TIP: For those writing the Canadian CPA board exams (CFE exams), Revenue recognition is an extremely important topic and is always found on the exam.
Revenue is found on the Statement of Profit and Loss (IFRS). Revenues are income that arise from ordinary activities such as: sales, fees, interest, and royalties.
An excerpt from the Statement of Profit and Loss, below, shows where and how Revenue is presented.
Operating Revenue includes Revenues that are brought in from regular operating activities. Other Revenue includes Revenues that are brought into the entity by means other than regular operations. For example, entities may earn Revenues through interest earnings, leasing extra office space, etc.. As long as these earnings are not part of their regular business operations, they will be considered Other Revenue. Revenue and Other Revenue are treated the same for accounting purposes. The difference is simply a matter of labeling. For the purposes of this post, I am using the term "Revenue" to refer to both Revenue and Other Revenue - they are interchangeable.
Revenue recognition can be a lengthy process. In general, there are three steps associated with Revenue recognition.
Determine whether or not the transaction should be considered Revenue. In some cases a transaction should be considered a Gain, and not Revenue. It is therefore important to first establish whether the transaction is considered Revenue.
Determine when the Revenue should be recognized.
Finally - determine how much Revenue should be recognized.
TIP: When recognizing Revenue, it is often best to step through the paragraphs in the IFRS criteria one at a time, in the order in which they are presented, to ensure that you correctly apply each of the principles. If you are a Canadian (aspiring) CPA, these criteria can be found in your CPA Handbook -> IFRS Standards in Effect on January 01, 2019 -> IFRS 15, and do not need to be memorized. You can simply refer to (and cut and paste) them from your handbook. This post will review the steps in detail.
Should the transaction be considered revenue?
The IFRS 15 standard uses a contract-based approach for identifying Revenue.
In order to categorize a transaction as being Revenue, we must identify the contract and the performance obligation(s) associated with that contract.
Part 1: Identifying the contract
In order to be considered revenue, all of the following five criteria must be met under
IFRS 15, Paragraph 9:
“the parties to the contract have approved the contract (in writing, orally or in accordance with other customary business practices) and are committed to perform their respective obligations;” AND
“the entity can identify each party's rights regarding the goods or services to be transferred;”AND
“the entity can identify the payment terms for the goods or services to be transferred;” AND
“the contract has commercial substance (ie the risk, timing or amount of the entity's future cash flows is expected to change as a result of the contract);” AND
“it is probable that the entity will collect the consideration ”
IFRS 15, Paragraph 12:
This paragraph outlines that a contract is not considered to exist if any of the parties can cancel at any time without compensation.
“A contract is wholly unperformed if both of the following criteria are met:
the entity has not yet transferred any promised goods or services to the customer; AND
the entity has not yet received, and is not yet entitled to receive, any consideration in exchange for promised goods or services.”
IFRS 15, Paragraph 15:
The transaction may not have been considered a contract under paragraph 9 if not all of the criteria had been met. However, the transaction might still be considered revenue if one of the following two conditions are met:
“the entity has no remaining obligations to transfer goods or services to the customer and all, or substantially all, of the consideration promised by the customer has been received by the entity and is non-refundable; OR
the contract has been terminated and the consideration received from the customer is non-refundable”
Part 2: Identify the performance Obligation(s)
In order to be considered Revenue, we will also need to identify the performance obligations within the contract using IFRS 15, Paragraph 22:
The entity will need to identify, at the start of the contract, either:
“a good or service (or a bundle of goods or services) that is distinct; "To be “distinct”, the following two criteria must be met:
"the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (ie the good or service is capable of being distinct); and” (IFRS 15, Paragraph 27)
"the entity's promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (ie the promise to transfer the good or service is distinct within the context of the contract).” (IFRS 15, Paragraph 27)
“a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer.”
When should the transaction be recognized?
IFRS 15, Paragraph 31 outlines when Revenue should be recognized. Revenue can either be recognized at a specific point in time, or over the course of time.
IFRS 15, Paragraph 31 states: “An entity shall recognize revenue when (or as) the entity satisfies a performance obligation by transferring a promised good or service (i.e. an asset) to a customer. An asset is transferred when (or as) the customer obtains control of that asset.”
IFRS 15, Paragraph 35: Obligations that are satisfied over time
Revenue should be recognized over a period of time, if one of the following criteria is met:
“the customer simultaneously receives and consumes the benefits provided by the entity's performance as the entity performs; OR
the entity's performance creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced; OR
the entity's performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.”
