This article is relevant to the Diploma in International Financial Reporting

and ACCA Qualification Papers F7 and P2

For almost all entities other than financial institutions, revenue is the
largest single number in the financial statements. It is also a number that
attracts a great deal of user attention. Whilst it might be accepted that
profit is the most important single indicator of corporate financial
performance revenue does not fall far behind. Indeed in many sectors, for
example the retail food sector, revenue is a ‘headline number’ that is often
announced first when results are communicated externally. In sectors
where this is true, the remuneration packages of senior executives often
include a ‘performance related element’ with revenue growth as the key
determinant of ‘performance’.

Given the importance of revenue to the picture painted by the financial

statements is it important that it is measured and presented fairly so that
the users are given useful information on which to base their performance
appraisal. The International Accounting Standards Board (IASB) has
issued two International Financial Reporting Standards (IFRSs) that
provide guidance in this area:

 IAS 18 – Revenue.

 IAS 11 – Construction Contracts.

IAS 18 is the IFRS that deals with revenue for the majority of entities,
whilst IAS 11 very much applies the principles of IAS 18 to entities in the
construction sector. Both standards are principles based and short on
detail (this is particularly true of IAS 18). Therefore this has led to calls by
some users for a more rigorous approach that removes some of the
uncertainty that is caused by the existing IFRSs. As a result, the IASB is
currently examining the existing standards with a view to replacing them
with a more comprehensive standard in the future.

In this article we will:

 Explain exactly what IAS 18 and IAS 11 mean by ‘revenue’.

 Outline the principles that underpin the recognition and measurement

of revenue.

 Review some of the implementation examples that are provided as an

accompaniment to IAS 18.

 Outline the changes that are likely to the method of accounting for
revenue in the future.

MEANING OF ‘REVENUE’

IAS 18 defines revenue as ‘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’ (1). The following implications
flow from this definition:
(a) Revenue should be stated before deduction of costs of sale. For
example if goods are sold for $100 that cost the seller $60 to manufacture
the revenue is $100, not $40.
(b) Revenue is recognised on the provision of goods and services that
relate to the ordinary activities of the entity. If an entity disposes of
property, plant and equipment at the end of its useful economic life the
proceeds of disposal are not revenue for the entity. Instead the profit or
loss on disposal is treated as a deduction from operating expenses (or as
a separate line item in the statement of profit or loss, if it is sufficiently
material).
(c) Sales taxes that are collected from the customer and remitted to the
relevant authorities are not ‘revenue’. For example if goods are sold for
$110, inclusive of recoverable sales taxes of 10%, the revenue is $100, not
$110.
(d) If the seller is acting as agent, rather than as the principal, in a
transaction, the revenue the seller should recognise is the amount of
commission receivable rather than the gross amount collected from the
customer. For example, if a travel agent sells a holiday to a customer for
$1,000 plus a commission of $100, so that the customer pays $1,100 and
the travel agent remits $1,000 to the entity actually providing the holiday,
then the travel agent recognises revenue of $100.

PRINCIPLES UNDERPINNING RECOGNITION OF REVENUE

IAS 18 outlines the recognition principles in three parts:

1. Sale of goods:
Revenue is recognised when all the following conditions have been
satisfied (2):
(a) The seller has transferred the significant risks and rewards of
ownership of the goods to the buyer.
(b) The seller does not retain control over the goods or managerial
involvement with them to the degree usually associated with ownership.
(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 seller
(e) The costs incurred or to be incurred by the seller in respect of the
transaction can be measured reliably.

As far as these conditions are concerned, it is notable that:

 A number of the conditions ((a) and (b) particularly) are subject to a

degree of interpretation and therefore there can be some uncertainty
about whether or not revenue should be recognised.

 The conditions are such that all are likely to be satisfied at a

particular point in time and so there is a critical point at which all the
revenue from the sale of goods would be recognised. This approach
contrasts with the approach taken to the recognition of revenue from
the provision of services (see below):
2. Provision of services:
As stated above, there is a different approach taken to the recognition of
revenue from the provision of services. IAS 18 states that ‘where the
outcome of a transaction involving the rendering of services can be
estimated reliably, associated revenue should be recognised by reference
to the stage of completion of the transaction at the end of the reporting
period’ (3). In other words, the revenue is recognised gradually, rather
than all at one ‘critical point’, as is the case for revenue from the sale of
goods. IAS 18 further states that the outcome of a transaction can be
estimated reliably when all the following conditions are satisfied (3):

(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 seller.
(c) The stage of completion of the transaction at the end of the reporting
period can be measured reliably.
(d) The costs incurred to date for the transaction and the costs to
complete the transaction can be measured reliably.

