Article:

IFRS 15 for the TMT industries – Long-term contracts

27 June 2018

Significant financing component

Contracts in the technology, media and telecommunications sectors can involve cash receipts from customers which do not correspond to the timing of the recognition of revenue.  If a financing component is significant, IFRS 15 requires an adjustment to be made for the effect of implicit financing.

As a practical expedient, adjustments for a financing component are not required when there is a period of less than one year between the transfer of goods or services and the receipt of payment from a customer.

In a major change from existing practice, adjustments for a financing component are required for circumstances in which customers pay in advance, as well as in arrears.  Payments in arrears will result in finance income and a reduction in revenue (because the vendor is providing finance to its customer), while payments in advance will result in a finance expense and an increase in (deferred) revenue (because the vendor is, in effect, borrowing funds from its customer). 

The purpose of this approach is to reflect the ‘cash selling price’ of the underlying good or service at the point at which it is transferred to the customer.  It also results in transactions which involve a significant financing component being split into two parts; one for the sale of the good or service and the other for the financing arrangement.  However, the implications for the internal processes and systems that are needed in order to identify when a financing component is to be recognised, and to account for this, may be significant.

Example 1 – Customer pays a deposit

Background

Software Co enters into a contract with a customer to build a software application. Control over the completed program will pass to the customer in two years’ time (assuming the vendor’s performance obligation will be satisfied at a point in time).

The contract contains two payment options:

  • The customer can pay $5 million in two years’ time when it obtains control of the software, or
  • The customer can pay $4 million on inception of the contract.

The customer decides to pay $4 million on inception. Software Co’s incremental borrowing rate is determined to be 6%.

Question
Does the upfront deposit represent a financing arrangement?

Answer
Because of the significant period of time between the date of payment by the customer and the transfer of the asset (the completed software program) to the customer, together with the effect of prevailing market rates of interest, there is a significant financing component in this arrangement.

The following journal entry is recognised at contract inception:

Dr Cash $4,000,000  
Cr Contract Liability    $4,000,000
Recognition of a contract liability for the payment in advance

The following journal entry is recognised over the two-year development period:

Dr Interest expense  $494,400  
Cr Contract Liability     $494,400
Accretion of the contract liability at a rate of 6% (6% compound interest x $4 million for 2 years)

The following journal is recognised at the date of the transfer of the asset to the customer:

Dr Contract Liability $4,494,400  
Cr Revenue    $4,494,400
Recognition of contract revenue after performance obligation has been satisfied

Current practice under IAS 18

The common practice under IAS 18 would be to recognise the $4 million as revenue in two years’ time when control passes to the buyer, and not account for the financing component.

Example 2 – Customer pays in arrears

Background

Media Co. enters into a contract with a customer to design a new advertising campaign for the following year. The advertising campaign will be finished and provided to the customer in 12 months’ time (assuming the vendor’s performance obligation will be satisfied at a point in time). The contract contains two payment options.

  • The customer can pay $4.5 million in 12 months’ time  when it receives the completed advertising materials, or
  • The customer can pay $4.77 million one year after control passes to the customer.

The customer decides to use the second payment option. Customer's incremental borrowing rate is determined to be 6%.

Question
Does the deferred payment arrangement represent a financing arrangement?

Answer
Because of the significant period of time between the date of payment by the customer and the transfer of the asset (the completed advertising campaign) to the customer, together with the effect of prevailing market rates of interest, there is a significant financing component in this arrangement.

The following journal entry is recognised at the date the advertising campaign is completed and delivered to the customer:

Dr Trade receivable $4,500,000  
Cr Revenue   $4,500,00
Recognition of revenue from sale of advertising at net present value of $4.77 million payable in 12 months’ time at incremental borrowing rate of 6%.

The following journal entry is recognised over the 12 months until payment is received from the customer:

Dr Trade receivable $270,000  
Cr Interest revenue   $270,000
Accretion of the interest on the trade receivable at a rate of 6% compound interest for 1 year

The following journal is recognised when the customer settles the debt 12 months after the delivery of the advertising:

Dr Cash $4,770,000  
Cr Trade receivable   $4,770,000
Recognition of cash received from customer.

Current practice under IAS 18

It is likely that there is divergent current practice regarding the treatment of the additional $270,000 deferred consideration. Some entities may recognise this as a financing component but it is likely that many may not.

BDO Comment

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 not recognised until a point in time (on transfer of the completed item to the customer), an adjustment for financing may be required even if services are being carried out over a period of time.

When a significant financing component is recognised, consideration may be required of whether the interest income or expense is required to be capitalised by IAS 23 Borrowing Costs.

Practical implications on systems and processes  

Some of the practical implications on systems and processes for Software Co and Media Co. include:

  • Identifying that there is a financing component
  • Working out the incremental borrowing rate of the entity
  • Systems to split out the transaction into its two components
  • Systems to recognise the impact of the financing component.