Chapter 6 — Step 3: Determine the Transaction Price

6.4 Significant Financing Component

In certain contracts with customers, one party may provide a service of financing (either explicitly or implicitly) to the other. Such contracts effectively contain two transactions: one for the delivery of the good or service and another for the benefit of financing (i.e., what is in substance a loan payable or loan receivable). The FASB and IASB decided that an entity should account for both transactions included in a contract with a customer when the benefit of the financing provided is significant.

ASC 606-10

32-15 In determining the transaction price, an entity shall adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer. In those circumstances, the contract contains a significant financing component. A significant financing component may exist regardless of whether the promise of financing is explicitly stated in the contract or implied by the payment terms agreed to by the parties to the contract.

In paragraph BC230 of ASU 2014-09, the boards note that the “objective of adjusting the promised amount of consideration for the effects of a significant financing component is to reflect, in the amount of revenue recognized, the ‘cash selling price’ of the underlying good or service at the time that the good or service is transferred.” This objective is consistent with the intent of the allocation guidance in step 4 (see Chapter 7) in that the goal is to arrive at an amount of revenue recognized that reflects the value of the goods or services transferred to the customer. If an entity were to ignore a significant financing component included in a contract, the revenue recognized from, and the cash flows associated with, the contract with the customer could be misrepresented to users in the entity’s financial statements. That is because the second service (namely, the financing) would not be reflected in the financial statements.

6.4.1 Practical Expedient Providing Relief From the Significant Financing Component Guidance

Under ASC 835-30, an entity is exempted from imputing interest on a receivable if the transaction with the customer is (1) in the normal course of business and with customary terms and (2) for one year or less. In developing the revenue standard, the FASB and IASB determined that the benefits to financial statement users of requiring an entity to account for the effects of significant financing when the period is for less than a year did not outweigh the costs to preparers.

Accordingly, the boards decided to grant a practical expedient in ASC 606-10-32-18 (paragraph 63 of IFRS 15) for financing components when the duration of the financing (i.e., the time between the transfer of control of the goods or services and when the customer pays for them) is one year or less. In paragraph BC236 of ASU 2014-09, the boards acknowledge that they provided the practical expedient as part of efforts to simplify the application of the revenue standard for financial statement preparers even though the expedient could produce undesirable reporting outcomes (e.g., when a one-year contract provides financing that is material to the contract’s value because of a relatively high interest rate).

ASC 606-10

32-18 As a practical expedient, an entity need not adjust the promised amount of consideration for the effects of a significant financing component if the entity expects, at contract inception, that the period between when the entity transfers a promised good or service to a customer and when the customer pays for that good or service will be one year or less.

50-22 If an entity elects to use the practical expedient in either paragraph 606-10-32-18 (about the existence of a significant financing component) or paragraph 340-40-25-4 (about the incremental costs of obtaining a contract), the entity shall disclose that fact.

As indicated in ASC 606-10-10-3 and ASC 606-10-50-22 (the latter of which is reproduced above), an entity that elects to use this practical expedient should (1) apply it consistently to contracts with similar characteristics and in similar circumstances and (2) disclose such election.

6.4.2 Existence and Significance of a Financing Component

ASC 606-10

32-16 The objective when adjusting the promised amount of consideration for a significant financing component is for an entity to recognize revenue at an amount that reflects the price that a customer would have paid for the promised goods or services if the customer had paid cash for those goods or services when (or as) they transfer to the customer (that is, the cash selling price). 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:

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

An entity is required to assess the factors in ASC 606-10-32-16 to determine the existence of a significant financing component for the following reasons:

As noted in paragraph BC232 of ASU 2014-09, the fact that an entity sells the goods or services in the contract with the customer at varying prices depending on the timing of the payment terms will generally provide both parties to the contract with relatively observable data to support a determination that the entity’s contracts with customers contain a financing component (and that the entity needs to adjust the transaction price to determine the cash selling price of the goods or services to be delivered).
If there is an alignment between the duration of the financing provided in the contract and the market interest rates available for a financing of that duration, there is a strong indication that the parties intend to include a financing transaction in the contract.

However, in the assessment of the factors noted above, a question arises about whether the “significance” of a financing component should be in the context of the associated performance obligation, the individual contract, or a portfolio of similar contracts. Sections 6.4.2.1 through 6.4.2.4 further discuss the considerations inherent in an assessment of the existence and significance of a financing component in a contract with a customer.

6.4.2.1 Unit of Account for Assessing the Significance of a Financing Component

ASC 606-10-32-16 specifically requires an entity to 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. Consequently, the significance of a financing component should be assessed in the context of the individual contract rather than, for example, a portfolio of similar contracts or at a performance obligation level.

The basis of this requirement is explained in paragraph BC234 of ASU 2014-09, which states, in part:

During their redeliberations, the Boards clarified that an entity should only consider the significance of a financing component at a contract level rather than consider whether the financing is material at a portfolio level. The Boards decided that it would have been unduly burdensome to require an entity to account for a financing component if the effects of the financing component were not material to the individual contract, but the combined effects for a portfolio of similar contracts were material to the entity as a whole.