IAS 18 does not prescribe one single method that should be used for
determining the stage of completion of a service transaction. However the
standard does provide some examples of suitable methods (4):
(a) Surveys of work performed.
(b) Services performed to date as a percentage of total services to be
performed.
(c) The proportion that costs incurred to date bear to the estimated total
costs of the transaction.

If it is not possible to reliably measure the outcome of a transaction

involving the provision of services (perhaps because the transaction is in
its very early stages) then revenue should be recognised only to the
extent of costs incurred by the seller, assuming these costs are
recoverable from the buyer (5).
Construction contracts
IAS 18 does not adequately address the issue of revenue recognition on a
construction contract. However, IAS 11 applies the basic principles we
have already identified to such contracts, which are defined in IAS 11 as
follows (6):
‘Contracts specifically negotiated for the construction of an asset or a
combination of assets that are closely interrelated or interdependent in
terms of their design, technology and function or their ultimate purpose or
use’.

Most construction contracts are ‘fixed price contracts’. In such contracts

the seller agrees to a fixed contract price, or a fixed rate per unit of
output, which in some cases could be subject to cost escalation
clauses (6).

Whilst a construction contract relates to the supply of goods, the ‘critical

event basis’ used in IAS 18 as a means of determining the timing of the
recognition of revenue on the supply of goods is not really suitable. This is
because the ‘supply’ by the seller in the case of a construction contract
takes place gradually over the term of the contract. Therefore IAS 11
basically requires that, where the outcome of a construction contract can
be recognised reliably, revenue on such contracts should be recognised
according to the stage of completion of the contract (7). IAS 11 imposes
conditions very similar to the ones included in IAS 18 for the provision of
services (3) that need to be satisfied before the outcome of a
construction contract can be recognised reliably (8):

(a) Total contract revenue can be measured reliably.

(b) It is probable that the economic benefits associated with the contract
will flow to the seller.
(c) Both the seller’s costs to complete the contract and the stage of
contract completion at the end of the reporting period can be measured
reliably.
(d) The seller’s costs to date attributable to the contract can be clearly
identified and measured reliably so that actual costs incurred can be
compared with prior estimates.

As is the case with service revenue recognition in IAS 18, IAS 11 does not
prescribe one single method of computing the stage of completion of a
construction contract. IAS 11 provides the following examples of methods
that might be suitable (9):

(a) The proportion that contract costs incurred for work performed to date
bear to total estimated contract costs.
(b) Surveys of work performed.
(c) Completion of a physical proportion of the contract work.

In another similarity with the treatment of revenue from the rendering of

services under IAS 18, IAS 11 states that (10):
‘Where the outcome of a construction contract cannot be estimated
reliably revenue shall be recognised only to the extent of contract costs
incurred that it is probable will be recoverable’.

In summary, then, IAS 11 very much applies the principles set out in IAS
18 (for the recognition of revenue on the rendering of services) to the
recognition of revenue from construction contracts.
3. Interest, royalties and dividends
IAS 18 states that entities should recognise revenue from the use of their
assets yielding interest, royalties and dividends when (11):
(a) It is probable that the economic benefits associated with the
transaction will flow to the entity.
(b) The amount of the revenue can be measured reliably.
The exact basis for the recognition of revenue from the use by others of
the ‘seller’s’ assets depends on the type of transaction (12):

(a) Interest revenue should be recognised on the ‘effective interest’ basis.

(b) Royalties should be recognised on an accruals basis in accordance
with amounts receivable as a result of ‘asset use’ up to the reporting date.
(c) Dividend revenue should be recognised when the right to receive
payment is established. Often this does not happen in the case of
dividends until the shareholder actually receives the dividend.

PRINCIPLES UNDERPINNING MEASUREMENT OF REVENUE

IAS 18 states that ‘Revenue shall be measured at the fair value of the
consideration received or receivable’ (12). In determining fair value it
would be necessary to take into account any trade discounts or volume
rebates granted by the seller.

