Article:

IFRS 15 for the TMT industries – Contract Modifications

27 June 2018

It is common for the scope and/or price of technology, media and telecommunications (TMT) contracts to be modified due to changes in the scope of work (often termed contract variations) or because additional goods or services are added to the contract.  IFRS currently has limited guidance for the accounting consequences of these changes.  In contrast, IFRS 15 has detailed guidance to be applied in determining whether, from an accounting perspective, contract modifications result in changes to the existing contract or the issue of a new contract. This links to whether there is either an adjustment to the amount of revenue recognised to date (resulting in a ‘true up’ in the income statement) or to revenue to be recognised in future.  These new requirements may result in significant changes to the pattern of revenue and profit recognition.

Example – Modification (distinct good/service)

Background

On 1 January 2019, a customer engages Software Co. to build a software application for $500,000 (estimated cost $300,000).

On 1 January 2020 Software Co and the customer agree to modify the contract to include hardware on which the software will be used for an additional $50,000 (estimated cost $40,000).

Software Co. regularly supplies this equipment on a standalone basis and the standard price for this is $60,000. 

Software Co. has determined that it should recognise revenue for the software build over time, and for the sale of the hardware equipment, at the point in time when the hardware is delivered to the customer.

On 1 January 2020, 50% of the original contract value for the software build has been completed.

Question
How should this contract modification be accounted for?

Answer
The supply of the hardware is a distinct good that should be accounted for as a separate performance obligation. As the contract price for the hardware ($50,000) is less than the standalone selling price of $60,000, the modification is treated as a termination of the original contract and a new contract is created. This means that any unperformed work on the old contract is combined with the new contract for the sale of hardware.

As such, total consideration for the ‘new contract’ is $300,000, being 50% of $500,000 remaining on the old contract, plus $50,000 for the hardware contract. This $300,000 consideration is then allocated to the two separate performance obligations in the ‘new contract’ in proportion to their standalone selling prices as follows:

Contract components Contract price Stand-alone selling price Revenue
Software Application $250,000
(50% x $500,000)
$250,000
(50% x $500,000)
$241,936
($300,000 x $250,000/$310,000)
Equipment $50,000 $60,000 $58,064
($300,000 x ($60,000/$310,000)
Total $300,000 $310,000 $300,000

This means that revenue on the remaining software development services will be $241,936 rather than $250,000 due to the discount on the hardware contract being allocated to both performance obligations.

Current practice under IAS 11/IAS 18

Currently, common practice would be to account for these two contracts separately and recognise the revenue for each separate contract.

Example – Modification (not a distinct good/service)

Background

On 1 December 2018, Customer A engages Media Co. to film a television advertisement that has been drafted by Customer A for $10,000. The advertisement will be filmed over a number of months and will require Media Co. to film in four different locations.

Halfway through the filming (100 hours of filming completed out of 200 budgeted filming hours), on 31 December 2018, Customer A alters the script and adds another filming location. The contract is modified to reflect this and the total contract value is changed to $12,000 (an additional 20 hours will be required due to the modification).

Assume Media Co. recognises revenue over time via the input method (actual hours as a % of total budgeted hours).

Question
How should this contract modification be accounted for at the modification date (31 December 2018)?

Answer
The additional filming required does not represent a distinct good or service and hence the contract should continue on, and a cumulative catch up adjustment is recognised.

  Modification date (31 December 2018)
Original % of completion 50% (100 actual hours/200 budgeted hours)
Original revenue $10,000
Revenue recognised at contract modification date $5,000 (50% x $10,000)
Additional revenue from contract modification) $2,000
Amended contract revenue $12,000
Amended % of completion (post modification) 45.5% (100 hours/220 budgeted hours)
Adjusted revenue $5,455 (45.5% x $12,000)
Cumulative catch-up adjustment $455 ($5,455 - $5,000)

The following journal entry will be processed by Media Co. on 31 December 2018:

Dr Trade receivable/contract costs $455  
Cr Revenue   $455

Current practice under IAS 11/IAS 18

There is limited guidance under current accounting standards, but common practice would be to account for the changes on a prospective basis.

Practical implications on systems and processes 

Some of the practical implications on systems and processes for Media Co. include:

  • Identifying whether the additional goods or services are distinct
  • Systems to determine the cumulative ‘catch up’ adjustment where additional goods or services are not distinct.