In this article, we're going to discuss IFRS 15 Accounting for Revenue. This is a relatively new accounting standard, and what it attempts to do is, (and it succeeds in my opinion), it formalizes and makes it quite easy to determine exactly when revenue is going to get recorded by giving you a good basic step by step approach. The article is broken into three parts:
First of all, we will talk about the basic five-step approach IFRS 15 requires us to use
Then we'll look in more detail at each of the five steps
Finally, we'll look at an example
Before we go through each of the above three parts, I think it's important to talk about what revenue actually is i.e. what is the definition of revenue.
Revenue is income, and it's a specific type of income. Income is increased equity as a result of an asset increasing in value or a liability decreasing in value. It's more likely to be the case that it's an asset increasing in value. And remember what equity is - equity is the remaining value of the business after all of the liabilities have been paid off using the assets. When I say that revenue is a particular type of income, I mean that it is direct income. It is the income that comes from the main activity of a company. Therefore, it's from the selling of goods or the providing of services. For example, if we're talking about a manufacturing business, then the revenue would be the selling of the goods. If it was a professional training company, the revenue would be providing the courses, providing the services etc.
Taking the example of a manufacturing company; if that manufacturing company sells goods, that would be revenue. If that manufacturing company had a couple of spare rooms or offices that they didn't need to use, and it decided to rent them out to another company and it received some rental as a result, that would be income but it would not be as a result of selling goods or services. Therefore, it would not be classified as revenue, it would be classified as incidental income, sundry income, other operating income, and is indirect in nature. So remember, revenue is direct income as a result of selling goods or services.
5 Step Model
Moving on specifically to IFRS 15 and the five-step model that it requires us to follow. We'll first look at the five steps in summary form to start with, and then we'll look at them all in a little bit more detail afterwards.
The first step is to identify the contract. There needs to be a contract, an agreement between the buyer and the seller. Secondly, IFRS 15 says to identify the performance obligations. Putting that in plain English: what are we going to do? How many things are we providing? Are we just selling one lot of goods? Are we selling four or five different types of goods? Are we selling some goods and providing a service? Identify how many different things it is that we're doing. So, how many performance obligations there actually are. Thirdly, determine the price. We're talking about the total price here i.e. the total value of the contract. Fourthly, allocate the price. If there's only one thing that we're doing, the price applies to that one thing, so we won't really need to allocate it very much at all. Sometimes we might need to split the price between different performance obligations, and this is why step four is so important because in such a case you would allocate the price between all of the obligations. If there are three things that we're doing, divide the price into three. It's not necessarily going to be three equal parts, but it will certainly need to be divided across the obligations. Step five, decide how much revenue is going to be recognised in any particular period. Now, remember what recognition means. Recognition means inclusion in the financial statements i.e. debit, credit, double-entry. Very briefly here, just think about the difference between goods and services. You recognise the revenue for goods when the goods are sold at a point in time. With recognition of revenue from services it's trickier. It can't be at a point in time because services apply over a period of time. When we get to step five, we might have a little bit of a problem if we've got some revenue for services; there might be more than one right or appropriate period.
Now let's look at these steps and stages in a little bit more detail.
Step 1 - Identify the Contract
Firstly, the identification of the contract. The contract is more than a handshake. A contract is a legal agreement, a signed document between the buyer and the seller. There will be consideration involved i.e. there will be some sort of payment or compensation paid, normally the cash to acquire the goods or the services. The contract needs to be identified. Now, I don't think in the context of exam questions that it's going to be very difficult at all to identify the contract because most of the time it just says, “Company A entered into a contract with Company B to provide the following…” But in the real world, there obviously needs to be a contract in place.
Step 2 - Identify the Performance Obligations
Then we identify the performance obligations. There could be three performance obligations, or four, five, ten, twenty, or just one perhaps. Remember what performance obligations are. They are the different things that you've agreed to do under the terms of the contract. It could be goods and services, which would make it two performance obligations. It could be goods and two or three different services, which would make it three or four performance obligations. However many there are, this is the point in time at which we need to identify them.
Step 3 - Determine the Price
The number and type of performance obligations will determine the price, and it's not really the price per obligation here, it's the total value of the contract. It might involve adding up lots and lots of different figures to get to the total price, but we need to know what the total value is. It might be that there's what's called variable consideration involved. Variable consideration can affect the price. If it's variable, it will vary and change according to circumstances that will occur at some point in the future. So, it could be that you are going to charge a higher price if it takes you longer to fulfill a contract, something along those lines. What IFRS 15 says is the variable consideration should be included as part of the overall contract value.
There might also be a degree of financing involved. It could be that a service is something that has been provided for two or three years. Therefore, we're expecting to receive a certain amount of cash in a number of years’ time. It might be that we're selling goods on interest-free credit and we're going to receive the cash in two or three years’ time, in which case we've got a receivable. It's a long-term amount and it is discounting back to present value. Once that discount is being unwound, there will be a financing element. A lot of companies will have a financing element to their income, so that might be something that you need to take into consideration when you're determining the overall contract value.
