters into a contract with Customer A to provide one year of access to its club in exchange for $1,200, an amount that is payable at contract inception. On April 1, 20X8, as a result of damage from a flood, Pepper is required to temporarily close its club to perform repairs. During this time, customers are unable to access or use the club. On July 1, 20X8, Pepper reopens its club. As a result of closing its club for three months, Pepper offers existing customers three additional months of access to its club (to be added to the end of the customers’ current contracts) for no additional charge. Consequently, A’s current membership is active through March 31, 20X9.

The extension of A’s membership represents a contract modification because it changes the parties’ enforceable rights and obligations under the contract. The contract modification is not accounted for as a separate contract in accordance with ASC 606-10-25-12 because the modification does not grant additional distinct goods or services at their stand-alone selling prices. Because Pepper’s performance obligation is a series, the months of service remaining under the contract are distinct from the months of service already provided to the customer. Therefore, Pepper accounts for its contract modification prospectively in accordance with ASC 606-10-25-13(a).

Before closing its club on April 1, 20X8, Pepper recognized $300 of revenue for A’s contract ($100 per month × 3 months). Because A is unable to access Pepper’s club during the three months in which the club is closed, Pepper is not standing ready to provide access to its club during those three months. Consequently, Pepper is not performing under the contract during those three months and therefore should not recognize revenue from April 1, 20X8, through June 30, 20X8. The remaining $900 of revenue for A’s contract should be recognized on a straight-line basis for the remainder of the contract beginning with Pepper’s reopening of the club on July 1, 20X8. As a result, Pepper recognizes $100 of revenue per month from July 1, 20X8, through March 31, 20X9.

On January 1, 20X8, Pepper enters into a contract with Customer B to provide one year of access to its club in exchange for $1,200, an amount payable at contract inception. As a result of personal health and safety concerns, B chooses not to use the club from April 1, 20X8, through June 30, 20X8, and B notifies Pepper that it will not use the club over this period. During this time, the club remains open. Customer B’s account is not frozen during this time (i.e., B is still contractually permitted to access the club). However, to maintain its relationship with B, Pepper offers B an additional three months of access to its club (to be added at the end of B’s current contract) for no additional charge. This extension is negotiated and agreed to on June 1, 20X8. As a result, B’s current membership is active through March 31, 20X9.

Like the membership extension in Case A, the extension of B’s membership should not be accounted for as a separate contract in accordance with ASC 606-10-25-12 because the modification does not grant additional distinct goods or services at their stand-alone selling prices. Rather, the extension of B’s membership represents a contract modification that should be accounted for prospectively in accordance with ASC 606-10-25-13(a). Before being notified that B would not be using the club for three months, Pepper recognized $300 of revenue for B’s contract ($100 per month × 3 months). Although B is not using the club from April 1, 20X8, through June 30, 20X8, Pepper is still standing ready to provide B with access to its club during this time (i.e., Pepper’s performance obligation for this period is unchanged). Because Pepper is still performing under the contract with B, it should continue to recognize revenue under the original contract until the modification (i.e., $100 per month). As a result of the June 1, 20X8, contract modification extending B’s contract term by three months, Pepper should recognize $70 of revenue per month from June 1, 20X8, through March 31, 20X9 ($700 of revenue remaining ÷ 10 months of service remaining). In addition, Pepper may need to consider whether it has established a business practice of providing contract extensions that creates a valid expectation on the part of Pepper’s other customers that they are entitled to an additional three months of access to the club. This could result in the provision of additional implied goods or services in other customer contracts and, therefore, additional contract modifications.

Cherry Co. (“Cherry”) sells kitchen appliances to customers. Control of each appliance is transferred to the customer at the point of shipment. Consequently, Cherry recognizes revenue at the point of shipment. Cherry’s standard payment terms require customers to pay within 30 days of an appliance’s shipment. Cherry elects the practical expedient in ASC 606-10-32-18, concluding that its contracts do not include a significant financing component because the timing between payment and performance (i.e., shipping the appliance) is one year or less. Therefore, Cherry is not required to adjust its transaction price, and thus revenue, for the time value of money.

As a result of an economic downturn, some of Cherry’s customers are experiencing difficulty paying for appliances within 30 days as required under the standard payment terms. To help its customers, Cherry agrees to extend its standard payment terms from 30 days to 90 days for the foreseeable future. While this represents a form of a concession, Cherry is not conceding on the amount of consideration to which it expects to be entitled; rather, it is conceding on the timing of receiving the consideration.

