Chapter 6 - Revenue and inventories Flashcards
What international accounting standards are we concerned with in this chapter?
- IFRS15 - Revenue from Contracts with Customers
- IAS2 - Inventories
Briefly outline what IFRS15 establishes
IFRS 15 establishes the principles for recognizing revenue from contracts with customers. It aims to provide a consistent framework to ensure that revenue is recognized in a way that reflects the transfer of goods or services and the related performance obligations.
Under IFRS15, what model is used to determine when revenue is to be recognised? Briefly explain its use
The 5-Step Revenue Recognition Model. This model ensures that revenue is recognized in line with the transfer of goods or services to customers and reflects the amount the entity expects to be entitled to.
Outline and explain the 5-step model establised in IFRS15
Under IFRS15 you must follow each step of the 5-step model to determine how revenue should be recognised:
- Identify the Contract(s) with a Customer: A contract must be approved by all parties, enforceable, and clearly define the rights and obligations of both the entity and the customer.
- Identify the Performance Obligations: Determine the distinct goods or services in the contract. A performance obligation is a promise to deliver goods, services, or a bundle of them to the customer.
- Determine the Transaction Price: This is the amount of consideration the entity expects to be entitled to in exchange for fulfilling its performance obligations. It may include fixed amounts, variable consideration (e.g., bonuses, discounts), and the effect of significant financing components.
- Allocate the Transaction Price to the Performance Obligations: If there are multiple performance obligations, the transaction price must be allocated to each one based on their relative stand-alone selling prices.
- Recognize Revenue as Performance Obligations Are Satisfied: a performance obligation is
satisfied when control of the goods or services has transferred to the customer. This can happen: at a point in time (typically the transfer of goods) or over a period of time (typically for services rendered)
Under IFRS15, how do you account for receiving consideration before a performance obligation is fulfilled?
Under IFRS 15, when consideration (payment) is received from a customer before the performance obligation is fulfilled, the entity cannot recognize it as revenue. Instead, the payment must be recorded as a deferred income liability
Outline the journal entries to account for consideration received before a performance obligation is fulfilled and then when it is
Under IFRS15, how do you account for offers a period of “interest free” credit (deferred consideration)?
Under IFRS 15 when a company offers a period of “interest-free” credit (also known as deferred consideration), this creates a significant financing you have to account for the financing effect separately. This is done by adjusting the transaction price to reflect the time value of money.
Outline the method to account for deferred consideration
- Calculate the present value of the future receipt at the end of the credit period: Discount the future payment (future receipt less any deposit or initial payment ) amount to its present value using a relevant discount rate (usually the prevailing market interest rate for similar credit arrangements).
- Then recognize the revenue: Recognize the present value of the deferred consideration as revenue plus any deposit or initial payment made when the performance obligation is satisfied (e.g., when the product is delivered) by debiting receivables (and bank for any deposit received) and crediting revenue in the P&L.
- Recognize Interest Income Over Time: As the deferred payment period progresses, recognize the unwinding of the discount (the financing component) as interest income in the income statement, using the effective interest rate method - debit receivables the receivables balance multiplied by the discount rate and credit finance income in the P&L
At the end of the credit period the receivables balance should equal the amount owed in full by the customer
Under IFRS15, how do you account for goods and services provided in one contract?
If an entity sells goods and services together as a package, the total transaction price will need to be “unbundled” and allocated to the separate performance obligations - split out the revenue to recognise the individual performance obligations, if some are yet to be met these will need to be recognised as deferred income liabilities
If the total of the fair value of the individual goods and services exceeds the overall price of the package, because a discount has been offered, the discount will be split between the two elements in proportion to the fair values.
What distinction is made under IFRS15 regarding warranties and separate performance obligations?
Warranties which provide a distinct service (such as free repairs over a specified period) and able to be purchased seperately are treated as a separate performance obligations.