As a consequence, some financing components will not be identified as significant — and, therefore, the promised amount of consideration would not be adjusted — even though they might be material in aggregate for a portfolio of similar contracts.

Although a financing component can only be quantified after individual performance obligations are considered, the significance of a financing component is not assessed at the performance obligation level. To illustrate, an entity may typically sell Product X, for which revenue is recognized at a point in time, on extended credit terms such that, when Product X is sold by itself, the contract contains a significant financing component. The entity may also sell Product X and Product Y together in a bundled contract, requiring the customer to pay for Product Y in full at the time control is transferred but granting the same extended credit terms for Product X. If the value of Product Y is much greater than the value of Product X, any financing component for Product X may be too small to be assessed as significant in the context of the larger bundled contract. Therefore, in such circumstances, the entity (1) would adjust the promised consideration for a significant financing component when Product X is sold by itself but (2) would not need to adjust the promised consideration for a significant financing component when Product X is sold together with Product Y in a single contract.

6.4.2.2 Assessing Whether a Significant Financing Component Exists When the Consideration to Be Received Is Equal to the Cash Selling Price

ASC 606-10-32-16 notes that the “difference, if any, between the amount of promised consideration and the cash selling price of the promised goods or services” is one of the factors relevant to an assessment of whether a significant financing component exists.

Sometimes, the implied interest rate in an arrangement is zero (i.e., interest-free financing) such that the consideration to be received at a future date is equal to the cash selling price (i.e., the amount that would be received from a customer who chooses to pay for the goods or services in cash when (or as) they are delivered). In such circumstances, it should not automatically be assumed that the contract does not contain a significant financing component. A difference between the amount of promised consideration and the cash selling price is only one of the indicators that an entity should consider in determining whether there is a significant financing component.

The fact that an entity provides what appears to be zero-interest financing does not necessarily mean that the cash selling price is the same as the price that would have been paid by another customer who has opted to pay over time. Accordingly, an entity may need to use judgment when determining a cash selling price for a customer who pays over time.

The above issue is addressed in Implementation Q&A 32 (compiled from previously issued TRG Agenda Papers 20, 25, 30, and 34). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

6.4.2.3 Requirement to Discount Trade Receivables When the Significant Financing Component Is Implicit

The example below illustrates when it may be necessary to discount trade receivables even though a significant financing component is not explicitly identified in the contract.

Example 6-12

Entity B, a retailer, offers interest-free financing to its customers. Depending on the type of product purchased, the financing arrangement gives the customer interest-free financing for a period of 12, 15, or 18 months. The customer pays equal monthly installments from the date of purchase over the financing period. This is common industry practice in the country where B is located, and other retailers offer similar financing arrangements; no recent cash transactions are available from which B can make an observable estimate of the cash sales price. On the basis of prevailing interest rates in the relevant market, B estimates that the customer would be able to borrow from other sources at an interest rate of 18 percent.

Further, on the basis of ASC 606-10-32-16(b), B believes that the arrangement contains a significant financing component as a result of the combination of (1) the length of time between the transfer of the good and payment and (2) the high interest rates the customer would have to pay to obtain financing from other sources.

In accordance with ASC 606-10-32-15, entities are required to adjust the promised amount of consideration, even when a significant financing component is not explicitly identified in the contract. However, ASC 606-10-32-18 provides a practical expedient for contracts with a significant financing component when the period between the transfer of goods and the customer’s payment is, at contract inception, expected to be one year or less.

Consequently, in the circumstances described, B is required to adjust the sales price for all arrangements other than those with a contractual period of 12 months or less. For arrangements with a contractual period of 12 months or less, B is permitted to adjust the sales price when it identifies a significant financing component, which it may wish to do to align with its other contracts; however, it is not required to do so.

If B takes advantage of the practical expedient under ASC 606-10-32-18, it is required to do so consistently in similar circumstances for all contracts with similar characteristics.

6.4.2.4 How to Evaluate a Material Right for the Existence of a Significant Financing Component

The determination of whether there is a significant financing component associated with the material right depends on the facts and circumstances. Entities are required to evaluate material rights for the existence of significant financing components in a manner similar to how they would evaluate any other performance obligation. That is, there is no safe harbor that a material right would not have a significant financing component. See Section 11.6 for an example of a material right that gives rise to a significant financing component.

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.

6.4.3 Circumstances That Do Not Give Rise to a Significant Financing Component

In paragraph BC231 of ASU 2014-09, the FASB and IASB acknowledge that the mere separation between the timing of delivery and the timing of payment does not always mean that a benefit of financing has been provided in the contract. That is, there are other economically substantive reasons for the existence of a significant period between delivery and payment. In light of this, the boards wanted to reflect in paragraph BC232 of ASU 2014-09 their intent for entities to account for a significant financing and not necessarily all aspects of the time value of money, which has a broader economic context than just the benefit of a financing. To further emphasize this distinction, the boards also provided indicators in ASC 606-10-32-17 (paragraph 62 of IFRS 15) of circumstances in which a difference in timing between delivery and payment does not require an entity to adjust the transaction price to reflect the cash selling price of the good or service delivered.

