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Modifying a contract? Your revenue recognition may change · PwC's accounting podcast

• 0:00
  SPEAKER_00: Thought Leadership from PWC's National Office.
• 0:07
  SPEAKER_03: Welcome to PWC's Accounting Podcast.
• 0:10
  SPEAKER_03: I'm Heather Horn.
• 0:11
  SPEAKER_03: In today's episode, we continue our series on revenue, focusing in on contract modifications.
• 0:17
  SPEAKER_03: Now, this is something that doesn't happen every day and often involves complex negotiations and non-standard terms.
• 0:25
  SPEAKER_03: Even if it's not something you're currently dealing with, I highly encourage you to stay tuned for this episode because there's a lot to learn and it will help you understand the overall revenue model just a little bit better.
• 0:37
  SPEAKER_01: We've definitely seen more activity in this space, I would say, over the last 18 months, two years, sort of in response to just this whipsaw we saw in the economic environment, right?
• 0:49
  SPEAKER_01: We had this kind of surge in demand, shortage of supply in different sectors.
• 0:54
  SPEAKER_01: So people maybe were interested in locking themselves into either pricing or supply when they thought the world was going one direction, and then it very quickly pivoted to a different sort of outlook.
• 1:06
  SPEAKER_01: And so that's when you get into these situations where people now maybe realize the terms they had, which seemed like a good deal originally are suboptimal for one of the parties that they're looking to renegotiate.
• 1:23
  SPEAKER_03: That was Pat Durbin, a deputy chief accountant in PWC's national office, who's joined by Angela Ferguson, who's the standard setting leader in the national office.
• 1:32
  SPEAKER_03: Both specialized in accounting for revenue arrangements and they bring their wealth of knowledge and experience to the conversation.
• 1:39
  SPEAKER_03: Let's listen in.
• 1:40
  SPEAKER_03: Pat, Angela, thanks so much for joining me today for a topic that we often talk about in the context of leases, but I don't think at least recently we've talked about in the context of revenue, and that would be contract modifications.
• 1:53
  SPEAKER_03: But perhaps before we get into things, Angela, can you just give us a quick overview of why now is a good time to talk about this topic?
• 2:00
  SPEAKER_02: Sure, Heather.
• 2:01
  SPEAKER_02: So contract modifications is an area where we get a lot of questions.
• 2:06
  SPEAKER_02: And one reason for that is for many companies, it's not necessarily like an everyday event, right, that you're modifying a contract.
• 2:13
  SPEAKER_02: So they may not just be as familiar with that guidance, right?
• 2:16
  SPEAKER_02: And oftentimes when you're modifying a significant contract or it's a significant renegotiation of a contract, you're gonna have, you know, not standard terms, right?
• 2:26
  SPEAKER_02: They're gonna have more complexity to the terms and conditions that the parties agree to.
• 2:31
  SPEAKER_02: So it's gonna require more judgment to apply the model.
• 2:35
  SPEAKER_02: And then looking at our statistics, uh, the section in the revenue guide on contract modifications is one of the most frequently viewed sections of our revenue guide.
• 2:46
  SPEAKER_02: So I guess the numbers are really backing up our anecdotal evidence that there's interest in this topic.
• 2:52
  SPEAKER_01: And you mentioned, Heather, like the context of leasing contract modifications.
• 2:57
  SPEAKER_01: And while I don't think it's something we're gonna get into in detail in this conversation, I think that's a really important intersection to highlight because there are contracts that may contain both lease and revenue elements.
• 3:11
  SPEAKER_01: And while the contract modification model is kind of similar, it is different, and you sort of get stuck in the leasing literature if part of the contract has a lease.
• 3:22
  SPEAKER_01: So you really need to kind of think through both modification frameworks then in those circumstances.
• 3:27
  SPEAKER_01: And just maybe to build on what Angela was talking about in terms of prevalence, um, we've definitely seen more activity in this space, I would say, over the last 18 months, two years, sort of in response to just this whipsaw we saw in the economic environment, right?
• 3:45
  SPEAKER_01: We had this kind of surge in demand, shortage of supply in different sectors.
