Accounting Standards Codification (ASC) 606 is the accounting standard that governs how companies recognize revenue in their financial statements. ASC 606 uses a five-step model to reflect the transfer of goods or services in revenue recognition; it does so by requiring companies to recognize revenue only as they meet performance obligations. This leads to clearer, more consistent financial reporting that better reflects how businesses earn revenue.

When the terms of a customer contract change—whether that’s from adding new products, adjusting prices, or other tweaks—businesses must also adjust revenue recognition practices under ASC 606. The standard requires them to decide if a change creates a new contract or modifies the existing one and to adjust their processes accordingly.

Below, we’ll explain the different types of contract modifications, how contract modifications impact revenue recognition, and challenges in recognizing revenue in modified contracts.

What’s in this article?

• Types of contract modifications
  
• How contract modifications impact revenue recognition
  
• Challenges in recognizing revenue in modified contracts
  

Types of contract modifications

A contract modification is any change that alters the scope of an existing contract, its price, or both. Modifications can result from mutual agreement between the parties or from external factors that require changes to the original contract terms.

Contract modifications fall into three main categories:

• Additions (scope increases): These modifications involve adding new goods or services that were not part of the original contract. They might include new deliverables, extra services, or extensions in the contract’s time frame. Contracts often price additions separately from the original terms.

• Changes (adjustments to existing terms): These modifications involve changes to the price, timing, or quantity of goods or services already covered under the existing contract. Changes could be due to new customer requirements, alterations in project scope, or adjustments in the deliverables. Adjustments to existing terms can be priced either at market rates or through a negotiated amount.

• Terminations (partial or complete cancellations): These modifications involve the partial or complete termination of the contract, which could be caused by a variety of reasons such as breach of contract, unforeseen circumstances, and changes in business strategy. Terminations can include a reversal of some or all of the contract’s obligations and can result in penalties or settlement payments.

Once modifications occur, the company must determine whether they have created a new contract or simply altered an existing one. The business treats a modification as a new contract if it involves:

• Adding distinct goods or services that are not included in the original agreement

• A price increase that reflects the stand-alone selling price of the additional goods or services

The business treats a modification as a change to an existing contract if:

• The modification does not add distinct goods or services

• The added goods or services are not priced at their stand-alone selling price

If the modifications create a new contract, then revenue recognition follows standard revenue recognition principles according to the new contract terms and from the modification date.

If the modifications do not create a new contract, the company must reallocate the transaction price to the modified, remaining performance obligations. If a contract modification changes the scope or price, it might also require a reassessment of the performance obligations identified at the contract’s inception. Modifications that do not create a new contract often require a cumulative catch-up adjustment, where the company adjusts revenue for the current period to reflect the modified contract terms.

Businesses must keep proper documentation of any contract modifications, the rationale behind classification decisions, and detailed disclosures for transparency and compliance with ASC 606.

How contract modifications impact revenue recognition

ASC 606 uses a five-step model. When a contract modification occurs, it impacts how each step of this model is applied. Here’s how contract modifications affect each step of the ASC 606 model.

Step 1: Identify the contract with a customer

• Impact: When a contract modification occurs, the company must determine if the modification creates a new contract or if the modification should be accounted for as part of the existing contract.

• Example: A construction company contracts to build a warehouse. During the project, the customer requests an additional parking lot. If the parking lot is distinct and priced separately, this modification creates a new contract under ASC 606. If not, the modification becomes part of the existing contract.

Step 2: Identify the performance obligations in the contract

• Impact: Contract modifications can change the performance obligations identified in the original contract. The business must determine which goods or services are now distinct and what constitutes a separate performance obligation.

• Example: A software company sells a subscription with an initial setup service. A modification adds an upgrade service. The company must determine if the upgrade is a separate performance obligation or if it integrates into the original service package and alters the original performance obligations.

Step 3: Determine the transaction price

• Impact: Modifications affect the transaction price by changing the total consideration for the contract. This change might involve additional or reduced consideration, which must be adjusted in the transaction price.

• Example: A telecommunications company agrees to a contract modification that adds more data services for a price below the standard rate. It must recalculate the transaction price to include the new discounted price and reflect the reduced stand-alone selling price for the additional services.

