EITF 88-18: Accounting for Sales of Future Revenues

Under U.S. Generally Accepted Accounting Principles (GAAP), the rules for sales of future revenues are outlined in the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC). This guidance covers transactions where a company receives an upfront cash payment from an investor in exchange for a specified amount or percentage of its future revenues or income. These arrangements are complex because they have characteristics of both a sale and a loan.

Companies must analyze the agreement’s terms to decide whether the cash received should be recorded as a liability or recognized as revenue over time. This determination hinges on which party to the transaction retains the significant risks and rewards associated with the future revenue stream. The guidance ensures that financial statements accurately reflect the transaction’s economic substance, preventing companies from immediately booking revenue from what is, in effect, a financing arrangement.

Scope of the Accounting Guidance

The accounting guidance applies to transactions where an entity receives cash for a portion of its future revenue. This can involve the transfer of a specified percentage of revenue, a fixed dollar amount from a future revenue stream, or a measure of income from a specific product line, business segment, or intellectual property like a patent.

Common examples include a pharmaceutical company selling the rights to a percentage of future sales of a newly approved drug. A film production studio could sell a share of a movie’s box office receipts to an investor before its release. Similarly, a technology firm might sell a portion of the future licensing fees from a specific patent, or a musician could sell their future royalty stream from a catalog of songs.

To determine the appropriate accounting, an entity must first assess whether the transaction falls within the scope of ASC 606, Revenue from Contracts with Customers. If the arrangement is not a contract with a customer, the principles for treating these transactions as debt are found in ASC 470.

This guidance does not apply to transfers of recognized financial assets, which are covered by ASC 860, Transfers and Servicing. A sale of future revenues involves revenues that do not yet exist and are not recorded as receivables. If a company were to sell its existing accounts receivable, that would be a transfer of a financial asset under ASC 860.

Determining the Accounting Treatment

The central question in accounting for these transactions is whether the cash received constitutes a liability or can be treated as revenue. The guidance establishes a default presumption that these transactions are, in substance, loans. Therefore, the proceeds must be classified as a liability unless specific, restrictive conditions are met that demonstrate the seller has passed the risks and rewards of the underlying revenue stream to the buyer.

The analysis hinges on several indicators that point toward the transaction being a form of financing:

• The seller’s significant continuing involvement: If the seller must continue to perform substantial activities to create the sales that will pay the investor, it suggests that the seller has not truly transferred the asset. For example, if a software company sells future subscription renewals but must continue to provide technical support, updates, and marketing to retain those customers, its involvement is significant.
• The cancellability of the transaction: If either the seller or the buyer has the right to unilaterally terminate the agreement, it undermines the notion of a completed sale. A true sale is final and irrevocable, so the ability to cancel suggests a more flexible, loan-like arrangement where the terms can be revisited or unwound.
• The presence of any repayment obligation: If the seller is required to repay the buyer the initial cash advance regardless of whether the designated revenues materialize, the transaction is economically a loan. This recourse provision means the buyer is protected from the risk of the revenue stream underperforming, and the seller ultimately bears the risk.
• The buyer’s rate of return is limited: If the buyer’s potential rate of return is limited by a specified interest rate or a fixed amount, it points toward a financing arrangement. In a true sale of an asset, the buyer typically assumes the full risk and reward, meaning their potential return is unlimited.
• The buyer has recourse to the seller’s other assets: If the buyer can make a claim against the seller’s other assets, such as property or other revenue streams, in the event the specified revenues fail to materialize, the transaction must be treated as a liability. This is a direct indicator of a loan secured by the company’s overall creditworthiness.

Accounting for Proceeds as a Liability

When the analysis of a sale of future revenues leads to the conclusion that the transaction is effectively a loan, the accounting must follow the guidance for debt. The initial cash proceeds received from the buyer are not recorded as revenue. Instead, they create a liability on the seller’s balance sheet, reflecting the obligation to the buyer. The journal entry is a debit to Cash and a credit to a liability account, such as “Obligation from Sale of Future Revenues.”

Because the transaction is treated as a financing, interest must be accounted for over the life of the arrangement. The company must calculate and record imputed interest on the liability balance. This process recognizes the time value of money, treating the difference between the cash received and the total expected payments to the buyer as interest expense over the term of the agreement.

As the company generates the specific revenues that were part of the agreement, it makes payments to the buyer. These payments reduce the outstanding liability balance and are allocated between a reduction of the principal and the recognition of interest expense. This is handled using the interest method, which applies a constant effective interest rate to the carrying value of the liability each period.

For example, assume a company receives $900,000 in cash in exchange for future revenues expected to total $1,000,000 over two years. The initial entry is a debit to Cash and a credit to the liability for $900,000. If the imputed interest is $45,000 in the first year, the company would debit Interest Expense and credit the liability for that amount. When the company then remits $500,000 to the buyer, it would debit the liability account and credit Cash.

Accounting for Proceeds as Revenue

In the less common scenario where a sale of future revenues does not have the characteristics of a liability, the transaction can be accounted for as a sale. This occurs only when the analysis demonstrates that the risks and rewards associated with the future revenue stream have been substantively transferred to the buyer. In this case, the accounting reflects a revenue-generating event.

Upon receiving the cash, the seller does not immediately recognize the full amount as revenue. Instead, the initial journal entry is a debit to Cash and a credit to a liability account called Deferred Revenue. This reflects that the company has received payment but has not yet earned the corresponding income, as the underlying revenues have not yet been generated.

The deferred revenue is then recognized systematically in the income statement as the specified revenues are earned over the life of the agreement. The recognition pattern should be rational and align with the timing of the underlying events. For instance, if the sale was for 10% of a product’s sales over five years, the company would recognize a portion of the deferred amount as revenue in proportion to the sales generated each year.

A related consideration is the accounting for the costs associated with generating the sold revenues. If the transaction involves the sale of future products, a portion of the cost of goods sold for those products should also be deferred and recognized in the same periods as the revenue. This adheres to the matching principle, ensuring that expenses are recorded in the same period as the revenues they help generate.

For example, a company receives $100,000 for a percentage of future royalties. The initial entry is a debit to Cash and a credit to Deferred Revenue for $100,000. If, in the first year, the company earns the underlying revenues that correspond to 20% of the total expected amount under the agreement, it would make an adjusting entry. This entry would debit Deferred Revenue for $20,000 and credit Royalty Revenue for $20,000.