4.7 Sale of goods
Revenue from the sale of goods should only be recognised when all these conditions are satisfied.
(a) The entity has transferred the significant risks and rewards of ownership of the goods to the buyer
(b) The entity has no continuing managerial involvement to the degree usually associated with
ownership, and no longer has 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 enterprise
(e) The costs incurred in respect of the transaction can be measured reliably
The transfer of risks and rewards can only be decided by examining each transaction. Mainly, the transfer occurs at the same time as either the transfer of legal title, or the passing of possession to the buyer –
this is what happens when you buy something in a shop.
If significant risks and rewards remain with the seller, then the transaction is not a sale and revenue
cannot be recognised, for example if the receipt of the revenue from a particular sale depends on the buyer receiving revenue from his own sale of the goods.
It is possible for the seller to retain only an 'insignificant' risk of ownership and for the sale and revenue
to be recognised. The main example here is where the seller retains title only to ensure collection of what is owed on the goods. This is a common commercial situation, and when it arises the revenue should be recognised on the date of sale.
The probability of the enterprise receiving the revenue arising from a transaction must be assessed. It may only become probable that the economic benefits will be received when an uncertainty is removed, for example government permission for funds to be received from another country. Only when the uncertainty is removed should the revenue be recognised. This is in contrast with the situation where revenue has already been recognised but where the collectability of the cash is brought into doubt. Where recovery
has ceased to be probable, the amount should be recognised as an expense, not an adjustment of the
revenue previously recognised. These points also refer to services and interest, royalties and dividends below.
Matching should take place, ie the revenue and expenses relating to the same transaction should be
recognised at the same time. It is usually easy to estimate expenses at the date of sale (eg warranty costs, shipment costs, etc). Where they cannot be estimated reliably, then revenue cannot be recognised; any consideration which has already been received is treated as a liability.
4.8 Rendering of services
When the outcome of a transaction involving the rendering of services can be estimated reliably, the associated revenue should be recognised by reference to the stage of completion of the transaction at the
year end. The outcome of a transaction can be estimated reliably when all these 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 enterprise
(c) The stage of completion of the transaction at the year end can be measured reliably
(d) The costs incurred for the transaction and the costs to complete the transaction can be measured
reliably
The parties to the transaction will normally have to agree the following before an enterprise can make reliable estimates.
(a) Each party's enforceable rights regarding the service to be provided and received by the parties
(b) The consideration to be exchanged
There are various methods of determining the stage of completion of a transaction, but for practical purposes, when services are performed by an indeterminate number of acts over a period of time, revenue should be recognised on a straight line basis over the period, unless there is evidence for the use of a
more appropriate method. If one act is of more significance than the others, then the significant act should be carried out before revenue is recognised.
In uncertain situations, when the outcome of the transaction involving the rendering of services cannot be estimated reliably, the standard recommends a no loss/no gain approach. Revenue is recognised only to
the extent of the expenses recognised that are recoverable.
This is particularly likely during the early stages of a transaction, but it is still probable that the enterprise
will recover the costs incurred. So the revenue recognised in such a period will be equal to the expenses incurred, with no profit.
Obviously, if the costs are not likely to be reimbursed, then they must be recognised as an expense immediately. When the uncertainties cease to exist, revenue should be recognised as laid out in the first
paragraph of this section.
4.9 Interest, royalties and dividends
When others use the enterprise's assets yielding interest, royalties and dividends, the revenue should be recognised on the bases set out below when:
(a) It is probable that the economic benefits associated with the transaction will flow to the enterprise;
and
(b) The amount of the revenue can be measured reliably.
The revenue is recognised on the following bases.
(a) Interest is recognised on a time proportion basis that takes into account the effective yield on the
asset.
(b) Royalties are recognised on an accruals basis in accordance with the substance of the relevant
agreement .
(c) Dividends are recognised when the shareholder's right to receive payment is established.
It is unlikely that you would be asked about anything as complex as this in the exam, but you should be aware of the basic requirements of the standard. The effective yield on an asset mentioned above is the
rate of interest required to discount the stream of future cash receipts expected over the life of the asset to equate to the initial carrying amount of the asset.
Royalties are usually recognised on the same basis that they accrue under the relevant agreement.
Sometimes the true substance of the agreement may require some other systematic and rational method of recognition.
Once again, the points made above about probability and collectability on sale of goods also apply here.
4.10 Disclosure
The following items should be disclosed.
(a) The accounting policies adopted for the recognition of revenue, including the methods used to
determine the stage of completion of transactions involving the rendering of services. (b) The amount of each significant category of revenue recognised during the period including
revenue arising from: (i) The sale of goods
(ii) The rendering of services (iii) Interest
(iv) Royalties (v) Dividends
(c) The amount of revenue arising from exchanges of goods or services included in each significant
category of revenue.
Any contingent gains or losses, such as those relating to warranty costs, claims or penalties should be
treated according to IAS 37 Provisions, contingent liabilities and contingent assets (covered in your earlier studies).
4.11 Question practice
The examiner has recently emphasised that revenue recognition is an important topic, so have a go at the questions below.
Question
RecognitionGiven that prudence is the main consideration, discuss under what circumstances, if any, revenue might be recognised at the following stages of a sale.
(a) Goods are acquired by the business which it confidently expects to resell very quickly. (b) A customer places a firm order for goods.
(c) Goods are delivered to the customer. (d) The customer is invoiced for goods. (e) The customer pays for the goods.
(f) The customer's cheque in payment for the goods has been cleared by the bank.
Answer
(a) A sale must never be recognised before the goods have even been ordered by a customer. There is no certainty about the value of the sale, nor when it will take place, even if it is virtually certain that goods will be sold.
(b) A sale must never be recognised when the customer places an order. Even though the order will be for a specific quantity of goods at a specific price, it is not yet certain that the sale transaction will go through. The customer may cancel the order, the supplier might be unable to deliver the goods as ordered or it may be decided that the customer is not a good credit risk.
(c) A sale will be recognised when delivery of the goods is made only when: (i) The sale is for cash, and so the cash is received at the same time; or
(ii) The sale is on credit and the customer accepts delivery (eg by signing a delivery note). (d) The critical event for a credit sale is usually the despatch of an invoice to the customer. There is
then a legally enforceable debt, payable on specified terms, for a completed sale transaction. (e) The critical event for a cash sale is when delivery takes place and when cash is received; both take
place at the same time.
It would be too cautious or 'prudent' to await cash payment for a credit sale transaction before recognising the sale, unless the customer is a high credit risk and there is a serious doubt about his ability or intention to pay.
(f) It would again be over-cautious to wait for clearance of the customer's cheques before recognising sales revenue. Such a precaution would only be justified in cases where there is a very high risk of the bank refusing to honour the cheque.