Revenue Recognition

1 Business Context

Revenue recognition and measurement is crucial to reporting financial performance. In recent years, different entities operating within the same business sector have adopted varying practices for revenue recognition, which has led to marked variations in the timing and measurement of revenue and hence profit. Aggressive earnings management policies have resulted in questionable revenue recognition practices. Many of the high profile accounting scandals of recent years have involved the manipulation of revenue, with revenue being recognized in an inappropriate manner leading to hugely inflated reported profits. In part the dot.com boom was fuelled by similarly aggressive revenue recognition policies. An effective and credible accounting standard on revenue is essential to ensure capital market confidence in corporate reporting, which is the purpose of IAS 18 Revenue.

2 Chapter Objectives

This chapter deals with:

 the recognition, measurement and disclosure of revenue in the statement of comprehensive income; and

 the different types of revenue; that arising from the sales of goods, the rendering of services and in other forms such as interest, royalties and dividends. On completion of this chapter you should be able to:

 demonstrate a knowledge of the objectives and scope of IAS 18;

 demonstrate a knowledge of the important terminology and definitions which relate to revenue;

 demonstrate an understanding of the key principles of revenue recognition; and

 apply IAS 18 knowledge and understanding in particular circumstances, through basic calculations.

3 Objectives, Scope and Definitions of IAS 18

Income is defined in the IASB Framework as ‘increases in economic benefits in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity.’ Revenue is simply income that arises in the course of the ordinary activities of the entity and is often known by different names, including sales, turnover, fees, interest, dividends and royalties. [IAS 18.7] The primary issue in accounting for revenue is one of timing. When should an entity recognize revenue? The timing of the recognition is critical to the timing of profits. Financial statements are prepared on the underlying assumption of the ‘accrual basis’ of accounting. Under this basis, the effects of transactions or events are recognized when they

occur rather than when the cash is received or paid. IAS 18 states that revenue should be recognised when it is probable that the economic benefits associated with the transaction will flow to the entity and these benefits can be measured reliably. IAS 18 applies to: [IAS 18.1]

 the sale of goods, which includes both goods produced by the entity for sale and goods purchased directly for resale;

 the rendering of services, which typically involves the performance of a contractually agreed task over an agreed period of time; and

 revenue earned from the use by others of the entity’s assets including interest, royalties and dividends earned by the entity.

Amounts collected on behalf of others, including sales taxes, value added taxes and amounts collected as agent on behalf of a principal, are excluded from the revenue figure.

4 Measurements

IAS 18 sets out that revenue should be measured at the fair value of the payment, which may take a number of different forms (i.e. it is not limited to cash), received or receivable.

The amount of the payment will normally be expressed in the agreement between the buyer and the seller. Revenue is measured net of trade discounts or volume rebates that are given. Generally cash will be paid on receipt of the goods or services, or within a short credit period of, say, 30 days. However, where payment is deferred for a long period of time to provide the buyer with an interest-free credit period, the deferred cash payment includes a form of financing. A typical example is a retail outlet selling furniture or household electrical equipment on a year’s interest-free credit. In such cases the entity will need to assess what the fair value of the payment is. This is determined by estimating what value the debt could be exchanged for between willing parties. The difference between the fair value and the actual amount paid will be classified as interest revenue.

Illustration 1

A company sells goods to a customer for CU2,500 on 5 July 2007. Although delivery will take place as soon as possible, the company has given the customer an interest-free credit period of 12 months. The fair value of the consideration receivable is CU2,294. In other words, if the company tried to sell this debt to a debt factoring company it would expect to receive CU2,294 rather than CU2,500. The balance of CU206 represents interest revenue. Therefore the company should split the CU2,500 between revenue and interest. Revenue of CU2, 294 should be recognized on 5 July 2007, with the balance of CU206 being recognized as interest revenue over the 12-month credit period. Where the entity receives similar goods or services as payment this is essentially a ‘swap’ transaction. The entity is replacing one asset with another similar asset. In such cases no revenue is generated, with no additional cost reported. Such transactions are quite common in the sale of commodities, for example milk, with suppliers exchanging inventories to fulfill demand in a particular location. When the payment is receivable in the form of dissimilar goods or services, revenue is generated and costs should be recognized. In such cases the transaction is measured based on the fair value of what will be received. If it is not possible to measure the value of the goods or services received reliably, then the revenue should be based on the fair value of the goods or services supplied.

