revenue recognition relevant to ACCA Qualification Paper F7 (INT and UK) and Paper P2 (INT and UK) how much? For many companies, their revenue (ie their turnover/sales) will represent the largest single figure in the financial statements, and one that has a direct impact on the measurement of profit. Creative accountants wishing to report the maximum profit in the current period have long been aware that one way of achieving their goal is to overstate revenue. The overstating of revenue takes place when it is anticipated (recognised before it is earned), or is simply measured incorrectly. It is important, therefore, for accounting standards to give clear guidance on how much revenue to recognise, and when to recognise it. For many transactions, however, there is no controversy over when revenue should be recognised or how it should be measured. Consider the revenue recognition issues when, at lunchtime, I visit my local shop to buy a sandwich. The sandwich is on the shelf, marked at a price of, say, $10. I pick up the goods, approach the cashier, pay cash and leave the shop carrying the sandwich in my hand. I now have the benefit of ownership of the sandwich as I can consume it, but I also have the risk of ownership as if I drop it on the floor it will be my misfortune. This transaction (the buying of the sandwich) all takes place in less than one minute. From the shop s perspective, there is no doubt as to when the revenue should be recognised, as all the features of the transaction take place on the same day the passage of the risks and rewards of ownership, the completion of the contract, payment, and delivery all occur simultaneously. Nor is there any doubt that the sale should be measured at $10, as the consideration was paid in the simplest and most measurable way in the form of cash. However, with more complex transactions, such as those that take place over a period of time, the amount of revenue to recognise in a particular period can be less clear. Accordingly, accounting regulators have created accounting standards to try and ensure companies take a consistent approach. Accounting regulators are always trying to enhance the usefulness of the financial statements by introducing accounting standards that create reliability and consistency, and thus comparability. With reference to IAS generally accepted accounting principles (GAAP) and UK GAAP, while the principles behind revenue recognition regulations are similar, the details of the accounting regulations can vary. A summary of the current IAS GAAP and UK GAAP on revenue recognition is given below. IAS 18, Revenue Recognition The IASB has long had an accounting standard on revenue recognition IAS 18, Revenue Recognition. The stated objective of IAS 18 is to prescribe the accounting treatment for revenue arising from certain types of transactions and events. Revenue is defined by the standard as the gross inflow of economic benefits (cash, receivables, other assets) arising from the ordinary operating activities of an enterprise (such as the sale of goods, sale of services, interest, royalties, and dividends). IAS 18 quite sensibly requires that revenue should be measured at the fair value of the consideration receivable. In effect, this means that where consideration is deferred, the time value of money has to be taken into account so that the revenue is measured at the present value of the future cash flow. When a payment is received in advance from customers, the company should recognise a liability, which is its obligation to provide goods and services. Sale of goods When selling goods, IAS 18 requires that revenue should be recognised only when all of the following conditions have been satisfied: The seller has transferred to the buyer the significant risks and rewards of ownership. The seller retains neither continuing managerial involvement to the degree usually associated with ownership, or effective control over the goods sold. The amount of revenue can be measured reliably. It is probable that the economic benefits associated with the transaction will flow to the seller. The costs incurred (or to be incurred) in respect of the transaction can be measured reliably. Services When providing a service, IAS 18 requires that revenue should only be recognised when all of the following conditions are met: The amount of revenue can be measured reliably. It is probable that the economic benefits will flow to the seller. The stage of completion at the reporting date can be measured reliably. The costs incurred (or to be incurred) in respect of the transaction can be measured reliably. When the above conditions are met, then revenue should be recognised only to the extent that it is earned, ie by reference to the stage of completion of the transaction at the reporting date (the percentage of completion method). If the above conditions are not met, revenue arising from the rendering of services should be recognised only to the extent of the expenses recognised that are recoverable (a cost recovery approach ). SUMMARY OF UK GAAP Until November 2003, there was no UK accounting standard for revenue recognition. Different companies and industries had developed practices that were inconsistent with each other. There were also different views on what revenue represented. In the absence of a UK standard, a number of 52 student accountant January 2008
companies used IAS GAAP, or adopted the rules in US GAAP for revenue recognition. Clearly, this was unsatisfactory. In November 2003, the Accounting Standards Board (ASB) published an Application Note to FRS 5, Reporting the Substance of Transactions. At the time, the chairman of the ASB was quoted as saying: We do not anticipate that the new material will give rise to significant changes in the approach adopted by the majority of UK entities. However, some have rather pushed the envelope in their recent reporting practices. The Application Note will enable auditors to remind companies that turnover can only be recognised when a business has done what it has agreed with its customers it would do. The Application Note covers the basic principles in respect of the supply of goods and services, which apply in all cases. A seller enters into an exchange transaction with its customers under formal or informal contractual arrangements, under which it obtains the right to consideration. The seller, in return for the performance of its obligations, defines the right to consideration as the right to the amount received or receivable under a contractual arrangement with a customer for the supply of goods and services. Basic principles recognition The Application Note first considers when the right to consideration should be reported as turnover, and concludes that turnover should be reported when a seller transfers to customers, goods and services that are its business to provide (its operating activities). Accordingly, the proceeds from the sale of fixed assets do not normally give rise to turnover. Furthermore, it is noted that when a payment is received in advance from customers, the company should recognise a liability, which is its obligation to provide goods and services. A seller may obtain the right to consideration when it has performed some, but not all, of its contractual January 2008 student accountant 53
