FRS 102: Section 23 Revenue

FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland deals with revenue at Section 23 Revenue.

This is a very comprehensive section with an Appendix of 26 examples to aid correct application of the principles.  It covers revenue arising from:

  • the sale of goods (whether produced by the entity or for the purpose of sale or purchased for resale);
  • the rendering of services;
  • construction contracts in which the entity is the contractor; and
  • the use by others of entity assets yielding interest, royalties or dividends.

Basic measurement principles

Paragraph 23.3 says that an entity shall measure revenue at the fair value of the consideration received or receivable.  The term ‘fair value’ is defined in the Glossary to FRS 102 as:

The amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged, between knowledgeable, willing parties in an arm’s length transaction.  In the absence of any specific guidance provided in the relevant section of this FRS, the guidance in paragraphs 11.27 to 11.32 shall be used in determining fair value.’

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Principal and agent relationship

Section 23 deals with the principal versus agent relationship in paragraph 23.4 and states that the agent must only recognise revenue to the extent of its commission. Any amounts which are collected on behalf of the principal must not be recognised as revenue of the agent.

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Deferred payment

Deferred payments (ie where the inflow of cash or cash equivalents is deferred) may constitute a financing transaction. A financing transaction will arise when, for example, the entity provides interest-free credit to its customer or agrees to a loan which attracts an interest rate below market rate.  In such cases the fair value of the consideration is the present value of all future receipts determined using an imputed rate of interest.  For the purposes of Section 23, the imputed rate of interest is the more clearly determinable of either:

  • the prevailing rate for a similar instrument of an issuer with a similar credit rating; or
  • the rate of interest that discounts the nominal amount of the instrument to the current cash sales price of the goods or services.
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The treatment of the interest above will allow the full £4,000 sale to be recognised as revenue in the company’s profit and loss account over the three years.

Exchanges of goods or services

Revenue should only be recognised in financial statements in respect of exchanges of goods or services when the transaction possesses commercial substance. A transaction is said to have ‘commercial substance’ when it is expected that the future cash flow of a business will change as a result of the transaction.

For exchanges of goods or services, paragraph 23.6 prohibits revenue being recognised:

  • when goods or services are exchanged for goods or services that are of a similar nature and value; or
  • when goods or services are exchanged for dissimilar goods or services but the transaction lacks commercial substance.
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When goods or services are exchanged for dissimilar goods or services in a transaction that does possess commercial substance, the entity measures the transaction:

  • at the fair value of the goods or services received adjusted by the amount of any cash or cash equivalents transferred;
  • if the amount under (a) cannot be measured reliably, then at the fair value of the goods or services given up adjusted by the amount of any cash or cash equivalents transferred; or
  • if the fair value of neither the goods or services received nor the goods or services given up can be measured reliably, then at the carrying amount of the goods or services given up adjusted by the amount of any cash or cash equivalents transferred.

Sale of goods

There are five criteria which must be fulfilled before an entity can recognise revenue in relation to the sale of goods (note all conditions must be fulfilled).  These conditions are as follows:

  • the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;
  • the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;
  • the amount of revenue can be measured reliably;
  • it is probable that the economic benefits associated with the transaction will flow to the entity; and
  • the costs incurred or to be incurred in respect of the transaction can be measured reliably.

The key judgement call on the part of the entity will be in establishing the point at which it has transferred all the significant risks and rewards of ownership of the goods. In many cases this might be clear; but in some cases it is often unclear and the transfer of risks and rewards might be at a later date than when legal title passes.  To that end, paragraph 23.12 offers four examples of when the selling entity retains the significant risks and rewards over the goods and hence must not recognise revenue.  These examples are:

  • when the entity retains an obligation for unsatisfactory performance not covered by normal warranties;
  • when the receipt of the revenue from a particular sale is contingent on the buyer selling the goods;
  • when the goods are shipped subject to installation and the installation is a significant part of the contract that has not yet been completed; and
  • when the buyer has the right to rescind the purchase for a reason specified in the sales contract, or at the buyer’s sole discretion without any reason, and the entity is uncertain about the probability of return.
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Condition (a) in paragraph 23.10 which outlines the conditions which must be satisfied to recognise a sale of goods refers to ‘significant risks and rewards’ being transferred from seller to buyer in order to recognise revenue. Where the entity only retains an insignificant risk of ownership, the transaction falls to be classed as a sale and revenue can be recognised.  This could be the case where, for example, the seller retains legal title to the goods in order that they can be taken back in the event on non-payment, a sale can still be recognised on the grounds that the selling company have retained an insignificant risk of ownership.