ASC 606-10

32-17 Notwithstanding the assessment in paragraph 606-10-32-16, a contract with a customer would not have a significant financing component if any of the following factors exist:

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.
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).
The difference between the promised consideration and the cash selling price of the good or service (as described in paragraph 606-10-32-16) 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.

The boards describe in paragraph BC233 of ASU 2014-09 a number of examples they had in mind when considering the factors included in ASC 606-10-32-17 (paragraph 62 of IFRS 15):

Connecting the Dots

It is important to note that the examples considered by the boards in paragraph BC233 of ASU 2014-09 illustrate more instances in which an advance payment is in return for something other than financing than instances in which a deferred payment is in return for something other than financing. We think that this disparity indicates that the boards thought that there are fewer real-life scenarios in which an entity would allow for a deferred payment from a customer for reasons other than to provide the customer with the benefits of financing. Accordingly, we think that it would generally be easier to align the indicators in ASC 606-10-32-17 with a contract that contains an advance payment and harder to align the indicators with a contract that contains a deferred payment. This understanding is consistent with discussions by TRG members as outlined in TRG Agenda Paper 34, which states, “TRG members discussed the factor in paragraph 606-10-32-17(c) [62(c)] relating to whether the difference in promised consideration and cash selling price is for a reason other than financing, noting that it might be more likely that an advance payment would meet that factor compared to payments in arrears.”

6.4.3.1 Difference Between Consideration and Cash Selling Price That Arises for Reasons Other Than Financing

A difference in timing between the transfer of goods or services and the payment of consideration does not create a presumption that a significant financing component exists, even if there is a difference between the consideration and the cash selling price. ASC 606-10-32-17(c) states that a contract would not have a significant financing component if the difference between the promised consideration and the cash selling price of the goods or services “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.”

An entity should use judgment to determine (1) whether the payment terms are intended to provide financing or are for another valid reason and (2) whether the difference between the promised consideration and the cash selling price of the goods or services is proportional to that reason.

The above issue is addressed in Implementation Q&A 31 (compiled from previously issued TRG Agenda Papers 20, 25, 30, and 34). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

6.4.3.1.1 SEC Staff Observations Regarding Significant Financing Components

In a speech at the 2018 AICPA Conference on Current SEC and PCAOB Developments, Sarah Esquivel, associate chief accountant in the SEC’s Office of the Chief Accountant (OCA), made the following observations about an SEC registrant’s consultation with the OCA on evaluating the existence of a significant financing component, in which the registrant concluded that there was no significant financing component in the arrangement:

In this consultation, the registrant was a retailer looking to expand a non-core existing line of business. To achieve this, the registrant entered into an arrangement with a third party to operate the non-core existing line of business, so that the registrant could maintain focus on its core operations. The registrant determined that the arrangement contained a symbolic license of intellectual property (IP), requiring revenue to be recognized over time, as the arrangement provided the third party with the right to access the registrant’s trademarks and brand. As part of the consideration exchanged in the transaction, the registrant received a large up-front payment. As a result of the timing difference between the up-front payment and the transfer of the symbolic IP license over time, the registrant considered whether there was a significant financing component in the contract.

The registrant’s analysis focused on consideration of the guidance in Topic 606 that indicates a contract would not have a significant financing component if the difference between the promised consideration and the cash selling price arises for reasons other than the provision of finance, and the difference between those amounts is proportional to the reason for the difference. In this consultation, the registrant asserted that it did not contemplate a financing arrangement with the third party when including a large up-front payment in the contract. Instead, the large up-front payment was to provide the registrant protection from the possibility that the third party could fail to adequately complete some or all of its obligations under the contract. The registrant concluded that the difference between the promised consideration and the cash selling price arose for reasons other than financing and that the difference between the up-front payment and what the customer would have paid, had the payments been made over the term of the arrangement, was proportional to the reason identified for the difference. In reaching this conclusion, the registrant considered the following:

A large up-front payment was critical in this arrangement to incentivize the third party to maximize value, and therefore profits to both parties, due in part to the registrant’s negative experience with other third parties where there was no up-front payment;
By the third party having sufficient “skin in the game” through the large up-front payment, it would mitigate some of the risk associated with third-party use of the registrant’s brand;
As evidenced by its strong operating results, the registrant believed that it would be able to obtain financing at favorable rates in the market place, if needed, and thus did not need the cash from the large up-front payment to finance its operations; and
Consideration was not given to structuring the transaction without a large up-front payment.

For these reasons, the registrant concluded that the contract did not have a significant financing component as the up-front payment was for reasons other than to provide a significant financing benefit. Like other Topic 606 revenue consultations that OCA has evaluated, this was a facts and circumstances evaluation, and in this fact pattern, the staff did not object to the registrant’s conclusion that the contract did not have a significant financing component based on the nature of the transaction and purpose of the up-front payment. [Footnotes omitted]

6.4.3.1.2 Codification Examples

The Codification examples below illustrate situations in which withheld payments or an advance payment would not indicate the existence of a significant financing component.

