ACCOUNTING STANDARDS BOARD JULY 2001 DISCUSSION PAPER DISCUSSION PAPER REVENUE RECOGNITION ACCOUNTING STANDARDS BOARD

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1 ACCOUNTING STANDARDS BOARD JULY 2001 DISCUSSION PAPER REVENUE RECOGNITION ACCOUNTING STANDARDS BOARD DISCUSSION PAPER

2 For the convenience of respondents, the text of the Invitation to Comment section of this Discussion Paper can be downloaded (in Word format) from the Revenue Recognition page in the Current Projects section of the ASB Website ( Comments should be addressed to: Phil Barden ACCOUNTING STANDARDS BOARD Holborn Hall 100 Gray s Inn Road London WC1X 8AL or sent by to: revenue.dp@asb.org.uk and should be dispatched so as to be received not later than 31 October All replies will be regarded as on the public record unless confidentiality is requested by the commentator.

3 REVENUE RECOGNITION ACCOUNTING STANDARDS BOARD DISCUSSION PAPER

4 The Accounting Standards Board Limited 2001 ISBN

5 REVENUE RECOGNITION CONTENTS page Summary 2 Preface and invitation to comment 8 Chapter 1 What should revenue represent? 22 Chapter 2 Revenue and contractual performance 45 Chapter 3 Chapter 4 Accounting for incomplete contractual performance 54 Rights of return and post-performance options 70 Chapter 5 Measuring consideration 92 Chapter 6 Other issues relating to contracts and performance 117 Chapter 7 Agency 135 Appendix A: Deep and liquid markets 140 Appendix B: Accounting for points schemes 144 Appendix C: FRS 5 and rights of return 147 1

6 REVENUE RECOGNITION SUMMARY At present in the UK and the Republic of Ireland, there is no accounting standard governing the recognition and measurement of revenue. Different entities and industries follow practices that are in some respects inconsistent with one another; more generally, there are different views of what revenue is or represents, and of how financial statements should portray a business s operating activities. In the longer term, it will be possible to agree on consistent solutions to the many and varied revenue problems and issues that arise in practice only if there is consensus on the overall objectives. Accordingly, this Discussion Paper examines revenue recognition and measurement from first principles. It sets out proposals intended to provoke discussion, with the longer-term aim of establishing a framework within which to address consistently revenue issues that arise in different contexts. The Paper asks first, in Chapter 1, what revenue which may be referred to by various names, including sales, fees, interest, dividends and royalties should represent in financial statements. It proposes the following definitions: In the context of a business operating cycle, revenue is the class of gains, before deduction of associated costs, arising as a result of benefit being transferred to a customer in an exchange transaction (ie under a contract). An operating cycle is a sequence of business activities, carried out with a view to profit, which involves the transfer of benefit to customers in exchange for consideration (ie payment). 2

7 SUMMARY Chapter 2 develops this definition of revenue, by exploring how benefit is transferred to customers in exchange transactions. It concludes that benefit is transferred when the seller honours the promises it has made under the contract in other words, performs its contractual obligations. In that light, the chapter builds on the definition of revenue from Chapter 1: In the context of a business operating cycle, revenue arises as a result of benefit being transferred to a customer through the seller s performance under a contract. Chapter 3 extends this discussion of performance to contracts where the seller s contractual performance is incomplete. It concludes that full performance is only sometimes necessary for revenue to arise, and suggests the following general principle for determining the extent to which revenue should be recognised on the basis of partial performance: Where contractual performance is incomplete, revenue should be recognised to the extent that the seller has performed and that performance has resulted in benefit accruing to the customer. Chapter 3 then considers, at a very high level, various techniques by which this general principle might be applied in practice. It acknowledges, however, that dealing with incomplete performance is likely to be the biggest single difficulty arising in practice, and that the application of the above proposal to specific industries will be an important part of the next stage of this project. 3

8 REVENUE RECOGNITION Chapter 4 considers how the approach developed above is affected by customer rights of return, which in effect give a customer the ability to unwind a contract after performance by the supplier has occurred. The chapter proposes the following two possible approaches to accounting for rights of return and asks for views on which is more appropriate: Expected sale approach: Where goods are transferred along with a right of return, revenue should be recognised on the transfer of benefit, with an appropriate adjustment to reflect the risk of returns. Accounting policy approach: Where goods are transferred along with a right of return, an entity should select and consistently apply whichever of the following accounting policies is most appropriate to its circumstances: either revenue should be recognised on the transfer of benefit, with an appropriate adjustment to reflect the risk of returns or revenue should be recognised on the expiry of the right to return. The most appropriate accounting policy should be judged by reference to the objectives and constraints set out in FRS 18 Accounting Policies, giving due weight to the objective of comparability between entities operating within the same industry. 4

