Concepts, Rules, and Examples | WILEY IAS 2003: Interpretation and Application of International Accounting Standards

Revenue.

The IASC's Framework defines "income" to include both revenue and gains. IAS 18 deals only with revenue. Revenue is defined as income arising from the ordinary activities of an enterprise and may be referred to by a variety of names including sales, fees, interest, dividends and royalties. Revenue encompasses only the gross inflow of economic benefits received or receivable by the enterprise, on its own account. This implies that amounts collected on behalf of others—such as in the case of sales tax or value added tax, which also flow to the enterprise along with the revenue from sales—do not qualify as revenue. Thus, these other collections should not be included in an entity's reported revenue. Put another way, gross revenue from sales should be shown net of amounts collected on behalf of third parties.

Similarly, in an agency relationship the amounts collected on behalf of the principal is not regarded as revenue for the agent. Instead, the commission earned on such collections qualifies as revenue of the agent. For example, in the case of a travel agency, the collections from ticket sales do not qualify as revenue or income from its ordinary activities. Instead, it will be the commission on the tickets sold by the travel agency that will constitute that entity's gross revenue.

Scope of the standard.

This standard applies to the accounting for revenue arising from

The sale of goods;
The rendering of services; and
The use of the enterprise's assets by others, yielding (for the enterprise) interest, dividends and royalties.

A sale of goods encompasses both goods produced by the enterprise for sale to others and goods purchased for resale by the enterprise. The rendering of services involves the performance by the enterprise of an agreed-upon task, based on a contract, over a contractually agreed period of time.

The use of the enterprise's assets by others gives rise to revenue for the enterprise in the form of

Interest which is a charge for the use of cash and cash equivalent or amounts due to the enterprise;
Royalties which are charges for the use of long-term assets of the enterprise such as patents or trademarks owned by the enterprise; and
Dividends which are distributions of profit to the holders of equity investments in the share capital of other enterprises.

The standard does not apply to revenue arising from

Lease agreements that are covered by IAS 17;
Dividends arising from investments in associates which are accounted for using the equity method, which are dealt with in IAS 28;
Insurance contracts of insurance enterprises, a topic presently not covered by any IAS although this is on the IASC's agenda for development of a standard in future;
Changes in fair values of financial instruments, which is addressed by IAS 39;
Natural increases in herds, agriculture and forest products, a subject currently in Exposure Draft stage and soon to be promulgated as a standard;
The extraction of mineral ores, presently not covered by any IAS but which is also on the agenda of the IASC for development of a standard in the future; and
Changes in the value of other current assets.

Measurement of revenue.

The quantum of revenue to be recognized is usually dependent upon the terms of the contract between the enterprise and the buyer of goods, the recipient of the services, or the users of the assets of the enterprise. Revenue should be measured at the fair value of the consideration received or receivable, net of any trade discounts and volume rebates allowed by the enterprise.

When the inflow of the consideration, which is usually in the form of cash or cash equivalents, is deferred, the fair value of the consideration will be an amount lower than the nominal value of the consideration. The difference between the fair value and the nominal value of the consideration, which represents the time value of money, is recognized as interest revenue.

When the enterprise offers interest-free extended credit to the buyer or accepts a promissory note from the buyer (as consideration) that bears either no interest or a below-market interest rate, such an arrangement would be construed as a financing transaction. In such a case the fair value of the consideration is ascertained by discounting the future inflows using an imputed rate of interest. The imputed rate of interest is either "the prevailing rate of interest 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." (IAS 18, Paragraph 11)

To illustrate this point, let us consider the following example:

Hero International is a car dealership that is known to offer excellent packages for all new models of Japanese cars. Currently, it is advertising on the television that there is a special offer for all Year 2003 models of a certain make. The offer is valid for all purchases made on or before September 30, 2002. The special offer deal is either a cash payment in full of $20,000 or a zero down payment with extended credit terms of 2 years—24 monthly installments of $1,000 each. Thus, anyone opting for the extended credit terms would pay $24,000 in total.
Since there is a difference of $4,000 between the cash price of $20,000 and the total amount payable if the car is paid for in 24 installments of $ 1,000 each, this arrangement is effectively a financing transaction (and of course a sale transaction as well). The cash price of $20,000 would be regarded as the amount of consideration attributable to the sale of the car. The difference between the cash price and the aggregate amount payable in monthly installments is interest revenue and is to be recognized over the period of 2 years on a time proportion basis (using the effective interest method).

Exchanges of similar and dissimilar goods and services.

