Table of Contents
Introduction
The Initial Recognition of Revenue
Measurement of Revenue
The concept of Sale of Goods
Disclosures
The Procedure of Revenue Recognition from Rendering Services
The Procedure of Revenue Recognition of Software Companies
The Principles of Revenue Recognition of Airline Companies
The Revenue Recognition Process of Construction Contracts
The Criteria of Revenue Recognition of Service Concession Arrangements
The Criteria of Revenue Recognition for Customer Loyalty Programs
The Accounting Treatment for the Rendering of Services and Sale of Goods
The Process of Revenue Recognition while transferring Assets from Customers
The Revenue Recognition Criteria of Telecommunication Company
References
Introduction
The International Accounting Standard 18 (IAS 18) was created in 1982 purposely to highlight and provide all the accounting conditions of how to treat revenue. Revenue is an important aspect for evaluating the financial accomplishment and performance of a particular business unit. IAS 18 was reviewed in 1993 in order to meet the requirements of financial statements such as the income statement. Revenue recognition conditions provided by IAS 18 are specific on how to identify and treat revenue arising from sale of goods.
Prior to the development of IAS 18, business entities experienced difficulties in separate revenue arising from sales of goods with other revenues as dividends and interests. IAS 18 covers all the revenues realized from business activities such as sales of goods or services, royalties and interest. IAS 18 was implement in 1995 and it has operational since then, however, from 1st January 2018, IFRS 15 is expected to replace IAS 18.
Revenue refers to gross income generated by a business activity, revenue is an important determinant of profit or loss. For instance in a company engages in the manufacture of software and hardware for computers. This company has two sources of revenue, the company acquires it revenue from selling computer software and at the same time, the company also generates revenue from sale of computer hardware. In accounting, revenue refers to either rise in assets or reduction in liabilities when the business is undertaking its activities. According to IAS 18, revenue refers to the aggregate economic benefits realized by a business entity as the business carries out its normal functions. This economic benefits include, cash, receivables and other additional assets.
The economic benefits realized by a business must cause a rise in equity in order to be included as revenue. A business enterprise can earn revenue by undertaking any of the following activities such as selling goods or services, earning interest, dividends and royalties. For example, if a business entity bought shares of another company, the dividend received by the business is recognized as revenue. A business may also purchase an interest bearing asset such as bonds, the interest received is also treated as revenue. Using the accrual basis, revenue is identified once the commodities or services reach the consumers from the seller or producer. The cash basis identifies revenue once the cash gets to the producer or seller that is revenue is identified after the consumer pays the cash of goods sold to him/ her by the producer. Revenue is the first entry to be made in an income statement
The Initial Recognition of Revenue
The main objective of accounting for revenue involves deciding at what time revenue is to be recognized. IAS 18 provides explicit details on when to recognize revenue. The process of recognizing revenue is based on whether the economic benefits such as cash, receivables or other assets are expected to flow into the business entity in the future after the business has undertaken its normal activities such as sales of goods or services. The revenue must also be calculated using reliable methods in accordance with the IAS 18. The revenue is not recognized when goods or services are traded for other goods or services of the same type and worth.
IAS 18 provides that revenue should be recognized before the costs of sale is subtracted from the total revenue. This is important in recognizing the total revenue realized by the business, for instance, if a company sells its products at $ 700 to a particular customer, and if the company used $ 250 to produce the products, the revenue recorder is $ 700 instead of % 450. The revenue is identified from the particular activity undertaken by the business entity such as sale of goods or services. For instance, the proceeds gained from disposal of business property or equipment are not recognized as revenue especially if the business ceases from operating.
The IAS has defined the actual revenue and sales taxes paid the consumers to the business entity are also not identified as revenue, if the business entity pays the sales taxes to the required authority. For example, consider that a business sells a particular commodity at $95 and the sales taxes is 5% of the total price, then the revenue realized by the business is 90.25. According to IAS 18, revenue must be calculated at the fair value of the consideration received.
