When a sale is more than revenue!

There are many things to keep in mind when accounting for revenue. In fact, because the nature of sales contracts can vary greatly from company to company, IFRS 15 Revenue from contracts from customers clarifies the accounting treatment for sales transactions in its 5-step model.

The 5-step model ensures that revenue gets recognised at an amount and at a time that faithfully reflects the sales contract. As one article could not possibly address all aspects of the model, I am going to look at one specific area.

More than credit

I will help you understand how revenue is accounted for where the contract contains a significant financing component. What do I mean by ‘a significant financing component’? Well, we should appreciate that virtually all sales these days are made on credit; it is normal for suppliers to provide very short-term finance to their customers in the form of credit. Normal credit terms may be 30, 60 or even 90 days, depending on industry norms.

If, however, the seller offers the buyer a longer credit period than is customary, say for example 12 or 24 months, it is clear that the seller is providing more than just standard credit – the seller is providing finance to the buyer and it must be accounted for as such. The seller is essentially allowing its customer a loan.

Therefore, by committing to the sales contract the seller is promising to deliver two things: the good or service itself and the loan. The income from delivering the good or service is classified as revenue, and the income earned from the provision of finance must be classified as finance income. This is consistent with the Conceptual Framework’s requirement that items in the financial statements must be classified in a way that faithfully represents the nature of those items – this is fundamental to the financial statements being useful to people who rely on them.

An example

Today, Sales Co sells and delivers a sofa to Buy Co for $2,000, with two years’ interest-free credit. Interest rates are 5%. It can be seen that although delivery of the sofa takes place today, because there is a significant financing component, the sofa is not the only thing being sold. Sales Co is promising to deliver two things: the sofa and a two-year loan. Even though the deal is marketed as being interestfree, accountants look beyond the surface and determine that there is in fact interest inherent in this arrangement.

Accounting treatment

According to IFRS 15’s 5-step model, the number of separate performance obligations (promises by the seller) should first be identified and a price be allocated to each performance obligation. The income generated from each ‘promise’ should be recognised as or when that promise is satisfied by the seller.

The first promise or performance obligation is the delivery of the sofa. The fair value of the sofa at the date of sale is equal to the present value of the amount receivable from the customer for the sofa in two years’ time. This amount will exclude any interest and equates to $1,814 (i.e. $2,000 x (1/1.052). Because the delivery of the sofa takes place at a point in time, the revenue from the sale of the sofa ($1,814) must get recognised in full at that date, the date of delivery, with a corresponding trade receivable being created:

The numbers

As mentioned above, a trade receivable (a financial asset) of $1,814 is recognised at the date of sale, and over two years this receivable, being measured at amortised cost, will grow to $2,000 as follows:

The remaining $186 (that is $2,000 – 1,814) is the interest income that is going to be earned by Seller Co over the two years it will provide finance to its customer. In other words, $186 is allocated to the performance obligation of selling finance. While the income from the sale of the sofa is classified as revenue, the income from providing finance is classified as finance income.

While the performance obligation to deliver the sofa was satisfied at a point in time (on delivery), the performance obligation to provide two years’ finance will be satisfied over time (over two years). The financial reporting implication of this is that revenue and finance income are not only presented separately on the statement of profit or loss, but they are also recognised at different times – so profit includes a faithful representation of the income generated by a company in a given year. While the revenue from the sale of the sofa gets recognised at the delivery date, the finance income earned from providing the loan to the customer will be recognised over two years.

The finance income recognised in profit or loss in the first year after the sale of the sofa is $91:

Dr Trade Receivables 91

Cr Finance Income 91

(Revenue of $1,814 is also recognised in Year 1).

In the second year, $95 is recognised in profit or loss for interest earned from the contract:

Dr Trade Receivables 95

Cr Finance Income 95

This means that by the end of the two-year period, the full interest income of $186 will have been recognised in profit by the seller and there will be an amount in Trade Receivables equal to the amount the seller must pay the buyer ($2,000).

• Sarah Ardiles is an ACCA FR online lecturer with FME Learn Online – see www.sarahardiles.com