This article is relevant to the Diploma in International Financial Reporting and ACCA Qualification Papers F7 and P2
For almost all entities other than financial institutions, revenue is the largest single number in the financial statements. It is also a number that attracts a great deal of user attention. Whilst it might be accepted that profit is the most important single indicator of corporate financial performance revenue does not fall far behind. Indeed in many sectors, for example the retail food sector, revenue is a ‘headline number’ that is often announced first when results are communicated externally. In sectors where this is true, the remuneration packages of senior executives often include a ‘performance related element’ with revenue growth as the key determinant of ‘performance’.
Given the importance of revenue to the picture painted by the financial statements is it important that it is measured and presented fairly so that the users are given useful information on which to base their performance appraisal. The International Accounting Standards Board (IASB) has issued two International Financial Reporting Standards (IFRSs) that provide guidance in this area:
- IAS 18 – Revenue.
- IAS 11 – Construction Contracts.
IAS 18 is the IFRS that deals with revenue for the majority of entities, whilst IAS 11 very much applies the principles of IAS 18 to entities in the construction sector. Both standards are principles based and short on detail (this is particularly true of IAS 18). Therefore this has led to calls by some users for a more rigorous approach that removes some of the uncertainty that is caused by the existing IFRSs. As a result, the IASB is currently examining the existing standards with a view to replacing them with a more comprehensive standard in the future.
In this article we will:
- Explain exactly what IAS 18 and IAS 11 mean by ‘revenue’.
- Outline the principles that underpin the recognition and measurement of revenue.
- Review some of the implementation examples that are provided as an accompaniment to IAS 18.
- Outline the changes that are likely to the method of accounting for revenue in the future.
Meaning of ‘revenue’
IAS 18 defines revenue as ‘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’ (1). The following implications flow from this definition:
(a) Revenue should be stated before deduction of costs of sale. For example if goods are sold for $100 that cost the seller $60 to manufacture the revenue is $100, not $40.
(b) Revenue is recognised on the provision of goods and services that relate to the ordinary activities of the entity. If an entity disposes of property, plant and equipment at the end of its useful economic life the proceeds of disposal are not revenue for the entity. Instead the profit or loss on disposal is treated as a deduction from operating expenses (or as a separate line item in the statement of profit or loss, if it is sufficiently material).
(c) Sales taxes that are collected from the customer and remitted to the relevant authorities are not ‘revenue’. For example if goods are sold for $110, inclusive of recoverable sales taxes of 10%, the revenue is $100, not $110.
(d) If the seller is acting as agent, rather than as the principal, in a transaction, the revenue the seller should recognise is the amount of commission receivable rather than the gross amount collected from the customer. For example, if a travel agent sells a holiday to a customer for $1,000 plus a commission of $100, so that the customer pays $1,100 and the travel agent remits $1,000 to the entity actually providing the holiday, then the travel agent recognises revenue of $100.
Principles underpinning recognition of revenue
IAS 18 outlines the recognition principles in three parts:
1. Sale of goods:
Revenue is recognised when all the following conditions have been satisfied (2):
(a) The seller has transferred the significant risks and rewards of ownership of the goods to the buyer.
(b) The seller does not retain control over the goods or managerial involvement with them to the degree usually associated with ownership.
(c) The amount of revenue can be measured reliably.
(d) It is probable that the economic benefits associated with the transaction will flow to the seller
(e) The costs incurred or to be incurred by the seller in respect of the transaction can be measured reliably.
As far as these conditions are concerned, it is notable that:
- A number of the conditions ((a) and (b) particularly) are subject to a degree of interpretation and therefore there can be some uncertainty about whether or not revenue should be recognised.
- The conditions are such that all are likely to be satisfied at a particular point in time and so there is a critical point at which all the revenue from the sale of goods would be recognised. This approach contrasts with the approach taken to the recognition of revenue from the provision of services (see below):
2. Provision of services:
As stated above, there is a different approach taken to the recognition of revenue from the provision of services. IAS 18 states that ‘where the outcome of a transaction involving the rendering of services can be estimated reliably, associated revenue should be recognised by reference to the stage of completion of the transaction at the end of the reporting period’ (3). In other words, the revenue is recognised gradually, rather than all at one ‘critical point’, as is the case for revenue from the sale of goods. IAS 18 further states that the outcome of a transaction can be estimated reliably when all the following conditions are satisfied (3):
(a) The amount of revenue can be measured reliably.
(b) It is probable that the economic benefits associated with the transaction will flow to the seller.
(c) The stage of completion of the transaction at the end of the reporting period can be measured reliably.
(d) The costs incurred to date for the transaction and the costs to complete the transaction can be measured reliably.
IAS 18 does not prescribe one single method that should be used for determining the stage of completion of a service transaction. However the standard does provide some examples of suitable methods (4):
(a) Surveys of work performed.
