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IFRS15 in the spotlight - Significant financing components in contracts

11 July 2017

From 1 January 2018, the new revenue recognition standard will apply specific rules where the timing of cash payments specified in a contract is different from the timing of the transfer of control of the related goods or services to the customer (ie different from the date the related revenue is recognised).

If the timing of payments agreed by the parties to the contract (either explicitly or implicitly) provides either the customer or the vendor with a significant financing benefit (eg if £4m is paid in full up front but delivery takes place 24 months later or vice versa), then IFRS 15 requires that the transaction price is adjusted to reflect this ‘financing component’.

This is a significant departure from previous requirements as, under IAS 18, similar financing arrangements will generally only have been considered where payment terms were deferred; typically payments in advance would not have affected revenue. The objective of including such new adjustments for significant financing components is for the vendor to recognise revenue at the cash selling price, even if the contract contains an element of financing.
 

Example - A significant financing component arising from a payment in advance

A company enters into a contract with a customer to construct a new building. An analysis of the contract has determined that the revenue for the building will be recognised at a point in time, rather than over time, with control over the completed building passing to the customer in two years’ time. The contract contains two payment options: Either the customer can pay £5 million in two years’ time when it obtains control of the building, or the customer can pay £4 million on the signing of the contract. The customer decides on the latter option.

The company concludes that, because of the significant period of time between the date of payment by the customer and the transfer of the completed building to the customer and the effect of prevailing market rates of interest, there is a significant financing component in the arrangement.

The interest rate implicit in the transaction is 11.8%. However, because the vendor is effectively borrowing from its customer, the vendor is also required to consider its own incremental borrowing rate which it has determined to be 6%. The accounting entries required to reflect the significant financing component are as follows:
 

Contract inception:

Cash  £4,000,000  
Contract liability     £4,000,000
Recognition of a contract liability for the payment in advance.

 

Over the two year construction period:

Interest expense       £494,000          
Contract liability   £494,000      
Accretion of the interest at 6% incremental borrowing rate.

 

At the date of transfer of the building to the customer:

Contract liability £4,494,000  
Revenue   £4,494,000

 

Ignoring costs of sales, over the two year duration of the project, cumulative profit before tax will not be affected (the increase in revenue being offset by the increase in interest expense). However, other possible KPIs may change (eg EBITDA will increase from £4,000 to £4,494 over that period).

As a practical expedient, IFRS 15 allows the effects of a significant financing component to be ignored if the vendor expects, at contract inception, that the period between the transfer of a promised good or service to the customer and the date of payment will be one year or less.

 

 

Practical issues

This may also lead to a change in current practice, particularly in environments where interest rates are high, as a financing component may have been recognised under IAS 18 for periods less than one year.

IFRS 15 also identifies a number of situations where there may be a timing difference between the supply of the goods or services and payment that is not regarded as giving rise to a significant financing component, for example where:

  • A customer has paid in advance and the timing of transfer of those goods or services is at the discretion of the customer (such as prepaid phone cards and customer loyalty points)
  • 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 difference between the promised consideration and the cash selling price of the goods or services is for a reason other than financing to either the customer or the vendor (such as to provide the customer with protection that the vendor will fail to adequately complete its obligations – like the completion of post construction remedial work on a building).

For help and advice on revenue recognition issues please get in touch with your usual BDO contact or Scott Knight.

Read more on revenue recognition:

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