• 3:50
  SPEAKER_01: So people maybe were interested in locking themselves into either pricing or supply when they thought the world was going one direction, and then it very quickly pivoted to a different sort of outlook.
• 4:01
  SPEAKER_01: And so that's when you get into these situations where people now maybe realize the terms they had, which seemed like a good deal originally, are suboptimal for one of the parties.
• 4:11
  SPEAKER_01: So they're looking to renegotiate.
• 4:13
  SPEAKER_01: And as Angela noted, that can you know end up with some unfamiliar, unusual things that you don't deal with all the time.
• 4:22
  SPEAKER_01: And so just a challenge to work through in the context of the model as well as just the negotiations that may be also iterative in in some cases.
• 4:30
  SPEAKER_03: All right, that's helpful context.
• 4:31
  SPEAKER_03: And I think good reminder, Pat, on the intersection with the lease guidance, and perhaps at some point I should get all of you guys on one episode to talk about uh some of the considerations because I do think there's a lot to think about there.
• 4:44
  SPEAKER_03: But today, focusing just then on revenue, Angela, maybe we should can just start off to say what would trigger or qualify as a contract modification.
• 4:55
  SPEAKER_02: Sure.
• 4:55
  SPEAKER_02: And as you might expect, a you know, contract modification is the change in the scope or price, or it could be both, of a revenue contract that's been approved by both of the parties to the contract.
• 5:09
  SPEAKER_02: And the important thing to note here is that it it doesn't really matter how it's structured legally.
• 5:14
  SPEAKER_02: So you could have an actual amendment to the contract that's created, or you could do a modification by entering into a separate new legal contract with the customer, or you could just decide to cancel the old contract entirely and enter into a new replacement contract.
• 5:35
  SPEAKER_02: But all of those are probably modifications that need to run through the model that we'll discuss today.
• 5:41
  SPEAKER_03: And I think that final case is sometimes the ones that trips people up because if you canceled the first one, you have a new one.
• 5:48
  SPEAKER_03: I think often people just want to start fresh.
• 5:51
  SPEAKER_03: And I think you're going to explain to us that that is not the case.
• 5:53
  SPEAKER_02: That is absolutely the case, Heather.
• 5:55
  SPEAKER_03: So good point.
• 5:56
  SPEAKER_03: Thank you.
• 5:57
  SPEAKER_03: All right.
• 5:57
  SPEAKER_03: So then what is the big picture accounting approach when you have a modification?
• 6:02
  SPEAKER_02: So the standard outlines three different types or categories of modifications that could occur and the accounting model for each.
• 6:11
  SPEAKER_02: So the first type is the most straightforward.
• 6:14
  SPEAKER_02: And this is when the modification adds additional goods or services, and they're priced at the standalone selling price, the current standalone selling price.
• 6:25
  SPEAKER_02: And in this situation, you account for that modification as a separate contract.
• 6:30
  SPEAKER_02: So basically, you've just sold new distinct goods and services at their market price.
• 6:35
  SPEAKER_02: So that kind of makes sense.
• 6:36
  SPEAKER_02: That's just a separate contract from the original.
• 6:39
  SPEAKER_02: The original, no change to that accounting.
• 6:41
  SPEAKER_02: And then you account for the new stuff as a separate contract.
• 6:45
  SPEAKER_02: And if it if you don't meet those criteria, that's where it gets a little more interesting and you're in one of two other categories.
• 6:53
  SPEAKER_02: And those two categories are.
• 6:54
  SPEAKER_02: So the second type of modification, you know, once you determine you are not in a separate contract, then you look at the remaining goods and services to be provided after the contract is modified.
• 7:08
  SPEAKER_02: If those remaining goods and services are distinct from the previous performance, then you're in this second category.
• 7:15
  SPEAKER_02: So let me go through an example to sort of bring this to life.
• 7:18
  SPEAKER_02: So an example is if you have a long-term supply arrangement and you're delivering products to the customer under that arrangement and you decide to modify the contract to change maybe the pricing of those products or the volume of products, but each product is distinct.
