The Financial Industry Regulatory Authority (FINRA) issued a notice in 2023 stating that widespread noncompliance with financial reporting requirements stemmed from revenue recognition mishaps involving contracts.
FINRA pinpointed select rules from Accounting Standards Codification (ASC) 606 as the problem area. One element that makes contracts so hard to account for is the dynamic nature of contracts, especially in SaaS businesses that see constant change.
Any business that provides goods or services over extended periods needs to track contract changes to those agreements to avoid possible penalties, misrepresented revenue, and reputational damage.
Below, we’ll explore revenue recognition, contract modifications, and the specific criteria used to determine whether a change warrants a contract modification. For now, it suffices to say that contract modifications involve specific kinds of contract changes that almost always impact revenue recognition.
Revenue Recognition Contract Modifications
According to ASC 606, revenue recognition contract modifications are “…when the parties to a contract approve a modification that either creates new or changes existing enforceable rights and obligations of the parties to the contract.” In other words, contract modifications are a subset of changes made to contracts that go beyond mere aesthetic or other adjustments. They are changes to the actionable parts of a particular contract that are directly related to revenue, scope, and price.
These changes happen regularly in industries where the business model revolves around service agreements. They’re commonly seen in Software as a Service (SaaS), outsourced information technology (IT) management, and other tech-heavy fields. They’re also present in industries like construction and maintenance.
Contract modifications can also occur at any stage of a company’s lifecycle. Any business that works on a contract model, whether it’s a brand-new startup or a full-blown enterprise, is likely to encounter contract modifications.
Types of Contract Modifications
Contracts undergo constant changes, including lower-level semantic switches and bigger, revenue-impacting adjustments. For our purposes, we’re examining the kinds of changes to scope and pricing that could necessitate technical modifications.
Three of the most common changes that could qualify as modifications are:
- Change orders: These are changes to the scope of a contract, generally considered upgrades or downgrades. They change the kinds of services or goods delivered, delivery methods, duration, or other factors. If the additions are distinct or use non-standard prices, they are likely modifications.
- Price adjustment: These are changes to a contract’s pricing, including changes to iterative payments or to the total contract value. Negotiations leading to pricing changes could require modifications, especially if the deal’s outcome has a retrospective impact on past revenue recognized.
- Additional deliverables: When new services are added to an ongoing service agreement between a business and its customer, like adding a new feature or additional users, the change may not qualify as a modification. If it’s distinct (i.e., can be sold separately) or uses regular prices, it’s likely a new contract for revenue recognition purposes.
All of these changes have the potential to impact revenue recognition, especially when they involve retrospective accounting for revenue that has already been recognized—such as when using the percentage of completion or the milestone methods. Complicated adjustments will be needed to avoid any issues.
One big issue is that adjustments often aren’t made or are made incorrectly.
Contract Modification and Revenue Recognition
One of the reasons modified contracts are so critical, despite being overlooked, is that they’re inextricably connected to revenue recognition. Contract modifications are examples of revenue recognition principles at work, as changes to an agreement could impact when or how revenue is calculated. They’re a major reason SaaS and other service-based companies fall into ASC compliance issues when neglected.
While most accounting teams understand how important contract modifications are, they often lack adequate resources to handle them. Analyzing and making adjustments manually across spreadsheets or other low- or no-tech workarounds requires time and high attention to detail. And in newer companies without fully fledged accounting departments, this issue might not be at the top of other leaders’ minds.
Too often, businesses disregard this important part of revenue recognition by generating a new contract whenever there’s a change in their service relationship(s) with a customer.
While there are many cases where a change does necessitate a new contract rather than a modification to the existing one, simply ignoring the issue is almost never the best strategy. It can often make for swift resolution at the moment, but it can also lead to revenue misclassification and non-compliance later.
Contract Modification Accounting Options
Not every contract change necessitates a technical modification. Even when new goods or services are offered, the change may require a new contract rather than a modification to the existing contract. In any case, revenue recognition could have serious implications, especially for modifications.
The two categories that contract changes generally fall into are:
- As a separate contract: In cases where an added good or service is distinct from those already offered and/or where it is being offered at its standard fixed price without impacting pricing for any items offered, it’s a new contract.
