Revenue Recognition*

6 Construction contracts 1 IAS 11 Dividends, royalties Sale of goods IAS 18, 28, 39 IAS 18 5 IAS 18, 39 2 IAS 18 SIC 31 IAS 18 Interest Rendering of services 4 3 Multiple elements Revenue Recognition Session outline Session outline: • Introduction • Objective • Scope • Identification of transactions • Timing of recognition • Measurement of Revenue • Sale of goods • Rendering of services • Interests, royalties and dividends • Disclosures

Revenue Recognition What is revenue? Revenue is • 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.

Revenue Recognition Exceptions does NOT apply to • leases agreements ; • dividends from investments accounted for under the equity method ( IAS 28 Investments in Associates); • insurance contracts within the scope of IFRS 4 Insurance Contracts; • changes in the fair value of financial assets and financial liabilities or their disposal (IAS 39 Financial Instruments: Recognition and Measurement); • changes in the value of other current assets; • initial recognition and from changes in the fair value of biological assets related to agricultural activity ( IAS 41 Agriculture); • initial recognition of agricultural produce ( IAS 41); and • the extraction of mineral ores • construction contracts (IAS 11)

Revenue Recognition Key issues in Revenue Recogniton • Identification of the Transaction • Timing of Recognition • Measurement of Revenue • Other issues-Gross vs Net

Revenue Recognition Key issues in Revenue Recogniton Identification of the Transaction Timing of Recognition Measurement of Revenue Other issues-Gross vs Net

Revenue Recognition Identification of the transaction The recognition criteria are usually applied separately to each transaction however in certain circumstances it is necessary to Apply the recognition criteria to two or more transactions together when they are linked in such a way that the commercial effect cannot be understood without reference to the series of transactions as a whole. Apply the recognition criteria to the separately identifiable components of a single transaction in to reflect the substance of the transaction.

Construction contracts 6 1 Risks/rewards transfer Royalties, dividends Sale of goods No continuing involvement Measurable revenue Probable benefits inflow 5 Measurable costs incurred Measurable costs to complete 2 Interest Rendering of services 4 3 Multiple elements Revenue Recognition Timing of Recognition Sale of goods SALE OF GOODS: • Risks/rewards transfer • No continuing managerial involvement • Probable inflow of benefits • Revenue measurable reliably • Costs measurable reliably

1 2 6 3 5 4 Revenue Recognition Timing of recognition Services Sale of goods SERVICES: • Percentage of completion • Probable inflow of benefits • The following is measurable reliably: • Stage of completion • Revenue • Costs incurred • Costs to complete Construction contracts Rendering of services Measurable revenue Probable benefits inflow Measurable costs incurred Measurable costs to complete Measurable stage of completion Dividends, royalties Multiple elements Interest

2 3 1 4 6 5 Revenue Recognition Timing of recognition Multiple elements Rendering of services Multiple elements IAS 18 para 13: In certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction to reflect substance. • Identifying components of a • transaction to reflect substance • Combining if commercial effect • cannot otherwise be understood • (linked transactions) Sale of goods Multiple elements Substance Construction contracts Interest Dividends, royalties

To assess the transaction's substance, view from customers’ perspective customer perceives there to be a number of elements to the transaction,. customer views the purchase as one product Customer’s Perspective Apply recognition criteria to transaction as whole Apply recognition criteria to each element separately. Revenue Recognition Multiple Elements transactions 1. Separation of Elements • A transaction may contain separately identifiable components that should be accounted for separately. • Apply the revenue recognition criteria to each separately identifiable component of a single transaction to reflect the transaction's substance.

Revenue Recognition Multiple Elements transactions 2. Allocation of Consideration • Revenue in respect of each separable component of a transaction = its fair value. • Fair value = price that is regularly charged for an item when sold separately Total revenue > the sum of the fair value of the separable elements Total revenue < the sum of the fair value of the separable elements additional revenue attributable to the activity of managing the two elements of the contract Difference = discount discount allocated between the separable components using:1. relative fair values 2. cost plus a reasonable margin additional revenue recognised when full contract substantially complete If overall loss on contract recognise immediately

2 3 1 4 6 5 Revenue Recognition Timing of recognition Multiple elements Rendering of services The company sells computers. Fair values of components are: CPU € 700 Monitor € 300 Keyboard € 100 € 1,100 The price of PC as a whole € 1,000 The company sold the whole PC but delivered only the CPU by year-end. Sale of goods Multiple elements Substance Construction contracts Interest Dividends, royalties

Revenue Recognition Multiple elements Analysis: The company’s receivable (total price) € 1,000 If monitor and keyboard remains undelivered, the customer does not have to pay € 300 + € 100 = (€ 400) Amount receivable for the delivered CPU: € 600 Portion of the total price of the PC normally allocable to the CPU is € 1,000 x € 700 / € 1,100 = € 636 Conclusion: Recognise revenue of € 600 on delivery of the CPU.