Measurement of Revenue
As discussed above IAS 18 provides that revenue be measured at the fair value of the consideration received by the seller. This consideration includes the value that the seller is expected to receive from the buyer. A fair value refers to the amount that an asset fetches after being sold, the amount a liability fetches once paid or the value of an equity instrument once it is paid considering that the participant of the business transaction had adequate knowledge and entered into the training on their own free will. Sometimes cash inflow may be postponed, the fair value of the consideration is calculated as the present value of the aggregate future receipts calculated using the interest rates agreed upon by both parties. The interest must reflect the prevailing market rates. The most widely accepted mode of consideration is cash.
The concept of Sale of Goods
The main activities of the majority of business entities includes sale of goods or services. Sale of goods in particular generates a lot of revenue for companies or industries that are not categorized under service industries. The process of recognizing the revenue generated as a result of sale of goods is based on the provided principles. The IAS 18 states that the following provisions must be met for revenue to be recognized from sale of products. The first provision states that, the producer or seller must transfer all the major risks as well as incentives associated with the possession of the particular products to the consumer, for instance, if the Apple Company sells a smartphone to a customer for $100.
The $100 revenue can only be recognized from that sale after Apple has transferred all the risks and rewards associated with smartphone to the buyer. The second provision states that, the seller must loss all the control over the particular commodity including managerial attachment to the consumer. The third provision requires that the expenditure incurred by the seller during the process of transferring the ownership of goods to the consumer be calculated reliably, this provision also applies for the future expenditures incurred by the seller. The fourth provision require the revenue to be determine reliability. IAS 18, stipulates that if any of the above provision is not present, then the revenue cannot be recognized from the sale of goods. The revenue is also recognized from sale of goods when the economic benefits of the business deal is obtained by the seller.
For instance, a producer offers goods at $100 per unit and allows the consumer a discount of 10% for 50 units and above. If the consumer purchases a single order of 50 units, the total revenue realized by the producer from the transaction is $4500 instead of $5000. Considering an agency relationship, the economic benefits are the sum total of the quantity of cash gathered on behalf of the principal. The revenue recognized for the agent is the commission. A seller is recognized as the principal, if he/she retains the major risks and incentives related to a good when that good is being sold.
Disclosures
According to IAS 18, a seller or business enterprise is supposed to unveil the following, the accounting rules used to identify the revenue, the quantity of revenue realized from each type of activities such as sales of goods or services, interest, dividends, or royalties. The seller or business unit must unveil all the contingent liabilities and assets from an element like claims, penalties among others.
The Procedure of Revenue Recognition from Rendering Services
The method used to recognize revenues arising from rendering services is different from the one used to recognize revenue arising from sale of goods. The service revenue is the primary revenue account for service entities. The level of completion of a business transaction is determined towards the end of the financial period using the percentage of completion method. The revenue can be recognized from rendering services when various conditions are fulfilled.
This is important in estimating the results of a business transaction. The first condition states that the amount of revenue from rendering services must be calculated reliably. This means that the service provider must disclose all details pertaining the revenue to the consumer. For example, if a bank rends services to a client, the revenue generated by the bank must be measured reliably. The second condition states that it is possible that the economic benefits from the transaction might go to the business enterprise. This shows that the economic benefits from a transaction will be acquired by the service provider.
The third condition states that the procedure used to calculate the period or stage of conclusion of a business transaction during the end of a financial period must be reliable. The procedure used to measure the stages must be in accordance with the provisions of the International Accounting Standards (IAS). The fourth condition states that the methods used to calculate the expenditures or costs incurred by the business entity that is rendering services must be reliable. The percentage of completion method is used to calculate the stage of completion of a business deal. Applying the percentage of completion method, revenue is only identified in the accounting period during which the services were provided by the business entity.
The revenue generated from rendering services is recognized if the economic benefits realized from the business deal is acquired by the business venture. The various evaluations are only reliable, if parties involved in the business deal agree on issues like the consideration expected by the business entity as well as the terms and conditions of the business deal. However, during the initial stages of a business deal, the revenue cannot be measured reliably. IAS 18 provides that, if any of the conditions discussed above is not present, the revenue cannot be recognized. For instance, a law firm enters into a contract with a third party to provide legal services for $ 250,000.
The legal firm has already approximated the total costs of the contract to be $50,000, but during the end of the reporting period, the firm had incurred $ 40,000 and is forecasting to incur 12,000 in order to complete the contract. The law firm should recognize the revenue from rendering the services in this manner. During the end of the reporting period the contract is 64.516 % complete, and hence the revenue recognized should be 64.516% * 250,000.
The Procedure of Revenue Recognition of Software Companies
The procedure of recognizing revenue for software companies incorporates a more complex approach. The procedure of revenue recognition for software is established by AICPA Statement of Position (SOP) N. 97-2. The process of revenue recognition for software transactions is considered complex since the terms of agreement are not the same for all the consumers and also the accounting literature is different for each transaction. The procedure of revenue recognition of software companies follows various provisions, For instance, both the parties involved in the transaction of a software must understand the terms of the agreement in order for revenue to be recognized, there must be a convincing evidence of a sales contract. This means that both the developer of a software and the buyer must have explicit understanding of the terms of the business transaction, for instance, the consideration expected and the settlement period.
Another important condition requires that the fee of the software developer to be fixed or determinable. For instance, Hewlett-Packard Company recognizes revenue from selling software when there is evidence of a sales agreement in case of a delivery or when services are provided. If the sales agreement has numerous items like hardware or software, Hewlett-Packard Company assigns revenue in accordance with the fair price of the item. In the case of a software, the revenue is assigned using the vendor-specific objective evidence (VSOE) of fair price. The revenue generated from sale of software is recognized once the delivery takes place. This means that the ownership of the software moves from the developer to the buyer once delivery takes place. For instance, Palm, Inc. recognizes software revenue once it’s delivered by the end users.
The Principles of Revenue Recognition of Airline Companies
Although the passenger and freight revenues are normally treated in the same manner for all airline companies, the principles of revenue recognition may be different if the services rendered by the airline company are different. This means that the policies used in identifying revenue are determined by the type of services rendered by the airline company. The airline company generates revenue from a number of activities such as carrier services for passengers and goods, food services among others. The process of evaluating the revenue generated by an airline company is complicated due to the following reasons. Both paper and electronic tickets are issued in advance of the date of flight. This means that the date of selling tickets does not match the date of recognizing the revenue. Tickets may be refunded if the customer fails to utilize them within the stipulated period. Some tickets are also exchangeable at a fee while others cannot be refunded.
Accounting policies employed in recognizing revenue for an airline company states that revenue generated from passenger and cargo should be calculated at fair value of the consideration obtained. This means that various elements such as discount allowed, commission and taxes should be included in evaluating the amount of consideration receivable. The policies state that the revenue received from sale of tickets to passengers or even cargo should be recognized only after the airplane takes off with these elements on board. In the instance where tickets have not been used, the revenue is evaluated and identified in accordance with the ticket’s terms. The revenue recognized from the frequent flyer that is through issuing points is normally treated like a liability prior to redemption of the points. The frequent flyer revenue is also recognized once the airplane takes off with the passenger on board. For instance, the Delta Airline identifies revenue from unused tickets once the expiry date of these tickets reaches. This Airline fuel surcharges as revenue once the passenger takes off, commissions to agencies is treated as expenses.
The Revenue Recognition Process of Construction Contracts
According to International Accounting Standards, a construction contract refers to a contract agreed upon in order to build a particular asset such as buildings, factories among others, this includes the construction of a number of assets that are interdependent. The main conditions for entering into a contract require that the contractor must agree on the terms of contract with the client this includes the performance obligation and transaction fee. The revenue from construction contracts is recognized after the results of a construction contract can be calculated reliably after the contractor has fulfilled the performance obligation. If the outcome of a construction contract cannot be calculated reliably, the revenue from such a contract is not recognized since there is uncertainty of outcome. Reliable calculation of a construction contract take into account the percentage of completion and future fees. Most construction contracts last more than one year.
The construction revenue is based on at the stage of completion during the closure of a reporting period. The procedure used to calculate the stage of completion is known as the stage of completion method, this method estimates the stage of completion in percentages. The contract costs and revenues are the main problems of the construction contract and also deciding the stage of completion of the contract. In a construction contract, the contract revenue is the sum total of initial revenue agreed on and various changes that take place in the course of a contract including claims. Contract costs on the other hand refer to all the costs incurred during the completion of a construction activity. Other costs that are not associated with the construction contract are not included in evaluating the total contract cost.
For instance, if a contractor enters into a two-year road construction contract at a fixed price of $50,000. The preliminary costs of the contract had been approximated to be $30,000 for two years, if by the end of the first year, the contractor approximate costs to rise to $40,000. Both the contractor and the client must agree on the increase in the contract costs that were not expected earlier on. The contractor is able to approximate the stage of completion of the construction contract by computing the percentage of the already incurred contract costs and comparing them with the approximated aggregate contract cost.
In summary, IAS 18 require that the revenue from construction contract be recognized using two criteria. The first criteria incorporates the percentage of completion method, using this criteria revenues and costs are recognized while the contract is going on. The second criteria incorporates the completed contract method in which revenues and costs are deferred and recognized once the contract is completed. Any contract modification must be agreed on by all the parties to the contract, the contractor should evaluate if the modifications in contract results to a new contract.
The Criteria of Revenue Recognition of Service Concession Arrangements
A service concession arrangement refers to a contract agreement between two parties whereby one party provides the other party with a right to carry out business activities with its assets. The government normally engages in service concession arrangements with other business whereby, it allows another business enterprise to conduct business activities with the assets of the government for a certain consideration. The business entity acquires the contractual right to access government’s assets such as cash or other assets.
The service concession arrangements clearly describes the relationship between the grantor or government and the operator. The operator is normally a private sector entity. The service concession arrangements must provide explicit terms and conditions of the relationship between the grantor and the operator, such terms include the particular services to be provided by the operator including the consideration to be received by the operator. The grantors’ role in the service concession arrangements is to provide infrastructure necessary for the provision of services by the operator. To an operator the infrastructure is not recognized as revenue since it’s under the control of the public sector organization that is the government. Under the service concession arrangements, the financial lease is not recognized by the operator in spite of the risks absorbed. The principle of recognizing revenue for the operator states in a situation where the operator is given a consideration for the services renders in the form of a financial asset, the financial asset should be recognized at its fair value. The infrastructure must fulfill particular qualities established by both the grantor and the operator.
The operator recognizes revenue for the various forms of consideration that is financial assets and intangible assets based of the agreement of the service concession arrangement. The operator must, however, calculate both the financial and intangible assets at fair price. The operator is also required to give back the assets provided in the same condition that the operator received them. For example, if the government leased a construction equipment to a private entity for $ 100,000 for 5 years. The private entity cannot recognize the construction equipment as revenue, after 5 years the private entity is required to return the construction equipment in the same condition it received.
The Criteria of Revenue Recognition for Customer Loyalty Programs
A customer loyalty program refers to program used by business to attract new customers or retain existing customers. A customer loyalty program is normally provided to those consumers procure goods regularly. Loyalty programs include, rewards, free goods or coupons. A business venture uses IAS 18 to determine the revenue recognition. The accounts of credit awards are also established. The criteria of revenue recognition for customer loyalty programs is governed by IFRIC 13, it highlight how a business venture account for the obligation of offering awards to consumers in case they redeem the award credits. The criteria of revenue recognition for a consumer’s loyalty programs provide that a business venture must post preliminary income to the award credits like a liability since the venture has an obligation of providing the awards. The income assigned to the award credits is calculated at its fair value. The fair value of award credits refers to its total worth if it was offered independently.
The deferred incomes are recognized as revenue by the business once it meets its obligations after it has provided the awards. When the costs of fulfilling the obligation are more than the receivable consideration, this is treated as a liability. For example, if a business venture uses a customer loyalty program of rewarding two points if the consumers purchases goods worth $40. The business will recognize the revenue from the transaction once it has met its obligation and the consumer has redeemed the points.
The Accounting Treatment of Revenue from Agreements for the Construction of Real Estate
The IFRIC 15 provides accounting policies of recognizing revenue from construction of real estate including the sales of units and how to treat a situation where units are sold prior to the completion of the buildings. The main problem involved in evaluating the revenue from agreements for the construction of real estate is if developer the sells the units while they are completed or prior to completion, another situation is where the developer offers services. The main criteria used in revenue recognition from agreements for the construction of the real estate provides that an agreement for the construction of real estate is recognized as a construction contract if the buyer is able to provide the particulars of the structure of the real estate prior to the construction process or if the buyer is able to provide particulars of the structure when construction is proceeding. If this condition is fulfilled, then revenue can be recognized from the construction of the real estate.
For example, if the buyer designs or proposes the structure of the construction this results into a construction contract and the developer estimates the consideration receivable at its fair value. The revenue is recognized using the percentage of completion method provided that future costs are taken into account and that the construction of the real estate is approximated reliably. In the case where the business enterprise is required to offer services and also the building materials, this kind of contract is treated as sale of goods.
The Accounting Treatment for the Rendering of Services and Sale of Goods
The accounting treatment of the services rendered incorporates bookkeeping, book keeping helps record various services rendered. In the case where an entity pays its staff by the number of hours, this means that the business entity pays the staff for the services provided by the staff. The accounts receivable is used to record the aggregate revenue for services provided, this is the accrued revenue accounts referring to a situation where the staff members have provided the services, but the entity is yet to pay them for services rendered.
Unearned revenue records the amounts received for those services that have not been provided. The account rendered evaluates the balance in the financial statement whereby the details are present in the former financial statement and hence the account is rendered. For example, in a situation where a software developer provides the software in April, but is paid in September, the particulars appear in the balance sheet of April while the payment appear in September, adjustment of the April entry must be made.
Accounting for sale of goods has elaborate steps. Sales cause expansion of income and assets. In this case, income is credited to show increase in revenue while assets are debited to reflect an increase, sales also have the impact of decreasing stock. Decrease in stock or inventory is not included in accounting for sales. A simple double entry is used to show the impact of the sale of goods.
The Process of Revenue Recognition while transferring Assets from Customers
The criteria of recognizing revenue while transferring assets from customers is provided by IFRIC 18. The business entity enters into an agreement with the consumers to transfer assets from the customer. The main criteria provided by IFRIC 18 explains that the item of property, plant or equipment moved from the consumer must meet the description of an asset provided by the IASB Framework. The entity receiving the asset should identify the asset in the financial statements. The asset description provided by IASB Framework requires the customer to lose the control over the asset to the entity. The revenue is identified once the service is rendered.
The cost of the particular asset being transferred from the customer to the business entity is measured at its fair value during the date of transfer. The IFRIC 18 highlights the procedure of transferring cash from the customers. In a situation where a business entity transfers assets worth $10, 000 from its customer, the revenue is recognized after the entity has fulfilled the particular services involved. The costs of transferring assets is deducted from the total revenue by the business entity and treated separated.
The Revenue Recognition Criteria of Telecommunication Company
The revenue recognition procedure of a telecommunication company selling talk time through scratch cards. IFRS 15 provides the new criteria of revenue recognition of the telecommunication company that sells talk time through scratch cards. The new principle provides that any modification made by the customer in regard to wireless services should be evaluated like completely new contract. These modifications are undertaken by a consumer, for instance when the customer adds and reduces data.
IFRS 15 provides the main principle of revenue recognition criteria. For a telecommunication company that sells talk time through scratch cards, the revenue is not recognized when the customer buys scratch cards. The revenue is recognized only after the customer uses the talk time to call that is after the customer uses the talk time. This principle is very important since it enables the telecommunication company evaluate when to recognize revenue. In the situation where the talk time expires before being used, the telecommunication company recognizes revenue after the expiry date stipulated. For example, a customer buys a scratch card for $10, the talk time is 50 minutes, if the customer decides to use only 20 minutes. If the rest of the talk time expires unused, the telecommunication company recognize revenue after the expiry date.
References