5 Recognition of the Sale of Goods

IAS 18 sets out five criteria that need to be met before revenue from the sale of goods should be recognized. The five criteria are that:

1 the significant ‘risks and rewards’ of ownership have been transferred from the seller to the buyer. In a simple scenario this will be when the legal title or actual possession of the goods passes between the two parties. The retention of insignificant risks and rewards would not necessarily prevent the recognition of the revenue. This might be the case in the retail industry where an item may be returned and a refund provided;

2 the seller no longer has management involvement or effective control over the goods;

3 the amount of the revenue can be measured reliably;

4 it is probable that payment for the goods will be received by the entity. The effect of this is that the revenue in relation to credit sales is recognized before actual payment is received; and

5 the costs incurred, or to be incurred, in relation to the transaction can be measured reliably. It may be difficult to estimate the costs in relation to a transaction in certain circumstances; however that does not prevent a reliable estimate being made, and therefore should not stop revenue being recognized. The provision of a warranty is an example of this. If, however, it is not possible to estimate reliably the costs to be incurred, this precludes the recognition of revenue and therefore any payment received should be recognized as a liability. As stated above in criterion 1, revenue should not be recognized until the ‘risks and rewards’ of ownership have been transferred to the buyer. The seller may retain significant risks and

rewards of ownership in a number of ways. Examples of these are as follows:

(a) the seller retains some obligation for unsatisfactory performance which is outside a normal warranty cover; and

(b) the particular goods, although shipped, may require installation by the seller as part of the contract before the buyer can utilize the goods (revenue should not be recognized until the full installation process has been completed). In (a) the seller retains a significant risk that the goods will not perform, and in (b) the buyer is not yet able to gain the rewards associated with using the goods. In both cases no revenue would be recognized.

Illustration 2

A motor car is sold for CU20,000 on 1 March 2007, and includes a two-year manufacturer’s warranty. As a special promotion a deferred payment option is being offered by the manufacturer – ‘buy now, pay in 12 months’ time’. The dealer has a 31 December year end. The following steps are needed to account for the sale:

 split the CU20,000 payment between the cash sale price and the effective interest;

 recognize the cash sale price as revenue on 1 March;

 recognize interest income for the 10 months’ credit given in the accounting period in

which the sale is recognized;

 recognize the remaining 2 months’ interest in the following period;

 production and selling costs will be recognized in the same period that the revenue relating to the sale of the motor car is recognized;

 a warranty provision will be set up in the period in which the revenue relating to the sale of the motor car is recognized for expected costs under the warranty provision (in accordance with IAS 37 Provisions, contingent liabilities and contingent assets); and

 costs incurred under the warranty provision will be charged to the warranty provision to the extent that the provision covers the costs. Any excess costs incurred will be recognized in profit or loss and any balance remaining on the provision at the end of the second year will be released to profit or loss..

6 Recognition of the Rendering of Services

The criteria for the recognition of revenue in relation to the rendering of services are similar to those for the sale of goods. However, the criteria which refer to ownership are clearly not relevant where services are being provided. Criteria 3 - 5 above are, however, equally relevant to the rendering of services. In addition, the entity should be able to assess accurately the stage of completion of the transaction. [IAS 18.20] Issues in relation to completion arise when a contract for services extends beyond the end of

the current accounting period. Some part of the total revenue needs to be recognized in the current period, with the remainder being carried forward to the future periods. This split of revenue is usually made by reference to the stage of completion of the contract. IAS 18 specifically mentions three methods of assessing the stage of completion but does not prohibit the use of other methods. The three methods are:

1 surveys of work performed;

2 assessing the services performed to date against the total services to be performed under the contract; and

3 assessing the costs incurred to date against the total costs to be incurred under the contract. It is generally not appropriate to recognize revenue based on payments received under the contract, as often stage payments set out under the terms of the contract bear little resemblance to the actual services performed. If the overall outcome of a service transaction cannot be estimated reliably, then revenue is only recognized to the extent that costs incurred to date are recoverable from the customer. If

costs are not recoverable under the contract, revenue should not be recognized although costs incurred should be expensed.

