Effective Contract Modifications for Business Success
Contract Modifications
Contract modifications are a crucial part of any contract-based business. Modifications are changes to the existing agreement between two or more parties that can be utilized for various reasons, such as extending the contract, adding additional services, or changing the terms and conditions of the agreement. As such, businesses need to understand the process of contract modifications and how to manage them properly to maximize revenue (Presentation and disclosure requirements under FASB ASC 606, 2020). Companies must also be aware of the legal implications of changing an existing contract, as these modifications can have significant consequences for both parties involved.
Steps for Modifying a Contract
Defining the Need for a Modification and Forecasting Its Consequences
The first step of the contract modification process is identifying the need for a change in the contract terms. This typically involves understanding the current contract, the services provided, and any changes the customer has requested. For instance, in the Boeing example, the company is only tasked to supply Delta Air Lines with $100 million in airplanes (Kieso et al., 2019). If more obligations are added to the organization, like plane maintenance, a need arises to amend the contract. Some obligations may be joint or separate, which should be established for pricing.
In another illustration of SoftTech, the company offers Lopez software tech and an additional consultation activity for the same software. Both cost $600,000 and should be treated as a single performance obligation since they are interdependent (Presentation and disclosure requirements under FASB ASC 606,2020).
However, in another case, General Motors provides Marquart Auto with automobiles and telematics services, which are distinct services that do not rely on each other (Kieso et al., 2019). Thus, they should be priced separately, as stated in the contract. Contract modifications should clearly state the interdependent products or services and those that are not, to promote fairness and clarity when pricing them.
When a contract is modified, it is important to consider how the modifications will affect the transaction price. Depending on the nature of the modification, the transaction price may remain the same, increase, or decrease. To determine the transaction price, companies must consider two key factors: the expected value and the most likely amount. The expected value is the probability-weighted cost, usually providing different outcomes.
Depending on how a company performs, the cost could land at any stated possibility (Zhaokai & Moffitt, 2019). This technique is most employed by organizations holding agreements with similar characteristics. The most probable amount is the single most probable from a range of potential outcomes. This is often used when there are only two possibilities in a contract.
Developing an Amendment to the Contract
Once the need has been identified, the next step is to develop an amendment or supplement the existing agreement. This amendment should outline the specifics of the change, such as the services to be added or removed, the duration of the change, and any other relevant details (Wishnia, 2021). It also requires a well-stated amount to be paid by the customer, as illustrated in the Boeing example, where $100 million is required (Kieso et al., 2019). This makes the agreement straightforward to avoid assumptions that either party could manipulate for their own gain.
Introducing the Modification to Customers
The third step is to present the amendment to the customer. Depending on the customer’s preference, this can be done in person or via email. During this step, it is crucial to ensure that the customer understands the terms and conditions of the amendment and is willing to accept the changes (Wishnia, 2021).
Getting a Customer Approval
The fourth step is to obtain written approval from the customer. This usually involves signing a document that states that the customer agrees to the amendment. Once the customer has signed this document, it is important to retain a copy as evidence of the agreement.
Documenting the Modification
The fifth and final step is to document the changes in the contract. This step is essential for both parties, as it ensures that the agreement is legally binding and that both parties are held accountable for any changes or obligations arising from the amendment (Presentation and disclosure requirements under FASB ASC 606,2020). Besides, there has to be a follow-up to ensure that the agreement is accomplished as written. For instance, all obligations to supply and maintain airplanes by Boeing must be satisfied, and the amount payable is given by Delta at the specified time.
Revenue Recognition
Contract modifications can directly affect a business’s revenue recognition and measurement. Sales returns and allowances, repurchase agreements, and bill-and-hold arrangements are contract modifications that significantly impact revenue recognition and measurement (Kieso et al., 2019). Sales returns and allowances involve refunds or discounts given to customers for returned goods or services. When a customer returns a product or service, the contract modification will affect the revenue a business can recognize (Presentation and disclosure requirements under FASB ASC 606,2020).
Similarly, repurchase agreements involve the sale of a product or service with a guarantee that the customer can return it for a full or partial refund if unsatisfied. In this case, the modification of the agreement can also affect the recognition and measurement of revenue. Principal-agent relationships also involve contract modifications that can influence the recognition and measurement of revenue (Zhaokai & Moffitt, 2019). In this agreement, one party (the principal) engages another party (the agent) to perform a service on the principal’s behalf. The contract modification in this situation can affect the recognition and measurement of revenue, as the agent may be entitled to a commission or other form of compensation.
Preventing the Abuse of Contract Modifications
Abusing contract modifications can have serious consequences. In some cases, it can constitute a breach of contract, which can lead to legal action, loss of money, or other benefits. Businesses must be aware of the implications of making changes to a contract and the legal requirements that must be met (Corbett, 2021).
One way of avoiding the abuse of contract modifications is to ensure that modifications are made with full disclosure (Kieso et al., 2019). All parties to the contract must be made aware of any changes and be given a chance to review the modifications and agree to them. It is also important to ensure that the changes are not made unilaterally, meaning that both parties must consent to the modifications.
Using contract modification clauses can also help prevent the abuse of contract modifications (Zhaokai & Moffitt, 2019). These clauses set out specific terms that must be agreed upon for a modification to be valid. They can also provide conditions that must be met before a modification, such as both parties agreeing to the change (Corbett, 2021).
Finally, businesses should also be aware of their rights and responsibilities when making contract modifications. They must know the legal implications of making changes and ensure they comply with the law (Wishnia, 2021). This includes ensuring that all parties to the contract are given a chance to review and agree to the modifications, and being aware of any legal requirements that must be met before a modification can be made.
References
Corbett, J. (2021). Abusive contracts. LegalMatch Law Library. Web.
Kieso, D. E., Weygandt, J. J., Warfield, T. D., Wiecek, I. M., & McConomy, B. J. (2019). Intermediate Accounting, Volume 2. John Wiley & Sons.
Presentation and disclosure requirements under FASB ASC 606. (2020). Revenue Recognition. Web.
Wishnia, J. (2021). Contract modification laws. LegalMatch Law Library. Web.
Zhaokai, Y., & Moffitt, K. C. (2019). Contract analytics in Auditing. Accounting Horizons, 33(3), 111–126. Web.