Warranties that simply provide assurance that product is manufactured to a certain standard is dealt with as a warranty provision under IAS37 - warranties built into the terms of purchase of the item
Under IFRS15, how do you account for revenue generated for performance obligations satisfied over a period of time?
IFRS15 establises that if an entity undertakes a performance obligation that is to be satisfied over a period of time it must recognise revenue by measuring progress towards completion. This may be using the output (sales value) method or the input (costs incurred) method.
Under IFRS15, what is the criteria for a performance obligation satisfied over a period of time?
A performance obligation satisfied over time will meet one of the following criteria:
* The customer simultaneously receives and consumes the benefits as the performance obligation is satisfied, such as a cleaning contract.
* The entity’s performance creates or enhances an asset that the customer controls as the asset is
created or enhanced, such as construction contracts.
* 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 the performance completed to date, such as the development of a website
Briefly describe the output (sales value) method used to recognise revenue generated for performance obligations satisfied over a period of time
It measures progress based on the value of goods or services transferred to the customer.
For example, if a construction company has completed 2 out of 10 floors of a building, it would recognize 20% of the total revenue
Briefly describe the input (costs incurred) method used to recognise revenue generated for performance obligations satisfied over a period of time
This method measures progress based on the entity’s efforts or inputs to the satisfaction of the performance obligation.
For example, if a company has incurred 30% of the total estimated costs for a project, it would recognize 30% of the total revenue.
When should an entity use the output method versus the input method for revenue recognition, and vice versa, under IFRS 15?
If the outcome can be estimated reliably, the output (sales value) method can be used
If the outcome cannot be estimated reliably, such as in the early stages of a contract, the input (costs incurred) method can be used
Under IFRS15, how do you account for consideration towards performance obligations satisfied over a period of time? Include journal entries
Contract Asset: If an entity has performed its obligations under a contract (i.e., delivered goods or services), but has not yet received payment and does not have an unconditional right to payment at that point and therefore not billed for it (i.e. payment is tied to a future milestone such as upon project completion) then the revenue recognised will appear as a contract asset on the SOFP. Once payment is received this will be netted off against this asset.
Receivable: If an entity has performed its obligations under a contract (i.e., delivered goods or services), but has not yet received payment but does have an unconditional right to payment at that point and therefore has billed for it, then the revenue recognised will appear as a receivable on the SOFP. Once payment is received this will be netted off against this asset.
Contract liability: If an entity has not performed its obligations under a contract (i.e., delivered goods or services), but has received payment, then this payment will be recognised as a liability on the SOFP. As the performace obligation is fulfilled, revenue will be recognised accordingly and will be netted off against this liability.
What specific examples of types of sales will we consider in this chapter?
- Consignment sales
- Bill and hold arrangements
- Repurchase agreement
- Subscriptions to publications
- Servicing fees
- Licensing
- Agent v principal
What is a consignment sale? According to IFRS15, how do you account for consignment sales regarding revenue recognition?
A consignment sale is an arrangement in which a seller (referred to as the consignor) delivers goods to another party (the consignee) to sell on their behalf. The consignor retains ownership of the goods until the consignee sells them to an end customer. The consignee acts as an intermediary and typically earns a fee or commission for their role.
In this arrangement:
* The consignor remains the owner of the inventory until it is sold to the end customer.
* The consignee does not recognize the inventory on their books but acts as an agent in the transaction.
Under IFRS 15 revenue is recognized when the performance obligation is satisfied, i.e., when control of goods or services is transferred to the customer. In consignment sales, control does not transfer to the consignee when the goods are delivered to them. Therefore, revenue is recognized by the consignor only when control of the goods transfers to the end customer.
What is a bill and hold arrangement? According to IFRS15, how do you account for bill and hold arrangements regarding revenue recognition?
A bill-and-hold arrangement is a sales agreement where the seller bills the customer for goods but retains physical possession of the goods until a later date, often due to the customer’s request. This may happen when the customer cannot take immediate delivery due to storage limitations, production schedules, or other reasons.