Revenue Recognition Multiple elements Classification in the P&L Revenue is the gross inflow of economic benefits during the period arising in the course of the ordinary activities ….. Multiple element transactions: Dr: Cash 100 Cr: Revenue 95 Cr: Liabilities 5 Free gifts, marketing costs etc. Dr: Cash 100 Cr: Revenue 100 Dr: Cost of sales 5 Cr: Liabilities 5

Revenue Recognition Exercise Multiple elements Practical examples: • ABC TVs – sale of big screen TVs and subsequent installation • Southern telecom – free DVD player • Retail vouchers

3 4 2 5 1 6 Revenue Recognition Timing of recognition Interests INTEREST: • Effective interest method • Origination fees • Commitment fees Multiple elements Rendering of services Interest IAS 39 effective interest method Right to payment established Sale of goods Royalties, dividends Construction contracts

4 5 3 6 2 1 Revenue Recognition Timing of recognition Royalties ROYALTIES: • On accruals basis based on substance of the agreement • Licencing – upfront or defer? • Contingencies DIVIDENDS: • When the right to receive payment is established • Revenue or adjust the cost of the investment Interest Multiple elements Dividends, royalties Substance Right to payment established Rendering of services Construction contracts Sale of goods

Revenue Recognition Timing of Recognition - Other issues 1. Risks/Rewards Transfer • Mostly, the transfer of the risks and rewards of ownership coincides with the transfer of the legal title or the passing of possession to the buyer. • In other cases, the transfer of risks and rewards of ownership occurs at a different time from the transfer of legal title or the passing of possession

Revenue Recognition Timing of Recognition – Other issues C. If the entity retains significant risks of ownership, the transaction is NOT a sale and revenue is not recognised. • Examples of situations in which the entity may retain the significant risks and rewards of ownership are • the entity retains an obligation for unsatisfactory performance not covered by normal warranty provisions; • 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; • 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; and • 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. Transaction Not a Sale; Revenue Not Recognised

Revenue Recognition Timing of Recognition – Other issues D. If an entity retains only an insignificant risk of ownership, the transaction is a sale and revenue is recognised. For e.g, a seller may retain the legal title to the goods solely to protect the collectibility of the amount due. In such a case, if the entity has transferred the significant risks and rewards of ownership, the transaction is a sale and revenue is recognised.

Revenue Recognition Timing of Recognition 2. No Continuing Managerial involvement Indicators of continuing managerial involvement or retention of effective control might include: • Control over future price of the item. • Responsible for the management of the goods subsequent to the sale. • Transaction allows the buyer to compel the seller, or give an option to the seller, to repurchase the item. • Guarantees the return of the buyer’s investment or a return on that investment for a limited or extended period. Continuing Managerial Involvement Exists! No Sale! No Revenue!

Revenue Recognition Timing of Recognition 2. No Continuing Managerial involvement Example: Entity A sells a racehorse to entity B. As part of the arrangement entity A continues to house and train the horse, determine which races the horse will enter and set stud fees for the horse. Should entity A recognise revenue on the sale of the horse to entity B? Ans: If a proper training agreement is in place that provides a market fee for the services that entity A provides and any winnings or fees achieved by the horse going to the buyer, it may be appropriate to recognise revenue on the sale. However, it would also be necessary to consider whether entity A had given any guarantees or incurred other obligations that may indicate it had not disposed of the significant risks and rewards of ownership of the horse

Revenue Recognition Timing of Recognition – Other issues 3. Revenue measurable reliably An entity can make reliable estimates after it has agreed with the other parties to the transaction on the following: • each party's enforceable rights regarding the service to be provided and received by the parties; • the consideration to be exchanged; and • the manner and terms of settlement. • The entity reviews and, when necessary, revises the estimates of revenue as the service is performed. The need for such revisions does not necessarily indicate that the outcome of the transaction cannot be estimated reliably The entity reviews and, when necessary, revises the estimates of revenue as the service is performed. The need for such revisions does not necessarily indicate that the outcome of the transaction cannot be estimated reliably

Revenue Recognition Timing of Recognition – Other issues 4. Costs measurable reliably Goods manufactured for sale All manufacturing costs IAS 2 Inventories Goods purchased for resale All purchase costs Pre-production cost segregated from manufacturing cost New entity/ product IAS 11 Construction Contracts Contracts for services Price paid or production cost

Revenue Recognition Timing of Recognition – Other issues Matching Concept Revenue and expenses that relate to the same transaction or other event are recognised simultaneously; this process is commonly referred to as the matching of revenues and expenses. E,.g Expenses, including warranties and other costs to be incurred after the sale can normally be measured reliably when the other conditions for the recognition of revenue have been satisfied. Hence cost should be provided for at the time the sale is recognised If expense not measurable reliably - revenue not recognised any consideration already received - recognised as a liability.

