Deegan5e Ch16

16-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 5e by Craig DeeganSlides prepared by Craig Deegan

Chapter 16

Revenue recognition issues


Objectives• Understand some of the concepts of income and revenue• Understand the points of an organisation’s operating cycle at

which income can be recognised• Appreciate that the amount of income recognised in a particular

period will relate directly to the accounting measurement model that has been adopted

• Understand how the existence of particular conditions associated with a sale (such as attached put and call options, or the right of return) will affect the timing of revenue recognition

• Understand the issues associated with recognising revenues for long-term construction projects and be aware of the requirements of AASB 111 ‘Construction Contracts’


Definition of income and revenue

Income defined (par. 70 of the AASB Framework) as• Increases in economic benefits during the accounting period in

the form of inflows or enhancements of assets or decreases in liabilities that result in an increase in equity, other than those relating to contributions from equity participants

• Income is divided into ‘revenues’ and ‘gains’


Definition of income and revenue (cont.)

Revenues and gains (par. 74 of the AASB Framework)• Revenue arises in the course of the ordinary activities of an

entity and is referred to by a variety of different names, including sales, fees, interest, dividends, royalties and rent

Gains (pars 74 and 75, AASB Framework)• Other items that meet the definition of income and may or may

not arise in the course of the ordinary activities of an entity. Gains represent increases in economic benefits and as such are not different in nature from revenue.



Revenues and gains (par. 75, AASB Framework)• Gains include, for example, those arising on the disposal of non-

current assets. The definition of income also includes unrealised gains, for example those arising on the revaluation of marketable securities and those resulting from increases in the carrying amount of long-term assets. When gains are recognised in the income statement, they are usually displayed separately because knowledge of them is useful in making economic decisions. Gains are often reported net of related expenses.



• Generally speaking, revenues relate to the ordinary income-generating activities of an entity, e.g. sales or rental receipts

• Gains relate to ‘other income’—not necessarily part of the ordinary activities of an entity

• Differentiation based on some degree of professional judgment

• What is an ‘ordinary’ activity for one business may not be ‘ordinary’ for another—so the benefits might be deemed ‘revenue’ in one entity and a ‘gain’ in another



• Differentiation between revenue and gains also embraced by AASB 118 ‘Revenue’ (par. 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



Scope of AASB 118 ‘Revenue’ is fairly restricted—applies to accounting for revenue arising from transactions and events relating to (par. 1)

a) the sale of goods

b) the rendering of services

c) the use by others of entity assets yielding interest, royalties and dividends

Recognition criteria provided for each of the above categories of revenue, e.g. sale of goods (par. 14)



Revenue from the sale of goods is to be recognised when all of the following conditions have been satisfied:

• the entity has transferred to the buyer the significant risks and rewards of ownership of the goods

• the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods

• 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 costs incurred or to be incurred in respect of the

transaction can be measured reliably



Where revenue has been recognised, AASB 118 requires that the revenue be measured at the fair value of the consideration or contributions received or receivable (par. 9)

– if cash is not to be received for some period of time the future amount to be received would need to be discounted to its present value and the present value recognised as revenue (refer to AASB 118, par. 11)

– if cash is received for goods and services provided the revenue recorded is equal to the cash received


Income and revenue recognition—current practice

AASB 118 (Appendix A) provides guidance in relation to the recognition of different types of revenues. In relation to the sale of goods, guidance is provided in relation to

– goods sold subject to conditions– lay-by sales– orders when partial payment received in advance– subscriptions to publications– instalment sales– real estate sales


Income and revenue recognition—current practice (cont.)

