Q1. For revenue to be recognized in relation to sale of goods, FRS18-Revenue states that the following conditions must be satisfied:
Entity has transferred significant risks and rewards of ownership of the goods to the buyer
Whether the entity has transferred the significant risks and rewards of ownership to the buyer depends on the circumstances of the transaction. Generally, the transfer of risks and rewards coincides with that of the legal title or with the passing of physical possession of the good, like in the case of retail sales. For example, as retail sales are usually sold on cash delivery terms, the risks and rewards of ownership of the goods would be transferred to the buyer when they are physically received and cash reaches the seller.
The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold
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For example, in the sale of a house, after the deed to the house has been passed over from the existing owner to a new buyer, the owner has effectively relinquished all ownership and rights to the house.
Amount of revenue can be measured reliably
With real estate sale as an example, the amount of revenue a real estate agent earns, which is basically the commission, e.g. 10% of the price of property, is usually built on the consensus between the agent and the owner of the property. The amount of revenue has a monetary value placed on it and can be measured reliably.
It is probable that economic benefits associated with the transaction will flow to the entity.
For example, in the case of a sale transaction in another country, it may be unsure if the governmental authorities in that country will grant permission to allow the sale transaction to take place. Hence, revenue can only be recognised when the governmental authorities acknowledge the sale transaction and allows it to take place.
Costs incurred or to be incurred in respect of the transaction can be measured reliably.
Owing to the matching principle, revenue and expenses must match each other. Hence, if the expenses cannot be recognised or measured reliably, revenue cannot be recognised. In the case if the revenue has already been received and expenses cannot be measured reliably, the revenue earned will be recorded as unearned revenue under liabilities.
Q2. The outcome of a transaction involving the rendering of services can be estimated reliably when all the following conditions are satisfied:
Amount of revenue can be measured reliably
Economic benefits associated with the transaction will flow to the entity
Stage of completion* of the transaction at the balance sheet date can be measured reliably
Costs incurred for the transaction and the costs to complete the transaction can be measured reliably
Source: Financial Reporting Standard 18
The conditions of provision of services and sale of goods differ as below:
The difference between the conditions for revenue recognition for sale of goods differs from that of rendering of services is that the concept of ownership. It is important to first distinguish between a good and a service. Firstly, a good has tangibility, as it can be possessed and passed from one to another, whereas a service lacks such tangible features. Ownership is applicable only to goods as goods are tangible objects whose possession can be passed on from buyer to seller, like the deed to a house, but a service is not.
A good is separable, i.e. it leaves no connection between the buyer and the seller once the transaction is concluded. A service however, creates a link between the entity and buyer, as the entity is obliged by the terms of a contractual agreement to provide a service to the buyer over a period of time. In addition, when rendering services, revenue is recognised by reference to the stage of completion of the transaction at the balance sheet date. This is known as the percentage-of-completion method. The journal entry required to recognise the current period's revenues is the difference between total revenues earned to date and revenues recognised in prior accounting period.
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The percentage-of-completion method attempts to recognise revenue in the applicable periods of service rendered and not just solely in the period where service has been completed. The determination of the stage of completion of a transaction may be carried out through any of the following methods:
(a) Surveys of work already performed
It is possible to gauge the percentage of completion of a project using a planning tool such as a Gantt chart. Most Gantt charts include "milestones" representing deadlines and other significant events that make it relatively easy to calculate how far a project is along, given that the expected time taken to complete the project has been determined beforehand. For example, if a Gantt chart shows that a contract for a project has reached the 50% milestone, then it is a fair assumption that 50% of the project has been completed, even if the proportion of costs incurred as a percentage of total costs do not exactly match.
(b) Services performed to date as a percentage of total services to be performed
(c) The proportion of costs incurred to date as a percentage of total costs of the transaction
Suppose that Wheelock is offered a Contract of $100,000, with total estimated costs of $80,000. Costs run up to $20,000 in Year 1, and $40,000 in Year 2.
To compute the percentage of completion, one divides the cost to date by the total estimated costs, so in Year 1 25% of the work has been done, and in Year 2 75% of the work has been done.
Therefore, total revenue earned in Year 1 = 25% x 100,000 =$ 25,000
Total revenue earned in Year 2 = 75% x 100,000 = $75,000
And current year's revenue = 75,000 - 25,000 = $50,000
Airfares sold by a travel agent
Airfare sold by a travel agent can be recognised under the revenue from provision of service. Revenue recognition policy states that as long as the revenue is earned and the sales transaction is complete, it can be recognised as revenue.
Travel agencies can earn service revenue from two parties:
Customer - When an airfare is sold by a travel agent, the agent provides the relative service to the customer, such as booking and confirming the air ticket with the airline company on behalf of the customer. Therefore, in the sale of an air ticket, the travel agent will earn a commission, which is basically the service revenue. As the service has already been rendered to the customer when the customer makes a booking of air ticket, revenue can be recognised upon the booking of air ticket by the customer.
