CHAPTER 4
REVENUE RECOGNITION
Connolly – International Financial Accounting and Reporting – 4th Edition
4.1 INTRODUCTION
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Significant weight and importance given to revenue, and
its recognition
Often a barometer of past performance and future
prospects
Susceptible to fraud
Numerous examples of improper revenue recognition
Connolly – International Financial Accounting and Reporting – 4th Edition
4.2 ACCOUNTING FOR REVENUE
Background
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Conceptual Framework for Financial Reporting (2010)
(See Chapter 1)
Sales, fees, interest dividends and royalties
Debate typically placed in the context of historical cost
double entry system
UK GAAP perspective – Statement of Principles, SSAP2,
FRS 5, FRS 18
IAS 18 Revenue (See next)
Connolly – International Financial Accounting and Reporting – 4th Edition
IAS 18 Revenue
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Objective
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To prescribe the treatment of revenue arising from
certain types of transactions and events
Definition
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Gross inflow of economic benefits...arising in the course
of ordinary activities...when those inflows result in
increases in equity, other than increases relating to
contributions from equity participants
Connolly – International Financial Accounting and Reporting – 4th Edition
IAS 18 Revenue
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×
×
×
×
Sale of goods (See next)
Rendering of services (See later)
Use by others of entity assets yielding interest, royalties
and dividends (See later)
Lease income (IAS 17 – See Chapter 8)
Dividends from associates accounted using equity
method (IAS 28 – See Chapter 29)
Changes in fair value/disposal of financial instruments
(IAS 39 – See Chapter 25)
Changes in value of other assets
Connolly – International Financial Accounting and Reporting – 4th Edition
1. Sale of goods
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Revenue from the sale of goods should be recognised when:
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Significant risks and rewards of ownership transferred to
buyer
Seller retains neither continuing managerial involvement
nor effective control over the goods involved
Amount of revenue can be measured reliably
Probable economic benefits will flow
Related costs can be measured reliably
See Chapter 4, Examples 4.1, 4.2 and 4.3
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 4.1: Contract performance
Chris Limited (Chris) received and accepted an order for
‘widgets’ from a regular customer, Toffer Limited (Toffer), on 21
December 2012 for an agreed price of €50,000. However, due
to the Christmas holidays, the goods were not despatched until
4 January 2013. Toffer received the goods on the same day,
and paid for them on 23 January 2013. The goods are included
in Chris’s inventory at 31 December 2012 at their cost price of
€40,000.
Requirement
Explain how this transaction should be accounted for in Chris’s
financial statements for the year ended 31 December 2012.
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 4.1: Suggested solution
Revenue should only be recognised when a critical event
occurs. Normally, this is when ‘performance’ has been carried
out via delivery of an asset to a customer (i.e. this is the point at
which the revenue recognition criteria have been met).
As this occurs in 2013, therefore the goods should remain in
Chris’s inventory at 31 December 2012 at their cost price of
€40,000.
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 4.2: Transfer of risks and rewards
Due to increased competition, particularly from overseas, Caiti
Limited (Caiti) began selling goods on a sale or return basis
during 2012. Under the terms of the sale, customers are able to
return items within 31 days from the date of sale. Payment for
goods not returned within this 31 day period is required within
28 days thereafter. During 2012, a number of Caiti’s customers
exercised their right of return. Caiti typically sells goods on this
basis at cost plus 20%. The sales figure in the draft financial
statements for the year ended 31 December 2012 is based
upon goods supplied to customers by 31 December 2012.
Sales on a sale or return basis in November and December
2012 were €1,000,000 and €1,200,000 respectively.
Requirement
Explain how this transaction should be reflected in the financial
statements of Caiti for the year ended 31 December 2012.
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 4.2: Suggested solution
IAS 18 states that revenue should not be recognised until the
risks and rewards associated with ownership have been
transferred to the buyer. In this instance, title does not pass
until the end of the return period (i.e. 31 days from date of sale).
