Contract modifications in power and utilities – Best IFRS 15 Revenue recognition

Contract modifications in power and utilities

One of the most judgemental aspects of implementing IFRS 15 for power and utilities entities is applying the contract modifications guidance to arrangements, such as ‘blend and extend’ arrangements.

Blend and extend arrangements

Blend and extend arrangements are common in the power and utilities industry. In a blend and extend arrangement, the buyer and seller negotiate amended pricing of an existing contractual arrangement, including extending the term of the existing arrangement. It is common for the buyer to benefit from a lower blended price (original price blended with the extension period price which is at a lower rate per unit) and for the seller to benefit from an extended term (original term plus the extension period term).

Management will need to evaluate these types of modifications in order to determine how and when they will be accounted for under the contract modification provisions in IFRS 15.

Blend and extend modifications will typically fall into one of the following scenarios:

  1. The modification creates a separate contract from the existing arrangement. This would be the case if the modification results in an increase in the amount of distinct goods (such as units of electricity to be delivered), and the additional consideration reflects the reporting entity’s stand-alone selling price of the additional promised goods.
  2. The modification represents a termination of the existing agreement and the creation of a new agreement, to be accounted for prospectively. This would be the case if the modification results in an increase in the amount of distinct goods (such as units of electricity to be delivered), but the additional consideration does not reflect the reporting entity’s stand-alone selling price of the additional promised goods (for example, the price per unit of the new distinct goods is different from the market due to the blended price).

Energy-related blend and extend arrangements would generally not require a cumulative catch-up adjustment to revenue, because the electricity to be delivered in the extension period will usually represent additional distinct goods.

Case – Contract modification prospective basis

Background

Power Sale Co (‘Seller’) and Electric Buy Co (‘Buyer’) are parties to an existing arrangement for the purchase and sale of electricity. The contract term began on 1 January 20X0 and ends on 31 December 20X7, and the contract price and annual contract quantities were $50/MWh and 87,600 MWh (10 MW per hour * 24 [hours per day] * 365 [days per year]), respectively.

Seller concluded that its obligation to sell electricity represents a single performance obligation that is satisfied over Contract modifications in power and utilitiestime (that is, the sale of electricity over the term of the agreement represents a series of distinct goods that are substantially the same and that have the same pattern of transfer to the customer).

See ‘Identifying performance obligations’ for more information on identifying performance obligations, and ‘Recognise revenue when (or as) the entity satisfies a performance obligation’ for more information regarding the concepts of satisfying performance obligations and measuring progress towards complete satisfaction of a performance obligation.

On 1 January 20X2, two years into the agreement, Seller and Buyer negotiate a modification (that is, a blend and extend arrangement) to the existing arrangement, which extended the contract term by two additional years. The contract price and annual contract quantities for the purchase and sale of electricity during the additional two years is $40/MWh and 87,600 MWh, respectively.

How should Seller account for the transaction?

Analysis

The blend and extend arrangement would be accounted for as a separate agreement if Seller concludes, at the date of the contract modification, that:

  1. the additional electricity to be delivered represents distinct goods; and
  2. the additional consideration of $7,008,000 (($40 * 87,600 MWh) [year 9] + ($40 * 87,600 MWh) [year 10]) reflects the stand-alone selling price of the additional promised goods.

Accounting for this contract modification as a separate arrangement reflects the fact that there is no economic difference between the entities entering into a separate contract and agreeing to the modification to the existing arrangement. Seller would continue to recognise revenue at $50/MWh until 31 December 20X7 and then recogniseContract modifications in power and utilities revenue at $40/MWh in 20X8 and 20X9.

The blend and extend arrangement would be accounted for as a termination of the existing contract and the creation of a new contract on a prospective basis if Seller concludes, at the date of the contract modification, that the additional electricity to be delivered represents distinct goods, but that the additional consideration of $7,008,000 (($40 * 87,600 MWh) [year 9] + ($40 * 87,600 MWh) [year 10]) does not reflect the stand-alone selling price of the additional promised goods.

In this case, the amount of total consideration to be recognised in the final six years of the existing arrangement (1 January 20X2 – 31 December 20X7) and the additional two years (1 January 20X8 – 31 December 20X9) is $33,288,000 (($50 * 87,600 * 6) + ($40 * 87,600 * 2)), or $4,161,000 per year. Accounting for this contract modification on a prospective basis reflects the effective termination of the existing arrangement and the execution of a new arrangement.

However, a cumulative catch-up adjustment might be required for some contract modifications (for example, a modification to a construction services arrangement that represents a single performance obligation). Here is a decision tree:

Cumulative catch-up approach

Case – Contract modification – construction services arrangement: cumulative catch-up adjustment

Background

Gas Pipeline Co (‘Seller’) contracts with Energy Co (‘Buyer’) to construct a natural gas pipeline to transport natural gas from delivery point A to delivery point B. The contract requires Seller to construct the natural gas pipeline over a 24-month period at a fixed price of $150,000,000, with construction beginning on 1 January 20X0 and ending on 31 December 20X1. Total expected costs to construct the pipeline are $110,000,000.

The construction of the natural gas pipeline is a single performance obligation. At the end of the first year, Seller has incurred total costs of $50,000,000, and Seller and Buyer agree to modify the grade of the steel used to construct the remainder of the natural gas pipeline, which will increase the transaction price and expected cost by $10,000,000 and $7,500,000, respectively.

How should Seller account for the modification?

Analysis

Seller should account for the modification as if it were part of the existing contract. The modification does not create a performance obligation, because the remaining goods and services to be provided under the modified contract are not distinct. Seller should update its estimate of the transaction price and its measure of progress, to account for the effect of the modification. This will result in a cumulative catch-up adjustment at the date of the contract modification.

Assuming that Seller has (1) accounted for its obligation to construct the gas pipeline to connect delivery point A to delivery point B as a single performance obligation that is satisfied over time, and (2) measured its progress towards complete satisfaction of its performance obligation via a cost-based input method, Seller would recognise cumulative revenue of $68,085,106 ($160,000,000 [$150,000,000 + $10,000,000] * ($50,000,000/$117,500,000 [$110,000,000 + $7,500,000])) for the year ended 31 December 20X0.

See ‘Recognise revenue when (or as) the entity satisfies a performance obligation’ for more information regarding the concepts of satisfying performance obligations and measuring progress towards complete satisfaction of a performance obligation.

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