IFRS 15, Paragraph 38: Obligations that are satisfied at one point in time
If none of the three criteria from Paragraph 35 are met, then the transaction should be recognized at one point in time. In order to determine at which point in time the Revenue is recognized, we must consider when the asset is considered to be “controlled” by the customer.
The asset is considered to be “controlled” by the customer when the customer:
Obtains substantially all of the benefits from the asset.
Benefits can include:
"using the asset to produce goods or provide services (including public services);
using the asset to enhance the value of other assets;
using the asset to settle liabilities or reduce expenses;
selling or exchanging the asset;
pledging the asset to secure a loan; and
holding the asset.” (IFRS 15, Paragraph 33)
The asset may also be considered controlled if the entity can prevent others from using and benefiting from the asset.
Additionally, we should consider the following aspects when considering transfer of control:
IFRS 15, Paragraph 38
“The entity has a present right to payment for the asset
The customer has legal title to the asset
The entity has transferred physical possession of the asset
The customer has the significant risks and rewards of ownership of the asset
The customer has accepted the asset”
How to measure the Revenue Recognized?
Under IFRS, there are two parts to measuring Revenue recognized. The first is to determine the amount, and the second is to determine how to apply the Revenue to the different performance obligations.
Part 1: Measuring Revenue recognized
IFRS 15, Paragraph 46 outlines how to measure the revenue recognized. The amount of revenue recognized is based on the transaction price, which is the amount received in exchange for the services. The revenue amount will exclude items such as sales-tax, and other considerations collected on behalf of third parties.
Other items that should be included in Revenues include:
IFRS 15, Paragraph 50
Variable considerations: If the contract includes an amount that is variable - for example, based on usage hours - we should estimate the amount of that variable component and add it to Revenue. This estimate should be based on either the expected value, or the most likely amount.
IFRS 15, Paragraph 60
Time-Value of money: Generally, if the time between offering the goods and services, and receiving payment is one or more years apart, then we should discount the Revenues based on time-value of money.
IFRS 15, Paragraph 66
Non-cash considerations: If the entity receives a non-cash consideration for the services, we will need to measure the revenues at Fair Value of what is received. If it is not possible to reasonably measure the fair value of what is received, then the revenue would be measured at the standard selling price for the good/service.
Part 2: Allocating Revenue Recognized
If the goods or services were recognized at one point in time, then Revenue does not need to be allocated. However, if the goods or services were recognized over time, then we turn to IFRS 15, Paragraph 73 to determine how to allocate the Revenue. This section states that the allocation of the Revenue should be done in a manner that accurately represents the separate selling price for each component.
IFRS 15, Paragraph 79 states that to estimate the stand-alone selling price for each component, the following methods of measurement can be used:
Adjusted market assessment approach — this price is based on the market value of each separate component.
Expected cost plus a margin approach — this price is based on the cost of producing the good or service, adjusted for an additional standard profit margin.
Residual approach — this method first allocates the prices to specific components for which standard market value has already been established, and then allocates the remaining amount to the components for which prices are more difficult to establish.
Allocating Discounts to Revenue
IFRS 15, Paragraph 81 states that if the bundled deliverables are sold at a discount, then that discount should be allocated proportionally among the different components.
However, if all of the following criteria are met, then we must allocate the discount to entirely one or more components:
“the entity regularly sells each distinct good or service (or each bundle of distinct goods or services) in the contract on a stand-alone basis; AND
the entity also regularly sells on a stand-alone basis a bundle (or bundles) of some of those distinct goods or services at a discount to the stand-alone selling prices of the goods or services in each bundle; AND
the discount attributable to each bundle of goods or services is substantially the same as the discount in the contract and an analysis of the goods or services in each bundle provides observable evidence of the performance obligation (or performance obligations) to which the entire discount in the contract belongs.” (IFRS 15, Paragraph 82)
This concludes our post on Revenue recognition. It is a long process, and so we have created a summary of steps which can be found below.
1. Demonstrate that the transaction meets the definition of Revenue:
Part 1: Identify the contract using IFRS 15, Paragraph 9
Part 2: Identify the performance obligations using IFRS 15, Paragraph 22
2. Explain when the transaction should be recognized:
Determine if the obligations are satisfied over time using IFRS 15, Paragraph 35; or if the obligations are satisfied at one point in time using IFRS 15, Paragraph 38.
3. Explain how to measure the Revenue recognized:
Part 1: Measure the amount of Revenue recognized using IFRS 15, Paragraph 46.
Part 2: Explain how to allocate the Revenue recognized if the goods are recognized over a period of time using IFRS 15, Paragraph 73, and 79.
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