Companies, e.g. Cruise, Coach, Restaurants - The agent earns commission by setting up accounts with these companies and be the middle person as they bring business to these companies when they recommend their customers to visit these companies and include in the itinerary. As the travel agent has already rendered the service to these companies by recommending these companies to their customers, revenue recognition can be recognised.
In most cases, the booking of an airline ticket will require the customer to place a deposit before paying the full amount. However, this does not meet the other requirement of the revenue recognition of the provision of services policy, which is the seller has to be sure that he or she is able to collect the money from the customer, as the customer may decide to cancel the booking and the travel agency will then be unable to collect the money from the customer. In such cases, as long as the company can be reasonably assured that sales transactions are eventually completed, revenue can still be recognised once a significant deposit is received, provided the goods are on hand, identified and ready to be delivered to the customer.
Gift Vouchers sold by a departmental store
The revenue of gift vouchers sold by a departmental store will be recognised under the sale of goods.
Before the gift certificate is redeemed, the revenue earned from the sale of gift certificates will be unearned revenue. As one of the conditions of the sale of goods suggests that the entity has to transfer significant risks and rewards of ownership of the goods to the buyer, revenue will only be recognised when the holder of the gift certificate benefits from the rewards of the gift certificates, which is when he or she redeems the gift certificates for products of the company.
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However, if in the event that a certificate goes unredeemed and expires, the revenue will be recognised at the point of the date of expiry printed on the gift certificate.
Course fees revenue of a university or education provider
The course fees revenue of a university can be recognised under revenue of the provision of a service, as service in the form of facilities or classes are rendered.
The course fees are recognised by the stage of completion of the services to be provided to the students, regardless of when it is received. This means that the revenue will be recognised throughout the semester, depending on when the service rendered completes. For example, if the semester is from August to December 2010, the revenue will be recognised from August to December 2010, when the classes begin, even though it may be paid before August 2010 or after December 2010.
Concert tickets sold by SISTIC, Ticketmaster, Ticketek
SISTIC, Ticketmaster, Ticketek are companies which provide ticketing services, where they handle the ticketing system of a wide variety of arts, entertainment and sports events.
Concert tickets sold by SISTIC, Ticketmaster, Ticketek and other similar companies are recognised under the provision of a service. According to the revenue recognition policy, the revenue is considered to be earned when the service is provided. Hence, when a concert ticket is successfully sold to a customer, revenue will be recognised at point of sale, as the service has been rendered to the customer.
Q5. Before one arrives at a conclusion regarding which policy is appropriate, one needs to consider the reasons that Pos Malaysia decided to recognise postage, prepaid mail and courier revenue on demand on cash basis:
From the financial statements of POS Malaysia, it is reasonable to assume that as the main source of revenue for Pos Malaysia comes from mail business, "contributing RM562.3 million or 62.3% of the group's revenue"; postage, prepaid mail and courier revenue on demand become insignificant in comparison. Hence, even though cash basis accounting is used, omission from the Balance Sheet would not understate POS Malaysia's assets and liabilities to such a great extent.
Under the framework for the preparation of financial statements, the evaluation of benefits and costs is substantially a judgemental process. One has to consider if the benefits obtained from the information should be more than the cost of providing it. Hence, as postage, prepaid mail and courier revenue on demand only contributes to a small percentage of revenue, POS Malaysia may consider the benefits from accounting for these sources of revenue to be less than the costs of collecting all the information necessary to compute the figures. It can also be argued that despite the omission of these sources of unearned revenue, the financial information provided overall is still sufficient to provide information for the various user groups in their economic making decision.
However, this is not in compliance with the accrual concept of accounting. Postage, prepaid mail and courier revenue on demand are unearned revenue by the company and should be recorded under accrual accounting. By following the case basis accounting, the revenue recognition principle and the matching principle are not accounted for. The revenue recognition principle suggests that revenue is recognised when it is earned and not when the cash is received. On the other hand, the matching principle suggests that revenue is matched with the expenses incurred, not the time when the cash is paid.
In comparison, SingPost's policy, which adopts accrual accounting, is more appropriate as it complies with the matching and revenue recognition principle as revenue is recognised when it is earned and service is rendered. It provides a greater degree of accuracy to users of its financial statements.
In conclusion, we agree that if an organization has to account for different streams of revenue, some of which are immaterial, and the costs of incorporating this information into the balance sheet outweighs the benefits, then the organization can use different accounting methods for each business, provided that it keeps internal and external users informed of such practices in the Notes to the Financial Statements, to minimise the potential for misleading users. This is in accordance with the guidance provided by the Framework for the Preparation of Financial Statements; the type of accounting method to be used should be evaluated as a pervasive constraint, where benefits are more than costs.