essentials of fa_chapter 13_income
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CHAPTER 13
INCOME
Chapter Objective
The objective of this chapter is to provide understanding of accounting principles and
methods for accounting for incomes. Incomes include revenue from sale of goods,
revenue from sale of services, royalty, interest and dividend income and income from
sale and construction of real estate.
13.1 DEFINITION
Income is defined as “increases in economic benefits during the accounting period in theform of inflows or enhancements of assets or decreases of liabilities that result in
increases in equity, other than those relating to contributions from equity participants”
In accordance with the above definition income arises from:
(i) Inflow of economic benefits (e.g. receipts from customers, return on investment, and
government grants); or
(ii) Enhancement of assets (e.g. increase due to revaluation of assets, and change in thefair value of held for trading and available for sale investments); or
(iii) Decrease of liabilities (e.g. waver of outstanding interest due on a loan by a bank
under the corporate debt restructuring scheme and final settlement with a trade creditor at
an amount lower than the outstanding liability).
In this chapter we shall discuss the principles and methods for accounting for income
arising from inflow of economic benefits.
Exhibit 13.1 presents classification of income arising from inflow of economic benefits:
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Exhibit 13.1: Classification of income arising from inflow of economic benefits
Revenue
Revenue is 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.
Revenue includes only the gross inflows of economic benefits received and receivable by
the entity on its own account . Amounts collected on behalf of third parties such as sales
taxes, goods and services taxes and value added taxes are not economic benefits which
flow to the entity and do not result in increases in equity. Therefore, they are excluded
from revenue. Similarly, in an agency relationship, the gross inflows of economic
benefits include amounts collected on behalf of the principal and which do not result in
increases in equity for the entity. The amounts collected on behalf of the principal are not
revenue. Instead, revenue is the amount of commission.
Examples of revenue are income from sales of goods by an entity engaged in
merchandising business, income from sales of goods by an entity engaged in
manufacturing of goods, export incentives received or receivable by an entity engaged in
the export of goods, income from sales of services by an entity engaged in selling
Inflow of economic benefits
RevenueIncome from
ordinary
activities
Other incomeIncome from
peripheral
activities
Government
grantsOthers
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services, interest income of an entity engaged in the banking business, fees earned by a
investment banker and fees earned by a professional accountant.
Revenue is measured at the gross amount received or receivable by the entity.
Illustration 13.1
A company is in crude oil business. It sells crude oil and gas produced from exploratory
wells in progress in exploratory areas.
Required
Explain how the company should account for the income from the sale of crude oil
produced during exploration.
Solution
The amount realized/realizable from such sale should not be recognized as revenue
because it is not arising from the ordinary activities of the company. It should be
deducted from expenses incurred to explore oil wells.
Other income
Income, other than those arising from activities other than ordinary activities are
classified as other income. For a non-finance entity, interest and dividend income are
classified as other income. Similarly, profit from sale of fixed assets is classified as other
income. Other income is recognised at the net amount that is net of expenses.
Government grant
Government grants are assistance by government in the form of transfers of resources to
an entity in return for past or future compliance with certain conditions relating to the
operating activities of the entity. Financial assistance to companies which invest in
pollution control equipment is an example of government grant.
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13.2 REVENUE: GENERAL PRINCIPLES
13.2.1 Recognition Principles
In accrual accounting, the timing for the recognition income does not coincide with the
timing of receipt and payment of cash. Recognition and measurement of revenue or
expenses involve judgement. Therefore, recognition and measurement of revenue has
significant potential for earnings management. An entity may overstate profit and asset
by recognising income before the earning process is complete and can understate profit
and asset by not recognising income even after the earning process is complete. Most
accounting fraud involves violation of the revenue recognition principles. Therefore,
managers should understand principles for recognising income and expenses.
Revenue recognition at the point of saleUsually revenue is recognised at the point of sale.
An entity should recognise revenue when the earning process is complete and it is
reasonably certain that it will be able to collect the amount from the customer.
Staff Accounting Bulletin (SAB)-101 issued by the Securities and Exchange Commission
(SEC) of USA describes the conceptual foundation for revenue recognition. It says that
revenue is generally realised or realisable and earned when all of the following criteria
are met:
(a) There is persuasive evidence that an arrangement exists.
(b) Delivery has occurred or services have been rendered.
(c) The sellers’ price to the buyer is fixed or determinable.
(d) Collectibility is reasonably assured.
Inappropriate application of the rule results in premature recognition of revenue or
recognition of fictitious revenue. For example, In order to boost sales, near the end of the
reporting period, an enterprise may allow buyers (e.g. dealers) rights of return and other
privileges that violate the realization principle. Similarly, an enterprise may record
license fees or membership fees when an agreement is signed, rather that over the term of
the agreement. A company that provides mobile telephony services may recognize the
initial fixed charges received from customers as revenue at the time of agreement rather
than allocating it over the period for which the company, on an average, retains
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customers. This violates the fundamental principle that ‘revenue should be recognized
only on completion of the earning processes’.
Indian GAAP comparison
Principles stipulated in the Indian GAAP as well as those stipulated in the IFRS for therecognition of revenue are based on the general principles discussed above.
Illustration 13.2
Himani Wines Limited (HWL) harvests grapes every year and processes them into
various types of wines. HWL enters into contracts with customers at the beginning of the
aging process, which takes several years to complete. Each customer pays 30% of the
selling price at the beginning of the aging process and the balance when it takes delivery
after aging.
Required
Explain when HWL should recognise the revenue from the sale of wines.
Solution
HWL should recognize revenue when the wine is delivered, that is, when the earning
process is complete. The 30 percent of the selling price received at the beginning of
aging process should be recognised as a liability (advance received from customers).
Illustration 13.3Urvashi Camera Limited (UCL) enters into an agreement with Trident Limited, which
runs the West-Side chain of family stores, to place cameras in West Side stores. As per
the agreement West Side receives the cameras on consignment basis and makes best
efforts to sell the cameras at the best price depending upon the competition and new
offerings by competitors. UCL maintains title to cameras until West Side sells them.
When West Side sells the cameras, it remits the selling price minus a fee to UCL. UCL
takes back any damaged or defective cameras.
Required
Explain when UCL should recognise the revenue from the sale of cameras.
Solution
The transaction is in the nature of consignment sale. UCL should recognize revenue when
West Side confirms the sale. It is inappropriate for UCL to recognise revenue when it
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initially ships the cameras to West Side, because it maintains titles to cameras until West
Side sells them and also because the price at which West Side will sell the cameras is not
determined until the sales takes place.
Revenue recognition at the point of production
In some situations, revenue or profit is recognised during the production process or on
completion of production but before the occurrence of sale. Examples are revenue/profit
from agricultural activity, revenue/profit from construction contracts and revenue/profit
from service contracts.
13.2.2 Measurement of Revenue
Revenue should be measured at the fair value (FV) of the consideration received. The
difference between the nominal amount of the consideration and the fair value of the
same, if any, is accounted for as interest income using the effective interest rate method.
Indian GAAP comparison
Revenue is measured by the charges made to customers or clients for goods supplied and
services rendered to them. Therefore, in no situation, except in case of installment sales,
the nominal consideration is allocated between sales revenue and interest income.
Consideration in the Form of CashWhen the consideration received is in the form of cash or cash-equivalents, the amount of
revenue is the amount of cash or cash-equivalents received or receivable. However, when
the inflow of cash or cash equivalents is deferred, the FV of the consideration may be less
than the nominal amount of cash received or receivable.
A sales transaction that allows credit for a significant period (usually longer than six
months) is in ‘substance’ a combination of sales transaction and financing transaction.
Therefore, the amount receivable from the customer should be apportioned between
revenue and interest income. Usually when an entity grants credit for a significant period,
it obtains an instrument such as ‘promissory note’ from the customer to protect its claim.
When the transaction is identified as a composite transaction constituted of sales and
financing, the FV of the consideration is determined by discounting all future receipts
using an imputed rate of interest .
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Imputed rate of interest
The imputed rate of interest is the more clearly determinable of either
(a) The prevailing rate for a similar instrument of an issuer with a similar credit rating
(b) A rate of interest that discounts the nominal amount of the instrument to the current
cash sales price of the goods or services
The imputed rate of interest is the market interest rate. Therefore, when an entity offers
credit at an interest rate below the market interest rate, it should apportion the amount
receivable between revenue and interest income using the market interest rate.
Illustration 13.4
Golden Tribute Limited (GTL) is engaged in manufacturing and selling designer
furniture. It allows three months credit to its customers, which is normal in the industry in
which the firm operates. GTL sold furniture for Rs. 2,000,000 to Ms. Mona Lisa. The
market interest rate on the date of the transaction was 10% per annum.
