Revenue

Chapter 11
Learning objectives
5-step approach
 IFRS 15 – Revenue
recognition: A 5 step process
An entity recognizes revenue by applying the
following five steps:
1. Identify the contract
2. Identify the separate performance
obligations within a contract
3. Determine the transaction price
4. Allocate the transaction price to the
performance obligations in the contract
5. Recognize revenue when (or as) a
performance obligation is satisfied
 Illustration 1 – The 5 steps
On 1 December 20X1, Wade receives an
order from a customer for a computer as
well as 12 months of technical support.
Wade delivers the computer (and transfers
its legal title) to the customer on the same
day.
The customer paid $420 on 1 December
20X1. The computer normally sells for
$300 and the technical support for $120.
 Illustration 1 – The 5 steps
(cont.)
Step 1 – Identify the contract
There is an agreement between Wade and its
customer for the provision of goods (the
computer) and services (the technical support).
Step 2 – Identify the separate performance
obligations within a contract
There are two performance obligations within
the contract:
• The supply of a computer
• The supply of technical support
Illustration 1 – The 5 steps
(cont.)
Step 3 – Determine the transaction price
The total transaction price is $420.
Step 4 – Allocate the transaction price to
the performance obligations in the
contract
Based on stand-alone sales prices, $300
should be allocated to the sale of the
computer and $120 should be allocated to
the sale of technical support.
Illustration 1 – The 5 steps
(cont.)
Step 5 – Recognize revenue when (or as) a
performance obligation is satisfied
Control over the computer has been passed to
the customer so the full goods revenue of $300
should be recognized on 1 December 20X1.
The technical support is provided over time, so
revenue from this should be recognized over
time. In the year ended 31 December 20X1,
revenue of $10 (1/12*$120) should be
recognized from the provision of technical
support.
Step 1: Identify the
contract
 Step 1
A contract is 'an agreement between two or
more parties that creates enforceable
rights and obligations' (IFRS 15, Appendix
A).
A contract can be agreed in writing, orally, or
through other customary business practices.
An entity can only account for revenue if the
contract meets the following criteria:
• 'the parties to the contract have approved
the contract and are committed to perform
their respective obligations
 Step 1 (cont.)
• the entity can identify each party’s rights
regarding the goods or services to be
transferred
• the entity can identify the payment terms for
the goods or services to be transferred
• the contract has commercial substance, and
• it is probable that the entity will collect the
consideration to which it will be entitled in
exchange for the goods or services that will
be transferred to the customer' (IFRS 15, para
9).
 Illustration 2 – Identifying
the contract
Mono Co has a year end of 31 March 20X6.
On 1 January 20X6, Mono Co signed a contract
with a customer to supply them with an asset on
31 March 20X6 in return for payment of $360,000
on 30 September 20X6. Control of the asset would
pass to the customer on 31 April 20X6.
By 31 March 20X6, Mono Co did not believe that it
would probably be paid the $360,000. Contract
exist as of 31 March 20X6?
The contract cannot be accounted for and no
revenue should be recognized.
Step 2: Identifying the
separate performance
obligations within a
contract
 Step 2.
Performance obligations are promises to
transfer distinct goods or services to a
customer.
Some contracts contain more than one
performance obligation. For example:
• An entity may enter into a contract with a
customer to sell a car, which includes one
year’s free servicing and maintenance
• An entity might enter into a contract with a
customer to provide 5 lectures, as well as to
provide a textbook on the first day of the
course.
 Step 2. (cont.)
An entity must decide if the nature of a
performance obligation is:
• to provide the specified goods or services
itself (i.e. the entity is the principal), or
• to arrange for another party to provide the
goods or service (i.e. the entity is an agent)
If an entity is an agent, then revenue is
recognized based on the fee or commission
to which it is entitled.
Illustration 3 – Agency sales
Hadrian Co's revenue includes $45,000
for goods it sold acting as an agent for
Offa. Hadrian Co earned a commission of
10% on these sales and remitted the
difference of $40,500 (included in cost of
sales) to Offa.
How should the agency sale be treated in
Hadrian's statement of profit or loss?
 Illustration 3 – Agency
sales. Solution
Hadrian should not have included $45,000 in
its revenue because it is acting as the agent
and not the principal. Only the commission
element of $4,500 ($45,000 10%) can be
recorded in revenue. The following
adjustment is therefore required:
Dr Revenue $40,500 Reducing revenue to
$4,500
Cr Cost of sales $40,500 Reducing cost of
sales to nil
Step 3: Determining the
transaction price
 Step 3
The transaction price is the 'amount of
consideration to which an entity expects
to be entitled in exchange for transferring
promised goods or services to a
customer' (IFRS 15, Appendix A).
Amounts collected on behalf of third parties
(such as sales tax) are excluded.
