CIMA Sri Lanka study group: LKAS 18 - revenue

Accounting standard study group CIMA Sri Lanka Division Study of LKAS 18: Revenue 1. Overview An increase in economic benefit during an accounting period is known as ‘income’. Income is of two types: revenue: income that is generated through the ordinary course of business in the form of sales, interest, royalties, fees, dividends etc. gains: profit on sale of investments, revaluation gains on assets and gains from currency exchange transactions etc.

LKAS 18 applies to the ‘revenue’ type of ‘income’ At the outset, LKAS 18 seems easy to understand and apply. Yet, given the intense competitiveness in the business world, products and services are priced with numerous underlying conditions to stay ahead of competition. Therefore, accounting for revenue is no longer simple and straightforward as it used to be a decade ago. Many revenue transactions cannot be evaluated at their face value. Knowing when and how to account for revenue is of paramount importance to ensure that the company’s financial statements are aligned to the regulatory framework and the stakeholders get a true, fair and consistent view of the performance of the company.

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The following transactions seem ordinary, but is accounting for them simple?

A hotel sells four consecutive nights with one additional free night on your next trip.

A manufacturing company sells stocks to a buyer on condition that he can pay once they are resold.

Sale on approval (guaranteed money back if not satisfied with the product) A mobile service provider gives the handset free on the condition of meeting a specified minimum monthly usage with a fixed rental.

A company sells free products on loyalty points.

Sale of gift vouchers.

Condominium property sales.

Sale of products with repayment terms at zero percent interest rate.

Incentive income (e.g. management fees).

Contract manufacturing (e.g. farmers producing for multinationals who are part financed by the multinationals themselves).

Ticket sales and packaged tour sales by agents in the airline industry.

We have addressed some of the above in the latter part of the report when evaluating the management accounting implications.

Management accountants who are often involved in costing, pricing and strategising should have a thorough knowledge of the regulatory framework surrounding recognition of revenue. Their decisions should ultimately enable the company to duly recognise the revenue as income. In the absence of such knowledge, the management accountant may take decisions that may not necessarily contribute positively to the bottom-line in real terms. As such, the application of this standard is not only for financial accounting purposes. It impacts management accounting practices such as budgeting, pricing, timing of cash flows, control processes and the application of information technology.

1.1 The objective of the revenue standard The objective of the revenue standard (hereinafter referred to as the ‘standard’) is to prescribe the accounting treatment of revenue arising from certain types of transactions and events. It questions the substance underlying the transaction prior to recognition and specifically addresses the following areas: when to recognise revenue: when it is probable that future economic benefit will flow to the organisation (collectability) and when these benefits can be measured reliably circumstances in which this criteria will be met and practical guidance on how to apply these criteria.

1.2 In scope The standard applies to revenue arising from: sale of goods (includes produced stock for sale, merchandise purchased for resale and land and other property held for resale) rendering of services (includes time bound contractually agreed services) usage of entity assets to derive interest, royalties and dividends.

1.3 Out of scope Revenue arising from construction contracts.

Lease agreements.

Insurance contracts.

Income by way of dividends from investments accounted under the equity method.

Gains due to changes in fair value of current assets.

Financial assets/liabilities.

Initial recognition of agricultural produce and biological assets.

Extraction of mineral ores.

1.4 Key definitions Revenue Revenue is the gross inflow of economic benefit during the period arising in the course of the ordinary activities of an entity when such inflows result in increases in equity, other than increases relating to contribution from equity participants.

Fair value Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable and willing parties in an arm’s length transaction.

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1.5 Effective date This standard becomes effective for financial statements covering periods beginning on or after the 1 January 2012.

2. Initial recognition Revenue should be measured at the fair value of consideration either received or receivable. In doing so, trade discounts and volume rebates should be considered. In a situation where the settlement is deferred (e.g. interest free credit, credit terms with interest below market etc.) the fair value is determined by discounting all future receipts using an imputed rate of return. The difference between the fair value and the nominal amount of the consideration is treated as interest income in accordance with LKAS 39.

If goods or services are exchanged, it is accounted based on the value of the goods or services given up, adjusted by the amount of any cash equivalent transferred.

2.1 Sale of goods 2.1.1 Revenue recognition criteria: transfer of significant risks and rewards to the buyer entity retains neither the managerial involvement nor effective control over the goods sold amount of revenue can be reliably measured inflow of economic benefit from the transaction to the entity costs incurred or to be incurred in respect of the transaction can be reliably measured.