• Traditionally, revenue has been recognised at several points in the earnings cycle (refer to Figure 16.1 on page 560—The earnings cycle), for example

(i) at point 5 (progressively throughout production) in the building industry for long-term construction contracts

(ii) at point 7 (receipt of orders after completing production) where it is the responsibility of the purchaser to collect the goods

(iii) at point 8 (delivery of goods to customers)—in most cases

(iv) at point 9 (receipt of cash) by some professional practices and for instalment credit sales



• Rarely, if ever, recognised prior to point 5 (progressively throughout production)

- uncertainty surrounding the ultimate irrevocable and unconditional claim to cash (or its equivalent) prior to this point

• In practice, point 9 (receipt of cash) is considered too conservative to be the general criterion

• At point 8 (delivery of goods to customers) any uncertainty remaining is accounted for by creating a ‘provision for doubtful debts’



• Currently, we have a system of accounting based predominantly on a historical cost, transaction-based system of accounting

• We also make use of other approaches to valuation (e.g. market values)– Increases in market values of marketable securities are

recognised as part of income—a departure from traditional historical accounting but still consistent with the definition of income provided in the AASB Framework

Note• Different measurement models of assets and liabilities, e.g.

historical cost vs the modified historical cost system, will generate different calculations of income and hence profits


Income and revenue recognition—according to the AASB Framework

Paragraph 83 of the AASB Framework

An item that meets the definition of an element (e.g. income) should be recognised if

(a) the item has a cost or value that can be measured with reliability

(b) it is probable that any future economic benefit associated with the item will flow to or from the entity


Income and revenue recognition—according to the AASB Framework (cont.)

Note• Probable refers to more likely than less likely• AASB 118 ‘Revenue’ provides recognition criteria

for revenue items– revenue that relates to sale of goods, rendering of

services, and interest, royalties and dividends– revenue from sales of goods and services is to be

recognised when the entity has transferred to the buyer the significant risks and rewards of ownership of the goods (refer to pars 16 and 17 AASB 118 for additional guidance)


Income and revenue recognition—at completion of production

• At times, revenue may be recognised at the completion of production, even when no sale has been made

• Examples of such cases include the production of precious metals or agricultural products


Income and revenue recognition—at the time of sale

• The two conditions (probable economic benefits and reliable measurement) for recognising revenue are usually met by the time the product or merchandise is delivered, or the services are rendered to customers

• Normally determined by shipping terms, i.e. time of sale is commonly interpreted as when title passes


Income and revenue recognition—at the time of sale (cont.)

• F.O.B. shipping point– title passes to the buyer (and revenue is recognised) when

the seller delivers goods to a common carrier who acts as an agent for the buyer

• F.O.B. destination– title does not pass (and revenue is not recognised) until the

buyer receives the goods from the carrier



In advance of cash receipt• When revenue is recognised in advance of receipt of

cash, it is common to recognise a ‘provision for doubtful debts’– determined on basis of past experience and industry

averages– journal entry

Dr Doubtful debts expenseCr Provision for doubtful debts

– provision for doubtful debts is contra account to debtors



In advance of cash receipt (cont.)• If goods are sold or services provided on credit terms,

not all amounts due from debtors will ultimately be collected

• To ignore this fact would lead to an overstatement of receivables and assets in the balance sheet

• This is consistent with the general principle provided in par. 18 of AASB 118


Income and revenue recognition—at the time of sale (cont.)In advance of cash receipt (cont.)Accounting for bad and doubtful debts• When actual debtor is identified as unlikely to pay when amount

was previously anticipated

Dr Provision for doubtful debtsCr Debtors

• When debtor is identified as unlikely to pay and amount was not previously anticipated

Dr Bad debts expenseCr Debtors


Accounting for sales with associated conditions

• Transactions involving the sale of assets with conditions attached should be reviewed to assess whether

– control of the future economic benefits has passed from the seller to the purchaser; and

– it is probable that the inflow of economic benefits to the seller has occurred


Accounting for sales with associated conditions—call and put options

Call option• Provides the holder of the option with the right to buy an asset at

a specified exercise price on or before a specified date• The party that writes the call option agrees to deliver a particular

asset to the call-option buyer, if that buyer instructs the other party to do so

• A call option is considered to have value when the value of the underlying asset exceeds the option’s exercise price

• If at exercise date the exercise price is above or equal to the market value of the asset, the option has no value and a sale could be recorded

• However, if something is sold to another party, but as part of the sales conditions, the seller has a call option which enables them to buy back the asset at a future date, then to the extent that the market price is greater than, or likely to be greater than, the option’s exercise price, then no sale should be recorded


Accounting for sales with associated conditions—call and put options (cont.)

