The reporting deadlines imposed by the ASC 606 and IFRS 15 standards are fast approaching. That means the time for companies to get serious about implementing the new revenue recognition standards is now. Embedded within the regulations is the concept of a significant financing component, which means for many companies, adopting the new revenue recognition standard and managing the time value of money will have a significant impact on their business processes.
The new standard, titled Revenue from Contracts with Customers, takes a five-step approach to determine proper revenue recognition. The third of these steps, ‘Determining the Transaction Price’, requires companies to consider the totality of an order, from inception to recognition, which includes a discussion around potential variance throughout the contract term. Among these potential types of variable consideration is the Time Value of Money (TVM). This may be straightforward for some, but for many accounting teams, it will become an extremely difficult component to calculate over time.
Tony Sondhi, a member of the FASB’s Emerging Issues Task Force, remarked during an ASC 606 webinar in early spring, “The application of the principles of the significant financing of the new standard will require reasonable judgment to be made. In some cases, it will vary depending on the circumstances of the transaction.”
The timing differences between revenue receipt and revenue recognition, the applicable interest rate, and the size of the order are key determinates to justifying the significance of the time value of money. Consider a scenario in which a payment is received in advance of satisfaction of the performance obligation. The recognized revenue will ultimately exceed the cash received due to the inherent interest expense embedded within the contract. On the flip side, consider a scenario in which payments are received in arrears, the company will then recognize less revenue than cash received because a portion of the revenue will be considered interest income. The longer the time between receipt and recognition, the more significant the timing differences become, and ultimately, the more important the consideration for the TVM becomes. In the case of the new standard, if companies are providing for a significant financing component within the terms of their contracts, they must be reporting this to the shareholders.
TVM can be calculated using one of two methods, Payment in Advance (FV) or Payment in Arrears (NPV); the overall goal is to recognize revenue in the amount that properly reflects the cash payment that the customer would have made at the time the goods or services were transferred. This sounds simple, but it is not always clear when or how to properly account for revenue, especially considering the complexities on an individualized level. Companies that offer contract incentives through the use of discounts and rebates should carefully determine whether this variable consideration should include consideration for TVM. All those in industries with long-term contracts, be warned.
Let’s discuss an example from one of our recent webinars, “Overcome the Challenges of ASC 606 Step 3: Determine the Transaction Price”. Mike Walworth, of GAAP Dynamics, discussed the topic of significant financing and provided a notable example of a company that typically offered a discount – a furniture store. In the example, the company offers to sell furniture to a customer with a “buy now, pay later” financing option. The option holds that the customer does not have to pay until a specified date, regardless of the furniture delivery date. Mike raised the question, “Would this be considered explicit or implicitly stated, because you give them a period of time to pay? Or the customer has the option to make payments ahead of time.” Mike explains that the furniture store should record this discount using interest income and interest expense applicable to a significant financing component, in consideration for the TVM.
Also during the webinar, SOFTRAX Sales Engineer, Kristen Lawson, recognized that the new standard doesn’t provide much guidance on calculating the time value of money, especially in the case of multi-element arrangements: “Because of the inherent length of time associated with these contracts, the application of subjective evidence becomes a greater responsibility. What happens when contract terms are modified or amended, and the overall transaction price changes? The contract price needs to be reallocated, and if only one of the performance obligations contains a significant financing component, how will the company handle the adjustment in allocated value? Companies will need to consider changing the present value of the obligation based on either the original transaction price, the originally allocated value, or the amended allocated value.” Kristen further indicated the complexities that ensue for companies considering FX rates. When and how companies should recognize the revenue can become very challenging, especially considering the manual efforts associated with applying subjective evidence.
Companies must consider what tools and systems they will use to properly and consistently make these judgments. Spreadsheets and manual workarounds are limited in functionality and make it excruciating for accounting and finance teams to determine the application of the significant financing component to the total transaction price. The SOFTRAX Revenue Manager software has enhanced features to automatically calculate the time value of money and consistently apply the guidance to all contracts in similar circumstances, making it easier for companies to apply and manage specific revenue policies.
SOFTRAX can significantly reduce the repetitive manual processes that hinder accounting teams today, allowing them to spend their valuable time on other core projects. Simply put, revenue recognition software can help companies scale their business.
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