IAS 18 - Revenue (detailed review)
In the Framework for Financial Reporting, income is defined as the increase in economic benefits in the form of inflows or increase in asset or decrease in liability which results in increase in equity, other than contributions by equity participants. The concept of income included the both the Revenue and the Gains. Revenue is the Gross Cash Inflows from the principal business activities in the regular course of the business such as sales, interest, commission, fees and dividend.
This standard deals with the accounting treatment of revenue and it includes the guidance for the main issues such as the recognition and the amount at which revenue will be measured.
- The requirements of this standard are applicable for the accounting treatment of revenue arising from:
(a) The sale of goods, which are either produced by the entity or purchased for resale.
(b) The rendering of services, which are offered by the entity as main part of its business
(c) Return on entity’s assets such as interest income, dividend income and royalty income.
- Following aspects are not covered under the scope of this standard:
(a) Revenue from the lease arrangements covered under IAS 17
(b) Revenue from construction contract covered under IAS11
(c) Revenue from the insurance contracts covered under IFRS 4
(d) Dividend income upon investments which are measured under Equity method under AS 28
(e) Any changes in fair value of financial instruments covered under IFRS 9
(f) Any disposal gain or loss of financial instruments at the disposal date, covered under IFRS 9
(g) Any changes in fair value of biological assets related to the agricultural activity at initial and subsequent recognition which are covered under IAS 41
It is the gross cash inflow of economic benefits from the principal or core business activities in the normal course of business, which results in increase in equity. However, revenue does not include the amounts which are collected on behalf of third parties such as amounts collected by agent on account of principal, sales taxes and value added taxes.
It is amount that is expected to be received to sell an asset or required to be paid to transfer a liability in an orderly transaction between the market participants at thedate of measurement. (IFRS 13)
Measurement of Revenue
The entity will initially measure the revenue at the fair value of consideration received or receivable by the entity, after deducting any trade discounts or volume rebates given by the enterprise.
For cash based transaction, the cash received will be the revenue.
If the goods are sold on extended credit period, the revenue will be the fair value of the goods which will be determined by discounting the future cash receipts using appropriate discount rate, and any excess received over the fair value of goods will be treated as Interest income which will be recognize over the period of credit.
Application of Measurement Role:
The entity will apply the measurement rule to the following aspects as:
Swap or Exchange of Goods:
If an entity chooses to exchange or swap the goods with another entity which are similar in nature, at different locations for some commercial reasons, in such circumstances no revenue will be recognize as such exchange or swap for the similar goods does not result in increase in economic benefits.
- If an entity chooses to exchange or swap the goods with another entity which are dissimilar in nature, at different locations for some commercial reasons this will result in revenue and entity will recognize such revenue:
(a) At the fair value of goods received ± any Cash involved
(b) If the fair value of the goods received is not measurable then revenue will be the fair value of goods given up ± any Cash involved
Identification of the Transaction:
The measurement requirement of this standard is normally applicable to the individual transaction as whole. However, for the transaction involving more than one component i.e. Complex Transactions, the entity will apply the measurement requirements for such complex transaction as follows:
(a) Sometimes each component of a complex transaction is accounted for separately to get the true substance of the complex transaction i.e. when goods are sold with after sale services in a single transaction, the fair value of the goods will be recognized immediately as revenue, and the revenue related to the after sale services will be treated as deferred income which will be recognized over the period of services.
(b) Sometimes the components of complex transaction are accounted for collectively to get the true commercial substance of the complex transaction such as Sale and buy back arrangements, in which goods are sold by the entity and at the same time entity enters into contact with the same party to buy back those goods on a future certain date.
In the above examples, both of the components involved in the transaction will be accounted for collectively to get the true commercial substance of the complex transaction.
Recognition of Revenue
The entity will recognize the revenue related to the following aspects as:
1. Sale of Goods:
The entity will recognize the revenue related to the sale of goods when following conditions are met:
(a) The entity has transferred the substantial risks and rewards incidental to the ownership of the goods, to the buyer.
(b) The entity retains no control over goods after sale.
(c) Revenue is reliably measureable
(d) The economic benefits related to the transaction are probable to flow to the entity; and
(e) The costs incurred or to be incurred related to the transaction reliably measurable.
The assessment that when the substantial risks and rewards related to the ownership of the goods are transferred to the buyer depends upon the circumstances. Normally, the transfer of the risks and rewards of ownership takes place, when the legal title or the possession of the goods is transferred to the buyer.
However in some cases, the risks and rewards of ownership are transferred to buyer at a different time from the transfer of legal title or possession i.e. some entities retain the legal title of the goods up to the recovery of related revenue but risks and rewards related to the goods are transferred with the possession of the goods, in such a case revenue will be recognize as substantial risks and rewards are transferred to the buyer with the possession.
- If the entity does not transfer the substantial risks of ownership and these rest with the entity, then such transaction is not a sale and revenue is not recognized. This may be the case in the following circumstance:
(a) When the receipt of the revenue is contingent on the sale of goods by the buyer;
(b) When the goods are sold with installation facility and the installation is a substantial part of the contract which has not yet been completed to date
(c) When goods are sold on sale or return basis for the reason specified in the sales contract.
Revenue will not be recognized if the collection of revenue is subject to an uncertain situation. However, revenue will be recorded when such uncertainty is removed.
If it is probable that an entity will not be able to recover the amount related to a sale transaction which has already been recorded as revenue, then such amount will be recorded as an expense in the relevant period instead of an adjustment to the revenue.
- Any expense related to the sale of goods will be recorded in the same period in which revenue is recognized, on the basis of matching concept.
