F7-06 IAS 18 Revenue - Lecture notes 6 PDF

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Session 6

IAS 18 Revenue FOCUS This session covers the following content from the ACCA Study Guide. B. Accounting for Transactions in Financial Statements 10. Revenue a) Apply the principle of substance over form to the recognition of revenue.

Session 6 Guidance Learn the definition of fair value according to IFRS 13 Fair Value Measurement (s.1.2). Read through the examples, taken from the standard itself, to understand the application of the concept of substance over form (s.5)

(continued on next page) F7 Financial Reporting

Becker Professional Education | ACCA Study System

Ali Niaz - [email protected]

VISUAL OVERVIEW Objective: To describe the principles of revenue recognition.

REVENUE • Scope • Measurement of Revenue • Revenue Recognition • Disclosure

SALE OF GOODS • Revenue Recognition • Risks and Rewards • Cost Recognition

RENDERING OF SERVICES

INTEREST, ROYALTIES AND DIVIDENDS

• Revenue Recognition

• Revenue Recognition

• Stage of Completion

• Recognition Bases

• Reliable Estimate of Outcome

SUBSTANCE OVER FORM • Conceptual Framework • Sale of Goods • Rendering of Services • Licence Fees and Royalties

Session 6 Guidance Learn, for example, the need to separate a service element from a sale of goods contract, where relevant (s.5.3.2). Understand how this session links to the substance over form issue covered in Session 3.

© 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Ali Niaz - [email protected]

6-1

Session 6 • IAS 18 Revenue

1

Revenue

1.1

Scope

F7 Financial Reporting

 The main issue in accounting for revenue is identifying when revenue should be recognised.

 The period of recognition can sometimes be difficult to identify as can whether revenue should be recognised at all; substance over form needs to be considered when deciding if revenue should be recognised or not.  IAS 18 Revenue identifies the three sources from which revenue arises:

SALE OF GOODS • Including goods produced or purchased for resale. • Examples: — merchandise purchased by a retailer — land and property held for resale.

RENDERING OF SERVICES • Typically involves performance of a contractually agreed task over an agreed period of time.

USE OF ENTITY ASSETS YIELDING INTEREST, ROYALTIES AND DIVIDENDS • Interest—charges for use of cash or amounts due. • Royalties—charges for use of long-term assets. • Dividends—distributions of profits to owners.

Revenue—the gross inflow of economic benefits during the period arising in the course of ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.*

*Only income receivable by an entity on its own account is included in revenue. The collection of taxes on behalf of the government is not revenue. Where an entity acts as an agent, revenue recognised is the commission receivable.

Fair value—the price which would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.*

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*This definition of fair value which is now used is defined in IFRS 13 Fair Value Measurement.

© 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Ali Niaz - [email protected]

F7 Financial Reporting

1.2

Session 6 • IAS 18 Revenue

Measurement of Revenue

 This takes into account trade discounts and volume rebates allowed.

 Where payment is made outside of normal credit terms then the cash flows should be discounted to present value in order to arrive at a fair value for the transaction. In accounting there is no such thing as interest-free credit.

Revenue is measured at fair value of the consideration received or receivable.

Illustration 1 Interest-Free C On 1 January 2014, SFD sold furniture for $4,000 with three years' interest-free credit. SFD's cost of capital is 8%. Revenue recognised in 2014 will be $3,175 ($4,000 × 1/(1.08)3). Also, SFD will recognise interest income of $254 ($3,175 × 8%). In 2015, interest income will be $274 ((3,175 + 254) × 8%). And in 2016, the remaining interest income of $297 will be recognised. This means that the full $4,000 will be recognised as revenue over the three years.

Exhibit 1

DETERMINING AND APPLYING FAIR VALUE

The following extract is taken from the notes to the financial statements of Vodafone Group plc's Annual Report 2013. Revenue recognition Arrangements with multiple deliverables In revenue arrangements including more than one deliverable, the deliverables are assigned to one or more separate units of accounting and the arrangement consideration is allocated to each unit of accounting based on its relative fair value. Determining the fair value of each deliverable can require complex estimates due to the nature of the goods and services provided. The Group generally determines the fair value of individual elements based on prices at which the deliverable is regularly sold on a standalone basis after considering volume discounts where appropriate.

1.3

Revenue Recognition

 According to the Framework, income is recognised (in profit or loss) when there is a probable increase in a future economic benefit which can be measured reliably.*

*Note that under the Framework's definition of "income" there is no distinction between revenue and gains which arise in the ordinary course of activities. However, such gains (which are often reported net of related expenses) are usually disclosed separately because the information is useful for decision-making purposes.

© 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Ali Niaz - [email protected]

6-3

Session 6 • IAS 18 Revenue

F7 Financial Reporting

 The recognition criteria in IAS 18: are usually applied separately to each transaction; but may be applied to separately identifiable components in a transaction; or  to two or more linked transactions.  

