Significant financing component in IFRS 15

Many transactions contain a significant financing component because the customer pays substantially before or after the goods or services have been provided. This can benefit the entity if the customer is financing the transaction by paying early, or this can benefit the customer if the entity finances the customer by delivering the good or service before payment occurs.

Under either circumstance, the entity is required to reflect the effects of the financing component in the transaction price by considering the time value of money (interest element). This requirement ensures that entities recognise revenue at the amount that reflects the cash payment that the customer would have made at the time the goods or services were transferred (cash selling price).

Practical expedient – no need to adjust for financing component (IFRS 15.63)

As a practical expedient, an entity is not required to adjust the promised amount of consideration for the effects of a significant financing component if the entity expects, at contract inception, that the period between when the entity transfers a promised good or service to a customer and when the customer pays for that good or service will be one year or less.

The Board added this practical expedient to the standard because it simplifies the application of this aspect of IFRS 15 and because the effect of accounting for a significant financing component (or of not doing so) should be limited in financing arrangements with a duration of less than 12 months. [IFRS 15.BC236] If an entity uses this practical expedient, it would apply the expedient consistently to similar contracts in similar circumstances. [IFRS 15.BC235]

It is important to note that if the period between when the entity transfers a promised good or service to a customer and the customer pays for that good or service is more than one year and the financing component is deemed to be significant, the entity must account for the entire financing component.

That is, an entity cannot exclude the first 12 months of the period between when the entity transfers a promised good or service to a customer and when the customer pays for that good or service from the calculation of the potential adjustment to the transaction price. An entity also cannot exclude the first 12 months in its determination of whether the financing component of a contract is significant.

Entities may need to apply judgement to determine whether the practical expedient applies to some contracts. For example, the standard does not specify whether entities should assess the period between payment and performance at the contract level or at the performance obligation level.

In addition, the TRG discussed how an entity should consider whether the practical expedient applies to contracts with a single payment stream for multiple performance obligations. See also the discussion in a TRG meeting on this subject:

The standard includes a practical expedient that allows an entity not to assess a contract for a significant financing component if the period between the customer’s payment and the entity’s transfer of the goods or services is one year or less.211 How should entities consider whether the practical expedient applies to contracts with a single payment stream for multiple performance obligations? [TRG meeting 30 March 2015 – Agenda paper no. 30]

TRG members generally agreed that entities either apply an approach of allocating any consideration received:

  1. To the earliest good or service delivered
    Or
  2. Proportionately between the goods or services depending on the facts and circumstances

The TRG agenda paper on this topic provided an example of a telecommunications entity that enters into a two-year contract to provide a device at contract inception and related data services over 24 months in exchange for 24 equal monthly instalments. [TRG Agenda paper no. 30, Significant Financing Components, dated 30 March 2015]

Under approach (1) above, an entity would be allowed to apply the practical expedient because the period between transfer of the good or service and customer payment would be less than one year for both the device and the related services. This is because, in the example provided, the device would be ’paid off’ after five months. Under approach (2) above, an entity would not be able to apply the practical expedient because the device would be deemed to be paid off over the full 24 months (i.e., greater than one year).

Approach (2) above may be appropriate in circumstances similar to the example in the TRG agenda paper, when the cash payment is not directly tied to the earliest good or service delivered in a contract. Approach (1) may be appropriate when the cash payment is directly tied to the earliest good or service delivered in a contract. However, TRG members noted it may be difficult to tie a cash payment directly to a good or service because cash is fungible. Accordingly, judgement is required based on the facts and circumstances.

Existence of a significant financing component

Entities determine the significance of a financing component at an individual contract level rather than at a portfolio level.

In making the assessment of whether a significant financing component exists, an entity needs to consider all relevant facts and circumstances, including (the following factors from IFRS 15 61):

  1. The difference between the cash selling price and the amount of promised consideration for the promised goods or services.
    and
  2. The combined effect of the expected length of time between the transfer of the goods or services and the receipt of consideration and the prevailing market interest rates. The Board acknowledged that a difference in the timing between the transfer of and payment for goods or services is not determinative, but the combined effect of timing and the prevailing interest rates may provide a strong indication that an entity is providing or receiving a significant benefit of financing. [IFRS 15.BC232]

Even if conditions in a contract would otherwise indicate that a significant financing component exists, the standard includes several situations that the Board has determined do not provide the customer or the entity with a significant benefit of financing. These situations, as described in IFRS 15.62, include the following:

  • The customer has paid for the goods or services in advance and the timing of the transfer of those goods or services is at the discretion of the customer. In these situations (e.g., prepaid phone cards, customer loyalty programmes), the Board noted in the Basis for Conclusions that the payment terms are not related to a financing arrangement between the parties and the costs of requiring an entity to account for a significant financing component would outweigh the benefits because an entity would need to continually estimate when the goods or services will transfer to the customer. [IFRS 15.BC233]
  • A substantial amount of the consideration promised by the customer is variable and is based on factors outside the control of the customer or entity. In these situations, the Board noted in the Basis for Conclusions that the primary purpose of the timing or terms of payment may be to allow for the resolution of uncertainties that relate to the consideration, rather than to provide the customer or the entity with the significant benefit of financing. In addition, the terms or timing of payment in these situations may be to provide the parties with assurance of the value of the goods or services (e.g., an arrangement for which consideration is in the form of a sales-based royalty). [IFRS 15.BC233]
  • The difference between the promised consideration and the cash selling price of the good or service arises for reasons other than the provision of financing to either the customer or the entity (e.g., a payment is made in advance or in arrears in accordance with the typical payment terms of the industry or jurisdiction) and the difference between those amounts is proportional to the reason for the difference . In certain situations, the Board determined the purpose of the payment terms may be to provide the customer with assurance that the entity will complete its obligations under the contract, rather than to provide financing to the customer or the entity. Examples include a customer withholding a portion of the consideration until the contract is complete (illustrated in Example 27 in IFRS 15.IE141-IE142) or a milestone is reached, or an entity requiring a customer to pay a portion of the consideration upfront in order to secure a future supply of goods or services.

A timing difference between when the consideration is paid and the goods or services are transferred to the customer does not always indicate that a significant financing component exists. The revenue standard provides three factors that decisively determine that a significant financing component does not exist. The figure below lists the three factors and an example of a transaction for each factor.

Factor (IFRS 15 61)

Example

The timing of the transaction is at the discretion of the customer.

A gift card has already been purchased, but the timing of when the card will be used is at the discretion of the customer.

A substantial portion of the consideration is variable and not under the control of the entity or customer.

The consideration of the transaction is a sales-based royalty.

The difference between the promised consideration and the cash selling price of the goods or services is due to something other than financing.

Customer withholds payment from the entity to ensure that all performance obligations are performed as specified in the contract,

If a significant financing component exists, the amount of revenue recognised differs from the amount of cash received from the customer. In transactions where payment is received in advance of the performance obligation, revenue recognised will exceed cash received to account for the interest expense that will be recognised until performance occurs.

In transactions where payments are received in arrears of performance, the entity will recognise less revenue than cash received since a portion of the consideration will be considered interest income. Any interest expense or interest income resulting from a significant financing component is recorded separately from revenue from contracts with customers.

If the payment is…

That in effect means…

Which results in…

In arrears

The vendor is providing finance to its customer

Finance income and a reduction in revenue

In advance

The vendor is borrowing funds from its customer

Finance expense and increased revenue

Assessment of significance
The assessment of significance is made at the individual contract level. As noted in the Basis for Conclusions, the Board decided that it would be an undue burden to require an entity to account for a financing component if the effects of the financing component are not significant to the individual contract, but the combined effects of the financing components for a portfolio of similar contracts would be material to the entity as a whole. [IFRS 15.BC234]

Determining The Discount Rate

When an entity concludes that a financing component is significant to a contract, in accordance with IFRS 15.64, it determines the transaction price by applying a discount rate to the amount of promised consideration. As stated above, the objective of requiring entities to adjust the promised consideration for the effects of a significant financing component is for the revenue recognised to approximate an amount that reflects the cash selling price that a customer would have paid for the promised goods or services.

However, to achieve this objective, the entity does not need to estimate that cash selling price. Rather, the entity determines an interest rate and applies it to the amount of the promised consideration.

The entity uses the same interest rate that it would use if it were to enter into a separate financing transaction with the customer at contract inception. The interest rate needs to reflect the credit characteristics of the borrower in the contract, which could be either the entity or the customer (depending on who receives the financing).

Using the risk-free rate or a rate explicitly stated in the contract that does not correspond with a separate financing rate would not be acceptable. [IFRS 15.BC239] Example 28, Case B illustrates a contractual discount rate that does not reflect the rate in a separate financing transaction. Furthermore, using a contract’s implicit interest rate (i.e., the interest rate that would make alternative payment options economically equivalent) would also not be acceptable if that rate does not reflect the rate in a separate financing transaction (as illustrated in Example 29 in IFRS 15 IE152 – IE154).

While not explicitly stated in the standard, an entity should consider the expected term of the financing when determining the interest rate in light of current market conditions at contract inception. In addition, IFRS 15.64 is clear that an entity does not update the interest rate for changes in circumstances or market interest rates after contract inception.

Advance payments

As explained in the Basis for Conclusions, the Board decided not to provide an overall exemption from accounting for the effects of a significant financing component arising from advance payments. This is because ignoring the effects of advance payments may skew the amount and timing of revenue recognised if the advance payment is significant and the purpose of the payment is to provide the entity with financing. [IFRS 15.BC238]

For example, an entity may require a customer to make advance payments to avoid obtaining the financing from a third party. If the entity obtained third-party financing, it would likely charge the customer additional amounts to cover the finance costs incurred. The Board decided that an entity’s revenue should be consistent regardless of whether it receives the significant financing benefit from a customer or from a third party because, in either scenario, the entity’s performance is the same.

