THE TIMING OF REVENUE RECOGNITION
The operating cycle refers to the time between the acquisition of assets for processing and their realisation in cash. Typically, this cycle has a number of stages for a business. For example:
- Receiving an order from a customer
- Purchasing raw materials
- Production
- Delivery
- Cash receipts
- After sales services
The time frame of the operating cycle varies from business to business. Some operating cycles, like that of a retail organisation, may be very short while a construction company’s cycle may stretch over several years.
However, financial statements are produced for specific periods of time and are not geared around the operating cycle of the entity. Thus, transactions must be allocated to accounting periods.
RECOGNITION
Before revenue is recognised in the statement of comprehensive income, two conditions must traditionally be met.
- The revenue must be earned i.e. the entity has substantially completed the activities necessary to create the revenue
- The revenue must be realised. This means the revenue must be capable of being measured reliably.
CRITICAL EVENT –V– ACCRETION APPROACH
During the operating cycle, there will come a point at which most or all of the uncertainty surrounding a transaction will disappear. This is called the “critical event” and it is the point at which revenue is recognised.
For example, in the operating cycle referred to earlier, most businesses would regard the delivery of the goods to the customer as the critical event, and thus the revenue would be recognised at this point. However, each business must be mindful of its own particular situation and adapt accordingly.
An alternative to the critical event approach is called the accretion approach and would be appropriate in situations where there is a long production period or where services are supplied over a period of time. Thus, the revenue, under this approach, will be recognised over a period of time rather than at a particular point in time, for example in IAS 11 Construction Contracts.
IAS 18 REVENUE – INTRODUCTION
Income can comprise both revenue and gains. Revenue is income that arises in the course of ordinary activities of the entity. It goes by a number of different names including sales, fees, interest, dividends and royalties.
IAS 18 sets out the accounting treatment of revenue that arises from certain types of transactions and events. But the main question addressed by the standard is when to recognise revenue.
Revenue is recognised when:
- It is probable that future economic benefits will flow to the entity; and
- These benefits can be measured reliably
The standard outlines when these conditions have been met and, thus, when revenue will be recognised.
IAS 18 applies to revenue arising from the following:
- Sale of goods
- The rendering of services
- The use by others of the entity’s assets yielding interest, royalties and dividends
Revenue is defined by the standard as 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.
This revenue must be measured at the fair value of the consideration received or receivable.
In most cases, consideration is in the form of cash or cash equivalents and therefore the amount of revenue is the cash or cash equivalents that is received or receivable.
If the sale is a credit sale, then the revenue is the amount of anticipated cash. Note, however, that bad debts and sales returns are usually disclosed separately. If, for example, an item was sold for RWF150 and only RWF120 becomes collectible, revenue shown would still be RWF150, with RWF30 shown separately as a bad debt.
If the inflow of cash or cash equivalents is deferred, the fair value of the consideration may be less than the nominal amount of cash receivable. An example might be providing interest free credit to the customer.
When an arrangement effectively constitutes a financing transaction, the fair value of the consideration is determined by discounting all future receipts. The difference between the fair value and the nominal amount is recognised as interest revenue in the periods over which the credit is granted.
SALE OF GOODS
Revenue from the sale of goods should be recognised when all the following conditions have been satisfied.
- The seller has transferred the significant risks and rewards of ownership of the goods to the buyer
- The seller 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
Therefore, identifying the critical event in the operating cycle is important. After the critical event, the conditions above will be met.
RENDERING OF SERVICES
When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction should be recognised by reference to the stage of completion of the transaction at the Statement of Financial Position date.
The outcome of a transaction can be estimated reliably when all the following conditions are satisfied: (a) 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 stage of completion of the transaction at the Statement of Financial Position date can be measured reliably
- The costs incurred for the transaction and the costs to complete the transaction can be measured reliably.
When the outcome of the transaction involving the rendering of services cannot be estimated reliably, revenue shall be recognised only to the extent of the expenses recognised that are recoverable.
INTEREST, ROYALTIES AND DIVIDENDS
These items of revenue should be recognised when:
- It is probable that the economic benefits associated with the transaction will flow to the entity; and
- The amount of the revenue can be measured reliably
Revenue should be recognised on the following bases:
- Interest should be recognised on a time basis that takes into account the effective yield on the asset
- Royalties should be recognised on an accrual basis in accordance with the substance of the relevant agreement
- Dividends should be recognised when the shareholders right to receive payment is established
DISCLOSURE
An entity must disclose:
- The accounting policies adopted for the recognition of revenue, including the methods adopted to determine the stage of completion of transactions involving the rendering of services
- The amount of each significant category of revenue recognised during the period, including revenue arising from:
- The sale of goods
- The rendering of services
- Interest
- Royalties
- Dividends
- The amount of revenue arising from exchanges of goods or services included in each significant category of revenue.