9 SUMMARY Whereas earlier chapters have been concerned primarily with the recognition of revenue, Chapter 5 discusses measurement principles and associated issues. It makes the following proposal for the measurement of revenue: Revenue should be measured as the change in fair value, arising from the seller s performance, of (i) assets representing rights or other access to consideration and (ii) liabilities in respect of consideration received in advance of performance. By restricting revenue to gains that arise from the seller s performance, the Paper avoids the measurement of revenue being distorted by the timing of payment from a customer. Chapter 5 spells out in more detail that changes to the value of consideration arising from factors other than performance for example, the time value of money where a customer pays a long time in advance do not form part of the measurement of revenue: Assets representing rights or other access to consideration should be remeasured to reflect the effect of the time value of money, where this effect is significant. Such remeasurement does not arise from performance and does not, therefore, give rise to revenue. Liabilities in respect of consideration received in advance of performance should not be remeasured to reflect changes in the fair value of performance that has not yet occurred. They should, however, be remeasured to reflect the effect of the time value of money, where this effect is significant. Such remeasurement does not arise from performance and does not, therefore, give rise to revenue. 5

10 REVENUE RECOGNITION Chapter 5 also considers different types of barter transaction, and asks which of them should give rise to revenue. Referring back to the discussion in Chapter 1, the chapter proposes that what is important is the role that the transaction has in the entity s operating cycle: A transaction is with a customer and hence gives rise to revenue if, on its completion, the entity has been rewarded for eliminating the risks previously outstanding in the relevant operating cycle. Chapter 6 draws together some other issues relating to contracts and performance. It first asks how, in the light of Chapter 5, customer payments for options should be dealt with, setting out the following proposals: Where a customer pays for an option to require future performance from a seller, that payment gives rise to a liability, which should be released as revenue only when the future performance to which it relates occurs. Because the number of options that will lapse unexercised cannot be known with certainty, the relationship between proceeds and performance should be estimated at the outset, and estimates should be revised over the period of performance. The chapter next considers which activities of a seller should be taken into account when assessing the extent to which performance has occurred: An activity will constitute part of the performance of a contract only if it is a necessary part of the contract, in that it is specific to the customer and would not have taken place had the contract not existed. 6

11 SUMMARY Chapter 6 concludes with a discussion of some issues that arise when two parties each provide goods or services to the other: Two contracts should be accounted for separately if they are genuinely independent of one another, but should be treated as one larger contract if, either legally or economically, one is conditional or dependent on the other. Such economic dependence may arise if, for example, contract prices are set so far from fair value that there is no realistic prospect that the second contract will not follow from the first. Finally, Chapter 7 considers the recognition of revenue in the context of agency agreements, making the following proposals: When a principal transacts with a customer through a disclosed agent, the principal s revenue should reflect the full consideration payable by the customer in the transaction. The principal should treat any commission or other amounts payable to the agent separately as an expense and not as a reduction of revenue. When an entity acts as a disclosed agent, its revenue should reflect the amount of commission or other income receivable from its principal. When an entity acts as an undisclosed agent, it should account for revenue in the same way as a principal. 7

12 REVENUE RECOGNITION Preface and invitation to comment PREFACE Revenue and financial statements Introduction This Discussion Paper is being published by the Accounting Standards Board as a first step towards the development of an accounting standard. It is expected that such development will be conducted in consultation with the International Accounting Standards Board and other standard-setters, and comments from those bodies and their constituents will be particularly welcome. For most businesses, the recognition of revenue is what triggers the recognition of profits in financial statements. It is unsurprising therefore that, in many industries, issues surrounding the recognition of revenue and profit are amongst the most important and sometimes the most difficult facing accountants. Different approaches to revenue In the absence, in the UK and the Republic of Ireland, of an accounting standard dealing comprehensively with revenue, 1 preparers of financial statements have looked to various notions such as earning, realisation, accruals/matching and prudence in order to develop suitable approaches to the recognition of revenue and, hence, profits. Unfortunately, these notions sometimes point in opposite directions: different entities and industries have found different solutions, and this has led to practices that are in some respects inconsistent with one another. 1 SSAP 9 Stocks and long-term contracts discusses the recognition of revenue for long-term contracts, but not other contracts. 8

13 PREFACE AND INVITATION TO COMMENT This inconsistency is not merely a practical problem. It reflects different views of what revenue is or represents, and of how financial statements should portray a business s operating activities. Moreover, the range of different views on these matters is likely to increase as business activities become more complex and financial reporting develops. In the longer term, it will be possible to agree on consistent solutions to the many and varied revenue problems and issues that arise in practice only if there is consensus on the overall objectives. The objective and structure of this Paper Accordingly, this Paper examines revenue recognition and measurement from first principles, with the aim of establishing a framework within which to address consistently revenue issues that arise in different contexts. It does this by considering the following questions in turn. Chapter 1 asks what revenue which may be referred to by a variety of names, including sales, fees, interest, dividends and royalties should represent in financial statements. It proposes that, although gains may in principle arise, and perhaps be recognised, at various stages in an entity s operating cycle, revenue arises only when benefit is transferred to a customer under a contract ie in an exchange transaction. Chapter 2 develops the proposal from Chapter 1, by considering how benefit is transferred to customers in exchange transactions. It proposes that revenue arises as a result of a seller s performance of its obligations under a contract ie contractual performance. Chapter 3 extends the discussion from Chapter 2 to contracts where the seller s contractual performance is incomplete. It proposes that, in such circumstances, revenue should be recognised to the extent that the seller has performed and that performance has resulted in benefit 9

