Contract modifications

The Boards considered possible improvements and clarifications to the requirements for contract modifications that were proposed in paragraphs 18-22 of the revised Exposure Draft Revenue from Contracts with Customers (the ‘2011 ED’).

The 2011 ED noted that some modifications should be accounted for prospectively, while other modifications should be accounted for on a cumulative catch-up basis in order to faithfully depict the rights and obligations arising from the modified contract. However, as part of the Boards outreach activities, it received feedback that the proposals in the 2011 ED were complex and difficult to understand. Specific feedback from respondents concentrated on the following topics:

• The application of the proposals to what US GAAP describes as unpriced change orders and contract claims.
• Suggested improvements or clarifications to the proposals, specifically relating to:
  • accounting for modifications that affect only price (paragraph 20 of the 2011 ED);
  • application of paragraph 22(a) of the 2011 ED to situations with variable consideration and contract assets; and
  • other drafting improvements to address confusion in applying paragraph 22.

As a result of feedback received, the staffs’ analysis and recommendations in response to each of the above concerns are outlined as follows:

• Clarify the proposed requirements for recognising revenue from contract claims.
  
  Some respondents to staff outreach requested clarification to the application of the proposals to what US GAAP describes as unpriced change orders (i.e., modification in which the change in scope is approved but the corresponding change in price is still to be negotiated) and contract claims (specifically those modifications in which the changes in scope and price are unapproved or in dispute). The respondents were concerned that paragraph 18 of the 2011 ED would not permit those contract claims to be accounted for as a contract modification until the claims are formally approved; resulting in a change to current practice. As a result, these respondents suggested that existing contract claims requirements from IAS 11 Construction Contracts and Topic 605-35 Revenue Recognition - Construction-Type and Production-Type Contracts should be incorporated into the revenue standard.
  
  While the staffs recommended that the proposed requirements for contract modifications should not be revised to explicitly refer to the accounting for contract claims, they recommended that the requirements could be made more clear by including an illustrative example. That example, while not yet drafted, would be expected to demonstrate that the accounting for contract claims should be based on whether the claim creates or modifies the rights and obligations of the parties to the contract. If the claim is enforceable (although the claim need not be in writing) but the price of the claim is subject to further negotiation, an entity should account for the claim in accordance with paragraph 19 (or others, where relevant) of the 2011 ED.
  
  Multiple Board members preferred to see draft wording to ensure the illustrative example appropriately responded to constituent concerns. However, both Boards tentatively agreed with the staff recommendation.

• Remove paragraph 20 from the 2011 ED.
  
  A few respondents to staff outreach contrasted the proposed accounting for modifications that affect only price (which would be accounted for on a cumulative catch-up basis under paragraph 20 of the 2011 ED) with modifications that affect scope and price (which would be accounted for prospectively if the criteria proposed in paragraph 22(a) of the 2011 ED are met). These respondents were concerned with the inconsistency in the accounting outcomes.
  
  In considering constituent feedback, the staffs recommended the removal of paragraph 20 from the 2011 ED to eliminate the difference in accounting between contract modifications that result only in a change in price and contract modifications that result in a change in the scope and price where the remaining goods or services are distinct. As a result, an entity would account for modifications that affect only price on the same basis as any other modification. With little feedback, the Boards tentatively agreed with the staff recommendation.

• Clarify the interaction of paragraph 22(a) with contract assets.
  
  Some respondents to the 2011 ED requested clarification on how an entity should allocate the transaction price to remaining performance obligations in accordance with paragraph 22(a) of the 2011 ED. They identified an error in the calculation of the transaction price available for allocation in paragraph 22(a) because no adjustment is proposed for promised amounts of consideration already allocated to performance obligations that have been satisfied and recognised as revenue. Without deducting promised amounts of consideration that have already been recognised from the transaction price that is available for allocation to the remaining performance obligations as revenue, the amount of the transaction price could be recognised as revenue twice.
  
  The staffs proposed to clarify that the transaction price available for allocation should be “...the amount of consideration received from the customer but not yet recognised as revenue plus the amount of any remaining consideration that the customer has promised to pay and that has not been recognised as revenue”. The Boards tentatively agreed with the staff recommendation.

• Clarify the interaction of paragraph 22(a) with variable consideration.
  
  Some respondents to the 2011 ED requested clarification of how paragraph 22(a) of the 2011 ED would apply when the transaction price allocated to some or all of the performance obligations includes variable consideration. Respondents requested clarification of whether the change in variable consideration should be accounted for prospectively (as paragraph 22(a) would require) or on a cumulative catch-up basis (as paragraphs 77-80 would require for changes in the transaction price).
  
  In response, the staffs proposed to clarify that modifications that fall into paragraph 22(a) shall be accounted for prospectively except for circumstances in which the variable component of the transaction price relates to satisfied performance obligations. If the variable component relates to satisfied performance obligations, any changes in variable consideration would be accounted for on a cumulative catch-up basis. With little feedback, the Boards tentatively agreed with the staff recommendation.

Measuring progress towards complete satisfaction of a performance obligation

The Boards discussed possible clarifications and refinements to the proposals on measuring progress towards complete satisfaction of a performance obligation in paragraph 38-48 of the 2011 ED.

