IFRS 15: Contract Combinations Vs Contract Modifications

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IFRS 15, the new accounting guidelines aim to simplify and harmonize revenue recognition practices. The new standards are based on one overarching principle: Companies must recognize revenue when goods and services are transferred to the customer, in an amount that is proportionate to what has been delivered at that point.

While this sounds reasonable, it can complicate matters for your business, especially your finance department. Let’s look at contract changes for example.

Contract Combinations under IFRS 15

IFRS 15.17 outlines the criteria for determining when an entity combines two or more contracts and accounts for them as a single contract. The key criteria being “Are the contracts entered into at or near the same time with the same customer or related parties of the customer?”

IFRS 15 is broadly similar to the requirements of IAS 11 and IAS 18. However, IAS 11 requires an entity to consider combining a group of contracts as a single contract when the contracts are performed concurrently or in a continuous sequence. In contrast, IFRS 15 states that contracts are combined when the goods or services promised in the contract are a single performance obligation. In addition, IFRS 15 provides more specific guidance on when to combine contracts than IAS 18, and combining of contracts is required when those conditions are met.

Contract Modifications under IFRS 15

Under IFRS 15.18, contract modification is a change in the scope or price of a contract, or both. This may be described as a change order, a variation, or an amendment. When a contract modification is approved, it creates or changes the enforceable rights and obligations of the parties to the contract. There is currently guidance in both IFRS and US GAAP on contract modifications for industries that have construction- and production-type contracts. However, neither revenue recognition framework includes a general framework for accounting for contract modifications.

Under the new standard, the guidance on contract modifications applies to all contracts with customers and may therefore result in a change in practice for entities in industries without construction- and production-type contracts – and even for industries with such contracts, depending on the type of modification.

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The Accounting Process

Some entities will need to develop new processes – with appropriate internal controls – to identify and account for contract modifications on an ongoing basis under the new guidance.

Let’s discuss with an example: Your company enters into two contracts, A & B, with the same customer within 15 days of each other. Your company policy considers 30 days as “near the same time”, hence these two contracts will form a Contract Combination and will need to be accounted for (allocations made) as a single contract. Now 90 days later another contract C is sold to the same customer which adds more products to contract A. This is not within the 30-day policy so doesn’t need to be combined, however if contract C is not sold at SSP then it forms a Contract Modification. This modification requires to be accounted along with the prior two combined contracts and allocations changed accordingly. This would not have been the case prior to IFRS 15. Hence there is a clear impact on revenue recognized.

Let’s also consider that contract C was sold at SSP so it did not form a Contract Modification and was accounted simply as a separate contract. But 10 days after contract C, contract D is sold to the same customer further adding more products to contract A. Now this contract needs to be combined to contract C as its within 30 days. Further contract D is not sold at SSP, so now the combination of contract C & D needs to be considered a Contract Modification of the previously combined contract A&B and accounted for as a Single Contract.

Imagine tracking and doing all these changes for multiple contracts, over different contract periods and we haven’t even touched on the requirement of considering entering into contracts with “related parties”!

It’s time for all companies to rethink how they compute their revenue and whether it’s time to automate the process.

For more on how Zuora RevPro can help, click here.

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