14 REVENUE RECOGNITION accruing to the customer. It acknowledges that dealing with incomplete performance is likely to be difficult in practice, and that the application of this proposal to specific industries will be an important part of the next stage of this project. Chapter 4 considers the impact of the preceding discussion on customer rights of return, which in effect give a customer the ability to unwind a contract after performance by the supplier has occurred. The chapter proposes two possible approaches to accounting for rights of return and asks for views on which is more appropriate. Whereas earlier chapters have been concerned primarily with the recognition of revenue, Chapter 5 discusses measurement principles and associated issues. It proposes that revenue should be measured as the change in fair value, arising from the seller s contractual performance, of (i) the seller s assets representing rights or other access to consideration and (ii) its liabilities in respect of consideration received in advance of performance. Chapter 6 considers other issues relating to contracts and performance. Finally, Chapter 7 considers the recognition of revenue in the context of agency agreements. Matters not addressed in this Paper Although revenue recognition is often closely linked with profit recognition, this Paper makes proposals only in respect of revenue, and not for profit recognition in itself. This is mainly to prevent the project becoming unmanageably large and to ensure that the debate focuses, for the time being, exclusively on revenue. 10

15 PREFACE AND INVITATION TO COMMENT Similarly, although it draws on examples, the Paper does not address revenue issues that have arisen in specific industries. This is because the objective at this stage is to develop consistent general principles, rather than to consider their application to specific circumstances. In some contexts, applying the general principles proposed in the Paper is likely to require careful and detailed consideration of associated industry issues. Accordingly, the Board is asking respondents for their views at this stage on the application of the principles to industries with which they are familiar. Such views will be valuable to the Board when refining the Paper s proposals. Existing approaches to revenue recognition The accruals concept and realisation Existing approaches to revenue recognition in the UK and the Republic of Ireland tend to draw on notions such as the accruals concept and realisation. The discussion below explains why, in the light of the Board s Statement of Principles for Financial Reporting, 2 this Paper is driven primarily by the former and not at all by the latter. 3 The accruals concept requires the effects of transactions and other events to be reflected, as far as is possible, in the financial statements for the accounting period in which they occur. This means that, where an entity trades for profit, the financial reporting objective is for that profit to be recognised providing it can be measured reliably in the period in which it arises, not before and not after. 2 for convenience, hereafter abbreviated to the Statement of Principles. 3 In the UK and the Republic of Ireland, companies legislation includes requirements based on the notion of realisation. Legal issues are discussed later in this Preface. 11

16 REVENUE RECOGNITION It is not always easy to determine precisely when profit arises, and the recognition of profit has, historically, been based on additional criteria. Profits have been recognised only when realised in the form either of cash or of other assets the ultimate cash realisation of which can be assessed with reasonable certainty. In other words, the notion of realisation has been used to ensure that only profits that are reasonably certain and unlikely to reverse are included in the profit and loss account. 4 The use of realisation as a basis for revenue recognition is not without difficulties. The notion can be difficult to interpret, which increases the risk that it may be inconsistently applied, particularly in complex situations. Moreover, use of the notion does not always avoid difficult questions about when revenues arise for example, where goods or services are paid for in advance under a binding contract. Difficulties in applying the notion are exacerbated by the increasing use in business transactions of consideration other than cash such as shares and share options and the development of new markets. The difficulties in understanding and applying the notion of realisation, and the developments that call into question its appropriateness in some circumstances, make it worth revisiting the basis on which revenues and profits are recognised. Rather than adopting the notion of realisation, the Statement of Principles states that assets and liabilities and hence gains, which result from changes to assets and liabilities should be recognised when they exist and are capable of being measured reliably. Accordingly, the main focus of this Paper is on the process that brings revenues into existence, rather than on when they become realised. 4 This Paper refers to the profit and loss account to be consistent with present generally accepted accounting practice. If proposals set out in FRED 22 Revision of FRS 3 Reporting Financial Performance (published in December 2000) are implemented, the profit and loss account will be replaced by a statement of financial performance. However, the only effect on this Paper would be to change the name used to refer to that primary statement. 12