The consideration promised in a contract
with a customer may include fixed amounts,
variable amounts, or both.
 Step 3 (cont.)
'When determining the transaction price,
an entity shall consider the effects of all of
the following:
• variable consideration
• the existence of a significant
financing component in the contract
• non-cash consideration
• consideration payable to a customer'
(IFRS 15, para 48).
 Financing
In determining the transaction price, an
entity must consider if the timing of
payments provides the customer or the
entity with a significant financing benefit.
If there is a significant financing
component, then the consideration
receivable needs to be discounted to
present value using the rate at which
the customer would be able to borrow.
 Financing (cont.)
The following may indicate the existence of a
significant financing component (IFRS 15,
para 61):
• a difference between the amount of
promised consideration and the cash
selling price of the promised goods or
services
• a significant length of time between the
transfer of the promised goods or services
to the customer and the payment date.
 Test your understanding 1
Keema Co enters into a contract with a customer
to supply furniture on 30 September 20X3.
Control of the furniture transfers to the customer
on that date. The price stated in the contract is
$750,000 and is due for payment on 30
September 20X5.
Market rates of interest available to this
particular customer are 7%.
Required: Explain how this transaction should
be accounted for in the financial statements of
Keema Co for the year ended 30 September
20X3 and 20X4.
Consideration payable to a
customer
If consideration is paid to a customer in
exchange for a distinct good or service, then
it is essentially a purchase transaction and
should be accounted for in the same way as
other purchases from suppliers.
Assuming that the consideration paid to a
customer is not in exchange for a distinct
good or service, an entity should account for
it as a reduction of the transaction price.
 Illustration 4
Golden Gate Co enters into a contract with a major
chain of retail stores. The customer commits to buy
at least $20m of products over the next 12 months.
The terms of the contract require Golden Gate Co to
make a payment of $1m to compensate the
customer for changes that it will need to make to its
retail stores to accommodate the products.
By 31 December 20X1, Golden Gate Co has
transferred products with a sales value of $4m to the
customer.
How much revenue should be recognized by
Golden Gate Co in the year ended 31 December
20X1?
 Illustration 4. Solution.
The payment made to the customer is not in
exchange for a distinct good or service.
Therefore, the $1m paid to the customer is a
reduction of the transaction price.
The total transaction price is being reduced
by 5% ($1m/$20m). Therefore, Golden Gate
reduces the transaction price of each good by
5% as it is transferred.
By 31 December 20X1, Golden Gate should
have recognized revenue of $3.8m
($4m*95%).
Step 4: Allocate the
transaction price
 Step 4.
The total transaction price should be
allocated to each performance obligation in
proportion to stand-alone selling prices.
The best evidence of a stand-alone selling
price is the observable price of a good or
service when the entity sells that good or
service separately in similar
circumstances and to similar customers.
If a stand-alone selling price is not directly
observable, then the entity estimates the
stand-alone selling price.
Test your understanding 2
Shinji Co sells a machine and one year’s free
technical support for $50,000. It usually sells the
machine for $60,000 but does not sell technical
support for this machine as a stand-alone
product. Other support services offered by Shinji
Co attract a mark-up of 50%. It is expected that
the technical support will cost Shinji Co $10,000.
Required:
How should the transaction price be allocated
between the machine and the technical support?
Step 5: Recognize
revenue
 Step 5.
Revenue is recognized 'when (or as) the
entity satisfies a performance obligation
by transferring a promised good or
service to a customer’ (IFRS 15, para 31).
For each performance obligation identified,
an entity must determine at contract
inception whether it satisfies the
performance obligation over time, or
satisfies the performance obligation at a
point in time.
 Satisfying a performance
obligation at a point in time
If a performance obligation is satisfied at a
point in time then the entity must determine
the point in time at which a customer
obtains control of a promised asset.
Control of an asset refers to the ability to
direct the use of, and obtain substantially all
of the remaining benefits (inflows or savings
in outflows) from, the asset. Control includes
the ability to prevent other entities from
obtaining benefits from an asset.
 Transfer of control
indicators
• The entity has a present right to
payment for the asset
• The customer has legal title to the asset
• The entity has transferred physical
possession of the asset
• The customer has the significant risks
and rewards of ownership of the asset
• The customer has accepted the asset.
Consignment inventory
This can raise the issue of consignment
inventory, where one party legally owns
the inventory but another party keeps
the inventory on its premises. The key
issue relates to which party has the
majority of indicators of control.
 Illustration 5.
On 1 January 20X3 Frod Motor Co, a car
manufacturer, entered into an agreement to provide
Dusty, a car retailer, with cars for resale.
The terms of the agreement were as follows:
• Dusty pays the cost of insuring and maintaining the
cars.
• Dusty can display the cars in its showrooms and
use them as demonstration models.