- As part of the existing contract: When an item is added, changes are made to the existing items such that the scope is now distinct, or any remaining goods or services are offered at different pricing; it’s a modification.
The most important contract consideration in revenue recognition management is whether a change warrants modifying the existing contract or creating a new one. This can be difficult for businesses to determine swiftly, and it’s one of the main reasons stakeholders ignore the issue.
Key Criteria for Determining Status
Determining whether and how a contract modification impacts revenue recognition comes down to two main factors—scope/distinction and how items impact pricing.
First, you must determine whether the goods or services added, removed, or changed are “distinct.” If they are, the change may warrant a new contract rather than a modification. One way to understand distinction for contract purposes is whether the specific items could be sold independently of the existing agreement.
For example, consider a SaaS contract in which a salesperson adds a feature to a customer’s existing subscription. If that feature is an add-on that requires the app or software they’re already paying for to function, then it likely would not qualify as distinct. But if it is a separate piece of software that could be used on its own and is just being bundled together for convenience, then it could be considered distinct.
The other factor concerns pricing and whether the new good or service impacts the standalone selling prices of any other items in the contract. If the items are (or stay) at their standalone selling prices, then a new contract might be required.
Using the same example, if the piece of software added to the subscription is offered at its normal price—or within its reasonable price range—then it likely requires its own revenue contract. But if it is being offered at a discount or inflated price, or if the addition changes the pricing of other items, it may be a modification to an existing contract.
In some cases, a modification may not be necessary, such as when non-fixed variable considerations are already built into a contract. However, accounting teams always need to triangulate final prices and obligations with initial configurations.
Examples of Contract Modifications’ Impact
Since contract modifications can happen in any industry or use case and at any point after contract inception, businesses need to be aware of many different circumstances. Some of the most common relate to price, scope, and termination.
Example 1: Price Adjustment
As the name suggests, a price adjustment is a contract modification involving a change to the price of goods or services provided, typically over a long period of time.
One of the most common instances is a concession, as in the following hypothetical:
- A SaaS company has a contract with a customer dating back a year or more. Over time, the customer becomes dissatisfied with the service. They may have found an alternative or had trouble resolving a complicated issue.
- To save face and retain the customer, the SaaS company offers a price concession that changes either the amount the customer pays each month or the total contract value (the entire amount they will have paid).
- If the contract price was originally $50K for the previous year of service, it might be adjusted to $25K for that span. However, if the $50K in revenue is recognized, the contract needs modification—removal and replacement.
- To save face and retain the customer, the SaaS company offers a price concession that changes either the amount the customer pays each month or the total contract value (the entire amount they will have paid).
In practice, the actual process is often more like a cumulative catch-up adjustment in the period of change. Still, the point stands that this is a complicated situation in which a contract modification impacts revenue recognition.
Even in cases where a concession is purely prospective and doesn’t impact total contract value, retrospective adjustments may still be required.
Example 2: Scope Expansion
Adding deliverables to a contract can impact its revenue recognition implications. In particular, adding distinct items that utilize non-standard pricing could necessitate retrospective modifications for revenue that had already been recognized.
Examples of scope expansion in software and technology services include:
- Adding new users or the capacity for many more users to an existing platform
- Adding a new feature within a given piece of software or a new app/program
- Adding a new performance obligation that previously wasn’t guaranteed
- Extending the term of service beyond what was agreed to originally
Across these instances, the new feature or service obligation would only be a modification for recognition purposes if it was contingent on existing goods or services and used pricing outside of what the given item would normally cost.
So, an add-on that requires the original app and is offered at a discount would require a modification because it would impact future (and possibly past) payments.
While non-standard pricing that includes cost inflation is unlikely, any scenario in which this occurs (e.g., increased selling-related costs) could require a modification.
Importantly, if the new service, feature, or other obligation being added is a distinct item that could be sold separately and you are using its stand-alone selling price, then it is most likely a new contract and not a modification. However, there may still be implications for revenue recognition timing, particularly for future projections.
Example 3: Contract Termination
Cases where a contract is terminated before its expected lifespan often impact how revenue is recognized. This is especially apparent in termination for convenience.
