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. This requirement ensures that entities recognize 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).
The purpose of this paper is to analyze the key issues of the significant financing component elements in Accounting Standards Codification (ASC) 606. This paper addresses the following topics: how to account for significant financing components, diversity in thought on the implementation of the new standard, and the changes from ASC 605 to ASC 606.
Identifying 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, ASC 606-10-32-16 provides the following factors that must be considered:
- The difference, if any, between the amount of promised consideration and the cash selling price of the promised goods or services.
- The combined effect of both of the following:
- The expected length of time between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services.
- The prevailing interest rates in the relevant market.
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.
|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 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 an entity to ensure that all performance obligations are performed as specified in the contract.|
The standard also provides a practical expedient that if the gap between payment and delivery is expected to be less than one year, there is no requirement to adjust the transaction price for a significant financing component. The practical expedient should be applied similarly to all transactions and must be disclosed if used.
Recognizing interest expense/revenue
If a significant financing component exists, the amount of revenue recognized differs from the amount of cash received from the customer. In transactions where payment is received in advance of the performance obligation, revenue recognized will exceed cash received to account for the interest expense that will be recognized until performance occurs. In transactions where payments are received in arrears of performance, the entity will recognize 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.
Determining the discount rate
ASC 606-10-32-19 requires that the entity “use the discount rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception.” This rate should also reflect the credit worthiness of the party receiving the financing in the arrangement (the entity or the customer). The discount rate is determined at contract inception and should not be reassessed.
Diversity in Thought About the Significant Financing Component
Identifying whether a significant financing component exists in a transaction requires judgment. Concerns have been expressed over whether the standard is defined narrowly enough to be applied consistently across industries. In a recent meeting, the Transition Resource Group (TRG) discussed three specific concerns about the treatment of significant financing components in the revenue standard.
Issue 1: Difference Between Consideration and Cash Selling Price for Reasons “Other Than Financing”
According to ASC 606-10-32-17(c), a significant financing component does not exist if the difference between consideration and cash selling price occurs for reasons “other than financing.” The phrase “other than financing” is open for broad interpretation and allows for a large measure of judgment.
Example 30 from ASC 606 presents a situation in which a technology product manufacturer enters a contract to provide support and repair coverage for three years in exchange for an upfront payment of $300. The guidance suggests that the entity requires the $300 payment upfront for three purposes: (1) to maximize profit by minimizing the risks of the customer not renewing the service, (2) to limit the customer from using the service (customers tend to use the service more if they are charged on a monthly basis), and (3) to minimize administration costs related to administering the renewals and collecting payments. Situations such as these are quite common in practice, which gives rise to the question, “Should the guidance regarding significant financing components be applied broadly, consistent with the above example?”
View A: Narrow Interpretation of “Other Than Financing”
The guidance in ASC 606-10-32-17(c) should not be applied broadly. Those that favor this viewpoint suggest that a timing difference between payment and recognizing revenue generally means that a significant financing component exists. The phrase “other than financing” should only be used in extreme cases where a truly valid reason exists for timing differences.
View B: Wide Interpretation of “Other Than Financing”
The guidance in ASC 606-10-32-17(c) should be applied broadly. Supporters of this viewpoint suggest that the phrase “other than financing” was intended to be applied broadly to allow entities to evaluate the reason for the timing difference between payment and revenue recognition. If the financing portion was considered in determining the timing and sales price, then a financing component clearly exists.
The key source of tension is that companies may cite business purposes “other than financing” for upfront or extended payment terms when a significant financing component may still exist. Two companies in the same industry and selling the same product at the same terms may account for the transactions differently. Applying the guidance broadly limits the consistent application across industries while applying the guidance narrowly may cause companies to recognize significant financing components when the company did not intend to finance the purchase of the customer.
TRG Memo 30 clarifies that the Board intended for an interpretation somewhere between View A and View B, which will require management to exercise more judgment. While this interpretation will lead to more diversity in practice, the Board feels that the majority of timing differences can easily be identified as financing related or not.
Issue 2: Interest-free Financing Offers
Some transactions arrange for the customer to receive interest free financing. In these cases, the amount of consideration received is already equal to the cash selling price. If the implied interest rate is zero (interest free financing), does a significant financing component exist?
View A: Price Reflects the Cash Payment
A significant financing component does not exist. The purpose of the significant financing component standard is for companies to recognize revenue at the amount that reflects the cash payment that the customer would have made at the time the goods or services were transferred. Since the objective of the standard is met, there is no need to recognize a significant financing component.
View B: Implied Interest
A significant financing component does exist. Whether the amount of consideration is equal to the cash selling price or not, the customer receives a financing benefit by paying for the product/service later. Since there is a financing benefit to the customer, the cash selling price should be adjusted to reflect the time value of money (financing received).
To illustrate, consider the following transaction. A company sells home fitness equipment for $1,560. A customer can purchase the equipment upfront for $1,560, or enter into a contract with the company to pay $65 monthly for a total of 24 months. In both situations, the cash selling price of the fitness equipment is $1,560. If the customer elects to enter into the 24 month payment plan, does a significant financing component exist (view B) or not (view A)?
In the March 2015 TRG meeting, the group discussed how to approach these transactions. Entities should determine if the list price is the same as the cash selling price of the good or service. In some transactions, if customers offer to pay cash up front rather than utilize the “free” financing, they are allowed to pay less than the list price. In these cases, the true cash selling price will be less than the list price. The “free” financing has an implicit interest rate built into the list price and a significant financing component may exist. If the list price, cash selling price, and zero-interest financing price are the same, as shown in the example above, a significant financing component is not likely to exist.
Issue 3: Adjusting for Time Value of Money
In a number of situations, consideration is received upfront and revenue is recognized over multiple years. If the entity concludes that the appropriate measure of progress is through straight-line revenue recognition, the issue arises of how to adjust for the time value of money and recognize revenue. Preliminary discussions regarding this topic have focused on three alternative views, which will be considered in the context of the following example.
An entity enters into an agreement with a customer for the use of a software license. The terms provide for the use of the software for five years in exchange for a $5 million upfront payment. The entity concludes that recognizing revenue on a straight-line basis is the appropriate measure of progress. The appropriate discount rate for a similar financing transaction is 5 percent. If the customer were allowed to make payments annually, the entity would have required the customer to pay more than $1 million per year. How should the entity account for the time value of money and recognition of revenue?
View A: Straight-Line Total Revenue
Use an effective interest rate amortization method with the 5 percent discount rate and allocate the principal in a way that recognizes the total transaction on a straight-line basis. This method is most easily understood by examining the journal entries at each point in the transaction. When the customer makes the upfront cash payment, the entity should record a contract liability in the following entry:
….Contract Liability: ……………….-………….$5,000,000
As shown in the amortization table below, the interest expense for the first year (5,000,000*5%) is recorded in the following entry:
Interest Expense: ……………….$250,000
….Contract Liability: …………………………..$250,000
Total revenue is then recorded for the year with the following entry:
Contract Liability: ………………. $1,154,874
The journal entries to record interest expense and revenue would be recorded for each subsequent year using the figures above. The amortization table illustrates how the principal is allocated in a way that allows the total revenue to be recognized each year on a straight-line basis. This method is straightforward and meets the straight-line revenue recognition criteria. The TRG appeared to have concerns about the journal entries associated with this method and proposed that the Financial Accounting Standards Board (FASB) provide further details. While the journal entries listed above are consistent with the underlying economics of the transaction, the topic will be readdressed in future TRG meetings to provide further clarification of the accounting under this method.
View B: Straight-Line Principal Amortization
Using the 5 percent discount rate, decrease the principal balance on a straight-line basis over five years ($1 million per year) and include all interest as revenue each year. The Contract Liability balance would decrease at $1 million a year over the five-year period and revenue would also be recognized to offset the interest expense each year. For example, in the first year the entity would recognize $250,000 of interest expense ($5,000,000*5%) and a total of $1,250,000 of revenue (principal and interest). This method obviously does not accomplish the objective of recognizing revenue on a straight-line basis. The example below illustrates the revenue to be recognized over the remaining four years.
View C: Straight-Line Interest Expense
Using the 5 percent discount rate, calculate the total interest expense assuming the principal is decreased on a straight-line basis over five years, and allocate the total amount of revenue associated with interest on a straight-line basis over the five years. Similar to View B above, the Contract Liability account would decrease by $1 million each year. For example, the table below shows the total interest expense ($750,000) that would be recognized over the five years if the principal is decreased on a straight-line basis. This amount would be allocated as revenue using the straight-line basis ($750,000/5) over the five years for a total of $1,150,000 of revenue (principal and interest) recognized each year.
|Time Period||Principal Revenue Recognized||Interest Expense||Total Revenue Recognized (Deferred in Contract Liability)||Principal|
View A is the best alternative to represent the underlying economics of the transaction and will commonly be used in practice. While View B provides a simple interest calculation, it does not accomplish the objective of recognizing revenue on a straight-line basis. View C does not provide an accurate representation of the accrued interest from year to year, which should exclude the method from consideration as an alternative.
