ACCA P2 (INT) Corporate Reporting - Study text

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Chapter 16: Reporting financial performance

However, in some cases when the payment is deferred, the fair value might be less

than the amount of cash that will eventually be received. For example, a company

might sell goods and give the customer interest-free credit. Giving interest-free

credit is a financing transaction, and if a period of credit is allowed to the customer,

the revenue recognised should be the discounted present value of the future

receipts.

The difference between the nominal sale value and the fair value of the

consideration is recognised as interest income during the time period between the

initial recognition of revenue in profit or loss and the time when the payment is

eventually received.

Example

An entity sells an item to a customer for $58,320. The customer is allowed 24 months

of interest-free credit. The sale is made on the last day of the entity’s financial year.

The discount rate appropriate for the transaction is 8%.

The discounted present value of the future receipt is $50,000 (= $58,320 × 1/(1.08)

In this situation, the revenue from the sale will be recorded as $50,000 in the year of

the sale, and a receivable of $50,000 will also be recorded.

In the following year, there will be additional interest income of $4,000, which is 8%

of the amount receivable. This is included in finance income for the year, and the

amount of interest is added to the amount receivable, so that the total amount

receivable at the end of the year is $54,000.

In the following year, there will be interest income of $4,320 (= 8% × $54,000). This

will be included in the finance income for the year and added to the amount

receivable. At the end of the year, the amount receivable will be $58,320, which is

the amount of the due payment.

4.3 Sale of goods: revenue recognition

IAS 18 specifies when revenue should be recognised for the sale of goods. An entity

may recognise revenue from the sale of goods only when all of the following

conditions have been met:

 The entity has transferred to the buyer the ‘significant risks and rewards of

ownership of the goods’. This normally occurs when legal title to the goods or

possession of the goods passes to the buyer.

 The entity does not retain effective control over the goods sold, or retain a

continuing management involvement to the degree usually associated with

ownership.

 The amount of revenue can be measured reliably.

 It is probable that economic benefits associated with the transaction will flow to

the entity.

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 The costs incurred (or to be incurred) for the transaction can be measured

reliably.

Examples

(1) Goods are sold by a manufacturer to a retailer, who has the right to return the

goods if it is unable to sell them. (The goods are supplied on a ‘sale or return’

basis.)

Revenue should not be recognised by the manufacturer if receipt of payment

from the customer is contingent on the customer being able to sell the goods.

The manufacturer still retains significant risks of ownership. Revenue should

be recognised when the customer sells the goods, and not before.

(2) A manufacturer of machinery ships machine parts to a business customer for

installation. The machine has not yet been installed. The manufacturer will do

the installation work and the cost of the installation work will be a significant

part of the total cost of the contract.

Revenue should not yet be recognised because the seller still retains

significant risks and rewards of ownership.

(3) Goods have been sold on credit to a customer in a country where there has

been a major political change, and there is now a ban in that country on

payments to other countries.

Revenue should not yet be recognised. It is not yet probable that the economic

benefits associated with the transaction (payment by the customer) will flow to

the seller.

(4) An entity receives $25,000 as an advance payment for goods that have not yet

been manufactured.

Payment in advance is not recognised as revenue. The money received should

be included as a current liability in the statement of financial position. (Debit

Cash $25,000, Credit Payments received in advance $25,000).

Revenue recognition and substance

Financial statements must present fairly the effects of the transactions entered into

by an entity. This means that preparers must observe the principle of ‘substance

over form’ by recognising the economic substance of transactions where this is

different from their legal form.

For example, A sells an asset to B for $100,000. However, A continues to use the

asset in exactly the same way as before, even though B is now its legal owner. A has

received $100,000 but IAS 18 does not allow A to recognise this amount as sales

revenue. The significant risks and rewards of ownership have not yet passed to B. A

still controls the asset and can use it in its business (a reward of ownership). No sale

has taken place.

The substance of the transaction is that A has raised a loan which is secured on the

asset. Therefore A must recognise a liability for $100,000.

Chapter 16: Reporting financial performance

4.4 Rendering of services: revenue recognition

When an entity provides a service to a customer, and the outcome of the transaction can

be estimated reliably, revenue should be recognised by reference to the stage of

completion of the transaction at the balance sheet date. (This means that revenue may

be recognised for a service that has not yet been completed at the end of the reporting

period).

The recognition of revenue by reference to the stage of completion of a transaction

may be referred to as the ‘percentage of completion method’.

IAS 18 states that the outcome of a service transaction can be estimated reliably

when all of the following conditions apply:

 The amount of revenue can be measured reliably.

 It is probable that the economic benefits associated with the transaction will flow

to the service provider.