In most cases, ‘fair value’ will represent the cash or cash equivalents
received or receivable by the seller. However, where the consideration is
deferred, IAS 18 explains that the arrangement effectively constitutes a
financing transaction and the substance of the transaction is a supply of
goods or services plus the provision of finance. In such circumstances,
the amount receivable is split into (13):

(a) An amount receivable for the supply of goods or services. This is

arrived at by discounting the future cash receivable by the seller. The
imputed rate of interest is the prevailing borrowing rate of the buyer or, if
more easily determinable, the rate that discounts the future cash
receivable to the current cash price of the goods or services. This is
recognised immediately.
(b) An amount receivable for the supply of finance to the buyer,
recognised over the implied term.
Example
A retail entity supplies products to the public on three year deferred
payment terms. On 1 January 2013 the entity supplies a product for a total
price of $13,310, payable on 1 January 2016. The credit rating of the
customer is such that a relevant imputed annual rate of interest is 10%.
The entity’s year end is 31 December.

On 1 January 2013 the total revenue from the sale would be split into:
(a) Revenue from the sale of goods of $10,000 ($13,310/(1.10) (3). This is
recognised immediately by crediting revenue and debiting receivables.
(b) Interest revenue of $3,310 ($13,310 - $10,000). This is recognised over
the three years as shown in the table below:

Finance
Year ended 31 Opening income Closing
December receivable (10%) receviable
$ $ $ $

2013 10,000 1,000 11,000

2014 11,000 1,100 12,100

2015 12,100 1,210 13,310

On 1 January 2016, the cash is received and the receivable derecognised.

IAS 11 uses similar principles to measure revenue from construction

contracts, stating that ‘Contract revenue is measured at the fair value of
the consideration received or receivable’ (14).
IAS 18 IMPLEMENTATION EXAMPLES

As stated earlier, these implementation examples accompany, but are not

part of, IAS 18. However they are useful as an aid to application and well
worth reviewing. They assume that the amounts of revenue and related
costs can be measured reliably, and that the economic benefits will
probably flow to the seller. Most of the examples are relatively self-
explanatory. We will review two of the more complex examples:

Example 5 – sale and repurchase agreements (15)

Where goods are ‘sold’ under conditions that either require the seller to
repurchase them in the future or contain options to repurchase that are
likely to be exercised then the substance of the transaction of often that
the ‘sale’ is actually a provision of finance.

Suppose entity A ‘sells’ goods to entity B on 1 January 2013 for $400,000.

The goods are inventories that need to mature for five years before being
ready for sale. Their market value on 1 January 2013 was $800,000 and
entity A has the option to repurchase the goods from entity B on 1 January
2018 for $600,000. The market value of the goods is expected to rise by
5% per annum from 2013 to 2017 inclusive. Entity A’s credit rating is such
that it would have to pay interest at 8.447% per annum on borrowings.
The goods are expected to remain at the premises of entity A throughout
the five year period beginning on 1 January 2013 and entity A is
responsible for their safe custody.

The fact pattern in this example indicates that at least two of the
conditions required for the recognition of revenue on the sale of goods
have not been satisfied:
 Entity A retains the risks and rewards of ownership despite the fact
that legal ownership has been transferred to entity B.
 Entity A retains managerial involvement to the degree usually
associated with ownership.

Therefore it is inappropriate for entity A to recognise revenue when the

goods are sold on 1 January 2013. The ‘sales proceeds’ should be
recognised as a borrowing with an annual finance cost of 8.447%. Over
the next five years the borrowing will grow as follows:

Year ended 31 Opening Finance cost Closing

December borrowing (8.447%) borrowing
$ $ $ $

2013 400,000 33,788 433,788

2014 433,788 36,642 470,430

2015 470,430 39,737 510,167

2016 510,167 43,094 553,261

2017 553,261 46,739 600,000

The almost certain ‘re-purchase’ on 1 January 2013 will eliminate the

borrowing.

Example 11 – servicing fees included in the price of a product (15)

When the selling price of a product includes an identifiable amount for
subsequent servicing that amount is deferred and recognised as revenue
over the period during which the service is performed. The amount
deferred is that which will cover the expected costs of the services,
together with a reasonable profit on those services.
Suppose an entity supplies a product to a customer for a total price of
$20,000. The price includes two years ‘free’ servicing of the product. The
entity estimates that the annual cost of servicing the product will be
$2,400. The entity normally earns a margin of 20% on service revenue.

