What is contract modification?
When the terms or price of a business deal are changed, this is called contract modification. Everyone involved in the deal knows about and agrees to these changes, whether in writing, over the phone, or in a standard way in business.
Businesses usually don’t pay much attention to contract changes, but they are generally the accounting issue that needs the most thought. It can be hard to tell if a change is part of the original plan or a modification, especially regarding revenue reporting standards like ASC 606.
Many businesses make their terms and conditions, buy orders, statements of work, and reseller agreements all the same. They also control the things going on around them. If the scope, terms, or agreed-upon price change, it could affect funds and delivery. In turn, this changes how income is recognized.
To keep standard terms from having unintended effects, the sales and law teams should work together to manage contracts. Before signing a contract, it should be constantly reviewed and approved to ensure all the rules are followed.
Synonyms
- Contract scope modification
- Contract price modification
- Contract terms modification
Changes to the contract Under ASC 606, the scope and price of a SaaS deal can change in several ways. As part of following the rules for recognizing income, SaaS companies must ensure they correctly record contract changes.
Here are some changes to contracts that might need to be looked at under ASC 606:
Clause for Termination
Some SaaS subscription agreements have a clause that lets either side end the agreement with little notice (usually 30 days). Because this changes the length of the term, it also changes how income is recorded.
Suppose the original contract had a one-year term, and revenue was recognized ratably over that year but was later changed to allow for termination. In that case, the new contract period will change how the leftover revenue is recognized.
When a contract is broken, sellers may be able to get paid all at once; revenue recognition could happen in stages since some services may still be provided within the 30-day termination frame. Payment could also be put off.
In some business-to-business contracts, the clause that lets you get out of the deal may also be linked to specific performance measures, like a minimum commitment or usage level. Any changes to this clause will also affect when and how much income is recognized in these situations.
License for on-premise software
SaaS works:
- Pay an amount every month or every year
- Get permission to use the platform
In some contracts, especially business contracts, a phrase lets the customer buy a perpetual license all by itself. Sometimes, a big customer wants an on-premise option instead of a cloud-based one.
These deals change both the way a business records income and the way it does its accounting. The business needs to think about more than just subscription fees. It must also consider professional services fees (like training) and custom software creation.
Some payments will happen over and over, while payments for other things will not happen over and over. One-time income is recorded as received, which may or may not be in the same period. On the other hand, subscription payments are usually made in advance for a month of access and are recorded as deferred income.
Prices and ways to pay
In SaaS contracts, price and payment terms also change constantly. Customers can get a better deal if they agree to pay for a more extended period (for example, two years instead of one). They may also ask for changes to the payment plans, like paying every three months or once a year instead of every month.
- Pricing and payment models: the fixed price, time- or material-based, milestone-based, and hybrid models have different payment and delivery plans that change how revenue is recognized.
- Product pricing: When prices change for a product, some changes stay within the normal range for selling that product or service. Others are very different from the standard list price, which affects the books differently.
- Prices cut: If discounts are given regularly or randomly, how are they split up among the contract’s obligations, and how is income recorded? When companies offer discounts for renewing a contract, they need to check to see if those savings are a material right.
- Situations where performance changes: For income recognition, rewards and penalties given for good or bad performance are seen as “variables.” They ask the party to the contract to think more about the price of the trade and maybe even the date of the report.
Obligations to Perform
The number of performance responsibilities may change based on how contract changes are set up. When a contract is changed, businesses need to figure out if adding or removing performance obligations will affect when they need to be done.
Terms of Delivery
It can change how much money is recognized if the buyer (FOB shipping place) or the seller (FOB destination) is responsible for damage during shipping. If the customer controls the things while they are shipped, they become the buyer’s property. That’s also when revenue should be recorded since the things and services would have been provided at that point.
Reselling or Getting a Third Party Involved
Most of the time, the vendor is the principal in a vendor deal. In an average reseller agreement, they’re an agent, which means they sell their goods to a third party (like a white-label reseller) or through a distributor.
The person who “owns” the product or service from the parent business is called a reseller, and their revenue is recorded as “gross” because they are the main person involved in the deal.
For the agent, which is the leading company, sales are counted even if there are commissions and fees. Third-party resellers, such as GSA schedule holders or value-added resellers, usually get paid a commission to sell goods and services to government organizations.
The agent’s net amount is the difference between the price they charged customers (the standard retail value) and the amount they paid in commission to wholesalers or resellers (the reseller price).
How to Make Changes to a Contract
As we already said, ASC 606 is the primary source of contract change information. If you follow this rule, changing a contract will take three steps.
