Revenue Recognition
Article relevant to Professional 2 Advanced Financial Accounting
Author: Ciaran Connolly, current Examiner.
Introduction
Revenue is often discussed in terms of inflows of assets to an organisation that occur as a result
of outflows of goods and services from that organisation. Consequently, the concept of revenue
recognition has traditionally been associated with specific accounting procedures that are
primarily directed towards determining the timing and measurement of revenue. Accordingly,
the revenue recognition debate has taken place in the context of the historical cost double entry
system, with accounting principles focusing on determining when transactions should be
recognised in the financial statements, what amounts are involved in each transaction, how these
amounts should be classified and how they should be allocated between accounting periods.
Historical cost accounting in its pure form avoids having to take a valuation approach to
financial reporting by virtue of the fact that it is transaction based, i.e. it relies on transactions to
determine recognition and measurement of assets, liabilities, revenues and expenses. Over an
organisation’s life, its total income will be represented by net cash flows generated. However,
because of the requirement to prepare periodic financial statements, it is necessary to break up an
organisation’s operating cycle into artificial periods. Therefore, at each reporting date, an
organisation will have entered into a number of incomplete transactions, e.g. a product has been
delivered or service rendered for which payment has not yet been received. As a result, the
important questions to be answered with respect to revenue recognition revolve around how to
allocate the effects of incomplete transactions between the periods for reporting purposes, rather
than simply letting them fall into the periods in which cash is received or paid.
Broad Approaches to Revenue Recognition
The critical event in the operating cycle of a business is the point at which most or all of the
uncertainty surrounding a transaction is removed. This is usually when the goods or services are
delivered, and is (normally) the point at which revenue is recognised. However the critical event
could occur at other times in the operating cycle, depending on the circumstances. The points in
the operating cycle are as follows:
Timing of
Recognition
Placing of an order by
a customer, prior to
manufacture.
During production.
At the completion of
production, i.e. from
goods in stock.
At the time of sale
(but before delivery).
On delivery.
Subsequent to
delivery.
On an apportionment
basis (revenue
allocation approach)
Criteria
As there is likely to be uncertainty
regarding the final outcome of such
contracts it would not be prudent to
recognise profit at this point.
Revenues accrue over time, and no
significant uncertainty exists as to
measurability or collectability.
A contract of sale has been entered into
and future costs can be estimated with
reasonable certainty.
This is nearing the point where most of
the uncertainties are resolved, however
recognition is usually delayed until
delivery. There should exist a ready
market for the commodity, together
with a determinable and stable market
price. There should be insignificant
marketing costs involved.
The goods must have already been
acquired or manufactured, and be
capable of immediate delivery. The
selling price should be established and
all material related expenses, including
delivery, ascertained. No significant
uncertainties remain, e.g. ultimate cash
collection or returns.
Criteria for recognition before delivery
were not met and no significant
uncertainties remain. In the vast
majority of cases this is the point at
which revenue is recognised.
Significant uncertainty regarding
collectability at the time of delivery.
At the time of sale it was not possible
to value the consideration with
sufficient accuracy.
Where the revenue represents the
supply of initial and subsequent
goods/services.
Examples of Practical
Application
Long-term contracts.
Accrual of interest, dividends
and royalties.
Accounting for long-term
contracts using the percentage
of completion method.
Certain precious metals and
commodities.
Certain sales of goods, e.g. bill
and hold sales.
Property sales where there is
an irrevocable contract.
Most sales of goods and
services. Property sales where
there is doubt that he sale will
be completed.
Sales where right of return
exist. Goods shipped subject
to conditions, e.g. installation,
inspection or maintenance.
Franchise fees. Sales of goods
with after sales services.
Sources of Guidance
In Ireland and Britain, attempts have been made to address revenue recognition in, for example,
SSAP 2 Disclosure of Accounting Policies, which has been replaced by FRS 18 Accounting
Policies, Chapter Five of the Statement of Principles for Financial Reporting and FRS 5
Reporting the Substance of Transactions. However, they arguably only offer limited guidance,
and thus reliance has to be placed on international pronouncements, such as, IAS 18 Revenue.
The Statement of Principles for Financial Reporting adopts a balance sheet approach, defining
gains and losses in terms of changes in assets and liabilities, rather than in terms of matching
transactions with accounting periods. The Statement of Principles for Financial Reporting
establishes three recognition criteria:
•
An item must meet the definition of an element within the statement;
•
There must be evidence that a change in the inherent asset or liability has occurred;
•
The item can be measured in monetary terms and with sufficient reliability.
The revenue recognition process starts with the effect the transaction has on the reporting
organisation’s assets and liabilities:
•
If net assets increase, a gain is recognised;
•
A loss is recognised if, and to the extent that, previously recognised assets are reduced or
eliminated.