1.4

Disclosure

 Accounting policies adopted for revenue recognition.  Amount of each significant category of revenue recognised during the period.

2

Sale of Goods

2.1

Revenue Recognition Criteria

 Neither continuing managerial involvement nor effective control over the goods sold is retained.  The amount of revenue can be measured reliably.  It is probable that economic benefits associated with the transaction will flow to the entity.  Costs (to be) incurred in respect of the transaction can be measured reliably.

2.2

Significant risks and rewards of ownership are transferred to the buyer.

Risks and Rewards

 The passing of risks and rewards is crucial to revenue recognition.

 If legal title passes but risk and rewards are retained, there is no sale to be recognised. For example: where the entity retains obligation for unsatisfactory performance not covered by normal warranty provisions; or  where the receipt of revenue is contingent on the buyer selling the goods; or  goods are to be installed and the installation is a significant part of the contract and remains uncompleted; or  the buyer has the right to rescind and the seller is uncertain about the outcome.  If legal title does not pass but the risks and rewards do, then the transaction is recognised as a sale. 

2.3

Cost Recognition

 Usually revenue and expenses are to be recognised simultaneously.  Expenses normally can be measured reliably when other conditions for revenue recognition have been satisfied.  Revenue cannot be measured when the related expenses cannot be measured reliably. In such cases, any consideration is recognised as a liability, not as revenue.

6-4

© 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Ali Niaz - [email protected]

F7 Financial Reporting

Session 6 • IAS 18 Revenue

3

Rendering of Services

3.1

Revenue Recognition Criteria

Revenue is recognised by reference to the "stage of completion" of the transaction at the end of the reporting period (but only if the outcome can be estimated reliably). This "percentage completion method" is also applied in IAS 11 Construction Contracts.

3.2

Stage of Completion

 Methods to determine the stage of completion include: surveys of work completed (or "work certified");  services performed as a percentage of total services;* and  proportion of costs to date to total estimated costs. 

3.3

Reliable Estimate of Outcome

3.3.1

Conditions

*The percentage completion method provides useful information on service activity in the period.

 A reliable estimate is subject to all the following conditions being 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 can be measured reliably; and  costs to complete can be measured reliably. 

3.3.2

Factors to Be Considered

 The ability to make a reliable estimate of an outcome depends on: Agreement with the customer about: — enforceable rights of each party; — consideration to be exchanged; and — manner and the terms of settlement.  The existence of an effective internal financial reporting and budgeting system.  If an outcome cannot be measured reliably, revenue is recognised only to the extent that expenses recognised are recoverable. 

© 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Ali Niaz - [email protected]

6-5

Session 6 • IAS 18 Revenue

F7 Financial Reporting

Illustration 2 Sale of Goods with Service Componen ABC sells a computer to a customer, on the first day of the period, for $20,000. Included in the sales contract is a servicing element for three years from the date of sale. ABC estimates that the cost of service will be $1,500 per year and expects to make a profit of 25% on the servicing work. $1,500/0.75 = $2,000 per year. Therefore, for two years, $4,000 will be excluded from revenue and presented as deferred income in the statement of financial position (ignoring the time value of money). Revenue of $16,000 will be recognised in the period of the sale: $14,000 for the sale of goods and $2,000 for the first year's servicing contract.

4

Interest, Royalties and Dividends

4.1

Revenue Recognition Criteria

 It is probable that economic benefits will flow to the entity.  The amount of the revenue can be measured reliably.

4.2

Recognition Bases

 Interest—using the effective interest rate method (see Session 20 Financial Instruments).

 Royalties—an accrual basis in accordance with the substance of the agreement.

 Dividends—when the shareholder's right to receive payment is established.

5

Substance Over Form

5.1

Conceptual Framework

 The Conceptual Framework defines the elements of financial statements as assets, liabilities, equity, income and expenses (see Session 2)  The substance and economic reality of a transaction, and not merely its legal form, is an important consideration in assessing whether an item meets a definition of an element.  An appendix to IAS 18 discusses the factors that might influence the recognition of revenue for different types of transactions.*

5.2

Sale of Goods

5.2.1

Bill and Hold Sales

 Delivery is delayed at the buyer's request, but the buyer takes title and accepts billing.  Revenue is recognised when title passes to the buyer because in substance there has been a sale but, at the buyer's request, goods are still physically held by the seller.  Revenue is not recognised when there is simply an intention to acquire or manufacture the goods in time for delivery.

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Examples generally assume that amounts of revenue and costs can be measured reliably and that economic benefits are probable.

