11.6 Whether There Can Be a Significant Financing Component as a Result of a Material Right
If an entity’s contract with a customer includes a material right in
the form of a customer option for additional goods or services, the entity should
evaluate whether there is a significant financing component as a result of the
option in accordance with ASC 606-10-32-17 and 32-18. A significant financing
component would not exist if, for example, the timing of transfer of additional
goods or services is at the customer’s discretion. In some circumstances, the
practical expedient in ASC 606-10-32-18 may be available.
Example 11-3
Entity C enters into a contract with a
customer under which the customer will receive Product W
immediately and will have the option to purchase Product X
five years later. The customer does not have the discretion
to choose when to exercise the option; rather, the customer
can exercise the option only at the point in time that is
five years after its purchase of Product W. Under the
contract, the customer is required to pay $340 at the outset
and an additional $300 five years later if it chooses to
exercise the option.
The stand-alone selling prices of Product W
and Product X are $200 and $600, respectively. Entity C
concludes that the option to purchase Product X provides the
customer with a material right. However, because the
customer pays for the material right at the outset but can
exercise the option only five years later, C also concludes
that the contract includes a financing component, which it
judges to be significant. Assume C determines that the
present value of the stand-alone selling price of the option
is $155, which it calculates by using a 10 percent interest
rate based on the rate that would be used in a separate
financing transaction between C and the customer and an
approximate 85 percent likelihood that the option will be
exercised.
The entity allocates the $340 transaction
price between Product W and the option as follows:
Accordingly, the entity (1) recognizes
revenue of $192 when Product W is delivered and (2)
recognizes a contract liability of $148 related to the
material right.
Each year, the entity records interest
expense related to the financing component of the material
right at the rate of 10 percent as follows:
Accordingly, over the five-year period, the
entity recognizes total interest expense of $91. This is
added to the price initially allocated to the option of
$148, resulting in a closing balance of $239 at the end of
year 5.
At the end of year 5, the customer exercises
the option and pays an additional $300. The entity applies
the “Alternative A” approach described in Section 11.7 and allocates to Product X the
balance of the material right ($239) and the additional $300
paid. Therefore, it recognizes revenue of $539 when Product
X is delivered.
Accordingly, C records the following journal
entries in each year of the contract:
At contract inception, to recognize
revenue for the transfer of Product W and establish the
contract liability for the customer’s option to purchase
Product X in five years:
At the end of year 1, to recognize
interest expense related to the financing component of
the material right:
At the end of year 2, to recognize
interest expense related to the financing component of
the material right:
At the end of year 3, to recognize
interest expense related to the financing component of
the material right:
At the end of year 4, to recognize
interest expense related to the financing component of
the material right:
At the end of year 5, to recognize
interest expense related to the financing component of
the material right:
At the end of year 5, to recognize
revenue upon the customer’s exercise of the option to
purchase Product X:
The above issue is addressed in Implementation Q&A 35 (compiled from previously issued
TRG Agenda Papers 18, 25, 32, and 34). For additional information and Deloitte’s summary of
issues discussed in the Implementation Q&As, see Appendix C.