LOS B and C requires us to:

Describe general principles of revenue recognition and accounting standards for revenue recognition;

and

calculate revenue given information that might influence the choice of revenue recognition method.

There are usually set guidelines for the recognition of revenue as per the reporting standards applicable for the reporting entities, depending upon their jurisdiction. Following points need to be noted about the revenue recognition concepts:

a.  Both IFRS and U.S. GAAP had their separate defined framework for preparation and presentation of financial statements, prior to the issuance of the converged standards in May 2014. These converged standards would be applicable with effect from the year 2017.

b.  When we speak about the revenues, it mainly consists of the income. Income is considered as:

     i.  an increase in economic benefits;

    ii.  resulting from:

          #  inflows,

          #  enhancement of assets, or

          #  the decrease in liability

   iii.  that results in an increase in equity.

c.  The revenues are usually recognized on an accrual basis. It means that they should be recognized when the income accrues, independent of the timings of the cash flow in respect of the same.

     i.  Thus, if all the goods are sold or services are rendered for cash and there is no other income, then the accruals equal the cash flows. In such a situation, the revenues will be equal to the cash value of the sale.

    ii.  However, if all the goods are not sold for cash and some of them are sold for credit; then the accrual will not equal the amount of cash received. Here, the amount of revenue for which the payment is still deferred on the date of the income statement will be recorded as an asset on the balance sheet.

   iii.  In another situation, if the cash is received in advance and the goods/ services have not been delivered/rendered on the date of reporting. Here, as much cash that is received for which the goods/services are not yet delivered/rendered should be recorded as unearned revenue. The unearned revenues should be recorded as a liability on the balance sheet.

1.         Revenue Recognition Principles

Under IFRS, the revenues should be recognized if the following criteria/conditions are fulfilled:

Under U.S. GAAP, however, the revenues should be recognized when they are:

a.  realized or realizable, or

b.  earned

The SEC guidelines give the following four additional criteria to determine whether revenue should be recognized or not:

a.  There should be evidence of an arrangement between the buyer and the seller.

b.  The product is either delivered or the service already rendered.

c.  The price is either determined or determinable (it is non-contingent).

d.  The seller is reasonably sure of the collectability of the revenue.

2.         Specific Revenue Recognition Applications

There are usually different types of revenue contracts. Due to the complexity of some of such contracts, the standards specify different treatments in recognizing the revenues. Following are some of the recognition criteria under different situations.

2.1.    Long-Term Contracts

a.  These are the contracts that usually span over a number of accounting periods.

b.  An example of a long-term contract is the contract for construction projects, which usually requires a period of more than one year before they get completed.

c.  The two generally accepted methods of accounting for the long-term contracts are: percentage of completion method and the completed contract method.

d.  Percentage Completion Method:

     i.  Both IFRS and U.S. GAAP require the use of the percentage completion method for the purpose of accounting for the long-term contract when the outcome of the long-term contract can be measured reliably.

    ii.  According to this method, the revenues for each of the intervening period is calculated as a percentage of completed of actual cost over the full cost (i.e. total cost incurred to date divided by the total expected actual cost of the project).

   iii.  For example, say a construction company takes a project to complete a building over a period of the next three years at an agreed price of $ 1 million and the estimated total cost of the project is $ 750,000. Now suppose the project cost incurred by the company is as follows:

Thus, the percentage cost incurred each year is as follows:

The revenues to be recognized each year and the respective profits would be as follows:

e.  However, if the outcome cannot be measured reliably but the cost recovery is probable, under IFRS, no profits would be recognized until all costs have been recovered. In such a situation for each of the reporting periods, the revenue will be equal to the cost incurred during that period. The remaining profit in such a situation would be recognized at the end of the project. Under this method, there will be no profits until the cost is recovered.

f.  Under S. GAAP, if the outcome cannot be measured reliably, the completed contract method is followed. No income is reported until the contract is substantially finished. The costs incurred during the intervening reporting periods are accumulated in the balance sheet and reported as construction in progress, which eventually is reported as an asset in the balance sheet.

g.  If a loss is expected on a contract, under both IFRS and U.S. GAAP it should be reported immediately and not deferred until the completion of the project irrespective of the method used for the accounting (i.e. percentage completion method or completed contract method). However, if there is any revision in the estimates then the same can be given effect to, as and when they arise.