Put option• Operates in reverse manner to a call option• Holder has the right to sell an asset at a specified exercise price

on or before a specified date• The writer or the seller of the put option agrees to buy the asset

at a future date for the exercise price if the put option holder (buyer) so requests

• The holder of the put option would typically exercise the option (require the other party to buy the asset) only if the exercise price is above the market price

• Guarantees holders a minimum price for their assets• If an asset is sold to another party, and the buyer has a put option

which enables that party to sell the asset back to the original seller, then a sale should not be recognised if the exercise price is, or is likely to be, above the market price


Accounting for sales with associated conditions—call and put options (cont.)

• Where a transaction involves concurrent use of a financial instrument, it is necessary to evaluate the conditions attaching to the transaction to establish whether, in substance, the transaction is a financial arrangement rather than a sale

• Probability of the exercise of the options must be considered in recognising revenue


Accounting for sales with associated conditions—revenue recognition when right of return exists

• Alternative treatments available when the seller is exposed to continued risks of ownership through return of the product

– not recording the sale until all return privileges have expired

– recording the sale but reducing sales by an estimate of future returns

– recording the sale and accounting for the returns as they occur


Accounting for sales with associated conditions—revenue recognition when right of return exists (cont.)

• If a company sells its product but gives the buyer the right to return the product, revenue from the sales transaction may be recognised at the time of sale if all of the following conditions have been met– the seller’s price to the buyer is substantially fixed or determinable

at the date of sale– the buyer has paid the seller, or the buyer is obligated to pay the

seller and the obligation is not contingent on the resale of the product

– the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product

– the buyer acquiring the product for resale has economic substance apart from that provided by the seller

– the seller does not have significant obligations for future performance to directly bring about the resale of the product by the buyer

– the amount of future returns can be reasonably estimated


Accounting for sales with associated conditions—sale and leaseback

• Although ownership of the leased property has been transferred to the purchaser/lessor, the vendor/lessee normally retains control

• The vendor/lessee has in effect entered into a financing arrangement—leased property used as collateral for a loan

• Transaction does not constitute a sale and does not give rise to revenue– inflow of economic benefits (proceeds from disposal) have

resulted in an equivalent liability (lease payable)– result is no increase in equity


Interest and dividends—interest revenue

• Interest revenue is recognised over time as the borrower has the benefit of the borrowings and the lender establishes claims for interest earned

• Prepayment of interest not regarded as revenue to lender as lender has present obligation to provide finance for the period to which the prepayment relates

• Interest revenue might be implicit in the terms of a transaction– for example, where goods are sold on extended credit, vendor

is effectively financing the purchaser– transaction gives rise to two forms of revenue

1. Sales revenue—present value of future payments2. Interest revenue from financing activities


Interest and dividends—interest revenue (cont.)

• To estimate the present value of the proceeds, an applicable interest rate inherent in the agreement must be determined

• AASB 118 (par. 11)– when the arrangement effectively constitutes a financing

transaction, the fair value of the consideration is determined by discounting all future receipts using an imputed rate of interest. The imputed rate of interest is the more clearly determinable of either

(a) the prevailing rate for a similar instrument of an issuer with a similar credit rating; or

(b) a rate of interest that discounts the nominal amount of the instrument to the current cash sales price of the goods or services


Interest and dividends—interest revenue (cont.)