Revenue Recognition Timing of Recognition – Other issues 5. Probable inflow of benefits • Revenue recognised only when it is probable that the economic benefits associated with the transaction will flow to the entity. • This may not be probable until the consideration is received or an uncertainty is removed. For e.g. it may be uncertain that a foreign governmental authority will grant permission to remit the consideration from a sale in a foreign country. When the permission is granted, the uncertainty is removed and revenue is recognised. • When an uncertainty arises -the uncollectible amount included in revenue • recognised as an expense, • not an adjustment of revenue already recognised.

Revenue Recognition Measurement of revenue Revenue shall be measured at the fair value* of the consideration received or receivable. • determined by agreement between the entity and the buyer or user of the asset; • after any trade discounts and volume rebates; *Fair Value is defined as • the amount for which an assets could be exchanged or a liability settled • between knowledgeable willing parties, • in an arm’s length transaction.

Revenue Recognition Measurement of revenue-I Consideration in the form of cash or cash equivalents amount of cash or cash equivalents received or receivable. Revenue = Other issues: • Whether a principal/agency relationship exists. If an entity is acting as an agent in a relationship, revenue should only be recognised to the extent that it represents payment for acting as an agent • The existence of trade discounts, volume rebates and other incentives,which should be taken into account in measuring the fair value of the consideration received. • Whether the transaction forms part of a multiple element transaction. Where this is the case, the total consideration should be allocated to each element of the transaction

Revenue Recognition Measurement of revenue-II Consideration is deferred Revenue = Both a sale and financing transaction. Discounted fair value of consideration* * The discount rate is the more clearly determinable of the following: • the prevailing rate for a similar instrument of an issuer with a similar credit rating; or • a rate of interest that discounts the nominal amount of the instrument to the current cash sales price of the goods or services. (refer exercise 1) The difference between the fair value and the nominal amount of the consideration is recognised as interest revenue (as per IAS 39)

Revenue Recognition Agency Arrangements • Principal or Agent ? • expectation by the customer that the entity is acting as the primary obligor in the arrangement. • freedom to set the selling price with the customer. • assumes inventory risk • performs part of the services provided or modifies the goods supplied. • assumes the credit risk • discretion in selecting suppliers Principal! Gross Reporting! If these conditions not satisfied – NET REPORTING ! Refer exercise 2

Revenue Recognition Agency Arrangements • Concession agreements • Only the commission or rent receivable from the concessionaire constitutes a source of revenue for the store and would be recognised as revenue. • Shipping and handling charges • where there is no profit element in the insurance and freight charged to the customer • i.e. these charges are merely the reimbursement of expenses • any consideration attributable to these elements should be netted off against carriage costs • Sales taxes • sales taxes that are collected on behalf of a government body • excluded from the revenue recognised. • but analyse if tax is production tax • Advertising agency commissions • recognised when the service is completed. • media commissions when the advertisement appears before the public • production commissions according to the stage of completion of the roject.

Revenue Recognition Agency Arrangements • Insurance agency commissions • No further service required during the life of the policy • Recognised on the effective date of commencement or renewal of the related policies • Further services required • the commission or part thereof is deferred and recognised as revenue over the period during which the policy is in force. • part or all of the commission is deferred depending on whether separate fair values can be ascertained for the initial and ongoing services • Consideration given by a vendor to a customer • Cash consideration given by a vendor to a customer is a reduction of the revenue earned from the customer • (refer exercise 3)

Revenue Recognition Sale of Goods-Some specific issues.

Revenue Recognition Bill and Hold Sales Revenue recognised when • all performance conditions satisfied, including delivery of the goods to the customer. • when there is substantive performance under the contract. • not recognised when there is only an intention to acquire or manufacture the goods in time for delayed delivery. . Refer exercise 4

Revenue Recognition Goods shipped subject to conditions • Installation and inspection. recognised when the buyer accepts delivery, and installation and inspection are complete. • On approval when the buyer has negotiated a limited right of return- If there is uncertainty about the possibility of return, revenue is recognised when the shipment has been formally accepted by the buyer or the goods have been delivered and the time period for rejection has elapsed. • Consignment sales- • recognised by the shipper when the goods are sold by the recipient to a third party. • Cash on delivery sales. recognised when delivery is made and cash is received by the seller or its agent

