Section 23: Revenue
Section 23 applies to the accounting for revenue arising from the sale of goods, rendering of services, construction contracts and the use by others of entity assets yielding interest, royalties or dividends. It does not apply to revenue or income arising from transactions and events dealt with in other sections of the standard (e.g. leases, changes in fair value in investment property).
Revenue is recognised at the fair value of the consideration received or receivable taking into account trade discounts, prompt settlement discounts and volume rebates. Revenue only includes the gross inflow of economic benefits for the entity’s own account. A number of examples of revenue recognition in different circumstances are included in an appendix to this section.
What is new?
Old GAAP defined contract revenue and profit, with costs being the derived amount whereas Section 23 defines contract costs and revenue which are recognised in profit (being the derived amount). As a result section 23 does not seek to achieve uniform profit margin in a contract that is not a cost plus contract which is what old GAAP achieved.
Section 23 makes it clear that contract costs include direct costs attributable to contract activity, and any costs specifically chargeable to the customer. Old GAAP was less prescriptive; an entity may have included selling costs in some instances which is not the case under FRS 102.
Section 23 does not require disclosure of the work in progress balance for long term contracts whereas old GAAP required this disclosure.
What is different?
Old GAAP spreads the guidance on revenue recognition over different sections. However, the overall scope of the guidance across the different sections is equivalent, with the exception of interest, royalties and dividends, for which no guidance is provided under old GAAP.
Old GAAP includes additional guidance, listing the features that indicate that an entity is acting as a principal. Therefore, different judgements may be made regarding principal vs. agent revenue recognition under FRS 102 compared to Old GAAP.
Section 23.5 is very prescriptive on the use of the imputed rate of interest for present valuing deferred consideration. This contrasts with old GAAP which did not dictate the rate of interest to use.
Old GAAP differs from Section 23 as whilst under both GAAPs no accounting recognition should be given to transactions which are artificial or lacking in substance, there is less general guidance on the treatment of exchanges under Old GAAP compared to FRS 102. Therefore, differences in treatment could occur.
Section 23.29 states that interest income shall be recognised under the effective interest method. For entities not applying FRS 26, old GAAP differs from FRS 102, as old GAAP mandated the constant rate of return which is not the same. Therefore, entities should evaluate the impact of the effective interest method.
Section 23.9 provides detailed guidance on accounting for customer loyalty programmes and emphasises the need to account for award credits as a separately identifiable component of the initial sales transaction. The award credit should be measured at its relative fair value i.e. the amount for which the award credits could be sold separately and this element of the consideration received deferred.
This contrasts with old GAAP (FRS 5) which provided very little guidance but did dictate that the adjusted fair value for the voucher should be used and the full fair value of the voucher should be deferred. Therefore, the measurement of the fair value amount may differ. Under old GAAP where fair value was not significant then the award was treated as an inducement and no revenue was deferred. This means that practice varied on the way in which award credits were accounted for under FRS 5 whereas under Section 23, it is made clear how such a transaction should be accounted for.
Old GAAP differs from FRS102 as whilst the definition of a long term contract is similar to a construction contract included in SSAP 9 (old GAAP), SSAP 9 focuses on the duration of the contract – usually greater than one year (old GAAP also applies to contracts shorter than a year but straddle year-end). There is unlikely to be huge adjustments as a result of this difference.
Section 23.14A provides detailed guidance on contracts for the construction of real estate. No detailed guidance was provided under old GAAP.
Section 23 allows for contracts to be separated or grouped provided that certain criteria are met whereas no such guidance was provided in SSAP 9. In reality there should be no major differences on transition as the principles in old GAAP would have given the same result.
Old GAAP provided detailed guidance on how variations to contracts should be accounted for, however, there is no such guidance in Section 23. It is likely the guidance in old GAAP will continue to be utilised.
Under old GAAP, long term contract balances were shown within inventory however under FRS 102, these balances are now shown within debtors/creditors in the line ‘Amounts due from/to customers for contract work’.
Other standards impacting revenue where differences arise:
Section 11 – Basic financial instruments – Trade debtors is classed as a financial instrument. Under section 11, where a sale is made on deferred credit terms (which are out of the ordinary) and a financing element is included (which are out of the ordinary), then the debtor balance needs to be carried at amortised cost. In effect the sale needs to be restated to what the sales value would have been had the financing element not been included. The financing element is then recognised in finance income using the effective interest method over the period of credit. There will likely be deferred tax consequences also where the financing period extends over more than one financial year.
What are the key points?
An entity shall recognise revenue from the sale of goods when all the following conditions are satisfied:
- the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;
- the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;
- the amount of revenue can be measured reliably; (d) it is probable that the economic benefits associated with the transaction will flow to the entity; and (e) the costs incurred or to be incurred in respect of the transaction can be measured reliably (Section 23.10).
When the outcome of a transaction involving the rendering of services can be estimated reliably, an entity shall recognise revenue associated with the transaction by reference to the stage of completion of the transaction at the end of the reporting period (sometimes referred to as the percentage of completion method). The outcome of a transaction can be estimated reliably when all the following conditions are satisfied:
- the amount of revenue can be measured reliably;
- it is probable that the economic benefits associated with the transaction will flow to the entity;
- the stage of completion of the transaction at the end of the reporting period can be measured reliably; and
- the costs incurred for the transaction and the costs to complete the transaction can be measured reliably (Section 23.14).
An entity shall determine the stage of completion of a transaction or contract using the method that measures most reliably the work performed. Possible methods include:
- the proportion that costs incurred for work performed to date bear to the estimated total costs. Costs incurred for work performed to date do not include costs relating to future activity, such as for materials or prepayments;
- surveys of work performed; and
- completion of a physical proportion of the contract work or the completion of a proportion of the service contract.
Where a loss is expected on a contract, the loss shall be recognised immediately.
When the outcome of a construction contract cannot be estimated reliably then revenue should only be recognised equal to the costs incurred and it is probable the costs will be recovered.
Interest income is recognised using the effective interest method.
Royalty income is recognised on an accruals basis.
Dividends are recognised when the shareholder’s right to receive payment is established.
An entity is acting as a principal when it has exposure to the significant risks and rewards associated with the sale of goods or the rendering of service. Features that indicate an entity is acting as principal include:
- the entity has primary responsibility for providing the goods or services to the customer or fulfilling the order;
- the entity has inventory risk;
- the entity has latitude in establishing prices; and
- the entity bears the customer’s credit risk.
Agreements for the construction of real estate where the buyer determines the structures and design then it is accounted for on a percentage of completion basis, however where the entity specifies the design and provides construction material then revenue is not recognised until the goods are delivered which is usually at the completion of the contract.
What do accountants need to do?
Be aware of the differences between the old and new standard and advise clients of these differences.
Review their client portfolios for clients that issue credit/operate loyalty programmes to ensure they meet the requirements of FRS 102, as well as identifying clients who provide extended payment terms where present value accounting will now have to be utilised.
What do companies need to do?
Be aware of the differences between the old and new standard and assess if any adjustments are required.
Construction companies should review its long term contracts and ensure that the way in which the method of completion is determined is in line with FRS 102.
Ensure sales on extended credit are present valued.