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Measurement criteria explained under IAS-18, to help the users of the financial statements in better application and proper understanding. A reporting entity should measure revenue arising from an increase in the assets or a decrease in its liabilities or the net effect of their combination at the fair value of that increase or decrease. Revenue should be measured at the fair value of the consideration received or receivable.
For a cash sale, the revenue is the immediate proceeds of sale.
For a credit sale, the revenue is the anticipated cash receivable.
If the effect of the time value of money is material, the revenue should be discounted to present value.
Revenue excludes sales taxes and similar items because these are not economic benefits for the entity.
Revenue from the sale of goods
The sales of goods should be recognised as revenue after the following conditions are satisfied.
The significant risks and rewards have been transferred from seller to buyer.
Managements and control of the commodities is not retained by the seller.
The transaction amount of the goods can be measured reliably.
The economic benefit of goods related transaction will flow to the seller.
The cost incurred or to be incurred can be measured reliably.
Revenue from services
The recognition of services rendered is measured in accordance with the stage of completion. The following conditions must be satisfied.
The revenue can be measured reliably.
The economic benefit of the transaction will probably flow to the provider.
The completion stage can be measured reliably at the reporting date.
The costs incurred and the cost to complete can be measured reliably.
When these conditions are not met, the revenue should be restricted to recoverable only and the rest should reflect as irrecoverable debts or provisions for irrecoverable debts in the financial statements.
Interest, Royalties and Dividends
Revenue received from these sources should only be recognised when they have been measured accurately and the receipt from it is probable. revenue should be recognised as follows.
Interest should be estimated on a time apportion basis where necessary, taking into account the effective yield of the asset.
Royalties are accrued in accordance with the relevant contract.
Dividends are recognised when they are declared and when the shareholder#s right to receive payment is established.
Examples in applying revenue recognition through a series of mini case studies
On 1st October in the current year, a private tuition provider enrols a student on a six-month course. Lectures are held regularly every week over the whole six-month period. The tuition fees are $6000 and once paid is non-refundable. All books and material have to be purchased separately. The student pays a first instalment of $3000 prior to the commencement of the course, and the balance of $3000 in six, $500 monthly instalments. The tuition provider has a financial year-end of 31 December and proposes to recognise revenue in the financial statements on a cash receipt basis. At the year end, the three monthly instalment due have been received.
Tuition provider should be advised on the correct accounting treatment for this transaction.
Answer to Example 1
At 31 December, it is necessary to determine how much revenue is to be recognised in respect of the provision of tuition, i.e. in the sale of a service. The proposal is to recognise revenue of $4500, this being the cash received. This is wrong. The measurement of profit, and hence the recognition of revenue, has to take some account of the matching process. At the year end, exactly one half of the course has been delivered. Accordingly, one half of the revenue can be recognised, i.e sales should be $3000.
While there are some staged payments, i.e. there is element of deferred consideration, these are paid over a matter of months rather than years. The time value of money is accordingly not regarded as material over this period, and so it is not necessary to discount the consideration received to arrive at the fair value of the consideration.
The $1500 received, but not yet recognised as revenue at the reporting date, is to be non-refundable there is, in fact, an obligation to complete the contract. As deferred income, it is included n the statement of financial position / balance sheet as a liability rather than as equity.
The original proposed treatment anticipated revenue and thus overstated profit in the short term.
The correct treatment can be summarised as follows:
Dr Cash 4500
(Being the receipt of cash)
Cr Revenue / Sales 3000
(Being the revenue earned being recognised)
Cr Deferred income 1500
(Being the monies received in advance of the delivery of the services)
On 1 November 2000, a car retailer agreed to sell a motor vehicle for $20000. At the time, the customer negotiated a three-year free service agreement as part of the transaction. This service agreement is normally sold for $1000. Also, on 1st November 2000, the customer paid a non-refundable deposit of $2000. A further $10000 is payable three months later on 1st February 2001. The customer has been taken advantage of a free offer and will pay the balance of the $8000 on 1st February 2003. Delivery of the car to the customer will take place on 1st February 2001. The car retailer has a financial year end of 31 December and proposes to recognise the sale of the car at $20000 in the financial accounts for the current year.
Advise the car retailer on the correct accounting treatment for, this transaction.
Answer to example 2
First let us consider the timing of the transaction- when the sales take place. this transaction is for sales of goods, and we should determine when the risks and rewards of the ownership have left the retailer. The timing if the sale is, therefore, 1st February 2001, as this is when the customer takes possession of the car and the performance of the sale contract is, in effect, substantially completed. No revenue can be recognised in the current accounting period.
