IFRS 15 and its Impact on Contract Modifications: What You Need to Know

Posted In | Finance | Accounting Software

International Financial Reporting Standard (IFRS) 15 has significantly changed the revenue recognition landscape across various industries. One crucial area where this new standard has a profound impact is the handling of contract modifications. This article aims to delve into the aspects of IFRS 15 related to contract modifications and how it may impact your business.

 

 

Understanding Contract Modifications under IFRS 15

Under IFRS 15, a contract modification arises when there is a change in the scope and/or the price (consideration) of a contract that is approved by the parties to the contract. A contract modification can either create new, or change existing, enforceable rights and obligations of the parties to the contract.

 

These modifications can take various forms, such as adding or changing promised goods or services, changing the transaction price, or a combination of both. Examples include expanding the scope of a service contract, extending the duration of an agreement, or changing the quantity of products to be delivered.

 

Accounting for Contract Modifications

IFRS 15 proposes a three-step approach to account for contract modifications:

 

1. Step One: Is it a separate contract? A contract modification should be treated as a separate contract if both of the following conditions are met: the scope of the contract increases because of the addition of promised goods or services that are distinct, and the price of the contract increases by an amount of consideration that reflects the entity's standalone selling prices of the additional promised goods or services and any appropriate adjustments to that price.
    

2. Step Two: If not a separate contract, then are the remaining goods or services distinct from those already transferred? If the remaining goods or services after the modification (whether original or new) are distinct from the goods or services transferred to the customer on or before the date of the contract modification, then the modification should be treated as terminating the old contract and creating a new contract. This means the transaction price should be allocated to the remaining separate performance obligations.
    

3. Step Three: If the remaining goods or services are not distinct, then account for the modification as if it were part of the existing contract. This involves updating the transaction price and the measure of progress towards complete satisfaction of the performance obligation, and recognizing revenue (or a reduction of revenue) to depict the transfer of control of the goods or services.

 

Impact on Financial Reporting

The rules concerning contract modifications can significantly impact the timing and amount of revenue recognition. For some companies, contract modifications may result in recognizing revenue earlier or later than under previous accounting standards. The impact can be particularly significant for industries that frequently deal with contract modifications, such as construction, telecommunications, software, and professional services.
 

Moreover, IFRS 15 increases the need for judgement in determining how to account for contract modifications. It requires entities to consider factors such as whether goods or services are distinct and how to estimate standalone selling prices. Therefore, it's crucial for businesses to have robust processes in place to make these judgements and document their reasoning.

 

Lastly, IFRS 15 requires entities to provide more detailed disclosures about their revenue and contracts with customers. These include information about the significant judgements, and changes in judgements, made in applying the standard to contract modifications.

 

In conclusion, contract modifications under IFRS 15 can have significant implications for businesses. Understanding these implications and applying the standard accurately are key to ensuring compliant and reliable financial reporting. It's also crucial to communicate effectively with stakeholders about the potential impacts of IFRS 15 on financial statements to maintain their confidence and trust.