7.2 Sales of Future Revenues
7.2.1 Background
A seller of future revenue should evaluate whether the proceeds received should
be accounted for as debt or deferred income under ASC 470-10. Sales of future
revenue that are accounted for as debt are subject to the interest method, as
further discussed below.
7.2.2 Scope
ASC 470-10
25-1 An entity receives cash
from an investor and agrees to pay to the investor for a
defined period a specified percentage or amount of the
revenue or of a measure of income (for example, gross
margin, operating income, or pretax income) of a
particular product line, business segment, trademark,
patent, or contractual right. It is assumed that
immediate income recognition is not appropriate due to
the facts and circumstances. The payment to the investor
and the future revenue or income on which the payment is
based may be denominated in a foreign currency.
In a sale of future revenue (such as a profit-sharing agreement, a securitization
of a participation in a future revenue stream, a celebrity bond, or other
contingent payment obligation that varies on the basis of future revenue or
income), an entity receives an up-front lump sum payment from an investor and,
in return, agrees to pass on a specified percentage or amount of its future
revenue or income to that investor for a specified period. The share of revenue
or income owed to the investor may be graduated (e.g., 50 percent of the first
$1 million of revenue and then 25 percent of the amount in excess of $1 million)
or may be different from year to year. Further, the entity might guarantee a
minimum amount to be paid to the investor or there may be a maximum total amount
payable. The underlying cash flows that the entity will pass on might originate
from its contractual arrangements with third parties (e.g., fees and royalties
that it will receive from the licensing of patents, copyrights, trademarks, or
technology and franchise agreements) or its operations (e.g., a specified
interest in revenue, gross margin, or income of the entity or one of its
subsidiaries, business segments, or product lines).
Example 7-1
Sale of Royalty Income
Company C makes an up-front payment of $60 million to
Company D in exchange for the right to collect five
years of future royalties from specified songs covered
by intellectual property rights owned by D.
Example 7-2
Sale of Patent Infringement Litigation Claims
Company L enters into a patent
litigation funding agreement with Company Y. Company Y
is engaged in the business of investing in commercial
legal claims it believes to be meritorious. Under the
agreement, Y agrees to pay up to $20 million of the
litigation costs that will be incurred by L to pursue
claims against defendants that may be infringing on L’s
patents. In exchange, L assigns to Y the rights to an
amount received in connection with a settlement in a
judgment equal to 100 percent of Y’s invested amount
plus a fixed percentage of consideration received in
excess of 100 percent of Y’s invested amount. Company L
would account for this arrangement as a sale of future
revenue only if the arrangement was not considered a
freestanding derivative or a hybrid instrument with an
embedded derivative that must be bifurcated. Generally,
arrangements such as these that are indexed to
litigation represent derivative instruments that are not
eligible for the scope exception in ASC
815-10-15-59(d).
Example 7-3
Sale of Net Income
Company E enters into an agreement with Company P under
which P makes an up-front cash payment of $10 million in
exchange for a right to 40 percent of E’s net profits
from the operation of a hotel for 72 calendar months.
Company E is responsible for the management of the
financial affairs of the hotel, including the payment of
all expenses of construction, opening, operating,
furnishing, supplying, marketing, maintaining, and
repairing the hotel. Company P does not have any
operational responsibilities or rights related to the
hotel. Further, the arrangement does not create a
partnership or joint venture between the parties.
Company E has the right to terminate the agreement at
any time, provided that it pays P a termination fee in
an amount equal to the net present value of the expected
net profits from the date of the termination until the
end of the term of the agreement.
Typically, an entity is not required to account for a contract
for the sale of future revenues as a derivative instrument because ASC
815-10-15-59(d) contains a scope exception for non-exchange-traded contracts for
which the settlement is based on a specified volume of sales or service revenues
of one of the parties to the contract (see Section 8.4.10). Therefore, any derivative
(or embedded derivative) would generally be subject to this scope exception.