(b) Services performed to date as a percentage of total services to be performed.
(c) The proportion that costs incurred to date bear to the estimated total costs of the transaction.
If it is not possible to reliably measure the outcome of a transaction involving the provision of services (perhaps because the transaction is in its very early stages) then revenue should be recognised only to the extent of costs incurred by the seller, assuming these costs are recoverable from the buyer (5).
IAS 18 does not adequately address the issue of revenue recognition on a construction contract. However, IAS 11 applies the basic principles we have already identified to such contracts, which are defined in IAS 11 as follows (6):
‘Contracts specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use’.
Most construction contracts are ‘fixed price contracts’. In such contracts the seller agrees to a fixed contract price, or a fixed rate per unit of output, which in some cases could be subject to cost escalation clauses (6).
Whilst a construction contract relates to the supply of goods, the ‘critical event basis’ used in IAS 18 as a means of determining the timing of the recognition of revenue on the supply of goods is not really suitable. This is because the ‘supply’ by the seller in the case of a construction contract takes place gradually over the term of the contract. Therefore IAS 11 basically requires that, where the outcome of a construction contract can be recognised reliably, revenue on such contracts should be recognised according to the stage of completion of the contract (7). IAS 11 imposes conditions very similar to the ones included in IAS 18 for the provision of services (3) that need to be satisfied before the outcome of a construction contract can be recognised reliably (8):
(a) Total contract revenue can be measured reliably.
(b) It is probable that the economic benefits associated with the contract will flow to the seller.
(c) Both the seller’s costs to complete the contract and the stage of contract completion at the end of the reporting period can be measured reliably.
(d) The seller’s costs to date attributable to the contract can be clearly identified and measured reliably so that actual costs incurred can be compared with prior estimates.
As is the case with service revenue recognition in IAS 18, IAS 11 does not prescribe one single method of computing the stage of completion of a construction contract. IAS 11 provides the following examples of methods that might be suitable (9):
(a) The proportion that contract costs incurred for work performed to date bear to total estimated contract costs.
(b) Surveys of work performed.
(c) Completion of a physical proportion of the contract work.
In another similarity with the treatment of revenue from the rendering of services under IAS 18, IAS 11 states that (10):
‘Where the outcome of a construction contract cannot be estimated reliably revenue shall be recognised only to the extent of contract costs incurred that it is probable will be recoverable’.
In summary, then, IAS 11 very much applies the principles set out in IAS 18 (for the recognition of revenue on the rendering of services) to the recognition of revenue from construction contracts.
3. Interest, royalties and dividends
IAS 18 states that entities should recognise revenue from the use of their assets yielding interest, royalties and dividends when (11):
(a) It is probable that the economic benefits associated with the transaction will flow to the entity.
(b) The amount of the revenue can be measured reliably.
The exact basis for the recognition of revenue from the use by others of the ‘seller’s’ assets depends on the type of transaction (12):
(a) Interest revenue should be recognised on the ‘effective interest’ basis.
(b) Royalties should be recognised on an accruals basis in accordance with amounts receivable as a result of ‘asset use’ up to the reporting date.
(c) Dividend revenue should be recognised when the right to receive payment is established. Often this does not happen in the case of dividends until the shareholder actually receives the dividend.
Principles underpinning measurement of revenue
IAS 18 states that ‘Revenue shall be measured at the fair value of the consideration received or receivable’ (12). In determining fair value it would be necessary to take into account any trade discounts or volume rebates granted by the seller.
In most cases, ‘fair value’ will represent the cash or cash equivalents received or receivable by the seller. However, where the consideration is deferred, IAS 18 explains that the arrangement effectively constitutes a financing transaction and the substance of the transaction is a supply of goods or services plus the provision of finance. In such circumstances, the amount receivable is split into (13):
(a) An amount receivable for the supply of goods or services. This is arrived at by discounting the future cash receivable by the seller. The imputed rate of interest is the prevailing borrowing rate of the buyer or, if more easily determinable, the rate that discounts the future cash receivable to the current cash price of the goods or services. This is recognised immediately.
(b) An amount receivable for the supply of finance to the buyer, recognised over the implied term.
A retail entity supplies products to the public on three year deferred payment terms. On 1 January 2013 the entity supplies a product for a total price of $13,310, payable on 1 January 2016. The credit rating of the customer is such that a relevant imputed annual rate of interest is 10%. The entity’s year end is 31 December.
On 1 January 2013 the total revenue from the sale would be split into:
(a) Revenue from the sale of goods of $10,000 ($13,310/(1.10) (3). This is recognised immediately by crediting revenue and debiting receivables.
(b) Interest revenue of $3,310 ($13,310 - $10,000). This is recognised over the three years as shown in the table below: