1. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-1 Chapter 15 Revenue recognition

2. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-2 Objectives of this lecture Understand the definition and recognition criteria for income Know how to measure revenue from contracts with customers when the contracted amount to be received is other than cash Appreciate that the amount of income recognised in a particular period will relate directly to the accounting measurement model that has been adopted Understand how the existence of particular conditions associated with a sale (such as attached put and call options, or the right of return) will affect the timing of revenue recognition Understand how to account for dividend and interest revenue

3. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-3 Objectives of this lecture (cont.) Understand how to account for sales where revenue receipts have been deferred to future periods Understand how to account for unearned revenue Understand the issues associated with recognising revenues for long-term construction projects Be aware of the new requirements being developed by the IASB in relation to revenue from contracts with customers and be aware that the transfer of control is fundamental to these proposals pertaining to revenue recognition

4. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-4 New requirements relating to revenue recognition Background to the Exposure Draft Revenue from Contracts with Customers was released in June 2010. Following a review of the submissions, and many public meetings, it was decided to issue yet another Exposure Draft Revenue from Contracts with Customers in November 2011. The November 2011 Exposure Draft and reference to it will be signified by referring to IASB (2011). When the accounting standard is finally released it will replace both IAS 18/AASB 118 Revenue, and IAS 11/AASB 111 Construction Contracts.

5. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-5 New requirements relating to revenue recognition (cont.) Argued that the recognition of revenue for some transactions, as required by IAS 18/AASB 118 and IAS 11/AASB 111, was inconsistent with the IASB Conceptual Framework. The recognition principles in these standards referred the ‘risks and rewards of ownership’ of the assets, rather than basing the recognition on the transfer of control. IASB and FASB embrace a view that revenue recognition should be a direct function of whether goods and services have been transferred to the control of the customer Under the proposed accounting standard, revenue recognition from contracts with customers is linked to the transfer of control of assets

6. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-6 Definition of income and revenue Income is defined (Conceptual Framework) as: Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases in liabilities that result in an increase in equity, other than those relating to contributions from equity participants

7. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-7 Definition of income and revenue (cont.) Income is divided into ‘revenues’ and ‘gains’ –Revenues relate to the ordinary income-generating activities of an entity, e.g. sales or rental receipts –Gains relate to ‘other income’—not necessarily part of the ordinary activities of an entity –What is an ‘ordinary’ activity for one business may not be ‘ordinary’ for another—so the benefits might be deemed ‘revenue’ in one entity and a ‘gain’ in another –Differentiation between revenue and gains also embraced in the IASB 2011 Exposure Draft

8. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-8 Recognition criteria for revenue from contracts with customers The Draft Accounting Standard (IASB 2011, paragraph 31) states: An entity shall recognise revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (ie an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset.

9. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-9 Recognition criteria for revenue from contracts with customers (cont) Transfer of ‘control’ of the asset is central to the recognition of revenue under the new Accounting Standard being jointly developed by the IASB and FASB. The new standard will relate to revenue from contracts with customers, but that income can come from other sources when the fair value of financial assets increases. Such income is addressed in other standards (for example, in AASB 9 Financial Instruments) and will not be directly influenced by the new standard relating to contracts with customers.

10. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-10 What does ‘control’ mean with respect to the recognition of control? IASB (2011) provides the following information in relation to the meaning of control: Goods and services are assets, even if only momentarily, when they are received and used (as in the case of many services). Control of an asset refers to the ability to direct the use of and obtain substantially all of the remaining benefits from the asset. Control includes the ability to prevent other entities from directing the use of and obtaining the benefits from an asset.

11. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-11 What does ‘control’ mean with respect to the recognition of control (cont.)? The benefits of an asset are the potential cash flows that can be obtained directly or indirectly in many ways, such as by: (a) using the asset to produce goods or provide services (including public services); (b) using the asset to enhance the value of other assets; (c) using the asset to settle liabilities or reduce expenses; (d) selling or exchanging the asset; (e) pledging the asset to secure a loan; and (f ) holding the asset.

12. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-12 When to recognise revenue Recognised at a point in time, or it might be recognised over a period of time Transfer of control is a required precondition before revenue shall be recognised at a point in time, or over a period of time IASB (2011) permits revenue to be recognised to the extent that the reporting entity’s performance creates or enhances an asset that the customer controls while the asset is being created or enhanced If the customer does not control the asset being constructed then revenue shall not be recognised

13. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-13 Measurement of revenue Where revenue has been recognised, revenue is to be measured at the fair value of the consideration or contributions received or receivable If the transaction price is not expected to be paid for more than a year then the transaction price must be discounted to recognise the time value of money Determining the discount rate Credit characteristics Increases in fair values of marketable securities are recognised as part of income (AASB 9) Different measurement models of assets and liabilities will generate different calculations

14. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-14 Income and revenue recognition— according to the Conceptual Framework An item that meets the definition of an element (e.g. income) should be recognised if: (a)the item has a cost or value that can be measured with reliability (b)it is probable that any future economic benefit associated with the item will flow to or from the entity

15. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-15 Income and revenue recognition points

16. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-16 Income recognition

17. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-17 Income and revenue recognition—at the time of sale The two conditions (probable economic benefits and reliable measurement) for recognising revenue are usually met by the time the product or merchandise is delivered, or the services are rendered to customers Normally determined by shipping terms, i.e. time of sale is commonly interpreted as when title passes In advance of cash receipt

18. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-18 Accounting for sales with associated conditions Transactions involving the sale of assets with conditions attached should be reviewed Call option –Provides the holder of the option with the right to buy an asset at a specified exercise price on or before a specified date Put option –Operates in reverse manner to a call option

19. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-19 Accounting for sales with associated conditions—revenue recognition when right of return exists Goods are often sold with a ‘right of return’ Alternative treatments available when the seller is exposed to continued risks of ownership through return of the product –Not recording the sale until all return privileges have expired –Recording the sale but reducing sales by an estimate of future returns –Recording the sale and accounting for the returns as they occur Refer to Worked Example 15.1 (p.530) Sale with a right of return

20. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-20 Accounting for sales with associated conditions—sale and leaseback A ‘sale and leaseback’ occurs when an entity sells an asset to another party and then immediately leases it back thereby not losing ‘control’ of the asset The vendor/lessee has in effect entered into a financing arrangement—leased property used as collateral for a loan Transaction does not constitute a sale and does not give rise to revenue

21. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-21 Interest and dividends—interest revenue Interest revenue is recognised over time Prepayment of interest by borrower is not regarded as revenue to lender Interest revenue might be implicit in the terms of some transactions –For example, where goods are sold on extended credit, vendor is effectively financing the purchaser –Such a transaction gives rise to two forms of revenue: 1. Sales revenue—present value of future payments 2. Interest revenue from financing activities

22. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-22 Deferred sales proceeds To estimate the present value of the proceeds, an applicable interest rate inherent in the agreement must be determined AASB (2011) –To adjust the promised amount of consideration to reflect the time value of money, an entity shall use the discount rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception. That rate would reflect the credit characteristics of the party receiving financing in the contract as well as any collateral or security provided by the customer or the entity, which might include assets transferred in the contract. Refer to Worked Example 15.2 (p.531) Recognition of interest inherent in a sales transaction

23. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-23 Interest and dividends—dividend revenue Dividends do not accrue over time but usually result from a decision of the board of directors Dividend revenue should be recorded once it is considered probable that inflow of future economic benefits has occurred and when these benefits can be measured reliably If a dividend needs final approval, perhaps at a meeting of shareholders, then the dividend revenue should not be recognised until such time as the dividend has been approved (or ratified)

24. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-24 Unearned revenue Recorded when payment is received in advance of services or resources being provided The receipts have not been earned Considered to be liabilities –under present obligation to transfer future economic benefits at a future date Refer to Worked Example 15.3 on p. 534—Revenue received in advance

25. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-25 Accounting for construction contracts Accounting issues result from some construction projects taking a number of financial periods to complete. Deferral of revenue recognition until completion of project would result in greater volatility of reported revenues and of related profits or losses To the extent that a customer has control of the asset being constructed then revenue from construction contracts can be recognised throughout the life of the contract.

26. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-26 Accounting for construction contracts (cont.) Accounting requirements Individual construction contracts must be accounted for separately IASB (2011) requires that an entity shall recognise revenue for a performance obligation satisfied over time only if the entity can reasonably measure its progress towards complete satisfaction of the performance obligation. Inability to reasonably measure its progress towards complete satisfaction of a performance obligation Inability to reasonably measure the outcome of a performance obligation Contractors can use the percentage-of-completion method to account for construction contracts

27. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-27 Accounting for construction contracts (cont.) Construction costs plus gross profit earned to date accumulated in inventory account Invoicing throughout the term of the construction contract When progress billings exceed the gross amount of construction in process Percentage-of-completion method When the outcome of a construction contract can be estimated reliably

28. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-28 Accounting for construction contracts (cont.) Types of construction contracts –Fixed-price contracts –Cost-plus contracts Type of contract determines the conditions that must be satisfied to use the percentage-of- completion method

29. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-29 Accounting for construction contracts (cont.) Conditions of use of percentage-of-completion method – With fixed-price contract – With cost-plus contract – If conditions are not satisfied – When outcome of construction contract cannot be estimated reliably

30. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-30 Accounting for construction contracts (cont.) Measuring progress towards completion Percentage of completion can be measured in a number of ways The entity uses the method that measures reliably the work performed. Progress payments and advances received from customers often do not reflect the work performed Cost basis

31. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-31 Accounting for construction contracts (cont.) Types of costs incurred by contractors a)Costs related directly to a specific contract, e.g. direct materials, direct labour, depreciation of equipment, costs of moving plant and equipment, expected warranty costs b)Costs that are attributable to contract activity in general and capable of being allocated on a reasonable basis to specific contracts, e.g. tender preparation, insurance, design and technical assistance c)Costs that relate to the activities of the reporting entity generally or that relate to contract activity generally and are not normally related to specific contracts, e.g. general administration and selling costs, finance costs and research and development costs not directly related to contract

32. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-32 Accounting for construction contracts (cont.) Calculation of percentage of completion (cost method) Costs incurred to the end of the current period ÷ Most recent estimate of total costs Current period revenue or gross profit –Estimated total revenue or gross profit from the contract multiplied by percentage complete less total revenue or gross profit recognised in prior periods

33. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-33 Accounting for construction contracts (cont.) Presentation requirements When a reporting entity has entered into a contract with a customer—including a long-term construction contract—then when either party to the contract has performed, the reporting entity might present the contract in the statement of financial position as either a contract liability, a contract asset, or a receivable depending on the relationship between the entity’s performance and the customer’s payment. IASB (2011) states: If a customer pays consideration or an amount of consideration is due before an entity performs by transferring a good or service, the entity shall present the contract as a contract liability. A contract liability is an entity’s obligation to transfer goods or services to a customer for which the entity has received consideration from the customer.

34. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-34 Accounting for construction contracts (cont.) Application of percentage-of-completion method to account for construction contracts Refer to Worked Example 15.4 on p. 539—Percentage-of- completion method Refer to Worked Example 15.5 on p. 541—Construction contract where outcome cannot be reliably estimated

35. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-35 Accounting for construction contracts (cont.) When current estimates of total contract costs and revenues for any contract indicate that a loss is probable: –provision should be made for any foreseeable loss on the contract regardless of the amount of work already performed –the loss is to be brought to account as soon as it is foreseeable Where a contract becomes likely to generate more in costs than it does in revenue this is now being referred to as an ‘onerous performance obligation’ (IASB, 2011). A performance obligation is considered onerous if the lowest cost of settling the performance obligation exceeds the amount of the transaction price allocated to that performance obligation.

36. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-36 Onerous performance obligation An entity would recognise a liability and a corresponding expense if the performance obligation is considered to be ‘onerous’ An entity would present a liability for onerous performance obligations separately from contract assets or contract liabilities For long-term construction contracts, where there is an expected loss on a contract an expense and related liability shall be recognised regardless of: –whether work has commenced on the project; –the stage of completion of the activity; or –the difference between total contract costs and total contract revenue expected to arise from other construction contracts Refer to Worked Example 15.6 on page 542—Percentage of completion with recognition of a loss

37. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-37 Summary In this lecture the recognition of income and revenue has been considered The Conceptual Framework requires that for income to be recognised the associated inflow of economic benefits or associated reduction in liabilities must be both probable and measurable with reasonable accuracy Revenue shall be recognised as the entity satisfies a performance obligation by transferring a promised good or service to a customer An asset is transferred to a customer when the customer obtains control of the asset

38. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-38 Summary (cont.) Sales transactions are often made with associated conditions (e.g. call and put options or a right to return the assets) –It is necessary to consider whether they reduce the probability that the inflow of resources will ultimately occur –If it appears that an option that will reduce the inflow of resources will probably be exercised or that the right of return will be exercised, the revenue should not be recognised by the reporting entity until such time as the requisite degree of certainty is attained that the inflow of economic benefits will occur –Determining whether revenue should be recognised will also depend on the system of accounting being used, i.e. measurement model being adopted

39. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-39 Summary (cont.) Under historical-cost accounting the increase in the value of marketable securities would not be considered as revenue until such time as the securities are sold If a fair values-based system is used increased market prices of assets could be treated as part of the period’s income (AASB 9) Revenue and expenses related to a construction contract are to be recognised by applying the percentage-of-completion method if the outcome and stage of completion of the construction contract can be reliably estimated and the asset under construction is in the control of the customer

40. Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs to accompany Deegan, Australian Financial Accounting 7e 15-40 Summary (cont.) Where percentage-of-completion method is applied, revenue is brought to account with a corresponding increase in construction in progress on the basis of percentage of completion Percentage of completion is measured typically by comparing costs incurred to date with the most recent estimate of the total costs to complete the contract Revenue will be recognised throughout the life of the contract, but if the percentage-of-completion method is used and it becomes apparent that a loss will be made, the entire loss must be recognised as soon as it is foreseeable—the contract then becomes an onerous performance obligation