ASC 606-10

Example 27 — Withheld Payments on a Long-Term Contract

55-233 An entity enters into a contract for the construction of a building that includes scheduled milestone payments for the performance by the entity throughout the contract term of three years. The performance obligation will be satisfied over time, and the milestone payments are scheduled to coincide with the entity’s expected performance. The contract provides that a specified percentage of each milestone payment is to be withheld (that is, retained) by the customer throughout the arrangement and paid to the entity only when the building is complete.

55-234 The entity concludes that the contract does not include a significant financing component. The milestone payments coincide with the entity’s performance, and the contract requires amounts to be retained for reasons other than the provision of finance in accordance with paragraph 606-10-32-17(c). The withholding of a specified percentage of each milestone payment is intended to protect the customer from the contractor failing to adequately complete its obligations under the contract.

Example 30 — Advance Payment

55-244 An entity, a technology product manufacturer, enters into a contract with a customer to provide global telephone technology support and repair coverage for three years along with its technology product. The customer purchases this support service at the time of buying the product. Consideration for the service is an additional $300. Customers electing to buy this service must pay for it upfront (that is, a monthly payment option is not available).

55-245 To determine whether there is a significant financing component in the contract, the entity considers the nature of the service being offered and the purpose of the payment terms. The entity charges a single upfront amount, not with the primary purpose of obtaining financing from the customer but, instead, to maximize profitability, taking into consideration the risks associated with providing the service. Specifically, if customers could pay monthly, they would be less likely to renew, and the population of customers that continue to use the support service in the later years may become smaller and less diverse over time (that is, customers that choose to renew historically are those that make greater use of the service, thereby increasing the entity’s costs). In addition, customers tend to use services more if they pay monthly rather than making an upfront payment. Finally, the entity would incur higher administration costs such as the costs related to administering renewals and collection of monthly payments.

55-246 In assessing the guidance in paragraph 606-10-32-17(c), the entity determines that the payment terms were structured primarily for reasons other than the provision of finance to the entity. The entity charges a single upfront amount for the services because other payment terms (such as a monthly payment plan) would affect the nature of the risks assumed by the entity to provide the service and may make it uneconomical to provide the service. As a result of its analysis, the entity concludes that there is not a significant financing component.

6.4.3.2 Accounting for Financing Components That Are Not Significant

When an entity concludes on the basis of ASC 606-10-32-16 and 32-17 that a significant financing component exists, the entity is required under ASC 606-10-32-15 to adjust the promised consideration for the effects of the time value of money in its determination of the transaction price. However, while there is no requirement for an entity to adjust for the time value of money when a financing component exists but is not significant, an entity is not precluded from doing so in such circumstances.

The above issue is addressed in Implementation Q&A 33 (compiled from previously issued TRG Agenda Papers 30 and 34). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

6.4.4 Determining the Discount Rate

In paragraph BC238 of ASU 2014-09, the FASB and IASB discuss an example in which an entity is receiving financing from a customer through an advance payment instead of obtaining that financing from a third party (e.g., a bank). The entity needs to obtain financing before it can perform its obligations under the contract with its customer. The boards note in discussing this example that the resulting financial reporting for the entity’s revenue in the contract with the customer should not differ depending on the source of the financing. The same can be said of the intent of the boards’ guidance in ASC 606-10-32-19 (paragraph 64 of IFRS 15) for determining the discount rate an entity should use to measure the significant financing component and adjust the promised consideration in the contract to the cash selling price.

ASC 606-10

32-19 To meet the objective in paragraph 606-10-32-16 when adjusting the promised amount of consideration for a significant financing component, an entity shall use the discount rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception. That rate would reflect the credit characteristics of the party receiving financing in the contract, as well as any collateral or security provided by the customer or the entity, including assets transferred in the contract. An entity may be able to determine that rate by identifying the rate that discounts the nominal amount of the promised consideration to the price that the customer would pay in cash for the goods or services when (or as) they transfer to the customer. After contract inception, an entity shall not update the discount rate for changes in interest rates or other circumstances (such as a change in the assessment of the customer’s credit risk).

In their deliberations, the boards considered requiring the use of either a risk-free rate or the rate explicitly specified in the contract with the customer. However, as noted in paragraph BC239 of ASU 2014-09, the boards reasoned that neither alternative would reflect the economics of the financing provided or the appropriate profit margin built into the contract (e.g., the entity could specify a “cheap” financing rate as a marketing incentive, which would be inappropriate for the entity to use in determining the transaction price). Consequently, as indicated in ASC 606-10-32-19 (paragraph 64 of IFRS 15), the boards decided that an entity should “use the discount rate that would be reflected in a separate financing transaction between the entity and its customer.”

