1. Topic: Revenue & Income Recognition Issues.. (IAS 18)
Week 6: Lecture 2
Topic: Revenue & Income Recognition Issues..
(IAS 18)
Reference: Deegan , Chapter 16
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2. Definition of income and revenue
Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases in liabilities that result in an increase in equity, other than those relating to contributions from equity partners.
Divided into:
Revenue
Revenue arises in the course of the ordinary activities of an entity and is referred to by a variety of different names, including sales, fees, interest, dividends, royalties and rent.
Gains (other Income)
Other items that meet the definition of income and may or may not arise in the course of the ordinary activities of an entity. Gains represent increases in economic benefits and as such are not different in nature from revenue.
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3. Revenues and gains
Gains include those arising on the disposal of non-current assets.
The definition of income also includes unrealised gains
e.g. those arising on the revaluation of marketable securities and those resulting from increases in the carrying amount of long-term assets.
When gains are recognised in the income statement, they are usually displayed separately because knowledge of them is useful in making economic decisions.
Gains are often reported net of related expenses.
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4. Revenues and gains
Generally revenues relate to the ordinary income-generating activities of an entity
e.g. sales or rental receipts.
Gains relate to ‘other income’—not necessarily part of the ordinary activities of an entity.
Differentiation based on some degree of professional judgment.
What is an ‘ordinary’ activity for one business may not be ‘ordinary’ for another—so the benefits might be deemed ‘revenue’ in one entity and a ‘gain’ in another.
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5. Revenues and gains
Differentiation between revenue and gains also embraced by IAS 18 ‘Revenue’ (par. 7):
The gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.
Scope of IAS 18 ‘Revenue’ is fairly restricted
applied to accounting for revenue arising from transactions and events relating to (par. 1):
The sale of goods
The rendering of services
The use by others of entity assets yielding interest, royalties and dividends.
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6. Revenues and gains
Revenue from the sale of goods is to be recognised when all of the following conditions have been satisfied:
The entity has transferred to the buyer the significant risks and rewards of ownership of the goods.
The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor 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.
The costs incurred or to be incurred in respect of the transaction can be measured reliably.
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7. Revenues and gains con’t
On the other hand, the revenue from a sale of service transaction can be recognised when all of the following conditions are satisfied:
The amount of revenue can be measured reliably;
It is probable that the 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.
Only paragraphs (a) and (b) of the recognition criteria for the sale of services are the same as those for the sale of goods.
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8. Revenues and gains
Where revenue has been recognised, IAS 18 requires that the revenue be measured at the fair value of the consideration or contributions received or receivable (par. 9):
If cash is not to be received for some period of time the future amount to be received would need to be discounted to its present value and the present value recognised as revenue (refer to IAS 18, par. 11).
If cash is received for goods and services provided the revenue recorded is equal to the cash received.
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9. Recognition—current practice
IAS 18 (Appendix A) provides guidance for:
goods sold subject to conditions…….
lay-by sales……
orders when partial payment received in advance…..
subscriptions to publications…..
installment sales……
real estate sales…..
etc..
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10. The earnings cycle
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11. Traditional recognition- mostly
At point 5
in the building industry for long-term construction contracts.
At point 7
where it is the responsibility of the purchaser to collect the goods.
At point 8 in most cases.
At point 9
by some professional practices and for instalment credit sales.
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12. Traditional recognition
Revenue is rarely, if ever, recognised prior to point 5, possibly because of the uncertainty surrounding the ultimate irrevocable and unconditional claim to cash (or its equivalent) arising from a revenue transaction or event.
As one proceeds through the earnings cycle from point 1 to point 9, this uncertainty decreases.
However, in practice, point 9 is considered too conservative to be the general criterion.
Point 8 is the point at which revenue is normally recognised and the slight amount of uncertainty remaining is accounted for by creating an ‘allowance for doubtful debts’.
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13. Recognition—current practice
Currently, this system is based predominantly on a historical cost, transaction-based system of accounting.
Other approaches to valuation (e.g. market values) are also used
Increases in market values of marketable securities are recognised as part of income
a departure from traditional historical accounting but still consistent with the definition of income provided in the NZ Framework.
Note:
Different measurement models of assets and liabilities
e.g. historical cost vs. the modified historical cost system, will generate different calculations of income and hence profits.
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14. Recognition—according to the NZ framework
Para. 83 of the Framework:
An item that meets the definition of an element (e.g. income) should be recognised if:
The item has a cost or value that can be measured with reliability.
It is probable that any future economic benefit associated with the item will flow to or from the entity.
Note:
Probable refers to more likely than less likely.
‘Income’ can be subdivided into ‘revenue’ and ‘gains’.
IAS 18 recognition criteria for revenue items
Revenue that relates to sale of goods, rendering of services, and interest, royalties and dividends.
