Principles of Revenue Recognition

Revenue is reported on the top line of the income statement. Accrual accounting allows revenue to be recognized, i.e., reported on the income statement when it is earned and not necessarily when cash is received.

Companies disclose their revenue recognition policies in the notes to their financial statements. Reviewing these policies to understand how and when a company recognizes revenue, especially compared with other companies, is useful.

General Principles of Revenue Recognition

The IASB and FASB released converged accounting standards in May 2014, introducing changes to revenue recognition principles. These standards are nearly identical, focusing on a principles-based approach applicable to various revenue-generating activities.

The converged standard asserts that revenue should be recognized to “depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.”

Based on the standard, recognition of revenue involves five steps:

Step 1: Identifying contracts with a customer

Based on the standard, a contract is a commitment and agreement with commercial substance between parties with established rights and responsibilities. A contract contains the obligations and rights of the parties involved and the payment terms. Notably, a contract exists only if collectability is probable. Both IFRS and US GAAP use the exact words while describing the standard. However, the description of probable collectability differs. In IFRS, “probable” implies more likely than not, and in US GAAP, it implies likely to occur.

Step 2: Identifying the separate or distinct performance obligations in the contract

Performance obligations are linked to the provision of distinct goods or services. A good or service is considered distinct if the customer can benefit from it independently or with easily accessible resources and if its transfer can be independently identified from other commitments in the contract. Each recognized performance obligation is treated individually in accounting.

Step 3: Determining the transaction price.

The transaction price is the amount the seller expects to receive to transfer the goods or services specified in the contract.

Step 4: Allocate the transaction price to the performance obligations in the contract

The price is then distributed across each identified performance obligation.

Step 5: Recognizing revenue upon performance obligation fulfillment.

Revenue is recognized when a performance obligation is met. The recognized amounts consider expectations regarding the likelihood of collection and, if relevant, the distribution across multiple obligations within the same contract.

Moreover, revenue should only be recognized when there is a high likelihood that it will not be reversed in the future. If there is a likelihood of reversal, the seller will record a minimal amount of revenue at the time of sale and recognize a refund liability and a “right to return goods” asset on the balance sheet, calculated as the carrying amount of the inventory minus any recovery costs.

The entity will recognize revenue when it can fulfill the performance obligation by transferring control of the good or service to the customer. Factors to consider when assessing whether the customer has obtained control include:

• The company has a right to payment.
• The customer has a legal claim to the asset.
• The customer has accepted the service or good.
• Significant rewards and risks of ownership have been transferred to the customer.
• The customer physically possesses the goods.

Completing the five steps for a contract with one obligation is easy. More complex contracts, such as those that are satisfied over time, are not as straightforward.

If no contingencies surround the payment, revenue and accounts receivable are recognized. However, if payment depends on an additional condition or obligation, a contract asset is recorded on the balance sheet until the condition or obligation has been met. If payment is made before the performance obligation is met, the seller records a contract liability.

IFRS 15 requires companies to disaggregate contracts with customers into different categories when disclosing revenue. Disclosure must also be made for balances related to any contract liability and assets.

Cases of Applying Revenue Recognition Standards

Case 1: Principal vs Agent

In cases where a company acts as principal ( controls the product before it is delivered to the customer), revenue is recorded as the total amount received for the product transfer. On the other hand, if a company acts as an agent (facilitates the transfer of a product controlled by a third-party seller), the company should record revenue only for the portion of the payment that corresponds to its fee or commission.

Lastly, for companies operating as both the principal and the agent, an analyst would need to assess the relative proportion of principal versus agent sales to evaluate and forecast overall margins.

Case 2: Franchising or Licensing Companies

In the case of franchising companies (such as McDonald’s), revenue recognition standards mandate that companies break down revenue from contracts with customers into categories that illustrate how the nature, amount, timing, and uncertainty of revenue and cash flows are influenced by economic factors. Companies must present disaggregated revenues in consolidated income statements to fulfill this requirement.