Because of the practical expedient in ASC 606-10-32-18 (paragraph 63 of IFRS 15) and the indicators of when a significant benefit of financing is not being provided to a party in the contract, the boards reason in paragraph BC241 of ASU 2014-09 that “in those remaining contracts in which an entity is required to account separately for the financing component, the entity and its customer will typically negotiate the contractual payment terms separately.” That is, in many circumstances in which there is an identified significant financing component that affects the transaction price, the entity will have access in the negotiation process to information about the discount rate implied in the arrangement.

The Codification examples below illustrate how an entity would determine the discount rate when adjusting the amount of consideration received in a significant financing arrangement.

ASC 606-10

Example 28 — Determining the Discount Rate

55-235 An entity enters into a contract with a customer to sell equipment. Control of the equipment transfers to the customer when the contract is signed. The price stated in the contract is $1 million plus a 5 percent contractual rate of interest, payable in 60 monthly installments of $18,871.

Case A — Contractual Discount Rate Reflects the Rate in a Separate Financing Transaction

55-236 In evaluating the discount rate in the contract that contains a significant financing component, the entity observes that the 5 percent contractual rate of interest reflects the rate that would be used in a separate financing transaction between the entity and its customer at contract inception (that is, the contractual rate of interest of 5 percent reflects the credit characteristics of the customer).

55-237 The market terms of the financing mean that the cash selling price of the equipment is $1 million. This amount is recognized as revenue and as a loan receivable when control of the equipment transfers to the customer. The entity accounts for the receivable in accordance with Topic 310 on receivables, Subtopic 326-20 on financial instruments measured at amortized cost, and Subtopic 835-30 on the imputation of interest.

Case B — Contractual Discount Rate Does Not Reflect the Rate in a Separate Financing Transaction

55-238 In evaluating the discount rate in the contract that contains a significant financing component, the entity observes that the 5 percent contractual rate of interest is significantly lower than the 12 percent interest rate that would be used in a separate financing transaction between the entity and its customer at contract inception (that is, the contractual rate of interest of 5 percent does not reflect the credit characteristics of the customer). This suggests that the cash selling price is less than $1 million.

55-239 In accordance with paragraph 606-10-32-19, the entity determines the transaction price by adjusting the promised amount of consideration to reflect the contractual payments using the 12 percent interest rate that reflects the credit characteristics of the customer. Consequently, the entity determines that the transaction price is $848,357 (60 monthly payments of $18,871 discounted at 12 percent). The entity recognizes revenue and a loan receivable for that amount. The entity accounts for the loan receivable in accordance with Subtopic 310-10 on receivables, Subtopic 326-20 on financial instruments measured at amortized cost, and Subtopic 835-30 on the imputation of interest.

Example 29 — Advance Payment and Assessment of Discount Rate

55-240 An entity enters into a contract with a customer to sell an asset. Control of the asset will transfer to the customer in two years (that is, the performance obligation will be satisfied at a point in time). The contract includes 2 alternative payment options: payment of $5,000 in 2 years when the customer obtains control of the asset or payment of $4,000 when the contract is signed. The customer elects to pay $4,000 when the contract is signed.

55-241 The entity concludes that the contract contains a significant financing component because of the length of time between when the customer pays for the asset and when the entity transfers the asset to the customer, as well as the prevailing interest rates in the market.

55-242 The interest rate implicit in the transaction is 11.8 percent, which is the interest rate necessary to make the 2 alternative payment options economically equivalent. However, the entity determines that, in accordance with paragraph 606-10-32-19, the rate that should be used in adjusting the promised consideration is 6 percent, which is the entity’s incremental borrowing rate.

55-243 The following journal entries illustrate how the entity would account for the significant financing component.

Recognize a contract liability for the $4,000 payment received at contract inception.
During the 2 years from contract inception until the transfer of the asset, the entity adjusts the promised amount of consideration (in accordance with paragraph 606-10-32-20) and accretes the contract liability by recognizing interest on $4,000 at 6 percent for 2 years.
Recognize revenue for the transfer of the asset.

6.4.4.1 Determining the Appropriate Discount Rate on an Individual Contract Basis

If an entity gives its customers a significant benefit of financing, it should adjust the transaction price and corresponding amount of revenue recognized for the sale to take into account the effects of the time value of money. If the entity does not intend to apply a portfolio approach in determining the effects of this financing benefit, it should use the discount rate that would be reflected in a separate financing transaction between itself and its customer at contract inception in accordance with ASC 606-10-32-19. The way in which the entity identifies this rate will depend on the type of information to which it has access for individual customers.

In determining an appropriate discount rate, an entity may find it useful to consider the following:

The normal rate at which the entity would provide secured or unsecured lending (whichever is appropriate) to its customer (e.g., any interest rate that would be normal for the entity to offer the customer).
The normal rate at which other entities would provide secured or unsecured lending (whichever is appropriate) to the customer (e.g., the rate charged to the customer for bank loans). Note, however, that ASC 606-10-32-19 requires a rate specific to a financing transaction between the entity and its customer.
The cash sales price offered for the good or service to customers with similar demographic characteristics.
Any interest rate explicitly stated in the contract with the customer. However, this will not always be an appropriate rate (e.g., when a customer is offered interest-free credit or when a low interest rate is used to incentivize the customer).
The level of certainty regarding the customer’s credit characteristics that the entity obtains as a result of its due diligence processes (e.g., obtaining credit ratings).
Historical evidence of any defaults or slow payment by the customer.