Furthermore, it appears that the ‘receivable’ is not due until title
has passed, i.e. after 28 days from the date of sale. Therefore,
Caiti should not recognise the revenue until the 31 day period
has expired. Thus, the December 2012 sales should not be
recognised and these goods should be included in inventory at
31 December 2012 at cost in accordance with IAS 2 Inventories
(See Chapter 11)The December sales of €1,200,000 are
included in inventory at their cost of €1,000,000. However, the
November sales of €1,00,000 would be recognised in revenue
as the risks and rewards have been transferred from Caiti to the
customer at 31 December 2012.
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 4.3: Substance of the transaction
Ruby Limited (Ruby) is a port manufacturer and the
manufacturing process involves maturing wine in stainless steel
for two years before bottling. The port is sold at cost plus 200%.
On 1 January 2012, the first day of its accounting period, Ruby
sold 100,000 litres of one year old port to its investment bank at
its cost to Ruby of €1,260,000 and agreed to buy it back two
years later for €1,524,600.
Requirement
Explain how this transaction should be accounted for in Ruby’s
financial statements for the year ended 31 December 2012 and
2013.
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 4.3: Suggested solution
Refer to IAS 18 revenue recognition conditions.
The substance of the transaction is not a sale but a means of raising
finance. The appropriate accounting entry would be to recognise the loan
and charge the interest related to this advance in the financial statements.
The interest is calculated as the difference between the cost of the wine and
the amount it will cost to buy it back in two years time.
Dr Bank
Cr Loan
Year ended 31 December 2012:
Dr SPLOCI – P/L – finance cost
Cr Loan
Year ended 31 December 2013:
Dr SPLOCI – P/L – finance cost
Cr Loan
1,260,000
1,260,000
126,000
126,000
138,600
138,600
Note: Interest charge 1,524,600 / 1,260,000 = 1.21
Square root of 1.21 is 1.1, therefore the interest rate is 10%
Connolly – International Financial Accounting and Reporting – 4th Edition
2. Rendering of services
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Revenue from the rendering of services should be
recognised when:
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Amount of revenue can be measured reliably
Probable that the economic benefits associated with
the transaction will flow to the enterprise
Stage of completion of the transaction at the reporting
date can be measured reliably
Costs incurred and costs to complete the transaction
can be measured reliably
See Chapter 4, Examples 4.4 and 4.5
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 4.4: Nature of relationship
Erin plc (Erin), a company based in Ireland, prepares its financial
statements to 31 December each year. Columbus Inc. (Columbus),
an American company, has approached Erin to sell Columbus’s
products in Ireland. Columbus has offered the following alternatives
to Erin:
a) Erin acts as Columbus’s agent and sells the products at a fixed
price calculated to yield a profit margin of 50%, receiving a
commission of 12.5% of sales; or
b) Erin buys the products from Columbus and sells them at a gross
profit margin of 25%.
It is estimated that Erin will achieve total sales of €140 million per
annum from Columbus’s products.
Requirement
Explain how the two proposals should be accounted for in Erin’s
financial statements.
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 4.4: Suggested solution
The two proposals put forward by Columbus are very different.
Under scheme a) Erin would act as Columbus’s agent. Under this
arrangement Erin must only record in income the amount of
commission it is entitled to under the agreement, amounting to €17.5
million (€140 million x 12.5%) based on the estimated figures.
Under scheme b) Erin would buy the goods from Columbus as
principal and the sales and cost of sales would be included in Erin’s
statement of profit or loss and other comprehensive income – profit
or loss as normal.
Sales
Cost of sales
Gross profit
€m
140
(105)
35
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 4.5: Bundling
Kitkar Limitied (Kitkar) sold a vehicle with a warranty for
€30,000. If it sold the vehicle and the warranty separately it
would cost €27,000 for the vehicle and €4,500 for the warranty.
Requirement
Explain how Kitkar should account for this transaction in its
financial statements.
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 4.5: Suggested solution
The overall transaction price is €30,000 should be allocated pro
rata to the two distinct obligations.