Revenue Recognition Warranties Initial warranty • recognise the full consideration if warranty • not a separate element and • represents an insignificant part of the transaction, • the seller has completed substantially all the required performance • expected future cost relating to the warranty • not a reduction of revenue • but a cost of sale, • costs of warranties determined at the time of the sale-make a provision for warranty costs • costs cannot be measured reliably - revenue recognised when the warranty period expires cost can be measured reliably • Case study A manufacturer of televisions sells them to retailers for C300 with a 1 year warranty. The manufacturer does not sell the televisions without this warranty, nor does any other manufacturer. Claims are made on one in every 100 televisions sold, avg. repairs cost C100. • Warranty not separable from the sale of the television. • Recognition criteria are applied to the transaction as a whole. • Completed substantially all the required performance, • Retains insignificant inventory risk Revenue = C300 Provision against cost of sales = C1 (being C100 for 1 in 100 sales)

Revenue Recognition Warranties Extended warranty • The revenue from the sale of the extended warranty should be deferred and recognised over the period covered by the warranty, • No costs should be accrued at the inception of the extended warranty agreement Case study Entity A sells electrical goods with 12 month warranty. Customers have option to purchase extended warranty to cover years 2 to 5.The sales price of the extended warranty is C100 and entity A typically receives valid warranty claims from 4% of customers during the extended warranty period. The average cost of repairing or replacing the goods under the warranty is C600 per valid claim. Ans: extended warranty hence, • defer the revenue • recognise it on a straight-line basis over years 2 to 5, • costs charged to cost of sales as incurred • no a provision for the expected costs • expected future cost should not exceed unamortised deferred revenue. • provision = future warranty costs - unamortised warranty revenue

Revenue Recognition Sale of Property Following factors are to be considered • Recognised when legal title passes to the buyer. • Recognise revenue immediately if • Transfer of risks and rewards • no further substantial acts • If significant acts after the transfer of the equitable and/or legal title, • Revenue recognised as the acts are performed. • If there is a degree of continuing involvement • the nature and extent of continuing involvement determines accounting. • the means of payment and buyer's commitment to complete payment. For example, when the aggregate of the payments received, including the buyer's initial down payment, or continuing payments by the buyer, provide insufficient evidence of the buyer's commitment to complete payment, revenue is recognised only to the extent cash is received. (Refer exercise 5)

Revenue Recognition Sale of Software Following points have to be considered • physical delivery of the software - less indicative of when a sale should be recognised • recognition delayed till acceptance by buyer • depends on type of software Recognise revenue on delivery Standard off the shelf Customised software Percentage of completion method • subject to installation upon the buyer's acceptance of delivery recognition after >installation >Inspection >customer acceptance Installation process is simple Process is substantial, Risk of non-acceptance

Revenue Recognition Sale of Software Following points have to be considered • physical delivery of the software - less indicative of when a sale should be recognised • recognition delayed till acceptance by buyer • depends on type of software

Revenue Recognition Rendering of Services-Some specific issues.

Revenue Recognition Rendering of services Outcome of a transaction estimated reliably Stage of completion method • Outcome be estimated reliably if: • revenue measured reliably; • probable that economic benefits flow to the entity; • the stage of completion measured reliably; • and • the costs incurred for the transaction and the costs to complete the transaction can be measured reliably

Revenue Recognition Rendering of services Outcome cannot be estimated reliably revenue recognised = recoverable expenses . During the early stages of a transaction, it is often the case that the outcome of the transaction cannot be estimated reliably. Is it probable that the entity will recover the transaction costs incurred? NO YES • Revenue is recognised only to the extent of costs incurred that are expected to be recoverable. • No profit is recognised. • Revenue is not recognised • The costs incurred are recognised as an expense. When the uncertainties that prevented reliable estimation no longer exist, revenue is recognised

Revenue Recognition Rendering of services • Measurement of Revenue • - by “Percentage of Completion method” depending on nature of transaction ,methods may include • surveys of work performed; • services performed to date as a percentage of total services to be performed; or • the proportion that costs incurred to date bear to the estimated total costs of the transaction. Only costs that reflect services performed to date are included in costs incurred to date. Only costs that reflect services performed or to be performed are included in the estimated total costs of the transaction. • Progress payments and advances received from customers often do not reflect the services performed.

Revenue Recognition Rendering of services • Treatment of certain specific services • Performance over Time • services are performed by an indeterminate number of acts • over a specified period of time, • Revenue is recognised on a straight-line basis unless a better method represents the stage of completion. • Contracts containing significant acts • recognised when significant act is executed. • Refer exercise 7

Revenue Recognition Rendering of services • Contracts with milestone payments- • payment of cash upon the achievement of certain ‘milestones’ identified in the contract. • Accounting is generally very complex. Following points need to be considered • The reasonableness of the payments compared to the effort, time and cost to achieve the milestones.. • The nature of royalty or licence agreements relating to the product being developed.. • The existence of any cancellation clauses.. • The risks associated with achievement of milestones. • Any obligations that must be completed to receive payment under the contract or the existence of penalties for failure to deliver. • Refer example 8

Revenue Recognition*