Revenue Recognition on Sale of Goods
ASPE 3400
When performance is achieved provided that collection is reasonably assured.
Performance is achieved when
- Transferred significant risks and rewards of ownership; i.e.
- All significant acts have been completed
- No continuing involvement in or control over the goods
- Reasonable assurance regarding measurement of consideration and extent of returns
In general (for good or services) performance is achieved when all are met;
- Persuasive evidence of an arrangement exists
- Delivery has occurred or services have been rendered
- The seller’s price is fixed or determinable
IAS 18
Revenue from the sale of goods shall be recognised when all the following conditions have been satisfied:
(a) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;
(b) the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;
(c) the amount of revenue can be measured reliably;
(d) it is probable that the economic benefits associated with the transaction will flow to the entity; (collectability)
(e) the costs incurred or to be incurred in respect of the transaction can be measured reliably.
Notes
Under both frameworks the revenue recognition on sale of goods have almost identical criteria. An easy way to remember these can be from the acronym RCMP
Risks and rewards have been transferred (point A)
Continuing involvement (point B)
Measurable costs and revenue that can be measured reliably (point C + E)
Probable economic benefits will flow to entity (point D)
Revenue Recognition on Provision of Services
ASPE 3400
In the case of rendering of services and long-term contracts, performance shall be determined using either the percentage of completion method or the completed contract method, whichever relates the revenue to the work accomplished.
Always use percentage of completion unless;
- Performance exists of a single act (in this case would use completed contract)
- Extent of progress cannot be measured reliably
- Consideration is not measurable
IAS 18
When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognised by reference to the stage of completion of the transaction at the end of the reporting period.
Always use percentage of completion unless;
- Outcome of contract cannot be measured reliably* (use cost recovery method)
- When specific act is much more significant and any other act (only measure after significant act is completed)
*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;
(b) it is probable that the economic benefits associated with the transaction will flow to the entity;(collectability)
(c) the stage of completion of the transaction at the end of the reporting period can be measured reliably; and
(d) the costs incurred for the transaction and the costs to complete the transaction can be measured reliably.
Notes
Under ASPE, percentage of completion or completed contract method are not acceptable accounting policy choices –the method that relates the revenue to the work accomplished is to be used. Completed contract method is only appropriate when performance consist of the execution of a single act or when the enterprise cannot reasonably estimate the extent of progress toward completion. You are supposed to use percentage of completion first, and only if it is not appropriate then you can use completed contract; it is not a simple matter of choice.
Also note under IFRS that there is no CC as there is only POC and the cost recovery method. Under this method you simply recognize revenue up to the extent of costs incurred. Take a construction contract that spans over several years. If the outcome cannot be estimated reliably then you would only measure revenue up to the amount of costs incurred for that period. You would report $nil gross profits on that contract currently. Once the outcome can be estimated (near the end of the contract) you would treat as a change in accounting estimate at that time (accounted for prospectively).
Revenue Gross Versus Net
Revenue can be presented either gross with related costs or netted as one line item and it depends on if the entity is either a principle or agent.
Factors that indicate treatment of entity as principle (recording gross);
- Entity has primary responsibility for providing good or service being purchased
- Entity has inventory risk
- Entity bears credit risk
- Entity has ability to establish prices
Factors that indicate treatment of entity as agent (recording net);
- Amount to be received is fixed or predetermined
- Has no risk associated with sale (as noted above)
Conceptually this makes sense. If you do not bear any risk with the sale, why should you be able to present gross revenues then present all related expenses? Notice that the impact on net income is $nil between the two. So why do we care? What if management’s bonus is based on gross revenues? In this case they would more inclined to present revenue gross as this amount would be higher than just the net amount.
Same under IFRS and ASPE
Multiple Deliverables
When a single transaction has multiple components the revenue recognition criteria should be applied to each component separately if it better reflects the substance of the transaction.
Take this example. You sell a machine to a customer for $1,000. As part of the sale you also include a maintenance contract that lasts for a year. At the sale the customer pays $1,100 for both the machine and the added maintenance contract. It would be inappropriate to recognize the full $1,100 immediately as performance may have been achieved on the machine sale but maybe not on the maintenance contract. Under this scenario it would likely be appropriate to measure revenue on the machine sale ($1,000) and defer and recognize the revenue on the maintenance contract on the percentage of completion basis using time to measure the progress.
Sometimes you will have to allocate the revenue to be recognized on multiple deliverable. You can use either relative fair values of a similar sale in a standalone transaction or you can use the residual method. Taking the example from above, you could use the residual method to allocate $100 to the maintenance contract after allocating $1,000 of the $1,100 to the machine.
There could be a scenario where you have the total purchase price of a machine and contract for $2,500 and you are given the prices or fair values of just the machine and the contract as a standalone value. Let’s say that to buy the machine alone would sell for $2,000 and the contract alone would sell for $1,000.
You might ask why would anyone do this; sell $3,000 of goods and services for $2,500. An entity might do this to bundle products in order to push new products that might not be otherwise bought.
Back to the example; to allocate the revenue in order to quantify which revenue can be recognized immediately and which can be deferred it should be based on the relative fair values. We know the total revenue to be recognized is $2,500 as this is what we actually receive. The fair value of the total package is $3,000 ($2,000 + $1,000). The machine makes up 66% of this and the contract is 33%. ($2,000 / $3,000 = 66% and $1,000 / $3,000 = 33%). Therefore by applying these percentages to the $2,500 will allocate revenue to each component. The immediate revenue to be recognized is then $1,667 to the machine and $833 to the contract which is deferred and recognized over life of contract.
Same under IFRS and ASPE.
Final Thoughts
Revenue recognition usually requires significant judgement. When are the “significant” acts completed or what is “managerial involvement”? It is hard to test judgement in a multiple choice question, but you can see expect to see a few questions on every exam. Usually they relate to calculating the amount of revenue to be recognized on a construction contract or a basic percentage of completion application.
However on a case exam, you will be hard pressed to find a final exam that doesn’t test revenue recognition. Because it requires judgement, they want to test you to know the handbook, apply the criteria then make a judgement and recommend how to treat. Almost always there are alternatives for revenue recognition, and as such is hard to test as a multiple choice.
I recommend knowing the revenue criteria for the CKE regardless as you will need to know these inside and out come time for case exams.
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