Contract Modification

What is Contract Modification?

Contract modification is a change to the scope or price outlined in a business contract. All parties involved in the contract acknowledge and agree upon these alterations, either through written communication, verbally, or as per established business norms.

Although businesses often gloss over them, contract modifications are usually an accounting consideration that requires the most judgment. Discerning whether a change falls within the original scope or is a modification can be quite intricate, especially when considering revenue recognition standards like ASC 606.

Most organizations standardize their terms and conditions, purchase orders, statements of work, and reseller agreements (among other documents). They also regulate the processes surrounding them. Changes to the scope, terms, and contracted price can affect delivery and payments. This, in turn, affects revenue recognition.

To avoid unintended consequences of changing standard terms, sales and legal teams should play a collaborative role in contract administration. For compliance purposes, reviews and approvals should always happen before executing a contract.

Synonyms

• Contract scope modification
• Contract price modification
• Contract terms modification

Contract Modification Under ASC 606

Several contractual changes may happen to the scope and price of a SaaS contract. SaaS companies need to properly account for contract modifications as part of revenue recognition compliance.

Here’s a look at a few contractual changes that could require consideration under ASC 606:

Termination Clause

Some SaaS subscription contracts have a termination clause that allows either party to terminate the contract on short notice (typically 30 days). Since this changes the term length, it also changes how revenue is recognized.

If the original contract was structured as a one-year term, with revenue recognized ratably over 12 months, but later modified to allow termination, the new contract period will affect how the remaining revenue is recognized.

In some cases of termination, vendors would have the right to payment all at once. For others, the revenue recognition could occur incrementally, given that some services may still be rendered within the 30-day termination window. Or, payment may be deferred.

For certain B2B contracts, the termination clause may also be tied to specific performance metrics, such as a minimum commitment or usage threshold. In these cases, the timing and amount of revenue recognition will also be impacted by any modifications to this clause.

On-Prem Software License

The SaaS model is simple:

1. Pay a monthly or annual amount
2. Receive access to the platform

However, some contracts — especially in the enterprise space — include a clause that gives the customer the right to buy a perpetual license outright. This is most common when a large customer needs an on-premise solution rather than a cloud-based one.

These transactions impact how a company recognizes revenue as well as the accounting model it uses. In addition to regular subscription revenue, the company must consider professional services fees (e.g., training) and custom software development.

Payments for some elements will be recurring, while others will be non-recurring. One-time revenue is recorded as it is earned (which may or may not be in the same period), while subscription payments are usually paid upfront for a month of access and recorded as deferred revenue.

Pricing and Payment Terms

Changes to pricing and payment terms are also common in SaaS contracts. Customers may negotiate a lower price for committing to a longer term (e.g., two years instead of one). They may also request changes to payment schedules, such as paying quarterly or annually instead of monthly.

• Pricing/payment models — Fixed price, time- or material-based, milestone-based, and hybrid models all have different delivery and payment schedules that affect revenue recognition.
• Product pricing — Some price changes stay within the standard selling price range for a product or service. Others significantly deviate from the standard list price, which leads to different accounting outcomes.
• Discounts — Whether discounts are given consistently or randomly can change how they are distributed across the contract’s obligations and how revenue is recognized. Additionally, when discounts are offered for renewing a contract, companies have to evaluate whether those discounts are a material right.
• Performance contingencies — Penalties and bonuses given for good/bad performance are considered ‘variable’ for revenue recognition. They require the contracting party to further assess the transaction price and, potentially, the reporting date.

Performance Obligations

Depending on how modifications of contracts are structured, the number of performance obligations may change. When a contract is modified, companies need to assess whether adding (or removing) performance obligations affects the timeline for delivering on those obligations.

Delivery Terms

Whether the buyer assumes responsibility for damages during shipping (FOB shipping point) or the seller does (FOB destination) can affect revenue recognition. If the customer is responsible for the goods while in transit, then that’s when the title transfers. Since the goods and services would have then been rendered, it’s also when revenue should be recognized.

Resale or Third-Party Involvement

In a regular vendor contract, the vendor is a principal. In the typical reseller agreement, they’re an agent — that is, they’re selling their products to an intermediary (e.g., a white-label reseller) or through a distributor.

For the reseller (i.e., the one who gains “ownership” of the product/service provided by the parent company), revenue is recognized gross because they act as the principal in the transaction.

For the agent (i.e., the parent company), revenue is recognized net of any commissions and fees. For example, third-party resellers like GSA schedule holders or value-added resellers typically earn a commission for selling products/services to government agencies.

The net amount reported on the agent’s end equals the difference between the selling price to the customers (standard retail value) and the commission paid to distributors or resellers (reseller price).

Contract Modification Process

As mentioned earlier, ASC 606 is the primary source of guidance for contract modification guidance. Following this standard, there are three steps to modifying a contract.

1. Identifying a Contract Modification

ASC 606-10-25-10 states that a contract modification occurs when all contracting parties approve a change “that creates new or changes existing enforceable rights and obligations.” So, whenever a change to the original contract alters aspects such as the scope, price, or terms, a business should apply the modification framework.

