Sunday, December 1, 2013

[IFRS] IAS 18 Reveue - Part 2: Recognition of Revenue - Sale of Goods

Recognition of Revenue

The revenue recognition criteria are usually applied separately to each transaction.
It may also be applied,
  • to separately identified components in a transaction 
If the selling price of a product is inclusive of an identifiable amount towards subsequent servicing, then the amount related to servicing is deferred and recognized over the period during which the services are performed.

In other words, when there are separately identifiable components to a transaction each must be accounted for applying revenue recognition criteria to each component separately.

Example (Service charges inbuilt in sale price of goods):
Good Sales and Services Co. is engaged in manufacturing and selling air-conditioner equipments. The cash price of air-conditioner is $120,000, however, the Company sells it for $170,000 with a commitment to service the equipment for a period of three years, with no further charge.

Good Sales and Service Co. should recognize revenue of $120,000 on sale of air-conditioner equipment. The balance amount of $50,000 would be recognized over the period of three years as service revenue 

Accounting Policies (Extract)
Koninklijke Philips Electronics NV, (AMS:PHIA), Consolidated Financial Statement December 2012
Revenue (Extract)
Revenues for transactions that have separately identifiable components are recognized based on their relative fair values. These transactions mainly occur in the HealthCare sector and include arrangements that require subsequent installation and training activities in order to become operable for the customer. However, since the payment for the equipment is contingent upon the completion of the installation process, revenue recognition is generally deferred until the installation has been completed and the product is ready to be used by the customer in the way contractually agreed.
  • to two or more inter-linked transaction
If an entity sales the product, and enters into separate agreement to back that product in future, thus negating the effect of transaction, then both the transaction be dealt together.   

Example: Sale and buy back (DIP IFR DEC 2005 Q4.1)
On 1 October 2004, Iota sold a plot of land to a bank for $10m. The land had a book value of $5m and a market value of $15m at the date of sale. Iota continued to develop the land and had a call option to buy the land back from the bank for $12m on 30 September 2006. The bank had a put option to sell the land to Iota for $12m on 30 September 2006 

In order for Iota to recognize revenue from this transaction, it is necessary for the risks and rewards of ownership of the land to have been transferred to the bank. There are three factors here that suggest this transfer has not taken place: 

(a) The ‘sales price’ of the land is less than its market value. 
(b) Iota is continuing to develop the land. 
(c) There is the certainty (with the existence of a call and a put option) that the land will be repurchased by Iota at the end of September 2006. 

Therefore revenue recognition is inappropriate. The receipt of $10m should be shown as a financial liability and the difference between the $10m sales price and the $12m repurchase price should be shown as finance cost over the two year period of the effective loan.

Accounting Policies (Extract)
Koninklijke Philips Electronics NV, (AMS:PHIA), Consolidated Financial Statement December 2012
Revenue (Extract)
For products for which a residual value guarantee has been granted or a buy-back arrangement has been concluded, revenue recognition takes place when significant risks and rewards of ownership are transferred to the customer. The following are the principal factors that the Company considers in determining that the Company has transferred significant risks and rewards:
  • the period from the sale to the repurchase represents the major (normally at least 75%) part of the economic life of the asset; 
  • the proceeds received on the initial transfer and the amount of any residual value or repurchase price, measured on the present value basis, is equal to substantially all (normally at least 90%) of the fair value of the asset at the sale date; 
  • insurance risk is borne by the customer; however, if the customer bears the insurance risk but the Company bears the remaining risk, then risks and rewards have not been transferred to the customer; and 
  • the re-purchase price is equal to the market value at the time of the buy-back.

Basic Conditions

Sale of Goods

Revenue from sale of goods be recognized when all of the following conditions are satisfied 
  1. Significant risks and rewards of ownership of the goods have been transferred to the buyer. 
  2. The seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold.
  3. The amount of the revenue can be reliably measured. 
  4. It is probable that economic benefits associated with the transaction will flow to the seller
  5. The costs incurred or to be incurred in respect of the transaction can be measured reliably.
The transfer of risk and reward is critical to economic substance of the transaction. The events like transfer of title or passing of possession of goods are regarded as transfer of risk and rewards to the buyer. Generally a signed contract determines the terms of performance and can be a good guide to determine when risk and reward passes to enable revenue recognition.

Example: Transfer of Significant Risk and Rewards
Interior Inside Limited enters into an agreement to sale furniture to HomeTown Limited. As the terms of the agreement, the title to furniture will pass to HomeTown on delivery, HomeTown will enjoy credit terms of thirty days from date of delivery and the furniture has warranty of two years. Further, Interior Inside is not responsible for post delivery services. 

Revenue should be recognized when title to the furniture passes to HomeTown, which coincides with the transfer of risks and rewards of ownership. So, Interior Inside should recognize on sale of furniture on delivery. 

Interior Inside has not retained significant risks of ownership, and it has no further obligations to perform after delivery of the furniture, except the terms specified in the warranty agreement.

If the entity passes on the legal title, but retains some of the risk and rewards, then no revenue is recognized for such transaction. 
If the entity retains legal title, but passes on the risk and rewards, then the transaction is recognized as sale. The seller may retain legal title, to ensure collectability of the amount due.

Examples: Legal title passed, but risk and rewards retained
·    when the entity retains an obligation for unsatisfactory performance not covered by normal warranty provisions
·         when the receipt of the revenue from a particular sale is contingent on the derivation of revenue by the buyer from its sale of the goods
·      when the goods are shipped subject to installation and the installation is a significant part of the contract which has not yet been completed by the entity;
·      when the buyer has the right to rescind the purchase for a reason specified in the sales contract and the entity is uncertain about the probability of return
·         when the seller retains the risk of physical delivery of the product
In case of retail sale, the seller may offer refund, if the customer returns the goods. However, adequate provision must be made for estimated returns.

Accounting Policies (Extract)
Koninklijke Philips Electronics NV, (AMS:PHIA), Consolidated Financial Statement Dec 2012
Revenues are recorded net of sales taxes, customer discounts, rebates and similar charges. For products for which a right to return exists during a defined period, revenue recognition is based on the historical pattern of actual returns, or in case where such information is not available, revenue recognition is postponed until the return period has lapsed. Return policies are typically based on customary return arrangements in the local market. 

The revenue is said to be measured reliably, when the parties to contract have agreement about,  
  • Each party’s enforceable rights relating to contract 
  • Consideration to be received or paid 
  • Manner and terms of settlement of the transaction
Economic benefits associated with the transaction will flow to the seller.
  • If there is any uncertainty regarding the collectability of an amount included in revenue, then the uncollectible amount or the amount in respect of which recovery has ceased to be probable is recognized as an expense, rather than as an adjustment of the amount of revenue originally recognized
  • In case of export sale, any restriction on release of foreign currency by authorities may lead to uncertainty about the receipt of consideration.
Cost can be measured reliably
  • The entity must match the revenue recognized with related cost.
  • When other conditions of revenue recognition are met, the entity must determine warranties and other costs that would be incurred during post shipment period, and that such cost be measured reliably.
  • Revenue cannot be recognized when the expenses cannot be measured reliably; in such circumstances, any consideration already received for the sale of the goods is recognized as a liability