Sales of future revenues that are addressed by ASC 470-10
represent transactions that are not within the scope of the guidance in ASC
860-10 on transfers of financial assets. ASC 860-10 only applies to transfers of
recognized financial assets (see Section 2.2 of Deloitte’s Roadmap
Transfers and Servicing
of Financial Assets). ASC 860-10-20 defines a financial
asset as follows:
Cash, evidence of an ownership interest in an entity, or
a contract that conveys to one entity a right to do either of the
following:
-
Receive cash or another financial instrument from a second entity
-
Exchange other financial instruments on potentially favorable terms with the second entity.
At the 1997 AICPA Conference on Current SEC Developments, then
SEC Professional Accounting Fellow Armando Pimentel noted that the SEC staff
“has applied this definition very strictly” (i.e., narrowly). Accordingly, a
seller of a right that entitles the holder to a share of receivables that have
not yet been recognized for accounting purposes (e.g., receivables that will be
recognized in the future related to existing or anticipated orders for the
entity’s goods or services) would apply the guidance on sales of future revenue
in ASC 470-10 instead of the guidance on transfers of financial assets in ASC
860-20. (See Deloitte’s Roadmap Revenue Recognition for further
discussion of the point in time at which a receivable should be recorded under a
contract with a customer in accordance with ASC 606.)
A contract to service a financial asset (i.e., a servicing
right) entitles the holder to a stream of future revenue associated with a
financial asset, but that contract is not a financial asset because it depends
on the delivery of future services. The accounting for a transfer of servicing
rights is addressed in ASC 860-50-40 (see Chapter 6 of Deloitte’s Roadmap Transfers and Servicing of
Financial Assets).
7.2.3 Classification
7.2.3.1 Background
ASC 470-10
25-2 While the
classification of the proceeds from the investor as
debt or deferred income depends on the specific
facts and circumstances of the transaction, the
presence of any one of the following factors
independently creates a rebuttable presumption that
classification of the proceeds as debt is
appropriate:
-
The transaction does not purport to be a sale (that is, the form of the transaction is debt).
-
The entity has significant continuing involvement in the generation of the cash flows due the investor (for example, active involvement in the generation of the operating revenues of a product line, subsidiary, or business segment).
-
The transaction is cancelable by either the entity or the investor through payment of a lump sum or other transfer of assets by the entity.
-
The investor’s rate of return is implicitly or explicitly limited by the terms of the transaction.
-
Variations in the entity’s revenue or income underlying the transaction have only a trifling impact on the investor’s rate of return.
-
The investor has any recourse to the entity relating to the payments due the investor.
ASC 470-10 requires a seller of future revenue to evaluate
whether the offsetting entry to the proceeds received should be classified
as debt or deferred income. It is generally inappropriate to record the
proceeds immediately as income, because the seller maintains some continuing
involvement and the earnings process is not completed when the cash is
received. Further, the proceeds cannot be recorded to equity unless the
contract legally represents an ownership interest that is not required to be
classified as a liability under GAAP (e.g., under ASC 480; see Deloitte’s
Roadmap Distinguishing
Liabilities From Equity).
ASC 470-10-25-2 requires an
entity to consider six factors in determining the appropriate classification
of the proceeds:
|
Factors That Create Rebuttable Presumption of
Debt
|
Factors That Could Help Overcome the Debt
Presumption
|
|---|---|
|
“[T]he form of the transaction is debt” (see
Section 7.2.3.2)
|
The transaction purports to be a sale
|
|
“The entity has significant continuing involvement in
the generation of the cash flows due the investor”
(see Section 7.2.3.3)
|
The entity is not significantly involved in the
generation of the cash flows owed to the
investors
|
|
“The transaction is cancelable by either the entity
or the investor through payment of a lump sum or
other transfer of assets by the entity” (see
Section 7.2.3.4)
|
The agreement is not cancelable
|
|
“The investor’s rate of return is implicitly or
explicitly limited by the terms of the transaction”
(see Section 7.2.3.5)
|
There is no cap on payments to the investor
|
|
“Variations in the entity’s revenue or income
underlying the transaction have only a trifling
impact on the investor’s rate of return” (see
Section 7.2.3.6)
|
Variations in the level of revenue or income can
produce at least moderate variations in the
investor’s return
|
|
“The investor has any recourse to the entity relating
to the payments due the investor” (see
Section 7.2.3.7)
|
The agreement includes no guarantees, recourse, or
collateral provisions
|
If any of the six factors in ASC 470-10-25-2 are present, there is a
rebuttable presumption that the proceeds should be classified as debt.
Accounting for the proceeds from the sale of future revenue as debt
highlights that the proceeds received will be repaid in cash, not in goods
or services. Such accounting is appropriate when the transaction is in the
form of debt or any of the factors in ASC 470-10-25-2 are present.
The presumption that the proceeds should be classified as
debt can be overcome, and the proceeds may be accounted for as deferred
income, if the transaction purports to be a sale and none of factors in ASC
470-10-25-2 are present. Such accounting suggests that the entity has
accelerated the collection of cash from the sales of goods or services in a
manner similar to a nonrefundable advance payment received from a customer.
However, in practice, accounting for the proceeds as deferred revenue is
rare.
Example 7-4
Sale of Future Revenue Accounted for as
Debt
On March 31, 20X0, Entity A enters into an agreement
with Entity B under which A agrees to sell $250
million of future receivables associated with its
anticipated sales of a specified product in exchange
for a $175 million up-front cash payment. Entity A
continues to be solely responsible for research and
development, regulatory compliance, intellectual
property protection, manufacturing, marketing,
distribution, sales, product liability, and
reimbursement associated with the product. Under the
agreement, A is required to make quarterly payments
for five years. Quarterly repayment amounts are
subject to both a fixed cap of $25 million each
quarter and a variable cap equal to 10 percent of
quarterly revenues. Any amounts that remain
outstanding after five years are to be paid in
subsequent quarters subject to the 10 percent of
quarterly revenues cap. Entity A has an option to
prepay its obligation at an amount equal to $250
million less amounts already paid at the time of
prepayment. Entity B has a security interest in A’s
rights related to the product and will have a
secured interest in the future receivables once they
come into existence. Entity A concludes that the
transaction should be accounted for as debt under
ASC 470-10 because the factors in ASC
470-10-25-2(b)–(f) are present. Entity A treats the
proceeds of $175 million as the principal amount of
the debt. The additional $75 million that will be
repaid is recognized as interest over the life of
the debt.
7.2.3.2 Legal Form of Debt
A sale of future revenue may have the legal form of a nonrecourse borrowing.
If the transaction’s legal form is that of debt (e.g., a securitization of
future revenue), the issuer should classify the transaction as debt.
Accounting for the transaction as deferred revenue would be inappropriate
since the form of a transaction that is legally debt is respected under U.S.
GAAP.
Even if the legal form of a transaction is not that of debt, it may have
debt-like characteristics that suggest that it should be accounted for as
debt. Such characteristics may include the following:
-
The proceeds must be used for a specific purpose (e.g., the purchase of equipment).
-
There are covenants restricting the entity’s level of indebtedness until the initial amount received is repaid.
-
The contract has a predefined prepayment schedule (e.g., periodic repayments and a final repayment).
-
There is a contractual interest charge.
-
The entity pledges its assets as collateral to ensure the repayment of the proceeds received.
-
Any portion of the proceeds received that remain unpaid becomes immediately due and payable on a specified date even if revenue or income is insufficient.
7.2.3.3 Seller’s Involvement in the Generation of the Cash Flows
If the entity has significant continuing involvement in the generation of the
cash flows, it is presumed that the transaction represents debt. Such
involvement might take the following forms:
-
Manufacturing.
-
Marketing.
-
Distribution.
-
Repairs and maintenance.
-
Intellectual property protection.
-
Customer service.
-
Billing and handling of customer accounts.
-
Decisions concerning delivery of service and operations.
The evaluation of whether the entity has significant
involvement in the generation of the cash flows depends in part on whether
the underlying cash flows originate from the entity’s contractual
arrangements or its operations. In a licensing or other contractual
arrangement, continuing involvement of the seller will vary on the basis of
the terms of the arrangement. For example, the licensing of a patent will
generally require little ongoing activity by the seller except for
protection from patent infringement claims, whereas the seller’s obligations
under a franchise arrangement are generally substantial, such as providing
inventory, advertising, and training. The cash flows generated from the
operations of a subsidiary, business segment, or product line are typically
within the entity’s control, and its involvement is continuous.
At the 1997 AICPA Conference on Current SEC Developments,
then SEC Professional Accounting Fellow Armando Pimentel suggested that this
criterion is often “very difficult to overcome . . . because the seller of
the item generally continues to be involved in the marketing, promotion, or
direct generation of the asset’s cash flows. For example, if the seller
continues to market and promote the asset, in order to preserve or improve
the future cash flows to the investor, then the transfer would meet this
rebuttable presumption.”
7.2.3.4 Cancellation Provisions
If either the seller or the investor has the right to cancel the transaction
in exchange for a payment by the seller, the transaction is presumed to be
debt. An agreement that is cancelable by the entity permits the entity to
retain the benefits of revenue or income that exceeds expectations. An
agreement that is cancelable by the investor limits the investor’s exposure
to the risk that revenue or income will not meet expectations. Examples of
cancellation provisions include call or prepayment features held by the
seller and put features held by the buyer.
7.2.3.5 Limited Investor Rate of Return
If the investor’s rate of return is either explicitly or implicitly limited,
the transaction is presumed to be debt. A cap on the rate of return limits
the investor’s potential upside associated with changes in revenue or
income. Examples of contractual limits include fixed repayment amounts or
stated ceilings on total payments or rates of return.
7.2.3.6 Limited Investor Exposure to Variability
If the transaction terms are designed so that variations in the underlying
revenue or income have, as described in ASC 470-10-25-2(e), “only a trifling
impact on the investor’s rate of return,” the transaction is presumed to be
debt. In such a case, the investor is not significantly exposed to the risks
and rewards of changes in revenue or income in the transaction. For
instance, if the entity is required to repay the proceeds received
irrespective of the amounts of revenue generated, this criterion is met.
7.2.3.7 Investor Recourse Rights
If the investor has recourse to the seller (e.g., collateral), the
transaction is presumed to be debt because recourse rights limit the
investor’s exposure to reductions in the amount of revenue or income.
Examples of recourse provisions include:
-
Guaranteed minimum annual cash flows.
-
Guaranteed minimum rates of return.
-
Carryover provisions (if annual cash flows are insufficient, the buyer is entitled to recover any shortfall in the following year).
-
Extensions of the term (the expected term of cash flows to generate the buyer’s return may be five years while the agreement is for eight years with a cap; the additional three years act as a guarantee).
-
Acceleration provisions (if certain negative events occur, payments to the buyer are accelerated).
At the 1997 AICPA Conference on Current SEC Developments, Mr. Pimentel
suggested that this criterion is often “very difficult to overcome,
especially in cases where the transfer of the item is structured as an asset
securitization. Typically, asset securitizations require the transferor to
retain some type of recourse, either by transferring cash or other assets to
the investor, or by subordinating future receipts from a retained
interest.”
7.2.4 Debt Model
7.2.4.1 Initial Accounting
If the proceeds received in a sale of future revenue are
accounted for as debt, the entity makes the following entry upon initial recognition:
Cash (or other consideration received)
Debt
If the transaction includes the exchange of separate freestanding financial
instruments or other rights or privileges (e.g., the buyer obtains a right
to reduced pricing in future purchases of a product), the entity may need to
allocate a portion of the proceeds received to such other units of account
(see Section 3.4) before determining
the initial carrying amount of the debt. Further, the entity should evaluate
whether the amount recognized as debt contains any embedded feature (e.g., a
contingent prepayment option) that must be bifurcated as a derivative
instrument (see Chapter 8).
7.2.4.2 Subsequent Accounting
ASC 470-10
35-3 Amounts recorded as
debt shall be amortized under the interest method
(see Subtopic 835-30) . . . .
After initial recognition, an entity uses the interest method (see Section 6.2) to account for the amount
recorded as debt. Because sales of future revenues typically do not involve
fixed contractual cash flows, the entity must make estimates of the timing
and amount of the cash flows payable. While the effective interest rate is
computed at inception by solving for the constant effective yield that
equates the proceeds received to the future estimated payments (see
Section 6.2.3.3), it would be
inappropriate to apply a negative effective interest rate (see below).