 The stage of completion of the transaction as at the end of the reporting period

can be measured reliably.

 The costs already incurred for the transaction and the costs that will be incurred

to complete the transaction can be measured reliably.

When these conditions are not met, revenue should be recognised only to the extent

of the expenses recognised that are recoverable.

For example, suppose that a contract to develop new computer software for a

customer has not been completed by the end of the reporting period. The revenue

from the transaction will be $70,000 and costs of $12,000 have been incurred to date.

It is not yet certain what stage of completion has been reached, nor what the further

costs to completion will be. Revenue in the current period should be $12,000 and

matching costs should be $12,000, so that there is neither a profit nor a loss in the

current financial period.

4.5 Interest, royalties and dividends: revenue recognition

Revenue from interest, royalties and dividends should be recognised when it is

probable that the benefits will flow to the entity and the amount of the revenue can

be measured reliably.

IAS 18 states that revenue from these sources should be recognised as follows:

 Interest. Interest income should be recognised on a time proportion basis that

takes into account the effective yield on the interest-earning asset.

 Royalties. Revenue from royalties should be recognised on an accruals basis, in

accordance with the terms of the royalty agreement.

 Dividends. Revenue from dividends should be recognised when the right to

receive the dividend is established.

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Examples

(1) A training company has a financial year that ends on 31 December. One of its

courses begins on 1 October Year 1 and runs for six months. Students pay a

total fee of $12,000, consisting of $6,000 on enrolment and $1,000 per month at

the beginning of each month for six months, beginning on 1 October when the

course begins. How much revenue should be recognised in Year 1 and in Year

2 for each student?

(2) A car dealer has a financial year that ends on 31 December. On 30 November

Year 1 it sold a car to a customer. The price was $40,000, but included in the

deal was a three-year free service warranty which normally costs $3,000. The

customer was required to pay $5,000 with the order and a further $20,000

when he took delivery of the car, which occurred on 1 January Year 2. The

balancing payment of $15,000 is not due until 1 January Year 4. The

company’s cost of capital is 10%. How should the revenue from the sale

transaction be recognised?

Answer

(1) Revenue should be recognised at an even accrued rate over the six-month

period of the course. By the end of Year 1, three months (50%) of the course

will have taken place, and so the revenue recognised in Year 1 should be just

$6,000 (= total course fee of $12,000 × 50%).

Cash received from each student by 31 December should be $9,000 (= $6,000

deposit plus three months × $1,000. Of this, $3,000 should be accounted for at

31 December Year 1 as deferred income (a liability in the statement of financial

position). Since this income is receivable within three months, there is no need

to discount it to a present value.

Year 1

Debit: Bank $9,000

Credit: Revenue $6,000

Credit: Deferred income $3,000

The deferred income is recognised as revenue in Year 2.

Year 2

Debit: Bank (three payments of $1,000) $3,000

Debit: Deferred income $3,000

Credit: Revenue $6,000

(2) The sale does not occur when the customer pays a deposit in November. It

occurs when the car is delivered and the customer takes possession. The

deposit paid in Year 1 of $5,000 is therefore deferred income. Since the sale

occurs on 1 January in Year 2, there is no need to discount the deferred income

to a present value.

Chapter 16: Reporting financial performance

Year 1

Debit: Bank $5,000

Credit: Deferred income $5,000

The sale occurs in Year 2. However, there are two issues to consider. First, the

customer has been given a free three-year warranty that normally sells for

$3,000. The substance of the transaction is that the customer has purchased

both a car and a service warranty, and these should be recognised and

accounted for separately.

The sale of the three year warranty should be accounted for with revenue of

$3,000 spread over the three year period of the warranty.

Second, there is a deferred payment of $15,000 payable after two years on 1

January Year 4. This should be recognised in Year 2 as revenue, but

discounted to a present value. If the cost of capital is 10%, the present value is

$12,397 (= $15,000 × 1/(1.10)

Year 2

Debit: Deferred income (deposit in Year 1) $5,000

Debit: Bank (cash on delivery) $20,000

Debit: Receivable (deferred payment) $12,397

Credit: Deferred income (service warranty) $3,000

Credit: Revenue (sale of car) $34,397

There will be interest income in both Year 2 and Year 3 at 10% on the deferred

receivable: $1,240 in Year 2 and $1,363 in Year 3.

4.6 IAS 18: disclosure requirements

Accounting standards commonly include disclosure requirements, setting out the

information that entities must disclose. IAS 18 requires disclosure of:

 the accounting policies adopted for recognising revenue, and

 each significant category of revenue in the period, including revenue from:

− the sale of goods

− the rendering of services

− interest

− royalties

− dividends.