2. Rendering of Services:
The recognition of revenue related to the services depends upon the outcome of the services. Therefore, the entity will recognize the revenue related to the services as:
a) When Outcome of the Services is reliably measurable:
If the outcome of the services is reliably measureable, then revenue related to the services will berecognized, on the basis of “stage of completion” measured at the end of the accounting period.
The outcome of the services will deem to be reliably measurable if:
(a) The stage of completion of the services is reliably measurable at the end of reporting period
(b) Revenue is reliably measureable
(c) The economic benefits related to the transaction are probable to flow to the entity; and
(d) The costs incurred or to be incurred related to the transaction are reliably measurable.
The reliable estimate for the outcome of the services also requires the entity to be agreed with the other parties in respect of the following:
(a) The rights of each party related to the contract of services
(b) The nature of consideration for the parties to the contract and
(c) The mode and terms for the settlement of consideration.
The stage of completion of a transaction can be determined by using one of the following methods depending on the nature of the transaction:
(a) The proportion of costs incurred to date compared to the estimated total costs of the transaction
(b) The proportion of the services performed to date compared to the total services to be performed
(c) Work survey Method.
When services are performed by the entity in a continuous manner over a specified period of time, then entity will recognize the revenue on a straight-line basis over the specified period unless some other method is appropriate to determine the stage of completion.
b) When Outcome of the Services is not reliably measurable:
If the outcome of the services is not reliably measureable, then revenue related to the services will be recognized only up to the extent of cost incurred, if it is probable that entity will be able to recover such cost.
- If the outcome of services is reliably measurable and it is not probable that the costs incurred will be recovered, revenue will not be recognized and the costs incurred will be recognized in the statement of profit or loss as an expense. However, when any such uncertainty no longer exists, then entity will recognize related revenue on the basis of stage of completion.
3. Return on Assets:
- The entity will recognize the revenue related to the use of entity assets by others such as interest, dividend and royalty income when:
(a) The economic benefits related to the transaction are probable to flow to the entity and
(b)The amount of revenue is reliably measurable.
- Revenue shall be recognized on the following bases:
(a) Interest will be recognized by the entity, on accrual basis using the effective interest rate method
(b) Dividend will be recognized by the entity, when it has been declared by the investee company.
(c) Royalty income will be recognized by the entity on accrual basis as per the terms of the contract.
This Standard requires an entity to disclose the following:
The accounting policies of the entity for the recognition of revenue
The methods adopted by the entity to determine the stage of completion of transactions
- The amount of revenue recognized during the current period relating to following:
(a) Sale of goods
(b) Rendering of services
(f) The amount of revenue arising from exchanges of goods or services
AB Ltd. operates in automobile industry and sells vehicles to the general public. The cars are supplied on consignment by two manufacturers, Smith and Alex, who trade on different contractual terms as follows:
(a) Smith supplies cars to AB Ltd. on terms that allow the entity to display the cars for a period of four months from the date of delivery or when the cars are sold by AB Ltd. to the customer in case it is less than four months period. Within this time period AB Ltd. has the right to return the cars to the supplier or can be asked by Smith to transfer the cars to another dealer (without any charge to AB Ltd.).
AB Ltd. pays the manufacturer's list price at the end of the four month period (or at the date of sale if earlier). In recent years AB Ltd. has returned several slow moving cars to the supplier and has also been required to transfer cars to the other dealers at supplier's request.
(b) Alex supplies cars on the terms that AB Ltd. has to pay 15% of the list price at the date of delivery and 1.5% of the outstanding balance per month as a display charge. After three months (or earlier if AB Ltd. chooses), the entity is required to pay the balance of the purchase price or return the cars to the supplier.
If the cars are returned to the supplier, AB Ltd. has to pay for the transportation costs and loses its 15% deposit. Due to this AB Ltd. has only returned the cars to the supplier only once in the last five years.
How the above transactions and events will be treated in the financial statements of AB Ltd.?
The transactions will be accounted for in the financial statements of the AB Ltd. as follows:
(a) As per the terms of the contract, it will neither be treated as the sale of supplies nor the purchase by AB Ltd. as the entity has the right to return the cars to supplier any time without incurring any charge. It is a consignment agreement. The cars will remain the property of the supplier as AB Ltd. bears no risks of ownership.
However, if the cars are sold or AB ltd. decides to keep it, at the end of four months period, at the list price in force at that date. This is therefore the point at which the risks and rewards pass to AB Ltd. Up to that point there is no sale and the cars will not appear in inventory of the AB Ltd.
(b) The nature of the contract terms with Alex reflects it is a credit purchase of the cars. As per the contract AB Ltd. is required to pay 15% initial deposit at the date on delivery of the car and obtains ownership of the vehicles at that point. If it fails to pay the remaining balance amount at the end of three months period, it loses its 15% deposit and has to return the cars at its own expense.
It reflects that AB Ltd. owns the risks of ownership of cars after the date of delivery. Therefore, AB Ltd. should show the cars in its inventory and recognize payable for the balance amount. The 1.5% display charge should be treated as interest expense.
AB Ltd. has secured a contract with a manufacturing entity Triangle Ltd on 1 January 2013. As per the contract AB Ltd. will provide repair and maintenance services to Triangle Ltd. for their plant and equipment in production department for a period of 5 years, when required by the entity. The contract price agreed was $2 million.
How the above transactions and events will be treated in the financial statements of AB Ltd. for the year ended 31December 2013?
IAS 18 requires,when services are performed by the entity in a continuous manner over a specified period of time, then entity will recognize the related revenue on a straight-linebasis over the specified period unless some other method is appropriate to determine the stage of completion. Therefore, AB Ltd. will recognize the revenue in respect of this contract over the 5 years period as:
$2,000,000 / 5 years = $400,000. p.a.