• When a car is sold to a customer, Dusty pays Frod
Motor Co the factory price prevailing at the time the
car was originally delivered.
• All cars remaining unsold 90 days after their
original delivery must be purchased by Dusty at the
factory price prevailing at the time of delivery.
 Illustration 5 (cont.)
• Frod Motor Co can require Dusty to return the
cars at any time within the 90-day period. In
practice, this right has never been exercised.
• Dusty can return unsold cars to Frod Motor Co
at any time during the 90- day period, without
penalty. In practice, this has never happened.
• At 31 December 20X3 the agreement is still in
force and Dusty holds several cars which were
delivered less than 90 days earlier.
How should these cars be treated in the
financial statements of Dusty for the year
ended 31 December 20X3?
Repurchase agreements
A repurchase agreement is where an entity sells an
asset but retains a right to repurchase the asset. This
is often not recognized as a sale, but as a secured
loan against the asset. Indications that this should not
be recognized as a sale may include:
• Sale is below fair value
• Option to repurchase is below the expected fair
value
• Entity continues to use the asset
• Entity continues to hold the majority of risks and
rewards associated with ownership of the asset
• Sale is to a bank or financing company
 Illustration 6.
Ardglen sells its maturing inventory, with a cost of
$1 million, to Alba, a bank, for its fair value of $1.5
million on 1 January 20X1. Ardglen has the option
to repurchase the inventory on 31 December
20X8 for $2.2 million.
Ardglen will continue to hold the inventory within
its warehouse as normal throughout the period,
and so is responsible for its maintenance and
insurance. At 31 December 20X8 the inventory is
expected to have a fair value of $4 million.
Giving reasons, show how Ardglen should
record the above transaction during the year
ended 31 December 20X1.
Bill-and-hold arrangements
A bill-and-hold arrangement is a contract under which
an entity bills a customer for a product but the
entity retains physical possession of the product
until it is transferred to the customer at a point of
time in the future.
For this to be recognized within revenue, the
customer must have obtained control of the product,
despite it physically remaining with the entity.
There may be a fee for custodial services, where the
entity recognizes a fee for holding the goods on
behalf of the customer. This performance obligation
would be satisfied over time, so any revenue would
be recognized on this basis.
Bill-and-hold arrangements
(cont.)
For a bill-and-hold arrangement to exist:
• The customer must have requested the
arrangement
• The product must be identified as
belonging to the customer
• The product must be ready for physical
transfer to the customer
• The entity cannot have the ability to use
the product or sell it to someone else.
 Substance over form
Common features of transactions whose substance
is not readily apparent are:
• the legal title to an asset may be separated from
the principal benefits and risks associated with
the asset (as with leases)
• a transaction may be linked with other
transactions which means that the commercial
effect of an individual transaction cannot be
understood without an understanding of all of the
transactions involved
• options may be included in a transaction where
the terms of the option make it highly likely that
the option will be exercised.
 Test your
understanding 3
 Step 5 over time
'An entity transfers control of a good or service over
time and, therefore, satisfies a performance
obligation and recognizes revenue over time, if one
of the following criteria is met:
• the customer simultaneously receives and consumes
the benefits provided by the entity’s performance as
the entity performs
• the entity’s performance creates or enhances an
asset (for example, work in progress) that the
customer controls as the asset is created or
enhanced, or
• the entity’s performance does not create an asset
with an alternative use to the entity and the entity has
an enforceable right to payment for performance
completed to date' (IFRS 15, para 35).
 Step 5 over time (cont.)
'For each performance obligation satisfied over time,
an entity shall recognize revenue over time by
measuring the progress towards complete satisfaction
of that performance obligation’ (IFRS 15, para 39).
Appropriate methods of measuring progress include (IFRS
15, para B14 – B19):
• output methods (such as surveys of performance (for
example the value of the work certified as completed so
far compared to the overall contract price), or time
elapsed (time spent on the contract compared to total
duration)).
• input methods (such as costs incurred to date as a
proportion of total expected costs).
• Revenue will be recognized based on the amount of
progress made compared to the total price.
 Contract costs
IFRS 15 says that the following costs must be
capitalized:
• The incremental costs of obtaining a contract.
• The costs of fulfilling a contract if they do not fall
within the scope of another standard (such as IAS
2 Inventories) and the entity expects them to be
recovered.
The capitalized costs will be amortized as revenue is
recognized. This means that they will be expensed to
cost of sales as the contract progresses.
These will be matched against revenue based on
either the input or output method of measuring
progress. This means cost of sales will be measured
as the percentage of progress made total costs.
 Contract costs (cont.)
For a contract with a customer where
revenue is recognized over time, there are
three important rules to be aware of:
1. If the expected outcome is a profit:
revenue and costs should be recognized
according to the progress of the contract.