The car retailer has received $2000 in the current period. This has been banked (Dr Cash) and is to be regarded as deferred income (Cr Deferred Income) as, at the reporting date of 31st December 2000, there has been no performance of the contract. While the deposit is said to be non-refundable, the car dealer does not have an obligation to complete the contract. Accordingly, deferred income is included in the statement of the financial position / balance sheet as ability rather than as equity.
There is also a need to consider how to measure the revenue generated from the ultimate sale of the car. Two issues arise here. First there are two transactions- the sale of the car and the sale of the three year service agreement. This is because, in substance, the service agreement has not been given away for free, and the revenue from that ($1000) should be acknowledged separately and then recognised over the three years. Second, the deferral consideration of $8000 that will be two years after the sale, should be measured at fair value by being discounted at the present value to reflect the time value of money.
All of this could be summarised up in journals as follows- if we assume a discount rate 10% for measuring the time value of money.
1st November 2000
Dr Cash 2000
(Being the receipt of cash)
Cr Deferred Income 2000
(Being monies received in advance of the sale being recognised and so deferred income)
1st February 2001
Dr Deferred Income 2000
(To clear out the brought forward deferred income account)
Dr Cash 10000
(Being the receipt of cash)
Dr Receivable 6612
(Measured at present value with a discount rate of say 10% [8000/1.12] )
Cr Deferred Income 1000
(In respect of the monies received in advance for the three-year service agreement)
Cr Sales/Revenue 17612
(Revenue in respect of the car balancing figure)
On 1st December in the current year, an internet travel agent accepts a payment by credit card of $1000 in respect of a hotel booking for the following February. The travel agent confirms the booking and issues the customer with an appropriate receipt. In due course, the internet travel agent will pay $900 to the hotel.
Having received $100 from the customer (Dr Cash $1000), the internet travel agent proposes to immediately recognise $1000 as revenue in the current year (Dr Sales $ 1000).
It will then record the liability to pay the hotel (Cr liability $900) and complete the double entry by posting this as an expense (Dr Expense $900), the internet travel agent has a financial year end of 31st December.
Advise the internet travel agent on the correct accounting treatment for this transaction.
Answer to example 3
It appears that the internet travel agent has indeed acted as only an agent and not as a principal. All it has done is to provide an introduction. It has not actually been responsible for the provision of a bed for night.
The revenue that it should recognise, therefore, should be confined to the commission that is due. This is only $100. This earned on 1st December and can be recognised as a liability.
When you can argue that the proposed accounting treatment does not, in fact, actually overstate profit, it is still misleading as it would give the casual reader an impression that the levels of activity in the company were higher than they actually are.
To sum up in journal form, the correct treatment is;
Dr Cash 1000
(Being the banking of the cash received)
Cr Revenue/Sales 100
(Being the commission earned as an agent)
Cr Hotel Creditor 900
(Being the liability to pay money over to the hotel)
Bill and hold arrangements
It is referred to the contract for the supply of goods, where the buyer accepts title to the goods but does not take physical delivery of the item until a later date. Provided the goods are available for delivery, the buyer gives explicit instructions to delay delivery and there are no alterations to the terms on which the seller normally trades with the buyer, revenue should recognise when the buyer accepts title.
Payments for goods in advance (e.g. deposits)
Revenue should be recognised when the delivery of the goods to the buyer takes place. Until then, any payments in advance should treated as liabilities.
Payments for goods by instalments
Revenue is recognised when the significant risks and rewards of the ownership have been transferred, which is usually when the delivery is made. If the effect of the time value of money is material, the sale price should be discounted to its present value.
Sale or return
Sometimes goods are delivered to the customer but the customer can return within a certain time period. Revenue is normally recognised when the goods are delivered.
Revenue should then be reduced by an estimate of the return. In most cases a seller can estimate return from the past experience. For example, a retailer would know on average what percentage of goods are returned after a year end and could adjust revenue by the amount of expected returns.
Presentation of revenue as a principal or as agent
The principal supplies the goods or services on its own account, while the agent receive a fee or commission for arranging provision of goods and services by the principal. The principal is exposed to the risk and rewards of the transaction and therefore records revenue as gross amount receivable. The agent only records the commission receivable on the transaction as revenue. An example would be a cosmetic agent who earns commission on the number of cosmetic sold. The agent owns no inventory, so is not exposed to obsolescence and therefore could only record commission as its revenue. The cosmetic is exposed to the inventory obsolescence and selling price changes, so would record the gross amount of the sale as revenue.
Separation and linking of contractual arrangements
Sometimes business provide a number of goods and services to customer as a package. For example, a customer might purchase software together with regular upgrades for one year. The problem here is whether the sale is one transaction or two separate transactions.