Required
(a) Explain whether GTL should allocate total amount realisable from the transaction
between revenue and interest.
(b) Will your answer be different if GTL uses the Indian GAAP for the preparation of
financial statements?
Solution(a) GTL would recognise the total amount of the consideration as revenue because the
credit period is short (less than six months) and consequently the time value of money is
not material. However, if GTL sells goods on cash basis, and the cash price is different
from the price to be realised from Mona Lisa, there is a case of apportioning the amount
realisable between revenue and interest income. The revenue should be recognised at the
cash sale price and the difference between the cash price and the considerations to be
realised from the customer should be recognised as interest income.
(b) If GTL uses the Indian GAAP for the preparation of financial statements, it should
measure the revenue at the total amount of the consideration even if the cash price is
different from the price at which the furniture is sold to Mona Lisa.
Illustration 13.5
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On January 1, 2010, Mohini Limited (ML) sold Cleopatra Furniture for Rs. 5,000,000
with a credit arrangement. Under this arrangement, Cleopatra would pay the
consideration (sale value) after twelve months with interest at the rate of 2% per annum.
The market interest rate on the date of the transaction is 12% per annum. ML closes its
financial year on December 31.
Required
(a) Explain how ML should account for the sale transaction.
(b) Explain how ML should account for the sale transaction if it uses the Indian GAAP
for the preparation of financial statements.
Solution
(a) The market interest rate is determined with reference to the credit risk, which depends
on the credit period, the amount of receivables, and credit rating (credit worthiness) of the
customer.
ML allowed credit to Cleopatra at a concessional rate of 2 per cent. The credit period is
longer than six months. Therefore, the time value of money is material. ML should
recognise the revenue and interest income as follows:
(i) Total amount receivable = (Rs. 5,000,000 × 1.02) = Rs. 5,100,000
(ii) PV of receivable (Revenue) = Rs. 5,100,000/ (1.12) = 4,553,571
(iii) Interest income = (Rs. 5,100,000 – 4,553,571) = Rs. 546,429
In substance ML granted a loan to Cleopatra on which it earned interest income at the
rate of 12% per annum. Therefore, in substance, ML allowed a discount on the list price.
Thus, it sold goods to Cleopatra below the list price.
(b) If ML uses the Indian GAAP for the preparation of financial statements, it should not
allocate the consideration received from Cleopatra between revenue and interest income.
It should recognise the revenue at Rs. 5,000,000. The interest of Rs. 100,000 receivedfrom the customers should be recognised as interest income. Indian GAAP does not
require the use of effective interest rate method to recognise the interest income.
Consideration other than in the Form of Cash
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When a firm receives consideration in a form other than cash or cash-equivalent, revenue
is recognised at the fair value (FV) of the consideration received or receivable. For
example, if the entity receives equity shares issued by the buyer as consideration, revenue
should be recognised at the FV of equity shares received by the seller. The FV should be
measured using the share price and measurement assumption at the earlier of the two
dates - grant date and vesting date. Grant date is the date on which the equity shares are
granted to the seller. Vesting date is the date on which the performance necessary to earn
the equity is completed by the seller and seller’s rights have vested.
FV cannot be measured reliably
In a situation when the FV of the consideration received cannot be measured reliably, the
entity should apply the well accepted accounting principle that a transaction involving
exchange of non-monetary considerations should be recorded at the FV of the
consideration given or consideration received, whichever is more clearly evident.
Therefore, in a sale transaction, if the FV of the consideration received cannot be
measured reliably, revenue should be measured based on the FV of the goods or services
sold.
Inability to measure outcome
If, the outcome of a transaction involving the rendering of services cannot be estimated
reliably (that is, the amount of revenue cannot be measured reliably), revenue should berecognised only to the extent of expenses recognised that are recoverable.
As a general principle, if FV of both the goods (services) sold and consideration received
cannot be determined reliably, no profit should be recognised.
Illustration 13.6
Namrata, a management graduate from a reputed business school, immediately after
graduation, started hospitality business in the name of ‘Namrata recreation and tourism’
(NRT). She purchased equipment from Allahabad Machineries Limited (AML) in
exchange of a haveli (private mansion), now abandoned, owned by her in a remote
village in UP. The village is in the development map of the UP government.
Required
Explain at what amount the revenue should be measured by AML.
Solution
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AML should recognize revenue at the fair value of the haveli determined by appraisal
method. However, if the fair value of the haveli cannot be determined reliably, AML
should recognize the revenue at the normal selling price of equipment sold to Namrata.
Barter Transactions
When goods or services are exchanged or swapped for goods or services, which are of a
similar nature or value, the exchange is not regarded as a transaction which generates
revenue. Therefore, exchange of similar items does not result in recognition of revenue.
Illustration 13.7
“Evening News” (EN), a very popular evening newspaper, under an arrangement swaps
advertising space with “Morning News” (MN).
Required
Explain how EN and MN should account for the transaction.
Solution
In absence of evidence to the contrary, it may be assumed that advertising spaces are of a
similar nature and value. Therefore, neither EN nor MN should recognise revenue and
corresponding expenses. Although recognition of revenue and corresponding expense
does not change the operating result presented in the profit and loss account, it misleads
users of financial statements and distorts analysis.
Illustration 13.8 Digital.Com Limited (DCL) provides services for advertising on Internet. Under an
arrangement with Champion Club Limited (CCL), DCL advertises the football, cricket
and rugby tournaments of CCL in exchange of CCL advertising the services of DCL in
all its correspondence to members. No other consideration flows between DCL and CCL.
DCL, as a part of its regular business, provides services similar to those being provided to
CCL to other clients on payment of cash. CCL does not provide any advertising services
to any client other than DCL.
Required
Explain whether DCL and CCL should recognise revenue.
Solution
Standard Interpretation Committee (SIC) of IASB issued SIC-31, which discusses barter
transactions involving advertising services. It concludes that revenue from a barter
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transaction involving advertisement cannot be measured at the FV of advertising services
received. However, a seller can determine the FV of services provided reliably with
reference to non-barter transactions. In identifying non-barter transactions, the seller must
ensure that those transactions:
(a) Involve advertising similar to the advertising in the barter transaction.
(b) Occur frequently.
(c) Represent a predominant number of transactions and amount when compared to all
transactions to provide advertising that is similar to the advertising in the barter
transaction.
(d) Involve cash and/or other form of consideration that has a reliably measurable FV.
(e) Do not involve the same counterparty as in the barter transaction.
In accordance with SIC-31, DCL should recognise revenue and expenses at FV of
services provided to CCL. It should determine the FV with reference to transactions
involving advertising similar to advertising in the barter transaction. However, CCL
should recognise neither revenue nor expenses, because it does not provide any
advertising services to any other client. There are no transactions that can be used as
benchmark transactions for determining the FV of services provided to DCL.
CCL may put forward an argument that it should be allowed to recognise the revenue and
expenses at FV determined with reference to advertising services received from DCL.SIC-31 concludes that measuring revenue at the FV of advertising services received from
the customer in a barter transaction is impractical, because reliable information that is
required to support the measurement is not available to the seller . In view of the
conclusions in SIC-31, CCL should not recognise the revenue.
Illustration 13.9
New Age Airlines Limited (NAAL) has an arrangement with Women’s Collections
Limited (WCL) to advertise ‘designer apparels’, being designed, produced and sold by
WCL. Under the arrangement, NAAL allots vacant seats in flights in metro sectors to
fashion models of WCL after the ticket window is closed and the boarding is announced.
WCL in return advertises the services of NAAL in its fashion shows. It does not provide
advertising services to any other customer.
Required
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Explain whether NAAL and WCL should recognise revenue.
Solution
Neither NAAL nor WCL should recognise revenue, because FV of considerations cannot be measured reliably. It is not appropriate for NAAL to measure revenue with reference
to normal fare being charged to customers, because only vacant seats are allotted to WCL
after the boarding is announced. In other words, NAAL sells only those assets (services)
whose FV is zero in the market for airlines services. It is impractical to determine the FV
of services being provided to WCL, which is unique. Similarly, in absence of benchmark
transaction, it is impracticable for WCL to measure the FV of advertising services being
provided to NAAL.
13.2.3 Collectibility
Reasonable assurance of collectibility implies that the entity is able to estimate the
uncollectible receivables with reasonable accuracy. In absence of reasonable assurance of
collectibility, an entity defers recognition of revenue. It recognises revenue when
uncertainties surrounding collectibility are resolved or the amount is collected. For
example, if it is uncertain whether a foreign government authority will grant permission
to remit the consideration from a sale in a foreign country, the recognition of the revenue
should be deferred. When the permission is granted, the uncertainty is resolved and
revenue should be recognised. However, when uncertainty arises about the collectibility
of revenue already recognised, the uncollectible amount is recognised as expense (bad
debt). Revenue already recognised is not adjusted. For example, in the year 2009 goods
sold to Ms. Nancy on credit for Rs. 10,000 were recognised as sales and debtors was
recognised in the balance sheet. In 2010, Ms. Nancy becomes bankrupt and collectibility
ceases to be probable. The asset, that is, debtors, should be de-recognised and the amount
should be recognised as an expense as bad debt in the profit and loss account for the year
2010.