17 PREFACE AND INVITATION TO COMMENT The Statement of Principles also reflects developments in the accruals concept that have occurred since it was discussed in SSAP 2 Disclosure of accounting policies. 5 In describing the accruals concept, SSAP 2 referred to revenue and costs being matched with one another so far as their relationship can be established or justifiably assumed, and dealt with in the profit and loss account of the period to which they relate. The Statement of Principles does not refer to matching, but instead focuses on reflecting the effects of transactions and other events in the period in which they occur. This change of focus directly affects the way that profits are recognised, but primarily in terms of when expenses are recognised rather than revenues. As such, it has rather less impact on this Paper than does the change in the role played by the notion of realisation. Revenue recognition outside the UK and the Republic of Ireland Although there is much accounting literature outside the UK and the Republic of Ireland dealing with revenue recognition, it may be particularly helpful to draw attention to the positions under International Accounting Standards (IASs) and in the USA. International Accounting Standards The main body of IAS 18 (revised 1993) Revenue includes both a revenue recognition objective and detailed application rules, and an appendix illustrates the application of the standard to a number of commercial situations. In the absence of a relevant accounting standard in the UK and the Republic of Ireland, IAS 18 has often been used as a source of guidance. 5 SSAP 2 has since been superseded by FRS 18 Accounting Policies. The discussion of the accruals concept in FRS 18 is based on that in the Statement of Principles. 13

18 REVENUE RECOGNITION The discussion in this Paper is broadly consistent with the objective described in IAS 18. However, although the application rules in IAS 18 reflect generally accepted accounting practice, the mechanism by which they were derived from IAS 18 s objective is not always precisely clear. Accordingly, this Paper focuses on underlying principles, seeking to demonstrate how its proposals are built up from them. As noted earlier, this Paper is intended to contribute to an international debate, which may involve a revision of IAS 18. Revenue recognition in the USA Although revenue is defined in a concepts statement, 6 revenue recognition in the USA is governed primarily by a number of accounting standards, most of which are industry-specific. In contrast, the Board s preference at this stage is to seek to develop a single accounting standard setting out general principles for revenue recognition; if necessary, industry-specific issues can be dealt with in Application Notes or industry guidance. In addition to the accounting standards mentioned above, SEC Staff Accounting Bulletin No. 101 Revenue Recognition in Financial Statements (SAB 101) identifies four criteria for the recognition of revenue. The staff believes that revenue generally is realized or realizable and earned when all of the following criteria are met: Persuasive evidence of an arrangement exists, Delivery has occurred or services have been rendered, The seller s price to the buyer is fixed or determinable, and Collectibility is reasonably assured. 6 The US Financial Accounting Standards Board s Statement of Financial Accounting Concepts No. 6 Elements of Financial Statements. 14

19 PREFACE AND INVITATION TO COMMENT The principles underlying these criteria are discussed in this Paper, though it approaches some of them in a slightly different way. The Paper proposes that a contract must exist before revenue can be recognised and generally a contract is not enforceable in law unless it specifies a price that is either fixed or determinable. The Paper also links the recognition of revenue to contractual performance, which will generally encompass delivery or the rendering of services. Finally, collectability is implicitly a factor in the proposal in Chapter 5 that consideration receivable should be measured at fair value. 7 It should, however, be emphasised that, although the Paper focuses on principles that are in essence similar to those identified in SAB 101, the two documents will not always be consistent in their detailed application. Other matters Terminology In the Statement of Principles, the terms gains and losses refer, broadly speaking, to inflows and outflows of economic benefit. Thus, in the context of the sale of an item of stock, the Statement of Principles refers to the sale proceeds and the cost of the item sold as a gain and a loss respectively. In other contexts, however, gain is commonly used to refer to a net increase in total assets less total liabilities; for example, in a contractual exchange, gain is often used to refer to the net of the sale proceeds and the cost of the item sold. Generally this Paper uses gain (or profit, where that term is more comfortable) to mean a net increase in total assets less total liabilities. In other words, gain is most often used to mean either the net of sale proceeds and the cost of an item sold or, where operating activities increase the value of an asset still held, 7 The term fair value is discussed later in this Preface. 15

20 REVENUE RECOGNITION the excess of that increase over associated expenses. However, in the Paper s proposed definition of revenue, gain should be understood in the gross sense of the Statement of Principles, eg before deducting the cost of the item sold. The Paper uses the term fair value when discussing both the measurement of incomplete contractual performance (in Chapter 3) and the measurement of consideration (in Chapter 5). However, it does not enter into a detailed discussion of the meaning of the term. This is in part because the Board does not think such a discussion necessary for the Paper s examination of general principles; moreover, the interpretation of fair value is still a matter for discussion between standard-setters. Accordingly, for the purposes of this Paper, the term fair value should be understood in the sense in which it is defined in FRS 13 Derivatives and other Financial Instruments: Disclosures : The amount at which an asset or liability could be exchanged in an arm s length transaction between informed and willing parties, other than in a forced or liquidation sale. FRS 5 Reporting the Substance of Transactions Some of the discussion in this Paper, particularly that in Chapter 4 dealing with rights of return, is concerned with matters also falling within the scope of FRS 5 Reporting the Substance of Transactions. The approach taken in the Paper, like that in FRS 5, is to ask what effect a transaction has had on assets and liabilities. Generally, however, the Paper does not draw in more detail on the analysis in FRS 5. Appendix C briefly summarises how FRS 5 deals with rights of return. 16

