International Financial Reporting Standard(s) Article on IAS 18 Revenue Certain specific specie of transactions and their recognition

Transcription

1 International Financial Reporting Standard(s) Article on IAS 18 Revenue Certain specific specie of transactions and their recognition By CA. Kishor Parikh - B.Com., F.C.A., DipIFR (U.K.) IAS 18 - Revenue One of the most important and relevant IAS amongst many is IAS -18 which deals with Revenue. Though the existing Accounting Standard-9 has been modeled based on IAS-18, there are certain fundamental differences and greater emphasis to the concept of recognition of revenue at a Fair Value. The terms Revenue and Fair Value have been defined in this standard. Accounting Standard 9 Revenue Recognition Para 4.1: Revenue is the gross inflow of cash, receivables or other consideration arising in the course of the ordinary activities of an enterprise from the sale of goods, from the rendering of services, and from the use by others of enterprise resources yielding interest, royalties and dividends. Revenue is measured by the charges made to customers or clients for goods supplied and services rendered to them and by the charges and rewards arising from the use of resources by them. In an agency relationship, the revenue is the amount of commission and not the gross inflow of cash, receivables or other consideration. International Accounting Standard 18 Revenue is 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. This standard applies to the accounting for revenue arising from (Inclusions): 1) the sale of goods; 2) the rendering of services; 3) the use by others of entity assets yielding interest, royalties, and dividends. This standard does not deal with revenue arising from (exclusions): 1) lease agreements; 2) dividends arising from investments which are accounted for under the equity method; 3) insurance contracts within the scope of IFRS 4 Insurance Contracts; 4) changes in the fair value of financial assets and financial liabilities or their disposal; 5) changes in the value of other current assets; 6) initial recognition and from changes in the fair value of biological assets related to agricultural activity; 7) initial recognition of agricultural produce; and 8) the extraction of mineral ores. Measurement of revenues Revenue should be measured at the fair value of the consideration received or receivable. Fair Value : The amount for which an asset can be exchanged or a liability settled, between knowledgeable, willing parties in an arm s length transaction. Sale of goods Revenue from the sale of goods or services shall be recognized when all the following conditions have been satisfied: 1) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods; 2) the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; 3) the amount of revenue can be measured reliably;

2 4) it is probable that the economic benefits associated with the transaction will flow to the entity; and 5) the costs incurred or to be incurred in respect of the transaction can be measured reliably. Practical example of Revenue Recognition Example 1:- Orbit Traders, sells a motor bike worth INR 5,000 to Ashwin. The risks and rewards of owning the motor bike transferred to Ashwin as the legal title and the delivery of motor bike handed over to Ashwin. What do we mean by risks and rewards? In the given case of selling the motor bike to Ashwin. RISKS: 1) Ashwin is responsible after taking the delivery of motor bike. It means that in the event of an accident, all the repairing charges have to be borne by him. 2) Any fault which is not covered under warranty shall be borne by Ashwin. 3) Orbit Traders is not responsible for any fault unless it had been observed and proved before the delivery of motor bike to Ashwin. REWARDS: 1) Ashwin can enjoy the driving as he likes. 2) Ashwin is free to hire or re-sell the motor bike. 3) Orbit Traders have no rights over the motor bike whatsoever. Specific instances and guidance of Revenue Recognition in such cases: 1) Goods & services sold subject to conditions: a) Installation and inspection: Revenue is normally recognized when the buyer willingly accepts delivery, and installation and inspection are complete. However, revenue is recognized immediately upon the buyer s acceptance of delivery when: 1. the installation process is simple in nature, for example, the installation of a factory tested television receiver, which only requires unpacking and connection of power and antennae; or 2. the inspection is performed only for purposes of final determination of contract prices, for example, shipments of iron ore, sugar or soya beans. Example 2:- M/s. Robinson sells a table fan to Girish. In this case as the installation process is simple in nature, Robinson can recognize revenue as soon as the buyer accepts the delivery of the table fan. b) On approval when the buyer has negotiated a limited right of return: If there is uncertainty about the possibility of return, revenue is recognized when the transfer and consignment has been formally accepted by the buyer or the goods have been delivered and the time period for rejection has elapsed. Example 3:- The Well Dressed Woman is a boutique which sells exclusive garments with the condition that goods can be returned only within one week of sale. In this case it can recognize revenue one week after the sale of any garment. c) Consignment sales under which the recipient undertakes to sell the goods on behalf of the shipper (Agency mechanism): Revenue is recognized by the shipper when the goods are sold by the recipient to a third party. d) Cash on delivery sales: Revenue is recognized when delivery is made and cash is received by the seller or its agent. 2) Sale transactions under which the goods are delivered only when the buyer makes