Rendering of services

This area of Section 23 lends itself to much more subjectivity in terms of revenue recognition than with the sale of goods. This is because in order to qualify for recognition of revenue, there often needs to be an estimate calculated of the amount of revenue to be recognised and this is done having reference to the ‘stage of completion’ of the transaction (which is often referred to as the ‘percentage of completion method’ and is dealt with in the ‘construction contracts’ section in the next section of this article).  In addition, the outcome of the transaction has to be reliably estimated and for the purposes of Section 23 and the rendering of services, the outcome of a transaction can be estimated reliably when all of the following conditions are satisfied:

  • the amount of revenue can be measured reliably;
  •  it is probable that the economic benefits associated with the transaction will flow to the entity;
  • the stage of completion of the transaction at the end of the reporting period can be measured reliably; and
  • the costs incurred for the transaction and the costs to complete the transaction can be measured reliably.
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Construction contracts

Construction contract accounting under Section 23 uses the ‘stage of completion’ method referred to in the ‘rendering of services’ section above.

When the outcome of a contract can be estimated reliably the entity recognises revenue and associated contract costs by reference to the stage of completion of the contract at the end of the reporting period. Paragraph 23.22 offers possible methods to determine the stage of completion of a transaction or contract which can include:

  • the proportion that costs incurred for work performed to date bear to the estimated total costs.  Costs incurred for work performed to date do not include costs relating to future activity, such as for materials or prepayments;
  • surveys of work performed; and
  • completion of a physical proportion of the contract work or the completion of a proportion of the service contract.
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Percentage of completion method

Accounting for construction contracts (and in many cases service contracts) will inherently involve a large degree of estimation on the part of the reporting entity. In terms of construction contracts the starting point is to determine the outcome of the contract.  There are generally three outcomes where construction contracts are concerned:

  • the contract is to yield a profit; or
  • the contract is to yield a loss; or
  • the outcome is uncertain.

Profit-making contracts

When it is expected that the contract will make a profit, revenue and costs will be recognised by way of the percentage of completion method.

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Loss-making contracts

When a contract is expected to make a loss, prudence should be exercised and the expected loss must be recognised immediately where cost recovery is not probable.

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Uncertain contracts

When the outcome of a contract is uncertain, no profit is recognised. The stage of completion method is still used to identify the amount of revenue that can be recognised on the contract, but cost of sales is again a balancing figure to generate a nil profit.

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Interest, royalties and dividends

There are additional revenue streams which Section 23 deals with, namely revenue from income-yielding assets in the form of interest, royalties and dividends. Revenue in respect of such income streams can only be recognised when:

  • it is probable that the economic benefits associated with the transaction will flow to the entity; and
  • the amount of the revenue can be measured reliably.

Interest revenue

Interest revenue must be recognised in the financial statements by way of the effective interest method. The effective interest method uses the effective interest rate and in calculating the effective interest rate, the entity must include any related fees, finance charges paid or received, transaction costs and other premiums or discounts.

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The effective interest method discounts the expected future cash inflows and outflows which are expected over the life of the underlying asset.

Royalties

Royalties are recognised on an accruals basis in accordance with the substance of the relevant agreement.

Dividends

Dividend income is to be recognised when the shareholder’s right to receive payment is established. In some situations, the right to receive the dividend may differ from the date on which the dividend is actually received so care must be taken in this regard.

Disclosure requirements

The disclosure requirements for revenue are contained in paragraphs 23.30 to 23.32 of Section 23. The disclosure requirements are split into two component parts:

  • disclosures relating to revenue; and
  • disclosures relating to revenue from construction contracts.

Disclosures relating to revenue

  • Reporting entities must disclose:
  • The accounting policies adopted for the recognition of revenue, including the methods adopted to determine the stage of completion of transactions involving the rendering   of services; and
  • The amount of each category of revenue recognised during the period, showing separately, at a minimum, revenue arising from:
  • the sale of goods;
  • the rendering of services;
  • interest;
  • royalties;
  • dividends;
  • commissions;
  • grants; and
  • any other significant types of revenue.

Disclosures relating to revenue from construction contracts

In respect of construction contracts, reporting entities must disclose:

  • the amount of contract revenue recognised as revenue in the period;
  • the methods used to determine the contract revenue recognised in the period; and
  • the methods used to determine the stage of completion of contracts in progress.

In addition, reporting entities should present:

  • the gross amount due from customers for contract work, as an asset; and
  • the gross amount due to customers for contract work, as a liability.

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Steve Collings is the audit and technical partner at Leavitt Walmsley Associates Ltd.

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