2.2.    Installment Sales

a.  Under such an agreement the proceeds of the sale are paid to the seller over an extended period of time (i.e. to multiple accounting periods).

b.  Such sales take place, usually for high-value goods, especially for the real estate business.

c.  For assets other than real estate, under both IFRS and GAAP the transaction should be recognized as follows:

     i.  First, separate the sales price and the interest component from the transaction value. The sales price is the amount that would have been charged by the seller, had the transaction on a cash basis (and not on installments). Since in the cash transaction there is no time delay in payments, therefore, there is no interest factor involved. Thus any amount charged above this value is the interest.

    ii.  Also, the sale price can be calculated as the net present value of all the future installments receivable against the sale.

   iii.  On the date of sale following accounting entries are passed:

Note: The amount of revenues is debited by the sales price i.e. the net present value of all the future installments receivable.

   iv.  When the payments are received following accounting entry is passed:

Note: Interest is calculated at the discount rate used for the calculation of the net present value.

d.  In case of the real estate transactions:

     i.  Under IFRS:

          #  If the transaction can be categorized as a long-term contract, then it must be treated as the one and revenues should be recognized as per the percentage of completion method or completed contract method, as applicable.

          #  Otherwise, treat them as a normal installment sale transaction and follow the revenue recognition principle as applicable to the non-real estate transactions.

    ii.  Under U.S. GAAP:

          #  If :

             :  the seller has completed significant activities in the earning process; and

             :  is assured of collecting the revenue, or is able to estimate reliably what is expected to be collected

            Then normal revenue recognition principles apply and as much profit as is calculated using the installment method is recognized. The total profit to be declared in such a situation equals:

(Amount Collected) / (Selling Price)  × Total Profit

            For example: Say in a real estate transaction the sale is made today and the installments for the same is expected to be received in two equal installments of  $500,000 at the end of year 1 and year 2. The cost of the sale is $ 700,000; which has already been incurred. The amount to be recognized as profits would be:

            Year 1 =   500,000 / 1,000,000 × 300,000 = $ 150,000

            Year 2 =  500,000 / 1,000,000 × 300,000 = $ 150,000 

          #  Else (if the above two conditions as mentioned in the U.S. GAAP are not satisfied), then some profit is declared using the cost recovery method. According to this method, no profits are declared until all the cost is recovered.

             In the above example, under this method, no profit would be declared in Year 1. Since in the first year, the amount recovered is $ 500,000 which is less than the total cost of $ 700,000. Hence, no profit will be recovered in year 1.

            In Year 2, the entire profit can be recovered as the cost is covered and the amount to be recovered will be:

$ 500,000 – $ 200,000 = $ 300,000

Note: Since the cost of $ 500,000 is already recovered in Year 1, the remaining cost of $ 200,000 (i.e. $ 700,000 – $ 500,000) would be recovered here.

2.3.    Barter Transactions

a.  In the barter transactions, the sales are made but cash is not recovered against the same. Instead, some goods or services are received against the same.

b.  Barter transactions also included round-trip transactions. In the round-trip transactions, the goods are sold in exchange for the near-identical items in return.

c.  Under IFRS the barter transactions are recorded as revenue at the fair values of the goods exchanged. Fair Value is the amount that is expected to be received if the goods were sold in a similar non-barter transaction with non-related parties (usually at the arms-length price).

d.  Under S. GAAP, such transactions are recorded at fair values only if the company has a history of making or receiving cash payments for such goods or services. Otherwise, the transaction is recorded at the carrying amount of the asset(s) given up.