The sale of the vehicle element is €25,714 (€27,000 / €31,500
X €30,000), and the amount allocated to the warranty element
is €4,286 (€4,500 / €31,500 X €30,000).
Kitkar can recognise revenue of €25,714 on the sale of the
vehicle immediately, with the revenue of €4,286 relating to the
warranty being recognised over the life of the warranty.
Connolly – International Financial Accounting and Reporting – 4th Edition
3. Interest, royalties and dividends
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Revenue arising from interest, royalties and dividends should
be recognised when:
 economic benefits probable
 reliable measurement possible
 Interest
 Time-proportion/effective yield basis
 Royalties
 Accrual basis per substance of agreement
 Dividends
 When right to receive established
See Chapter 4, Example 4.6
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 4.6: Right to receive
Seasons Limited (Seasons) is a wholly owned subsidiary of
Vivaldi Limited (Vivaldi), with both companies preparing their
financial statements to 31 December each year. On 23 January
2013, after reviewing the draft financial statements for the year
ended 31 December 2012, the directors of Seasons proposed
an ordinary dividend of 10 cent per ordinary share in respect of
the year ended 31 December 2012.
Requirement
Explain how this transaction should be accounted for in the
financial statements of both Seasons and Vivaldi for the year
ended 31 December 2012.
Connolly – International Financial Accounting and Reporting – 4th Edition
Example 4.6: Suggested solution
In accordance with IAS 10 Events after the reporting Period
(See Chapter 15) equity dividends declared after the end of the
reporting period do not meet the definition of a liability at the
end of the reporting period and should not be accrued in
Seasons’ 2012 financial statements (i.e. there is no obligation
as the dividends have not been approved at the reporting date).
These dividends should be disclosed in a note to the financial
statements.
The dividend receivable by Vivaldi cannot be recognised as
investment income for 2012 as Vivaldi’s right to receive only
arises when the dividends have been approved.
Connolly – International Financial Accounting and Reporting – 4th Edition
Effect of uncertainties on revenue recognition
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When the outcome of a transaction cannot be reliably
estimated, revenue should be recognised only to extent of
those expenses incurred that are recoverable.
Connolly – International Financial Accounting and Reporting – 4th Edition
Disclosure requirements
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Accounting policies – including methods to determine stage
of completion of services
Amount of each significant category of revenue arising in the
period, including that from:
 sale of goods
 rendering of services
 interest
 royalties
 dividends
Amount of revenue arising from exchanges of goods and
services included in each significant category of revenue
See Chapter 4, Example 4.7
Connolly – International Financial Accounting and Reporting – 4th Edition
4.3 The Revenue Operating Cycle
Timing of Recognition
Placing of an order by a
customer, prior to
manufacture
During production
At the completion of
production
Criteria
Little or no uncertainty
regarding final outcome.
However, in most cases, there
is likely to be uncertainty,
therefore generally not
prudent to recognise revenue.
If revenues accrue over time,
and no significant uncertainty
as to measurability or
collectability, then revenue m
Nearing point where most
uncertainties resolved,
however recognition usually
delayed until delivery. Ready
market exists, together with
market price. Insignificant
marketing costs involved.
Connolly – International Financial Accounting and Reporting – 4th Edition
Examples of Practical
Application
In rare circumstances, longterm construction contracts.
Accrual of interest, dividends
and royalties.
Accounting for long-term
construction contracts using
the percentage of completion
method.
Certain precious metals and
commodities.
4.3 The Revenue Operating Cycle (cont’d)
Timing of Recognition
At the time of sale (but before
delivery)
On delivery
Subsequent to delivery
On an apportionment basis
(revenue allocation approach)
Criteria
Goods acquired or manufactured,
and capable of immediate delivery.
Selling price established and
expenses ascertained. No
significant uncertainties (i.e. cash
collection reasonably certain and
likelihood of returns low)
Recognition criteria before delivery
not met and no significant
uncertainties remain. Usually
revenue recognised at this point.