• 7:38
  SPEAKER_02: So after you've modified the contract, the products to be delivered after the modification are distinct from the products that were delivered prior to the modification.
• 7:49
  SPEAKER_02: So in this situation, the modification is accounted for on a prospective basis.
• 7:55
  SPEAKER_02: It's basically as if you've canceled the old agreement and entered into a new agreement.
• 8:00
  SPEAKER_02: And again, that's not anything to do with what le how legally it was structured, right?
• 8:05
  SPEAKER_02: It's only if you are in this type of modification, you apply this accounting model.
• 8:12
  SPEAKER_02: So under that prospective accounting, you're going to take any remaining transaction price that's unrecognized from the original contract, and you're going to adjust it for any changes in the modification, meaning adding any additional transaction price or reducing it if the transaction price has been reduced.
• 8:31
  SPEAKER_02: And so that modified amount after the modification is then allocated to what's remaining under the contract.
• 8:39
  SPEAKER_02: So it's almost like you're starting fresh with a new contract.
• 8:43
  SPEAKER_02: You're taking the revised transaction price and then allocating it to what's left to perform.
• 8:49
  SPEAKER_02: And you do that at the current standalone selling price.
• 8:53
  SPEAKER_02: I'd also note that this model also applies if your original contract is a series of goods and services that's being accounted for as a single performance obligation, because that comes up a lot.
• 9:04
  SPEAKER_02: That could be a software as a service arrangement where you're providing access to a platform.
• 9:10
  SPEAKER_02: It could be a series of repetitive services that you're providing over some period of time.
• 9:15
  SPEAKER_02: And in that case, even though your accounting is a for the service as a single performance obligation, the remaining services to be provided within that series are distinct from the prior service.
• 9:29
  SPEAKER_02: So you're still in this prospective accounting model.
• 9:32
  SPEAKER_01: And maybe just to jump in, just to sort of like level set recap.
• 9:36
  SPEAKER_01: So the first category, right, we had distinct goods and services at standalone selling price.
• 9:41
  SPEAKER_01: The second category, distinct goods and services not at standalone selling price.
• 9:47
  SPEAKER_01: So as we sort of progress through these different scenarios, just to sort of kind of recap so you can track where where we're at.
• 9:53
  SPEAKER_02: Yeah, or even it's just more complicated that you're not just adding new things, but you're also changing the, you know, reducing things or taking stuff away.
• 10:02
  SPEAKER_02: It's not as straightforward as just adding more at SSP.
• 10:06
  SPEAKER_02: You're in one of these other two categories.
• 10:08
  SPEAKER_03: All right.
• 10:08
  SPEAKER_03: And so then what about, I'm assuming third category is if you are not distinct, then what do you do?
• 10:15
  SPEAKER_03: Very good.
• 10:15
  SPEAKER_02: So the last category is when you're again not a separate contract.
• 10:20
  SPEAKER_02: And when you look to the remaining goods or services to be provided, they're not distinct from prior performance.
• 10:27
  SPEAKER_02: So an example of this could be a contract under which you're doing some sort of complex construction project that's being accounted for as a single performance obligation.
• 10:38
  SPEAKER_02: And then you modify that contract to change the scope or the pricing somehow for that project.
• 10:45
  SPEAKER_02: Then the finishing up the construction post-modification is not distinct from prior performance because it's all a single performance obligation.
• 10:55
  SPEAKER_02: In that case, the accounting is done as a cumulative catch-up adjustment.
• 11:00
  SPEAKER_02: So you're going to recalculate the total transaction price depending on any changes made in the modification.
• 11:08
  SPEAKER_02: You're going to reassess your measure of progress depending on what's been performed and what's left to do.
• 11:14
  SPEAKER_02: And then you're going to recalculate your percent complete to determine how much revenue should you have recognized to date and do an adjustment to revenue.
• 11:23
  SPEAKER_02: Now that could be more revenue or it could be less revenue, just depending on the situation.
• 11:33
  SPEAKER_02: Well, it's possible you could have a combination of the second and third type, right?
• 11:39
  SPEAKER_02: So you uh you don't meet the first, you're not a separate contract, but when you look at the contract, it has both something that's not distinct and something that is.