21 PREFACE AND INVITATION TO COMMENT Reliable measurement A necessary condition for the recognition of revenue and/or profit is that reliable measurement is possible. Reliable measurement is discussed in Chapter 5, but the condition that reliable measurement is possible should be taken as applying throughout the Paper, including where, for ease of reading, it is not made explicit. Legal issues The Paper is concerned primarily with the principles underlying revenue recognition, rather than their detailed application, and its proposals have been developed with an international context in mind. Accordingly, the Paper does not consider legal issues that might arise if its proposals were to be implemented as a standard in the UK and the Republic of Ireland. Such issues will be addressed in a future exposure draft of a standard dealing with revenue recognition. Not-for-profit entities The Paper discusses revenue recognition in the context of entities trading for profit. It does not focus directly on not-forprofit entities, and in particular it does not consider nonreciprocal transactions, such as donations. Nevertheless, the discussion in the Paper may have some relevance for not-forprofit entities. INVITATION TO COMMENT The Board would welcome comments on any aspect of the Discussion Paper. Respondents views are especially sought on the matters set out below. It would be helpful if respondents could support their views with reasons and, where applicable, preferred alternatives. 17

22 REVENUE RECOGNITION Chapter 1: What should revenue represent? Q1 Do you agree that revenue should be a measure of exchanges with customers, irrespective of the extent to which gains may be recognised in advance of such exchanges? (If not, and if you would favour a wider value added definition of revenue, how would you respond to the associated difficulties highlighted under paragraph 1.38?) Q2 Do you agree that revenue should be defined in the context of the business operating cycle being presented? Chapter 2: Revenue and contractual performance Q3 Do you agree that revenue recognition should be driven by a seller s performance under a contract in transferring benefits to a customer? Chapter 3: Accounting for incomplete contractual performance Q4 Do you agree that, where contractual performance is incomplete, revenue should be recognised to the extent that the performance has resulted in benefit accruing to the customer? Q5 The Board envisages that measuring incomplete performance will be one of the most difficult issues arising. What practical problems do you foresee with the approaches to measuring incomplete performance, such as unbundling, proposed in Chapter 3? Could these approaches be amended or refined in order to deal with any difficulties that you foresee? 18

23 PREFACE AND INVITATION TO COMMENT Chapter 4: Rights of return and post-performance options Q6 When discussing how to account for goods transferred with a right of return, Chapter 4 considers and rejects an approach that would never recognise revenue until the option to return lapses. Do you agree that this approach should be rejected? Q7 Chapter 4 suggests two approaches that might be acceptable where goods are transferred with a right of return an expected sale approach and an accounting policy approach. Which of these approaches, if either, do you favour? If you favour neither approach, how would you account where goods are transferred with a right of return? Chapter 5: Measuring consideration Q8 Do you agree that revenue should reflect the amount to which a seller becomes entitled under a contract as a result of performance, rather than the fair value of that performance? If so, do you agree that revenue should be measured as the change in fair value, arising from the seller s contractual performance, of (i) the seller s assets representing rights or other access to consideration and (ii) its liabilities in respect of consideration received in advance of performance? Q9 Do you agree that revenue should not include changes in the fair values described in question 8 above arising from the time value of money rather than from performance? Q10 Chapter 5 proposes two possible approaches an expected sale approach and an accounting policy approach where the amount of revenue is determinable by a factor within the control of a customer. These alternative approaches are based on those discussed in Chapter 4 (see question 7 above). Which of these approaches do you favour, if either? If your answer to question 7 was different, what are the important aspects of each scenario that led you to different conclusions? 19

24 REVENUE RECOGNITION Q11 Do you agree with the analysis of the principles applicable to barter transactions in Chapter 5? In particular, do you agree that whether a transaction (such as a barter transaction) forms part of revenue should depend on whether, on its completion, the seller has been rewarded for eliminating the risks previously outstanding in the relevant operating cycle? Chapter 6: Other issues relating to contracts and performance Q12 Do you agree with the proposal in Chapter 6 that, where a customer pays for an option to require future performance from a seller, revenue relating to that payment should be recognised only when that future performance occurs? If so, do you also agree that, because the level of future option lapses cannot be known with certainty, the relationship between proceeds and performance should be estimated at the outset and revised over the period of performance? Q13 Do you agree that an activity should constitute part of the performance of a contract only if it is a necessary part of the contract, in that it is specific to the customer and would not have taken place had the contract not existed? Q14 Do you agree with the proposal that two contracts should be accounted for separately if they are genuinely independent of one another, but should be treated as one larger contract if, either legally or economically, one is conditional or dependent on the other? Chapter 7: Agency Q15 Where a principal transacts with a customer through a disclosed agent, do you agree that the principal s revenue should reflect the full consideration payable by the customer, with any commission or other amounts payable to the agent being treated as an expense and not as a reduction of revenue? 20