Figuring out a change to the contract
It says in ASC 606-10-25-10 that a contract is modified when all parties agree to a change “that creates new or changes existing enforceable rights and obligations.” So, a business should use the modification structure whenever a change to the original contract affects things like the scope, price, or terms.
Keeping track of changes to contracts
If a change counts as a modification, the contracting group’s next step is to consider the contract. The change will be treated as either a separate contract or one of the following, depending on whether the obligations in the contract are different and whether the selling price matches the price for the item on its own.
- The old contract will end, and a new one will be made (no change to the past cost).
- A cumulative catch-up adjustment to the transaction price of the new deal (an adjustment to the cost of doing business in the past)
- A mix of the two.
The new contract will be handled separately when new items or services are priced at their selling prices. If they are priced lower, on the other hand, the change will be seen as an addition to the original deal.
Recording income as modified obligations are met
ASC 606 states income isn’t recorded when the contract is signed or paid. As time goes on or when goods and services are provided, it’s seen that the performance obligations are met. Changes, on the other hand, change this timing.
A new contract is made when different goods or services are added to a current contract; if there are different prices for the new goods or services, they will be counted as separate revenue.
For other changes, income is still recorded when the performance obligations are met. For instance, a price drop in the middle of a contract will change the amount of income recognized, but not always when it happens.
But there is thought given to endings, cancellations, and other changes that affect the price and time frame of the deal. In these situations, businesses will have to do more work to ensure that recording income matches when the goods or services are delivered. To do this, you might need to record some income at the deal’s start, middle, and end.
Different Kinds of Contract Changes
When a business and its customer agree to change what it promises to deliver or how much the customer will pay, this is called a contract update. To put it another way, it means changing the terms and conditions of the deal.
Here are the four types of contract changes we talked about above, along with how a business would go about making them:
A separate agreement
ASC 606-10-25-12 says that a contract modification is a different contract if it meets these two conditions:
- The deal includes new goods or services.
- The contracted prices go up by the same amount as the prices of each good and service on their own.
A new contract is made when the responsibilities are separate from what was sold before and are sold at the price you set.
As far as recognizing income goes, the old contract stays in place. There will be a different account for the extra money from the new contract.
If you only change the price of a contract and not the scope, it is not considered a different contract. This is because the change doesn’t add any new goods or services.
For example, a change that only lowers the price of goods or services the customer will buy in the future would not be seen as a different contract.
Changes that might happen
Like the first type of change, this one comes with extra duties. The significant difference is that the new products and services are sold at a price different from the original products and services. This is why they belong to the same contract.
ASC 606-10-25-13(a) says it’s treated as if the first contract finished on the date the new obligations were added, making a new contract from that point on.
For example, all the income recorded before the changes stayed the same. The new changes and any responsibilities that haven’t been met are then added together to make a single transaction price. This whole amount is then split again based on the separate selling prices, which keeps happening as long as you meet your performance responsibilities.
So, the revenue that was already recorded stays the same. Still, the leftover amounts from the original contract act, plus the new addition, are moved around and recorded as obligations being met.
Adjustment for cumulative catch-up
The most difficult method is the accumulated one. ASC 606-10-25-13(b) says that this change can be made when the additions are not separate, which means they were already part of the original contract. They are sold separately at a price different from the price they were sold at (for example, a discount or price increase for the whole project or product bundle). The changes are seen as part of the original contract in this case.
This could happen in construction contracts where the terms change over time, like when some parts of a building project are changed and the price changes to reflect that. If this happens, the amount paid and work are changed to reflect the new contract terms.
You change old records of income based on the new amounts for the current time. This change could bring in more or less money for that period, but it will properly show how much money you’ve made since the contractual update.
This is a way to ensure that the total amount of money made up until the change date is the same as the new transaction price. From now on, income recognition will continue as usual.
Adding up and looking ahead
When a contract modification is changed, there may be a mix of performance obligations. Some may involve providing goods or services different from what was agreed upon in the first place. In contrast, others do not (for example, a scope change in a partially fulfilled performance obligation). In this case, it might make sense for a single contract to use both the methods in ASC 606-10-25-13(a) and (b).
How Software for Contract Lifecycle Management Handles Changes
Contract lifecycle management (CLM) software is beneficial for tracking contract changes. It puts all contracts in one place, making it easier to keep track of changes and ensure that ASC 606 rules are followed.
Cloud-based collaborative contract management software also makes it easy for each stakeholder to make changes, keep track of them, and add notes. This makes it easy for them to talk about changes.
When you connect CLM to your company’s other business tools, like CPQ, subscription management, and billing, those duties and changes are immediately taken care of and shown in your accounting system.