When goods or services are exchanged or swapped for similar goods or services, the earning process is not considered to be complete. Thus the exchange is not regarded as a transaction that generates revenue. Such exchanges are common in certain commodity industries, such as oil or milk industries, where suppliers usually swap inventories in various locations in order to meet geographically diverse demand on a timely basis.

When goods or services of a dissimilar nature are swapped, the earning process is considered to be complete, and thus the exchange is regarded as a transaction that generates revenue. The revenue thus generated is measured at the fair value of the goods or services received or receivable. If in this process cash or cash equivalents are also transferred, then the fair value should be adjusted by the amount of cash or cash equivalents (commonly referred to as "boot") transferred. In certain cases, the fair value of the goods or services received cannot be measured reliably. Under such circumstances, fair value of goods or services given up, adjusted by the amount of boot transferred, is the measure of revenue to be recognized. Barter arrangements are examples of such exchanges involving goods that are dissimilar in nature.

Identification of the transaction.

While setting out clearly the criteria for the recognition of revenue under three categories—sale of goods, rendering of services and use of the enterprise's assets by others—the standard clarifies that these should be applied separately to each transaction. In other words, the recognition criteria should be applied to the separately identifiable components of a single transaction consistent with the principle of "substance over form."

For example, a washing machine is sold with an after-sale service warranty. The selling price includes a separately identifiable portion attributable to the after-sale service warranty. In such a case, the standard requires that the selling price of the washing machine should be apportioned between the two separately identifiable components and each one recognized according to an appropriate recognition criterion. Thus, the portion of the selling price attributable to the after-sales warranty should be deferred and recognized over the period during which the service is performed. The remaining selling price should be recognized immediately if the recognition criteria for revenue from sale of goods (explained below) are satisfied.

Similarly, the recognition criteria are to be applied to two or more separate transactions together when they are connected or linked in such a way that the commercial effect (or substance over form) cannot be understood without considering the series of transactions as a whole. For example, company X sells a ship to company Y and later enters into a separate contract with company Y to repurchase the same ship from it. In this case the two transactions need to be considered together in order to ascertain whether or not revenue is to be recognized.

Revenue recognition criteria.

According to the IASC's Framework, revenue is to be recognized when it is probable that future economic benefits will flow to the enterprise and reliable measurement of the quantum of revenue is possible. Based on these fundamental tenets of revenue recognition stated in the IASC's Framework, IAS 18 establishes criteria for recognition of revenue from three categories of transactions—the sale of goods, the rendering of services, and the use by others of the enterprise's assets. In the case of the first two categories of transactions producing revenue, the standard prescribes certain additional criteria for recognition of revenue. In the case of revenue from the use by others of the enterprise's assets, the standard does not overtly prescribe additional criteria, but it does provide guidance on the bases to be adopted in revenue recognition from this source. This may, in a way, be construed as an additional criterion for revenue recognition from this source of revenue.

Revenue recognition from the sale of goods.

Revenue from the sale of goods should be recognized if the all of the five conditions mentioned below are met.

The enterprise has transferred significant risks and rewards of ownership of the goods to the buyer;
The enterprise does not retain either continuing managerial involvement (akin to that usually associated with ownership) or effective control over the goods sold;
The quantum of revenue to be recognized can be measured reliably;
The probability that economic benefits related to the transaction will flow to the enterprise exists; and
The costs incurred or to be incurred in respect of the transaction can be measured reliably.

The determination of the point in time when an enterprise is considered to have transferred the significant risks and rewards of ownership in goods to the buyer is critical to the recognition of revenue from the sale of goods. If upon examination of the circumstances of the transfer of risks and rewards of ownership by the enterprise it is determined that the enterprise could still be considered as having retained significant risks and rewards of ownership, the transaction could not be regarded as a sale.

Some examples of situations illustrated by the standard in which an enterprise may be considered to have retained significant risks and rewards of ownership, and thus revenue is not recognized, are set out below.

A contract for the sale of an oil refinery stipulates that installation of the refinery is an integral and a significant part of the contract. Therefore, until the refinery is completely installed by the enterprise that sold it, the sale would not be regarded as complete. In other words, until the completion of the installation, the enterprise that sold the refinery would still be regarded as the effective owner of the refinery even if the refinery has already been delivered to the buyer. Accordingly, revenue will not be recognized by the enterprise until it completes the installation of the refinery.
Goods are sold on approval, whereby the buyer has negotiated a limited right of return. Since there is a possibility that the buyer may return the goods, revenue is not recognized until the shipment has been formally accepted by the buyer, or the goods have been delivered as per the terms of the contract, and the time stipulated in the contract for rejection has expired.
In the case of "layaway sales," under terms of which the goods are delivered only when the buyer makes the final payment in a series of installments, revenue is not recognized until the last and final payment is received by the enterprise. Upon receipt of the final installment, the goods are delivered to the buyer and revenue is recognized. However, based upon experience, if it can reasonably be presumed that most such sales are consummated, revenue may be recognized when a significant deposit is received from the buyer and goods are on hand, identified and ready for delivery to the buyer.

