Recent widespread marketplace volatility has created a rapidly evolving economic environment that continues to provide challenges to entities operating in the energy industry. Dramatic changes in the cost of materials and labor, labor availability, inflationary pressures and interest rate increases, supply chain disruptions, geopolitical events, tightening capital markets, international trade tension, and an overall volatile commodity market have created strain throughout the economy.
These factors, coupled with the continued regulatory and market pressures of the energy transition and the increased environmental, social, and governance (ESG) focus, have resulted in entities modifying their operating plans and financial forecasts and planning for continued uncertainty. Some of these operational and financial changes include reviewing an entity’s customer and vendor mix as well as reassessment of an entity’s contractual arrangements and commitments.
While the evolving economic environment and related financial constraints and uncertainties may create numerous financial accounting and reporting implications, including the ability for an entity to continue as a going concern, asset impairments, challenges in calculating fair value measurements, including unpredictability in long-term operational and financial forecasts, revisions to compensation arrangements, and increased complexities in financing transactions, revenues from contracts with customers are also impacted. (The impacts of any income tax and tax-related accounting and financial reporting ramifications are beyond the scope of this article.)
Revenue contract modifications in today’s evolving environment
A change in the scope or price within an arrangement accounted for using Accounting Standards Codification Topic 606, Revenue from Contracts with Customers (ASC 606), may result in a contract modification that impacts both current and prospective accounting. A contract modification, which must be agreed to by both parties, may be in the form of a change order, contract amendment, or variation to terms of a current arrangement, such as through the granting of a concession or revisions of payment terms. Additionally, entry into a separate arrangement with a customer in an existing contract may be within the scope of a contract modification, depending on the nature and substance of both the initial and subsequent arrangement.
As the intention of ASC 606 is to provide revenue recognition that faithfully depicts the transfer of goods or services to a customer, there are multiple methodologies for accounting for modifications, dependent on the nature of the modification.
Separate Contracts
If the modified arrangement includes goods or services that are distinct from the good or service included within the initial contract, and the consideration for the goods or services included in the modified arrangement are priced at their standalone sales price, the result is that there is no change to the initial contract and the arrangement containing the new goods and services is treated as a separate contract.
Determination of whether the modified arrangement’s good or services are distinct, which is defined using the same definition as used in “Step 2” of the revenue recognition model within ASC 606, can require significant judgment. To be distinct, the goods or services must both be capable of being distinct (the customer can benefit from the good or service on its own or with other readily available resources) and distinct within the context of the contract (the promise to transfer is separately identifiable from other promises within the contact such as when the promises aren’t related or interdependent on one another). Additionally, determination of the standalone sales price, which is the price that an entity would sell the promised good or service on its own, may be challenging in the current period of market volatility.
This type of modification may be present, depending on the facts and circumstances of the arrangements, in common arrangements to increase commodity volumes to be sold under an arrangement, where such additional volumes are priced at the standalone sales price at the time of the modification.
Treatment of New Contract as part of Initial Contract
When the remaining goods and services, post-modification, aren’t distinct from those transferred prior to the modification, the resulting impact is that the modified arrangement is treated as a part of the initial contract. As of the date of the modification, a cumulative catch-up adjustment is recorded, based on the revised purchase price as well as any necessary and applicable measurement of progress revisions.
This type of modification may be present, depending on the facts and circumstances of the arrangements, in common long-term construction arrangements, such as energy infrastructure construction contracts.
Termination of the Initial Contract and Creation of a New Contract
When the remaining goods or services, post-modification, are distinct from those transferred prior to the modification, but the consideration for the good or services in the modified arrangement aren’t priced at their standalone sales price, the initial contract is treated as a terminated contract and a new contract is created, that includes the remaining goods and services from the initial contract as well as those from the modified arrangement. While the revenue recognized to date under the initial contract isn’t changed, the remaining consideration is allocated to the remaining performance obligations.
This type of modification may be present, depending on the facts and circumstances of the arrangements, in arrangements commonly referred to as “blend and extend,” which add on goods or services at a price that does not reflect the standalone sales price at the time of the modification but generally blends a current market price for the additional goods or services with the contractual price for the remaining goods or services under the initial contact.
Multiple elements of a modification
A modified arrangement may have elements of both the Treatment of New Contract as part of Initial Contract scenario and the Termination of the Initial Contract and Creation of a New Contract scenario, depending on the nature and type of performance obligations contained in the arrangements. If so, the resulting accounting shall be performed in a manner consistent with such applicable scenarios.
Reassessment of collectability
In today’s evolving economic environment, the financial profile of a customer may be rapidly changing. One of the five elements that is required for an arrangement to be considered a contract under ASC 606 is that it must be probable that the entity will collect substantially all consideration that it is entitled to in exchange for the goods and services that will be transferred to the customer. While this assessment is performed upon entry to the arrangement, reassessment is generally required when facts and circumstances necessitate, such as when a modification occurs. A modification in today’s environment may provide indications of financial difficulties and this assessment can require significant judgment.
If collection isn’t probable, either at inception of the arrangement or as determined at a later date, the arrangement thus doesn’t meet the definition of a contract under ASC 606 and revenue isn’t recognized until the contract is either terminated, and the consideration received isn’t refundable, or there are no remaining contractual performance obligations (either through completion of previous performance obligations or ceasing the transfer of goods or services with no obligations to continue to provide such) and the consideration received isn’t refundable.
As a result, if it isn’t probable that the entity will collect substantially all consideration that it is entitled to in exchange for the goods and services that will be transferred but an entity has received consideration from the customer, the entity accounts for the consideration received as a liability until collection for substantially all consideration that it is entitled to becomes probable, with the recognized liability representing either the entity’s obligation to transfer goods or services in the future or refund the amounts received.
Evolving disclosures
ASC 606 requires numerous financial statement disclosures, many of which require disclosure of the nature or terms of the contractual arrangements as well as disclosure of the use of significant judgments. When contact modifications occur, regardless of any resulting changes in revenue recognition, updating the related disclosures may be necessary to meet disclosure requirements.
A sample of disclosures that may require revisions include the disclosure of the disaggregation of revenue recognized, categorically, through depiction of how the nature, timing, amount, and uncertainty of revenue and cash flows are impacted by economic factors; providing descriptive information about performance obligations, including the nature of the goods or services, when such are satisfied, and the terms of payment of consideration; and significant judgments used in the methodology or measurements used to recognize revenue, such as standalone sales prices, when goods and services are distinct, and measures of progress, including any changes of such judgment.