A 'Package' such as this can only be treated as more than one separate transaction, if each product or service is capable of being sold independently and if a reliable fair value can be assigned to each separate component. Using the example above, if support service is an optional extra and the software can be operated without it, the sale is two (or more) separate transactions. If the sale is one transaction and the amount of revenue recognised depends on the extent to which the seller has performed at the reporting date.
Disclosure requirement of IAS-18
According to IAS-18 an entity should disclose:
Its accounting policies for revenue including the methods adopted to determine the stage of completion of service transaction.
The amount of each significant category of revenue recognised during the period.
The amount if revenue arising from exchange of goods and services
Assets and liability model for revenue recognition
The revenue recognised requirements in IAS-18 focus on the occurrence of the critical events rather than changes in assets and liabilities. Some believe that this approach leads to debits and credits that do not meet the meet the definition of assets and liabilities being recognised in the statement of the financial position.
The International Financial Reporting Standard Board has developed two approaches to implement the asset and liability model:
The far value (measurement) model, in which performance obligation are initially measured at fair value.
The customer consideration model, in which performance obligation are initially measured by allocating the customer consideration amount.
It is likely that neither of these will be the final model and the final standard is expected to be drawn from both of them.
Weaknesses under IAS-18
A practical weakness of IAS-18 is that ir gives insufficient guidance on contract that provides more than one goods or services to the customer. It is unclear when the contracts should be divided into components and how much revenue should be attributable to each component. IFRS (International Financial Reporting Standard Board) frequently receives requests for guidance on the application of IAS-18.
Since IAS-18 was originally issued, businesses and transaction have become much more complex. For example, computer companies frequently enter into barter transactions. Transactions may include options, for example, to buy shares or to return goods within a specified time.
Some entities have exploited the weaknesses in IAS-18 in order to artificially enhance revenue (a practical sometimes called aggressive earnings management). For example, some software companies recognise sales when order are made, well before it is
Reasonably certain that cash will be received.
The main issue is one of timing. At what point in a transaction should an entity recognise revenue?
Three questions can be helpful in dealing with an unusual transaction or situation:
When is the 'critical event'? This is the point at which most or all of the uncertainty surrounding a transaction is removed.
Has the seller actually performed? Transaction that gives rise to the revenue are legally contractual arrangements, regardless of whether a formal contract exists. Revenue can only be recognised when an entity has performed its obligations under the contract. For example, an entity cannot recognise revenue at the time that it receives payment in advance.
Has the transaction increased the entity's net assets/equity? For example, when an entity makes a sale, its assets increase, because it has receivable (access to future economic benefits in the form of cash). Therefore it recognises a gain. This is one of the main principal in the standard framework.
Current Developments in Revenue Recognition
The board of International Financial Reporting Standard have been making steady progress since July 2010 to re-deliberate the proposed guidance and have finalized their re-liberations on key revenue measurement and recognition issues. Some of the more significant decisions to date include:
Clarifying when performance obligations are distinct.
Confirming that offers to provide goods or services that the customer can provide to its customer are performance obligations.
Clarifying the criteria for when performance obligations are satisfied over time.
Retaining the proposals relating to the use of a residual approach to estimate the standalone selling price of a performance obligation.
Removing the requirement to assess onerous performance obligations.
Retaining the requirement to account for time value of money in contracts with a significant financing component.
Clarifying the objective of the constraint on recognizing revenue from variable consideration removing the exception for licenses of intellectual property where payments vary based on the customer's subsequent sales (for example, sales-based royalties).
Retaining the requirement to capitalize contract acquisition costs if they are incremental and recoverable.
Affirming collectability is not a threshold for revenue recognition and agreeing that initial and subsequent impairments of customer receivables should be presented as a separate expense item in the statement of comprehensive income.
Agreeing that a license is either a promise to provide a right which transfers at a point in time or a promise to provide access to intellectual property which transfers benefits to the customer over time; and
Deciding on disclosures, transition, and effective date for public companies and non-public companies.
The International Financial Reporting Standard substantively concluded re-deliberations of their joint 2011 exposure draft, Revenue from Contracts with Customers, in February 2013. The boards reached decisions on the remaining key issues including disclosures, transition, and effective date at their most recent meetings.
The boards' timeline indicates the final standard is expected in the second quarter of 2013. The standard will be effective for the first interim period within annual reporting periods beginning on or after January 1, 2017. Entities will have the option to apply the final standard retrospectively or use a simplified transition method. An entity will not restate prior periods if it uses the simplified method.
Details of these decisions, as well as a comprehensive look at the model at the end of the key re-deliberations, are included in this Data line. Any remaining "sweep" or new issues identified by the boards will be discussed at future board meetings, as needed.