The staffs noted that as part of the Boards outreach activities, it has received feedback on the following topics:

• The suitability of ‘units of delivery’ or ‘units produced’ as output methods to measure progress;
• Accounting for uninstalled materials; and
• Accounting for wasted materials and inefficiencies.

Suitability of ‘units of delivery’ or ‘units produced’ as output methods to measure progress’

Paragraph 41 of the 2011 ED mentioned units produced as an example of an output method used to measure progress. Paragraph BC118 went on to state that “a ‘units of delivery’ method may be an appropriate method for a long-term manufacturing contract of standard items that individually transfer an equal amount of value to the customer”. Respondents to the 2011 ED requested clarification on whether a units of delivery method could be used to measure progress in a production contract which has a single (or separate) performance obligation that is satisfied over time.

The staffs believed it was possible for an entity to use a units produced or units delivered measure of progress if those methods provided a reasonable proxy for the entity’s performance. The staffs also recommended the inclusion of a practical expedient in the final revenue standard to allow the use of ‘units of delivery’ in contracts for manufacturing large volumes of homogeneous goods that have a short production cycle.

Hearing the staffs’ proposal, many Board members were concerned with the introduction of a practical expedient. They feared that a practical expedient introduced more questions; namely, how ‘large volumes’ and ‘short production cycles’ would be defined. Other Board members believed the introduction of a practical expedient undermined the basis of paragraph 35 of the 2011 ED.

FASB members expressed a number of alternatives to the inclusion of a practical expedient. For example, one Board member suggested including application guidance in the final revenue standard regarding when the use of a units of delivery method would be acceptable. However, it would not be expressed as a practical expedient. Another Board member believed that paragraph 35 of the 2011 ED was too broad. Therefore, he suggested that the Boards consider redefining good and service contracts in paragraph 35 of the 2011 ED such that ‘typical’ contract manufacturing arrangements are seen as a sale of goods as opposed to services. However, others were concerned with unintended consequences in amending paragraph 35 of the 2011 ED. A number of other alternatives were expressed, but the Boards were unable to achieve a consensus on any of the alternatives.

After a lengthy debate, IASB members expressed a clear preference not to include a practical expedient in the final revenue standard. Instead, they believed that materiality guidance should govern the suitability of units of delivery or units produced as output methods to measure progress. The IASB staff suggested that an amendment could be made to the final revenue standard to describe circumstances where use of the units delivered/produced method may be appropriate. Most IASB members appeared supportive of this suggestion. The FASB, upon hearing the IASB’s tentative decision, tentatively agreed with the IASB’s approach.

Accounting for uninstalled materials

To ensure that a cost-to-cost method for measuring progress properly depicts the entity’s performance in satisfying a performance obligation, paragraph 46 of the 2011 ED was added to require an adjustment to the cost-to-cost calculation in specified circumstances in which the customer obtains control of goods significantly before receiving the services related to those goods (i.e., uninstalled materials). Respondents to the 2011 ED have requested clarification in determining the scope of application of paragraph 46, whereby many have interpreted the scope of the uninstalled materials requirement more broadly than intended.

To address the concerns raised with respect to the scope and application of paragraph 46, the staffs recommended explaining more clearly in the standard that the adjustment to the input method proposed by paragraph 46 is to ensure that the input method meets the objective of measuring progress that is specified in paragraph 38 of the 2011 ED. The staff also recommended refining the fact pattern in Illustrative example 8 to help clarify the scope of the proposal.

One Board member questioned whether paragraph 46 of the 2011 ED was necessary given paragraph 39 of the 2011 ED. This Board member asserted that paragraph 39, like 46, makes clear that revenue should not be recognised when it does not reflect performance. However, other Board members expressed support with the proposed clarification of paragraph 46. When put to a vote, both Boards tentatively agreed with the staff recommendation.

Accounting for wasted materials and inefficiencies

The 2011 ED proposed that when an input method is used, an entity should exclude the effects of any inputs that do not depict the transfer of control of goods or services to the customer (e.g., the costs of wasted materials, labour or other resources to fulfil the contract that were not reflected in the price of the contract). Respondents to this proposal, focusing on paragraph 45 of the 2011 ED, requested clarity on the definition of ‘inefficiency’ and ‘wasted materials’. Some noted that the scope of paragraph 45 should be narrowed, while others noted that identifying and tracking the costs of wasted materials or other inefficiencies could be difficult.

The staffs noted paragraph 45 of the 2011 ED was added to ensure that a cost-to-cost method meets the objective for measuring progress. However, the staff agreed with many of the concerns raised by constituents. As the staffs did not believe it would be possible to develop additional guidance that clearly and consistently identifies the costs of inefficiencies and wasted materials that should be excluded from a costs-to-cost measure of progress, the staffs recommended that the revenue standard should emphasise the objective of measuring progress in paragraph 38 of the 2011 ED and acknowledge that, if an input method such as cost-to-cost is used to measure progress, an entity would need to adjust the cost-to-cost calculation if some of the costs incurred do not contribute to the progress in the contract. With little feedback, the Boards tentatively agreed with the staff recommendation.