Revenue and its importance Flashcards
Why is revenue important?
The typical convention under accrual accounting is to match the expenses to the revenue that it generates in the same accounting period. Thus revenue drives expenses and therefore is a key driver of net income.
What one of the biggest cases for revenue recognition misstatement?
Tesco plc 2014.
What was the Tesco plc 2014 scandal?
Tesco was a part of the big 4 grocery stores in the UK, which competed on price competition. Due to this abnormal profits were eroded away and there is investor pressure to deliver returns. They reported six month ended prejected profit of 1.1 billion and 2.5 billion for the year, however this was not enough, in september 2014, there was public allegations that tesco was overstating income, especially with the treatment of commercial income.
What is commercial income?
What did this judgement of comemrical income mean?
Tesco were heavily optimistic as the income could total 100s of millions pounds. So tesco used this to overstate income.
Now what is the IFRS which links to revenue recognition and what does it exclude?
IFRS 15 deals with revenue recognition from contracts with customers.
It excludes
Lease contracts
Financial instruments
And a few more but these are the main one.
IFRS 15 revenue from contracts with customers has a 5 step model for revenue recognition. If you want to determine how and when to determine revenue recognition then this is the way.
What is the 5 step framework?
1) Identify the contract with the customer
2) Identify the performance obligations
3) Determine the transaction price
4) Allocate the transaction price to the performance obligations
5) Recognise revenue once obligations fullfilled.
What does identify the contract with the customer mean?
A contract is an agreement between 2 or more parties which creates enforceable ( you can hold the contracting party to their promise if they fail or refuse to uphold it, e.g. law) rights and obligations.
IFRS 15 deals with contract modifications e.g. as a separate contract or by modifying the accounting for the current contract.
What does identify the performance obligations mean?
Performance obligations are promises in the contract to deliver a distinct good ( separable and can enjoy on its own) and have the same pattern of transfer to customer ( single measure over progress) or service of series of distinct goods and services which are almost the same e.g when you sign up to monthly cleaning services, they are the same each month.
Do PO have to be explicit( in the contract)?
If there is no transfer to the company, what does it mean?
No it can be implicit( based on practices)
No PO ( e.g. buying a new IT system to fufil contract, these don’t transfer anything to the customer. )
What does Determine the transfer price mean?
The expected amount of consideration an entity expects to receive under the contract for that delivered goods and services.
It can be determined by variable consideration - where you have to estimate the amount of variable consideration if highly probable e.g. discounts, bonsues - expected value method
What does allocate the transfer price to the performance obligations in the contracts mean? ( as revenue is going to be recognised as soon as these performance obligations are fufiled.
When a contract has mutliple PO, you have to allocate the transaction price by reference to their relative standalone price. If the standalone is not identifiable then entity needs to estimate it.
Give an example of allocating transaction price by regerence to their standalone price?
Lets say you get a discount when you buy shoes for £100 and get free socks, but the company cannot recognise socks for free, so you have to allocate the standalone selling price, so if socks price is £20 normally then you allocate the transaction price like that.
What does Recognise revenue once obligations fullfilled mean?
It is fufiled when a promised good or service is delivered to customer, at the moment when the control of good or service is transferred ( the ability to use and obtain substantially all of the benefits from the asset.)
How can a performance obligation be satisfied?
1) over time ( recognise revenue gradually over the contract period and not a single amount when contract is completed, e.g. real estate projects). IF NOT THIS THEN ITS :
2) At the point of time
LETS LOOK AT SOME EXAMPLES SO WE ARE LOOKING AT STEP 1 Entity M promises to sell 120 products to a customer for €12,000 (€100 per product). The products are transferred to the customer over a sixmonth period. After the entity has transferred 60 products, the contract is modified to require the delivery of an additional 30 products (a total of 150 identical products).
Evaluate this contract modification and the effect on revenue recognition in Case A. The price of the additional 30 products is €100 per product. The pricing
reflects the stand-alone price ( NOT CONDITIONAL ON PREVIOUS SALES) of the additional products.
Step 3: Determine the transaction price.
* Buybuy is a retailer company selling consumer electronics online. Every customer has the right to return the product within 20 days if they are not satisfied. They will receive a full refund when the product is returned in its original state. One of the products sold is a tablet. The cost of each
product is €200; the sale price is €500. Based on its experience, Buybuyexpects that 5 per cent of the products sold will be returned. The amount of consideration is estimated by using the expected value method.
* How should Buybuy account for the sale of a tablet ( HINT YOU HAVE TO THINK ABOUT REVENUE AND COSTS?
You create a refund liability because you expect in advance that you have to give that money back.
Recognise revenue when (or as) the entity satisfies a
performance obligation.
* Hollystone hires the audit firm XYZ to write a memo to assist management to account for a major acquisition during the year in accordance with
IFRS. XYZ charges based on hours taken. XYZ receives payment even if Hollystone terminates the contract early or management does not agree with the memo, unless the audit firm has performed culpably badly.
* Analyze whether XYZ satisfies the performance over time, based on hours taken, or at a point in time, upon delivery of the memo. Use the three
criteria outlined in the previous slides for a performance obligation to be satisfied over time.
It needs to satisfy one of them.
Criterion (a) has not been met. During the writing of the memo, the listed entity does not receive the benefits. Those are only
received when the listed entity receives the memo.
* As there is no asset that Hollystone could control as it is created, criterion (b) is not applicable.
* But criterion (c) has been met. There is not an asset with an
alternative use because the memo is specific to the acquisition made by Hollystone. Furthermore, XYZ has an enforceable right of payment.
* So the performance obligation is satisfied over time
Lets look at a practical application? Why is OI = CI and why is NOA = CSE?
Because it is a full equity financed firm
Moreover with the practical application, Triana’s accounting policy is to recognise revenue on a contract
in accordance to the percentage of completion method.
Revenue from contract A has been recognised based on the proportion that the cost of work certified(input method) bears to total estimated costs. Revenue from contract B has been recognised based on the proportion that labour hours to date bear to total expected labour hours.
The question we are going to answer is why Triana has used 2 different percentage of completion methods to account for equivalent contracts, also why is it based on cost or labour hours and not value of work certified?
So firstly work out Revenue, then OI for contract A and compare it with value of work certified (output method)?
Moreover with the practical application, Triana’s accounting policy is to recognise revenue on a contract
in accordance to the percentage of completion method.
Revenue from contract A has been recognised based on the proportion that the cost of work certified(input method) bears to total estimated costs. Revenue from contract B has been recognised based on the proportion that labour hours to date bear to total expected labour hours. WORK OUT CONTRACT B, IN ADDITION OI AND THEN CALCULATE USING VALUE OF WORK CERTIFIED AND OI?
What can we see from Triana’s selection of Accounting policies?
She has recognised revenues by selecting those policies that resulted in the highest possible revenue even if doing so required to treat contracts differently. Hence there is a high degree of subjectivity in firms revenue recognition policies.
Classwork Do all of this for contract A?
Classwork: Do all of this for contract B?
Hint you have to create a provision?
Which is what?
When a business sets aside some money to cover future costs or liabilities
(ii) Assume Arfbilt Contracting is an all equity financed company with equity capital equal to £20,000,000 at the beginning of the year. Show whether (and how) these different completion methods change RNOA, profit margins and asset turnovers. Use beginning balances for stock variables.