Appropriate adjustments should be made to rates associated with any of these factors when they are not directly comparable to those of the transaction being considered.

6.4.4.2 Determining the Appropriate Discount Rate Under a Portfolio Approach

In accordance with ASC 606-10-32-15, if an entity determines that the contract terms give customers a significant benefit of financing the purchase of the entity’s products, the entity should adjust the transaction price and corresponding amount of revenue recognized for the sale of the goods to take into account the effects of the time value of money.

Further, if the entity has a large number of similar contracts with similar payment terms and reasonably expects that the financial statement effects of calculating a discount rate that applies to the portfolio of contracts would not differ materially from the discount rates that would apply to individual contracts, it may apply a portfolio approach in accordance with ASC 606-10-10-4. See Section 3.1.2.2.1 for guidance on how to decide whether an entity may use a portfolio approach when applying ASC 606.

In applying a portfolio approach, the entity will need to consider the demographic characteristics of the customers as a group to estimate the discount rate on a portfolio basis. If the demographic characteristics of customers within this group vary significantly, it may not be appropriate to treat them as a single portfolio. Rather, it may be necessary for the entity to further subdivide the customer group when determining the appropriate discount rate.

6.4.5 Measuring the Amount of Revenue When a Transaction Includes a Significant Financing Component Related to Deferred Payments

When a significant financing component is identified, ASC 606-10-32-15 requires an entity to “adjust the promised amount of consideration for the effects of the time value of money.”

ASC 606-10-32-16 states, in part:

The objective when adjusting the promised amount of consideration for a significant financing component is for an entity to recognize revenue at an amount that reflects the price that a customer would have paid for the promised goods or services if the customer had paid cash for those goods or services when (or as) they transfer to the customer (that is, the cash selling price).

However, ASC 606-10-32-19 states, in part:

To meet the objective in paragraph 606-10-32-16 when adjusting the promised amount of consideration for a significant financing component, an entity shall use the discount rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception. That rate would reflect the credit characteristics of the party receiving financing in the contract, as well as any collateral or security provided by the customer or the entity, including assets transferred in the contract.

ASC 606-10-32-19 also notes that “[a]n entity may be able to determine that rate by identifying the rate that discounts the nominal amount of the promised consideration to the price that the customer would pay in cash for the goods or services when (or as) they transfer to the customer” (emphasis added).

Accordingly, although the objective described in ASC 606-10-32-16 is to determine the “cash selling price,” ASC 606-10-32-19 makes clear that such price is required to be consistent with the price that would be determined by using an appropriate discount rate to discount the promised consideration.

Therefore, in practice, the entity may make an initial estimate of the amount of revenue either (1) by determining the appropriate discount rate and using that rate to discount the promised amount of consideration or (2) by estimating the cash selling price directly — but only if the discount rate thereby implied is consistent with a rate that would be reflected in a separate financing transaction between the entity and its customer.

Regardless of the approach it adopts, the entity may need to perform further analysis if the amounts estimated appear unreasonable or inconsistent with other evidence related to the transaction. For example:

If the entity estimates revenue by discounting the promised consideration, it may be required to perform further analysis if that estimate appears unreasonable and inconsistent with other evidence of the cash selling price. For example, if the amount of revenue estimated appears significantly higher than the normal cash selling price, this may indicate that the discount rate has not been determined on an appropriate basis.
If the entity estimates revenue by estimating the cash selling price directly, it may be required to perform further analysis if the resulting discount rate appears unreasonable and inconsistent with other evidence of the rate that would be reflected in a separate financing transaction between the entity and its customer. If the rate is clearly significantly lower or higher than would be reflected in a separate financing transaction, it will not be appropriate to measure revenue by reference to the cash selling price; instead, the entity should estimate revenue by discounting the promised consideration at an appropriately estimated discount rate.

The example below illustrates how an entity would (1) estimate revenue by discounting promised consideration and subsequently recognize the associated financing component and (2) determine and subsequently recognize the financing component when revenue is estimated on the basis of the cash selling price.

Example 6-13

On January 1, 20X1, Entity B sells an item of equipment for $100,000 under a financing agreement that has no stated interest rate. On the date of sale, B transfers control of the equipment to the customer, and B concludes that the contract meets the criteria in ASC 606-10-25-1, including the collectibility criterion. The first annual installment of $20,000 is due on December 31, 20X1, one year from the date of sale, and each subsequent year for five years. The policy of not charging interest is consistent with normal industry practice. Entity B has separately determined that the transaction includes a significant financing component.

Case A — Discounting on the Basis of Interest Rate

To estimate the transaction price by discounting the future receipts, B uses a “rate that would be reflected in a separate financing transaction between [Entity B] and its customer at contract inception.” Entity B determines that the appropriate annual rate is 10 percent. Assume that the receivable arising from the transaction is measured at amortized cost after initial recognition.