• The difference between the fair value and the nominal amount of the consideration is recognised as interest revenue

• Rate used for valuation purposes will normally be at least equal to the rate at which the debtor can obtain financing of a similar nature from other sources at the date of the transaction

• Objective is to approximate the rate that would have resulted if an independent borrower and an independent lender had negotiated a similar transaction on comparable terms and conditions

Refer to Worked Example 16.1 on pp. 571—Recognition of interest inherent in a sales transaction


Interest and dividends—dividend revenue

• Dividends do not accrue over time but usually result from a decision of the board of directors

• Dividend revenue should be recorded once it is considered probable that inflow of future economic benefits has occurred and when these benefits can be measured reliably– in most cases this will be at the time the board of directors or

other governing body proposed the dividend


Unearned revenue

• Recorded when payment is received in advance of services or resources being provided

• The receipts have not been earned• Considered to be liabilities

– under present obligation to transfer future economic benefits at a future date

Refer to Worked Example 16.2 on page 573—Revenue received in advance


Accounting for construction contracts

• Accounting issues result from some construction projects taking a number of financial periods to complete– should revenue be recognised progressively throughout

the contract?– if so, how would the amount of revenue be determined?

• Deferral of revenue recognition until completion of project would result in greater volatility of reported revenues and of related profits or losses


Accounting for construction contracts (cont.)

• Governed by AASB 111 ‘Construction Contracts’• Applies to the accounting methods adopted by a

contractor for all construction contracts• Construction contract defined (AASB 111, par. 3)

– a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function of their ultimate purpose or use

• Refer also to AASB 111 (par. 4)



Accounting requirements• Individual construction contracts must be accounted for

separately and the requirements of the standard must be applied separately to each contract

• AASB 111 (par. 9)– a group of contracts, whether with a single customer or

with several customers, is to be treated as a single contract when

(a) the group of contracts is negotiated as a single package;(b) the contracts are so closely interrelated that they are, in

effect, part of a single project with an overall profit margin; and

(c) the contracts are performed concurrently or in a continuous sequence



Accounting requirements (cont.)• AASB 111 requires (if certain criteria are satisfied)

that contractors use the percentage-of-completion method to account for construction contracts– Profit on construction contract is recognised in proportion

to the work performed in each reporting period in which construction occurs



• Construction costs plus gross profit earned to date accumulated in inventory account (construction in progress)

• Progress billings accumulated in contra inventory account (billings on construction in progress account)



• Percentage-of-completion method should be used provided that certain conditions are met that enable the outcome of the contract to be reliably estimated

AASB 111 (par. 22)• When the outcome of a construction contract can be

estimated reliably, contract revenue and contract costs associated with the construction contract are to be recognised as revenue and expenses respectively by reference to the stage of completion of the contract activity at the reporting date



Types of construction contracts• Fixed-price contracts• Cost-plus contracts• Type of contract determines the conditions that must

be satisfied to use the percentage-of-completion method

• Defined in par. 3 of AASB 111



Conditions of use of percentage-of-completion method (AASB 111, par. 23)

• With fixed-price contract– total contract revenue can be measured reliably;– it is probable that economic benefits arising from the

contract will flow to the contractor;– both the contract costs to complete the contract and stage

of contract completion as at reporting date can be measured reliably; and

– the contract costs attributable to the contract can be clearly identified and measured reliably so that actual costs can be compared with prior estimates



Conditions of use of percentage-of-completion method (AASB 111, par. 24)

• With cost-plus contract– it is probable that the economic benefits arising from the

contract will flow to the contractor; and – the contract costs attributable to the contract, whether or

not specifically reimbursable can be clearly identified and measured reliably



• If conditions are not satisfied- no profit is to be brought to account until they are satisfied- at the extreme, no profit to be recognised until project completion

Note• When outcome of construction contract cannot

be estimated reliably (AASB 111, par. 32)(a) revenue is to be recognised only to the extent of

contract costs incurred that it is probable will be recoverable; and

(b) contract costs are to be recognised as an expense in the period in which they are incurred



Measuring progress towards completion• Percentage of completion can be measured in a number of

ways (per AASB 111, par. 30)– the entity uses the method that measures reliably the

work performed. Depending on the nature of the contract, the methods may include(a) the proportion that contract costs incurred for work

performed to date bear to the estimated total contract costs;

(b) surveys of work performed; or

(c) completion of physical proportion of the contract work.

