Revenue and its importance

Question 1

Why is revenue important?

Answer 1

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.

Question 2

What one of the biggest cases for revenue recognition misstatement?

Answer 2

Tesco plc 2014.

Question 3

What was the Tesco plc 2014 scandal?

Answer 3

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.

Question 4

What is commercial income?

Answer 4

Question 5

What did this judgement of comemrical income mean?

Answer 5

Tesco were heavily optimistic as the income could total 100s of millions pounds. So tesco used this to overstate income.

Question 6

Now what is the IFRS which links to revenue recognition and what does it exclude?

Answer 6

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.

Question 7

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?

Answer 7

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.

Question 8

What does identify the contract with the customer mean?

Answer 8

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.

Question 9

What does identify the performance obligations mean?

Answer 9

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.

Question 10

Do PO have to be explicit( in the contract)?
If there is no transfer to the company, what does it mean?

Answer 10

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. )

Question 11

What does Determine the transfer price mean?

Answer 11

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

Question 12

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.

Answer 12

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.

Question 13

Give an example of allocating transaction price by regerence to their standalone price?

Answer 13

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.

Question 14

What does Recognise revenue once obligations fullfilled mean?

Answer 14

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.)

Question 15

How can a performance obligation be satisfied?

Answer 15

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

Question 16

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.

Answer 16

Question 17

Case B. The price of the additional 30 products was initially agreed to be €80 per product, which is not the stand-alone price. Before modification, the customer had identified minor defects in the 60 units already delivered. Parties agree that for this reason a credit of €15 per product will be given. The total credit of €900 (60 × €15) results in a price for the 30 additional units of…

Answer 17

€50 (€80 − (€900 / 30)).

Question 18

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 B The price of the additional 30 products was initially agreed to be €80 per product, which is not the stand-alone price. Before modification, the customer had identified minor defects in the 60 units already delivered. Parties agree that for this reason a credit of €15 per product will be given. The total credit of €900 (60 × €15) results in a price for the 30 additional units of €50 (€80 − (€900 / 30)).

Answer 18

The post modification agreed price was not on a standalone basis, it was a discounted price given the customer brought a given amount of units, hence contract modification doesn’t mean a separate contract.
Because the remaining products to be delivered are distinct from those already transferred, the entity accounts for the modification as a termination of the original contract and the creation of a new contract.

Question 19

Case B The price of the additional 30 products was initially agreed to be €80 per product, which is not the stand-alone price. Before modification, the customer had identified minor defects in the 60 units already delivered. Parties agree that for this reason a credit of €15 per product will be given. The total credit of €900 (60 × €15) results in a price for the 30 additional units of €50 (€80 − (€900 / 30)).
Because the remaining products to be delivered are distinct from those already transferred, the entity accounts for the modification as a termination of the original contract and the creation of a new contract.What is the new price, and what happens to the 900 at point of modifcation?

Answer 19

The amount recognised for the remaining products is a blended price of €93.33 (€100 × 60) + (€80 × 30). The €900 credit is accounted for as a reduction of revenue at the time of contract modification.

Question 20

SOFT is a software developer that is hired to perform an installation
service and provide unspecified software updates and technical support for a two-year period. The entity sells the license, installation service, and technical support separately. The installation service includes changing the web screen for each type of user. It is routinely performed by other entities and does not significantly modify the software. The software
remains functional without the updates and technical support.
* Identify the performance obligations in the contract.

Answer 20

Because the customer can benefit from each of the goods and services either on their own or together with the other goods and services that are readily available, and because the promise to transfer each good and service is separately identifiable, the goods and services are distinct and SOFT identifies four
performance obligations: the software license, installation service, software updates, and technical support.
* All four are separately accounted for in recognising revenue.

Question 21

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?

Answer 21

You create a refund liability because you expect in advance that you have to give that money back.

Question 22

Step 4: Allocate the transaction price to the performance obligations.
* An entity enters a contract with a customer to sell products A, B, and C in exchange for €100. The entity will satisfy the performance obligations for each of the products at different points in time. The stand-alone selling prices are €50 (A), €25 (B), and €75 (C), totalling €150. The customer
receives a discount of €50 for purchasing the bundle of goods.
1) Determine the transaction price of A, B and C based on the fact that The discount could not be allocated to a specific performance obligation. ( HINT SIMILIAR TO THE SOCKS EXAMPLE EARLIER).
2) The discount would be allocated to B and C, based on
objective evidence.