3 the final payment in a series of installments: Revenue from such sales is recognized when the goods are actually delivered. However, when experience and historical data indicates that most such sales are consummated, revenue may be recognized when a significant deposit is received provided the goods are on hand, identified and ready for delivery to the buyer. 3) Advance Payment Transactions: Orders when payment (or partial payment) is received in advance of delivery for goods or services not presently held in inventory, for example, the goods are still to be manufactured or will be delivered directly to the customer from a third party. Revenue is recognized when the goods are delivered to the buyer. 4) Sale and repurchase agreements: Sale and repurchase agreements (other than swap and transactions of conditional sale) under which the seller expressly agrees to repurchase the same goods at a later date, or when the seller has a call option to repurchase, or the buyer has a put option to require the repurchase, by the seller, of the goods. For a sale and repurchase agreement on an asset other than a financial asset, the terms of the agreement need to be analysed to ascertain whether, in substance, the seller has transferred the risks and rewards of ownership to the buyer and hence revenue is recognized. When the seller has retained the risks and rewards of ownership, irrespective of whether the legal title has been transferred, the transaction is a financing arrangement and does not give rise to revenue. For a sale and repurchase agreement on a financial asset, IAS 39 Financial Instruments: Recognition and Measurement applies. 5) Sales to intermediaries, such as distributors, dealers or others for resale: Revenue from such sales is generally recognized when the risks and rewards of ownership have passed. However, when the buyer is acting, in substance, as an agent, the sale is treated as a consignment sale. Whether a company should recognize revenue based on (a) the gross amount billed to a customer because it has earned revenue from the sale of the goods or services or (b) the net amount retained (that is, the amount billed to the customer less the amount paid to a supplier) because it has earned a commission or fee is a matter of judgment and circumstances that the factors or indicators set forth below should be considered. Indicators of Gross Revenue Reporting: 1. The company is the primary obligor in the arrangement. 2. The company has general inventory risk (before customer order is placed or upon customer return). 3. The company has latitude in establishing price. 4. The company changes the product or performs part of the service. 5. The company has discretion in supplier selection. 6. The company is involved in the determination of product or service specifications. 7. The company has physical loss inventory risk (after customer order or during shipping). 8. The company has credit risk. Example 4:- A major Chain of readymade garment stores obtains 70 percent of its seasonal garments from the supplier. The lead-time for the order is three months and the season lasts for one month. Chain takes title to the products upon delivery and is obligated to pay the Supplier according to payment terms. Selling prices for the products are determined exclusively by Chain. As long as Chain devotes at least 30 percent of its advertising budget to the Supplier's brands and prices the garments within 25 percent of the national average price, Chain

4 may return for full credit any unsold garments and including customers returns within 30 days of the end of the season. Sales to customers are by cash or credit card. Evaluation: After applying the indicators, revenue from sales of products from the supplier should be reported based on the gross amount charged to customers. Indicators of gross reporting are (a) Chain is the primary obligor to the customer, a strong indicator, as Chain is responsible for fulfillment and customer remedies in the event of dissatisfaction, (b) Chain has general inventory risk as a result of taking title and maintaining inventory, although that risk is mitigated through the return provisions with the supplier, (c) Chain has complete latitude to set the prices for the products (even though product pricing may affect Chain's return rights and expose it to greater inventory risk) and the net amount to be earned varies with that selling price, and (d) Chain also has credit risk for credit card transactions (a weaker indicator). No indicators of net reporting are present. Indicators of Net Revenue Reporting: 1. The supplier (not the company) is the primary obligor in the arrangement 2. The amount the company earns is fixed. 3. The supplier (and not the company) has credit risk. Example 5:- A Servicer provides Internet-based college admission services to students electronically on servicers website. Applicants provide complete application form with credit card information so that Servicer can charge the applicant's credit card for the college's admission fee. Before accepting the application, Servicer verifies the applicant's credit availability and charges the applicant's credit card. The Servicer then promptly forwards the application to the college. Servicer is the merchant of record in the transaction with the applicant and collects the proceeds from the applicant's credit card issuer. The contract with the college compensates Servicer with either a fixed dollar fee or a fixed percentage of the admission fees. The college determines its own admission fees in advance. On the fifteenth day of each month, Servicer remits to the college all proceeds collected in the prior month, net of the Servicer's fees. If the applicant subsequently denies the credit card charge, Servicer is at full risk of loss for the admission fee and remains obligated to remit the college's share of the admission fee to the college. Evaluation: After applying the indicators, Servicer concludes that revenue should be reported for the net amount earned in the application transactions. Indicators of net reporting are (a) the college, and not the company, is the primary obligor to the applicant, because the college is responsible for reviewing and accepting or denying applications, and (b) the college sets the admission fee and Servicer receives a fixed percentage of that amount. An indicator of gross reporting is present only for credit risk in the form of collecting credit card charges, a weaker indicator. 6) Subscriptions to publications and similar items: When the items involved are of similar value in each time period, revenue is recognized on a straight-line basis over the period in which the items are dispatched. When the items vary in value from period to period, revenue is recognized on the basis of the sales value of the item dispatched in relation to the total estimated sales value of all items covered by the subscription. 7) Installment sales, under which the consideration is receivable in staggered installments in future: Revenue attributable to the sales price, exclusive of effective interest, is recognized at the date of sale. The sale price is the present value of the consideration, determined by discounting the installments receivable at the imputed rate of

5 interest. The interest element is recognized as revenue as it is earned, using the effective interest method. 8) Real estate sales: Revenue is normally recognized when legal title passes to the buyer. However, in some jurisdictions the equitable interest in a property may vest in the buyer before legal title passes and therefore the risks and rewards of ownership have been transferred at that stage. In such cases, provided that the seller has no further substantial commitment to complete under the contract, it may be appropriate to recognize revenue. In either case, if the seller is obliged to perform any significant acts after the transfer of the equitable and/ or legal title, revenue as recognized as the acts are performed. At instances, seller may also consider the means of payment and evidence of the buyer s commitment to complete payment. For example, when the aggregate of the payments received, including the buyer s initial down payment, or continuing payments by the buyer, provide insufficient evidence of the buyer s commitment to complete payment, revenue is recognized only to the extent cash is received. 9) Rendering of services: When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognized by reference to the stage of completion of the transaction at the end of the reporting period. a) Installation fees: Installation fees are recognized as revenue by reference to the stage of completion of the actual installation, unless they are incidental to the sale of a product, in which case they are recognized when the goods are sold. b) Insurance agency commission: Insurance agency commission received or receivable from the Insurance company which do not require the agent to render further service are recognized as revenue by the agent on the effective commencement or renewal dates of the related policies. However, when it is equally probable that the agent will be required to render further services during the life of the policy, the commission, or part thereof, is deferred and recognized as revenue over the period during which the policy is in force. c) Financial service fees: The recognition of revenue for financial service fees depends on the purposes for which the fees are assessed and the basis of accounting for any associated financial instrument. The description of fees for financial services may not be indicative of the nature and substance of the services provided. Therefore, it is necessary to distinguish between fees that are an integral part of the effective interest rate of a financial instrument, fees that are earned as services are provided, and fees that are earned on the execution of a significant act. d) Placement fees for arranging a loan between a borrower and an investor: The fee is recognized as revenue when the loan has been arranged and there is reasonable surety on receipt of the fees. e) Loan syndication fees received: A syndication fee received by an entity that arranges a loan and retains no part of the funding (loan) package for itself (or retains a part at the same effective interest rate for comparable risk as other participants) is compensation for the service of syndication. Such a fee is recognized as revenue when the syndication has been completed. f) Admission fees \ Performance fees: Revenue from artistic performances, banquets and other special events are recognized when the events take place. When a subscription to a number of events is sold, the fee is allocated to

6 each event on a basis which reflects the extent to which services are performed at each event. g) Initiation, entrance and membership fees: Revenue recognition depends on the nature of the services provided. If the fee permits only membership, and all the services or products are paid for separately, or if there is a separate annual subscription, the fee is recognized as revenue when no significant uncertainty as to its reasonable surety of receivability exists. If the fee entitles the member to services or publications to be provided during the membership period or to purchase goods or services at prices lower than those charged to non-members, it is recognized on a basis that reflects the timing, nature and value of the benefits provided. h) Supplies of equipment and other tangible assets: The amount based on the fair value of the assets sold, is recognized as revenue when the items are delivered or title passes. i) Agency transaction: On most occasions transactions may take place between the franchisor and the franchisee which, in substance, involve the franchisor acting as agent for the franchisee. Such transactions do not give rise to revenue. j) Fees from the development of customized \ modified software: Fees from the development of customized software are recognized as revenue by reference to the stage of completion of the development, including completion of services provided for post-delivery service support. k) Interest, royalties and dividends: Revenue shall be recognized on the following basis: a) interest shall be recognized using the effective interest method as set out in IAS 39. b) royalties shall be recognized on an accrual basis in accordance with the substance of the relevant agreement; and c) dividends shall be recognized when the shareholder s right to receive payment is established. The standard addressing revenue principles in general terms is IAS 18. It prescribes the accounting treatment for revenue arising from certain types of transactions and events and, while useful, is not a comprehensive treatise on the peculiarities on all the diverse forms of revenue and of possible recognition strategies that could be encountered. Various customized transaction may give rise to different accounting methodology to be applied. The basic premise is that revenue should be measured at the fair value of the consideration that has been received when the product or service promised has been provided to the customer. Specific guidance applies to various categories of revenues. Thus, in the normal sale of goods, revenue is presumed to have been realized when the significant risks and rewards have been transferred to the buyer, accompanied by the forfeiture of effective control by the seller, and the amount to be received can be reliably measured. Overriding and guiding principle: When the outcome of the transaction involving the rendering of services cannot be estimated reliably, revenue shall be recognized only to the extent of the expenses recognized that are recoverable. Revenue recognition for certain service transactions, as set forth in the standard, requires that the percentage-of-completion method be used unless certain defined conditions are not met.

7 IAS 18 mandates certain disclosure requirements, including the revenue recognition accounting policies of the reporting entity. Contingent liabilities and contingent assets arising from items such as warranty costs, claims, penalties or possible losses also need disclosure as per IAS-18. The alignment of Indian Accounting Standard 9 with International Accounting Standard-18 is already under process and the draft of the aligned standard is under consideration with the Accounting Standard Board of the Institute of Chartered Accountants of India. This Standard becomes operative for financial statements covering periods beginning on or after 1 January Interpretations pertaining to IAS-18 include: SIC-13 Jointly Controlled Entities Non-Monetary Contributions by Venturers. SIC-27 Evaluating the Substance of Transactions involving the Legal Form of a Lease. SIC-31 Revenue Barter Transactions Involving Advertising Services. IFRIC-12 Service Concession Arrangements. IFRIC-13 Customer Loyalty Programmes. IFRIC-15 Agreements for the Construction of Real Estate. We intend to cover the specific Interpretations in subsequent issues of the Journal.