The expected total cost to the entity of providing the ‘free service’ is
$4,800 (2 X $2,400). Given the normal margin on service work this would
equate to revenue of $6,000 ($4,800 X 100/80). Therefore the entity would
recognise revenue from the sale of the product of $14,000 ($20,000 -
$6,000) at the date of supply and service revenue of $6,000 over the two
years following the supply.

The situation is further complicated when a ‘package’ such as the one

outlined above is supplied at a special price and the fair value of both
components is known. Suppose in the above example the normal selling
price of the product without any ‘free’ servicing was $18,000. We would
then have two components to the transaction with fair values totalling
$24,000 ($18,000 for the product + $6,000 for the servicing). If the whole
package were supplied for $20,000 then this would be at 20/24 or 5/6 of
the ‘normal’ price. This would be allocated to the components so that the
total revenue of $20,000 would be allocated as follows:

 Sale of goods $15,000 ($18,000 X 5/6).

 Service revenue $5,000 ($6,000 X 5/6).

CHANGES THAT ARE LIKELY TO THE METHOD ACCOUNTING FOR

REVENUE IN THE FUTURE

The background
As already stated, revenue is a crucial number to users of financial
statements in assessing an entity’s financial performance and position.
However, revenue recognition requirements in US generally accepted
accounting principles (GAAP) differ from those in International Financial
Reporting Standards (IFRSs).

Both sets of requirements need improvement. US GAAP comprises broad

revenue recognition concepts and numerous requirements for particular
industries or transactions that can result in different accounting for
economically similar transactions. Although IFRSs have fewer
requirements on revenue recognition, the two main revenue recognition
standards, IAS 18, Revenue and IAS 11, Construction Contracts, can be
difficult to understand and apply. In addition, IAS 18 provides limited
guidance on important topics such as revenue recognition for multiple-
element arrangements.
The detail
The International Accounting Standards Board (IASB) and the US national
standard-setter, the Financial Accounting Standards Board (FASB),
initiated a joint project to clarify the principles for recognising revenue
and to develop a common revenue standard for IFRSs and US GAAP that
would (16):

(a) Remove inconsistencies and weaknesses in existing revenue

requirements
(b) Provide a more robust framework for addressing revenue issues
(c) Improve comparability of revenue recognition practices across
entities, industries, jurisdictions and capital markets
(d) Provide more useful information to users of financial statements
through improved disclosure requirements, and
(e) Simplify the preparation of financial statements by reducing the
number of requirements to which an entity must refer

The proposed requirements would affect any entity that enters into
contracts with customers unless those contracts are in the scope of other
standards (for example, insurance contracts or lease contracts).
To achieve that core principle, an entity would apply all of the following
steps (17):

(a) Identify the contract with a customer.

(b) Identify the separate performance obligations in the contract.
(c) Determine the transaction price.
(d) Allocate the transaction price to the separate performance obligations
in the contract.
(e) Recognise revenue when (or as) the entity satisfies a performance
obligation.

From an IFRS perspective, the new standard arising out of the project is
likely to be more robust than the existing standards. This should assist in
future convergence between IFRS and US GAAP.

The project is in its final stage of development and a new standard is

likely to apply for accounting periods beginning on or after 1 January
2017.

References
1. Paragraph 7 – IAS 18.
2. Paragraph 14 – IAS 18.
3. Paragraph 20 – IAS 18.
4. Paragraph 24 – IAS 18.
5. Paragraph 26 – IAS 18.
6. Paragraph 3 – IAS 11.
7. Paragraph 22 – IAS 11.
8. Paragraph 23 – IAS 11.
9. Paragraph 30 – IAS 11.
10. Paragraph 32 – IAS 11.
11. Paragraph 29 – IAS 18.
12. Paragraph 9 – IAS 18.
13. Paragraph 11 – IAS 18.
14. Paragraph 12 – IAS 11.
15. IAS 18 IE
16. IN 2, ED 2011/6 Revenue from Contracts with Customers
17. Paragraph 4, ED 2011/6 Revenue from Contracts with Customers