Revenue from sales of goods and services is to be recognised when the entity has transferred to the buyer the significant risks and rewards of ownership of the goods.
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15. Recognition—at completion of production
At times, revenue may be recognised at the completion of production, even when no sale has been made.
Examples of such cases include the production of precious metals or agricultural products.
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16. Recognition—at the time of sale
The two conditions for recognising revenue:
probable economic benefits and reliable measurement
usually met by the time the product or merchandise is delivered, or the services are rendered to customers.
Normally determined by shipping terms i.e. time of sale is commonly interpreted as when title passes.
F.O.B. shipping point
Title passes to the buyer (and revenue is recognised) when the seller delivers goods to a common carrier who acts as an agent for the buyer.
F.O.B. destination
Title does not pass (and revenue is not recognised) until the buyer receives the goods from the carrier.
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17. Recognition—at the time of sale
In advance of cash receipt.
When revenue is recognised in advance of receipt of cash, it is common to recognise an ‘allowance for doubtful debts’
Determined on basis of past experience and industry averages……………
Journal entry
Dr Doubtful debts expense
Cr Allowance for doubtful debts
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18. Recognition—at the time of sale
Allowance for doubtful debts is contra account to debtors.
If goods are sold or services provided on credit terms, not all amounts due from debtors will ultimately be collected.
To ignore this fact would lead to an overstatement of receivables and assets in the financial position.
Consistent with general principles in par. 18 of NZ IAS 18.
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19. Recognition — at the time of sale
Accounting for bad debts
When actual debtor is identified as unlikely to pay when amount was previously anticipated:
Dr Allowance for doubtful debts
Cr Debtors
When debtor is identified as unlikely to pay and amount was not previously anticipated:
Dr Bad debts expense
Cr Debtors
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20. Accounting for sales with associated conditions
Transactions involving the sale of assets with conditions attached should be reviewed to assess whether:
control of the future economic benefits has passed from the seller to the purchaser; and
it is probable that the inflow of economic benefits to the seller has occurred.
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21. Call and Put options Call option
Provides the holder of the option with the right to buy an asset at a specified exercise price on or before a specified date.
The party that writes the call option agrees to deliver a particular asset to the call-option buyer, if that buyer instructs the other party to do so.
A call option is considered to have value when the value of the underlying asset exceeds the option’s exercise price.
If at exercise date the exercise price is above or equal to the market value of the asset, the option has no value.
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22. Call and put options Put option Operates in reverse to calls.
Holder has the right to sell at a specified exercise price on or before a specified date.
The writer or the seller of the put option agrees to buy the asset at a future date for the exercise price if the put option holder (buyer) so requests.
The holder of the put option would typically exercise the option (require the other party to buy the asset) only if the exercise price is above the market price.
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23. Call and put options Put option (continued)
Guarantees holders a minimum price for their assets.
Where a transaction involves concurrent use of a financial instrument, it is necessary to evaluate the conditions attaching to the transaction to establish whether, in substance, the transaction is a financial arrangement rather than a sale.
Probability of the exercise of the options must be considered in recognising revenue.
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24. Revenue recognition when right of return exists
Alternative treatments available when the seller is exposed to continued risks of ownership through return of the product
Not recording the sale until all return privileges have expired
Recording the sale but reducing sales by an estimate of future returns
Recording the sale and accounting for the returns as they occur.
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25. Revenue recognition when right of return exists
If a company sells its product but gives the buyer the right to return the product,
Revenue from the sales transaction may be recognised at the time of sale if all the following are met:
The seller’s price to the buyer is substantially fixed or determinable at the date of sale.
The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on the resale of the product.
The buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product.
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26. Revenue recognition when right of return exists
Continued from previous slide:………. Conditions….
The buyer acquiring the product for resale has economic substance apart from that provided by the seller.
The seller does not have significant obligations for future performance to directly bring about the resale of the product by the buyer.
The amount of future returns can be reasonably estimated.
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27. Recognition—sale and leaseback
Although ownership of the leased property has been transferred to the purchaser/lessor, the vendor/ lessee normally retains control.
The vendor/lessee has in effect entered into a financing arrangement
leased property used as collateral for a loan.
Transaction does not constitute a sale and does not give rise to revenue
Inflow of economic benefits (proceeds from disposal) have resulted in an equivalent liability (lease payable).
Result is no increase in equity.
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28. Interest revenue
Interest revenue is recognised over time as the borrower has the benefit of the borrowings and the lender establishes claims for interest earned.
Prepayment of interest not regarded as revenue to lender as lender has present obligation to provide finance for the period to which the prepayment relates.
