Question

Dealer Financing On 1/1/X1, Tractor Co. sold a new combine to Jim’s U-Pick farm. The purchase agreement establishes a base price of $100,000, plus a contractual interest rate of 5%, payable in 48 monthly installments of $2,302.93. Control of the combine transferred to Jim when Jim signed the contract and had the combine delivered that same day. If Jim had obtained separate financing (say, a bank loan) for the purchase, his interest rate would have been 6%.

What amount of revenue should Tractor Co. record at the date of sale? What guidance should Tractor Co. apply to the subsequent measurement of its receivable?

Consider the measurement attribute used to record Tractor Co.’s revenues. How does this approach achieve the objective of this measurement attribute?

Hint: You might find it useful to use Microsoft Excel’s formula options: PMT and PV for this example. Excel walks you through how to input numbers into each formula.

Answer 1

• 1: What amount of revenue should be recorded at the date of sale? ASC 606-10-32-15 requires that Tractor Co. 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 provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer. Tractor Co. is providing significant benefit to the customer, Jim, by receiving payment after performance. ASC 606-10-32-16 provides guidance on how to recognize revenue with the adjustment: 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: a. The difference, if any, between the amount of promised consideration and the cash selling price of the promised goods or services b. 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. According to this guidance, the financing component is significant to the contract. The difference between the amount of promised consideration, $110,540.64, and the cash selling price, $100,000, is $10,540.64. Tractor has completed its performance obligation to Jim 48 months before the asset will be paid off by Jim. ASC 606-10-32-18 provides that Tractor need not adjust for the effects of the significant financing component if Tractor expects to receive payment for the asset within one year or less. This amount of time between the performance and the payment is significant. The interest rate offered by Tractor at 5% is one percent lower than the market rate, at 6%. The difference in interest rates is also significant. ASC 606-10-32-19 provides the following guidance: 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). According to this guidance, Tractor shall use the market discount rate of 6% to adjust the promised amount of consideration for the significant financing component. ASC 606-10-32-20 requires that Tractor shall present interest income separately from revenue in the statement of comprehensive income. Interest income is recognized only to the extent that a contract asset is recognized in accounting for a contract with a customer (ASC 606-10-32-20). ASC 606-10-32-2 requires the following: An entity shall consider the terms of the contract and its customary business practices to determine the transaction price. The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes). The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both. According to this guidance, Tractor shall recognize revenue in the amount of $98,059.46. This calculation is attached on an Excel workpaper, and is as follows: present value of the monthly installments of $2,302.93, for 48 months, at the market interest rate of 6% per year. Although the base price is $100,000, Tractor must adjust for the significant financing component as described above.   2: What guidance should be applied to the subsequent measurement of Tractor’s receivable? : ASC 835-30-45-3 requires that amortization of premium shall be reported as interest income. ASC 606-10-32-20 requires that Tractor present the effects of interest income separately from revenue from contracts with customers. Under this guidance, each month, given that Jim pays each payment on time, Tractor shall record a debit to cash, a credit to finance receivable- Jim, and a credit to interest income. ASC 820-10-35-24A requires the following: The objective of using a valuation technique is to estimate the price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions. Three widely used valuation approaches are the market approach, cost approach, and income approach. The main aspects of valuation techniques consistent with those approaches are summarized in paragraphs 820-10-55-3A through 55-3G. An entity shall use valuation techniques consistent with one or more of those approaches to measure fair value. According to this guidance, Tractor shall continue applying the income approach throughout subsequent measurement of its receivable, since this is the method used initially.                                                                                                                                                                                                                     3: Consider the measurement attributes used to record Tractor Co.’s revenues. How does this approach achieve the objective of this measurement attribute? The measurement attribute used to record Tractor Co.’s revenues is the present value of the monthly installments, at a current market rate of 6% per year. The income approach, as described above, converts future amounts, such as cash flows or income, to a single current amount. This allows for the fair value measurement to be determined on the basis of the value indicated by current market expectations (ASC Glossary, Income Approach). Conclusion The above analysis supports the conclusion that Tractor shall record revenue from the sale of the combine in the amount of $98,059.46. Tractor shall then account for the interest income received separately from the revenue received, this includes a debit to cash, credit to note or finance receivable- Jim, and a credit to interest income each month as Jim pays off the financing of the combine. The income approach allows for Tractor to account for the transaction according to its fair market value. FINANCIAL STATEMENT AND DISCLOSURE IMPACTS                                 DATE                                   ACCOUNTS                            DEBIT                     CREDIT                    1/1/X1                   NOTE RECEIVABLES-JIM 98059.46 SALES REVENUE 98059.46 1/1/X1 CASH 2302.93 NOTE RECEIVABLES - JIM 1812.63 INTEREST INCOME 490.30 2/1/X1 CASH 2302.93 NOTE RECEIVABLES - JIM 1821.70 INTEREST INCOME 481.23