• Progress payments and advances received from customers often do not reflect the work performed



Measuring progress towards completionCost basis• The percentage of completion is measured by comparing

costs incurred to date with the most recent estimate of the total costs to complete the contract

• Only those contract costs that reflect the work performed are included in costs incurred to date. Examples of contract costs excluded are

– contract costs that relate to future activity on the contract, such as costs of materials delivered or set aside but as yet not installed, used or applied

– payments made to subcontractors in advance of work performed



Types of costs incurred by contractors(a) Costs related directly to a specific contract, e.g. direct materials, direct

labour, depreciation of equipment, costs of moving plant and equipment, expected warranty costs, costs of design and technical assistance directly related to contract, costs of securing contract, costs of hiring plant and equipment

(b) Costs that are attributable to contract activity in general and capable of being allocated on a reasonable basis to specific contracts, e.g. tender preparation, insurance, design and technical assistance

(c) Costs that relate to the activities of the reporting entity generally or that relate to contract activity generally and are not normally related to specific contracts, e.g. general administration and selling costs, finance costs and research and development costs not directly related to contract

Note• Costs (a) and (b) are normally included in accumulated contract costs• Costs (c) are usually excluded from accumulated contract costs because

they do not relate to reaching the present stage of completion of a specific contract



• Calculation of percentage of completion (cost method)

Costs incurred to the end of the current period Most recent estimate of total costs

• Current period revenue or gross profit- estimated total revenue or gross profit from the contract multiplied by percentage complete less total revenue or gross profit recognised in prior periods


Accounting for construction contracts (cont.)Journal entries for construction contract accountingTo record costs of construction

Dr Construction in processCr Materials, cash, payables, etc.

To record billings to customersDr Accounts receivableCr Billings on construction in process

To record collections of billingsDr CashCr Accounts receivable

To record contract revenue and contract expensesDr Construction in processDr Construction expenses (costs incurred)Cr Revenue from long-term contracts

To record final approval of contractDr Billings on construction in processCr Construction in process



Disclosure requirements• AASB 111 requires that the balance sheet or

accompanying notes– disclose the gross amount of work in progress (or contract

costs incurred)– the related aggregate billings deducted from the work in

progress



Disclosure requirements (cont.)

• Work in progress will include the profit recognised throughout the contract

• If progress billings exceed the gross amount of construction work in progress, the net amount should be shown as a liability or otherwise disclosed as an asset

• Disclosure requirements are outlined in AASB 111 (pars 39–42)

• Appendix to AASB 111 provides an example of a disclosure that might appear in an entity’s financial report



Application of percentage-of-completion method to account for construction contracts

– Refer to Worked Example 16.3 on pp. 581—Percentage-of-completion method

– Refer to Worked Example 16.4 on pp. 582—Construction contract where outcome cannot be reliably estimated



Accounting for long-term contract losses

When current estimates of total contract costs and revenues for any contract indicate that a loss is probable– provision should be made for any foreseeable loss on the contract

regardless of the amount of work already performed

– loss is to be brought to account as soon as it is foreseeable

AASB 111 (par. 36)

When it is probable that total contract costs will exceed total contract revenue, the expected loss shall be recognised as an expense immediately


Accounting for construction costs (cont.)