Significant uncertainty over
collectability at delivery. At time of
sale not possible to value
consideration with sufficient
accuracy.
Revenue represents the supply of
initial and subsequent
goods/services.
Connolly – International Financial Accounting and Reporting – 4th Edition
Examples of Practical
Application
Certain sales of goods (e.g. bill
and hold sales).
Property sales where there is an
irrevocable contract.
This is the point at which revenue
is recognised for most goods and
services.
Property sales where there is
doubt that sale will be completed.
Sales where right of return exist.
Goods shipped subject to
conditions (e.g. installation,
inspection or maintenance).
Franchise fees or the sale of
goods with after-sales service.
Revenue Recognition – Summary
Goods
Services
• Transfer of risks &
rewards
• Management
involvement
• Substance of the
transaction
1. Measure reliably
2. Flow of economic
benefits probable
3. Costs measured
reliably
• Percentage of
completion method
• IAS 11 Construction
Contracts
Interest – time apportion
Royalties – accruals basis
Dividends – when right to receive established
Connolly – International Financial Accounting and Reporting – 4th Edition
Revenue Recognition – Summary
Measurement:
Fair value of consideration received or receivable
If consideration is receivable in the future, use present
value and recognise interest income as discount unwinds
Connolly – International Financial Accounting and Reporting – 4th Edition
Further Example: Bundling
During the year ended 31 December 2012, LN began selling a
particular model of TV with a three-year warranty at no extra
cost to the customer. LN sells the TV for €500, and during the
year ended 31 December 2012, 200 of these TVs were sold
and included in revenue for the year ended 31 December 2012
at €500 each. One of LN’s competitors sells an identical TV
without a warranty for €475, while an unrelated insurer offers
an equivalent warranty for €75. The experience of other
retailers suggests that the TVs have an equal probability of
breaking down in each of the three years covered by the
warranty.
Connolly – International Financial Accounting and Reporting – 4th Edition
Further Example: Bundling – suggested solution
Substance = LN has sold two products: TV & warranty.
Should be ‘unbundled’ and revenue recognised separately.
FV of TV:
€500 x (€475/(€475+ €75)) = €431.82 say €432
Recognise in 2006 as LN has fulfilled contractual obligation.
FV of warranty:
€500 - €432 = €68
Recognise over the 3 year warranty period.
Therefore defer €68 x 200 x 2/3 = €9,067.
DR
CR
CR
Revenue
Current liabilities
Non current liabilities
€’000
9,067
Connolly – International Financial Accounting and Reporting – 4th Edition
€’000
4,534
4,533
IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
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IFRS 15 was issued in May 2014 and is effective for an
entity's first annual IFRS financial statements for periods
beginning on or after 1 January 2017. Earlier application is
permitted.
IFRS 15 replaces IAS 11 Construction contracts, IAS
18 Revenue and IFRIC 13 Customer Loyalty Programmes
IFRS 15 moves away from a revenue recognition model
based on an ‘earnings process’ to an ‘asset-liability’
approach based on transfer of control
The core principle of IFRS 15 is that an entity will
recognise revenue to depict the transfer of promised
goods or services to customers in an amount that reflects
the consideration (payment) to which the entity expects to
be entitled in exchange for those goods or services.
Connolly – International Financial Accounting and Reporting – 4th Edition
IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS
To apply this principle, a five-step model framework must be
followed:
• Step 1: Identify the contract(s) with a customer.
• Step 2: Identify the performance obligations in the contract.
• Step 3: Determine the transaction price.
• Step 4: Allocate the transaction price to the performance
obligations in the contract.
• Step 5: Recognise revenue when (or as) the entity satisfies
a performance obligation.
• The industries most impacted by IFRS 15 are likely to be
telecom, software development, real estate and other
industries with long-term contracts. This includes an
industry where bundled contracts of ‘product + service’ are
quite common.
Connolly – International Financial Accounting and Reporting – 4th Edition