• 11:50
  SPEAKER_02: So you could have kind of a combination of my examples.
• 11:52
  SPEAKER_02: You could have the construction project, but also within that contract, a promise to deliver distinct goods in the future.
• 12:00
  SPEAKER_02: And so you sort of have both things.
• 12:02
  SPEAKER_02: In that case, the standard honestly is not very prescriptive.
• 12:06
  SPEAKER_02: It just tells you to follow the same process or the same principles as you do for the other types of modifications.
• 12:15
  SPEAKER_02: So a reason a reasonable approach here may be you know, you determine what the revised transaction price is, you reallocate it to the construction project and the goods to be delivered, and then the construction project, you do the cumulative catch-up adjustment, and then for the products to be delivered, that would be done on a prospective basis.
• 12:38
  SPEAKER_02: So you're just going to come up with some reasonable approach, but again, it's not as prescriptive.
• 12:43
  SPEAKER_01: And I know Angela always likes to plug our guides in these podcasts, but we do have a very nice sort of uh decision tree on like the modification framework, which type of modification, and then kind of just following that sort of an explanation of the accounting for each of these different scenarios.
• 13:00
  SPEAKER_01: And I know we'll get in some maybe some more specific details, but just to for our listeners to refer to.
• 13:05
  SPEAKER_03: Yeah, I think that's helpful because even as I was trying to follow along, I was kind of in my mind making a flowchart.
• 13:10
  SPEAKER_03: So definitely uh we will make sure we include a link to that in the show notes so people can look at that.
• 13:16
  SPEAKER_03: So to your point, Pat, that you started to make, I can think of many, many different scenarios uh that fit into these different categories that Angela's talking about.
• 13:25
  SPEAKER_03: And I could see how those would get very complicated very fast.
• 13:29
  SPEAKER_03: So can we kind of run through some of the more common ones that we see and talk a little about some of the pitfalls?
• 13:35
  SPEAKER_01: Yeah, and as I alluded to in the beginning and sort of the motivation for some of these, a lot of times it is in the context of sort of a longer-term supply arrangement where for whatever reason the market has shifted from the pricing that was originally agreed to.
• 13:50
  SPEAKER_01: So the parties come back together to try to realign to you know kind of current market expectations.
• 13:57
  SPEAKER_01: And I think you made the point earlier that you know people would just like to kind of reset everything, get the old stuff behind them, and have kind of a new model going forward.
• 14:07
  SPEAKER_01: And unfortunately, in in many cases, when you're modifying a revenue contract, because you're in this context of it's an ongoing relationship, you have additional goods and services that are going to be continue to be provided, you can't really disconnect sort of where you were to where you want to be following the modification framework.
• 14:28
  SPEAKER_01: So, you know, if we talk about the okay, it's a long-term supply agreement, I had pricing, I want to adjust it.
• 14:35
  SPEAKER_01: Um, you might get into this what we might refer to as a blend and extend modification, right?
• 14:40
  SPEAKER_01: The price was too high, the customer wants me to reduce the price, um, but I've still got some undelivered products under the old pricing, and I've agreed to maybe extend on a lower price going forward.
• 14:55
  SPEAKER_01: So there's two scenarios there.
• 14:57
  SPEAKER_01: Either I would say, okay, those remaining goods and services are distinct at a standalone selling price, and therefore I am going to just continue to run out the old price at the old amount, and then start recognizing those additional goods if they're at their standalone selling price.
• 15:13
  SPEAKER_01: But if the substance is really more of a retroactive price adjustment on what I've previously delivered, then I may end up, you know, attributing some of that remaining unrecognized consideration to those future deliveries and have sort of a higher price than just the notional invoice price on those future deliveries.
• 15:34
  SPEAKER_01: So it really kind of depends in that case on sort of you know a little bit of a judgment of is that new price standalone selling price or not?
• 15:44
  SPEAKER_01: Because if it's standalone selling price, as Angela mentioned, we'd account for that as kind of a just a new contract.
• 15:49
  SPEAKER_01: If it's not, then we take the remaining consideration on the old contract, add the new consideration, and then spread it over those goods and services.
• 15:58
  SPEAKER_03: And Pat, do you see this scenario also when they agree to raise the price at the same time that extend, or is this always that the price is being lowered?
• 16:08
  SPEAKER_01: Aaron Powell No, it would be the same scenario.
• 16:10
  SPEAKER_01: I mean, you might wonder why you know a customer would be interested in doing it.
• 16:14
  SPEAKER_01: Maybe they wanted the expensive more like a a truly, well, the market shifted and now the higher price is the standalone selling price.
• 16:21
  SPEAKER_01: And so, in order to, you know, for the customer to get what they want, they're going to have to pay the higher price.
• 16:27
  SPEAKER_01: But it it could, in theory, work work both ways.
• 16:29
  SPEAKER_03: Aaron Powell All right, that's helpful.
• 16:31
  SPEAKER_03: And then uh any other scenarios with this sort of pricing or similar Well, I I think the other so we talked about changing the pricing.
• 16:40
  SPEAKER_01: I mean, the other thing that can happen is you kind of reduce the committed quantities, right?
• 16:45
  SPEAKER_01: And sometimes that pricing that was um originally negotiated contemplated a certain volume level.
• 16:53
  SPEAKER_01: So you reduce that volume commitment, um, you might expect the vendor would want to be compensated for that.
• 17:01
  SPEAKER_01: And they might think, well, you've sort of, I'll call it, partially terminated the contract because you've reduced the scope.
• 17:08
  SPEAKER_01: But the fact of the matter is, as long as you're continuing to perform, continuing to deliver services, any consideration you receive essentially relates to those future goods that are going to be delivered.
• 17:21
  SPEAKER_01: So you don't get immediate recognition of any sort of incremental payment that's being made for that reduction in scope.
• 17:28
  SPEAKER_01: You'd have to spread that over the remaining goods to be provided.
• 17:32
  SPEAKER_03: So, Pat, if I'm thinking about the examples you gave and thinking about the categories.
• 17:37
  SPEAKER_03: In the first category, we said, okay, it's a new contract because it's it's additional at the standalone selling price.
• 17:45
  SPEAKER_03: But for any of these other modifications, it seems like at least the presumption would be going in that one of the parties is giving a concession.
• 17:55
  SPEAKER_03: And so you have to take that into account in the accounting.
• 17:59
  SPEAKER_03: Is that generally fair?
• 18:00
  SPEAKER_01: I mean, I think that's probably a fair way to think about it.
• 18:03
  SPEAKER_01: I mean, that's not really explicit in the guidance, but I think that's probably an underlying concept that drives you to the accounting framework we have.
• 18:10
  SPEAKER_01: I mean, I one thing we get a lot is this concept that people like to call a partial termination.
• 18:16
  SPEAKER_01: And I think the reality is a termination is sort of an absolute concept.
• 18:20
  SPEAKER_01: Like you've either terminated the relationship, in which case you might then have a situation where you would just, you know, sort of clear the decks, recognize any unremaining remaining unrecognized consideration as revenue and be done.
• 18:34
  SPEAKER_01: But to the extent you're continuing to do business, well, that's a modification, right?
• 18:39
  SPEAKER_01: And there probably was some commercial consequence to that that's going to have to be reflected in that modified arrangement.
• 18:47
  SPEAKER_02: Well, yeah, I mean it's it's it's not unusual that as part of a renegotiation, there's some sort of lump sum payment being made from one party to the other.
• 18:56
  SPEAKER_02: And like who's who's getting the payment is really gonna depend on who sort of has the upper hand as part of this modification.
• 19:05
  SPEAKER_02: And I think the instinct for a lot of companies is I'm gonna take that lump sum arrangement or that lump sum payment and recognize it immediately, whether that's income or an expense, you know, that they want to put that behind them and recognize that immediately.
• 19:21
  SPEAKER_02: But the framework really tells you that that additional lump sum payment just becomes part of the revised transaction price.
• 19:29
  SPEAKER_02: And right, since we're typically accounting for the modification on a prospective basis, that gets allocated to the goods or services that are going to be delivered post-modification.
• 19:41
  SPEAKER_02: So this is a really important point to take away is that the lump sum payment is really just part of negotiating that modification.
• 19:50
  SPEAKER_02: And so it's unusual to recognize that immediately.
• 19:54
  SPEAKER_02: Although you brought up the term concession.
• 19:57
  SPEAKER_02: I mean, there are some limited situations where a payment being made might relate to past performance.
• 20:07
  SPEAKER_02: So an example of that could be a situation where the contract is being renegotiated or modified because the customer is unhappy because the vendor actually did not perform as expected previously under the original contract.
• 20:23
  SPEAKER_02: And that might be something like goods were delivered, but they had a defect, or they weren't at the quality that was promised originally.
• 20:32
  SPEAKER_02: So if the vendor is making a payment to the customer as part of the renegotiation, um, all or a portion of that might really be a refund for that quality issue or that defect in the products that were delivered initially.
• 20:48
  SPEAKER_02: And this is really where there's a lot of judgment that needs to be applied because you would have to assess well, you know, what is the basis for concluding that that payment relates to the past?
• 20:59
  SPEAKER_02: It might not be all of it, it might just be a portion of it.
• 21:02
  SPEAKER_02: And so a portion of it relates to the past, and a portion of it really relates to the negotiation of the modified contract.
• 21:10
  SPEAKER_02: So it needs to be included in the post-modification transaction price.
• 21:15
  SPEAKER_01: Yeah, I think that's like the key judgment.
• 21:17
  SPEAKER_01: And I would say definitely if you're receiving a lump sum payment from the customer, in all likelihood that is going to be attributed to the future goods and services.
• 21:27
  SPEAKER_01: It's only in that scenario where you're making a payment, perhaps for some failure of performance in the past, that you might have some immediate recognition, which if we're talking about this from the perspective of the vendor, they they might not prefer that outcome, but that's generally where you're going to end up.
• 21:43
  SPEAKER_01: Um, I think it's really important just to try to understand, as we usually say, what's really happening economically, because that is going to drive it.
• 21:52
  SPEAKER_01: Um and I guess the other just underlying concept that I think drives a lot of this that maybe people lose sight of sometimes is the revenue.
• 22:00
  SPEAKER_01: Standard really is designed to recognize revenue when the entity performs, when it delivers goods, when it provides services.
• 22:10
  SPEAKER_01: So anytime you're thinking about should I recognize revenue, you've really got to anchor back to did something happen?
• 22:17
  SPEAKER_01: Did I do something?
• 22:18
  SPEAKER_01: Have I delivered something?
• 22:19
  SPEAKER_01: If nothing happened, we just traded cash, then there's probably not a revenue event.
• 22:23
  SPEAKER_03: Yeah.
• 22:24
  SPEAKER_03: And I guess to that same point, if I still need to do something, then it sounds like there's a good chance that whatever payments are being made could relate to that future something, or maybe likely relate to that future something.
• 22:36
  SPEAKER_01: Yeah, I mean, this sort of I alluded to it earlier, but this kind of notion of, well, we want to kind of reset, re-baseline, get back to current market.
• 22:44
  SPEAKER_01: I mean, that's, you know, maybe economically where you're getting to, but you're still stuck with sort of where you were, and you know, it's part of a broader arrangement.
• 22:53
  SPEAKER_01: You modify it, you sort of you can't just have a clean break and say, okay, let's let's reset and get the past behind us.
• 23:00
  SPEAKER_02: Yeah.
• 23:00
  SPEAKER_02: And that's a common argument we hear is, you know, I should take this lump sum payment immediately because everything after that will now be at market price.
• 23:08
  SPEAKER_02: But I mean, that the payment being received was all part of the renegotiation of that pricing.
• 23:13
  SPEAKER_02: So it really needs to be spread, you know, really and allocated to the future performance.
• 23:19
  SPEAKER_03: Yeah.
• 23:19
  SPEAKER_03: So definitely it seems like a lot comes down to economics.
• 23:22
  SPEAKER_03: And so I wanted to go to the scenario you touched on earlier briefly, which is this idea that the customer just says, I'm terminating, I'm not amending it.