Illustration 3

An entity enters into a CU210,000 fixed price contract for the provision of services. At the end of 2007, the first accounting period, the contract is assessed as being one-third complete, and costs incurred to date are CU45,000. If costs to complete can be estimated reliably at CU90,000, the overall contract is profitable,

as the total revenue of CU210,000 exceeds total costs (CU45,000 plus CU90,000). Revenue to be recognized in the first accounting period will be CU70,000, calculated as one-third of the total contract revenue. Costs of one-third of total estimated costs i.e. CU45,000 would also be recognized and matched against the related revenue. If the costs to complete cannot be estimated reliably, then the outcome of the total contract cannot be estimated reliably, and revenue is recognized to the extent that the costs incurred

are believed to be recoverable from the client.

7 Recognition of Revenue Generated on Entity Assets

Assuming an entity is able to measure reliably the revenue and that it expects to receive payment, the recognition of revenue generated on the use by others of the entity’s assets should be recognized as follows:

 Interest should be recognized on a time basis;

 Dividends should be recognized when the entity, as a shareholder, has a right to receive payment. This is usually when the dividends are declared, rather than when they are proposed; and

 royalties should be recognized on an accrual basis, i.e. they should be recognized as they fall due under the terms of the relevant agreement.

8 Disclosure Requirements

The entity should clearly set out its accounting policy for the recognition of revenue in the notes to the financial statements. This description should include any methods used to assess the stage of completion of transactions. If revenue has been recognized from the exchange of goods or services, this amount should be clearly identified for each category of revenue. Revenue should be analysed into a number of different categories where the amount recognized is significant. Categories include, for example, the sale of goods, the rendering of services, interest, dividends and royalty payments. [IAS 18.35]

9 Practical Application and Examples

IAS 18 includes an appendix of illustrations of how to apply its concepts in a variety of particular circumstances. What follows is a selection of the more commonly encountered applications.

9.1 Consignment sales

Under such arrangements, the buyer takes delivery of the goods and undertakes to sell them

on, on behalf of the original seller. Although the buyer takes delivery of the goods, he is in

such circumstances really acting as an agent on behalf of the original seller. The original seller only recognizes his sale when his buyer sells the goods on to a third party, since it is only at this point that the seller passes on the significant risks and rewards of ownership. This treatment is also relevant in sale and return transactions, i.e. revenue should not be recognized until the goods are sold to third parties.

Illustration 4

An entity sells recorded music from emerging artists through a number of retail outlets. The outlets can return any unsold material within three months of receipt. The artists are unproven in a commercial market and it is unclear if the sale of the music will be successful. There is uncertainty about the timing of receipts from the retailers. This uncertainty is only removed when the retailer sells the music or the three-month period has expired. The risks and rewards of ownership do not pass until the retailer has sold the music. Revenue should be recognized at the end of the three-month return period, or when the retailer has sold the music if earlier (this could be based upon monthly returns demanded from the retailer).

9.2 Subscriptions to publications

Where a series of publications are subscribed to and each publication distributed is of similar value, revenue should be recognized on a straight-line basis over the period of the subscription. Where the value of each publication varies, revenue is recognized based on the value of the individual publication compared with the total subscription paid.

9.3 Servicing fees included in the price of the product

When the sale price for goods includes an amount in relation to the ongoing servicing of the product, and the servicing element is identifiable, it should be deferred and recognized as revenue over the period of the service contract.

Illustration 5

On the last day of the current accounting period an entity completes the handover of a new system to a client at an agreed price of CU800,000. The price includes after-sales support for the next two years. The cost of providing the support is estimated at CU48,000 per annum, and the entity earns a gross profit of 20% on support contracts. The after-sales support revenue should be deferred and recognised over the next two years and should include a reasonable element of profit. This is often computed by reference to

similar contracts. The revenue deferred on the after-sales contract will be CU60,000 (cost and the 20% gross profit on selling price) per annum. The revenue to be recognised on the handover of the system will be CU680,000 (CU800,000 – (2 x CU60,000)).