obligations. It would then recognise revenue to the extent that it has obtained the right to revenue through its performance. Basic principles measurement The Application Note states that revenue should be measured at the fair value of the consideration receivable. In effect, this means that where consideration is in the form of deferred consideration, then the time value of money has to be taken into account so that the revenue is measured at the present value of the future cash flow. Additional guidance In addition, the Application Note gives specific guidance in respect of the following situations: long-term contractual performance separation and linking of contractual arrangements bill and hold arrangements sales with rights of return presentation of turnover as a principal or agent. Long-term contracts The Application Note gives additional guidance on, but does not amend, the requirements of SSAP 9, Stocks and Long-term Contracts. The seller should recognise its right to consideration as changes in assets or liabilities and related turnover, over the course of the contract. Turnover recognised should represent the stage of completion of the contract, using the fair value of the goods or services supplied to the year end as a proportion of the total fair value of the contract. This will not necessarily be the same as the proportion of expenditure incurred compared to the total expenditure. The fair values should be those agreed at the start of the contract, unless the contract specifies that changes in price will be passed to the customer. Separation and linking of contractual arrangements The Application Note includes guidance on whether a contract should be accounted for as two separate transactions or one contract. A sale will be accounted for as two or more separate transactions when the commercial substance is that the components operate separately, in other words, only when: the seller can supply each component on a stand alone basis or as an optional extra or a different supplier could provide one component. This is sometimes referred to as unbundling of contracts. If components do not operate independently, or reliable fair values cannot be obtained for at least uncompleted components, the seller should account for them together. Bill and hold arrangements This is a contract for the supply of goods where the seller transfers the title but does not physically deliver the goods until a later date. The key issue in deciding whether to record turnover is whether the seller has performed its contractual obligations and transferred the principal risks and benefits of the goods to the customer. From the customer s point of view these include the following: Benefits right to obtain goods when required sole right to the goods and future cash flows from their sale to a third party insulation from changes in price charged by the seller. Risks slow movement being compelled to take delivery of goods which are obsolete or not readily saleable. The contract must meet all the following criteria for the seller to recognise change in its assets and turnover from a bill and hold arrangement: Bill and hold terms should fulfil the commercial objectives of the customer. Subject to the normal right to return, the seller has the right to consideration regardless of whether goods are shipped, at the customer s request, to its delivery address. The seller has not retained any performance obligations other than the safekeeping and shipping of the goods. Goods must be separately identified from the seller s other stock, and should not be capable of being used to fill other orders received between the date of the bill and the shipment of the goods to the customer. Goods must be complete and ready for delivery. In these circumstances, the substance is that the goods are an asset of the customer and therefore the seller recognises the change in assets and turnover. If all the criteria are not met then, in substance, the goods remain an asset of the seller in other words, there has been no sale. Stocks remain in the seller s balance sheet and any amounts received from the customer are included in creditors until the earlier of the following takes place: The criteria for recognising the sale under bill and hold arrangements are met. The goods are delivered to the customer. The stocks would then be removed from the balance sheet and any related creditor transferred to turnover. Sales with rights of returns The rights that the buyer may have to return the goods to the seller may be statutory, or may be explicitly or implicitly included in the contract. In the seller s accounts, the recognition of turnover and a contractual right to return are linked transactions. Turnover should therefore exclude 54 student accountant January 2008
the sales value of estimated returns. Usually, the seller can reliably estimate sales returns from past experience. However, if the seller cannot reliably estimate the expected value of returns, the maximum value as per stated in the contract should be excluded from turnover. In extreme cases, where no reasonable estimate can be made and substantially all the risks remain with the seller, the seller should not record turnover. Any payment received from the customer is included in creditors. Presentation of turnover as a principal or agent A principal supplies goods or services on its own account, whereas an agent receives a fee or commission for arranging the provision of goods or services by the principal. To be a principal, an entity must be exposed to all significant benefits and risks for either (or both) the selling price and the stock (eg obsolescence, damage). If the seller acts as a principal, then turnover is reported as the gross amount received or receivable under the contract. However, if the seller is acting as an agent then the revenue to be recognised is