If the enterprise retains only an insignificant risk of ownership, the transaction is considered a sale and revenue is recognized. For example, a department store has a policy to offer refunds if a customer is not satisfied. Since the enterprise is only retaining an insignificant risk of ownership, revenue from sale of goods is recognized. However, since the enterprise's refund policy is publicly announced and thus would have created a valid expectation on the part of the customers that the store will honor its policy of refunds, a provision is also recognized for the best estimate of the costs of refunds, as explained in IAS 37.

Another important condition for recognition of revenue from the sale of goods is the existence of the probability that the economic benefits will flow to the enterprise. For example, for several years an enterprise has been exporting goods to a foreign country. In the current year, due to sudden restrictions by the foreign government on remittances of currency outside the country, collections from these sales were not made by the enterprise. As long as it is uncertain if these restrictions will be removed, revenue should not be recognized from these exports, since it may not be probable that economic benefits will flow to the enterprise. Once the restrictions are withdrawn and uncertainty is removed, revenue may be recognized.

Yet another important condition for recognition of revenue from the sale of goods relates to the reliability of measuring costs associated with the sale of goods. Thus, if expenses such as those relating to warranties or other postshipment costs cannot be measured reliably, then revenue from the sale of such goods should also not be recognized. This rule is based on the principle of matching of revenues and expenses.

Revenue recognition from the rendering of services.

When the outcome of the transaction involving the rendering of services can be estimated reliably, revenue relating to that transaction should be recognized. The recognition of revenue should be with reference to the stage of completion of the transaction at the balance sheet date. The outcome of a transaction can be estimated reliably when each of the four conditions set out below are met.

The amount of revenue can be measured reliably;
The probability that the economic benefits related to this transaction will flow to the enterprise exists;
The stage of completion of the transaction at the balance sheet date can be measured reliably; and
The costs incurred for the transaction and the costs to complete the transaction can be measured reliably.

This manner of recognition of revenue, based on the stage of completion, is often referred to as the "percentage-of-completion" method. IAS 11 also mandates recognition of revenue on this basis. Revenue is recognized only when it is probable that the economic benefits related to the transaction will flow to the enterprise. However, if there is uncertainty with regard to the collectability of an amount already included in revenue, the uncollectable amount should be recognized as an expense instead of adjusting it against the amount of revenue originally recognized.

In order to be able to make reliable estimates, an enterprise should agree with the other party to the following:

Each other's enforceable rights with respect to the services provided;
The consideration to be exchanged; and
The manner and terms of settlement.

It is important that the enterprise has in place an effective internal financial budgeting and reporting system. This ensures that the enterprise can promptly review and revise the estimates of revenue as the service is performed. It should however be noted that because there is a need for revisions it does not by itself make the estimate of the outcome of the transaction unreliable.

Progress payments and advances received from customers are not a measure of the stage of completion. The stage of completion of a transaction may be determined in a number of ways. Depending on the nature of the transaction, the method used may include

Surveys of work performed;
Services performed to date as a percentage of total services to be performed; or
The proportion that costs incurred to date bear to the estimated total costs of the transaction. (Only costs that reflect services performed or to be performed are included in costs incurred to date or estimated total costs.)

In certain cases services are performed by an indeterminable number of acts over a specified period of time. Revenue in such a case should be recognized on a straight-line basis unless it is possible to estimate the stage of completion by some other method more reliably. Similarly when in a series of acts to be performed in rendering a service, a specific act is much more significant than other acts, the recognition is postponed until the significant act is performed.

During the early stages of the transaction it may not be possible to estimate the outcome of the transaction reliably. In all such cases, where the outcome of the transaction involving the rendering of services cannot be estimated reliably, revenue should be recognized only to the extent of the expenses recognized that are recoverable. However, in a later period when the uncertainty that precluded the reliable estimation of the outcome no longer exists, revenue is recognized as usual.

Note

The "percentage-of-completion" method is discussed in detail in the second part of this chapter. For numerical examples illustrating the method, please refer to the second part of this chapter relating to "Construction Contracts."

Revenue recognition from interest, royalties, and dividends.

Revenue arising from the use by others of the enterprise's assets yielding interest, royalties and dividends should be recognized when both of the following two conditions are met:

It is probable that the economic benefits relating to the transaction will flow to the enterprise; and
The amount of the revenue can be measured reliably.

