Accounting for the ASC 606 Significant Financing Component

The revenue recognition standard, ASC 606, requires that revenue reflects the consideration an entity expects to receive for its goods or services, which includes adjusting for the time value of money. When the timing of customer payments and the transfer of goods or services are substantially different, the contract may contain a significant financing component. The purpose is to recognize revenue at an amount that reflects the cash selling price at the time of the transfer, separating financing effects from the core transaction. If a customer pays far in advance, they are financing the seller; if they pay long after delivery, the seller is financing them.

Identifying a Significant Financing Component

Determining if a contract contains a significant financing component requires evaluating the facts and circumstances of each contract. The primary indicator is a notable length of time between when a customer pays and when the entity provides the goods or services.

The guidance outlines specific factors to consider in this analysis. The first is the difference between the promised consideration and the cash selling price of the goods or services. A large variance suggests the payment terms include a charge for financing. The second factor is the combined effect of the expected time between performance and payment and the prevailing market interest rates. A long payment period with high interest rates is more likely to result in a significant financing component.

For instance, if a customer pays $100,000 for a service to be delivered in two years, a significant financing component likely exists. Similarly, if a customer receives a product today but does not pay the $121,000 price for 24 months, the seller is financing the purchase. This arrangement implicitly contains an interest charge that should be accounted for separately from the product revenue.

Certain situations do not constitute a significant financing component, even if payment and performance timing differ. If a customer pays in advance but the timing of the transfer is at their discretion, a financing component does not exist. Another exception occurs when a substantial portion of the consideration is variable and based on future events outside the control of either party. Additionally, if the difference between the promised consideration and the cash price is for a reason other than financing, it is not treated as financing.

Accounting for the Significant Financing Component

When a significant financing component is identified, the transaction price is adjusted using a discount rate to separate the interest from the revenue. This results in the recognition of either interest income or interest expense, depending on the payment structure.

The discount rate used should be the rate from a separate financing transaction between the entity and its customer at contract inception. This rate must reflect the credit characteristics of the party receiving the financing. For example, a customer with a higher credit risk would have a higher discount rate, resulting in less revenue and more interest income recognized over the contract term. This rate is determined at the start of the contract and is not updated.

Consider a company selling an asset for $5,000, with control transferring to the customer in two years. The customer pays $4,000 at signing. The company determines its incremental borrowing rate is 6%, which is appropriate for the transaction. At inception, the company records the cash and a contract liability: Debit Cash for $4,000 and Credit Contract Liability for $4,000.

In the first year, it recognizes interest expense of $240 ($4,000 x 6%) and credits the Contract Liability. In the second year, the interest expense is $254.40, calculated on the new liability balance of $4,240 ($4,240 x 6%). When the asset is transferred, the company recognizes revenue equal to the adjusted contract liability of $4,494.40 and clears the liability.

The Practical Expedient

ASC 606 includes a practical expedient to simplify this guidance. An entity is not required to adjust for a significant financing component if the period between the transfer of goods or services and customer payment is expected to be one year or less at contract inception. This is an accounting policy choice that must be applied consistently to similar contracts. If an entity chooses to use this expedient, it must disclose this fact. This option is beneficial for businesses with a high volume of contracts where payment terms are typically within one year of performance, as it avoids the need to determine a discount rate and perform present value calculations.

Presentation and Disclosure Requirements

The presentation of the significant financing component is clearly prescribed. Interest income or interest expense recognized from a significant financing component must be presented separately from revenue from contracts with customers on the income statement. This presentation allows financial statement users to distinguish between revenue from primary operations and income or expense from financing activities.

In the notes to the financial statements, an entity must disclose its significant payment terms, which includes stating whether contracts have a significant financing component. If an entity uses the practical expedient for contracts of one year or less, that fact must also be disclosed.

Entities are also required to disclose the judgments made in determining the transaction price, including the methods, inputs, and assumptions used for adjusting consideration for the time value of money. This provides transparency into how the discount rate was determined. Furthermore, entities must explain significant changes in their contract asset and liability balances, which would include the effects of interest accreted on those balances.