25 PREFACE AND INVITATION TO COMMENT Q16 Where an entity acts as a disclosed agent, do you agree that its revenue should reflect the amount of commission or other income receivable from its principal? Q17 Where an entity acts as an undisclosed agent, do you agree that it should account for revenue in the same way as a principal? Other matters Q18 The objective of this Paper is to explore general principles of revenue recognition, which can be refined and applied to a variety of specific industry issues. Do you have any comments at this stage on difficulties that may be encountered in applying this Paper s proposals to specific industry issues? Q19 The Board would welcome examples illustrating particular problems of revenue recognition that may or may not be dealt with by the proposals set out in this Paper. Could you provide the Board with examples that you believe it would be useful to consider? 21

26 REVENUE RECOGNITION Chapter 1 What should revenue represent? Summary 1.1 This chapter asks what revenue which may be referred to by various names, including sales, fees, interest, dividends and royalties should represent in financial statements. In discussing this question, the Paper considers how revenue, which is generally reported gross (ie before deducting associated expenses), might be distinguished from other gains, which are often reported net. Before this, however, the chapter considers: how revenue has been seen in a historical cost context, and the role it plays within financial statements when and how gains associated with operating activities come into existence how gains generally are recognised under current value and historical cost principles two different views of how gains arising from operating activities should be reported. 1.2 Based on the discussion of these matters, the chapter puts forward the following proposals, which are developed in subsequent chapters. 22

27 CHAPTER 1: WHAT SHOULD REVENUE REPRESENT? In the context of a business operating cycle, revenue is the class of gains, before deduction of associated costs, arising as a result of benefit being transferred to a customer in an exchange transaction (ie under a contract). An operating cycle is a sequence of business activities, carried out with a view to profit, which involves the transfer of benefit to customers in exchange for consideration (ie payment). 1.3 Although this Paper is concerned with the recognition of revenue rather than gains generally, much of this chapter focuses on gain recognition. This is necessary because one of the most important aspects of revenue, at least under historical cost accounting, is as a potential trigger for gain recognition. 1.4 Although the discussion considers how both revenues and gains generally might be recognised under current value principles, 8 this does not imply that the Board favours requiring entities to report using such an approach. The discussion of current value principles is included for the light it casts on how revenue should be recognised under historical cost principles. The Board expects that, as at present, most entities will continue to report revenues, and associated net gains, under historical cost principles. 8 For the avoidance of doubt, the current value principles discussed are not those of current cost accounting (CCA). Whereas CCA, in essence, updates a historical cost framework for changing prices (holding gains and losses), the current value principles discussed in this Paper are concerned with how gains arise from an entity s activities. 23

28 REVENUE RECOGNITION What should revenue represent? How has revenue been seen in a historical cost context? Revenue and exchange 1.5 In the past, revenue recognition questions have most often been concerned with when to recognise revenue, rather than asking what revenue is for a particular business. This is because for most businesses the answer to the second question has appeared obvious indeed, often so obvious that the question has not even needed asking. Nevertheless, it might be suggested, rather crudely, that revenue has been seen in terms of what you get paid for selling things. Identifying revenue often seems obvious, in that the what is usually cash, and selling things is easily distinguished from buying things because in the latter case a business usually parts with cash rather than receiving it. 1.6 Later, this chapter will consider why and how such an approach to revenue would need to be refined in order to be workable in less straightforward transactions. 9 At this stage, the main point to observe is that revenue recognition has been seen as linked to a process of exchange. The seller gives something to the customer (goods, services, rights) and, in exchange, becomes entitled to consideration, triggering the recognition of revenue. 9 For example, the answers may not always seem so obvious when attempting to apply such a commonsense approach to barter transactions. 24