2. If the expected outcome is a loss: the
whole loss should be recognized
immediately, recording a provision as an
onerous contract.
 Contract costs (cont.)
3. If the expected outcome or progress is
unknown (often due to it being in the very early
stages of the contract):
– Revenue should be recognized to the level of
recoverable costs (usually costs spent to date).
– Contract costs should be recognized as an
expense in the period in which they are
incurred.
In the majority of cases, this will mean that
revenue and cost of sales will both be stated at
costs incurred to date, with no profit or loss
recorded.
 Illustration 7.
The following information relates to a construction
contract:
Contract price $800,000
Costs to date $320,000
Estimated costs to complete $280,000
Estimated stage of completion 60%
a) What amounts of revenue, costs and profit should
be recognized in the statement of profit or loss?
b) Take the same contract, but now assume that the
business is not able to reliably estimate the outcome of
the contract although it is believed that all costs
incurred will be recoverable from the customer.
What amounts should be recognized for revenue,
costs and profit in the statement of profit or loss?
Presentation in the statement
of financial position
As well as revenue and expenses, there are likely
to be contract assets or liabilities. These will
depend on the amounts recorded in the statement
of profit or loss compared to the cash received or
the costs to date.
The detail of these is covered further in step 4.
In calculating the entries to be made for a contract
where the performance obligation is satisfied over
time, such as a building project for a customer, a 4-
step approach can be helpful.
 Step 1.
Step 1 – Calculate overall profit or loss
$
Contract price X
Less: Costs to date (X)
Less: Costs to complete (X)
––––
Overall profit/loss X/(X)
 Step 2.
Step 2 – Determining the progress of a
contract
There are two acceptable methods of measuring
progress towards satisfying a performance
obligation:
• Input methods – based on the inputs used. A
commonly used measure looks at contract
costs incurred to date as a percentage of total
expected costs.
• Output methods – based on performance
completed to date. This is commonly done
based on the value of the work certified to
date as a of the total contract price.
 Step 2 (cont.)
If revenue is earned equally over time (e.g.
providing a monthly payroll service), then
revenue would be recognized on a straight
line basis over that period.
Where progress cannot be measured
Revenue should be recognized only to the
extent of contract costs incurred that will
probably be recoverable.
 Step 3.
Step 3 – Statement of profit or loss (if
profitable)
$
Revenue (Total price progress %)
less revenue recognized in previous years X
Cost of sales (Total costs progress %)
less cost of sales recognized in
previous years (X)
–––
Profit X
–––
 Step 3. (cont.)
If a contract is in the second year, it is important
to remember that any revenue/costs recognized
in previous years should be deducted from the
cumulative revenue/costs. This will give the
figures to be recognized in the current year.
For example, if a contract is worth $10 million and
it is 90% satisfied by the end of year 2, and was
50% satisfied by the end of year 1, then $9 million
has been earned to date, of which $5 million
would have been recognized in year 1. This
means that $4 million would be recognized as
revenue in year 2.
 Step 4.
Step 4 – Statement or financial position
At the year end, there will either be a contract
asset or liability, recorded in current assets or
current liabilities. This will be calculated as shown
below:
$
Costs to date (Actual costs, not
necessarily cost of sales) X
Profit/loss to date X/(X)
Less: Amount billed to date (X)
––––
Contract asset/liability X/(X)
 Step 4. (cont.)
Note that these figures are cumulative
and not annual.
If an item of property, plant and equipment
is used in the contract, the asset will be
held at carrying amount at the year-end.
The depreciation will be charged to the
statement of profit or loss according to the
progress made towards satisfying the
contract.
 Contract asset
IFRS 15 is not prescriptive about the
treatment of contract assets/liabilities.
As alternatives to the term 'contract
asset', IFRS 15 also allows the terms
receivable and work-in-progress to be
used. If revenue exceeds cash received,
this could be included within trade
receivables. If costs to date exceed cost
of sales, this could be included within
inventory, as work-in-progress.
 Contract liability
If the cash received exceeds the revenue
recognized to date, there will be a
contract liability (effectively deferring the
income).
If a contract is loss-making, there will be a
provision recorded to recognize the full
loss under the onerous contract, as per
IAS 37. This can either be termed as a
contract liability or a provision.
TYU 4. Baker
Test your understanding 5
On 1 January 20X1, Castle entered into a contract with
a customer to construct a specialized building for
consideration of $10m. Castle is not able to use the
building themselves at any point during the
construction.
At 31 December 20X1, Castle had incurred costs of
$6m. Costs to complete are estimated at $6m. Castle
measures progress towards completion based on
costs incurred.
At 31 December 20X1 Castle had received $3 million
from the customer.
Required: How should this transaction be
accounted for in the year ended 31 December
20X1?
Test your understanding 6
Test your understanding 8