2.1.2 An ‘incomplete sale’ is where the entity retains significant risks and rewards of ownership.

As such, revenue cannot be recognised when: there is a retention of an obligation for unsatisfactory performance (outside normal warranty) receipt of revenue is dependent on resale by the buyer goods shipped are subject to an installation and the installation forms a major part of the contract the buyer retains the right to rescind (revoke) the purchase by contract.

2.2 Rendering of service Revenue is recognised by reference to the stage of completion (percentage completion method) of the transaction. Other criteria are similar to revenue recognition of sale of goods. Examples of service based revenue recognition include the following.

Service

Revenue

Installation

Service fee

After sales service

Servicing fees, product enhancements etc Media commissions Fees that are an integral part of the effective interest rate

Advertising Financial services

Financial services

Fees earned for services provided

Financial services

Fees earned on execution of a significant act

Timing of recognition Either reference to stage of completion, or If incidental to the sale of a product at the time of sale of the product Revenue is deferred and recognised over the period of the service When the commercial appears before the public Adjusted effective interest rate and recognised as such, e.g.

Customer credit status evaluation, collateral arrangements, documentation, etc Commitment fees to originate a loan (when it is outside the scope of LKAS39) Origination fees received on issuing financial liabilities measured at amortised cost Loan servicing fees Commitment fees to originate a loan (when it is outside the scope of LKAS 39) Investment management fees Commission on allotment of shares to a client Placement fees for arranging a loan between a borrower and an investor Loan syndication fees

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Admission fees

Tuition fees Initiation, entrance and membership fees Franchise fees Development of customised software

Revenue from artistic performances, banquets, special events, etc Fees Fees

When the event takes place

Fees

Recognised as revenue on a basis that reflects the purpose for which the fees were charged.

Revenue is recognised by reference to the stage of completion of the development

Fees

Over the period of instruction If it entails provision of services or publications during the membership period, revenue is recognised on a basis that reflects the timing, nature and value of the benefits provided

2.3 Recognition of interest, royalties and dividend interest Interest: using the effective interest method.

Royalties: on an accrual basis.

Dividends: when the shareholder’s right to receive payment is established.

Fees and royalties for an entity’s assets (trademarks, patents, software, music copyright, record masters and motion pictures) are recognised in accordance with the substance of the agreement. This may be on a straight-line basis, over the term of the agreement, or at the time of sale, if the licensor has no control over the distribution and cannot expect further revenue from usage by the buyer. If the license or the royalty is contingent on a future occurrence, revenue is recognised at the time of such contingent occurrence.

In general, if collectability of revenue is doubtful, the uncollectible amount is recognised as an expense, rather than as an adjustment of the amount of revenue originally recognised.

3. Measurement Revenue should be measured at the fair value of the consideration received or receivable.

4. Impact on management accounting 4.1 Impact on costing and calculation of margins (contribution and profit) This standard impacts pricing.

Actual against planned margin: disconnect between what a management accountant will plan in the forecast P&L and how the financial accountant will account in compliance to the revenue standard. The, matching process will take place only at a quarter end or a year end.

Projects that seem viable and feasible from the perspective of the management accountant might actually not generate the required/expected return when accounted according to LKAS 18.

Illustration 1 In the hospitality industry it is very common to offer complimentary stays. For example, a hotel sells four nights with an additional complimentary stay upon the guest’s next arrival. Provided the guest takes the offer, the hotel incurs costs for five nights though it receives actual payment only for four nights. Therefore, under the LKAS 18 the hotel has to apportion the revenue of four nights across five nights and account for the initial four nights deferring the revenue for one night (complimentary night) to be recognised as and when it is taken.

Similarly, if the guest claims his additional night after the accounting period; the revenue and costs reflected in the financial statements depicting the performance of the hotel will be higher than it actually is.

4.2 Impact on risk management Risk is the probability of the actual outcome deviating from the planned outcome. Risk can stem from various activities of the business one of which includes the generation and collection of revenue. Illustration 2 outlines how LKAS 18 deals with risks associated with the revenue of a business.

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Illustration 2 Contingent risk In some businesses it is common to provide a ‘money back guarantee’ as a selling proposition. For example, AB Ltd. (AB) retailing electrical equipment sells on the condition that unsatisfied customers can return the product within 7 days with a cash back guarantee. If AB sells a washing machine today, can it actually recognise the revenue immediately as a sale when there is a risk that the customer may return the washing machine within seven days? The answer is ‘No’. LKAS 18 requires AB to account for the revenue as differed income and only take into the P&L (through the sales account) after the lapse of 7 days provided it is not returned.