Interest revenue might be implicit in the terms of a transaction
E.g. where goods are sold on extended credit, vendor is effectively financing the purchaser
Transaction gives rise to two forms of revenue:
Sales revenue—present value of future payments
Interest revenue from financing activities.
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29. Interest revenue
To estimate PV of proceeds, applicable interest rate must be determined.
IAS 18 (par. 11):
When the arrangement effectively constitutes a financing transaction
the fair value of the consideration is determined by discounting all future receipts using an imputed rate of interest.
The imputed rate of interest is the more clearly determinable of either:
The prevailing rate for a similar instrument of an issuer with a similar credit rating; or
A rate of interest that discounts the nominal amount of the instrument to the current cash sales price of the goods or services.
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30. Interest revenue
Difference between fair value and nominal amount of consideration is recognised as interest revenue.
Rate used for valuation purposes will normally be at least equal to the rate at which the debtor can obtain financing of a similar nature.
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31. Dividend revenue
Dividend revenue should be recorded once it is considered probable that inflow of future economic benefits has occurred and when these benefits can be measured reliably
In most cases this will be at the time the board of directors or other governing body proposed the dividend.
If a dividend needs final approval, the dividend revenue should not be recognised until it has approval.
Dividends received from pre-acquisition profits (cum-div purchases) recognised as dividend revenue
Previously recognised as reduction of investment.
No dividend can be recognised, until a solvency certificate is signed by the authorising directors.
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32. Unearned revenue
Recorded when payment is received in advance of services or resources being provided.
The receipts have not been earned.
Considered to be liabilities
Under present obligation to transfer future economic benefits at a future date.
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33. Customer loyalty programs
Previously considered ‘marketing expenses’.
IFRIC 13 treats loyalty programs as multiple event revenue transactions.
Fair value of transaction apportioned to:
goods or services delivered
the awards credit to be redeemed in the future
If entity supplies awards itself
Consideration allocated to award credits as revenue when award credits are redeemed (its obligation is fulfilled).
If by a third party
The awarding entity shall measure revenue as the net amount retained on its own account.
Recognise this amount when third party is obligated to supply goods.
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34. Revenue disclosures the sale of goods the rendering of services
The accounting policies adopted for the recognition of revenue, including the methods adopted to determine the stage of completion of transactions involving the rendering of services.
The amount of each significant category of revenue recognised during the period including revenue arising from:
the sale of goods
the rendering of services
interest
royalties
Dividends.
The amount of revenue arising from exchanges of goods or services included in each significant category of revenue.
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35. Recap ……Question ?
Compare and contrast the revenue recognition criteria for the sale of goods with those for the rendering of services.
2. State which of the following meets the definition of ‘revenue’ under IAS 18 for Company Z, a retailer of toys. Give reasons for your answer:
(a)Sales tax collected on behalf of the taxing authority.
(b)Gain on the sale of an investment property.
(c)Amounts receivable from customers who have purchased toys.
(d)Gain on the sale of equity securities held as investments.
(e)Revaluation increment on the revaluation of operating properties under IAS 16.
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36. The amount can be reliably estimated
Question !:
Revenue from the sale of goods can be recognised when the following conditions have been satisfied:
The entity has transferred to the buyer the significant risks and rewards of ownership of the goods;
The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;
The amount can be reliably estimated
It is probable that the economic benefits associated with the transaction will flow to the entity; and
The costs incurred or to be incurred in respect of the transaction can be measured reliably.
The revenue from a service transaction can be recognised when all of the following conditions are satisfied:
The amount of revenue can be measured reliably;
It is probable that the 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.
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37. (a) Sales tax collected on behalf of the taxing authority.
Questions :
(a) Sales tax collected on behalf of the taxing authority.
(b) Gain on the sale of an investment property.
(c) Amounts receivable from customers who have purchased toys.
(d) Gain on the sale of equity securities held as investments.
(e) Revaluation increment on the revaluation of operating properties under IAS 16.
Solutions:
1. No. This is an agency relationship.
2. No. This is not ordinary operations.
3. Yes. This falls within ordinary operations.
4. No. This is outside of the scope of IAS 18.
5. No. This is not ordinary operations.
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38. Is Company B obliged to make payment.
Analyse these sale of goods contact below as to weather sale has occurred and can /when revenue be recognised. Support your answers with reasons as per IAS18.
Case 1.
Company A sells goods to Customer B. On this delivery date, Company A invoices Customer B and is obliged to install the goods and further test that the goods perform when installed. Co A does not meet this obligation.
Case 2.
Company A sells goods to Customer B. The agreement between the two parties states that Customer B has the right to return the goods within 5 days of delivery.
Is Co A right in limiting the right of return. When can revenue be recognised?
Is Company B obliged to make payment.
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39. End of Lecture :
WEEK 5
Check class share for Tutorial Questions on this topic
Read more on IAS 18.
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