In addition, there should be disclosure, for each significant category of income, of

the amount of revenue arising from the exchange of goods or services.

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4.7 DP: Revenue recognition in contracts with customers

Revenue is a key component of a company’s financial statements. Revenue is an

important indicator for providers of capital and is also important to financial

statement preparers, auditors and regulators.

This discussion paper is the result of a joint project between the IASB and FASB (the

US Financial Accounting Standards Board)

The aim of the joint project is primarily to clarify the principles for recognising

revenue.

US GAAP on revenue recognition comprises more than a hundred standards and

can produce conflicting results for economically similar transactions.

IFRS has two main revenue recognition standards (IAS 18 Revenue and IAS 11

Construction Contracts). These are inconsistent and vague, and can be difficult to

apply beyond simple transactions. In particular, those standards provide limited

guidance for transactions involving multiple components or multiple deliverables.

The aim of the project is to provide clearer guidance on when an entity should

recognise revenue and reduce the number of standards to which entities have to

refer. This should remove inconsistencies and improve the comparability and

understandability of revenue for users of financial statements. The proposed

approach would cause little (if any) change for many contracts.

The proposed approach

This discussion paper proposes a single, contract-based revenue recognition model.

This proposed model would only apply to contracts with customers. It might not be

appropriate to apply the model to certain categories of contracts with customers (eg

leases) and the boards will consider this as their deliberations proceed

Recognition

The DP proposes that revenue should be recognised on the basis of increases in an

entity’s net position in a contract with a customer. Revenue would be recognised

when a contract asset increases or a contract liability decreases. That occurs when an

entity performs by satisfying an obligation in the contract.

Identification of performance obligations

A company’s performance obligation is a promise in a contract with a customer to

transfer an asset (such as a good or a service) to that customer. That contractual

promise can be explicit or implicit.

When an entity promises to provide a good, it is promising to transfer an asset to

the customer.

When an entity promises to provide a service, it similarly is promising to transfer an

asset, even though the customer may consume that asset immediately.

A company would account for performance obligations separately if the promised

assets (goods or services) are transferred to the customer at different times. The

objective of separating performance obligations is to ensure that an entity’s revenue

faithfully represents the pattern of the transfer of assets to the customer over the life

of the contract. For example, if a photocopier were sold with a service agreement the

revenue from each would be recognised separately as appropriate.

Chapter 16: Reporting financial performance

Satisfaction of performance obligations

Revenue would be recognised when a company satisfies a performance obligation.

In the case of a good, a company satisfies its performance obligation when the

customer obtains control of the good so that the good is the customer’s asset.

Typically, that occurs when the customer takes physical possession of the good.

In the case of a service, a company satisfies a performance obligation when the

customer has received the promised service.

Measurement

A company would have to measure its rights and its performance obligations in a

contract in order to recognise it. Measurement of the rights would be based on the

amount of the transaction price (ie the promised consideration).

Paper P2: Corporate Reporting (International)

Paper P2 (INT)

Corporate Reporting

CHAPTER

Provisions and events after

the reporting period

Contents

1 IAS 10: Events after the reporting period

2 Provisions

3 Contingent liabilities and contingent assets

4 IAS 37: applications and future developments

Paper P2: Corporate Reporting (International)

IAS 10: Events after the reporting period

 Purpose of IAS 10

 Adjusting and non-adjusting events

 Accounting for adjusting events after the reporting period

 Disclosures for non-adjusting events after the reporting period

 Dividends. The going concern assumption

 Problems of accounting for events after the reporting period

1 IAS 10: Events after the reporting period

1.1 Purpose of IAS 10

The financial statements are prepared as at the end of the reporting period, but often

the accounts are not authorised by the directors until some months later. During this

time events may take place within the entity that should be communicated to the

shareholders.

IAS 10: Events after the reporting period has two main objectives:

 to specify when an entity should adjust its financial statements for events that

occur or become apparent after the reporting period, but before the financial

statements are authorised for issue, and

 to specify the disclosures that should be given about events that have occurred

after the reporting period but before the financial statements were authorised for

issue.

IAS 10 also includes a requirement that the financial statements should disclose

when the statements were authorised for issue, and who gave the authorisation.

1.2 Adjusting and non-adjusting events

IAS 10 sets out the following key definitions:

Events after the reporting period are events, favourable and unfavourable, that

occur between the end of the reporting period and the date the financial statements

are authorised for issue.

There are two types of event after the reporting period:

 Adjusting events. These are events that provide evidence of conditions that

already existed at end of the reporting period.

 Non-adjusting events. These are events that have occurred due to conditions

arising after the end of the reporting period.

ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)

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