Step 4: Allocate the transaction price to the performance obligations

• Impact: If the modification does not create a new contract, the company must reallocate the revised transaction price to all unfulfilled performance obligations based on their stand-alone selling prices.

• Example: An online learning platform offers a contract for access to courses and additional tutoring services. A modification adds more tutoring sessions at a bundled price. The platform must reallocate the total transaction price to both the original and additional services based on their stand-alone selling prices.

Step 5: Recognize revenue when (or as) performance obligations are satisfied

• Impact: Contract modifications can lead to changes in the timing and pattern of revenue recognition. If the modification affects unfulfilled performance obligations, the company must adjust revenue recognition to align with the modified contract terms.

• Example: A manufacturer of specialized equipment enters into a contract to deliver machines over several years. Partway through, a contract modification accelerates the delivery schedule and increases the quantity. The company must now adjust revenue recognition to reflect the new delivery timeline and quantities. This might accelerate recognition or defer revenue based on the modified performance obligations.

Contract modification scenarios

Here are three scenarios of contract modifications and how they impact the revenue recognition process.

Scenario 1

A software company sells a two-year license for accounting software with customer support. After six months, the customer requests an additional cybersecurity module that wasn’t part of the original contract.

If the cybersecurity module is distinct and priced at its stand-alone selling price, this modification creates a new contract. The new contract starts from the modification date and the revenue recognition process begins anew for this contract.

Scenario 2

A vendor contracts to provide maintenance services for equipment for $100,000 over five years. After two years, the scope of the maintenance expands to include additional parts replacement for another $20,000.

Because it does not add distinct goods or services, this modification does not create a new contract. Instead, it requires a cumulative catch-up adjustment. The vendor must reallocate the new transaction price of $120,000 over the remaining performance obligations.

Scenario 3

A retailer contracts to purchase 10,000 units of a product for $50 each. Midway through, it modifies the contract to increase the order to 15,000 units at a discounted price of $45 per unit.

Since the additional units are not distinct and are not priced at their stand-alone selling price, the modification affects the existing contract. The seller must recalculate the transaction price and reallocate it to the revised total of 15,000 units. The seller must recognize revenue over the remaining delivery schedule.

Challenges in recognizing revenue in modified contracts

Revenue recognition under ASC 606 can become difficult when contract modifications are involved. Every time a contract gets modified—whether it’s a price tweak, the addition or removal of obligations, or a shift in scope—the accounting team needs to reassess how to handle revenue recognition. New pricing terms impact the overall transaction price, new performance obligations might constitute a new contract or require adjustments to existing obligations, and changes in scope can require changes in how and when revenue is recognized for remaining deliverables.

Here are the challenging aspects of revenue recognition after contract modifications.

Bundled services or goods

• Determining distinct vs. indistinct additions: If the contract modification involves adding something new to a bundle, you must determine whether it’s distinct from what’s already being delivered. This decision affects whether the modification counts as a separate contract or is part of the existing one.

• Reallocating the price: If the modification doesn’t create a new contract, you must reallocate the original (and now revised) transaction price across the newly defined bundle. This can be difficult, especially if the original goods and services are interdependent and don’t have clear stand-alone selling prices.

Variable consideration

• Reassessing what’s probable: After a modification, you’ll need to look again at any variable consideration such as discounts, bonuses, rebates, and penalties. Revisit your estimates to see what is still “highly probable” under the new terms and what isn’t.

• Introducing new variables: You might need to consider new variables such as a new bonus structure and penalty terms after a contract modification. You must factor them into revenue recognition going forward.

• Adjusting the timing: With a revised variable consideration, you might need to change both how much revenue is recognized and when it’s recognized. This can affect both current and future periods.

Prospective accounting vs. catch-up adjustments

• Prospective accounting: If a modification is distinct from the goods or services already delivered, you can treat it prospectively. That means it only affects revenue going forward. You will still have to reassess and reallocate the transaction price for the contract’s remaining obligations.

• Catch-up adjustments: If a modification affects obligations that are not distinct from the goods or services already delivered, you can adjust revenue for the period of the modification to reflect the new contract terms. This can be a technical headache if the contract is complicated and involves multiple performance obligations.