Step 4 - Allocation of Price to Obligation
The next thing we do is allocate the price to the obligation, or the price to the obligations, really, because it will be a separate price for each. Each of the things that we do will carry a certain value. Now, if it says in a question that something is being given away for free, that is not the normal value of a transaction. You don't normally give away something for free. So, when we allocate the price to obligations, we're not going to allocate the stated price in the question if it says something is given away for free; that is not what we use. What we use is the normal market value of the goods or the normal market value of the services. This is the idea of an arm's length third-party normal rate transaction; that is what we'll be doing and that is what we'll be using to allocate the prices to the obligations.
Step 5 - Recognise the Revenue
Finally, we recognise the revenue, and the normal practice for the recognition of revenue is you recognise the revenue when the performance is complete. Well, that's certainly what you do for the recognition of goods revenue, because goods are sold at a point in time. Therefore, you recognise the revenue when the goods are sold. If it's to do with service revenue, services are normally provided over a period of time. Therefore, the revenue is going to get recognised over the period. That's good and logical, because if you're providing a service over a long period of time, it's going to cost you to do that, and the costs are going to get incurred over that two, three, four, five year period. Therefore, the revenue should be recognised in accordance with the same: two, three, four, five year period. So, revenue is going to get recognised over a period of time, which may well require us to end up time apportioning the revenue and including a certain amount in year one, a certain amount in year two, and a certain amount in year three etc.
A Worked Example
Let's look at an example.
Poppy PLC operates a computer supply and maintenance business and has a year-end of 31st December. On November 1st 2019 Poppy supplies hardware and a maintenance contract to a customer. The maintenance contract is for two years and is given for free (the normal value is $12,000 per year). The total value of the sale is $40,000.
Now, immediately here, we're saying that the company is doing two things only. They're supplying computers and they're providing maintenance. It's a sale of goods and the sale of services on the 1st of November 2019, which is 10 months through the year with just two months left in the year. The maintenance contract is for two years and Poppy is giving this away for free (or at least that's what Poppy is telling the customer; that it’s being given away for free). The normal value of this will be $12,000 per year which is $24,000 for the two years. All Poppy is telling the customer is that the total value of the sale is $40,000, and the customer doesn't really know how much they're paying for the computer hardware and the maintenance. They think they're paying $40,000 for the hardware and nothing for the maintenance; that's what they are under the impression is actually happening.
We've got to decide how much revenue is actually going to be recorded and recognised in the first year, which is only the two months to the end of December. Now, let's assume here, it doesn't say so, but let's assume that Poppy charges $40,000 upfront straightaway, so all of the $40,000 is actually paid on the 1st of November 2019. It's very, very unlikely that we're going to recognise all of that $40,000 in the first two months, and indeed, the revenue to be included in the year to the 31st of December is actually going to end up being $18,000, not $40,000, despite the fact that $40,000 is received upfront.
Let's see why. Let's go through the five-step approach.
1. Is there a contract to supply? Yes, there is a contract to supply. A contractual agreement has been signed.
2. Then we look at the number of obligations. Well, there were two things. There's the computer hardware, and there's the maintenance agreement. So, there are two things being supplied.
3. What's the total contract value? $40,000. It's stated in the contract. It's stated in the question.
4. We then need to split the price across the two performance obligations, the two things that are being provided. And we split using the normal going rate i.e. market-rate values. We don't say: “It's $40,000 for the hardware and nothing for the maintenance because Poppy says it's free.” We say the maintenance is an arm's length market value of $12,000 per year, so $24,000 in total over the two years. So, $24,000 for the maintenance contract and $16,000 for the hardware.
5. Think about when the hardware is being sold. On the 1st of November 2019. Think about when the maintenance contract is being sold - over 24 months, which is $1,000 a month. So, when we come down to allocating the amount and actually deciding how much revenue is going to get recognised, we're going to say all of the hardware revenue, which is $16,000, and 2/24th of the maintenance contract revenue, which is $2,000. So, the amount that will be recognised in year one is $18,000.
Let's think about this for a minute. Poppy has actually received $40,000. We are assuming that all of the $40,000 is received upfront but Poppy has only recorded $18,000 as revenue. In accordance with the five-step approach that we can see here, there is a contract, there are two things, the total price is $40,000, the split is $24,000 / $16,000 between maintenance and hardware, the amount of revenue being recognised is $18,000. So, the actual revenue split is $18,000 this year and $22,000 later.
Looking at the double-entry. Don't forget, the revenue double entry is for $18,000. That has been received into the bank, so we debit the cash/bank, and we credit revenue.
But we've actually received extra. The income received too early here is $22,000, from the total of $40,000. We're not going to give that back. We're going to keep it and say "thank you very much". The debit side of the entry is going to be the same as the revenue side of the entry, the revenue debit, which is into the cash bank account. The credit side of the entry is not to revenue though. We've received this income too early. We credit it to deferred income. The deferred income actually goes on the statement of financial position as a liability. It's not a liability because we owe the money back. It's a liability because we owe the service. We're acknowledging that we owe the service by recording the $22,000 as a liability. And in actual fact that liability will be split between one year and more than one year because some of it is actually related to the third period here.
In the next period, $12,000 worth of revenue needs to be recorded, because it's service income, and it's $1,000 a month ($24,000 for two years overall). We're not going to receive any more cash. All we do is we take the $12,000 out of deferred income, so there won't be $12,000 in there anymore. It was $22,000, so it's going to go down to $10,000. So, we're going to debit the deferred income with $12,000 and we're going to release it to revenue. Now, that actually means that $10,000 is left in deferred income and that gets released to revenue in the following accounting period.
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