In each period, the net carrying amount is the present value of the estimated
future cash payments, discounted by using the effective interest rate (see
Section 6.2.3.5). However, in the
absence of a TDR, it would be inappropriate to reduce the debt’s net
carrying amount below the initial carrying amount (i.e., the proceeds), less
payments previously made by the borrower to the investor, since ASC
450-30-25-1 precludes the recognition of contingent gains (see Section 6.2.5.5), and a debt obligation
cannot be derecognized unless either of the extinguishment conditions in ASC
405-20-40-1 is met (see Section 9.2). Actual cash
repayments are recorded as either interest expense or a reduction of the
outstanding debt balance, including accrued interest, in accordance with the
interest method.
Interest cost is accrued in each period by applying the
effective interest rate against the debt’s net carrying amount (see
Section
6.2.3.4).
Interest expense
Debt (or accrued interest)
Example 7-5
Application of Interest Method to a Sale of Future
Revenue
Entity R enters into a sale-of-future-revenue
arrangement within the scope of ASC 470-10 and
determines that the arrangement must be accounted
for as debt by applying the interest method in ASC
835-30. Entity R receives initial cash proceeds of
$10 million. It prepares a preliminary amortization
schedule on the basis of the initial proceeds and
the estimated future cash payments shown in the
second column of the table below. The final column
shows the maximum remaining undiscounted cash flows
that the entity could be required to be pay under
the contractual terms (such payments are limited to
a maximum amount of $5 million per year). (The
effective interest rate of this series of cash flows
is approximately 14.9 percent.)
If the timing or amount of the actual or estimated cash
flows changes, the effective interest rate or the net carrying amount (or
both) may need to be updated (see the next section).
7.2.4.3 Changes in Actual or Estimated Cash Flows
7.2.4.3.1 Background
If the timing or amount of the actual or estimated cash flows changes,
the original amortization schedule for the debt should be updated to
reflect the revised cash flows, subject to the limitation on reducing
the net carrying amount discussed in Section 7.2.4.2. An entity generally should apply one of
the methods identified in the table below to account for changes in the
amount or timing of cash flows.
|
Updated Effective Interest Rate?
|
Updated Net Carrying Amount?
|
Immediate Earnings Effect?
| |
|---|---|---|---|
|
Prospective (see Section
7.2.4.3.2)
|
Yes
|
No
|
No
|
|
Retrospective (see Section
7.2.4.3.3)
|
Yes
|
Yes
|
Yes
|
|
Cumulative catch-up (see Section
7.2.4.3.4)
|
No
|
Yes
|
Yes
|
The application of any of these methods is an entity-wide accounting
policy election. Once an accounting policy has been adopted, ASC
250-10-45-11 requires the entity to use it consistently.
7.2.4.3.2 Prospective Interest Method
Under the prospective interest method, the entity recalculates the
effective interest rate on the basis of the current carrying amount and
the revised estimate of remaining future payments as of the date on
which the estimate changes. This method of recognizing interest is
similar to that in (1) ASC 470-50-40-14 related to debt modifications
and exchanges that do not qualify for extinguishment accounting (see
Section 10.4.3) and (2) ASC 470-60-35-5 related
to TDRs in which the net carrying amount is less than the future cash
flows (see Section 11.4.4.2).
Unlike the retrospective and catch-up methods, the prospective method
does not require an entity to immediately adjust the current carrying
amount of the debt or the recognition of a gain or loss in earnings as a
result of the change in estimated cash flows. Instead, the change in the
estimate of remaining future cash flows is recognized prospectively as a
yield adjustment.
A benefit of the prospective interest method is that it is relatively simple to apply. As noted in paragraph 99 of FASB Concepts Statement 7,
a drawback of this method is that it can “[obscure] the impact of
changes in estimated cash flows.” Further, the “interest rate that is
derived . . . is unrelated to the rate at initial recognition or to
current market rates for similar assets and liabilities.”
Connecting the Dots
An entity may determine that because of a
significant unexpected change in circumstances, the remaining
undiscounted cash flows payable on a sale of future revenue that
is accounted for as debt is less than the current net carrying
amount of the debt. For example, assume that on January 1, 20X1,
an entity receives cash proceeds of $25 million in return for
repayment of a specified percentage of sales on a newly
commercialized product. As of December 31, 20X2, the entity had
adjusted the carrying amount of the debt obligation to $27
million, which included the recognition of interest expense of
$5 million less cash payments made of $3 million. Further,
assume that on March 31, 20X2, because of litigation related to
the product that generates the repayments on the debt, the
entity determines that it now expects the total future
undiscounted cash flows payable to be only be $5 million.