29 CHAPTER 1: WHAT SHOULD REVENUE REPRESENT? 1.7 This notion of exchange has also been reflected in the balance sheet, in that the event of exchange has caused new assets to be recognised. For example, on the sale of goods a company has ceased to recognise stocks as an asset and has instead recognised cash or a debtor. Similarly, on the supply of services, although there was no asset in the balance sheet to derecognise, the supplier has nevertheless recognised a new asset: cash or a right to cash (ie a debtor) from the customer. Revenue and profit recognition 1.8 In a historical cost context, 10 the point of revenue recognition has also been the earliest point at which profits arising from the transaction have been recognised. In effect, before revenue has been recognised, any costs associated with the transaction have either been accumulated (as part of the cost of the asset to be exchanged) or charged as an expense; but because the carrying amount of the asset has not been remeasured, no profits have been recognised. For example, a manufacturer producing goods for stock has valued that stock by reference to historical costs associated with it, but has not recorded any gain arising from manufacturing activities until such time as the goods are exchanged. 10 References in this Paper to the recognition of revenues and profits in a historical cost context mean, in particular, a context in which stocks are carried at their historical cost and are not remeasured except to net realisable value, if lower. This is the norm for most businesses in the UK and the Republic of Ireland. 25

30 REVENUE RECOGNITION 1.9 Another way of thinking about this is to say that, in a historical cost context, profits have not arisen before the point of revenue recognition because this is the first point at which asset measurement may cease to be backward-looking and instead become forward-looking. Thus, stocks have been valued by reference to outflows (usually of cash) that have occurred in the past; 11 however, debtors have usually been valued by reference to inflows to be received in the future. In a sense, therefore, debtors have included profits whereas stocks have not. 12 The role of revenue in financial statements 1.10 The significance of revenue recognition is not limited to asset classification and the timing of profit recognition. In particular, when revenues and associated profits are reported under historical cost principles, the presentation of a revenue figure (such as sales or turnover) in the profit and loss account can help users of financial statements in two ways. 11 or outflows to which the business has become committed as a result of a past event. 12 For completeness, it should be noted that stock valuation in a historical cost context is not purely backward-looking, in that a forward-looking measure (net realisable value) is substituted if lower. This does not detract from the main point, however, which is that in a historical cost context the point of revenue recognition is the first point at which profits may be recognised. The inclusion of profit in the valuation of debtors is so generally accepted as to appear entirely obvious. Nevertheless, it should be noted that, in principle, historical cost accounting could have developed in a way that would have required cash to be received before profits could be recognised. Under such an approach, debtors would be measured at the historical cost (if any) of goods or services supplied, and asset measurement would cease to be backward-looking only on the receipt of cash. Equally, historical cost accounting could in principle have developed so that profits would be recognised on entering into a contract with a customer (though some strong arguments against this are discussed in Chapter 2). Under such an approach, the measurement of stocks would, like debtors, become forward-looking when a customer entered into a binding agreement to buy them. These points are picked up in the discussion of revenue and unexpired risk in Chapter 2. 26

31 CHAPTER 1: WHAT SHOULD REVENUE REPRESENT? For many businesses, the revenue figure is a key measure of economic activity during the period, in that it reflects the extent to which the business has supplied goods or services to customers. Revenue for a period can be compared with that for earlier periods, and with that of competitors, as part of an assessment of the business s performance. The separate disclosure of revenue and of costs enables users to compare a business s gross margin in percentage terms with that in earlier periods, and with that of competitors, and also to assess the sensitivity of gross profits to volume and price changes The usefulness of revenue information will of course vary from business to business. Nevertheless, to summarise the preceding discussion, it has been noted that in a historical cost context: revenue has traditionally been associated with exchanges with customers the point of revenue recognition is also the earliest point at which profits may be recognised the gross revenue figure presented in the profit and loss account may be useful as a measure of economic activity the separate gross presentation of revenue and associated costs may be useful when assessing trends in, and the quality of, profitability. 27

32 REVENUE RECOGNITION How and when do gains come into existence? 1.12 So far, this chapter has summarised how revenue has traditionally been seen in a historical cost context. Accordingly, the focus has been on how and when revenues and associated profits have been recognised in financial statements, but has not been on how and when gains may be thought to arise in the underlying business. The following paragraphs are therefore concerned with how and when gains come into existence Accountants are not accustomed to distinguishing existence from recognition in the context of revenue, but such a distinction is familiar for another class of gains. Specifically, where a tangible fixed asset such as a building increases in value, the gain will be recognised only if the business has a policy of revaluing such assets. Nevertheless, the gain exists irrespective of whether it is recognised It may of course be argued that there is an important difference between such a gain and a trading profit. Where a building increases in value, the gain will often be unrelated to any activity of the owner; it will simply reflect changing prices in the property market. It may therefore be described as a holding gain, in the sense that the property is still the same asset after the gain has arisen: it simply has a different value The gains that arise in a revenue context, however, are not for the most part holding gains. They are operating gains, in the sense that they arise as a result of the business s activities, rather than external price changes. Accordingly, in order to determine when gains arise in the operating cycle, it will be necessary to consider more carefully the factors that bring them into existence. 13 Although assets and liabilities can be said to exist in time, gains arise from changes to assets and liabilities and are by their nature of the instant. Nevertheless, for the sake of brevity, the following discussion refers to gains coming into existence, rather than referring always to changes in existing assets and liabilities. 28