Cherry concludes that it is still probable that Cherry will collect the consideration to which it is entitled for shipments to its customers. Although Cherry is providing customers with extended payment terms, Cherry determines that doing so does not create a significant financing component since the timing between payment and performance is still one year or less. Accordingly, Cherry does not adjust the amount of revenue recognized as a result of extending its payment terms from 30 days to 90 days.

However, Cherry should continue to monitor the timing of its customers’ payments to ensure that payments are being received within 90 days of shipment. If a customer does not pay within the required 90-day period, Cherry should consider whether it is implicitly providing financing to its customer (which would require adjustment to the transaction price if Cherry expects to receive payment more than one year after shipment) or whether the contract consideration is not collectible.

Albus Inc. (“Albus”) provides lawn and gardening services to customers in Connecticut. Customers can choose from various packages, which require each customer to select the level of services it would like to receive over the six-month period from April 15 through October 15. The price paid will vary depending on the package the customer selects.

On March 26, Albus enters into a contract with Customer C to provide weekly lawn and gardening services from April 15 through October 15 (26 weeks) in exchange for $50 per week ($1,300 total). Because the number of services is predetermined in the contract, Albus determines that the nature of its obligation is to provide distinct weekly lawn and gardening services, as opposed to standing ready to provide the services throughout the contract term. Further, Albus determines that each of its performance obligations is satisfied over time because the customer simultaneously receives and consumes the benefits of Albus’s performance as Albus performs by providing the lawn and gardening services. However, because each service is completed within a day, Albus elects to recognize the $50 weekly fee as revenue at the end of the day upon completion of the services.

On July 15 (halfway through the contract), C issues a complaint to Albus about the services that Albus has provided to date. Specifically, C states that the fertilizer that Albus has been using harmed C’s plants and did not stop the spread of the weeds. As a result of the complaint and to maintain its customer relationship with C, Albus agrees to reduce the weekly amount paid for the entire contract by $10 per week so that the services are priced at $40 per week ($1,040 total). The parties agree that Albus will continue to provide the same level of service for the remainder of the contract term (i.e., C acknowledges the Albus will continue to provide a lower level of services than what C originally expected). Albus concludes that the stand-alone selling price of the lower level of services is $40 per week. Although Albus is reducing the weekly service fee for the entire contract term, the parties agree that Albus will not refund C any amounts previously paid. Rather, the parties agree that C will pay a reduced weekly fee of $30 for the remainder of the contract term. The difference between the original transaction price of $1,300 and the amended transaction price of $1,040 ($260) represents a price concession.

Because of the prior service issues, Albus concludes that it did not perform as promised under the original contract. Accordingly, Albus concludes that the change in the transaction price does not result from a change in the enforceable rights and obligations under the contract. This is because Albus concludes that it could not enforce its right to $50 per week because of the service issues. The price concession does not represent a change in the parties’ enforceable rights and obligations; rather, it represents a change in the transaction price. Thus, Albus should account for the price concession as a change in the transaction price in accordance with ASC 606-10-32-43 and 32-44 rather than as a contract modification in accordance with ASC 606-10-25-12 and 25-13.

Albus recalculates its total transaction price and recognizes a cumulative adjustment to revenue on the date of the price concession, which is calculated as follows:

Because the parties agree that Albus is not required to refund amounts previously paid (rather, C will pay $30 per week for the remaining contract term), the $130 reversal of revenue will result in the recording of a contract liability. The contract liability will be reduced as Albus transfers services to C over the remaining contract term. As a result, Albus will recognize revenue of $40 per week.

On August 15, C requests a price concession from Albus on the grounds of financial hardship. To maintain its relationship with C, Albus agrees to accept a reduced weekly fee of $25 from C for the remainder of the contract term. Unlike the price concession in Case A, Albus’s concession in this case represents a contract modification because it changes the enforceable rights and obligations of the parties to the contract (i.e., instead of being related to variability that existed at contract inception, the concession was negotiated as a result of changes in facts and circumstances related to Albus’s customer after contract inception). Accordingly, Albus considers the guidance in ASC 606-10-25-12 and 25-13 to account for the modification. Because the modification is only a change in the transaction price, it should not be accounted for as a separate contract under ASC 606-10-25-12 (i.e., the modification does not add any promised goods or services). Therefore, Albus applies the guidance in ASC 606-10-25-13 to account for the modification. Since the lawn and gardening services remaining are distinct from the services already provided to C, Albus accounts for the modification prospectively in accordance with ASC 606-10-25-13(a). As a result, Albus does not adjust revenue previously recognized; rather, it recognizes the reduced $25 per week fee as revenue on a prospective basis.