Termination for convenience allows a customer to exit from a contract before its full term, provided they give notice on a previously agreed-upon timeline. In most cases, customers are expected to provide 30 to 60 days’ notice that they want a cancellation, and it will be granted (and their obligations removed) at that later date.
In a termination for convenience, revenue recognition needs to be halted, and depending on how prior payments were recognized, an impairment may occur. Allotment could have over- or under-recognized revenue, which must be accounted for.
However, some contracts are “iron-clad” and require fulfilling the entire agreement (e.g., three years). In these cases, the company and customer may negotiate a new deal or settle the matter with a significant financing component, such as an upfront, one-time payment of a portion of the remaining balance plus additional fees. Depending on the specific terms, this could impact future or past revenue recognition.
Best Practices for Managing Contract Modifications
In all cases, whether or not an actual contract modification is needed, companies need to pay attention to the minute details to avoid misrepresenting their revenue.
Three practices that are essential for maintaining accurate revenue recognition are:
- Documentation and communication: All information relevant to a contract and any requests for changes must be documented. Those documents (or summaries thereof) should be shared with all stakeholders they impact.
- Regular contract review and updates: Contracts need to be reviewed at regular, frequent intervals and cross-referenced with information about any services or goods delivered. The timing itself can necessitate a change.
- Collaboration with accounting teams: Sales and account managers need to work closely with accounting teams and apprise them of any key changes to services, pricing (e.g., discounts offered), or requests for changes to contracts.
Lastly, bringing custom-built software to streamline the contract and revenue management process is a win-win for all parties involved. Leaders can avoid insidious issues, and accounting teams can generate accurate results with significantly less effort, allowing them to dedicate their focus to higher-value projects.
Ultimately, contract modifications require attention to detail and rigorous application of revenue recognition methods and best practices, regardless of your approach.
Compliance and Regulatory Considerations
Maintaining compliance with ASC and other regulations requires attention to detail regarding whether and how a contract change impacts revenue recognition. It also requires planning for audits, detailed records, and justifications for all decisions.
As noted above, FINRA has tied noncompliance with the Securities Exchange Act (SEA) to ASC 606 issues. SEA Rule 15c3-1 is the specific part of the regulation that mandates accurate net worth reporting per the US’s Generally Accepted Accounting Principles (GAAP). FINRA attributes misreporting to a general lack of understanding of how contract-related revenue should be accounted for.
Our ASC 606 revenue recognition guide details five steps to staying compliant:
- Identifying customer contracts, including all approvals, rights, and terms
- Identifying and monitoring for any remaining performance obligations
- Determining transaction prices, including cash and non-cash compensation
- Allocating a contract’s transaction prices to its performance obligations
- Recognizing revenue when performance obligations are satisfied
As noted above, ASC 606 is the most important revenue recognition regulation for most organizations in the US. However, other standards apply if your business operates globally.
The International Financial Reporting Standards (IFRS) 15 includes similar reporting requirements but differs in definitions and flexibility with respect to contract completion, transfer, and more.
Keeping every contract modification ASC-compliant means scrutinizing all details closely and communicating proactively—ideally with the help of RightRev solutions.
Contract Modifications Made Easy
Contract modifications can have extremely important implications for revenue recognition under ASC 606. Namely, any change to scope or pricing that requires prospective and/or retrospective changes to allocations could require significant adjustments to avoid noncompliance.
Too often, companies ignore these key calculations for revenue recognition, contract modifications aren’t documented, or organizations tackle them inefficiently through spreadsheets or other means. RightRev is an end-to-end revenue recognition software that automates much of the process so that you can ensure accurate reporting and compliance with minimal human input. RightRev enables easy identification of contract modifications and swift, accurate adjustments to revenue recognition. To learn how, watch our contract modification tutorial.
PS- The answer to the trivia question from our email newsletter is: A) Mick Jagger
Mick Jagger, the lead singer of The Rolling Stones, was an avid student of finance and accounting at the London School of Economics before his music career skyrocketed. He apparently saw accounting as a practical fallback plan in case his “side gig” of singing in a band didn’t work out.
