How IFRS 15 might affect the accounting for a specialized area of practice
As we summarized here, the IASB has issued IFRS 15, Revenue from Contracts with Customers, effective for annual reporting periods beginning on or after January 1, 2017 (NB this was subsequently amended to January 1, 2018). The standard is much longer than the combined page count of the various things it replaces, addressing many areas in greater detail than the current material. One such area is that of repurchase agreements – contracts in which an entity sells an asset and also promises or has the option (either in the same contract or in another contract) to repurchase it. IAS 18 addressed such arrangements only in a few sentences, saying their terms need to be analyzed to ascertain whether, in substance, the seller has transferred the risks and rewards of ownership to the buyer so that revenue can be recognized; where this isn’t achieved, the transaction is a financing arrangement and doesn’t give rise to revenue. Clearly, such brief guidance has left significant room for variation in practice.
IFRS 15 defines the territory more specifically, noting that such agreements generally come in three forms:
- (a) an entity’s obligation to repurchase the asset (a forward);
- (b) an entity’s right to repurchase the asset (a call option); and
- (c) an entity’s obligation to repurchase the asset at the customer’s request (a put option).
If an entity has an obligation or a right to repurchase the asset (a forward or a call option), then the customer doesn’t obtain control of the asset – the customer is limited in its ability to direct its use and to obtain substantially all of the remaining benefits from it (even though it may have physical possession). The entity accounts for the contract in one of two ways. If it can or must repurchase the asset for an amount less than the asset’s original selling price, it accounts for the arrangement as a lease, reflecting that the apparent intention of the arrangement is to convey to the customer/lessee the right to use the asset in question for a defined period of time. Depending on the terms, this may constitute either a finance or an operating lease.
On the other hand, if the entity can or must repurchase the asset for an amount equal to or more than its original selling price, then it accounts for the transaction as a financing arrangement, reflecting its apparent substance as a borrowing. In this case, the entity continues to recognize the asset and also recognizes a financial liability for any consideration received from the customer. It recognizes the difference between the amount of consideration received from the customer and the amount of consideration to be ultimately paid back to the customer as interest and, if applicable, as processing or holding costs (for example, insurance). The IASB notes that an entity doesn’t need to consider the likelihood that a call option can be exercised, because the very existence of the option effectively limits the customer’s ability to control the asset. However, it observes that if the call option is non-substantive, then it should be ignored in assessing whether and when the customer obtains control of a good or service (this is consistent, the Board points out, with the general requirement for any non-substantive term in a contract).
Where the entity has an obligation to repurchase the asset at the customer’s request (a put option) at a price lower than its original selling price, it considers at contract inception whether the customer has a significant economic incentive to exercise that right. If it does, then the entity again accounts for such an arrangement as a lease in accordance with IAS 17, reflecting that the customer’s exercising of that right will result in the customer having effectively paid the entity to use the asset for a period of time. If the customer doesn’t have a significant economic incentive to exercise its right, the entity accounts for the agreement as the sale of a product, but one subject to a right of return (as we addressed here). The assessment of whether a customer has a significant economic incentive to exercise its right depends on such matters as the relationship of the repurchase price to the expected market value of the asset at the date of the repurchase, and the amount of time until the right expires. The standard notes for example that if the repurchase price is expected to significantly exceed the asset’s market value, this may indicate that the customer has a significant economic incentive to exercise the put option. But then, where this is the case, and the repurchase price of the asset is also equal to or greater than the original selling price, then such a contract is also in substance a financing arrangement, treated in the way described above.
I’m not sure how often entities venture into such territory on a one-off or ad hoc basis; when they do, the story behind the transaction (e.g. is this the only quick financing they could get?) may often be as important to an investor’s overall consideration of things as the accounting treatment is. Still, the IASB would hope that the approach set out above will help to clarify that story for investors…
The opinions expressed are solely those of the author