Are your contract modification accounting issues creating unnecessary headaches? Learn about three process challenges and how to resolve them in 2021.
Accounting for contract modifications requires time, effort, and meticulous attention to detail. What made 2020 more difficult was the sheer volume of modifications that landed on the (virtual) desks of accounting teams: stacks of lease concessions, debt modifications, modifications to revenue contracts, amendments to employee compensation agreements – all of them urgent tasks for companies seeking financial relief to stay afloat during the COVID-19 crisis.
The financial reporting challenges alone have been overwhelming. Accounting teams put in extra hours, poring over the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) in search of the correct accounting model for a given contract modification. They also grappled with overarching issues of communication, details, and processes that made the task more difficult.
We’ve identified three of the top challenges of accounting for contract modifications, based on our hands-on experience assisting businesses of all sizes. Read on to learn how to remedy each of them by applying the three fundamental concepts of completeness, clarity, and control – what we call the 3 C's.
Challenge 1: Poor communication about contract modifications in process
Organizations can’t correctly account for contract modifications in their financial statements if they don’t have all the relevant details. Too often, teams across an organization don’t keep accounting and finance fully in the loop.
For example: Sales representatives at a manufacturing company might make new offers or modify contracts to retain their customers’ business. But they might not always remember to relay their activities or discussions with customers back to accounting and finance, or they might convey incomplete information with an email saying one thing and a contract saying another.
Many contract modifications might not be formally documented, either. Instead, a business manager might offer a one-month-free discount during a phone conversation or communicate a simple agreement about a rent deferral in a short email. A verbal offer or an email might not give accounting and finance the necessary details to identify the correct accounting.
The solution: Organizations should follow the principle of completeness (the first C of the 3 C's) and enable accounting and finance to have a full view of what’s happening. That includes compiling an inventory of all the contract modifications entered into and identifying the responsible parties involved – sales, treasury, finance, or real estate teams. Additionally, organizations must establish strong channels of communication so that the accounting and finance departments obtain the needed clarity (the second of the 3 C's) on the terms of modifications, especially ones made verbally or over email.
Challenge 2: Confusion about what constitutes a contract modification
At times, accounting and finance teams might expend precious time wrestling with a key gating question: Is a contract change truly a modification for accounting purposes, or should it be treated as something else (for example, a marketing offer)? Organizations can’t move forward without a clear answer to the question.
For example: When a lessee is granted a concession by a lessor due to COVID-19 hardship, should the concession be treated as a modification, or is it simply the application of the original terms of the lease agreement (for example, under a force majeure clause)? Or, if an organization offers free or discounted goods for a period of time to both new and existing customers, should the offer be treated as a marketing incentive or a contract modification?
The solution: Accounting and finance teams need to obtain clarity (one of the 3 C's again) on the proper accounting treatment as efficiently as possible. They can start by gaining a basic knowledge of contract modification definitions and the appropriate accounting standards to apply. With these basics, the responsible parties can be better equipped to ask the right questions and arrive at the correct accounting conclusion.
These detailed Crowe reference materials offer additional insights on important factors to consider when accounting for contract modifications:
- FAQ: Debt modifications
- Report: Evaluating accrued interest receivable on loan deferrals and modifications
Challenge 3: Inadequate processes and controls
Organizations’ financial reporting processes and control environments were stress-tested by 2020. In some cases, it brought to light deficiencies. In the context of accounting for contract modifications, accounting and finance teams may have been overwhelmed by a higher-than-normal volume of modifications, and resource constraints may have led to improper handling of contract modifications.
The solution: Organizations should pause and reflect on the lessons learned from 2020 to identify where financial reporting processes and controls fall short and where they can be strengthened. Ultimately, organizations should establish proper internal controls over financial reporting (control, the last of the 3 C's) to help them achieve completeness and clarity in financial reporting. Three questions to continually ask to assess and improve internal controls over financial reporting include:
- What internal controls are in place to support completeness of the organization’s contract modification population?
- What internal controls exist to verify accounting analyses have considered all relevant terms of the modifications?
- What internal controls are in place to confirm the financial statements and related disclosures are free of material misstatement?
The 3 C's – completeness, clarity, and control – can be considered a mindset that organizations can bring to their approach for accounting for contract modifications. By fully embracing the 3 C's, organizations can reduce pain points that make accounting for contract modifications so challenging.
