Example financing component in a contract

This is an example of the workings of IFRS 15.60 – 64.

A vendor 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’ time (the vendor’s performance obligation will be satisfied at a point in time). The contract contains two payment options. Either the customer can pay CU 5 million in two years’ time when it obtains control of the machine, or the customer can pay CU 4 million on inception of the contract.

The customer decides to pay CU 4 million on inception.Deemed costs Deemed costs Deemed costs Deemed costs

The vendor 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, that there is a financing component which is significant to the contract.

The interest rate implicit in the transaction is 11.8%. However, because the vendor is effectively borrowing from its customer, the vendor is also required to consider its own incremental borrowing rate which is determined to be 6%.

The accounting entries required are as follows:

Beginning Year 1: Contract inception (Amounts in CU’000):


DT Cash at bank

4,000

CR Contract performance liability

4,000

Recognition of the contract performance liability for the payment in advance

Year 1 interest (Amounts in CU’000):


DT Interest expense

247

CR Contract performance liability

247

Year 2 interest (Amounts in CU’000):


DT Interest expense

247

CR Contract performance liability

247

End of Year 2: at the date of the transfer of the machine to the customer


(Amounts in CU’000):

DT Contract performance liability

4,494

CR Revenue from sales of machines

4,494

For consideration:

For the purposes of identifying whether there is a significant financing component, the comparison made is between the timing of payment and the timing of transfer of control of the related goods or services. For those entities that provide goods or services where revenue is recognised at a point in time (such as in the above example) an adjustment for financing may be required even if the services are being carried out over a period of time. Example financing component in a contract

Entities must also consider whether interest expense arising from adjusting the transaction price for the effect of a significant financing component should be capitalised into particular assets in accordance with IAS 23 Borrowing Costs. For example, consider an entity that receives an up-front payment for the construction of apartment units for clients that will take approximately three years, with revenue being recognised at a point in time. Example financing component in a contract

The entity must consider whether the apartment building is a ‘qualifying asset’ in accordance with IAS 23.5. Assuming that this criterion is met, in our view, interest expense that accrues on the contract liability should be capitalised into the value of the apartment complex as it is constructed. That is because the interest expense is a ‘borrowing cost’ (IAS 23 5), since the finance charge is incurred in connection with the borrowing of funds. Example financing component in a contract

This arrangement differs from the unwinding of the discount rate on asset retirement obligations, where the IFRS Interpretations Committee concluded that capitalisation should be precluded. That is because the unwinding of a discount on the asset retirement obligation does not represent the ‘borrowing of funds’, since the interest expense relates solely to deferred payment. In the case outlined above, the customer provides consideration to the vendor in advance of the receipt of goods and services, with the vendor using the funds in order to fulfil the performance obligation, which is consistent with the concept of the ‘borrowing of funds’.

Example financing component in a contract

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