Contract Modifications Parts I and II introduce contract modifications and provide explanations of proper accounting treatment. This article continues the series with a discussion of stakeholder concerns about implementation as well as the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) actions to address them.
Contract Modification Implementation Issues
By January 2015, a number of stakeholders voiced implementation concerns. Transition guidance requires entities to choose either the full retrospective or modified retrospective approach. Some entities have significant volumes—even millions—of customer contracts that are frequently modified. Regardless of which transition approach is selected, some stakeholders insisted that retrospective application of the contract modification guidance is impracticable, especially when considering that some modified contracts have durations spanning decades.
During the transition, an entity would need to separately evaluate the effects of each sequential contract modification (as required by Accounting Standards Codifications (ASC) 606-10-25-12 to 13). These entities believe that evaluating these contracts would be overly cumbersome, expensive, and have questionable benefits no matter what transition method is adopted. As such, several entities asked for a practical expedient that would not require evaluation of contracts with modifications taking place before initial adoption.
The Hindsight Expedient
In March 2015, the FASB and IASB (the Boards) met to discuss practical expedients. The Boards tentatively agreed to provide a practical expedient on transition (referred to as the “use of hindsight” expedient). It permits an entity to account for a modified contract by determining a transaction price and performing a single standalone selling price allocation (with the benefit of hindsight) that includes all satisfied and unsatisfied performance obligations in the contract from inception. In other words, instead of going back to the time of contract inception and then recalculating the total impact of each modification sequentially, entities are permitted to use hindsight to account for all modifications at once. These include modifications from contract inception through a specified date called the contract modification adjustment date (CMAD).
An entity can apply the practical expedient using the following steps:
- Identify all the satisfied and unsatisfied performance obligations in the contract at the contract modification adjustment date (CMAD); this includes those resulting from modifications from contract inception to the CMAD.
- Determine the transaction price at the CMAD that reflects all modifications from inception to the CMAD.
- Allocate the transaction price to the performance obligations identified at the CMAD based on the historic standalone selling price of each good or service.
Any subsequent modifications will be accounted for in accordance with the regular guidance in ASC 606. The tentative decisions of the Boards include adding CMAD to the revenue standard. However, each board has decided to define CMAD differently—this is a point of divergence between International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP). Under IFRS, the CMAD is the beginning of the earliest period presented in the financial statements regardless of transition approach (full or modified retrospective). For an entity that has a calendar year-end and includes one comparative period in its financial statements, this would be January 1, 2017 (assuming a public entity has chosen the delayed January 1, 2018 implementation date).
The FASB decided that the CMAD will be the beginning of the earliest period presented in accordance with ASC 606. With two years of comparative data, the CMAD under the full retrospective method is January 1, 2016; and January 1, 2018 under the modified retrospective method.
The IASB also plans to implement a practical expedient allowing an entity using the full retrospective approach to only apply the new standard to contracts that are not completed under prior IFRS. The FASB decided not to issue this expedient. As a result, US GAAP preparers using the full retrospective approach will need to examine whether there are any remaining performance obligations under ASC 606 that would otherwise be considered completed contracts under ASC 605.
Potential Outcomes from Hindsight Expedient Application
The practical expedient may not provide much relief to some entities. Eliminating the requirement to separately evaluate contract modifications fails to remove some of the more consequential difficulties preparers face. For example, an entity still needs to identify all satisfied and unsatisfied performance obligations and their standalone selling prices. The process of obtaining this data may be arduous enough that the “relief” provided by the practical expedient does not meaningfully reduce the amount of work required to apply the transition guidance.
Difficulties arising from synthesizing enormous quantities of data might be compounded by impractical time constraints. For example, if an entity preparing in accordance with US GAAP uses the modified retrospective approach, the CMAD is the date of initial ASC 606 application. An entity will need to identify all satisfied and unsatisfied performance obligations from contract inception through the CMAD, which under the modified retrospective approach is January 1, 2018. By definition, it is impossible to make conclusive hindsight calculations before this date. As such, an entity may not have sufficient time and resources to finalize hindsight calculations in time for its March 31, 2018 interim financial statements—especially if it is an entity with frequent contract modifications.
Ultimately, the Boards’ agreement to the hindsight expedient sustains the position that separate accounting for each contract modification prior to the CMAD does not provide sufficient, useful information to justify the costs of accounting for each sequential modification.
|US GAAP (two years comparative)||IFRS (one year comparative)|
|CMAD – Full Retrospective||Earliest period in accordance with 606 (Jan 1, 2016)||Beginning of earliest presented period (Jan 1, 2017)|
|CMAD – Modified Retrospective||Earliest period in accordance with 606 (Jan 1, 2018)||Beginning of earliest presented period (Jan 1, 2017)|
|Contracts treated as completed under prior revenue recognition standards, but not under joint guidance – Full retrospective||No practical expedient. Entities must determine whether any performance obligations remain.||Practical expedient allows entities to treat all previously completed contracts as completed|
Under ASC 605, many entities relied on firm guidance and other non-authoritative sources to develop accounting policies for contract modifications. The transition to ASC 606 forces entities to review longstanding policies and practices to ensure they are in line with authoritative guidance. The Boards are dealing with impracticalities of transition guidance pertaining to contract modifications. Some companies find it costly and overly difficult to retrospectively apply this guidance to all their contract modifications because they have numerous decades-long contracts with multiple modifications. The Boards have issued a tentative practical expedient to help transition from ASC 605 to ASC 606.
- ASC 606-10-25-10 to 25-13
- Deloitte, Heads Up: “FASB Continues to Clarify the New Revenue Standard.” 20 March 2015.
- EY, Financial Reporting Developments: “Revenue from contracts with customers.” October 2018. Section 3.4.
- FASB Memorandum: “Minutes of Match 18, 2015 Joint Board Meeting.” 24 March 2015.
- FASB TRG Memo 7A: “Practical Expedients upon Transition – Contract Modifications and Completed Contracts.” 10 March 2015.
- FASB TRG Memo 24: “Contract Modifications.” 26 January 2014.
- KPMG, Handbook: “Revenue Recognition.” November 2018. Section 11.
- PWC, “Revenue from contracts with customers.” September 2018. Section 2.9.