Chapter 8 Revenue and inventories

Question 1

1.1 Revenue recognition

Answer 1

Revenue is defined as income arising in the course of an entity’s ordinary activities. Revenue results from the sale of goods, the rendering of services and the receipt of interest, royalties, and dividends. Ordinary activities means normal trading or operating activities.

Question 2

1.2 Core principle

Answer 2

The core principle of this Standard is that an entity shall recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

Question 3

1.3 Five step process for revenue recognition

Answer 3

• Identify the contract: a contract is an agreement between two parties that creates rights and obligations. You can only recognise revenue from a contract if parties have approve the contract and each party’s rights can be identified, if payment terms are identified, the contract has commercial substance, and it is probable that the selling entity will receive consideration
• Identify the separate performance obligation are promises to transfer distinct goods or services to a customer. Distinct means sold separately and has a function.
• Determine the transaction price: this is the consideration the selling entity is entitled to once it has fulfilled the performance obligations in the contract. The entity must have an estimate in place if the contract includes variable consideration (bonuses or penalties etc), the estimate is only included in the transaction price if it is highly probable that a significant reversal in the amount of revenue recognised will not occur when the uncertainty is resolved. Any non-cash consideration is measured at FV at the date of transfer, if FV cannot be determined the stand-alone selling price should be used
• Allocate the transaction price to the performance obligations: total transaction price should be allocated to each performance allocation in proportion to standalone selling prices. If a standalone selling price is not directly observable, then it must be estimated.
• Recognise revenue as or when a performance obligation is satisfied: revenue recognised when entity satisfies performance obligation by transferring a promised good or service. A contract the entity determines if performance is satisfied over time or at a point in time. If over time, revenue is spread otherwise the full revenue is recognised at a fixed point in time when control of the asset transfers to the customer. IFRS 15 states a performance obligation is met over time if the customer simultaneously receives and consumes the benefits from performance, the entity is creating or enhancing an asset controlled by the customer or the entity cannot use the asset for an alternative use and the entity can demand payment for its performance to date. Satisfied at a point in time is when the customer controls the asset, indicators of transfer of control are customer having physical possession, customer accepted the asset, customer has the risks and rewards of ownership, customer has legal title, and the seller has a right to payment.

Question 4

1.4 Principal or agent

Answer 4

If another party is involved in providing a service, the entity must determine the nature of its performance obligation. This might be providing the service itself (principal) or arranging for the goods and services to be provided by another party (agent). An entity is the principal if it controls the good or service before it is transferred to the buyer. The agent is entitled to recognise commission only as revenue.

Question 5

1.5 Warranties

Answer 5

Treatment depends on whether an extra service is received by the customer, or whether it simply provides an assurance that the item will work as intended. The treatment is:
- A warranty providing an extra service falls under IFRS 15 and is treated as a separate performance obligation
- A warranty providing assurance is recognised as a provision under IAS 37

Question 6

1.6 Practical application

Answer 6

• Consignment sales: where buyer of goods undertakes to sell them on behalf of the original seller. Originally seller only recognises the sale when they buyer sells them to a third party
• Bill and hold arrangements: entity bills a customer, but delivery is delayed with the agreement of the customer. Entity must determine whether control has been transferred to the customer
• Sale with a right of return: recognise revenue for the goods transferred and a liability for refunds
• Warranties: if warranty has been separately purchased by the customer or provides a service, it should be recognised as a separate performance obligation under IFRS 15. Otherwise, it is accounted for under IAS 37.

Question 7

1.7 Disclosure requirements

Answer 7

Main disclosure requirement of IFRS 15 is that revenue from contracts with customers disclosed separately from other sources of revenue.

Question 8

2.1 Inventory

Answer 8

Inventory consists of raw materials (components and consumables used in production process), work in progress partly finished goods) and finished goods (completed items by the business purchased for resale). Inventories are valued at the lower of cost and net realisable value for each separate product line.

Question 9

2.2 Cost

Answer 9

Cost is the cost of bringing items of inventory to their current location and condition (cost = cost of purchase + conversion costs).
- Cost of purchase: purchase price plus directly attributable costs such as import duties and delivery costs.
- Conversion costs: costs directly related to producing inventory units (labour, materials). Allocation of overheads that are incurred in converting materials into finished goods.
IAS 2 identified three methods of arriving at cost:
- Actual unit cost: actual cost of purchasing identifiable units of inventory. Used when items of inventory are individually distinguishable and of high value
- FIFO: first items of inventory received are the first ones sold. When a sale is made, the cost of sales is the cost of the oldest goods purchased
- Weighted average cost: cost of item of inventory is calculated by taking the average of all inventories held. Appropriate where the inventory physically mixes.

Question 10

2.3 Net realisable value

Answer 10

Net realisable value is actual or estimated selling price less all future costs to complete sale (including all costs to be incurred in marketing, selling and distribution).

Question 11

2.4 Disclosure requirements

Answer 11

IAS 2 requirements for inventory are
- Accounting policy adopted, including the cost formula used
- Total carrying amount, classified appropriately
- Amount of inventories carried at NRV
- Amount of inventories recognised as an expense during the period
- Details of any circumstances that have led to the write-down of inventories to their NRV.