In the April 2018 edition of Accounting News we discussed the five step model for revenue recognition introduced by IFRS 15 Revenue from Contracts with Customers:
Step 1 | Identify the contract(s) with the customer |
Step 2 | Identify the performance obligations in the contract |
Step 3 | Determine the transaction price |
Step 4 | Allocate the transaction price to the performance obligations |
Step 5 | Recognise revenue when a performance obligation is satisfied |
Since then we have included a number of articles on IFRS 15 in Accounting News:
In this article, we look at some more examples of Step 3 of the IFRS 15 five step model.
The transaction price is defined in IFRS 15 as the ‘amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties’.
The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both. When determining the transaction price, the entity needs to consider the effects of:
Following on from February’s article on variable consideration, we continue our way through Step 3, this month demonstrating how the existence of a financing component can change the amount of the transaction price previously recorded under IAS 18 Revenue.
If the timing of payments agreed to by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer, the entity will need to adjust the promised amount of consideration for the effects of the time value of money when determining the transaction price.
The table below outlines the impact of a significant financing component:
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 |
In determining whether a contract contains a financing component, and whether that financing component is significant to the contract, the entity must consider all relevant facts and circumstances, including both of the following:
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.
In addition, a contract with a customer will not have a significant financing component if any of the following apply (IFRS 15, paragraph 62):
Some examples in practice where there would be no financing component include:
When adjusting the promised amount of consideration for a significant financing component, the entity must use the discount rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception.
The discount rate would reflect:
The ‘cash selling price’ for the goods or services is the price that the customer would pay in cash for the goods or services when (or as) they transfer to the customer.
After contract inception, the entity must not update the discount rate for changes in interest rates or other circumstances (such as a change in the assessment of the customer’s credit risk).
The effects of financing (interest revenue or interest expense) must be presented separately from revenue from contracts with customers in the statement of comprehensive income.
The following example, taken from Illustrative Example 29 that accompanies IFRS 15, 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.
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%.
At inception of the contract, Company A processes the following journal entry to recognise a contract liability:
Dr ($) | Cr ($) | |
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 + $240,000] x 6%). The journal entry for the two years combined will be:
Dr ($) | Cr ($) | |
Interest expense | 494,400 | |
Contract liability | 494,400 | |
Being interest for Year 1 of $240,000 plus interest for Year 2 of $254,400 |
At the date of transfer of the machine to the customer, Company A then processes the following journal entry:
Dr ($) | Cr ($) | |
Contract liability | 4,494,400 | |
Revenue | 4,494,400 | |
$4,000,000 at inception plus $494,400 interest accreted |
Following on from Example 1 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.
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 $494,400 consideration as interest income.
At inception of the contract, Company B processes the following journal entry to recognise revenue:
Dr ($) | Cr ($) | |
Receivable | 4,000,000 | |
Revenue | 4,000,000 |
Company B then accretes 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 entry for the two years combined will be:
Dr | Cr | |
Receivable | 494,400 | |
Interest received | 494,400 | |
Being interest for Year 1 of $240,000 plus interest for Year 2 of $254,400 |
When revenue is earned it would be unusual for there to be a substantial time difference between delivery of the goods or services and payment for those goods or services. Where a substantial time difference does exist, we need to consider whether there is a significant financing component in the transaction price, or whether the time delay occurred for a reason other than a significant financing component in the contract (e.g. the customer having paid for the goods or services in advance and the timing of the transfer of those goods or services being at the discretion of the customer). Finance teams will need to ensure that they fully understand the terms and conditions of contracts with their customer so that they can identify the existence of a significant financing component and ensure that it is accounted for correctly.