• 23:31
  SPEAKER_03: How does that fit in then from a modification point of view?
• 23:34
  SPEAKER_02: Yeah, I mean, and that really is a type of modification, right?
• 23:37
  SPEAKER_02: You're changing the scope and potentially even the price of the contract.
• 23:41
  SPEAKER_02: So you're gonna think of that similar to a modification.
• 23:45
  SPEAKER_02: But if the contract is, as Pat was saying, completely terminated and there's no further relationship with that customer, then it it is probably more straightforward.
• 23:54
  SPEAKER_02: I mean, if you're looking, if you still have amounts that were unrecognized from that contract, you're obviously gonna consider whether there's any potential for having to make a refund.
• 24:04
  SPEAKER_02: But if you're not going to have to make a refund to the customer, you would recognize any of those amounts immediately.
• 24:10
  SPEAKER_02: And then if there are any termination penalties that uh were received or had to be paid as part of the termination, then those also would typically be recognized immediately.
• 24:21
  SPEAKER_02: And generally all of this is still running through the revenue line item because it's effectively a you know an adjustment to the transaction price for that revenue contract.
• 24:32
  SPEAKER_02: I know sometimes the question comes up: should this be in revenue, should it be in some sort of like other income?
• 24:37
  SPEAKER_02: I mean, there are always sort of unusual situations that can come up, but typically this is just sort of the resolution of the revenue contract.
• 24:45
  SPEAKER_02: So everything is going through the revenue line item.
• 24:48
  SPEAKER_01: Yeah, and I think I hit on it a little bit earlier, but it's definitely, I think, an area that bears some repeating is sort of the just because the word termination is somewhere in there, it may not be a termination.
• 24:59
  SPEAKER_01: Like there's a lot of scenarios where, you know, if you have a continuing relationship, other contracts with the customer, you're gonna have to look very carefully at a termination of a single contract to conclude that that's not just a modification of some of the other ongoing contracts.
• 25:16
  SPEAKER_01: You know, the idea of a partial termination, um, you still have an ongoing contract, so that's a modification.
• 25:23
  SPEAKER_01: And Angela mentioned it, but this idea that any of the penalties that might arise in the event of a termination, they're just another form of consideration, another form of transaction price, and they're gonna go back into the modification framework.
• 25:38
  SPEAKER_01: And to the extent you have a modified contract, not a terminated contract, those are just gonna get attributed then to the future goods and services following the modification framework.
• 25:49
  SPEAKER_02: Another point I'd like to bring up, just because it comes up from time to time, is that there's also guidance on contract terminations in ASC 420, which is talking more about like restructuring activities.
• 26:00
  SPEAKER_02: And sometimes we see people look there and say, well, should I be recording this as an expense?
• 26:05
  SPEAKER_02: Because I'm terminating a contract.
• 26:08
  SPEAKER_02: But I mean, if you're terminating a contract with a customer, you're really starting in the revenue standard.
• 26:14
  SPEAKER_02: So that doesn't, you know, you can't look to 420 and say I'm automatically recording this as an expense.
• 26:20
  SPEAKER_02: I mean, the first thing you're gonna think about is I'm modifying a revenue contract.
• 26:24
  SPEAKER_02: So what is the implication there?
• 26:26
  SPEAKER_03: I think that's helpful.
• 26:27
  SPEAKER_03: And also, Pat, you referenced uh in the point you're just making a single contract.
• 26:32
  SPEAKER_03: So led me to another question.
• 26:34
  SPEAKER_03: So if I have a multiple relationships with a customer and I terminate one or payments are made related to one, do we see where that could impact accounting for the other contracts, or would that be more unusual?
• 26:49
  SPEAKER_01: So I think there's um a couple of things to think about.
• 26:52
  SPEAKER_01: I mean, there is guidance specifically in the revenue standard for you know identifying the contract and would talk about entering into um multiple arrangements with a contra a customer at at the same time.
• 27:03
  SPEAKER_01: You know, you would typically look to combine those into one arrangement.
