Identifying a significant financing component

Identifying a significant financing component in a contract can require judgment. It could be particularly challenging in a long-term arrangement where product or service delivery and cash payments occur throughout the term of the contract.

Management does not need to consider the effects of the financing component if the effect would not materially change the amount of revenue that would be recognized under the contract. The

determination of whether a financing component is significant should be made at the contract level. A determination does not have to be made regarding the effect on all contracts collectively. In other words, the financing effects can be disregarded if they are immaterial at the contract level, even if the combined effect for a portfolio of contracts would be material to the reporting entity as a whole. While a reporting entity is not required to recognize the financing effects if they are immaterial at the contract level, a reporting entity is not precluded from accounting for a financing component that is not significant. Refer to Revenue TRG Memo No. 30 and the related meeting minutes in Revenue TRG Memo No. 34 for further discussion of this topic.

The revenue standard includes the following factors to be considered when assessing whether there is a significant financing component in a contract with a customer.

Excerpt from ASC 606-10-32-16

An entity shall consider all relevant facts and circumstances in assessing whether a contract contains a financing component and whether that financing component is significant to the contract, including both of the following:

a. The difference, if any, between the amount of promised consideration and the cash selling price of the promised goods or services

b. The combined effect of both of the following:

1. 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

2. The prevailing interest rates in the relevant market

A significant difference between the amount of contract consideration and the amount that would be paid if cash were paid at the time of performance indicates that an implicit financing arrangement exists. In some cases, the stated interest rate in an arrangement could be zero (for example, interest-free financing) such that the consideration to be received over the period of the arrangement is equal to the cash selling price. Management should not automatically conclude that there is no financing component in zero-percent financing arrangements. All relevant facts and circumstances should be evaluated, including assessing whether the cash selling price reflects the price that would be paid absent the financing. Refer to Revenue TRG Memo No. 30 and the related meeting minutes in Revenue TRG Memo No. 34 for further discussion of this topic.

The longer the period between when a performance obligation is satisfied and when cash is paid for that performance obligation, the more likely it is that a significant financing component exists.

A significant financing component does not exist in all situations when there is a time difference between when consideration is paid and when the goods or services are transferred to the customer.

The revenue standard provides factors that indicate that a significant financing component does not exist.

Excerpt from ASC 606-10-32-17

A contract with a customer would not have a significant financing component if any of the following factors exist:

a. The customer paid for the goods or services in advance, and the timing of the transfer of those goods or services is at the discretion of the customer.

b. A substantial amount of the consideration promised by the customer is variable, and the amount or timing of that consideration varies on the basis of the occurrence or nonoccurrence of a future event that is not substantially within the control of the customer or the entity (for example, if the consideration is a sales-based royalty).

c. The difference between the promised consideration and the cash selling price of the good or service…arises for reasons other than the provision of finance to either the customer or the entity, and the difference between those amounts is proportional to the reason for the difference. For example, the payment terms might provide the entity or the customer with protection from the other party failing to adequately complete some or all of its obligations under the contract.

4.4.1.1 Timing of control transfer is at customer’s discretion

The effects of the financing component do not need to be considered when the timing of performance is at the discretion of the customer. This is because the purpose of these types of contracts is not to provide financing. An example is the sale of a gift card. The customer uses the gift card at his or her

discretion, which could be in the near term or take an extended period of time. Similarly, customers who purchase goods or services and are simultaneously awarded loyalty points or other credits that can be used for free or discounted products in the future decide when those credits are used.

4.4.1.2 Consideration is variable and based on future events

The amount of consideration to be received when it is variable could vary significantly and might not be resolved for an extended period of time. The substance of the arrangement is not a financing if the amount or timing of the variable consideration is determined by an event that is outside the control of the parties to the contract. One example is in an arrangement for legal services when an attorney is paid only upon a successful outcome. The litigation process might extend for several years. The delay in receiving payment is not a result of providing financing in this situation. Another example is a license to a patented technology when the licensor is compensated based on a sales-based royalty that will be received over multiple years. Although the performance obligation is satisfied upfront, the delay in receiving payment is not the result of providing financing in the context of the revenue standard.

4.4.1.3 Timing difference arises for reasons other than financing

The intent of payment terms that require payments in advance or in arrears of performance could be for reasons other than providing financing. For example, the intent of the parties might be to secure the right to a specific product or service, or to ensure that the seller performs as specified under the contract. The effects of the financing component do not need to be considered if the primary intent of the payment timing is for reasons other than providing a significant financing benefit to the reporting entity or to the customer. Assessing whether there are valid reasons for the timing difference, other than providing financing, will often require judgment.

Any difference between the consideration and the cash selling price should be a reasonable reflection of the reason for the difference. In other words, management should ensure that the difference between the cash selling price and the price charged in the arrangement does not reflect both a reason other than financing and a financing.

Example RR 4-17 illustrates a situation in which a difference in the timing of payment and the timing of transfer of control of goods or services arises for reasons other than providing financing. This concept is also illustrated in Examples 27 and 30 of the revenue standard (ASC 606-10-55-233 through ASC 606-10-55-234 and ASC 606-10-55-244 through ASC 606-10-55-246).

EXAMPLE RR 4-17

Significant financing component — prepayment with intent other than to provide financing

Distiller Co produces a rare whiskey that is released once a year prior to the holidays. Retailer agrees to pay Distiller Co in November 20X1 to secure supply for the December 20X2 release. Distiller Co requires payment at the time the order is placed; otherwise, it is not willing to guarantee production levels. Distiller Co does not offer discounts for early payments.

The advance payment allows Retailer to communicate its supply to customers and Distiller Co to manage its production levels.

Analysis

There is no significant financing component in the arrangement between Distiller Co and Retailer. The upfront payment is made to secure the future supply of whiskey and not to provide Distiller Co or Retailer with the provision of finance.