© 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Ali Niaz - [email protected]

F7 Financial Reporting

5.2.2

Session 6 • IAS 18 Revenue

Goods Shipped Subject to Conditions— Installation and Inspection

 Revenue is normally recognised when the buyer accepts delivery, and installation and/or inspection are complete (i.e. there is no difference between substance and form). If installation is a significant activity that is necessary to the buyer being able to use the goods the seller should delay revenue recognition until installation has been completed.  If, however, the activity is simple or routine (e.g. unpacking) the seller will recognise revenue on acceptance of the delivery. 

5.2.3

Consignment Sales*

 As the buyer is an agent for the seller revenue is not recognised by the seller until the goods have been sold onwards by the agent.  The seller does not pass on to the agent the risks and rewards of ownership so in substance a sale has not occured. The goods may be held by the agent but he cannot use or dispose of them as he likes. 5.2.4

*Under consignment sales contracts, the buyer undertakes to sell the goods on behalf of the seller.

Sale and Repurchase Agreements

 As previously explained (see Session 3) the substance of a contract for a sale of goods with a repurchase clause is that of a financing contract. Therefore: revenue from the legal sale must not be recognised; the "seller" must recognise the liability to repay the "sale proceeds" (i.e. loan) received;  over the life of the contract the "seller" will accrue interest expense (charged to profit or loss).  

5.3

Rendering of Services

The substance of most service-based contracts tends to be consistent with their legal form. The main accounting issue is when revenue should be recognised (rather than whether revenue should be recognised). 5.3.1

Installation Fees

 Recognise as revenue by reference to the stage of completion of the installation (similar to accounting for construction contracts), unless they are incidental to the sale of a product (in which case they are recognised when the goods are sold). 5.3.2

IAS 11 Construction Contracts is detailed in Session 8

Servicing Fees Included in the Price of the Product

 The cost of servicing needs to be separated from the physical cost of the goods. In substance there are two contracts: one for the sale of goods; and  another for the servicing/maintenance of the goods sold.  Revenue for the service element is recognised over the period during which the service is performed.  The amount to be deferred is enough to cover the expected costs of the services under the agreement, plus a reasonable profit on those services. 

© 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Ali Niaz - [email protected]

6-7

Session 6 • IAS 18 Revenue

5.3.3

F7 Financial Reporting

Franchise Fees

Franchise fees are recognised as revenue on a basis that reflects the substance of the franchise agreement. Franchise fees may cover:

 Supplies of equipment and other tangible assets The amount, based on the fair value of the assets sold, is recognised as revenue when the items are delivered or title passes.  Supplies of initial and subsequent services 

The initial fee is recognised as the initial service is completed.  Fees for the provision of continuing services are recognised as revenue as the services are rendered.  Sufficient fee must be deferred to cover the costs of continuing services and to provide a reasonable profit on those services.*  Continuing franchise fees 



5.4

Recognise as revenue as the services are provided or the rights used.

License Fees and Royalties

 Fees and royalties received are normally recognised in

*This means that some of the fee for the initial service may need to be deferred to satisfy this requirement.

accordance with the substance of the agreement.

 Such fees may be received for the use of an entity's assets.  Examples: Trademarks  Patents  Software  Music copyright  Motion picture films.  As a practical matter, this may be on a straight-line basis over the life of the agreement (e.g. when a licensee has the right to use certain technology for a specified period of time).  If receipt of a licence fee or royalty is contingent on the occurrence of a future event, revenue is recognised only when it is probable that the fee or royalty will be received (normally when the event has occurred). 

6-8

IAS 18 Revenue considers when revenue should be recognised in respect of the sale of goods, giving of services and interest, royalties and dividends. It could be the subject of a question which asks for explanation and application of its requirements.

© 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Ali Niaz - [email protected]

Session 6 Summary   

Revenue is the gross inflow of economic benefits arising from ordinary operating activities.



Recognition means incorporating an item in income when it meets the "probability" and "reasonable measurability" criteria.

 

Revenue is recognised according to the substance of a transaction.

  

The usual point of revenue recognition is on sale/delivery of goods.

Revenue is measured at the fair value of consideration received or receivable. Discounting is appropriate where the fair value of future consideration is less than the nominal value.

Revenue from the sale of goods is recognised when all of the specified criteria are met. As well as the Framework criteria, these include transfer of risks and rewards and effective control. For services rendered, the stage of completion must be measurable. Revenue is recognised at the earliest point from which profits arising from the transaction are recognised.

Session 6 Quiz Estimated time: 15 minutes

1.

Define "fair value". (1.1)

2.

Explain how revenue is measured. (1.2)

3.

State the FIVE criteria which must be satisfied before the sale of goods is recognised. (2)

4.

Describe the methods which can be used to estimate the stage of completion for a service contract. (3)

5.

Give the recognition bases for interest, royalties and dividends. (4)

6.

State THREE examples of transactions which illustrate the concept of substance over form. (5)

Study Question Bank Estimated time: 70 minutes

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