On the basis of informal discussions with staff
in the SEC’s Office of the Chief Accountant (OCA), we understand
that in such a situation, an entity that applies the prospective
method could either (1) cease recognizing any interest on the
debt (in which case it would apply the future cash payments to
the net carrying amount of the debt until there is a change in
future cash flow expectations or the debt is legally
extinguished) or (2) amortize the net carrying amount (i.e., $27
million) to the initial carrying amount less the payments made
(i.e., $22 million) on the basis of the interest method. Under
the latter alternative, in the absence of a change in cash flow
expectations, the entity would recognize interest income of $5
million over time (which reflects a reversal of the $5 million
in interest expense previously recognized). The entity could
not, however, reduce the net carrying amount below the initial
amount borrowed less payments previously made since the
conditions for liability extinguishment in ASC 405-20 would not
be met on the basis of the revised expectations of future cash
flows.
7.2.4.3.3 Retrospective Interest Method
Under the retrospective interest method, an entity periodically
recalculates the effective interest rate on the basis of the rate that
would have existed at the debt’s inception and takes into account the
original carrying amount, actual payments to date, and the revised
estimate of remaining future payments. (However, the effective interest
rate should not be reduced to the extent that the net carrying amount in
any period would decline below the initial carrying amount less payments
made to date; see Section 7.2.4.2.) Under this method, the debt’s carrying
amount is adjusted in each period to an amount equal to the present
value of the estimated remaining future payments, discounted by using
the revised effective interest rate. The adjustment to the carrying
amount is recognized in earnings as an adjustment to interest expense in
the period in which it occurs.
This method is similar to the prepayment interest method discussed in ASC 310-20-35-26. Unlike the catch-up and prospective methods, the retrospective method requires an entity to adjust both the current carrying amount and the effective interest rate when the amount or timing of actual or estimated cash flows change. As noted in paragraph 100 of FASB Concepts Statement 7, a drawback of this method is that it
“requires that entities retain a detailed record of all past cash
flows.”
7.2.4.3.4 Cumulative Catch-Up Method
Under the cumulative catch-up method, the effective interest rate is not
revised when actual or estimated cash flows change from those estimated
as of the date on which the debt was issued. Instead, the debt’s
carrying amount is adjusted to an amount equal to the present value of
the estimated remaining future payments, discounted by using the
original effective interest rate as of the date on which the estimate
changes. (However, the net carrying amount cannot be reduced to an
amount less than the initial carrying amount less payments made to date;
see Section 7.2.4.2.) The adjustment to the carrying amount is recognized in earnings as an adjustment to interest expense in the period in which the change in estimate occurred. Paragraph 98 of FASB Concepts Statement 7 suggests that this method is “consistent with the
present value relationships portrayed by the interest method.”
7.2.5 Deferred Income Model
ASC 470-10
35-3 Amounts . . .
recorded as deferred income shall be amortized under the
units-of-revenue method.
ASC Master Glossary
Units-of-Revenue Method
A method of amortizing deferred revenue that arises under
certain sales of future revenues. Under this method,
amortization for a period is calculated by computing a
ratio of the proceeds received from the investor to the
total payments expected to be made to the investor over
the term of the agreement, and then applying that ratio
to the period’s cash payment.
If the proceeds received in a sale of future revenue are
presented as deferred income, the entity makes the following entry on initial recognition:
Cash (or other consideration received)
Deferred income
Subsequently, the entity amortizes the amount of deferred income over time. At
inception, the entity determines a unit-of-revenue method ratio equal to the
fraction of the proceeds received to the total expected cash payments to be made
over the term of the agreement. In each period, the amount of amortization is
calculated by applying the unit-of-revenue method ratio to that period’s cash
payment. Periodically, the ratio is updated to reflect changes in estimated cash
flows. Under the deferred income method, no interest expense is accrued.