IFRS 15 specifies that revenue can be recognized in a bill-and-hold arrangement only if control of the goods has transferred to the customer, even though the seller retains physical possession. IFRS 15 outlines several criteria that must be met for revenue to be recognized under a bill-and-hold arrangement:
- Substantive Reason for the Arrangement:
The customer must have a genuine reason for requesting the bill-and-hold arrangement, such as a lack of storage space or delayed production schedules. - Goods Identified and Separately Stored:
The goods must be specifically identified, physically separated from the seller’s inventory, and designated as belonging to the customer. - Transfer of Control to the Customer: The customer must have control of the goods, which may be evidenced by legal title or ownership rights,
- Risks and rewards of ownership being passed to the customer: The customer having the right to decide when the goods are shipped.
- The Goods are Ready for Immediate Transfer: The goods must be complete and ready for delivery to the customer at the time of billing, meaning no further processing or manufacturing is required.
If these criteria are met then the seller can recognise the revenue
What is a repurchase agreement? According to IFRS15, how do you account for repurchase agreements regarding revenue recognition? Outline the relevant journal entries
A repurchase agreement is a contractual arrangement where an entity sells a good (or asset) to a customer but retains an obligation or right to repurchase the same good at a future date. Essentially, it is a financing arrangement disguised as a sale, where the seller temporarily transfers an asset but plans to buy it back later.
IFRS 15 establishes that if the seller has a substantive repurchase obligation or right, control of the asset has not transferred, and revenue should not be recognized as a sale. Instead, it may be accounted for as a financing arrangement or lease.
What is a subscription to publications? According to IFRS15, how do you account for subscription to publications regarding revenue recognition? Outline the relevant journal entries
A subscription to publications is a contractual arrangement where a customer pays for access to content, typically magazines, newspapers, journals, or digital content, over a defined period.
IFRS15 states, revenue is recognized over time, as the entity fulfills its obligation by delivering each issue or by providing continuous access. If the publications are of similar value revenue should be recognised on a straight line basis over the period the publications are despatched. Where the value varies, revenue should be recognised in relation to estimated sales values of publications despatched.
What are servicing fees? According to IFRS15, how do you account for servicing fees regarding revenue recognition?
Servicing fees are payments made to an entity for providing ongoing services to a customer, typically after an initial sale of a product or asset.
IFRS15 states, revenue is recognized over time, as the entity fulfills its obligation therefore revenue in relation to that servicing should be deferred and recognised over the service period.
What is licensing? According to IFRS15, how do you account for licensing regarding revenue recognition?
Licensing refers to granting a customer the right to use intellectual property (IP), such as trademarks, copyrights, patents, software, media content, or franchises. Licensing agreements allow the customer to benefit from the licensor’s IP in exchange for a fee (fixed, variable, or both).
IFRS 15 requires that entities assess whether the license transfers a right that is satisfied at a point in time or over time, based on the nature of the license.
Right to Use the IP (Point-in-Time Recognition):
* If the license grants the customer the right to use the IP as it exists at the point the license is granted, without significant ongoing involvement by the licensor, revenue is recognized at a point in time (typically when the license is transferred). - revenue recognised upon receipt
Right to Access the IP (Over-Time Recognition)
* If the license grants the customer the right to access the IP as it evolves over the license period, and the licensor continues to update or maintain the IP, revenue is recognized over time - revenue deferred and recognised over the licensing period.
Under IFRS15, how do you account for an entity acting as an agent rather than a principal and vice versa? Why is this distinction important? Outline relevant journals
Under IFRS 15 , an entity must determine whether it is acting as a principal or an agent in a transaction. This distinction is crucial because it affects how and when revenue is recognized and how much revenue is reported.
An entity is a principal if it controls the goods or services before they are transferred to the customer. The principal is primarily responsible for fulfilling the contract and recognizes revenue as the gross amount of consideration received from the customer - revenue is recognized based on the total sales price.