2.4.    Gross and Net Reporting of Revenue

a.  Under gross revenue reporting, the seller reports the sales revenue and cost of sales separately.

b.  However, under net revenue reporting the difference between the revenues and the cost of sales is reported.

c.  The profits remain the same under both methods but the reported revenue is higher in the gross method.

d.  For Example: Say a company sells goods for $ 100,000 and the cost of goods sold was $ 80,000; under gross reporting both the total revenue of $100,000 and the cost of goods sold, $ 80,000 would be reported in the financial statements. However, under net reporting just $ 20,000 (i.e. $100,000 minus $ 80,000) of net revenues would be reported.

e.  Under S. GAAP, the gross reporting mechanism is permissible only if the following conditions are met:

     i.  The seller is the primary obligor under the contract.

     ii.  The seller bears the inventory risk and the credit risk.

   iii.  The selling firm must be able to choose its supplier.

   iv.  The selling form has reasonable latitude to establish a price.

3.         Revenue Recognition Process

In May 2014, IASB and FASB issued a set of converged principle base standards. These standards are yet to be adopted.

The core principle behind these standards is that ‘revenues should be recognized in order to depict the transfer of promised goods and services to the customers in an amount that reflects the consideration to which the entity expects to be entitled in an exchange for those goods and services upon their transfer, for the amount that the seller is entitled to’.

There are basically five steps for recognizing the revenues. They are:

1.  Identify the contract(s) with the customer.

2.  Identify the performance obligation in the contract.

3.  Determine the transaction price.

4.  Allocate the transaction price to the performance obligation.

5.  Recognize the revenue when, or as, the entity satisfies the performance obligations.

So let us discuss the above steps/terminology used in detail.

a.  What is the contract? It is an agreement and commitment with commercial substance, which exists only when its collectability is probable. However, not all such transactions are considered contracts. There are certain exclusions from this definition, they are leases, financial instruments (like options, derivatives, etc.), guarantees, non-monetary exchanges, etc. There is a different interpretation of probability under IFRS and U.S. GAAP. If the collectability is more likely than not (51% or more probability), it can be considered as a contract under IFRS. However, under U.S. GAAP a likeliness of occurrence is considered as the probability (the percentage is not necessary).

b.  A performance obligation is on distinct goods and services:

     i.  If, customer can benefit from it on its own or in combination with readily available resources;

    ii.  And, the promise to transfer can be separated from another promise(s) in the contract.

Each performance obligation should be accounted for separately.

c.  Transaction Price is the amount that the seller estimates that may be expected to be received on the transfer of goods and services identified in the contract.

d.  In the fourth step, depending upon the expectation of collectability, the transaction price is allocated to each of the performance obligations.

e.  In the last step, revenue is recognized when the obligation satisfying the transfer is made. Here, the obligations may be satisfied at a point of time, or over a period of time, or maybe for multiple performance obligations.

     i.  If the obligation is satisfied at a point in time, recognize the revenue when the obligation satisfying the transfer is made.

    ii.  And, if the obligations get satisfied over a period of time, revenue can be recognized over a period of time if any of the following conditions are satisfied:

          #  The consumer consumes as and when the performance obligation is performed.

          #  The customer controls the assets as it is created.

         #  The seller creates an asset with no other alternative use to the seller and the payment for the progress is required even if the contract is canceled.

   iii.  In case of multiple performance obligations, steps 2-4 are followed i.e. identify the performance obligation for each contract, determine the transaction price, and allocate the same to the contract.

NOTE: The cost of obtaining a contract must be capitalized and not expensed.

3.1.    Disclosure Requirements

The reporting entity must report the following in its financial reports:

a.  Details of the contracts, category wise;

b.  Balances of contract assets/contract liabilities; and

c.  Details of remaining performance obligations and transaction price allocated to performance obligations.

3.2.    Transition to New Converged Standards

There are two ways of converging to the newly revised standards:

a.  Convergence with full retrospective effect. Here the changes are made to reflect the cumulative effect adjustment on the opening retained earnings of the earliest period presented.

b.  Modified Retrospective Amendment. Here the amendments are made to the current period data only. There is no need to restate the previous year’s data. This, however, requires more disclosures.