Issue 4: Single Payment Stream Over Multiple Performance Obligations
As previously discussed, the standard also provides a practical expedient that if the gap between payment and delivery is expected to be less than one year, there is no requirement to adjust the transaction price for a significant financing component. A number of stakeholders have raised the question of how to apply the practical expedient in which a single payment stream occurs for multiple performance obligations. Consider the following example, which was used in TRG Memo 30.
An entity offers a 24-month contract which includes the delivery of a device at contract inception and related services over 24 months. The entity concludes that the device and services are each distinct. The promised amount of consideration (combined amount for device and services) is $2,400 payable in 24 monthly installments of $100. The transaction price is allocated to the device ($500) and services ($1,900 [$79 per month]). Assume that the entity transfers the device first and recognizes revenue for $500. Each of the 24 months, the entity transfers the services and recognizes revenue for $79. Assuming a significant financing component exists, does the practical expedient apply?
View A: Meets the Practical Expedient
The transaction price allocated to the device ($500) will be “paid” in full after 5 months ($100/month for 5 months), which meets the “less than one year” requirement for the practical expedient. After the first five months of installment payments are allocated to the device, the remaining installment payments will be allocated to each month of service. In this sense, the time between delivery of the service and payment from the customer is less than one year. For example, the services performed in January will be paid in June, the services performed in February will be paid in July, etc. Since both the device and services will meet the “less than one year” requirement, the practical expedient applies.
View B: Does Not Meet the Practical Expedient
The entity proportionally allocates the monthly consideration to the device ($21) and services ($79). The services are settled monthly, but the device is not paid off until month 24 ($21 a month for 24 months). Since the device does not meet the “less than one year” requirement, the practical expedient does not apply.
The FASB agrees that view B more appropriately represents the intent of the standard. The substance of the transaction is that the customer is financing the device and not the services, and view A does not represent the underlying economics of the transaction. When a single payment stream occurs for multiple performance obligations, entities should apply the logic of view B when determining if the practical expedient applies.
Issue 5: Applying a Significant Financing Component to a Subset of Performance Obligations in the Contract
The examples included in ASC 606 apply the standard to situations that contain only one performance obligation. In situations containing multiple performance obligations, stakeholders have questioned whether an adjustment for a significant financing component should ever be contributed to one or more, but not all of the performance obligations in the contract (similar to the guidance on bundled discounts and variable consideration). The transaction price is the amount of consideration an entity expects to receive in exchange for a good or service, not financing. Under this assumption, the financing component should be excluded in determining the transaction price under step 3 and applied to the specific performance obligations to which it relates under step 4.
The FASB determined that attributing a significant financing component to one or more, but not all of the performance obligations in a contract may produce an allocation result that reflects what the entity expects to receive from the customer. Attributing the financing component to specific performance obligations will require judgment and may result in diversity of practice, but follows the more principle-based approach of the new revenue standard.
Significant Financing Component Comparison to ASC 605
The biggest change between ASC 605 and ASC 606 is for entities that regularly receive long-term advanced payments from their customers. Under both ASC 605 and ASC 606, long-term receivables (payment is not due for more than one year) are generally discounted to reflect the effects of the time value of money. In contrast, ASC 605 does not require advanced payments to reflect the effects of the time value of money while the new revenue standard requires that interest be accrued for advanced payments. This change will lead to higher gross revenue recognition under ASC 606 for advanced payments.
As noted above, the guidance on significant financing components requires a substantial amount of judgment. The broad language included in the revenue standard permits multiple interpretations, varying by entity, which may lead to considerable diversity in practice. This topic will certainly be revisited in future meetings of the Board and the Transition Resource Group to provide clearer direction for companies adopting the new revenue standard.
- ASC 606-10-32-15 to 32-20, 55-244 to 55-246.
- EY, Financial Reporting Developments: “Revenue from Contracts with Customers.” October 2018. Section 5.3.
- FASB TRG Memo 20: “Significant Financing Components.” 26 January 2015.
- FASB TRG Memo 30: “Significant Financing Components.” 30 March 2015.
- KPMG, Issues In-Depth: “Revenues from Contracts with Customers.” May 2016. Section 5.3.2.
- PWC, “Revenue from contracts with customers.” August 2016. Section 4.4.