The bases prescribed for the recognition of the revenue are the following:

In the case of interest—the time proportion basis that takes into account the effective yield on the assets;
In the case of royalties—the accrual basis in accordance with the substance of the relevant agreement; and
In the case of dividends—when the shareholder's right to receive payment is established.

According to IAS 18, para 31, "the effective yield on an asset is the rate of interest used to discount the stream of future cash receipts expected over the life of the asset to equate to the initial carrying amount of asset." Interest revenue includes the effect of amortization of any discount, premium or other difference between the initial carrying amount of a debt security and its amount at maturity.

When unpaid interest has accrued before an interest-bearing investment is purchased by the enterprise, the subsequent receipt of interest is to be allocated between preacquisition and postacquisition periods. Only the portion of interest that accrued subsequent to the acquisition by the enterprise is recognized as income. The remaining portion of interest that is attributable to the preacquisition period is treated as a reduction of the cost of the investment, as explained by IAS 39. Similarly, dividends on equity securities declared from preacquisition profits are treated as reduction of the cost of investment. If it is difficult to make such an allocation except on an arbitrary basis, dividends are recognized as revenue unless they clearly represent a recovery of part of the cost of the equity securities (IAS 18, para 32).

Disclosures.

An enterprise should disclose the following:

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 recognized during the period including revenue arising from
- The sale of goods;
- The rendering of services; and
- Interest, royalties, and dividends.
The amounts revenue arising from exchanges of goods or services included in each significant category of revenue.

Accounting for barter transactions.

The much-heralded era of e-commerce (i.e., commerce conducted via Internet, based on commercial websites directed at end consumers ["B-to-C" business] or at intermediate consumers, such as wholesalers and manufacturers ["B-to-B" business]) began to rapidly gain favor by the late 1990s. Although profits have proven to be elusive for many early entrants, it is nonetheless true that the majority of businesses today believe that they cannot afford to ignore e-commerce, if only to maintain a presence in that marketplace as their competitors do likewise.

This phenomenon corresponded with another trend, that of investors and others finding value in new "performance" measures such as gross sales volume and numbers of "hits" on websites, while discounting the importance (for high technology and start-up entities in particular) of the traditional measure of success, namely profits. The confluence of these two structural changes (at least as long as they both endured: the market crash in 2000 may have tempered, if not ended, the illusion of growth and successful operations based solely on reported revenues) provided unfortunate motivation to some entities to seek ways to inflate reported revenues, if not profits. In the case of e-commerce enterprises, this proved to be readily accomplished, as cooperating groups of such entities could provide "banner advertising" among themselves. With each entity "buying" advertising and "selling"" advertising, a liberal interpretation of financial reporting standards could enable each of them to inflate reported revenues. While corresponding expenses were also necessarily exaggerated and net earnings affected not at all (unless revenues and expenses were reported in different fiscal periods, which also occurred), with investors mesmerized by gross revenue, the impact was to encourage overvaluation of the entities' shares in the market.

As certain recently publicized financial reporting frauds have demonstrated, distortion of revenues via "swap" arrangements has hardly been constrained to the providing and acquiring of advertising (e.g., the "capacity swaps" of many US telecom and energy companies). However, the bartering of advertising services has been the first to receive the attention of the SIC, which issued SIC 31 at year-end 2001 to prescribe revenue recognition principles to be applied to these transactions.

This interpretation addresses how revenue from a barter transaction involving advertising services received or provided in a barter transaction should be reliably measured. The SIC agreed that the enterprise providing advertising should measure revenue from the barter transaction based on the fair value of the advertising services it has provided to its customer, and not on the value of that received. In fact, the SIC states categorically that the value of the services received cannot be used to reliably measure the revenue generated by the services provided.

Furthermore, the Interpretation holds that the fair value of advertising services provided in a barter transaction can be reliably measured only by reference to nonbarter transactions that involve advertising similar to the advertising in the barter transaction, when those transactions occur frequently, are expected to continue occurring after the barter transaction, represent a predominant source of revenue from advertising similar to the advertising in the barter transaction, involve cash and/or another form of consideration (e.g., marketable securities, nonmonetary assets, and other services) that has a reliably fair value, and do not involve the same counterparty as in the barter transaction. All of these conditions must be satisfied in order to value the revenue to be recognized from the advertising barter transaction.

Clearly, based on the criteria now mandated by SIC 31, the more common barter transactions, involving mere "swaps" of advertising among the members of the bartering group, will henceforth not be the basis for any revenue recognition by any of the parties thereto.