Financing Component In The Contract – FAQ | IFRS

Financing component in the contract

IFRS 15 Revenue from Contracts with Customers (contents page is here) introduced a single and comprehensive framework which sets out how much revenue is to be recognised, and when. The core principle is that a vendor should recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the vendor expects to be entitled in exchange for those goods or services. See a summary of IFRS 15 here.

The existence of a significant financing component in the contract

This section is part of step 3 determining the transaction price. The timing of payments specified in a contract may be different from the timing of recognition of the related revenue (and, consequently, the timing of transfer of control of the related goods or services to the customer). If the timing of payments specified in the contract provides the customer or the vendor with a significant benefit of financing the transfer of goods or services, the transaction price is adjusted to reflect this financing component of the contract.

Again, it is necessary to look more widely than the documented contractual terms. A significant financing component may exist regardless of whether a financing component is explicitly stated in the contract or implied by the payment terms agreed to by the parties to the contract.

As a practical expedient, adjustments for the effects of a significant financing component are not required if the vendor expects at contract inception that the period between the point at which the vendor recognises revenue for the transfer of the goods or services, and the date of payment from the customer, will be one year or less.

The new guidance brings a significant change in practice, because although some entities have previously adjusted for a financing component when payment is received after the supply of goods or services, adjustments have not typically been made by a vendor when payment is received in advance. In addition, for those arrangements where customers pay in arrears, there may be a change in practice. For example, in high interest rate environments when the financing component is material but relates to a period of less than one year, some vendors currently account for the financing effect; this will no longer be required under IFRS 15.

The objective of including adjustments for significant financing components to require revenue to be recognised at the amount that would have been paid if the customer had paid for the goods or services at the point at which they are supplied (that is, when control transfers to the customer). This is because the result of excluding the effects of, for example, a substantial payments in advance from a customer, could result in two economically similar transactions giving rise to substantially different amounts of revenue.

For example, a vendor may require a customer to pay in advance for a long-term construction contract because the vendor requires funds in order to obtain materials to carry out the contract. In the absence of such an advance payment, the vendor would typically need to borrow the funds from a bank (or other financial institution). If the vendor obtained financing from the bank, the vendor would need to pay finance charges and would be likely to recharge those costs to the customer by way of a higher transaction price. However, the fair value of goods and services transferred to the customer would be the same. It is only the party providing the financing to the vendor that changes. Consequently, the vendor‘s revenue should not vary depending on whether the vendor receives financing from the customer or from a third party.

Factors to consider in assessing whether a contract contains a significant financing component include: Financing component in the contract

  • The difference, if any, between the amount of consideration and the cash selling price of the goods or services,
  • The combined effect of: Financing component in the contract
    • The expected length of time between the point at which the vendor transfers the goods or services to the customer, and the point at which the customer pays for those goods or services, and  Financing component in the contract
    • The prevailing interest rates in the relevant market. Financing component in the contract

When the existence of a significant financing component is identified, the applicable interest rate will not always be the rate which is implied by the contractual terms for the sales transaction. In addition to considering any difference between the amount of consideration and the cash selling price of the goods or services, the interest rate that would apply to a particular borrowing arrangement needs to be considered.

In some cases, although there may be a difference between the timing of the goods or services and payment, this is not regarded as giving rise to a significant financing component. This is the case in any of the following circumstances:

  • A customer has paid in advance, and is able to call off the related goods or services at any point (such as a prepaid phone card),
  • A substantial amount of consideration payable by the customer is variable, and the amount or timing of that consideration will be determined by future events that are not substantially within the control of either the vendor or the customer (such as a sales-based royalty),
  • The timing of payment in comparison with the timing of supply of goods or services is for a reason other than financing (such as to provide the customer with protection that the vendor has or will adequately complete its obligations – such as completion of post completion remedial work on a building).

The discount rate used is the rate that would apply to a separate financing transaction between the vendor and the customer at contract inception. It needs to reflect the credit characteristics of the party receiving financing, as well as any collateral or security provided by that party (which might include assets transferred in the contract). The discount rate may be capable of being determined by identifying the rate that discounts the nominal amount of consideration to the cash selling price of the good or service. However, the discount rate will not necessarily be the same as the implied rate that would be derived by using the timing of the amount(s) payable by the customer and the timing of the transfer of the related goods or services to the customer. For example, a lower than market interest rate might be granted as a sales incentive which would not reflect the creditworthiness of the customer.

After contract inception, the discount rate is not updated for changes in interest rates or other circumstances (including a change in the customer’s credit risk).

The effects of a financing component are presented separately from revenue in the statement of comprehensive income. Interest revenue or interest expense is only recognised by a vendor to the extent that a related contract asset/receivable or contract liability (such as deferred revenue) is recognised.

See example in: Financing component in the contract

https://www.faqifrs.com/example-of-a-significant-financing-component-in-a-sales-contract/

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