Illustration 13.10
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Indian Thermal Power Corporation (ITPC) sells electricity to State Electricity Boards
(SEB). As per the agreement, penal interest at the rate of 11% is payable on amount
overdue for more than one year. Accordingly, in the year 2010, ITPC invoiced Rs. 10
million on various SEBs towards penal interest on claims overdue for more than three
years.
Required
Explain whether ITPC should recognise Rs. 10 million as income.
Solution
ITPC should not recognise the interest income of Rs. 10 million, because of theuncertainty surrounding its collectibility. The collectibility of the interest from SEBs is
not reasonable certain because of the inability of ITPC to collect its dues on account of
supply of electricity.
Illustration 13.11
Millennium Equipment Ltd. (MEL) operates as the distributor for Boston Equipment
Ltd. (BEL). MEL supplies imported equipment to various universities and researchinstitutions. As per the original agreement, equipment is to be supplied at the quoted price
without any provision for escalation claim. While renewing the contract in 2010, some
universities agreed to compensate MEL for the additional cost that might arise due to
exchange rate fluctuations, provided it managed exchange risks to their satisfaction. MEL
submitted an escalation claim to National University of India (NUI) for Rs. 50,000 for
equipment supplied in 2010.
Required
Explain when MEL should recognise the escalation claim as revenue.
Solution
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MEL should not recognise Rs. 50,000 as revenue until the claim is accepted by the
university, because the amount that would be accepted by the university cannot be
estimated reliably. However, if NUI agrees to compensate MEL for the additional cost
arising due to exchange fluctuation unconditionally, the escalation claim should be
recognised as revenue immediately on submission of the claim.
13.2.4 Matching Principle
Revenue and expenses that relate to the same transaction or other event are recognised
simultaneously. Therefore, revenue should not be recognised when the related expenses
cannot be measured reliably. In such circumstances, any consideration already received
for the sale of goods or rendering of services is recognised as a liability. If an entity
recognises revenue without recognising related expenses, it overstates profit.
Summary
Usually revenue is recognised at the point of sale. An entity should recognise revenue
when the earning process is complete and it is reasonably certain that it will be able to
collect the amount from the customer. Revenue should be measured at the fair value (FV)
of the consideration received. The difference between the nominal amount of the
consideration and the fair value of the same, if any, is accounted for as interest income
using the effective interest rate method.
In some situations, revenue or profit is recognised during the production process or on
completion of production but before the occurrence of sale.
13.3 SALE OF GOODS
Revenue from the sale of goods should be recognised when all the following conditions
have been satisfied:
(a) The entity has transferred to the buyer the significant risks and rewards of ownership
of the goods;
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(b) The entity retains neither continuing managerial involvement to the degree usually
associated with ownership nor effective control over the goods sold;
(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 entity; and
(e) The costs incurred or to be incurred in respect of the transaction can be measured
reliably.
Indian GAAP comparison
Revenue from sales should be recognised when requirements as to performance are
satisfied, provided that at the time of performance it is not unreasonable to expect
ultimate collection.
In a transaction involving sale of goods, performance should be regarded as being
achieved when the following conditions have been fulfilled:
(i) The seller of goods has transferred to the buyer the property in the goods for a price or
all significant risks and rewards of ownership has been transferred to the buyer and the
seller retains no effective control of the goods transferred to a degree usually associated
with ownership; and
(b) No significant uncertainty exists regarding the amount of the consideration that will
be derived from the sale of goods. In most situations, application of the principles stipulated in the Indian GAAP will give
the same results that will be applied by applying principles stipulated in the IFRS.
13.3.1 Transfer of Significant Risks and Rewards
An entity should assess the point in time when significant risks and rewards of ownership
have transferred to the buyer taking into account the terms of contract and circumstances
of each transaction. In most cases, risks and rewards get transferred to the buyer with the
transfer of the legal title or passing of possession to the buyer. This is the case for most
retail sales. For example, in ex-factory sales, risks and rewards of ownership are
transferred when goods are delivered to the buyer at the factory or to the transporter who
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acts as an agent of the buyer. In a Free on Board (FOB) contract, risks and rewards get
transferred to the buyer when goods have been delivered to the shipping agent.
There are circumstances in which risks and rewards do not get transferred to the buyer
with the transfer of the legal title or passing of possession. IAS-18 provides the following
examples of those situations:
(a) When the entity retains an obligation for unsatisfactory performance not covered by
normal warranty provisions.
(b) When the receipt of the revenue from a particular sale is contingent on derivation of
revenue by the buyer from its sale of the goods.
(c) When goods are shipped subject to installation and the installation is a significant part
of the contract which has not yet been completed by the entity.
(d) When the buyer has the right to rescind the purchase for a reason specified in the sales
contract and the entity is uncertain about the probability of return.
If an entity retains only an insignificant risk of ownership, the transaction is a sale and
revenue is recognised. For example, an entity retains only an insignificant risk of ownership in a retail sale when a refund is offered if the customer is not satisfied.
Revenue in such cases is recognised at the time of sale provided the seller can reliably
estimate future returns and recognises a liability for returns based on previous experience
and other relevant factors.
Illustration 13.12
Aviana Electricals Limited (AEL) has sold five high pressure boilers to a public utilityfirm for Rs. 50 lakhs each. The contract includes delivery and installation of boilers. The
customer will accept the boilers only after final inspection of boilers after installation.
Required
Explain when AEL should recognise the revenue from the sale of boilers.
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Solution
AEL should recognise the revenue only when the delivery is accepted by the customer
after installation and inspection. Risks and rewards of ownership will be transferred to the
buyer only on acceptance of the boilers by the buyer after installation and inspection.
Installation is a significant activity and therefore, until inspection AEL retains risks of
ownership, which are not immaterial.
Illustration 13.13
Sony Mony Limited (SML) sells branded TV sets which are tested and certified by the
manufacturer. As a practice, SML installs the TV set sold in the location decided by the
customer.
Required
Explain when SML should recognise the revenue from the sale of TV sets.
Solution
SML should recognise the revenue immediately on delivery of the TV set to the
customer. The installation process is simple and it is almost certain that the installation
will be complete to the satisfaction of the customer. Therefore, until installation, SML
retains risks, which are immaterial.
Illustration 10.14
Genuine Ores Limited (GOL), a mining company, exports zinc raw ore to various firms
on FOB contract basis. Contracts with different firms establish prices for different grades
of the ore. GOL determines the sale value of each consignment and prefers invoice based
on test results in its own laboratory. However, the final price is determined by the
customer after inspection and test of the ore in its laboratory. The customer does not
reject the ore unless it is below the acceptable grade. GOL, while dispatching a
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consignment, ensures that the ore is of such a quality that the consignment would not be
rejected by the customer.
Required
Explain when GOL should recognise the revenue from the sale of ore.
Solution
GOL should recognise revenue when the consignment is delivered to the shipping
company. Risks and rewards of ownership are substantially transferred at that point in
time. Inspection and testing for determining the price do not defer the transfer of risk and
rewards of ownership. GOL should estimate the reduction in price and should provide for the same.
Illustration 10.15
Neo machines Limited (NML) manufactures equipment for the production of innovative
electric ICMIC cookers. An ICMIC cooker is a steam cooker. It cooks several items
simultaneously. It calls for slow cooking, as a result of which many foods taste better. No
attention is needed during cooking. The demand for this product has not yet picked up inthe market. NML promotes this product as a strategy to achieve target growth. It sells the
equipment that it manufactures with a condition that if the customer fails to achieve target
revenue by selling ICMIC cookers in the first full year after the purchase of the
equipment, NML will take back the equipment and will refund the full amount received
as consideration.
Required
Explain when GOL should recognise the revenue from the sale of ore.
Solution
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NML should recognise the revenue from the sale of the equipment after the expiry of the
period within which the customer can claim refund of the sale consideration. By
guaranteeing the target revenue from the sale of ICMIC cookers by the buyer of the
equipment, NML retains significant risks. Risks and rewards of ownership of the
equipment get transferred only when the buyer’s right to return the equipment ceases.
13.3.2 Bill and Hold Sales
‘Bill and hold sales’ refers to a situation when an entity holds goods on behalf of a
customer. For example, an entity manufacturing and selling equipment against firm
orders, holds finished goods ready for dispatch on behalf of a customer, if the site for
installation is not ready. The accounting principle is that the entity should recognise the
revenue when the buyer takes the title provided:
(a) It is probable that the delivery will be made.
