Understanding IAS 18 Revenue

IAS 18: REVENUE

Objective of IAS 18

The objective of IAS 18 is to prescribe the accounting treatment for revenue arising from certain types of transactions and events.

Classification of Revenue

1.      Sale of goods

2.      Rendering of services

3.      Others e.g Interests, Dividends and Royalties

Definitions

1.      Revenue

The gross inflow of economic benefits (cash, receivables, other assets) arising from the ordinary operating activities of an entity (such as sales of goods, sales of services, interest, royalties, and dividends).

2.      Fair Value

Is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

3.      Interests

Is the charge for the use of cash or cash equivalents or amounts due to the entity.

4.      Royalties

Are charges for the use of intangible NCA of an entity. Such as patents, computer software, trademarks etc.

5.      Dividends

Are distributions of profits to holders of equity investments in proportion with their holdings of each class of capital

Measurement of Revenue

Revenue should be measured at the fair value of the consideration received or receivable. An exchange for goods or services of a similar nature and value is not regarded as a transaction that generates revenue. However, exchanges for dissimilar items are regarded as generating revenue.

If the inflow of cash or cash equivalents is deferred, the fair value of the consideration receivable is less than the nominal amount of cash and cash equivalents to be received, and discounting is appropriate. This would occur, for instance, if the seller is providing interest-free credit to the buyer or is charging a below-market rate of interest. Interest must be imputed based on market rates.

Recognition of Revenue

Recognition, as defined in the IASB Framework, means incorporating an item that meets the definition of revenue (above) in the income statement when it meets the following criteria:

1. It is probable that any future economic benefit associated with the item of revenue will flow to the entity, and
2. The amount of revenue can be measured with reliability

IAS 18 provides guidance for recognising the following specific categories of revenue:

1.      Sale of Goods

Revenue arising from the sale of goods should be recognised when all of the following criteria have been satisfied:

1. The seller has transferred to the buyer the significant risks and rewards of ownership
2. The seller 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
4. It is probable that the economic benefits associated with the transaction will flow to the seller, and
5. The costs incurred or to be incurred in respect of the transaction can be measured reliably

2.      Rendering of Services

For revenue arising from the rendering of services, provided that all of the following criteria are met, revenue should be recognised by reference to the stage of completion of the transaction at the balance sheet date (the percentage-of-completion method):

1. The amount of revenue can be measured reliably;
2. It is probable that the economic benefits will flow to the seller;
3. The stage of completion at the balance sheet date can be measured reliably; and
4. The costs incurred, or to be incurred, in respect of the transaction can be measured reliably.

When the above criteria are not met, revenue arising from the rendering of services should be recognised only to the extent of the expenses recognised that are recoverable (a "cost-recovery approach".

3.      Others: Interest, Royalties, Royalties and Dividends

For interest, royalties and dividends, provided that it is probable that the economic benefits will flow to the enterprise and the amount of revenue can be measured reliably, revenue should be recognised as follows:

1. Interest: using the effective interest method as set out in IAS 39
2. Royalties: on an accruals basis in accordance with the substance of the relevant agreement
3. Dividends: when the shareholder's right to receive payment is established

Disclosure

1. Accounting policy for recognising revenue
2. Amount of each of the following types of revenue: sale of goods, rendering of services, interest, royalties, dividends. Within each of the above categories, the amount of revenue from exchanges of goods or services

Accruals concept and matching concept applications

Unearned Revenue in subscription sale

A liability exists when a customer pays in advance. Only the realized period revenue should appear in the current year’s profit and loss with the remaining portion taken to the balance sheet as a liability.

Unearned Revenue in service contract sales

Divide the entire sales Revenue into two components, the asset sale and the servicing sale. The contract service revenue is not earned by the end of year 1 if it’s a 3 year contract. A liability should be created by DR sales account and CR the liability/provision account for the two year unearned revenues for serving.

Example 1

On 1^st October, 2001 a company received total subscription in advance of $288,000 for 12 months publications of a magazine. At the year end the company had produced and dispatched 3 of 12 publications. The total cost of producing one issue of the magazine is estimated at $20,000.

Required

Using the traditional approach to revenue recognition how the company should treat the subscription in the a/c for the year ended 31^st December, 2001.

Example 2

On 1^st July, 2003, Company A signs a contract with a customer under which company A delivers off the shelf IT system on that date and then provides support services for the next 3 years. The contract price is $740,000. The cost of support services is estimated at $60,000 per annum and company A normally makes a profit margin of 25% on such work. Company A makes up financial statements to 31^st December each year.

Required What revenue should be recognized in the financial statements for the year ended 31^st December, 2003

Sale and Lease back of Non Current Assets.

The purported sale of a non current asset should be carefully examined to identify whether risks and rewards have been transferred to the buyer (Bank). If in fact the firm has transferred risks and rewards then a sale is recognized and a profit or loss on disposal exists. However if the firm still retains risks and rewards of ownership, then no sale is recognized. It is a creative accounting model to reduce gearing as the liability is now conveniently converted to a sale. To correct the anomaly, CR Loan (To show the substance of the transaction) and Dr Sales Account that had been erroneously CR. The correct DR is the Bank account.