Significant Financing Component – FAQ | IFRS

Significant financing component

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 does not need 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.

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, IFRS 15 61 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.

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

Determining The Discount Rate

IFRS 15 64 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.

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

See also: https://www.ifrs.org


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