• 27:06
  SPEAKER_01: Certainly a simultaneous cancellation and new contract, even in the modification guidance, that'd be pretty specifically, that's a modification.
• 27:15
  SPEAKER_01: There are probably a lot of other scenarios where you're gonna have to apply some judgment to figure out, like, okay, they were around the same time, but they were really completely unrelated.
• 27:25
  SPEAKER_01: Um, it's clear that there was no kind of commercial interaction between them.
• 27:29
  SPEAKER_01: So it's it's gonna be more of a facts and circumstances based judgment and not necessarily a hard and fast rule, but you definitely have to pay attention to those because I think this notion of sort of the relationship, the payment to the customer, how that interacts with your expectation of future goods and services, all kind of intersect around both the modification and then just figuring out what the right transaction price is for the future work that you're doing.
• 27:55
  SPEAKER_03: All right.
• 27:56
  SPEAKER_03: Well, definitely a complex area and an overall complex topic.
• 28:00
  SPEAKER_03: So a lot to think about here.
• 28:02
  SPEAKER_03: If we were just to take a step back then, if you had some sort of words of wisdom for clients that are dealing with some type of modification or termination, maybe Angela, starting with you, what are some of the things that you would recommend?
• 28:16
  SPEAKER_02: Yeah, and I said this before, but just to repeat, I mean, you really have to understand the um the substance of the transaction between the parties.
• 28:23
  SPEAKER_02: So you you can't do the modification accounting in a vacuum, right?
• 28:28
  SPEAKER_02: You first need to understand why was the contract modified, what were the business reasons, what was the intent between the parties, especially if there's any of these lump sum payments that are being made between the parties.
• 28:40
  SPEAKER_02: You need to understand why was that negotiated, what is that intended to be for in order to work through the accounting model?
• 28:47
  SPEAKER_02: And you know, I laid out those three categories of modification.
• 28:51
  SPEAKER_02: It sounds pretty straightforward, pretty mechanical, but it isn't always that clear as we've been talking through our conversation.
• 28:58
  SPEAKER_02: And so you can't just make it a mechanical exercise, right?
• 29:02
  SPEAKER_02: You need to step back and understand again the business purpose and intent behind the modification.
• 29:09
  SPEAKER_03: Well, yeah, it seems like, Angela, anytime it's just not the standalone selling price, there's more to think about.
• 29:14
  SPEAKER_03: I mean, this is a rule of thumb if I'm thinking about revenue.
• 29:18
  SPEAKER_03: Yeah, I think that's fair.
• 29:19
  SPEAKER_03: Pat?
• 29:19
  SPEAKER_01: Yeah, well, I think we've hit on the idea that a lot of times these modifications were not necessarily anticipated, they're not routine, they're not part of the normal business operation.
• 29:30
  SPEAKER_01: So you always need to be thinking about do I have the right controls and processes in place to both identify when the modifications happen and then how to handle them when they happen.
• 29:43
  SPEAKER_01: So do you have the right, you know, kind of checkpoint exception model to pick that up and get it right?
• 29:49
  SPEAKER_01: And then also because you're dealing with this somewhat complicated modification framework, you really need to understand exactly what's happening.
• 29:57
  SPEAKER_01: It might be hard for like sort of a systematic solution to that.
• 30:01
  SPEAKER_01: So you may need some manual intervention, which also means you need to have the right processes and controls around that.
• 30:08
  SPEAKER_01: So just sort of making sure you're equipped to deal with these when they come up from sort of a controls and process perspective, not just the accounting side of it.
• 30:17
  SPEAKER_03: Well, and it sounds like Pat making sure that the accounting people have good contact with either the salespeople or whoever is negotiating these contracts is also going to be very important here.
• 30:26
  SPEAKER_01: Definitely.
• 30:27
  SPEAKER_03: All right.
• 30:27
  SPEAKER_03: Well, both it's always such a pleasure to talk to you.
• 30:30
  SPEAKER_03: Definitely a great topic today.
• 30:31
  SPEAKER_03: So thanks so much for joining me.
• 30:32
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• 30:34
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• 30:57
  SPEAKER_03: From Thought Leadership at PWC, I'm Heather Horn.
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