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Why Contract Assets are not Financial Assets
In a previous post, I explained the difference between Trade receivables and Contract assets. Essentially, you will notice that both Trade receivables and Contract assets are concepts created by IFRS 15. However, only trade receivables meets the definition of a financial asset.
To understand the reason better, let's start with what a financial asset is.
What is a Financial Asset?
A financial asset is something that is either cash, a share of another company (like owning a piece of Microsoft shares), or a guaranteed right to receive cash. The key here is that this right to receive cash is unconditional, that is, the business is not expected to do anything or satisfy any future performance before being entitled to receive cash from the other party (customer, borrower, etc.)
To illustrate this, a trade receivable is a perfect example of a financial asset. This is because they are contractual rights to payment (to be paid) held by a business for goods supplied or services rendered that customers have ordered but not paid for.
If you sell a t-shirt to a customer and they take the shirt with a promise to pay you later. That promise is called a "trade receivable." It is a financial asset because you have done your part contractually by giving them the shirt, and now you have an unconditional right to get paid. The only thing that might stop you from getting paid is if the customer does not have the money (referred to as credit risk), but that is entirely separate from you fulfilling your part of the deal - because your part (obligation) is already fulfilled.
What is a Contract Asset?
A contract asset is also a right to receive cash, but it is conditional. This means you have to do something more before you are entitled to the money.
A right is unconditional if nothing other than the passage of time is required before payment of that consideration is due. Hence, a contract asset is not a financial asset because the right to receive cash has conditions, that is, asides from credit risk (which arises as a result of passage of time), there is a performance risk that the entity might not fulfil it’s remaining obligation that makes it entitled to receive cash from the customer. This right is conditioned on something other than the passage of time (the entity’s future performance).
Imagine you're a consultant hired to train a company's employees. They agree to pay you after you've completed all the training sessions. After you've done half the sessions, you have a contract asset. You've earned some of the money, but your right to receive it is conditional on you finishing the remaining training.
Say you are a consultant hired to train a company's employees. They agree to pay you $1,000 after you have completed all the training sessions. If you have only done half of the sessions by the end of the year, at this point, you only have a contract asset. This is because you have the right to receive some of the fees, but it is conditional on you finishing the remaining training. When you are recording at the end of the year, it is not a financial asset that you will record, rather a contract asset because you have not completed your side of the bargain yet. You still have an obligation to fulfil.
The core difference is the conditions attached to the right to receive cash.
Why this matters
At the end of the year when reporting the performance of the company, readers of the financial statement will be able to tell which assets are contract asset (meaning that not all performance obligation from the company's part has been fulfilled) and which assets are receivables (meaning the company has fulfilled all performance obligations). This also affects the company's financial ratios and metrics used to assess the company.
Even though IFRS 15 requires Contract Assets to be assessed for impairment using IFRS 9, they are still not considered financial assets.
Watch video below explaining the difference between contract assets and trade receivables.
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