Revenue

Chapter 4

ACTG 6580

Objectives

1. Understand the definition of “income” under the Conceptual Framework

2. Distinguish between “income” and “revenue”

3. Explain and apply the meaning of “fair value” when applied to the measurement of revenue

4. Apply the recognition criteria for revenue

Objectives

5. Interpret and analyze revenue recognition issues and disclosures

6. Understand the relationship between IAS 18 and other standards

7. Describe the disclosure requirements of IAS 18

8. Describe expected future developments

The Definition of Income

The Conceptual Framework defines income as “increases in economic benefits …in the form of inflows or enhancements of assets, or decreases in liabilities that result in increases in equity, other than those relating to contributions from equity holders”

The definition is very broad and based on statement of financial position movements

Income includes both revenue and gains

The Distinction Between Income & Revenue

Conceptual framework states that income encompasses both revenue and gains

Revenue arises in the course of the ordinary activities of an entity

Gains represent other items that meet the definition of income and may or may not arise in the course of the ordinary activities

The Distinction Between Income & Revenue

Scope of IAS 18

Establishes the principles of recognizing revenue from: The sale of goods The rendering of services The use by others of entity assets yielding interest,

royalties and dividends

Does not deal with revenue arising from: Constructions contracts – IAS 11 Insurance contracts – IFRS 4 Lease agreements – IAS 17 Changes in FV of financial assets & liabilities – IFRS 9

Measurement at Fair Value

IAS 18 requires that revenue be measured at the “fair value of the consideration received or receivable”.

Trade discounts Where a seller offers trade discounts to resellers, the

amount of revenue recorded must be net of the trade discount

Volume rebates Where a seller offers volume rebates to customers, the

amount of revenue recorded must be net of the volume rebate

Applying the FV Measurement Requirement

Deferred Consideration:Where payment is deferred, this represents a

financing transactionIAS 18 requires the seller to recognize both sales

revenue and interest incomeSales revenue is measured at the discounted

present value of the future payments

Applying the FV Measurement Requirement

Exchanges or swaps: Sometimes two sellers may swap goods that are of a similar

nature and value

If the swap or exchange is for goods of a similar nature and value then this transaction does not generate revenue

If the swap or exchange is not for goods of a similar nature and value then this transaction does generate revenue

The Recognition Criteria

IAS 18 sets out specific recognition factors

Conceptual Framework recognition criteria: “ Income is recognized when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. This means in effect that the recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities.”

Identifying the Transaction

It is possible for a single transaction to involve two or more separate revenue producing components

In such cases the revenue recognition criteria must be separately applied to each component of the transaction

This may result in deferring a portion of revenue received up-front

Sale of Goods

Revenue from the sale of goods is recognized when all of the following conditions have been satisfied:

Risks and rewards of ownership have been transferred The entity retains no managerial involvement and exerts

no effective control over the goods The amount of revenue can be reliably measured It is probable that benefits will flow to the seller The costs of the transaction can be measured reliably

Comparison of general revenue recognition

US GAAP IFRS Difference

Delivery has occurred or services have been rendered.

Risks and rewards have transferred to the buyer.

No continuing managerial involvement.

Under IFRS, might be able to demonstrate transfer of risks and rewards without delivery (bill and hold).

Persuasive evidence of an arrangement exists.

None. US GAAP contains criteria that IFRS does not.

Price is fixed or determinable.

Revenues and costs can be reliably measured.

No significant differences.

Collectibility is reasonably assured.

Probability that economic benefits will flow to the entity.

No significant differences.

Transferring Risks & Rewards of Ownership It is this condition that is most difficult to assess

In most cases, delivery of the goods triggers revenue recognition

Exceptions included in IAS 18:Receipt of revenue is conditional on the buyer

reselling the goodsGoods are shipped subject to installation and this

is a significant part of the contract that has not yet been performed

Insignificant risks may be retained and revenue can still be recognized

Example 1 – revenue recognition when a right of return exists

Identify for which of the following situations, if any, it would be inappropriate to recognize revenue under US GAAP. Also, identify for which situations it would be inappropriate to recognize revenue under IFRS. Provide an explanation of your answers.

Revenue Recognition When Right of Return Exists

Example

► Company A introduced a new product that had sales of $1.0 million in the first month. Total returns in the first month were $200,000.

► Company B wanted to sell its product in Mexico. It contacted a local businesswoman in Mexico City and established a joint venture. Company B provided the initial financing and the businesswoman agreed to broker the product to local companies. In the first month, Company B sold $2.0 million of product to the joint venture to cover anticipated sales. Assume that Company B properly concluded that this is not a consignment sale. Company B has extensive experience selling its product and believes it can reliably estimate future returns.

► Company C has a long history of selling small motors to Company D. Company D mounts these motors on its lawn mowers and sells the completed lawn mowers to hardware stores. When Company D receives payment from the hardware stores it pays Company C for the motors. Company D has the right to return any unused motors at the end of the year. Historically, these returns have averaged 2% of sales.

Example 1 solution:

Company A — Because this is a new product, it is unlikely Company A could reliably estimate future returns. Therefore revenue should not be recorded currently under either US GAAP or IFRS.

Company B — Under US GAAP, the requirement that the buyer has economic substance separate from the seller does not appear to have been met so no revenue should be currently recorded. It is possible that under IFRS the conclusion might be to record the revenue since Company B can reliably estimate returns. The question that would need to be addressed is whether sales returns in Mexico will follow the same pattern as historical experience.

Company C — It appears the buyer’s payment is dependent on the buyer selling the lawn mower. Therefore under US GAAP it would appear that revenue should not be currently recognized. Under IFRS at first glance it would appear that the revenue would be recorded because it is probable that the economic benefits from the sale of the motors will flow to the seller and the returns can be reliably determined. One of the specific criteria for revenue recognition under IAS 18 is that Company C has transferred to the buyer the significant risks and rewards of ownership of the goods. However since the payment for the motors is only made if Company D is able to sell its lawn mowers, it appears significant risk of ownership has been retained by Company C and, therefore, revenue should not be recognized.

Revenue Recognition When Right of Return Exists

Example

Revenue From Services

Revenue from services is recognized based on the percentage of completion of the service project

The following conditions must first have been satisfied: The amount of revenue can be reliably measured It is probable that benefits will flow to the seller The costs of the transaction can be measured reliably

Note that these are the same as the last three conditions relating to the sale of goods

Example 2 – revenue recognition when rendering services

Advisco, a strategic advisory firm, contracted with Temple Manufacturing Company (Temple) on January 1, 2010, to provide services to help compare Temple’s business to peer groups, determine leading practices and develop strategic alternatives for performance improvements.

The services provided by Advisco will include subscription offerings that provide a mix of on-demand leading practice research, advisor access, benchmarking and business transformation services over a period of 18 months for a fixed fee of $180,000.

Advisco is unable to specify the type and number of items that will be delivered to Temple through its services as of January 1, 2010. However, based on past experience, Advisco can make reasonable estimates of the costs that will be incurred to fulfill its contractual obligations and each stage of completion. Advisco estimates that it will cost $144,000 to complete its obligations under this contract.

Revenue Recognition When Rendering Services Example

March 31,

2010

June 30,

2010Sept.

30, 2010Dec. 31,

2010March

31, 2011June 30,

2011

Costs incurred $7,200 $28,800 $50,400 $ 36,000 $ 14,400 $ 7,200

Cumulative costs incurred

$7,200 $36,000 $86,400 $122,400 $136,800 $144,000

Cumulative percentage complete

5% 25% 60% 85% 95% 100%

Example 2 (continued):

Costs incurred and progress toward completion by quarter (in dollars).

Revenue Recognition When Rendering Services Example

Example 2 (continued):

Using US GAAP:

► Assuming all other revenue recognition criteria have been met for the year ended December 31, 2010, how much will Advisco record as revenue related to its arrangement with Temple (SAB 104)?

► Assuming all other revenue recognition criteria have been met, how much revenue should Advisco record through the end of the project in 2011?

Using IFRS:

► Assuming all other revenue recognition criteria have been met for the year ended December 31, 2010, how much will Advisco record as revenue related to its arrangement with Temple?

► Assuming all other revenue recognition criteria have been met, how much revenue should Advisco record through the end of the project in 2011?

Revenue Recognition When Rendering Services Example

Example 2 solution:

US GAAP:

► Advisco should record revenue of $120,000 ($180,000 x 12 months /18 months) based on the straight-line method of recognizing revenue.

Under US GAAP (as stated by the SEC staff in SAB 104), service revenue should be recognized on a straight-line basis, unless evidence suggests that revenue is earned or obligations are fulfilled in a different pattern. Consistent with this view, since Advisco is not able to determine a pattern of performance (other than by applying a percentage-of-completion model, which is prohibited by US GAAP for service contracts), revenue should be recognized on a straight-line basis over the service period.

► Advisco should record revenue of $60,000 ($180,000 x 6 months /18 months) or the remaining portion of the contracted amount.

Revenue Recognition When Rendering Services Example

Example 2 solution (continued)

IFRS:

► Advisco should record revenue of $153,000 ($180,000 x 85%), or 85% of the total revenue, based on the stage of completion of the transaction (or percentage-of-completion method).

Unlike US GAAP, IAS 18 allows companies to account for service contracts using a stage/percentage-of-completion model, provided the stage/percentage-of-completion can be reasonably estimated, which is the case in this example.

► Advisco should record revenue of $27,000 ($180,000 x 15%), or the remaining portion of the contracted amount, based on the stage of completion of the transaction (or percentage-of-completion method).

Revenue Recognition When Rendering Services Example

Understanding Multiple-Element Arrangements

Accounting for Multiple Elements Example

Example 3 – accounting for multiple elements

On January 1, 2010, Robots Inc. (Robots) sold Wings Company (Wings) its packaging machine and other services for $500,000. The sales arrangement includes the packaging machine, installation services, training on the machine for a period of 18 months and three years of maintenance services.

The maintenance agreement is not separately priced and is not within the scope of paragraphs 1 through 6 of ASC 605-20-25 which deals with Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts. The packaging machine is never sold without the related installation services; however, it is sold exclusive of training and maintenance services. In addition to being included in the original sales of the packaging machine, training contracts are sold on a stand-alone basis and maintenance contracts are sold on a stand-alone basis as renewals of existing contracts. The installation services do not have any stand-alone value as they are never sold separately and no other vendors provide these services.

Based on vendor-specific objective evidence, the selling price of the packaging machine, including installation services, is $420,000, the selling price of the training sessions is $60,000 and the selling price of three years of maintenance services is $120,000.

Example 3 (continued):

The packaging machine was installed at Wings and operational on June 30, 2010, at which time the training services commenced. The training sessions are held weekly at Wings for the entire 18-month period. In addition, per the contract, the maintenance service period starts upon the completion of the installation (i.e., June 30, 2010). Management of Robots wants to report as much revenue as possible on the contract with Wings in 2010 so they earn their bonuses.

► Under US GAAP and IFRS, answer the following three questions:

1. How many units of accounting are included in this arrangement?

2. If there is more than one accounting unit, how should the $500,000 arrangement fee be allocated to the accounting units?

3. How much revenue for each accounting unit should be recorded as of December 31 of each year?

► How much total revenue would be reported in 2010 under IFRS compared to US GAAP?

Accounting for Multiple Elements Example

Example 3 solution (US GAAP):

1. There should be three units of accounting. Robots applies the separation criteria of ASC 605-25 and determines that the packaging machine and installation services represent one unit of accounting (installation does not have stand-alone value to the customer) , the training sessions represent a second unit of accounting and the maintenance services represent a third unit of accounting.

2. The $500,000 arrangement fee should be allocated to the different units of accounting based on their selling price (VSOE). The allocation would be as follows:

Accounting for Multiple Elements Example

VSOE (fair

value)

Percent of

relative fair

value

Allocated discount

Allocated arrangement consideration

Packaging machine and installation services

$420,000 70% $ (70,000) $350,000

Training 60,000 10% (10,000) 50,000

Maintenance 120,000 20% (20,000) 100,000

Total $600,000 $(100,000) $500,000

(1) The training session began weekly starting once the installation was complete (June 30, 2010) for 18 months; therefore, six months of training has lapsed by year-end (6 months/18 months * $50,000 = $16,667). The remaining sessions are completed by the end of 2011 and the remaining revenue related to the session would be recognized.

(2) The maintenance program coincides with the completion of the installation and runs for three years; therefore, at Dec. 31, 2010, six months of the contract had run its course and the remaining amounts are recognized for the remaining three-year period. [2010 - (6/36) x $100,000 = $16,667; 2011 and 2012 - (12/36) x $100,000 = $33,333; 2013 - (6/36) x $100,000 = $16,667]

Accounting for Multiple Elements Example

2010 2011 2012 2013

Packaging machine and installation $350,000

Training (1) 16,667 $33,333

Maintenance (2) 16,667 33,333 $33,333 $16,667

3. Under the proportional-performance method, the outputs are used to measure the proportional performance of the contract. Therefore, based on the timing of the installation and commencement of the training and maintenance contracts, the following illustrates when the units of accounting should be recognized into revenue for each year ended December 31:

Example 3 solution (continued):

IFRS:

The solution under IFRS is the same as for US GAAP. However, it should be noted that the standards under US GAAP are explicit and structured for determining allocation of multiple elements, while there is very limited guidance under IFRS. Likewise, IFRS does not provide guidance on how to determine fair value other than some analogous guidance contained in IFRIC 13, which is being used in practice for multiple element arrangements overall. The guidance in IFRIC suggests that some measures to determine fair value include: the amount for which items may be sold separately (selling price), amounts paid to third parties plus a reasonable profit margin (cost plus profit margin = selling price) or an estimated amount. This guidance is very similar to US GAAP with the end result being the same. However, students should be cautioned that a thorough analysis needs to be made for multiple-element arrangements under IFRS due to a lack of specific guidance, but generally there are no differences in accounting under either US GAAP or IFRS (excluding multiple-element arrangements for software).

Accounting for Multiple Elements Example

Interest, Royalties & Dividends

Interest Interest revenue is recognized on a time-

proportion basis using the effective interest method

Dividends Dividend revenue is recognized when the

shareholders right to receive the dividend is established

In most cases this is when the directors declare the dividend

Interest, Royalties & Dividends

Royalties Fees earned for allowing another party to use the

entity’s intangible assets Examples include copyrights, trademarks, brand

names, patents, etc. Royalty revenue is recognized on an accrual basis

in accordance with the relevant agreement

Interaction Between IAS 18 and Other Standards

IAS 18 interacts closely with a number of accounting standards including:

IAS 39 – revenue recognition for financial instrumentsIAS 1 – disclosuresIAS 16 & 38 – gains on the sale of non-current assetsIAS 11 – revenue recognition on long-term construction contracts

Disclosure Requirements of IAS 18

IAS requires an entity to disclose:It’s accounting policies adopted for revenue

recognitionThe amount of each significant category of

revenueThe amount of revenue arising through

exchanges

Homework

Exercises 4.6, 4.9, 4.10DUE THURSDAY, NOVEMBER 20