2. Accounting for Contract Modifications

If a change qualifies as a modification, contract consideration is the next step for the contracting organization. Depending on whether obligations in the contract are distinct and if the selling price reflects the standalone selling price, the modification will be accounted for as either a separate contract or one of the following:

• Termination of the old contract and creation of a new one (no adjustment to historical cost)
• Cumulative catch-up adjustment to the new contract’s transaction price (adjustment to historical cost)
• A combination of the two

The new contract will be treated separately when newly added goods or services are priced at their standalone selling prices. If they are priced at a discount, however, the change will be treated as a modification to the original contract.

3. Recognizing Revenue as Modified Obligations are Fulfilled

Under ASC 606, revenue isn’t recognized at contract inception or payment. It’s recognized as the performance obligations are fulfilled over time or when goods and services are delivered. Modifications, however, affect this timing.

When a new contract is formed (i.e., when distinct goods/services are added to an existing contract), revenue from additional services/goods will be recognized separately if distinct pricing exists for those items.

For other types of modifications, revenue is still recognized as the performance obligations are satisfied. For example, a mid-contract price reduction will affect the amount of revenue recognized, but not necessarily the timing.

There is, however, consideration when it comes to terminations, cancellations, and other modifications that affect the transaction timeline and price. In these cases, companies will have additional work to make sure revenue recognition timing aligns with when goods or services are provided. This might require recognizing some revenue at the contract’s beginning, middle, and end.

Types of Contract Modifications

A contract modification happens when an entity and its customer agree to change the scope of what the entity promises to deliver or the amount the customer will pay. In other words, it involves altering the contractual obligations and pricing.

Here’s a look at the four abovementioned types of contract modifications and how a business would approach them:

Separate Contract

According to ASC 606-10-25-12, a contract modification qualifies as a separate contract, it meets the following two criteria:

• It adds distinct goods or services to the contract.
• Contracted pricing increases by an amount equal to the standalone selling prices of each good and service.

When obligations are distinct, meaning they weren’t part of what was sold before, and are sold at your standalone selling price, then it’s a new contract.

From a revenue recognition standpoint, the old contract goes on as normal. The additional revenue from the new contract will be accounted for separately.

A contract modification that solely adjusts the price (without altering the scope) is not treated as a separate contract. This is because the modification does not introduce new goods or services.

For instance, if a modification only reduces the price that a customer must pay for future goods or services, it would not be treated as a separate contract.

Prospective Modification

Like the first type of modification, additional obligations are distinct here. The main difference (and why it belongs in the same contract) is that the new products/services are sold at a price that does not reflect the standalone selling price.

According to the guidance in ASC 606-10-25-13(a), it’s essentially treated as if the original contract ended on the date the new obligations were added, thus forming a new contract from that point.

To illustrate, all revenue recognized before the modifications remains unchanged. Any unfulfilled obligations, plus the new changes, are then grouped together into a single transaction price. This total amount is then redistributed based on the standalone selling prices, moving forward as you meet the performance obligations.

So, the previously recognized revenue remains intact, while the remaining amounts from the original contract plus the new additions are reallocated and recognized as the obligations are fulfilled.

Cumulative Catch-Up Adjustment

The cumulative approach is the most complex. Guidance in ASC 606-10-25-13(b) states this modification applies when the additions are not distinct — meaning they were already part of the original contract — and they are sold at a price other than the standalone selling price (e.g., a discount or price increase over an entire project or product bundle). In this scenario, the additions are treated as part of the original contract.

This might happen in construction-type contracts where the terms change over time, like altering some features of a building project and adjusting the price accordingly. In such a case, the total transaction price and progress measure are updated based on the revised contract terms.

Essentially, you adjust previous revenue recordings based on the updated values, within the current period. This adjustment could either increase or decrease the revenue for that period, but it will accurately reflect the total revenue you’ve earned with the contractual update.

This is a way to ensure that the total revenue up to the modification date aligns with the new transaction price. Moving forward, revenue recognition continues as usual.

Cumulative and Prospective

In certain contract modifications, a mix of performance obligations may exist where some involve remaining goods or services that are distinct from those previously provided under the initial agreement, while others do not (for instance, a scope change in a partially fulfilled performance obligation). In such scenarios, it could be apt for an entity to employ both the models outlined in ASC 606-10-25-13(a) and ASC 606-10-25-13(b) to a singular contract.

How Contract Lifecycle Management Software Manages Modifications

Contract lifecycle management (CLM) software is invaluable for managing contract modifications. It centralizes all contracts and streamlines the process of tracking changes and ensuring compliance with ASC 606 requirements.

Collaborative, cloud-based contract management software also makes it easy for individual stakeholders to make/track changes and add comments, so they can discuss modifications seamlessly.

Furthermore, integrating CLM with the company’s other business software (CPQ, subscription management, and billing) means those obligations and changes are managed and automatically reflected in your accounting system.

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