9.4 Advertising commissions

Revenue should be recognized for media commissions, for example running a series of advertisements, when the related advertising appears before the public.

9.5 Franchise fees

Fees which are received for the use of continuing rights, granted as part of a franchise

agreement, should be recognized as revenue as the services are provided, or the rights are

used.

9.6 Agency transactions

No revenue is recognized when the party is acting as agent for another (the principal). In such transactions, the sale does not represent revenue of the agent who is, in fact, acting as ‘intermediary’ for another party. The agent is often paid a commission in such transactions, and it is this commission receivable which is, instead, recorded as revenue for the agent. 10 SIC-31 Barter Transactions Involving Advertising Services As mentioned earlier, some entities have been criticized in the past for adopting aggressive revenue recognition policies. One way this was done was by one entity exchanging advertising space on its website for advertising space on another entity’s website. Although no cash or other consideration changed hands, each entity would recognize revenue and costs in relation to these items, boosting their revenues and their perceived worth in the eyes of investors. SIC-31 Revenue – barter transactions involving advertising services states that unless specific conditions are met no revenue should be recognized in these circumstances, as it is not normally possible to measure reliably the fair value of such transactions; this means that the definition of revenue is not met.

11 IFRIC 13 Customer Loyalty Programmes

Customer loyalty programmes are a popular marketing tool used by a diverse range of businesses, from supermarkets to airlines to credit card providers. Entities have recognized such schemes in a number of different ways, such as:

 setting up a liability for an entity’s future obligation to supply something to a customer and recognizing the costs as a marketing expense; and

 deferring part of the revenue received which generated the customer reward. As a result IFRIC 12 Customer loyalty programmes was published and is applicable to accounting periods beginning on or after 1 July 2008. IFRIC 13 applies to customer loyalty programmes where an entity grants awards to its customers as part of a sales transaction and where customers can redeem, in the future, free or discounted goods or services. Such programmes should be recognized by an entity by treating the customer award as a separate component of the original sales transaction in accordance with IAS 18. The original sales revenue should be split on a fair value basis between the separate components of the sale and the amount allocated to the customer award deferred until the award is redeemed or, in the case of time-limited awards, entitlement to it lapses. The fair value of “award credits” is the amount which they could be sold for separately.

Illustration 6

A supermarket awards loyalty points to customers who use the supermarket’s own credit card to pay for purchases. The award is at the rate of one point for every CU250 charged to the card and each point entitles the customer to a certain credit against future purchases, without

time limit. The supermarket estimates the fair value of each point at CU5 and in one period CU250 million is charged to the supermarket’s credit card. The number of points awarded in this period is 1 million (CU250 million ÷ CU250) and at CU5 per point their total fair value is CU5 million. The supermarket defers revenue of CU5 million and recognizes the other CU245 million immediately. The deferred revenue of CU5 million will be recognized as the award points are redeemed. Where the entity supplies the awards itself, the deferred amount should be recognized as revenue when the award credits are redeemed (so in the case of the supermarket referred to in Illustration 6 when the customers claim their credits). The amount of revenue recognized should be based on the award credits redeemed as a percentage of the total expected to be redeemed. Where a third party supplies the awards, an entity needs to consider whether it is acting as agent or principal in relation to the transaction. If the entity is considered to be collecting the revenue for the award credits for itself (i.e. acting as principal) the entity should measure the deferred revenue as set out above. The revenue should be recognized when the entity no longer has any obligations outstanding in relation to the transaction. If the entity is collecting the revenue on behalf of the third party supplying the awards (i.e. acting as agent) it should only recognize the net amount of deferred revenue that it will retain. This amount should be recognized when the third party is obliged to deliver the awards and receive the consideration for doing so. The net amount retained by the entity will be the difference between the fair value of the revenue allocated to the award credits and the amount that it will have to pay the third party for delivering the awards themselves. If the unavoidable costs of delivering the promised awards to customers are greater than the revenue allocated to the award credits, then the entity has an onerous contract and should recognize a liability in accordance with IAS 37. [IFRIC 12.9]