Default risk From a revenue collection perspective the standard requires companies to account for default risks in a more prudent manner. In other words, companies are now required to assess credit risk of revenue receipts and account for ‘potential’ loss in the P&L if the credit period exceeds the normal credit terms or the customer has a previous record of defaulting a certain percentage of credit facility utilised.

4.3 Impact on corporate strategy Corporate strategy may influence the revenue and its very recognition.

Pricing strategy: review pricing decisions, to ensure that the price fetched by its goods or services does not contravene the ‘fair value’ concept.

Sales promotion strategies: required to ensure expected revenue is after considering rebates/discounts granted by the entity as per the standard.

Debt collection policy: revise policy to remove any uncertainties in the flow of economic benefits of the transactions flowing into the entity. Discount the receivables if it goes beyond the normal credit terms of the company etc.

Improve the information technology strategy to ensure high quality data is available to clearly determine that the management of the entity has: - no ownership of the goods post sale - made the sale adhering to arms length principle and fair value concept, and - transferred all risks and rewards to the buyer.

4.4 Impact on inventory Quality of management information pertaining to inventory is impacted by the recognition point at which revenue is accounted.

Illustration 3 Company B is in the merchandising business and recognises revenue when items are billed, but before goods are delivered to the buyers. However, under the sales agreement the onus of the seller includes, among other things, the delivery of the merchandise to the buyer’s premises.

The policy of company B does not comply with the first revenue recognition criterion of the standard stated above (section 2.1.1).As such, the closing inventory will not include items which have been billed, but not yet delivered to the buyers, giving an incorrect inventory value for management accounting decision-making and also recognise revenue which ideally should not yet have been recognised. The following areas of management accounting may also get affected in addition to the closing inventory value: cost of goods sold gross profit margin inventory turnover ratio inventory holding period.

4.5 Impact on the budgeting process Since revenue recognition criteria are specific, it is essential that an entity has an effective internal financial budgeting and reporting system where estimates can be easily revised when required. Processes need to be in place to measure the amount of work/services performed and proportion of expenses relating to work/services performed to date. In the budgeting process estimates need to be reliable if targets are to be achieved as planned. The challenge is to align progress payments and advances received from customers with the services performed.

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4.6 Impact on performance management Total annual revenue is a factor commonly used to judge a company’s performance and some companies use target revenue as a key input in calculating employee benefits. Therefore, the method in which revenue is recognised is vital for both the organisation and the employees. (e.g.Sales force targets and compensation to be aligned in such a manner that there is a direct link between what is achieved and what is reflected in the financial statements. The failure to align as such could lead to dysfunctional behaviour).

5. Way forward The International Accounting Standard Board is looking at issuing a fresh standard for revenue recognition possibly in 2011 with an applicable date no earlier than 2014. The exposure draft of this was already issued in June 2010 with the commenting period ending in October 2010. The key change this brings is the recognition of revenue based solely on the transfer of goods and services.

6. Conclusion Revenue recognition deals with the top-line while much of management accounting focus is on the bottom-line, which is ultimately what the shareholders would seek to improve. This standard however, is of particular importance to a management accountant from a budgeting and planning perspective to ensure effective resource allocation, avoid dysfunctional behaviour and build predictable and consistent bottom line growth.

Disclaimer This document is compiled with the objective of presenting a basic overview of the respective Sri Lanka accounting standard, and does not construe professional advice in the application of the standard. For specific application and understanding of all facets of the standard, the relevant Sri Lanka Accounting Standard issued by The Institute of Chartered Accountants of Sri Lanka should be referred.

References and useful web-links pertaining to accounting standards http://www.cimaglobal.com/Thought-leadership/Research-topics/Financial-reporting/CIMA-Sri-Lanka-accounting-standardstudy-group/ http://www.iasplus.com/standard/ias18.htm http://www.icasrilanka.com/Technical/Accounting%20Standards.html?bcsi_scan_ECD903E68216D30C=0&bcsi_scan_filena me=Accounting%20Standards.html http://www.pwc.co.uk/eng/publications/practical_guide_to_ifrs.html http://www.ey.com/AU/en/Issues/IFRS/Revenue-recognition-project-appendices-June-09

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Compiled by the ‘team two’ members of the accounting standard study group Manil Jayesinghe, Partner, Ernst and Young (Chairman of the accounting standard study group) R. Sherin Cader, Financial Controller, John Keells Holdings (team leader) Sarah Afker, Assistant Manager- KPMG Ford Rhodes, Thornton & Co. Nilushika Gunasekera, Regional Technical Manager, CIMA Kandeepan Kumarasamy, Finance Manager, Central Finance Company Sharika Mubarak, Assistant Accountant, Royal Palms Beach Hotels PLC

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