In previous posts we’ve covered the accounting for revenue recognition under ASC 606, Revenue from Contracts with Customers and more specifically Step 3, Determining the Transaction Price. But did you know that when determining the transaction price under ASC 606 you must consider whether a significant financing component exists in the contract? If it does, it must be presented separately by recognizing interest expense (when payment is obtained in advance) or interest income (when payment is made in arrears). Overall, the “net” impact on the income statement is the same, and the accounting for the financing component is an allocation between revenue and interest.
The guidance states that time value of money is reflected in a vendor’s estimate of the transaction price if the contract has a financing component that is significant to the contract using the discount rate that would be reflected in a separate financing transaction between the vendor and the customer at the inception of the contract. The financing component would be recognized as interest expense (when the customer pays in advance) or interest income (when the customer pays in arrears). An entity should 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. If so, financing component must be presented separately. Let’s take a look at an example.
Neil Construction, Inc. enters into a contract to build a bridge for the California Department of Transportation at a total cost of $2 million. The project will last two years, and Neil determines that revenue should be recognized over time based on percentage of completion. Upon signing the contract, Neil receives an upfront payment of 20% of the total contract price. The funds will be used to purchase materials and hire additional workers. Is there a significant financing component in this contract that should be accounted for?
Yes. There is a significant financing component that must be presented separately. While the standard does not define what is “significant” it can be assumed in this example that a 20% upfront payment is significant. In addition, the standard includes a practical expedient whereby time value of money can be ignored for periods that are one year or less. However, that is not the case here as this is a two-year contract. In this example, the customer paid in advance, which will result in interest expense being recognized by Neil (the vendor). This might seem counterintuitive, but a practical way to look at it is that the customer provided Neil with financing that it would otherwise have had to obtain from another party, thus incurring interest expense. In order to account for this, revenue is “grossed up” using the same discount rate that Neil would use if it were to enter into a separate financing transaction with the customer. Interest expense is then recognized over time, resulting in a net P&L impact of $2 million in this example.
Assume that the reason for the upfront payment was not a need for funds to purchase materials and hire workers. Instead, the DOT actually requested the upfront payment because the contract was signed at the end of the year and they needed to use budgeted funds for that year. Does that change your answer?
Solution to follow-up question
Yes. ASC 606 includes some scenarios when a significant financing component should not be recognized separately. One such scenario is if the difference between promised consideration and the cash selling price of the service arise for reasons other than financing and the difference approximates the value of such reason. The standard also states that a significant financing component does not exist when a customer pays in advance and the timing of the transfer of the goods and services is at the discretion of the customer. In our example of Neil Construction, the upfront payment was at the request of the customer, which indicates that it is for a reason other than financing requirements of the vendor.
Here is the full list of scenarios when a significant financing component does not exist and therefore should not be presented separately:
- 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
- Contract consideration is variable based on the occurrence (or nonoccurrence) of a future event that is not within the customer’s or entity’s control
- Differences between promised consideration and the cash selling price of the good or service arises for reasons other than financing and the difference is approximates the value of such reason
- As a practical expedient, the financing period is one year or less, OR the financing component is not significant to the contract
Consideration of a significant financing component when determining the transaction price is a new concept under ASC 606 and therefore may present difficulty when applying the standard. To learn more about the guidance, check out chapter 5 of KPMG’s Revenue Recognition handbook. The SEC has noted that the evaluation of whether a significant financing component exists can be challenging and often requires judgment and discussed this during a speech at the 2018 AICPA Conference. For more information on that discussion, check out EY’s 2018 AICPA Conference on Current SEC and PCAOB Developments – Compendium of Significant Accounting and Reporting Issues.
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