(b) The item is on hand, identified, and ready for delivery.
(c) The buyer specifically acknowledges the deferred delivery instructions.
(d) The usual payment terms apply.
Illustration 13.16
Happy Home Furniture Limited (HHFL) manufactures standard teak wood furniture for use in home. However, it modifies standard furniture according to interior decoration
plan of the customer. It receives full payment with the firm order. On 15 December 2010,
it received an order from Ms. Lovely for Rs. 500,000. Execution of the order will require
modification of standard furniture. The modification would be completed by 15 January
2011.
Required
Explain whether HHFL should recognise revenue in the profit and loss account for the
year 2010.
Solution
HHFL should not recognise the revenue in the year 2010, because on 31 December 2010,
furniture were not ready for delivery and the buyer did not accept the title, although she
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paid the full amount. HHFL should recognise the amount received as a liability (advance
from customers) in the balance sheet as at 31 December 2010.
13.3.3 Lay Away Sales
‘Lay away sales’ are similar to ‘bill and hold sales’. In lay away sales, the goods and
equipment are on hand, identified and ready for delivery to the buyer, but delivery is
deferred until final payment is received. Usually, sufficient payment is received to
support commitment of the buyer and consequently the collectibility of the sale value. An
entity recognises the lay away sales as revenue for the period in which the sales occurred.
Illustration 13.17
Sun Sports Limited (SSL) manufactures and sells sports equipment. It normally allows
30 days credit. At the request of a local club it agreed to special terms of payment. Under
the arrangement, the club identified sports goods and equipment worth Rs. 500,000. The
club would make payment for those items in a series of installment. SSL would deliver
the items only on receipt of final payment. On 31 December 2010, Rs. 150,000 was due
from the club.
Required
Explain whether SSL should recognise the revenue in the year 2010.
Solution
SSL should recognise the revenue in the year 2010, because it has received significantdeposit, and the goods and equipment are on hand, identified and ready for delivery to the
buyer. Although physical delivery is not complete as on 31 December 2010 sales are
consummated and it is probable that delivery will be made. It is assumed that the seller is
holding goods for the buyer.
13.3.4 Sales and Repurchase of Goods
Accounting for a sales and repurchase transaction depends on the substance of the
transaction. If the seller transfers the risks and rewards of ownership to the buyer,
revenue is recognised. If, in substance, the seller transfers the legal title, but retains the
risks and rewards of ownership through a repurchase arrangement, the transaction is a
financing arrangement and does not give rise to revenue.
If the product or good is readily available in the market (e.g. securities being traded in the
capital market) and the seller has the option to buy back the same at a specified date at
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the then prevailing market price, the seller transfers the risk and reward of ownership to
the buyer. If, the price of the good sold increases during the intervening period, the gain
due to increase in the price goes to the buyer. Similarly, if, the price of the good sold goes
down during the intervening period, the resultant loss is borne by the buyer.
Illustration 13.18
Sujal Limited (SL) sold 10,000 shares of Castrol Limited, which is a listed company, to
Kangna Limited (KL) on June 11, 2010 at the rate of Rs. 400.10 per share. As per the
arrangement, SL will buy back the shares on June 11, 2011 at the closing price of the
share in BSE at that date.
Required
Explain whether SL should recognise the transaction as a sale transaction.Solution
SL should recognise the transaction as a sale transaction as it has passed the risk and
reward of ownership of the shares to KL. For example, if the closing price on June 11,
2011 is higher than Rs. 400.10 per share, KL will benefit from the increase as SL will
buy back the shares at that increased price. On the other hand, if the closing price on June
11, 2011 is lower than Rs. 400.10 per share, KL will suffer a loss due to decrease in the
share price as SL will buy back the shares at that reduced price. We have assumed thatKL holds the shares in stock. But, it is quite possible that KL might have sold the shares
during the intervening period and booked profit. It will purchase the shares from the
market on June 11, 2011 and will return the shares to SL. This shows that if the item is
readily available in the market, the buyer can take advantage of intervening changes in
the price of the item. The seller cannot take the benefits of intervening changes in the
price of the item.
If the product or good is readily available in the market (e.g. securities being traded in the
capital market) and the seller has the option to buy back the same at a specified date and
at a specified price, the seller does not transfer the risk and reward of ownership to the
buyer. If, the price of the good sold increases during the intervening period, the gain due
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to increase in the price goes to the seller. Similarly, if, the price of the good sold goes
down during the intervening period, the resultant loss is borne by the seller.
Illustration 13.19
Sudipti Limited (SL) sold 10,000 shares of Castrol Limited, which is a listed company, to
Kanti Limited (KL) on June 11, 2010 at the rate of Rs. 400.10 per share. As per the
arrangement, SL will buy back the shares on June 11, 2011 at the rate of Rs.450 per
share.
Required
Explain whether SL should recognise the transaction as a sale transaction.
SolutionSL should recognise the transaction as a financing transaction as it has retained the risk
and reward of ownership of the shares. For example, if the closing price on June 11, 2011
is lower than Rs. 450 per share, SL will lose as it will buy back the shares at the pre-
specified price of Rs. 450.00 per share. On the other hand, if the closing price on June 11,
2011 is higher than Rs. 450.00 per share, SL will gain as it will buy back the shares at the
pre-specified price of Rs. 450.00 per share. It is quite possible that KL would book profit
taking advantage of intervening changes in the price of the shares. But, by specifying thebuyback price, SL has retained the risk, which is not immaterial.
If the product or good is not readily available in the market (e.g. special equipment) and
the seller has the option to buy back the same at a specified date, the seller does not
transfer the risk and reward of ownership to the buyer, because non-availability of the
product in the market restrains the buyer to sell or mortgage the good.
Illustration 13.20
Sunshine Limited (SL) sold goods to Moonlight Limited (ML) on 15 December 2010 for
Rs. 5,000,000 with an arrangement that SL would repurchase the goods from ML on 15
January 2011 for Rs. 5,050,000.
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Required
Explain whether SL should recognise the transaction as a sale transaction.
Solution
SL and ML should recognise the transaction as a financing transaction. SL shouldrecognise Rs. 5,000,000 as loan (asset) in the balance sheet as at 31 December 2010 and
should recognise Rs. 25,000 as interest income in the profit and loss account for the year
2010. ML should recognise Rs. 5,000,000 as borrowing in its balance sheet as at 31
December 2010 and Rs. 25,000 as interest expense for the year 2010.
13.3.5 Goods Shipped Subject to Approval
If, there is uncertainty about the possibility of return, revenue should not be recogniseduntil the goods have been formally accepted by the buyer or the time period for rejection
has elapsed. Although not explicitly provided, IAS-18 does not preclude recognition of
revenue at the time of sale, if there is no significant uncertainty about the possibility of
return. In other words, if the seller can reasonably estimate the amount of future return, it
should recognise the revenue at the time of sale and provide for estimated return.
Indian GAAP comparison
Indian GAAP requires that revenue should not be recognised until the goods have been
formally accepted by the buyer or the time period for rejection has elapsed.
13.3.6 Installment Sales
When the consideration is receivable in installments, revenue attributable to the sales
price, exclusive of interest , is recognised at the date of sale. Sale price is the present value
of the consideration, determined by discounting the installments receivable at the imputed
rate of interest. The interest element is recognised using the effective interest rate
method.
13.3.7 Subscriptions to publications and similar items
When the items involved are of similar value in each time period, revenue is recognised
on a straight-line basis over the period in which the items are despatched. When the items
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vary in value from period to period, revenue is recognised on the basis of the sales value
of the item despatched in relation to the total estimated sales value of all items covered by
the subscription.
Illustration 13.21
Sarthak Publications Limited (SPL) publishes a monthly magazine targeted to youth in
the age group of 25 to 30 years. The yearly subscription is Rs. 1,300. A subscriber
receives 13 issues, which include one annual number, which is issued in January. The
annual number is a special issue and the management estimates that its sale value should
be four times of the sale value of monthly issues. SPL closes its financial year on
December 31.
RequiredIf SPL receives subscription from a subscriber on July1, 2010, how much of the annual
subscription it should recognise in the year 2010.
Solution
During the full year a subscriber receives equivalent to 16 (12 + 4) issues in terms of sale
value. The subscriber in consideration will receive only six issues during the year 2010.
Therefore, SPL should recognise only Rs. 487 .50 [(1,300/16) × 6] as revenue for the
year 2010.
13.3.8 Servicing Fees Included in the Price of the product
When the selling price of a product includes an identifiable amount for subsequent
servicing (for example, after sales support and product enhancement on the sale of
software), 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 under the agreement, together with a reasonable profit on
those services.