Answer 22

1) The discount of €50 is allocated proportionately, resulting in the following transaction prices: €33 (€50 / €150 × € 100( 150 -50 post discount price) ) for A, €17 (€25 / €150 ×€100) for B, and €50 (€75 / €150 × €100) for C.
2) The discount of €50 is allocated to B and C, resulting in the following transaction prices: €50 for A, €12.50 (€25 / €100 × €50) for B, and €37.50 (€75 / €100 × €50(100-50) ) for C.
original cost/ total bundle price x post discount price.

Question 23

So when companies sell products in bundle and these products are being sold at different points of time, if the company wants to recognise revenue for one of the products of the bundle…

Answer 23

they should be able to allocate total bundle price to individual products.

Question 24

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.

Answer 24

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

Question 25

An entity enters into 100 separate contracts with customers to provide one-year maintenance services for €1,000 per contract. The contract specifies that customers have the option to renew the maintenance
contract for a second year by paying an additional €1,000. The entity
charges a significantly higher price (€3,000) for customers that do not sign up for the maintenance service in the first year.
Has a performance obligation been satisfied here?
The entity expects that 90 per cent of customers will renew. What is the expected consideration for each contract?

Answer 25

This renewal option provides a material right to the customer and the entity concludes that the promise to provide the option is a performance obligation.

The expected consideration for each contract is therefore €1,900 (€1,000 + 90% ×€1,000).

Question 26

So we have identified that a performance obligation has been satisifed. Additional to the information in previous slide,
The entity expects that 90 per cent of customers will renew. The expected consideration for each contract is therefore €1,900 (€1,000 + 90% ×€1,000). Estimated costs for maintenance are €600 for each contract in year 1 and €750 in year 2. Revenue is recognised based on costs incurred. - KEY HERE
How much revenue is recognised per contract in year 1 and how much in year 2?

Answer 26

Total costs per contract are €1,275 (€600 + €675 (90% × €750)). Revenue in year 1 will therefore be €894 (€600 / €1,275 × €1,900) and revenue in year 2 will be €1,006 (€675 / €1,275 × €1,900).
Cost for each year /Total cost X Contract price.

Question 27

So now lets look at the Recognising revenue when (or as) the entity satisfies a performance obligation
But look at it from the process of Revenue recognition over time, this is commonly used in construction contracts , IAS 11 has two methods of recognising revenue, however we are only interested in one, which is?

Answer 27

Percentage-of-completion method. Contract revenue and contract costs associated shall be recognised as revenue and expenses respectively by reference to the stage of completion of the contract at the statement of financial position date.

Question 28

What is contract revenue and costs?

Answer 28

Contract revenue: primarily the amount agreed in the contract. Other revenue if probable and reliably measured.
* Contract cost: costs directly related or attributable to the contract. Exceptions: SG&A,R&D and depreciation of assets not specified in the contract.

Question 29

Lets look at a practical application? Why is OI = CI and why is NOA = CSE?

Answer 29

Because it is a full equity financed firm

Question 30

What does the value of work certified mean?

Answer 30

is the value placed by the clients’
surveyors on the work completed towards the end of the financial year (this is regarded as transferred to the customer’s control).

Question 31

What is the cost of work certified and cost of work not certified?

Answer 31

Cost of work certified = represents the costs incurred in
reaching the stage of development represented by the value of work certified.
Cost of work not certified = represent materials
costs incurred relating to future activities on the contracts.

Question 32

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)?

Answer 32

Question 33

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?

Answer 33

Question 34

What can we see from Triana’s selection of Accounting policies?

Answer 34

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.

Question 35

Classwork Do all of this for contract A?

Answer 35

Question 36

Classwork: Do all of this for contract B?
Hint you have to create a provision?
Which is what?

Answer 36

When a business sets aside some money to cover future costs or liabilities

Question 37

(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.

Answer 37

Question 38

Assome investors extrapolate this years performance into the future. What are the valuation implications of these different completion methods?

Answer 38

If investors extrapolate this years performance into the future, the method that leads to higher ROA will lead to higher valuations keeping everything equal.

Question 39

If there is no comprehensive income in our reformulations what does this mean?

Answer 39

Operating income at time t = Net income at time t.

Question 40

Whats the difference between a reserve and provision?

Answer 40

The Provision means to keep some money for a known liability which is probable to arise after a certain time. The Reserve is to retain some money from the profit to for any particular future use.