FRS 5 stipulates that the seller needs to have performed its contractual obligations by
transferring the principal benefits and risks of the goods to the customer:
•
If the substance of the transaction is that the goods represent an asset of the customer, then
the seller has a right to be paid and the seller should recognise the related changes in the
assets or liabilities and turnover. The amount recognised should be adjusted for the time
value of money where significant and risk (in particular, returns risk where applicable);
•
If the substance of the transaction is that the goods represent an asset of the seller, it should
be retained in the seller’s balance sheet. Any amounts received from the customer should be
included within creditors. The stock should be removed from the seller’s balance sheet and
part or all of any related creditor balance released to turnover on the earlier of the point at
which the criteria for recognition of the bill and hold arrangement as a sale have been met,
even if the goods remain in the hands of the seller, or the goods are delivered to the
customer.
In November 2003, the Accounting Standards Board (ASB) issued an Application Note ‘G’ to
FRS 5, which sets out the basic principles of revenue recognition and specifically addresses five
types of arrangement that give rise to turnover and have been subject to differing interpretations
in practice:
•
Long-term contractual performance;
•
Separation and linking of contractual arrangements;
•
Bill and hold arrangements;
•
Sales with right of return;
•
Presentation of turnover as principal or as agent.
The Application Note also provides guidance on the measurement of turnover where there are
deferred payment terms or where there is a significant risk about the customer’s ability to pay.
Introducing the Application Note, Mary Keegan, ASB Chairman, said ‘Many investors focus on
revenue growth as an important indicator of a company’s performance. Recent reports of
questionable practice have highlighted the need for us to set out best practice. Our consultation,
earlier this year, and our subsequent research have emphasised the need for this new standard’.
She added ‘The standard will also assist those faced with making the transition to International
Financial Reporting Standards in 2005, as both its principles and its specific requirements are
consistent with the international standard, IAS 18’.
IAS 18 defines revenue as ‘the gross inflow of economic benefits (cash, receivables, other assets)
arising from the ordinary operating activities of an organisation (such as sales of goods, sales of
services, interest, royalties, and dividends’ [IAS 18.7]. Revenue should be measured at the fair
value of the consideration receivable [IAS 18.9]. The consideration is usually cash. If the inflow
of cash is significantly deferred, and there is no interest or a below-market rate of interest, the
fair value of the consideration is determined by discounting expected future receipts. This would
occur, for instance, if the seller is providing interest-free credit to the buyer or is charging a
below-market rate of interest. Interest must be imputed based on market rates [IAS 18.11]. If
dissimilar goods or services are exchanged (as in barter transactions), revenue is the fair value of
the goods or services received or, if this is not reliably measurable, the fair value of the goods or
services given up.
The objective of IAS 18 is to prescribe the accounting treatment for revenue arising from certain
types of transactions and events, namely:
•
the sale of goods;
•
the rendering of services;
•
the use by others of organisation assets yielding interest, royalties and dividends.
Sale of Goods
Revenue arising from the sale of goods should be recognised when all of the following criteria
have been satisfied [IAS 18.14]:
•
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 nor 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.
However, if it is unreasonable to expect ultimate collection then it should be postponed. In most
cases the transfer of legal title coincides with the transfer of risks but in other cases they may
occur at different times. Each transaction must be examined separately. In certain specific
industries, e.g. harvesting of crops, extraction of mineral ores, performance may be substantially
complete prior to the execution of the transaction generating revenue.
Rendering of Services
For revenue arising from the rendering of services, provided that all of the following criteria are
met, revenue should be recognised by reference to the stage of completion of the transaction at
the balance sheet date (the percentage-of-completion method) [IAS 18.20]:
•
the amount of revenue can be measured reliably;
•
it is probable that economic benefits will flow to the service provider;
•
the stage of completion of the transaction can be measured reliably;
•
the costs of the transaction (including future costs) can be measured reliably.
When the above criteria 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’) [IAS 18.26].
Interest, Royalties, and Dividends
For interest, royalties and dividends, provided that it is probable that the economic benefits will
flow to the organisation and the amount of revenue can be measured reliably, revenue should be
recognised as follows [IAS 18.29-30]:
•
Interest - on a time proportion basis that takes into account the effective yield;
•
Royalties - on an accruals basis in accordance with the substance of the relevant agreement;
•
Dividends - when the shareholder's right to receive payment is established.
In foreign countries revenue recognition may need to be postponed if exchange permission is
required and a delay in remittance is expected. Where the ability to assess the ultimate collection
with reasonable certainty is lacking revenue recognition should be postponed. In such cases, it
may be appropriate to recognise revenue only when cash is collected. If the uncertainty relates to
collectability, it is more appropriate to make a separate provision for bad debts.
Conclusion
The growing complexity and diversity of business activity has resulted in a variety of forms of
revenue-earning transactions that were never considered when the ‘point of sale’ was established
as the general rule for revenue recognition. As we move further towards a balance sheet based
fair-value approach to revenue recognition, long established principles centred on accruals and
prudence may no longer be appropriate. In addition, with the prospect of a single statement of
financial performance, there is the possibility that traditional concepts of revenue resulting from
success, or otherwise, of selling goods and services may become meshed with newer concepts of
holding gains and losses.