Illustration 13.22
Hansa Limited (HL) sells water purifiers, primary for use in offices and factories. The
selling price is Rs. 25,000 per unit. HL provides four free after sales service at the end of
each three-month period from the date of sale. Service includes replacement of parts. HL
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earns a gross profit of 25 per cent on the product. The management estimates that the cost
of each service comes to Rs. 1,000. HL closes its financial year on December 31.
In October 2010 HL sold four purifiers.
Required
Explain how HL should account for the revenue earned on the sale of the purifiers on
October 2010.
Solution
We may assume that HL completed on free service during the year 2010.
The selling price of Rs. 25,000 includes servicing fees of Rs. 5,000 [(1,000 × 1.25) × 4].
Immediately on sale, HL should recognise revenue of Rs, 20,000 (25,000 – 5,000) per
purifier. Recognition of fees for Identifiable services at Rs. 5,000 per purifier should be
deferred.
In the year 2010, one service on the four purifier sold was complete. Therefore, HL
should recognise Rs. 85,000 [(20,000 × 4) + (5,000/4) × 4] as revenue for the year 2010
from the transaction of selling four purifiers in October 2010.
Summary
Revenue from the sale of goods should be recognised when all the following conditionshave been satisfied:
(a) The entity has transferred to the buyer the significant risks and rewards of ownership
of the goods;
(b) The entity retains neither continuing managerial involvement to the degree usually
associated with ownership nor effective control over the goods sold;
(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 entity; and
(e) The costs incurred or to be incurred in respect of the transaction can be measured
reliably.
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In most cases, risks and rewards get transferred to the buyer with the transfer of the legal
title or passing of possession to the buyer. This is the case for most retail sales.
Accounting for a sales and repurchase transaction depends on the substance of the
transaction. If the seller transfers the risks and rewards of ownership to the buyer,
revenue is recognised. If, in substance, the seller transfers the legal title, but retains the
risks and rewards of ownership through a repurchase arrangement, the transaction is a
financing arrangement and does not give rise to revenue.
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.
13.4 SERVICE REVENUES
13.4.1 General Principles
Outcome can be measured reliably
Usually service contracts cover more than one accounting period. Therefore, revenue is
recognised with reference to the stage of completion of the transaction on the balancesheet date. The same rule is followed in the case of construction contracts, which are also
multi-period contracts. However, the rule can be applied only if the outcome of the
transaction can be measured reliably.
The outcome of a transaction can be estimated reliably when all the following conditions
are satisfied:
(a) The amount of revenue can be measured reliably;(b) It is probable that economic benefits arising from the transaction will flow to the
entity;
(c) The stage of completion at the balance sheet date can be measured reliably; and
(d) The costs incurred for the transaction and the costs to complete the transaction can be
measured reliably.
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Measurement of the stage of completion
The stage of completion can be determined in a variety of ways such as survey of the
work performed and services rendered till the balance sheet date as a percentage of total
services to be performed. Depending on the nature of the transaction, the methods may
include:
(a) Surveys of work performed;
(b) Services performed to date as a percentage of total services to be performed; or
(c) The proportion that costs incurred to date bear to the estimated total costs of the
transaction. Only costs that reflect services performed to date are included in costs
incurred to date. Only costs that reflect services performed or to be performed are
included in the estimated total costs of the transaction.
Progress payments and advances received from customers often do not reflect the
services performed.
Illustration 13.23
Krittika IT Solutions Limited (KITSL) develops and implements IT systems for large
companies. Average cycle time for the completion of a contract is about three years. On
January 1, 2010 it initiated work on a contract for a client operating in the automobile
sector. Total cost to complete the contract is estimated at Rs. 100 million. The contract
price is Rs. 130 million. Costs incurred till the end of the year 2010 amounted to Rs. 25
million.
Required
Estimate the amount of revenue to be recognised by KITSL in the profit and loss account
for the year 2010 against the subject contract.
Solution
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The total revenue and the total costs to completion are measured reliably by the
management. Therefore, we can conclude that the outcome of the contract can be
measured reliably. The revenue from the contract should be measured using the stage of
completion method.
The stage of completion as at December 31, 2010 was 25 per cent (25/100). Therefore, 25
per cent of the total revenue should be recognised in the profit and loss account for the
year 2010. Accordingly revenue for the year 2010 should be recognised at Rs. 32.50
million.
Outcome cannot be measured reliably
When the outcome of the transaction involving the rendering of services cannot be
estimated reliably, the entity recognises revenue only to the extent of the expenses
recognised that are recoverable.
Usually, during the early stages of the transaction, the outcome of the transaction cannot
be measured reliably. However, it is probable that the entity will be able to recover the
costs incurred. Therefore, the entity does not recognise profit from the transaction and
recognise revenue only to the extent of expenses recognised in the profit and loss
account. As a practice, entities do not recognise any profit until more than 20 per cent of
the work is completed.
When the outcome of a transaction cannot be estimated reliably and it is not probable that
the costs incurred will be recovered, revenue is not recognised and the costs incurred are
recognised as an expense.
Illustration 13.24
Sangeeta IT Solutions Limited (SITSL) develops and implements IT systems for large
companies. Average cycle time for the completion of a contract is about three years. On
May 1, 2010 it initiated work on a contract for a client operating in the automobile sector.
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Total cost to complete the contract is estimated at Rs. 100 million. The contract price is
Rs. 130 million. Costs incurred till the end of the year 2010 amounted to Rs. 15 million.
Required
Estimate the amount of revenue to be recognised by KITSL in the profit and loss account
for the year 2010 against the subject contract.
Solution
Although the total revenue and the total costs to completion are measured reliably by the
management, it is incorrect to conclude that the outcome of the contract can be measured
reliably because only 15 per cent (15/100) of the transaction is complete as at the end of the year 2010. Therefore, revenue for the year 2010 from the subject transaction should
be recognised only to the extent of expenses recognised for the year 2010. Accordingly,
only Rs. 15 million should be recognises as revenue for the year 2010.
13.4.2 Application of General Principles
Indeterminate number of acts
For practical purposes, when services are performed by an indeterminate number of acts
over a specified period of time, revenue is recognised on a straight line basis over the
specified period, unless there is evidence that some other method better represents the
stage of completion.
When a specific act is much more significant than any other act, the recognition of
revenue is postponed until the significant act is executed. For example, revenue from
artistic performance, banquets and other special events is recognised when the eventtakes place.
Subscription
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When subscription to a number of events is sold, the fee is allocated to each event on a
basis that reflects the extent to which services are performed at each event.
Customized software
Fees for the development of customized software are recognised as revenue by reference
to the stage of completion of the development, including completion of services provided
for post-delivery service support. Usually, the service provider establishes milestones in
consultation with the customer for transfer of sales consideration. Sometimes revenue
from incomplete contracts is recognised as and when the milestones are achieved.
Advertising Commission
The general principle is that revenue should be recognised when the service is completed.
Media commission is normally recognised when the related advertisement or commercial
appears before the public and the necessary intimation is received by the agency.
Production commission should be recognised when the project is completed.
Insurance Agency Commission
Insurance agency commissions received or receivable which do not require the agent torender further service are recognised as revenue by the agent on the effective
commencement or renewal dates of the related policies. However, when it is probable
that the agent will be required to render further services during the life of the policy, the
commission, or part thereof, is deferred and recognised as revenue over the period during
which the policy is in force.
Admission Fee
Admission fee that relates to a number of events sold is allocated to each event on a
systematic and rational basis.
Tuitions Fee
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Revenue is recognised over the period of instruction.
Institution Entrance and Membership Fees
Entrance fee received is generally capitalised.
Revenue recognition from membership fees depends on the nature of services provided.
If the fee permits only membership, the fee should be recognised as revenue when no
significant uncertainty as to its collectibility exists. If the membership fee entitles the
member to service or publications to be provided during the membership period or to
purchase goods or services at prices lower than those charged to non-members, it is
recognised on the basis that reflects the timing, nature and value of the benefits provided.
Illustration 13.25
Divya Limited (DL) maintains an auction site on its web. It charges customers an upfrontfee to list products for sale and a transaction fee when a sale takes place. The transaction
fee is refundable if the auction winner fails to honour its commitment to purchase the
product.
Required
Explain the appropriate revenue recognition principles to be followed by DL in
recognising revenue from transactions mentioned in the illustration.
Solution
DL should recognize the upfront fee as revenue on time proportion basis over the average
period over which it retains its customers and recognize the transaction fee when the
buyer of the customer’s product honours the commitment. It will be inappropriate for DL
to recognise the upfront fee as revenue immediately because, its contract with a customer
is a multi-period contract and it cannot be said that the delivery is complete immediately
on receipt of the fee.