the commission receivable, to be reported as turnover (amount billed to the customer less the amount paid to the principal). EXAMPLES IN APPLYING REVENUE RECOGNITION Let us review our understanding of revenue recognition through a series of mini case studies. These are applicable to both IAS GAAP and UK GAAP, although, for simplicity, all transactions are given in dollars. EXAMPLE 1 On 1 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 $6,000 and once paid are non-refundable. All books and materials have to be purchased separately. The student pays a first instalment of $3,000 prior to the commencement of the course, and the balance of $3,000 in six, $500 monthly instalments. The tuition provider has a financial year-end of 31 December, and proposes to recognise revenue in the financial accounts on a cash receipt basis. At the year end, the three, monthly instalments due have been received. Advise the tuition provider on the correct accounting treatment for EXAMPLE 2 On 1 November 20X0, a car retailer agreed to sell a motor vehicle for $20,000. At that time, the customer negotiated a three year free service agreement as part of the transaction. This service agreement is normally sold for $1,000. Also, on 1 November 20X0, the customer paid a non-refundable deposit of $2,000. A further $10,000 is payable three months later on 1 February 20X1. The customer has taken advantage of an interest-free offer and will pay the balance of the $8,000 on 1 February 20X3. Delivery of the car to the customer will take place on 1 February 20X1. The car retailer has a financial year end of 31 December and proposes to recognise the sale of the car at $20,000 in the financial accounts for the current year. Advise the car retailer on the correct accounting treatment for EXAMPLE 3 On 1 December in the current year, an Internet travel agent accepts a payment by credit card of $1,000 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 $1,000 from the customer (Dr Cash $1,000), the Internet travel agent proposes to immediately recognise $1,000 as revenue in the current year (Cr Sales $1,000). 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 31 December. Advise the Internet travel agent on the correct accounting treatment for EXAMPLE 1 ANSWER At 31 December, it is necessary to determine how much revenue is to be recognised in respect of the provision of tuition, ie in the sale of a service. The proposal is to recognise revenue of $4,500, 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, ie sales should be $3,000. While there are some staged payments, ie there is an 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 receivable to arrive at the fair value of the consideration. The $1,500 received, but not yet recognised as revenue at the reporting date, is to be regarded as deferred income. While the monies are said to be non-refundable there is, in fact, an obligation to complete the contract. As deferred income, it is included in 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. Although not asked for, the correct treatment can be summarised in journals as follows: January 2008 student accountant 55
Dr Cash 4,500 Being the receipt of cash Cr Revenue/Sales 3,000 Being the revenue earned being recognised Cr Deferred income 1,500 Being the monies received in advance of the delivery of the services EXAMPLE 2 ANSWER First let us consider the timing of the transaction when the sale takes place. This transaction is for the sale of goods, and we should determine when the risks and rewards of ownership have left the retailer. The timing of the sale is, therefore, 1 February 20X1, 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 therefore be recognised in the current accounting period. The car retailer has received $2,000 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 31 December 20X0, there has been no performance of the contract. While the deposit is said to be non-refundable, the car dealer does have an obligation to complete the contract. Accordingly, deferred income is included in the statement of financial position/balance sheet as a liability 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 ($1,000) should be acknowledged separately and then recognised over the three years. Second, the deferred consideration of $8,000 that will be received two years after the sale, should be measured at fair value by being discounted to a present value to reflect the time value of money. Although not asked for, all of this could be summed up in journals as follows if we assume a discount rate of 10% for measuring the time value of money: 1 November 20X0 Dr Cash 2,000 Being the receipt of cash Cr Deferred income 2,000 Being monies received in advance of the sale being recognised and so deferred income 1 February 20X1 Dr Deferred income 2,000 To clear out the b/f deferred income account Dr Cash 10,000 Being the receipt of cash Dr Debtor/ Receivable 6,612 Measured at present value with a discount rate of say 10% (8,000/1.1 2 Cr Deferred income 1,000 In respect of the monies received in advance for the three-year service agreement Cr Sales/Revenue 17,612 Revenue in respect of the car balancing figure EXAMPLE 3 ANSWER 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 the night. The revenue that it should recognise, therefore, should be confined to the commission that it is due. This is only $100. This revenue is earned on 1 December and can be recognised immediately in the current accounting period. The balance of the monies that it has received is to be recognised as a liability. While 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. Although not asked for, to sum up in journal form, the correct treatment is: Dr Cash 1,000 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 REVENUE RECOGNITION NEW DEVELOPMENTS There are proposals to produce a new accounting standard on revenue recognition, based on two key principles: The Fundamental Revenue Recognition Principle A reporting entity should recognise revenues in the accounting period in which they arise and measure them at their fair value on the date that they arise if it can determine both their occurrence and measurement with sufficient reliability. The Fundamental Measurement Principle A reporting entity should measure revenues arising from an increase in its assets or a decrease in its liabilities (or a combination thereof) at the fair value of that increase or decrease. Visit www.iasplus.com for further details of current accounting developments. Tom Clendon FCCA is a lecturer at Kaplan Financial 56 student accountant January 2008