IAS 18 provides us with criteria for the recognition of revenue relating to: 1. Sale of goods 2. Rendering of services, and 3. Interest, royalties and dividends Let’s take a look.
1. Sale of Goods
An entity may recognise revenue from the sale of goods only when all of the following conditions have been met:
- The entity has transferred to the buyer the ‘significant risks and rewards of ownership of the goods’. This normally happens when legal title to the goods or the buyer takes possession of the goods.
- The entity does not retain managerial involvement, or effective control over the goods sold, to the same extent associated with ownership.
- The amount of revenue can be measured reliably.
- It is probable that economic benefits associated with the transaction will flow to the entity.
- The costs incurred or to be incurred in respect of the transaction can be measured reliably.
Make sure all of these conditions are met before recognising revenue. You’ll have to take a look at the circumstances surrounding the transaction before making an assessment whether the entity has transferred the significant risks and rewards of ownership to the buyer.
When a Transaction is not a Sale
If the entity retains the significant risks and rewards of ownership, the transaction is not a sale and revenue is not recognised. Let’s look at some examples:
- The entity retains an obligation for unsatisfactory performance not covered by normal warranty provisions. Revenue should not be recognised until the obligation goes away.
- The receipt of the revenue is contingent on the subsequent sale of the goods by the buyer. The goods are supplied on a ‘sale or return’ basis. Revenue should be recognised when the goods are sold, not earlier.
- An advanced payment of goods was made which have not yet been manufactured. This advance payment, or deposit is not recognised as revenue. Instead is should be recognised as a current liability in the balance sheet.
- The goods are shipped subject to installation, which is a major process and significant cost of the total contract. This may occur when a manufacturer sells a machine requiring installation. Revenue should not be recognised until the installation is complete as the seller still retains significant risks and rewards of ownership.
- The buyer has the right to cancel the purchase for any reasons and the entity is uncertain of the probability of return. Revenue should not be recognised until the probability of return is assessed.
- Goods were sold on credit to a customer in a country experiencing political unrest. No foreign payments are allowed in or out. Revenue should not be recognised yet as it is not probable the economic benefits associated with the transaction will flow to the entity.
When a Transaction is a Sale
If the entity only retains an insignificant risk of ownership, the sale transaction and revenue may be recognised. Examples of this include:
- Retailers who sell goods which may be exchanged or refunded within a certain period. The retailer should make an estimate based on previous experience, on how many customers will return the product, and recognise the rest as revenue now.
- A seller may retain legal title to the goods, for example in a reservation of title sale. If the purchaser doesn’t pay the seller may recover the goods. In this instance revenue may be recognised.
Revenue and Delivery of Goods
In many cases the conditions for recognising revenue are met at the time the goods are delivered to the customer. If the contract terms oblige the seller to deliver the goods to the customer in good condition, revenue should only be recognised at time of delivery. Sometimes this will require looking at the shipping terms associated with the sale of goods:
- Free on board (‘FOB’) – When selling goods free on board, the seller is responsible up until the goods are handed over to the delivery company. Once the goods are shipped, revenue is recognised.
- Cartage, Insurance, Freight (‘CIF’) – Under CIF terms, the seller is responsible for ensuring the goods are delivered to the customer in good condition. Revenue should be recognised at delivery, when the goods arrive.
Substance Over Form
Financial statements must present fairly the effects of the transactions entered into by an entity. This means the substance of the transactions should be recorded, not merely their legal form. Say for example a company sells a machine for €50,000 but continues to use the machine in exactly the same manner as before. No change or delivery takes place. If this happens, the substance of the transaction is a loan, which is secured on the asset, and it should be recorded as such.
2. Rendering of Services
When an entity provides a service to a customer, the rules for recognising revenue depend on whether the contract can be estimated reliably or not. When the outcome can be measured reliably, the contract revenue must be recognised by reference to the stage of completion of the contract. So revenue may be recognised for a service that is still not completed at the end of the financial period. This method of measurement may also be known as the ‘percentage of completion method’. The outcome of a service transaction can be estimated reliably when all the following conditions have been satisfied.
- The amount of revenue can be measured reliably.
- It is probable that the economic benefits associated with the transaction will flow to the entity.
- The stage of completion of the transaction at the balance sheet can be measured reliably.
- The costs already incurred for the transaction and the costs that will be incurred to complete the transaction can be measured reliably.
If any of these conditions are not met, or the contract cannot be reliably estimated, revenue should be recognised only to the extent of the expenses recognised that are recoverable. Expenses should be recognised in the period incurred.
An entity will be able to make reliable estimate once it has agreed with the customer:
- Each parties enforceable rights regarding the service
- The consideration payable
- Terms of settlement.
The stage of completion may be determined by:
- Surveys of work completed
- Services performed to date as a percentage of total services to be performed
- The proportion of costs incurred as a percentage of total estimated costs of the transaction.
You’ll also find the stage of completion method for calculating revenue in IAS 11 – Construction Contracts. Make sure you don’t confuse the receipt of payments and advances from customers with stage of completion. Often these don’t relate to each other.
Working Example of a Rendered Service
Crossmolina Limited a software developer is working on a bespoke software product for a government client. The contract price of the software is €100,000. To date €18,000 costs have been incurred, and the stage of completion is uncertain. What is the correct accounting treatment for this contract?
As the stage of completion is uncertain, the revenue from the contract should be €18,000 which matches the costs of €18,000. In this case there will be neither a profit or loss recognised in the financial period.
3. Interest, Royalties and Dividends
Revenue arising from interest, royalty payments and dividends shall be recognised when:
- It is probable that the economic benefits associated with the transaction will flow to the entity,
- The amount of the revenue can be measured reliably.
Revenue from these sources should be recognised as follows:
- Interest – on a time proportionate basis that takes into account the effective yield on the financial asset.
- Royalties – recognised on an accrual basis in accordance with the substance of the relevant agreement. In some cases, depending on the agreement it may be more appropriate to measure revenue on some other systematic basis.
- Dividends – recognised when the shareholders right to receive the dividend is established. This is once the board or shareholders approve the dividends and the company is obliged to pay them. Proposed dividends should not be recognised as revenue. Also, if the dividends were declared from pre-acquisition income, they are deducted from the cost of the shares.
- Sale of goods: once control has passed to the buyer
- Rendering of services: entity has a right to be compensated for services rendered, and the stage of completion can be reliably measured.
- Interest: time proportionate basis that takes into account the effective yield on the financial asset.
- Royalties: actual basis in accordance with the substance of the relevant agreement
- Dividends: when the entity’s right to payment is established.