Illustration 13.26
Priyanka Software Limited (PSL) develops software and sells it to customers for an
upfront fee. PSL provides its customers with password-protected access to its website for
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two years after delivery of the software. With this access, customers can download
updates to the software. PSL has an obligation to provide update on the website.
Required
Explain how PSL should account for the upfront fee received from customers.
Solution
PSL should recognize the total upfront fee as revenue on receipt of the amount and
should simultaneously recognise a provision for the estimated costs of providing updates.
It is not appropriate for PSL to recognize the total upfront fee as revenue on time
proportion basis over a period of two years, because the earning process is substantiallycomplete when the software is sold and the add-on service is only a small part of the total
contract.
Illustration 13.27
Zee Tele films Limited sells advertisement space to its customer.
Required
Explain when Zee should recognise the commission earned by selling the advertising
space.
Solution
It recognizes the advertising space selling commission when the related advertisement or
commercial appears before the public i.e. on telecast.
Illustration 13.28
Balaji Tele-films Limited produces television programmes. It earns revenue by selling the
programme produced by it.
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Required
Explain the appropriate accounting policy for the recognition of revenue.
Solution
In respect of sponsored programs, revenue should be recognised as and when the relevant
episodes of the programs are telecast. In respect of commissioned programs, revenue is
recognised as and when the relevant episodes of the programs are delivered to the
channels.
Illustration13.29
UPS Limited provides courier services. It collects fees from customers while collecting
letters and other packages. The delivery time and costs depend on locations, distance
between locations, mode of transport and types of packages.
Required
Explain the appropriate accounting policy for the recognition of revenue.
Solution
Revenue should be recognized upon delivery of a letter or package because the earning
process completes only on delivery.
Summary
Revenue is recognised with reference to the stage of completion of the transaction on the
balance sheet date if, the outcome of the transaction can be measured reliably. When theoutcome cannot be estimated reliably, the entity recognises revenue only to the extent of
the expenses recognised that are recoverable. Usually, during the early stages of the
transaction, the outcome of the transaction cannot be measured reliably. When the
outcome of a transaction cannot be estimated reliably and it is not probable that the costs
incurred will be recovered, revenue is not recognised and the costs incurred are
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recognised as an expense. For practical purposes, when services are performed by an
indeterminate number of acts over a specified period of time, revenue is recognised on a
straight line basis over the specified period When a specific act is much more significant
than any other act, the recognition of revenue is postponed until the significant act is
executed.
13.5 ROYALTY, INTEREST AND DIVIDEND
13.5.1 Royalties and License Fees
Entities allow others to use its assets such as trademarks, patents, software, music
copyright, record masters and motion picture films on payment of fees or royalties. Fees
and royalties received for such an arrangement are recognised as revenue in accordance
with the substance of the agreement. In practice revenue from such an arrangement is
recognised on a straight line basis over the life of the agreement.
Sometimes, an entity assigns rights for use of its assets for a fixed fee or non-refundable
guarantee under a non-cancellable contract which permits the licensee to exploit those
rights freely and the licensor has no remaining obligations to perform. Such an
arrangement is in substance a sale, and revenue is recognised at the time of sale.
Examples of such transactions are:
(a) A licensing agreement for use of software when the licensor has no obligations
subsequent to delivery.
(b) Assignment of rights to exhibit a motion picture film in markets where the enterprise
has no control over the distributor and it does not expect to receive further revenues from
the box-office receipts.
If the receipt of fees or royalties is contingent on the occurrence of a future event, theenterprise recognises the revenue when the event has occurred.
Interests and dividends
Revenue from interests and dividends should be recognised on the following bases:
(a) Interest: Interest income is recognised using the effective interest method.
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(b) Dividends ( from investment in shares): When the owner’s right to receive payment
is established.
The effective interest method is discussed in chapters 11 and 12. When unpaid interest
has accrued before the acquisition of an interest-bearing security, the subsequent receipt
of interest is allocated between pre-acquisition and post-acquisition periods. Only post-
acquisition period interest is recognised as revenue, and pre-acquisition period interest is
reduced from the cost of investment as a part recovery of the cost. Similarly, dividend
declared from pre-acquisition net income is reduced from the cost of investment as a part
recovery of the cost.
Indian GAAP comparison
Interest income is recognised on a time proportion basis taking into account the amount
outstanding and the rate applicable.
The principles for the recognition of royalty and dividend are the same as those stipulated
in IFRS.
13.6 FINANCIAL SERVICE FEES
The recognition of revenue for financial service fees depends on the purposes for which
the fees are assessed and the basis of accounting for any associated financial instrument.
It is necessary to distinguish between fees that are an integral part of the effective interest
rate of a financial instrument, fees that are earned as services are provided, and fees that
are earned on the execution of a significant act.
13.6.1 Fees that are Integral Part of the Interest
Fees that are integral part of the interest are generally treated as an adjustment to the
effective interest rate. However, when the financial instrument is measured at fair value
with the change in fair value recognised in profit or loss, the fees are recognised as
revenue when the instrument is initially recognised. Accounting for financial assets and
financial liabilities is discussed in chapters 11 and 12.
Origination fees in creating a financial asset
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Origination fees may include compensation for activities such as evaluating the
borrower’s financial condition, evaluating and recording guarantees, collateral and other
security arrangements, negotiating the terms of the instrument, preparing and processing
documents and closing the transaction. These fees are an integral part of generating an
involvement with the resulting financial instrument and, together with the related
transaction costs are deferred and recognised as an adjustment to the effective interest
rate.
Illustration 13.30
National Bank Limited (NBL) provides housing finance to buyers of new apartments in
bank approved projects. It charges a flat amount of Rs. 10,000 for each loan application.
The only cost that is directly attributable to the processing, approving and sanctioning of
loan is the amount that it pays to an analytic firm to assess the risk of the loan. In a
particular case the bank received an application for a loan of Rs. 2 million (20 lakhs). It
paid Rs. 2,000 to the analytic firm to assess the risk of the loan. After due assessment of
the risk the bank has sanctioned the loan at an interest rate of 10 per cent per annum. The
loan will be repaid in equal instalments over a period of 120 months.
Required
Explain how the bank should account for the origination fee of Rs. 10,000.
Solution
The origination fee (Rs. 10,000) adjusted for the transaction cost (Rs. 2,000) should be
considered as cash inflow at the date of disbursement of loan to calculate the effective
interest rate. Thus the cash outflow at the date of disbursal should be taken at Rs.
1,992,000 (2,000,000 – 10,000 + 2,000).
Commitment fee
If it is probable that the entity will enter into a specific lending arrangement, the
commitment fee received is regarded as compensation for an ongoing involvement with
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the acquisition of a financial instrument and, together with the related transaction costs is
deferred and recognised as an adjustment to the effective interest rate. If the commitment
expires without the entity making the loan, the fee is recognised as revenue on expiry.
13.6.2 Fees Earned as Services are Provided
Fees charged for servicing a loan
Fees charged by an entity for servicing a loan are recognised as revenue as the services
are provided.
Commitment fees to originate a loan
If it is unlikely that a specific lending arrangement will be entered into, the commitment
fee is recognised as revenue on a time proportion basis over the commitment period.
Investment management fees
Fees charged for managing investments are recognised as revenue as the services are
provided. Incremental costs that are directly attributable to securing an investment
management contract are recognised as an asset if they can be identified separately and
measured reliably and if it is probable that they will be recovered. The asset represents
the entity’s contractual right to benefit from providing investment management services,
and is amortised as the entity recognises the related revenue. If the entity has a portfolio
of investment management contracts, it may assess their recoverability on a portfolio
basis.
13.6.3 Fees that are Earned on the Execution of a Significant Act
The fees are recognised as revenue when the significant act has been completed.
Commission on the allotment of shares to a client
The commission is recognised as revenue when the shares have been allotted.
Placement fees for arranging a loan between a borrower and an investor
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The fee is recognised as revenue when the loan has been arranged.
Loan syndication fees
A syndication fee received by an entity that arranges a loan and retains no part of the loan package for itself (or retains a part at the same effective interest rate for comparable risk
as other participants) is compensation for the service of syndication. Such a fee is
recognised as revenue when the syndication has been completed.
13.7 FRANCHISE FEES
Franchise fees may cover the supply of initial and subsequent services, equipment and
other tangible assets, and know-how. Accordingly, franchise fees are recognised asrevenue on a basis that reflects the purpose for which the fees were charged.
Supplies of equipment and other tangible assets
The amount, based on the fair value of the assets sold, is recognised as revenue when the
items are delivered or title passes.
Supplies of initial and subsequent services
Fees for the provision of continuing services, whether part of the initial fee or a separate
fee, are recognised as revenue as the services are rendered.