AASB 111 (par. 37)Expected loss (excess of total contract costs over total contract revenue) arising from a construction contract is recognised as an expense irrespective of– whether work has commenced on the project– the stage of completion of the activity; or– the difference between total contract costs and total contract

revenue expected to arise from other construction contracts

Refer to Worked Example 16.5 on page 583—Percentage of completion with recognition of a loss


Illustration – accounting for a construction contract

XYZ signed a contract on January 1, 2008, agreeing to build a warehouse for ABC at a contract price of $20,000,000. XYZ estimated that construction costs would be as follows2008 $5,000,0002009 $8,000,0002010 $3,000,000

$16,000,000

The contact provided that ABC would make payments on December 31 of each year as follows2008 $ 4,000,0002009 $10,000,0002010 $ 6,000,000

$20,000,000The contract was completed and accepted on December 31, 2010. Assume that actual costs and cash collections coincided with expectations.


Illustration – accounting for a construction contract (cont.)(a) INCOME RECOGNISED EACH YEAR

YEAR P.O.C.2008 $1.252009 $2.002010 $0.75

$4.00

P.O.C. 2008 2009 2010Revenue(5/16)x20 6.25(13/16)x20-6.25 10.0(16/16)x20-16.25 3.75Expense5/16 x 16 (5)13/16 x 16 - 5 (8.0)16/16 x 16 - 13 (3.0)

1.25 2.00 0.75


(b) Journal Entries P.O.C. Method2008 2009 2010

(i) To record costs incurred

Dr. Construction in process 5 8 3

Cr. Cash, accounts payable 5 8 3

(ii)To record billings to customers

Dr. Accounts Receivable 4 10 6

Cr. Billings on Contracts 4 10 6

in Process


(iii)To record cash collections 2008 2009 2010

Dr. Cash 4 10 6

Cr. Accounts Receivable 4 10 6

(iv) To record periodic income recognised

Dr. Construction in Process 1.25 2 0.75

Dr. Construction expenses 5.00 8.00 3.00

Cr. Revenue from L.T. Contract 6.25 10 3.75

(or could separately show the revenue and expense)

(v) To record final approval and acceptance

Dr. Billings on Contracts in Process - - 20

Cr. Construction in Process - - 20


Summary• In this chapter the recognition of income and

revenue has been considered• AASB ‘Framework for the Preparation and

Presentation of Financial Statements’ requires that for income to be recognised the associated inflow of economic benefits or associated reduction in liabilities must be both probable and measurable with reasonable accuracy

• AASB 118 ‘Revenue’ provides a number of additional recognition criteria, e.g. for revenue to be recognised, the risks and rewards of ownership of the asset (for the sale of the goods) must be transferred to the purchaser


Summary (cont.)

• Sales transactions are often made with associated conditions (e.g. call and put options or a right to return the assets)– it is necessary to consider whether they reduce the probability

that the inflow of resources will ultimately occur– if it appears that an option that will reduce the inflow of

resources will probably be exercised or that the right of return will be exercised, the revenue should not be recognised by the reporting entity until such time as the requisite degree of certainty is attained and in the inflow of economic benefits will occur

– determining whether revenue should be recognised will also depend on the system of accounting being used, i.e. measurement model being adopted


Summary (cont.)• Under historical-cost accounting the increase in the value of

marketable securities would not be considered as revenue until such time as the securitiies are sold

• If a market values-based system is used increased market prices of assets could be treated as part of the period’s income

• Revenue and expenses related to a construction contract are to be recognised by applying the percentage-of-completion method if the outcome and stage of completion of the construction contract can be reliably estimated

• Where percentage-of-completion method is applied, revenue is brought to account with a corresponding increase in construction in progress on the basis of percentage of completion


Summary (cont.)

• Percentage of completion is measured typically by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract

• Revenue will be recognised throughout the life of the contract, but if the percentage-of-completion method is used and it becomes apparent that a loss will be made, the entire loss must be recognised as soon as it is foreseeable

• For disclosure purposes, billings on construction in progress account is shown in the balance sheet as a deduction from construction in progress account—if billings account balance exceeds construction in progress account the net amount represents a liability

Deegan5e Ch16

Education

Transcript of Deegan5e Ch16