In order to conclude that an advance payment does not represent a significant financing component, we believe that an entity needs to support why the advance payment does not provide a significant financing benefit and describe its substantive business purpose. [Consistent with the discussions within TRG Agenda paper no. 30, Significant Financing Components, dated 30 March 2015]

As a result, it is important that entities analyse all of the relevant facts and circumstances. In a 2018 speech, a member of the SEC staff discussed a consultation with the Office of the Chief Accountant (OCA) in which a registrant concluded that a contract with a large upfront payment did not have a significant financing component because:

  1. the upfront payment was made for reasons other than to provide a significant financing benefit; and
  2. the difference between the upfront payment and what the customer would have paid, had the payments been made over the term of the arrangement, was proportional to the reason identified for the difference.

The SEC staff member noted that, like other consultations that OCA has evaluated in relation to the revenue standard, the evaluation was based on the facts and circumstances. In this fact pattern, the staff did not object to the registrant’s conclusion that the contract did not have a significant financing component based on the nature of the transaction and the purpose of the upfront payment. [Speech by Sarah N. Esquivel, Associate Chief Accountant, SEC Office of the Chief Accountant, 10 December 2018]

Example – Receipts in advance

The following example, based on Example 29 in IFRS 15 IE152 – IE154, illustrates how a significant financing component in a contract with a customer is accounted for under IFRS 15 where the entity receives payment in advance of the transfer of goods or services to the customer.

The case

  • Company A enters into a contract with a customer to build and supply a new machine.
  • Control over the completed machine will pass to the customer in two years (which is the point in time at which Company A’s performance obligation will be satisfied).
  • The contract contains two payment options, i.e. the customer can pay:
  • $5 million in two years (when it obtains control of the machine), or $4 million at inception of the contract.
  • The customer decides to take the option of paying $4 million at inception.

What does it mean under IFRS 15?

Company A concludes that, because of the significant period of time between the date of payment by the customer and the transfer of the machine to the customer, together with the effect of prevailing market rates of interest, there is a financing component which is significant to the contract.

The interest rate implicit in the transaction is 11.8% (which is the interest rate necessary to make the two alternative payment options economically equivalent). However, because Company A is effectively borrowing from its customer, Company A is also required to consider its own incremental borrowing rate, which is determined to be 6%.

Journal entries

At inception of the contract, Company A processes the following journal entry to recognise a contract liability:

Balance sheet

Income statement

Cash

$4,000,000

Contract liability

$4,000,000

During the two years from contract inception until the transfer of the asset, Company A must adjust the promised amount of consideration, and increase the contract liability by recognising interest on $4,000,000 at 6% per year for two years.

Interest in Year 1 will be $240,000 ($4,000,000 x 6%) and interest in Year 2 will be $254,400 ([$4,000,000 + $240,000] x 6%). The journal entries for the two years are:

Year 1

Balance sheet

Income statement

Interest Expense

$240,000

Contract liability

$240,000

Year 2

Interest Expense

$254,400

Contract liability

$254,400

At the date of transfer of the machine to the customer, Company A then processes the following journal entry (the contract liability is $4,000,000 + $250,000 + $254,400 = $4,494,400):

Balance sheet

Income statement

Contract liability

$4,494,400

Revenue

$4,494,400

Example – Deferred consideration

Following on from Example 29 above, the example below illustrates how a significant financing component in a contract with a customer is accounted for under IFRS 15 where the entity receives consideration after it has transferred goods or services to the customer.

The case

  • On 1 May 2018, Company B enters into a contract with a customer to sell Property A.
  • Control over Property A passes to the customer on 1 July 2018 when the keys are handed over.
  • Selling price is $4,494,400, payable 30 June 2020.
  • Had the customer paid for the building on 1 July 2018, the consideration would have been $4 million.
  • The rate that discounts the deferred consideration of $4,494,400 to the cash price of $4 million is 6%, which reflects the credit characteristics of the customer.

What does it mean under IFRS 15?

Company B concludes that the contract contains a significant financing component because the selling price (deferred consideration) of $4,494,400 includes a 6% interest charge to the customer for two years’ financing.

Company B therefore recognises only $4 million as revenue and the remaining $494,400 consideration as interest income.

Journal entries

At inception of the contract, Company B processes the following journal entry to recognise revenue:

Balance sheet

Income statement

Receivable

$4,000,000

Revenue

$4,000,000

Company B then accrues 6% interest income to the receivable during the period from 1 July 2018 (date Property A is transferred to customer) and 30 June 2020 (payment of total consideration of $4,494,400).

Interest in Year 1 will be $240,000 ($4,000,000 x 6%) and interest in Year 2 will be $254,400 ([$4,000,000 + $240,000] x 6%). The journal entries for the two years are:

Year 1

Balance sheet

Income statement

Interest Income

$240,000

Contract asset

$240,000

Year 2

Interest Income

$254,400

Contract asset

$254,400

Receipt of the cash on 30 June 2020:

Balance sheet

Income statement

Cash

$4,494,400

Receivable

$4,000,000

Contract asset

$494,400


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