Step A — Calculate the Net Present Value of the Stream of Payments

If there is no down payment and there are five annual installments of $20,000 with an interest rate of 10 percent, the net present value of the stream of payments forming the consideration is $75,816.

Therefore, upon transfer of control of the equipment, $75,816 is recognized as revenue from the sale of goods, and the related receivable is recognized.

Step B — Calculate the Amount of Interest Earned in Each Period

The difference between $100,000 and $75,816 (i.e., $24,184) will be recognized as interest income as it becomes due each year, as calculated below.

Step C — Record Journal Entries

On the date of sale, control of the equipment transfers to the customer and B records the following journal entry:

To record the first annual payment due one year from the date of purchase:

As of each subsequent year-end, B should record the same journal entry by using the amounts from the table above.

Note that this example does not take into account any impairment assessment that would be required in accordance with ASC 326.

Case B — Discounting to Current Cash Sales Price

If the buyer had paid in full for the equipment at the point of transfer, B estimates that the cash selling price would have been $76,000.

Assume that the receivable arising from the transaction is measured at amortized cost after initial recognition.

Step A — Determine the Discount Rate for the Customer

ASC 606-10-32-19 indicates that a selling entity may be able to determine the discount rate to be used to adjust the transaction price “by identifying the rate that discounts the nominal amount of the promised consideration to the price that the customer would pay in cash for the goods or services when (or as) they transfer to the customer.” Therefore, Entity B determines the interest rate that discounts $100,000 to $76,000 (i.e., the cash selling price) over a five-year period, given no down payment and five annual installments of $20,000. This interest rate is approximately 9.905 percent per annum, which is judged to be consistent with a rate that would be reflected in a separate financing transaction between B and its customer. Upon transfer of the equipment, $76,000 is recognized as revenue from the sale of goods, and the related receivable is recognized.

Step B — Calculate the Amount of Interest Earned in Each Period

The difference between $100,000 and $76,000 (i.e., $24,000) will be recognized as interest income as it becomes due each year, as calculated below.

Step C — Record Journal Entries

On the purchase date, control of the equipment transfers to the customer, and B records the following journal entry:

Entity B records the following journal entry to reflect the first annual payment due one year from the date of purchase:

As of each subsequent year-end, B should record the same journal entry by using the amounts from the table above.

Note that this example does not take into account any impairment assessment that would be required in accordance with ASC 326.

6.4.6 Measuring the Amount of Revenue When a Transaction Includes a Significant Financing Component Related to an Advance Payment

The example below illustrates how an entity should account for an advance payment that represents a significant financing component.

Example 6-14

Entity A, a home builder, is selling apartment units in a new building for which construction has not yet commenced. The estimated time to complete construction is 18 months. Entity A has concluded that its performance obligation (i.e., delivery of the apartment) will be satisfied upon completion of construction (i.e., at a point in time), which is also when title and possession are passed to the customer. The cash sales price upon completion of construction is $500,000. Customers are offered a discount of $75,000 on the cash sales price if they pay in full in advance; therefore, the price for customers paying in advance is $425,000.

Entity A has concluded after analysis of the contract that the advance payment represents a significant financing component; that is, its customers are providing financing to pay for construction costs. On the basis of interest rates in the market, A has concluded that an annual rate of approximately 10 percent reflects the rate at which A and its customer would have entered into a separate financing transaction. Consequently, A imputes a discount rate of approximately 10 percent to discount the cash sales price (i.e., $500,000) to the “advance” sales price (i.e., $425,000).

When an advance cash payment is received from a customer, A recognizes a contract liability of $425,000. Subsequently, A accrues interest on the liability balance to accrete the balance to $500,000 over the 18-month period in which A expects to complete construction and satisfy its performance obligation. Entity A capitalizes into inventory the interest in accordance with ASC 835-20 (i.e., interest expense is not recognized). When control of the apartment transfers to the customer, A recognizes $500,000 as revenue (and recognizes the related inventory balance as cost of goods sold). Essentially, the transaction price is increased by the amount of interest recognized over the 18-month period. As a result, revenue is recognized in an amount greater than the amount of initial cash collected.

The following journal entries illustrate how A should account for the significant financing component:

Step 1

Journal Entry: At contract inception

Step 2

Journal Entry: Over 18 months from contract inception to transfer of asset

Step 3

Journal Entry: On transfer of control of the asset

6.4.7 Presenting the Effects of Financing

ASC 606-10

32-20 An entity shall present the effects of financing (interest income or interest expense) separately from revenue from contracts with customers in the statement of comprehensive income (statement of activities). Interest income or interest expense is recognized only to the extent that a contract asset (or receivable) or a contract liability is recognized in accounting for a contract with a customer. In accounting for the effects of the time value of money, an entity also shall consider the subsequent measurement guidance in Subtopic 835-30, specifically the guidance in paragraphs 835-30-45-1A through 45-3 on presentation of the discount and premium in the financial statements and the guidance in paragraphs 835-30-55-2 through 55-3 on the application of the interest method.