An entity is an agent if it just arranges for goods or services to be provided by another party. The agent typically earns a fee or commission for facilitating the transaction and recognizes revenue as the net amount of consideration - revenue is recognized based on the agent’s portion (e.g., commission).
With regards to IFRS15, what is meant by ‘substance over form’?
Substance over form is a key accounting principle that emphasizes the economic reality of a transaction rather than its mere legal form. Under IFRS 15 – Revenue from Contracts with Customers, this principle plays a critical role in revenue recognition, requiring entities to look beyond the legal terms of a contract and assess the actual performance obligations and the true nature of the transaction.
In simpler terms, it means that revenue should be recognized based on what is really happening in the transaction, not just based on how the contract is worded.
Briefly outline what IAS2 establishes
IAS 2 – Inventories establishes the accounting treatment for inventories. It outlines how to measure, value, and report inventories in financial statements
According to IAS2, what is the definition of inventory?
Assets that are held for sale in the ordinary course of business, in the process of production for such sale, or in the form of materials or supplies to be consumed in the production process or the provision of services
Inventories can include:
* Goods purchased and held for resale
* Finished goods
* Work in progress being produced
* Raw materials awaiting use
According to IAS2, how should the value of inventory be measured?
Under IAS 2, the value of inventory should be measured at the lower of cost and net realizable value (NRV)
According to IAS2, how should the cost of inventory items be initially measured?
The cost directly attributable to bringing the item to its present location and condition.
According to IAS2, what expenditure related to the purchase of inventory items can be included in the initial measurement of its value?
Any costs attributable to bringing the asset to its present location and condition, i.e.:
* Purchase price – Including import duties, non-refundable taxes, and after deducting any trade discounts.
* Delivery and handling costs – Expenses related to transporting the asset to its location.
* Conversion costs – Fixed and variable production overheads incurred in converting materials to finished goods.
* Other costs – Such as design costs for a specific customer.
According to IAS2, what are the allowed methods of inventory valuation? Which is not allowed?
✅ Allowed methods:
* FIFO (First-In, First-Out)
* Weighted Average Cost
❌ Not allowed:
* LIFO (Last-In, First-Out) – prohibited under IAS 2
Outline the method for calculating inventory value using FIFO
METHOD
Outline the method for calculating inventory value using weighted average costing
METHOD
According to IAS2, how is Net Realisable Value (NRV) measured?
Net Realisable Value (NRV) is the estimated selling price of inventory in the ordinary course of business, less:
* Estimated costs of completion, and
* Estimated costs necessary to make the sale (e.g., selling or distribution costs).
NRV = EstimatedSellingPrice − CoststoComplete − SellingCosts
Why might cost NRV fall below cost?
NRV may drop below cost due to the following reasons:
* Decline in Selling Prices: Market prices may fall due to economic downturns, oversupply, or increased competition, reducing the amount the inventory can be sold for.
* Obsolescence or Slow-Moving Inventory: Products may become outdated due to newer models or technology, or may be slow to sell, making them less valuable.
* Physical Damage or Deterioration: Items that are broken, expired, or otherwise damaged cannot be sold at full price, reducing their net value.
* Changes in Consumer Demand: Shifts in trends or preferences can make certain products undesirable, lowering expected sale prices.
* Increased Costs to Complete or Sell If costs to finish production or distribute goods rise significantly, they may eat into the selling margin, reducing NRV.
According to IAS2, when NRV falls below cost, how should this be recognised?
Where NRV falls below cost the inventory is written down to its recoverable amount and the fall in value is charged to profit or loss.
If the write-down is of such size, incidence or nature it may need to be disclosed separately
CONTEMPORARY BUSINESS MODELS
Outline the key differences between UK GAAP and IFRS for the following aspects:
* Revenue recognition
* Inventories