When the separate fee does not cover the cost of continuing services together with a
reasonable profit, part of the initial fee, sufficient to cover the costs of continuing services
and to provide a reasonable profit on those services is deferred and recognised as revenue
as the services are rendered.
The franchise agreement may provide for the franchisor to supply equipment, inventories,
or other tangible assets, at a price lower than that charged to others or a price that does
not provide a reasonable profit on those sales. In these circumstances, part of the initial
fee, sufficient to cover estimated costs in excess of that price and to provide a reasonable
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profit on those sales, is deferred and recognised over the period the goods are likely to be
sold to the franchisee. The balance of an initial fee is recognised as revenue when
performance of all the initial services and other obligations required of the franchisor
(such as assistance with site selection, staff training, financing and advertising) has been
substantially accomplished.
The initial services and other obligations under an area franchise agreement may depend
on the number of individual outlets established in the area. In this case, the fees
attributable to the initial services are recognised as revenue in proportion to the number
of outlets for which the initial services have been substantially completed.
If the initial fee is collectible over an extended period and there is a significant
uncertainty that it will be collected in full, the fee is recognised as cash instalments are
received.
Continuing franchise fees
Fees charged for the use of continuing rights granted by the agreement, or for other
services provided during the period of the agreement, are recognised as revenue as the
services are provided or the rights used.
Agency transactions
Transactions may take place between the franchisor and the franchisee which, in
substance, involve the franchisor acting as agent for the franchisee. For example, the
franchisor may order supplies and arrange for their delivery to the franchisee at no profit.
Such transactions do not give rise to revenue.
13.8 REAL ESTATE
Agreement for the construction of real estate
Real estate developers undertake the construction of real estate directly or through
subcontractors. They usually enter into agreements with one or more buyers before
construction is complete. Such agreements take diverse forms. For example, entities that
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undertake the construction of residential real estate often start to market individual units
(apartments or houses) ‘off plan’, i.e. while construction is still in progress, or even
before it has begun. Each Buyer enters into an agreement with the entity to acquire a
specified unit when it is ready for occupation. Typically, buyers make progress payments.
Entities that undertake the construction of commercial or industrial real estate enter into
an agreement with a single buyer. The buyer may be required to make progress payments
between the time of the initial agreement and contractual completion. Construction may
take
Within a single agreement, an entity may contract to deliver goods or services in addition
to the construction of real estate (e.g. a sale of land or provision of property management
services). Such an agreement may need to be split into separately identifiable components
including one for the construction of real estate. The fair value of the total consideration
received or receivable for the agreement shall be allocated to each component.
Nature of the agreement
Determining whether the transaction is to be accounted for as a construction contract (see
section 13.8 below) or as a sale of goods or services, needs consideration of the terms of
the agreement and all the surrounding facts and circumstances. Such a determination
requires judgement with respect to each agreement.
The agreement is in the nature of a construction contract when the agreement meets the
definition of a construction contract. Construction contract is defined as ‘a contract
specifically negotiated for the construction of an asset or a combination of assets’. An
agreement for the construction of real estate meets the definition of a construction
contract when the buyer is able to specify the major structural elements of the design of the real estate before construction begins and/or specify major structural changes once
construction is in progress (whether or not it exercises that ability).
In contrast, an agreement for the construction of real estate in which buyers have only
limited ability to influence the design of the real estate, e.g. to select a design from a
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range of options specified by the entity, or to specify only minor variations to the basic
design, is an agreement for the sale of goods.
Accounting for revenue from the construction of real estate
When the agreement is a construction contract, the transaction is to be accounted for as
per the principles and methods described in section 13.8.
If the agreement does not meet the definition of a construction contract, the entity
determines whether the agreement is for the rendering of services or for the sale of goods.
If the entity is not required to acquire and supply construction materials, the agreement
may be only an agreement for the rendering of services In this case, if the outcome can
be estimated reliably, revenue to be recognised by reference to the stage of completion of
the transaction using the percentage of completion method.
If the entity is required to provide services together with construction materials in order
to perform its contractual obligation to deliver the real estate to the buyer, the agreement
is an agreement for the sale of goods.
Usually an entity transfers to the buyer control and the significant risks and rewards of
ownership of the real estate in its entirety at a single time (e.g. at completion, upon or
after delivery). In this case, the entity recognises revenue only when all the criteria of
revenue recognition, including the delivery of goods, are satisfied.
Revenue is normally recognised when legal title passes to the buyer. However, in many
situations the equitable interest in a property vests in the buyer before legal title passes
and, therefore, the risks and rewards of ownership get transferred at that stage. In such
cases, provided that the seller has no further substantial acts to complete under the
contract, it is appropriate to recognise revenue. If the seller is obliged to perform any
significant acts after the transfer of the equitable and/ or legal title, revenue is recognised
as acts are performed.
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The entity may transfer to the buyer control and the significant risks and rewards of
ownership of the work in progress in its current state as construction progresses. In this
case, if all the criteria of revenue recognition are met continuously as construction
progresses, the entity recognises revenue by reference to the stage of completion using
the percentage of completion method.
Indian GAAP comparison
Under the Indian GAAP, real estate developers recognise revenue by reference to the
stage of completion using the percentage of completion method irrespective of the nature
of contract.
13.9 CONSTRUCTION CONTRACTS
13.9.1 Characteristics of Construction Contracts
Definition
A construction contract is a contract 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.
Characteristics
The unique feature of construction contracts is that the date at which the contract activity
is entered into and the date when the activity is completed usually fall into the different
accounting periods. Therefore, the primary issue in accounting for construction contracts
is the allocation of contract revenue and contract costs to the accounting periods in which
the construction work is performed.
Although, usually contracts are carried at the job site, accounting principles for
accounting for construction contracts are applicable in appropriate cases to the
manufacturing or building of special items on a contract basis in a contractor’s own plant.
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Examples of construction contracts are civil construction contracts and contracts for
shipbuilding.
As earned approach
‘As earned’ approach is adopted to recognise revenue from a construction contract. ‘As
earned’ approach is justified, because in most situations both the buyer and the contractor
obtain legally enforceable rights. The buyer has the legal right to enforce specific
performance and, in effect, has ownership claim to the contractor’s work-in-progress. The
contractor usually has the right to require the buyer to make progress payments during the
construction period. Therefore, in substance, continuous sale occurs as the work
progresses.
13.9.2 Types of Contracts
A fixed price contract is a construction contract in which the contractor agrees to a fixed
contract price, or a fixed rate per unit of output, which in some cases is subject to cost
escalation clauses.
A cost plus contract is a construction contract in which the contractor is reimbursed for
allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee.
Construction contracts include:
(a) Contracts for the rendering of services which are directly related to the construction of
the asset, for example, those for the services of project managers and architects.(b) Contracts for the destruction or restoration of assets, and the restoration of the
environment following the demolition of assets.
13.9.3 Recognition of Contract Revenue and Expenses
Outcome can be estimated reliably
When the outcome of a construction contract can be estimated reliably, contract revenue
and contract costs associated with the construction contract should be recognised using
the ‘percentage-of-completion’ method.
Outcome cannot be estimated reliably
When the outcome of a construction contract cannot be estimated reliably:
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(a) Revenue is recognised only to the extent of contract costs incurred that it is probable
will be recoverable; and
(b) Contract costs are recognised as an expense in the period in which they are incurred.
An expected loss on the construction contract should be recognised as an expense.
immediately. During the early stages of a contract it is often the case that the outcome of
the contract cannot be estimated reliably. Nevertheless, it may be probable that the entity
will recover the contract costs incurred. Therefore, contract revenue is recognised only to
the extent of costs incurred that are expected to be recoverable. As the outcome of the
contract cannot be estimated reliably, no profit is recognised. However, even though the
outcome of the contract cannot be estimated reliably, it may be probable that total
contract costs will exceed total contract revenues. In such cases, any expected excess of total contract costs over total contract revenue for the contract is recognised as an
expense immediately.
Recovery of costs is not probable
Contract costs recovery of which is not probable are recognised as an expense
immediately. Following are examples of circumstances in which the recoverability of contract costs incurred may not be probable:
(a) Contracts which are not fully enforceable, that is, their validity is seriously in question
(b) Contracts the completion of which is subject to outcome of pending litigation or
legislation
(c) Contracts relating to properties that are likely to be condemned or expropriated
(d) Contracts where the customer is unable to meet its obligations
(e) Contracts where the contractor is unable to complete the contract or otherwise meet its
obligations under the contract
When the uncertainties that prevented the outcome of the contract being estimated no
longer exist, revenue and contract costs should be recognised using the percentage-of-
completion method.
13.9.4 Reliability of Estimates
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A contractor should be able to estimate the outcome of a contract reliably, if the contract
establishes:
(a) Each party’s enforceable rights.
