TPA 5100.39 and Contract Accounting

[henry]

I desperately need help from the rec rev professionals out there as to how to account for a contract that is seemingly an addition to the original contract for which revenue is already being recognized.

About a year ago, Company A signed a contract with Company B to provide a customized software solution (SOP 81-1 Contract Accounting, Rev Rec based on the POC method) with the contract period approximately 2 years. Now, we’re half way through the project and Company B (customer) wants to sign a contract to add another module to the software solution to be provided under the original contract.

Unfortunately, the last payment for this new contract (additional module) is tied to the performance of the 1st contract, and in the eyes of Company B (customer) both of these contracts are part of the same software solution. The terms of the contract for the additional module is still under negotiation..

The questions are

1) How should the terms of the new contract be amended to separate it from the original contract (for customized software solution)? Is there any other consideration to be made to ensure that these two contracts and not combined into a single arrangement?

2) If these two contracts cannot be separated, what are the consequences given that some revenue has already been recognized for the original contract?

You inputs and thoughts will be much appreciated!

Thanks, Henry

[Tomuchrevrec]

Hello Henry,

Based on your information "in the eyes of Company B (customer) both of these contracts are part of the same software solution" and "last payment for this new contract (additional module) is tied to the performance of the 1st contract", It seems like this amendment is by its very nature linked to the first contract.

the difficult part now however, if we assume this amendment is linked to the original contract (which as the new terms are an amendment would automatically make it linked for a lot of companies), is that the total estimated cost to complete the contract maybe put into question since the deliverables can be amended over time. This means that you may not be able to apply the percentage of completion method any more since you cannot estimate the total cost to complete the new total arrangement.

If you are able to prove that the pricing per estimated cost increase to complete new additional work was based on the same discount or pricing schedule as the original contract you may have a chance. However if the pricing was very different then you will need to either go through a concession analysis as to why you gave a greater discount or go through a new costing and revenue matching analysis if you gave less of a discount.

If they are linked and you are not able to continue to use the percentage of completion method, then I would not restate any revenue that you have previously recorded as long as you have collected enough cash to cover the revenue you have recognized. Then I would stop any future revenue recognition based on percentage of completion and recognize the remaining revenue and the new billable revenue based on the amendment together based on a completed contract basis.

I should note that it is odd that you can take percentage of completion based revenue if payments are tied to performance testing upon completion. This condition sounds like an acceptance clause which would normally mean you would need to be in a completed contract model under SOP 81-1.

I hope this helps.

[henry]

Hi ToomuchRevRec,

Can’t tell you how much I appreciate your kind and thorough response.
My initial reaction when I encountered the below situation was that if the two contracts need to be combined into a single arrangement, then any revenue that was booked in the past should be reversed. I had thought that rev rec can only begin once you have a complete arrangement, hence, if the first contract is not deemed complete, then revenue should not have been recorded for it in the first place.

But then again, it didn’t feel fair to have to reverse all these revenue since when the first contract was signed nobody was anticipating any additional contract relating to the first contract. (The fact that there is a one year gap between two contracts is a strong sign of this) This is despite the fact that in the eyes of the customer the new contract should be part of the original contract, because that is an argument that can be easily made by the customer. Hence, I agree with your approach of leaving what has already been recognized alone, but after the new contract is signed, wait until the entire project is completed before taking any revenue.

Now, I just wanted to confirm two things with you, and these may sound a little redundant...

1)Theoretically speaking, it is correct to wait until there is a complete set of arrangement before you can start taking revenue? What I’d like to know is if there is any chance that an auditor could argue that the revenue taken in relation to the original contract should be adjusted or reversed even. Can’t they argue that the date when the new contract was signed should be Day 1 as far as rev rec goes? If this is the case, we can probably apply the percentage of calculation (POC) method for the combined arrangement, but the POC should begin from the date when the new contract was signed? (as opposed to the date when the original contract was executed)?

2)Is your approach of “don’t need to touch the revenue already recognized, but use the completed contract method once the new contract is signed” based on the fact that at the time we took revenue for the 1st contract, that was based on the best available information available at the time?

Thanks again for your help ToomuchRevRec. You’re a life saver 

[Tomuchrevrec]

Hello Henry,

I do not think it is correct to reverse the revenue that you have historically recorded. I believe that you should ensure that the revenue that you have historically recorded does not exceed the amount of payments you have collected. I would then either adjust the revenue treatment for the combined deal to recognized an adjusted percentage of completion (as long as the per hour pricing for the hours excepted to be completed is consistent) or change the balance of the uncollected revenue and unrecognized revenue to be deferred until the new total project is completed. If the pricing is not consistent then you have a possible larger issue of a concession analysis depending on how large of a difference you have.

For example if you first project was for 1,000 hours with a billing rate of $200 per hour to equal a $200,000 contract where you are recognizing the revenue on POC basis and your amendment is for 500 hour of estimated work but you only are charging a fixed price of $10,000 it means you are only charging $2 per hour. This is a significant enough of a change that I believe you should stop all revenue and recognize the balance upon completion and conduct an analysis to see if the amendment pricing is a concession on the original project.

If your amendment was priced at $195 per hour then I think the pricing is close enough to just change your percentage of completion.

One issue that I did not address is if you can determine the true hours to completion or if your contract is for a fixed price and does not allow for extended billable hours if the project runs over. These factors should also come into review when looking at the accounting treatment.


For your 2nd question...yes, the decision to leave revenue already recognized as revenue is based on the fact that at the time of recognition you were following all the guidance correctly. One item that maybe questioned is your linked arrangement analysis once you knew that the company was starting to talk about amending the agreement. Once you found out about this discussion you should most likely stop the POC based revenue pending the final decision on the amendment.

I hope this helps.

[dwood]

I concur with toomuchrevrec with a couple of thoughts.

You do need to pay special attention to the pricing methodology for the 2nd contract. Basically, you will have a concession in a situation if you grant the customer a right they didn't previously have (and was accounted for).

Secondly, if you have a number of other contract situations where you have the same situation, you may find yourself in completed contract mode for everything. This would be on business practice - could you every know when you have a completed contract if an amendment is probable later? You probably don't but it's advice you can slip in during a discussion with sales for future reference.

My first reaction to this situation would be to try to simply amend the original estimates and contract amount and continue to do the POC accounting on a go forward basis. That is probably the best business answer if you can get to it.