IAS18 Revenue: Current Accounting Treatment and New Developments Article by Martin Kelly, BSc (Econ) Hons, DIP. Acc, FCA, MBA, MCMI Examiner in P2 Advanced Corporate Reporting 1. Introduction In the CPA Ireland Advanced Corporate Reporting examination paper, students will often encounter questions that require them to apply the technical aspects of an accounting standard within the context of the particular facts presented within the case study. In addition to having a technical knowledge of accounting standards, candidates are also expected to demonstrate professional judgement and an awareness of contemporary issues in the area of financial reporting. Revenue is often the single biggest item in the financial statements. Indeed, recent high profile cases involving financial statement fraud have involved revenue manipulation. A consistent approach to revenue recognition is critically important if financial statements are to fairly reflect the true economic activity of an entity. However, more recently IAS 18 Revenue has been criticised for being vague resulting in inconsistencies in how the standard has been interpreted and applied by differing entities. As per the Conceptual Framework for Financial Reporting, financial statements are prepared on the underlying assumption of the accruals basis of accounting which is based on the matching of costs with the revenue they generate. However, this inevitably leads to questions about when a transaction occurs. For example, is it when the buyer takes possession of the goods, or is it when the services are actually provided? When does the profit arise on a contract for the provision of services to a customer over time, such as under a maintenance contract of three years duration? The decision has a direct effect on reported profit since under the prudence concept it would be unacceptable to recognise the profit on sale until a sale had taken place in accordance with the criteria of revenue recognition. Furthermore, there are also issues surrounding which costs should be included in the carrying amount of inventories, in the statement of financial position. Should only variable costs be included or should fixed costs also be included? The timing of the recognition of revenue is therefore crucial to the timing of profits, whilst the amount of year-end inventories has a for effect on profits earned for the period. The way revenue is calculated is essential to any meaningful understanding of the financial performance of an entity. Generally, revenue is recognised at the point of sale, because at that point four criteria will normally have been met: the product or service has been provided to the buyer; the buyer has recognised their liability to pay for the goods or services provided; the buyer has indicated their willingness to hand over the consideration in settlement of the obligation; and the monetary value of goods or services has been established. It should be noted that there are times when revenue is recognised at times other than the completion of sale. For example, under IAS 11 Construction Contracts revenue and contract costs associated with the construction contract should be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the end of the reporting period. To defer taking profit into account until completion may result in the statement of profit or loss and other comprehensive income reflecting, not so much a true and fair view of relevant activity during the year, but rather the results relating to contracts which has been fully completed by the end of the reporting period. For example, an entity might still recognise inventory because not all of the significant risks and rewards of ownership have been transferred to the customer, even though the customer has obtained substantial control of the good. This is inconsistent with the International Accounting Standards Board s (IASB) definition of an asset, which depends on control of the good, not the risks and rewards of owning the good. Key judgements required of management include: When do risks and rewards of ownership of goods and services pass to the buyer? In what circumstances is management involvement in the asset retained? How is the decision made as to whether the stage of completion of a service transaction can be measured reliably? Page 1 of 6
As a consequence of revenue having such a direct impact on earnings and because many external investors use revenue growth as a key performance indicator, management may be tempted to behave opportunistically in relation to judgements on recognising revenue. Certified Public Accountants, of course, need to be very clear to ensure that, notwithstanding the guidance provided in the relevant international accounting standard, there are well documented internal policies for the recognition of revenue which are applied on a consistent basis from one period to another. 2. Scope and definitions 2.1 Revenue IAS 18 prescribes the accounting treatment of revenue recognition in common types of transaction. Generally, revenue should be recognised when it is probable that future economic benefits will flow to the enterprise and that these benefits can be measured reliably. Income, as defined by the IASB s Framework, includes both revenues and gains. IAS 18 covers revenues from the sale of goods, rendering of services and use by others of entity assets yielding interest, royalties and dividends. The standard explicitly excludes various streams of revenue arising from leases, insurance contracts, changes in value of financial instruments or other current assets, natural increases in agricultural assets and mineral ore extraction. IAS 18 provides the following definition of Revenue: The gross inflow of economic benefits during the period arising from the ordinary activities of an entity when those flows result in increases in equity, other than increases relating to contributions from equity participants 1. 2.2 Measurement When a transaction takes place, the amount of revenue is usually decided by the agreement between the buyer and seller. The revenue, however, should be measured at the fair value 2, of the consideration received or receivable. The fair value will take into account any trade discounts and volume rebates allowed by the seller. In straightforward situations the requirement to measure revenue at fair value provides few problems. So sales on credit terms of thirty days will be measured at amounts receivable in thirty days net of all sales allowances such as quantity discounts. Normally, it will be possible to look at each transaction as a whole. Sometimes, however, transactions are more complex, and it may be necessary to break down a transaction into its component parts. For example, a particular sale may include the transfer of goods and provision of future maintenance (servicing), the revenue for which should be deferred over the period the maintenance is to be performed. 