(b) The consideration to be exchanged.
(c) The manner and terms of settlement.
In case of a fixed price contract, the contractor can estimate the outcome reliably when all
the following conditions are satisfied:
(a) The contract revenue can be measured reliably.
(b) It is probable that the economic benefits associated with the contract will flow to the
enterprise.
(c) Both the contract costs to complete the contract and the stage of completion at the
balance sheet date can be measured reliably.
(d) The contract costs attributable to the contract can be clearly identified and measured
reliably so that the actual contract costs incurred can be compared with prior estimates.
In case of cost plus contract, the outcome can be measured reliably when all the
following conditions are satisfied:
(a) It is probable that the economic benefits associated with the contract will flow to the
enterprise.
(b) The contract costs attributable to the contract, whether or not specificallyreimbursable, can be clearly identified and measured reliably.
13.9.5 Percentage-of-Completion Method
Under percentage-of-completion method, contract revenue and contract costs (expenses)
are recognised in the profit and loss account for the accounting periods in which the work
is performed.
The stage of completion of a contract may be determined in a variety of ways, including:
(a) The proportion that the contract costs incurred for work performed to date bear to the
estimated total contract costs
(b) Surveys of work performed
(c) Completion of a physical proportion of the contract work
Progress payments and advances received from customers often do not reflect the work
performed .
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Cost to cost method
Cost-to-cost method is commonly used to measure the percentage-of-completion of the
contract. Costs incurred to the balance sheet date should include only those contract costs
that reflect work performed to that date. Total costs should be adjusted based upon most
recent information. The following steps are involved in determining the revenue for the
current period:
(a) Determine the contract accosts incurred to the balance sheet date from the
commencement of activities associated with the contract.
(b) Estimate the total contract costs for completing the contract based on most recent
information.
(c) Determine the ratio of (a) to (b).
(d) Apply the ratio at (c) to the contract price to determine the amount of revenue earned
to the balance sheet date.
(e) Deduct from (d) above the revenue previously recognised to determine the current
Illustration 13.31
Amishi Construction Limited (ACL) constructs commercial spaces in Kolkata. It
involves the buyer in planning and designing the space. The buyer has the right to advice
ACL on construction activities during the construction of the contract. ACL started
construction of a commercial building for one of its esteemed client on the land provided
by the client in the year 2009. By the end of the year 2010, ACL incurred Rs. 50 million
towards construction costs. As per the latest estimate prepared by the management of
ACL, total construction cost comes to Rs. 100 million. The selling price is Rs. 130
million. In the year 2009, ACL recognised revenue from the contract at Rs. 30 million.
Required
(a) Explain the principles of accounting to be applied in accounting for the transaction.
(b) Calculate the amount of revenue to be recognised in the profit and loss account for the
year 2010.
Solution
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(a) The nature of the contract is that of construction contract because of buyer’s
involvement in planning, designing and during the construction of the commercial
building. Therefore, principles of contract accounting should be applied to account for the
transaction.
(b) The percentage completion at the end of the year 2010 was 50 per cent (50/100).
Therefore, cumulative revenue of Rs. 65 million (.50 × 130) should be recognises.
Revenue of Rs. 30 million was reognised in the profit and loss account for the year 2009.
Therefore, revenue for the year 2010 should be recognised at Rs. 35 million (65 – 30).
13.10 BUNDLED OFFERS
The recognition criteria for revenue recognition are usually applied separately to each
transaction. However, in certain circumstances, it is necessary to apply the recognition
criteria to the separately identifiable components of a single transaction in order to reflect
the substance of the transaction. For example, 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.
Usually the total selling price is allocated to different components based in fair values of
different components which constitute the transaction. However, some times, allocation
becomes too complicated. For example, in case of accounting for revenue in the
telecommunication sector, large are large number of issues involved in allocating the
selling price to different components. In most situations, different entities provide
different components (e.g. hand set and contents), which are delivered by the mobile
service providers. This makes the accounting for revenue a complex issue.
Loyalty programmes
Customer loyalty programmes are used by entities to provide customers with incentives
to buy their goods or services. If a customer buys goods or services, the entity grants the
customer award credits (often described as ‘points’). The customer can redeem the award
credits for awards such as free or discounted goods or services.
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An entity accounts for the award credits as a separately identifiable component of the
sales transaction(s) in which they are granted (the ‘initial sale’). The fair value of the
consideration received or receivable in respect of the initial sale is allocated between the
award credits and the other components of the sale.
The consideration allocated to the award credits is measured by reference to their fair
value, i.e. the amount for which the award credits could be sold separately.
If the entity supplies the awards itself, it shall recognise the consideration allocated to
award credits as revenue when award credits are redeemed and it fulfils its obligations to
supply awards. The amount of revenue recognised is based on the number of award
credits that have been redeemed in exchange for awards, relative to the total number
expected to be redeemed.
If a third party supplies the awards, the entity assesses whether it is collecting the
consideration allocated to the award credits on its own account (i.e. as the principal in the
transaction) or on behalf of the third party (i.e. as an agent for the third party).
If the entity is collecting the consideration on behalf of the third party, it measures its
revenue as the net amount retained on its own account, i.e. the difference between the
consideration allocated to the award credits and the amount payable to the third party for
supplying the awards; and recognises this net amount as revenue when the third party
becomes obliged to supply the awards and entitled to receive consideration for doing so.
If the entity is collecting the consideration on its own account, it measures its revenue as
the gross consideration allocated to the award credits and recognises the revenue when it
fulfils its obligations in respect of the awards.
13.11 GOVERNMENT GRANTS
Government grants or other types of government assistance are usually provided to
enterprises to encourage certain types of activities. Perhaps in the absence of government
grants, enterprises would not have undertaken such activities.
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13.11.1 Accounting Principles
No government grant should be recognised until there is a reasonable assurance that: (a)
the enterprise will comply with the conditions attached to them; and (b) the grants will be
received.
Government grants should be recognised in profit or loss on a systematic basis over the
periods in which the entity recognises as expenses the related costs for which the grants
are intended to compensate.
13.11.2 Application of Accounting Principles
Grants related to specific expenses
In most cases the periods over which an entity recognises the costs or expenses related to
a government grant are readily ascertainable. Thus grants in recognition of specific
expenses are recognised in profit or loss in the same period as the relevant expenses.
Grants related to depreciable assets
Grants related to depreciable assets are usually recognised in profit or loss over the
periods and in the proportions in which depreciation expense on those assets is
recognised.
Grants related to non-depreciable assets
Grants related to non-depreciable assets may also require the fulfilment of certain
obligations and would then be recognised in profit or loss over the periods that bear the
cost of meeting the obligations. As an example, a grant of land may be conditional upon
the erection of a building on the site and it may be appropriate to recognise the grant in
profit or loss over the life of the building.
Grants for immediate financial assistance
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In some circumstances, a government grant may be awarded for the purpose of giving
immediate financial support to an entity rather than as an incentive to undertake specific
expenditures. Such grants may be confined to a particular entity and may not be available
to a whole class of beneficiaries. These circumstances may warrant recognising a grant in
profit or loss of the period in which the entity qualifies to receive it, with disclosure to
ensure that its effect is clearly understood.
A government grant may become receivable by an entity as compensation for expenses or
losses incurred in a previous period. Such a grant is recognised in profit or loss of the
period in which it becomes receivable, with disclosure to ensure that its effect is clearly
understood.
Non-monetary grants
Non-monetary grants should be recognised at fair value. For example, if an asset, such as
land, is received free of cost from the government towards a government grant, both the
grant and the asset are recognised at the fair value of the asset. Alternatively, both the
grant and the asset are recognised at a nominal amount.
There are two alternative acceptable methods for presentation of grants related to assets.
Under the first method, the government grant is recognised as deferred income. The
deferred income is recognised as income over the period and in the proportion in which
depreciation on the asset is charged. Under the second method, the government grant is
deducted in arriving at the carrying amount of the asset. The net carrying amount is
allocated over the useful life of the asset by way of depreciation.
Repayment of grants
A government grant becomes repayable due to non-compliance of stipulated conditions
or due to disbursement of excess grant by mistake. A government grant that becomes
repayable should be accounted for as a revision to an accounting estimate. Repayment of
a grant related to income should first be adjusted against the unamortized balance of
deferred income set up against the grant. The balance amount, that is, the excess of
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amount repayable over the unamortized balance of the related deferred income, should
immediately be recognised as an expense in the profit and loss account. Repayment of
grant related to an asset, should be recorded by increasing the carrying amount of the
asset, or by reducing the deferred income balance by the amount repayable. The
cumulative additional depreciation that would have been recognised to date as an expense
in the absence of the grant should be recognised immediately as an expense.
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