Chapter 9: Revenue THEORY IN ACTION 9.1 AFR 14 March 2007 No income gained from revaluations 1. Explain why Westfield’s result for 2006 was 30% better than the previous year. How do reporting requirements of AIFRS differ to AGAAP for companies in the property sector? The increase in operating profit reflects the adoption of IFRS. Westfield has elected under AASB 140 Investment Property to include increases in value of property in the income statement when they occur, irrespective of whether the gains are realised or not. Under IFRS the company included $5.1 billion of asset revaluations in income. Previous AGAAP did not include a specific investment property standard. It allowed, but did not require, companies to revalue property under the general rules for measurement of property, plant and equipment. Companies recording asset revaluations under AGAAP showed an increase in assets but the increase was not taken to the income statement, but rather directly to equity. DR Property (Asset, balance sheet) CR Asset revaluation reserve (Reserve, equity) Thus the change under AIFRS is that AASB 141 allows companies to choose a policy of including increases/decreases in value of investment property to form part of property trusts’ income. DR Property (Asset, balance sheet) CR Gain on remeasurement of asset (Gain, income statement) 2. Why does the IASB consider that revaluation gains are part of income? (Refer to material in the chapter) The IASB Framework states that ‘income is recognised in the income statement when an increase in future economic benefits related to an increase in assets or decrease in liability has arisen and can be measured reliably’ (paragraph 92). This approach to income measurement has been called the asset/liability approach and means that ‘recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities’ (paragraph 92). Gains and losses are recognised in the period they occur, and form part of income of the period, irrespective of realisation. The IASB approach is based on Hicks’ (1934) concept of income: that changes in net assets (excluding transactions with owners) represent an increase/decrease in net income. It is argued by members of the IASB (e.g. Mary Barth) that there is indeed no other way to measure income than based on the changes in net assets. 3. What is meant by the statement that “IFRS has made the production of financial statement a compliance exercise; the market does not use the financial statements to assess financial performance.” The IFRS approach is that the return for investors in property trusts reflects both cash income and capital gain. Therefore both should be included in profit. However, in the view of the CFO quoted in the article (Kieran Pryke), investors regard property trusts as a cash flow business and are therefore interested in the cash flow generated by the business, not the value of the assets. Property investment companies have responded by providing a distribution reconciliation statement which shows the source of income (both cash income and remeasurement gains) so that investors can distinguish between distributable income and gains relating to revaluation. It seems unrealistic to suggest that investors are not interested in the increase in property values, as in the long term these are increases in wealth for the owners of the trust. In the short term, the reconciliation statement should mitigate any confusion among investors as to the nature of the gains, i.e. realised cash flows or unrealised remeasurement gains. Another point of interest is that companies have a choice under AASB 140; to use the cost or revaluation model for investment property. The article implies trusts must use the revaluation model, but they choose to use it, implying some benefits from the revaluation model. Students could explore the incentives for companies/trusts to use the revaluation model and the costs and benefits of their choice. Theory in Action 9.2 ‘Revenue recognition is Isoft’s curse’ P. Stafford, Financial Times 9 August 2006, p. 17 1. When did Isoft traditionally recognise revenue? Is the policy acceptable under GAAP? Revenue was recognised in a two stage process. The value of product licences was recorded as sales at the time the licences were delivered. The subsequent support and services were recognised in the accounts when they were performed, rather than when they were paid for. Current work of the IASB and FASB in project on Revenue recognition supports the ‘unbundling’ of contracts (see Chapter 9). The standard setters consider that the separate recognition of each stage of the contract is necessary to accurately reflect the underlying economics of the contract. Thus, Isoft’s approach is consistent with the standard setters’ views. The policy of recognition on performance rather than receipt of cash is acceptable under GAAP. Traditional accrual accounting allows for (indeed encourages) recognition when the service is completed and the revenue earned. If analysts are questioning the recognition policy, can we assume that there is some significant delay between performance and receipt of cash or some uncertainty about the amount to be received which suggests revenue recognition be delayed? The article is silent on this point. 2. What accounting issues were identified by analysts in relation to recognition of revenue for software companies? An analyst suggested that the purchaser may see the sale as one contact because they want to have a working end product. On the other hand, the provider sees the contract as having two parts: buying the software and providing the service to maintain it. The implication in the article is that the different views could lead to different timing for revenue recognition. However, the amount of revenue should be the same irrespective of which view is taken. Analysts are querying the company’s recognition policy, implying that they suspect the company has been aggressive in the early recognition of revenue. Analysts want sufficient information to understand the persistence of revenues. Factors affecting persistence include timing (when will cash be received?) and subjectivity (to what extent is reported revenue subject to intentional and unintentional measurement error?). The article implies that analysts have been suspicious of the company’s policy for some time. The statement that Deloitte found revenue has been recognised earlier than it should be seems to confirm analysts’ concerns. 3. Why did the company restate revenue and/or change its accounting policies? The article states that revenue ‘irregularities’ uncovered by the company’s auditor Deloitte would not have a material impact on revenue in the coming year (estimated at GBP 195 – 200 million). However, the company decided to change its revenue recognition policy resulting in a reduction in revenue of GBP 70 million in 2005 and GBP 55 million in 2004. The company denied a link between the ‘irregularities’ and the policy change. However, both seem to relate to the same issue: the early recognition of revenue. The company’s response is to recognise revenue later for the current (2006) and prior years (2004 and 2005). Is the company in ‘damage control’? Are they concerned about how they are perceived in the market place, for example, that analysts do not consider the company’s reported revenue to be reliable? The company has attempted to reassure the market about its revenue recognition policy. For example, although a contract was signed on the last day of the financial year, the company indicated that the revenue was not included in that financial year. Students could discuss why the company would make this announcement and to what extent the announcement should alleviate analysts’ concerns about the company’s revenue recognition policy. Theory in Action 9.3 Banking group attacks IFRS with double set of accounts 1. Why does HBOS provide a second set of financial results? HBOS provides a second set of results based on ‘embedded value criteria’. It provides the second set of financial results so that HBOS can provide more detail of contracts with expected future revenues (i.e. HBOS’s insurance contracts). The article states that investors find the additional information helpful. Analysts state that IFRS valuations are ‘misleading’. The implication is that revenue recognition rules for insurance contracts under IAS 39 are according to a set of criteria which may not accurately reflect underlying earnings in relation to the contracts. 2. What is the revenue recognition rule of IFRS, according to this article? What are the differences in profit for HBOS under IFRS and embedded value? The article states that IFRS requires the recognition of revenues when they are accrued. It also claims that under IFRS, growing firms are disadvantaged compared to their more mature competitors as IFRS allows mature firms to report higher profits. