A. Revenue recognition: content and application of IAS 18 – Revenue and
2. Revenue recognition according to IAS 18
IAS 18, which only covers recognition of revenue, defines revenue as follows:
Revenue (IAS 18.7)
“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.”
Revenue excludes amounts collected on behalf of third parties and shall be recognized when the following conditions are met:
Revenue recognition principle (framework) Revenue shall be recognized
x when it is probable that future economic benefits will flow to the entity, and x these benefits can be measured reliably.
IAS 18 specifies this general principle by addressing recognition of revenue for certain types of transactions in greater detail. Those types of transactions are:
x sale of goods;
x rendering of services; and
x use by others of entity assets yielding interest, royalties and dividends.
Revenue shall be measured at the fair value of the consideration received or receivable. Usually, it is the amount agreed on by the counterparties. In determining the amount of revenue to be recognized, amounts of any trade discounts and volume rebates allowed by the entity shall be taken into account (IAS 18.10).
a. Recognition of revenue for sale of goods2
According to IAS 18 revenue arising from the sale of goods shall only be recognized when all the following conditions have been met:
2 The term “goods” includes goods produced by the entity for the purpose of sale and goods purchased for resale.
Recognition of revenue on sale of goods (IAS 18.14)
x the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;
x the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;
x the amount of revenue can be measured reliably;
x it is probable that the economic benefits associated with the transaction will flow to the entity; and
x costs incurred or to be incurred in respect of the transaction can be measured reliably.
According to the general criteria of revenue recognition, revenue can only be recognized if it is probable that economic resources will flow to the entity and that those inflows can be measured reliably. IAS 18 specifies these general criteria by establishing a critical events test: revenue can only be recognized if risks and rewards have been transferred. Only then is the inflow of economic benefits considered to be probable. The critical event of transfer of risks and rewards shall ensure that the revenue number reported is reliable. By doing so the risk of having to reverse revenue which has already been shown in the income statement is significantly decreased.
A company that applies IAS 18 will most likely have the following questions:
x What are the significant risks and rewards of ownership that can be transferred?
x What does significant’ mean in that context?
x When can one consider risks and rewards as being transferred?
The assessment of when an entity has transferred the significant risks and rewards of ownership to the buyer requires an examination of the circumstances of the transaction.3 IAS 18.15 goes on stating that, in most cases, the transfer of the risks and rewards of ownership coincides with the transfer of the legal title or the passing of possession to the buyer. However, there are cases for which this general guidance is not sufficient and more detail is needed for solving accounting problems which arise in practice.
This leaves room for interpretation and implies the risk of treating identical transactions differently. The appendix to IAS 18 reflects that the IASB was aware of this risk at the time the standard was published. The appendix contains a number of examples serving as application guidance for certain transactions such as bill and hold sales, goods shipped subject to conditions or subscription to publications and similar items.
IAS 18.16 gives examples of situations in which an entity may retain significant risks and rewards of ownership:
3 See IAS 18.15.
Significant risks and rewards of ownershipare retained:4
x when the entity retains an obligation for unsatisfactory performance not covered by normal warranty provisions;
x when the receipt of the revenue from a particular sale is contingent on the derivation of revenue by the buyer from its sale of the goods;
x when the goods are shipped subject to installation and the installation is a significant part of the contract which has not yet been completed by the entity;
and
x when the buyer has the right to rescind the purchase for a reason specified in the sales contract and the entity is uncertain about the probability of return.
However, if, for example, the entity retains the legal title to the goods solely to protect the collectibility of the amount due, revenue shall be recognized. In this case, retaining the legal title for that reason is considered keeping only insignificant risks and rewards. IAS 18.17 gives another example of a case in which the entity only retains an insignificant risk of ownership: An entity might enter into a retail sale and offer a refund if the customer is not satisfied. The general rule in this case is that revenue shall be recognized at the time of sale provided the seller can reliably estimate future returns and recognises a liability for returns based on previous experience and other relevant factors.5 In practice this leads to the question what percentage of return cannot be considered insignificant risk so that the reporting entity would be precluded from recognizing revenue.
b. Recognition of revenue for rendering of services
In contrast to the sale of goods, rendering of services typically involves the performance by the entity of a contractually agreed task over an agreed period of time.
Examples include a cleaning service offered by an entity which is performed on every Monday over the next twelve months. In those cases clearly no transfer of title or significant risks and rewards takes place which could determine the timing of revenue recognition.
Therefore, IAS 18 establishes special principles for recognition of revenue from service transactions:
Recognition of Revenue on Rendering Services (IAS 18.20)
Revenue associated with a transaction involving the rendering of services shall be recognized when the outcome of that transactioncan be estimated reliably.
The outcome of a transaction can be estimated reliably when all the following conditions are satisfied:
x the amount of revenue can be measured reliably;
x it is probable that the economic benefits associated with the transaction will flow to the entity;
4 See IAS 18.16.
5 See IAS 18.17.
x the stage of completion of the transaction at the balance sheet date can be measured reliably; and
x thecosts incurred for the transaction and the costs to complete the transaction can bemeasured reliably.
If the criteria are satisfied, revenue shall be recognized by reference to the stage of completion of the transaction at the balance sheet date. Another name for the recognition of revenue by reference to the stage of completion is the percentage of completion method. Under this method, revenue is recognized in the accounting periods in which the services are rendered. Recognition of revenue on this basis reflects the extent of service activity during an accounting period and provides useful information on the performance of the reporting entity. Further guidance on how to apply the percentage of completion method is given in IAS 11, which is covered in this article in section C.
A company which applies the criteria given for the recognition of revenue according to the stage of completion will most likely have the following questions:
x How can the stage of completion be measured reliably?
x How can the costs incurred be measured reliably?
In order to be able to apply the percentage of completion method a company needs an effective internal financial budgeting and reporting system. An entity is required to review and, when necessary, revise the estimates of revenue as the service is performed. According to IAS 18.23, the need for such revisions does not necessarily indicate that the outcome of the transaction cannot be estimated reliably.
IAS 18.24 shows a variety of methods for determining the stage of completion of a transaction. An entity shall use a method that measures reliably the services performed. Depending on the nature of the transaction, the methods may include:
x surveys of work performed;
x services performed to date as a percentage of total services to be performed;
or
x the proportion that costs incurred to date bear to the estimated total costs of the transaction. Only costs that reflect services performed to date are included in costs incurred to date. Only costs that reflect services performed or to be performed are included in the estimated total costs of the transaction. Progress payments and advances received from customers often do not reflect the services performed.
According to IAS 18.25, for practical purposes, when services are performed by an indeterminate number of acts over a specified period of time, revenue is recognized on a straight-line basis over the specified period. This is valid unless there is evidence that another method better represents the stage of completion. Sometimes it might be the case that one specific act is much more significant than any other acts.
If this is true, revenue recognition is postponed. Revenue shall only be recognized once that significant act is executed.
According to IAS 18.27, during the early stages of a transaction, it is often the case that the outcome of the transaction cannot be estimated reliably. It may nevertheless be probable that the entity will recover the transaction costs incurred.
Therefore, revenue is recognized only to the extent of costs incurred that are expected to be recoverable. In cases where the outcome of the transaction cannot be estimated reliably, no profit is recognized.
In cases where the outcome of a transaction cannot be estimated reliably and it is not probable that the costs incurred will be recovered, revenue is not recognized and the costs incurred are recognized as an expense.6 Once the uncertainties that prevented the outcome of the contract being estimated reliably no longer exist, revenue is recognized according to the stage of completion.
c. Unsolved issues: multiple element arrangements
One of the main problems arising in conjunction with the application of IAS 18 is the question of how and when to recognize revenue if an entity provides multiple interrelated goods and/or services to a customer. These transactions are called multiple element arrangements are common in everyday business life.
Case study of a multiple element arrangement
On 20 December Mr. Schmidt decides to buy a hi-fi system. The system is available with speakers which are also sold separately. The price of the set is lower than the combined price of the separate goods. As he buys the system and the speakers he is entitled to a 30 per cent discount on a DVD player of the same design which he then decides to buy as well. For the whole package (hi-fi system, speakers, DVD player) he is given an additional discount of 3 per cent. Unfortunately the speakers and the DVD player are not in stock anymore, but is told that it would be delivered within the next three weeks. Mr. Schmidt decides to buy the whole package anyway but asks for a right to return the whole package if the speakers and the DVD player are not delivered within three weeks. He is granted that right to return.
The question is how to account for such a transaction. IAS 18.13 only states that “in certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction.” However, IAS 18 is silent on the issue of how to disaggregate such a contract into separately identifiable components.
Because of the lack of guidance under IFRS, companies currently apply US GAAP in order to account for multiple element arrangements. This recourse to US GAAP is in line with IAS 8.12 which allows management to “consider the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards, other accounting literature and accepted industry practices”. However, this can only happen as long as these sources do not conflict with existing IFRS and the framework.
6 See IAS 18.28.
Pronouncements applied on this base include, for example, Emerging Issues Task Force’s Accounting for Revenue Arrangements with Multiple Deliverables (EITF 00-21) which was approved by the EITF in November 2002. This is an unsatisfactory situation. The absence of guidance under IFRS is therefore one of the reasons for the current IASB project on revenue recognition which is addressed in section IV of this paper.