2.3 Sale of goods Revenue should only be recognised when all of the following conditions are satisfied: The entity has transferred the significant risks and rewards of ownership 3 of the goods to the buyer; The seller no longer has management involvement or effective control over the goods; The amount of revenue can be measured reliably; It is probable that the economic benefits associated with the transaction will flow to the entity; and The costs incurred in respect of the transaction can be measured reliably. 1 The reference to gross inflow requires revenue to be shown gross of the costs associated with earning it (an example of the general prohibition against netting off in financial statements). 2 Fair value is the amount for which an asset could be exchanged, or liability settled, between knowledgeable, willing parties in an arm s length transaction. 3 In most cases the transfer of risks and rewards of ownership coincides with the transfer of legal title, or the passing of possession to the buyer. This is the case for most retail sales. Page 2 of 6
It may be the case that the seller retains only an insignificant risk of ownership and for the sale and revenue to be recognised. The main example here is where the seller retains title only to ensure collection of what is owed on the goods. This is a common commercial situation, and when it arises the revenue should be recognised on the date of sale. Furthermore, the probability of the entity receiving the revenue must be assessed. For example, in the majority of cases revenue in relation to credit sales is recognised before payment is received. However, where collectability is doubtful and recovery is not probable, then the amount should be recognised as an expense and not an adjustment to revenue previously recognised. Finally, matching should take place, i.e. the revenue and expenses relating to the same transaction should be recognised at the same time. It is normally easy to estimate expenses at date of sale (e.g. warranty costs, shipment costs, etc). Example 1 Cambridge Ltd publishes a monthly magazine, which is sold for 4 per issue with costs of 2 per issue to produce. Cambridge Ltd received 60,000 in annual subscriptions and had produced four issues by the year end of 31 January 2013. In accordance with IAS 18 Revenue what revenue in relation to the magazines should be recognised by Cambridge Ltd for the year ended 31 January 2013? Revenue for the magazines should be recognised over the period in which the magazines are despatched, provided the items are of similar value in each time period. The revenue recognised in the year ended 31 January 2013 is therefore 60,000 x 4/12 = 20,000 In some sectors of the retail industry it is common practice to provide interest-free credit to customers in order to encourage sales of, for example, new cars. Where an extended period of credit is offered, the revenue receivable has two separate elements: The fair value of the goods on date of sales (cash selling price) Financing income. In order to separate these two elements the future receipts are discounted to present value at an imputed interest rate. Example 2 A car retailer sells new cars by requiring a 20% deposit followed by no further payments until the full balance is due after two years. The price of cars is calculated using 10% per annum finance charge. On 1 January 2013 a car was sold to a customer for 30,000. How should the revenue be recognised in the year ended 31 December 2013 and what should the carrying amount of the customer receivable be on that date? Revenue to be recognised: Sale of goods ( 6,000 + 19,835) 25,835 Financing income (19,835 x 10%) 1,983.5 Carrying amount of receivable ( 19,835 x 1.10) 21,818.5 Working: the deposit is 6,000 (20% x 30,000), so the amount receivable in two years is 24,000. This is discounted for two years to 19,835 ( 24,000 x 1/1.10 2 ). Page 3 of 6
3. Rendering of services When the outcome of a transaction involving the rendering of services can be estimated reliably, the associated revenue should be recognised by reference to the stage of completion of the transaction at the end of the reporting period. The outcome of a transaction can be measured reliably when all of the following conditions are met: The amount of revenue can be measured reliably; It is probable that economic benefits associated with the transaction will flow to the entity; The stage of completion of the transaction at the end of the reporting period can be measured reliably; and The costs incurred for the transaction and the costs to complete the transaction can be measured reliably. These recognition criteria are similar to those for sale of goods. However, a key difference is the need to be able to determine the stage of completion of the transaction. This is particularly important when the completion of a contract extends beyond more than one reporting period. Methods of assessing the stage of completion referred to in IAS 18 include: surveys of work performed; services performed to date as a percentage of total services to be performed; and the proportion that costs incurred to date bear to the estimated costs of the transaction. In uncertain situations, when the outcome of the transaction involving the rendering of services cannot be estimated reliably, IAS 18 recommends a no loss/no gain approach. Revenue is only recognised to the extent of the expenses recognised that are recoverable. This is more likely during the early stages of a transaction, but it is still probable that the entity will recover the costs incurred. Therefore, the revenue recognised in such a period will be equal to the expenses incurred, with no profit. Example 3 A company entered into a contract for the provision of services over a two year period. The total contract price was 300,000 and the company initially expected to earn a profit of 40,000 on the contract. In the first year costs of 120,000 were incurred and 50% of the work was completed. The contract did not progress as expected and management was unsure of the ultimate outcome, but believed that the costs incurred to date would be recovered from the customer. What revenue should be recognised for the first year of the contract? As the outcome of the service transaction cannot be estimated reliably, revenue should only be recognised to the extent that expenses are recoverable from the customer. In this case, contract revenue of 120,000 should be recognised. 4. Goods and services provided in one contract It is often the case that goods and services can be bundled into one transaction. For example a car dealer may sell new or used cars with one year s free servicing. While IAS 18 does not specify how each component should be measured, general principles require that each component should be measured at its fair value and recognised as revenue only when it meets the recognition criteria. Example 4 A company sells a piece of equipment to a customer on 1 January 2013 for 1.5m. Due to the specialised nature of the equipment the entity agreed to provide free support service for the next two years, the cost of which is estimated to be 120,000 in total. The entity has traditionally earned a gross margin of 20% on such contracts. Page 4 of 6
