The ASC 606 transition for construction contractors: Identifying the contract – Contract modifications

Contract modifications or change orders

Contract modifications or change orders are extremely common in the construction industry. ASC 606 requires additional judgment and documentation when determining how to properly account for a contract modification. A contract modification must change the scope or price (or both) originally agreed by the parties. The modification can be written, oral, or in accordance with customary practice as long as it has commercial substance. A modification can also occur when both parties have agreed to the scope change, but not the price. When that occurs, the contractor must estimate the consideration it expects to receive in accordance with guidance on variable consideration.

The new accounting standard provides a number of prescribed methods to account for modifications including 1) as a separate contract; 2) as a termination of the original contract and creation of a new contract; or 3) as part of the existing contract. 

Contract modifications are accounted for in two ways, either as a separate contract or as modification to the original contract, depending on the following guidance:

Separate contract:

• The scope of the contract changes due to 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 contractor’s standalone selling price.

Modification (the changes are not accounted for as a separate contract):

• A contractor shall account for the contract modification as if it were a termination of the existing contract and the creation of a new contract, if the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification and the consideration does not reflect the standalone selling price. The revenue recognized to date on the original contract (i.e. the amount associated with the completed performance obligations) is not adjusted. Instead, the remaining consideration from the original contract is combined with the additional consideration promised in the modification to create a new transaction price, which will be accounted for on a prospective basis that is allocated to all remaining performance obligations.
• A contractor shall account for the contract modification as if it were a part of the existing contract if the remaining goods or services are not distinct and, therefore, form part of a single performance obligation that is partially satisfied at the date of the contract modification. The effect that the contract modification has on the transaction price, and on the contractor’s measure of progress toward complete satisfaction of the performance obligation, is recognized as an adjustment to revenue (either as an increase in or a reduction of revenue) at the date of the contract modification (that is, the adjustment to revenue is made on a cumulative catch-up basis).