33 CHAPTER 1: WHAT SHOULD REVENUE REPRESENT? The role of risk 1.16 The view outlined below, which is drawn on later in this Paper, is that in principle profits (ie operating gains) can be expected to come into existence only as a result of taking and eliminating risk This is of course a very imprecise statement, and there is much about it that must immediately be clarified. It is not the case that a business should, except by chance, expect to earn profits by taking unnecessary risks. Furthermore, a business that takes only necessary risks may still not be rewarded with profit. The following example may help to illustrate what is meant. Example 1.17: a component-testing business Suppose that the most efficient manufacturing process for a particular type of component results in a relatively high proportion that do not work on average, about 50 per cent. Suppose also that history has shown the skills needed to test such components are very different from those needed to be a manufacturer, so that manufacturers choose only to sell untested components. Thus separate businesses buy untested components, test them, throw away those that do not work and sell those that do. How does such a component-testing business make profits? To answer this question, it is necessary to consider how much someone will rationally pay for a tested component. The component-tester s potential customers have two choices; they can either buy untested components and do the testing themselves, or they can buy working components from a component-tester. 29

34 REVENUE RECOGNITION Suppose a potential customer chooses the former option. If the price of untested components is 1.00, and the failure rate is on average 50 per cent, then over the longer term the average cost per working tested component will be 2.00 plus the cost (say a further 1.00) of testing two components a total of However, if the potential customer chooses to buy tested components rather than test them itself, it will rationally pay more than 3.00 for a tested component. This is because the two situations are not directly comparable. If it tests the components itself, it is still bearing the risk that the failure rate will be higher (or lower) than the average of 50 per cent; if it buys tested components, it is not bearing that risk. 14 There is an analogy here with the rate of return that will be required on a risky investment. If an entity is choosing between two investments that are expected to generate the same rate of return, and one is more risky than the other, the entity will rationally choose the less risky investment. In order to choose the more risky investment, it will need to be offered a higher rate of return. Accordingly, the component-testing business can expect to receive more than 3.00 for each tested component it sells. Over the longer term, however, its costs per tested component should not exceed It is making profits by taking and eliminating risks one of those risks being that the component failure rate will deviate from expectations. 14 In other words, the price that a customer will pay for tested components is the certainty equivalent that adjusts the expected failure rate for risk. 15 Economies of scale may mean that its testing costs are less than the 1.00 that the potential customer would incur, but this does not detract from the rest of the argument. 30

35 CHAPTER 1: WHAT SHOULD REVENUE REPRESENT? 1.18 Accordingly, this Paper argues that gains arise over a business s operating cycle, as it takes and eliminates necessary risks. Of course, those necessary risks may fall at different stages of the operating cycle for different entities. For some entities, such as pharmaceutical companies perhaps, a large element of risk may be concentrated at the development and trial stage. For others, predicting levels of demand may be one of the chief risks. Nevertheless, to the extent that an entity has eliminated necessary risks before entering into an exchange transaction, gains associated with those risks may be said to have come into existence, even if they have not yet been recognised. How might gains be recognised under current value and historical cost principles? 1.19 The following discussion is intended only as a very broad outline of how gain recognition might operate under current value principles. In practice, many difficult issues might be expected to arise over how to apply current value principles, not least because of differing views of how current value and fair value should be defined Rather than dealing with those issues, the discussion below illustrates the broad differences that might be expected between gain recognition under historical cost and current value principles. Thus, purely for the sake of illustration, it is assumed that gain recognition under current value principles would be broadly equivalent to the continuous remeasurement of assets and liabilities to fair value, in the sense in which that term is described in the Preface. 16 The Statement of Principles explains the Board s view that the deprival value model provides the most relevant measure of current value. Under that model, current value is the lower of replacement cost and recoverable amount, which is itself the higher of value in use and net realisable value. 31

36 REVENUE RECOGNITION Gain recognition under current value principles 1.21 Paragraph 1.9 discussed how, at the point of revenue recognition, asset measurement ceases to be backward-looking and instead becomes forward-looking, so that debtors, for example, are valued by reference to future cash inflows. No matter how it is defined, fair value is inherently a forwardlooking measure. For example, where an asset s fair value is determined by reference to a market, the market price will reflect market participants assessments of the uses to which the asset can be put (and, ultimately, the cash flows associated with those uses) and the degree of risk associated with those uses Thus, although there may be different views as to which future cash flows to include and the appropriate perspective from which those cash flows and risks should be assessed, 17 fair value may in principle be thought of as equivalent to the value of future cash flows discounted for risk When an entity carries out operating activities, thereby taking and eliminating necessary risks, the risks associated with future cash flows will have reduced, no matter whose perspective they are judged from. Thus if assets and liabilities are continuously remeasured to fair value, gains will be recognised as the entity moves through its operating cycle. 17 for example, a market perspective or the perspective of the transacting entity. 32