For franchising companies, such disaggregated revenue items include owned stores or restaurants, franchise royalties, fees, and supply chain revenues.

Case 3: Software Services or License

Under IFRS 15, if a company grants a license to use software where the company will install the software on its system, the company will recognize revenue either over the term of the license or at the time the license is transferred.

Specifically, companies should spread out the revenue recognition from a software license over the duration of the license if, according to the contract or the company’s usual operations:

• the software provider continues to perform significant activities that impact the software (such as updates or improvements),
• the customer’s rights are affected by these activities, either positively or negatively, and
• these activities do not constitute a delivery of goods or services.

If these conditions are not satisfied, revenue should be recognized when the license is handed over to the customer.

Case 4: Long-Term Contracts

Consider a company that enters into long-term contracts spanning several years and that the performance obligations are fulfilled over time.

According to IFRS 15, a performance obligation is satisfied over time if it meets one of the following criteria:

• The customer immediately receives and utilizes the benefits provided by the entity’s performance as it is carried out, such as in regular service agreements.
• The entity’s performance leads to the creation or improvement of an asset that the customer controls as the asset is being created or enhanced. For example, renovating a factory that the customer owns and controls.
• The entity’s performance does not result in an asset that can be used for other purposes by the entity, and the entity has a legally enforceable right to payment for the work completed so far. For example, building a large, specialized asset that cannot easily be sold to another customer, such as a weapons system.

The company recognizes revenue from long-term contracts over the duration of the contract as work progresses, either through the production of products or the provision of services, due to the ongoing transfer of control to the customer.

Under IFRS 15, the degree of progress towards completion can be assessed using output methods such as appraisals or units completed or input methods such as costs incurred relative to estimated total costs.

The cost of sales is recorded as it occurs. The revenue reported is calculated by adding a proportional amount of the estimated profit to the cost of sales reported.

For instance, consider a manufacturing company with a 2-year contract with a buyer to deliver goods for USD 100 million for USD 70 million. In the first year, the company incurred USD 40 million in costs. In the first year, the company will recognize a revenue of USD 57.14 million (= 40/70 \(\times\)100) and a profit of USD 17.14 million [= 40/70 \(\times\)(100-70)].

In the sound year, the actual cumulative costs turned out to be USD 77 million. The company will recognize revenue of USD 42.86 million (=100-57.14), cost of  USD 37 million (=77-40), and cumulative profit of USD 23 million.

Case 5: Companies with Bill and Hold Arrangements

Consider a company that manufactures products the customer may be unable to take possession of immediately due to constraints such as lack of storage. IFRS 15 stipulates that in a “bill and hold” arrangement, a company can ascertain when its performance obligation is fulfilled based on when the customer gains control of the product.

According to IFRS 15, this occurs when the following conditions are satisfied:

• There must be a substantial reason for the bill and hold arrangement (e.g., it is requested by the customer).
• The product must be distinctly identified as the customer’s property.
• The product must be prepared for physical delivery to the customer.
• The entity cannot have the ability to use the product or to direct it to
  another customer.

Revenue Disclosure Requirements under IFRS 15

Under IFRS 15, the disclosure requirements are extensive to provide ample information to users of financial statements about the nature, amount, and timing of cash flows from customers. Some of the disclosures include:

• Companies must disclose revenue from contracts with customers, broken down into different categories of contracts. These categories could be based on factors such as product type, geographic region, customer type or sales channel, pricing terms of the contract, contract duration, or the timing of transfers.
• Companies must also disclose the balances of any assets and liabilities associated with contracts and significant changes in those balances, remaining performance obligations and the transaction price allocated to those obligations, and any significant judgments and changes in judgments related to revenue recognition.

Question

When should revenue be recognized according to the fundamental principle of accrual accounting?

1. When the company delivers the goods or services.
2. When the company receives cash for the goods or services.
3. When the company decides to recognize it.

Solution

A is correct. The fundamental principle of accrual accounting states that revenue should be recognized when the company delivers the goods or services and the risk and reward of ownership are transferred.