How much revenue should the entity recognise for the year ended 30 April 2013? Revenue sale of goods 1,350,000 sale of services 25,000 Total 1,375,000 Workings After-sale support (120,000 / (100%-20%) 150,000 Remainder = sale of goods (balancing figure) 1,350,000 1,500,000 Revenue for sale of services recognised in the four months to 30 April 2013 should be 150,000/2 years x 4/12 = 25,000. Example 5 On 1 April 2013, Christy plc sold security systems to a chain of high street banks for 2,250,000 under a promotional offer. The promotion included free maintenance services for the first two years. A two year maintenance contract would normally be sold for 500,000, and the list price of the security systems (including installation) would be 2,500,000. The transaction has been included in revenue at 2,250,000. Christy plc prepares financial statement for the year ending 30 June 2013. Explain the required IFRS financial reporting treatment of the above transaction, preparing relevant calculations and setting out the required adjustments in the form of journal entries. Christly plc has offered the sale of goods and the service with two years maintenance. In such cases the components of the package which could be sold separately should be identified and each should be measured and recognised as if sold separately, unbundled. IAS 18 Revenue does not state specifically how each component should be measured, but as only three month of the maintenance service has been provided, we should only recognise 3/24 of the maintenance fee as revenue in the current reporting period. The remainder should be treated as deferred income and recognised as the service is provided. The sale of goods should be recognised immediately. As the total fair value exceeds the overall price of the contract, a discount has been provided. As we do not know what has been discounted, it would seem reasonable to apply the same discount percentage to each separate component. The discount is 25% on listed prices [i.e. 2,250,000/ (2,500,000 + 500,000) -1]. Sale of goods ( 2.5m x 75%) 1,875,000 Sale of services (3/24 x 0.5m x 75%) 46,875 1,921,875 Deferred income should be measured at 328,125 (21/24 x 0.5 x 75%). Revenue should therefore be reduced by 328,125. The journal required is: Dr Sales (Profit and loss and other comprehensive income) 328,125 Cr Deferred income (SOFP) 328,125 Page 5 of 6
5. Disclosure The following items should be disclosed: The accounting policies adopted for the recognition of revenue, including the methods used to determine the stage of completions of transactions involving the rendering of services. The amount of each significant category of revenue recognised during the period including revenue arising from: sale of goods; rendering of services; interest; royalties; and dividends. The amount of revenue arising from exchanges of goods or services include in each significant category of revenue. 6. Current developments in relation to IAS 18 Revenue IAS 18 Revenue has been criticised for being vague, leading to an inconsistency in how it has been applied in practice. IAS 11 Construction contracts has also been criticised and, in some cases there has been uncertainty about which standard should be applied. More specifically the weaknesses in the current standard include: i. Timing of revenue recognition Some companies remain uncertain about when they should recognise revenue because of there is lack of clear and comprehensive guidance in both IAS 18 and IAS 11. This is particularly the case for goods and services because goods are sold at a point in time whereas services may be provided over time. ii. Distinguishing between goods and services IFRS does not make a clear distinction between goods and services, so some companies may not be entirely sure whether to account using IAS 18 or IAS 11. Even though construction contracts are effectively sale of goods, IAS 11 uses the stage of completion method. Under IAS 18, however, revenue from sale of goods is only recognised when risks and rewards of ownership are transferred to the customer. Revenue reported could vary considerably depending on which standard is applied. iii. Multi-element arrangements IFRS does not provide guidance on how to deal with transactions that involve the delivery of more than one good or service. IAS 18 states that in certain situations the revenue recognition criteria must be applied to separately identifiable components of a transaction. However, it does not explain the circumstances when a transaction can be broken down into separate components. An Exposure Draft (ED) was issued in June 2010, following a 2008 discussion paper and re-issued with some modifications in November 2011. The ED sets out a five stage approach in relation to revenue recognition and contracts. These steps include; identify the contract with the customer; identify separate performance obligations; determine the transaction price; allocate the transaction price to the performance obligations; and, recognise revenue when a performance obligation is satisfied. These proposals would mean that revenue would only be recognised on the transfer of goods or services to customers. Therefore, under the proposal, a company would only apply the percentage of completion method of revenue recognition only if the company transfers services to the customer throughout the contract. The proposed standard also provides guidance on cost. For example, the costs of obtaining a contract (selling and marketing costs) would be treated as expenses when incurred. 7. Conclusions At P2 level, students are expected to apply their professional judgement and technical ability in the preparation and analysis of financial statements for a range of business entities. As already discussed, the current standard on revenue recognition requires management to exercise their professional judgement. A consistent approach to revenue recognition is essential if financial statements are to present the true economic activity of an entity. This article has set out some of the key issues that need to be considered when applying and discussing the current accounting treatment in relation to recognition and measurement of revenue for goods and services. Page 6 of 6