In paragraph BC244 of ASU 2014-09, the FASB and IASB note that the presentation of a significant financing component in the financial statements should not be any different from the presentation that would have resulted if the party receiving the financing in the arrangement had instead obtained financing from a third-party source (e.g., if instead of obtaining the financing from the entity, the customer had obtained financing from the bank and purchased the good or service from the entity at the cash selling price). Accordingly, as a result of the presentation requirements in ASC 606-10-32-20, economically similar transactions are reflected similarly in the financial statements.

Interest income arising from a significant financing component should be presented separately from revenue from contracts with customers in an entity’s statement of comprehensive income in accordance with ASC 606-10-32-20. However, this requirement to separately present interest income does not necessarily prevent interest income from being presented as revenue on the face of the statement of comprehensive income. For more information about whether it is appropriate to classify interest income as revenue, see Section 14.7.3.

Example 26 in ASC 606, which is reproduced below, illustrates (1) the presentation of the effects of financing in a contract with a customer that also contains a right of return and (2) the concept in the second sentence of ASC 606-10-32-20 that a significant financing component affects profit and loss at the time the contract asset (receivable) or liability is recognized rather than at contract inception.

ASC 606-10

Example 26 — Significant Financing Component and Right of Return

55-227 An entity sells a product to a customer for $121 that is payable 24 months after delivery. The customer obtains control of the product at contract inception. The contract permits the customer to return the product within 90 days. The product is new, and the entity has no relevant historical evidence of product returns or other available market evidence.

55-228 The cash selling price of the product is $100, which represents the amount that the customer would pay upon delivery for the same product sold under otherwise identical terms and conditions as at contract inception. The entity’s cost of the product is $80.

55-229 The entity does not recognize revenue when control of the product transfers to the customer. This is because the existence of the right of return and the lack of relevant historical evidence means that the entity cannot conclude that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur in accordance with paragraphs 606-10-32-11 through 32-13. Consequently, revenue is recognized after three months when the right of return lapses.

55-230 The contract includes a significant financing component, in accordance with paragraphs 606-10-32-15 through 32-17. This is evident from the difference between the amount of promised consideration of $121 and the cash selling price of $100 at the date that the goods are transferred to the customer.

55-231 The contract includes an implicit interest rate of 10 percent (that is, the interest rate that over 24 months discounts the promised consideration of $121 to the cash selling price of $100). The entity evaluates the rate and concludes that it is commensurate with the rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception. The following journal entries illustrate how the entity accounts for this contract in accordance with paragraphs 606-10-55-22 through 55-29:

When the product is transferred to the customer, in accordance with paragraph 606-10-55-23.
During the three-month right of return period, no interest is recognized in accordance with paragraph 606-10-32-20 because no contract asset or receivable has been recognized.
When the right of return lapses (the product is not returned).

55-232 Until the entity receives the cash payment from the customer, interest income would be recognized consistently with the subsequent measurement guidance in Subtopic 835-30 on imputation of interest. The entity would accrete the receivable up to $121 from the time the right of return lapses until customer payment.

6.4.8 Reassessment of Significant Financing Component

ASC 606-10-32-19 (reproduced in Section 6.4.4) states, in part, that “[a]fter contract inception, an entity shall not update the discount rate for changes in interest rates or other circumstances (such as a change in the assessment of the customer’s credit risk).” An entity is thus not required to update the discount rate used to measure a significant financing component as it would otherwise be required to reassess and remeasure, for example, variable consideration (see Section 6.3.6). Paragraph BC243 of ASU 2014-09 indicates that as much as for any other reason, the FASB and IASB deemed reassessment of the discount rate inappropriate because of the impracticality of updating it in each subsequent reporting period for changes in facts and circumstances.

Connecting the Dots

The boards’ decision with respect to reassessing the discount rate reflects a conscious and substantial form of relief to preparers. In a manner consistent with the boards’ decision to establish stand-alone selling prices in step 4 as of contract inception (see Chapter 7), the boards decided that the determination of the discount rate and stand-alone selling prices should not be adjusted even if facts and circumstances change over the course of the entity’s performance under the contract (e.g., when, over the term of a 5- or 10-year contract, it is likely that the discount rate or the stand-alone selling prices of individual goods or services will economically shift). This relief may pose challenges when the timing of delivery of the goods and services shifts after contract inception. The complexity is exacerbated when variable consideration is reassessed and the reassessment results in an updated estimate that needs to be reallocated to individual performance obligations. Unlike the static discount rate and stand-alone selling price estimates, estimates of variable consideration need to be reassessed and updated as uncertainties become known. In addition, the timing of delivery of goods and services may change from estimates made at contract inception and directly contributes to when revenue and the impact of financing are recognized. As a result, when a contract includes multiple performance obligations that are expected to be satisfied over a longer period and also contains a significant financing component and variable consideration, the recognition of revenue for those separate performance obligations may become complex and challenging.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.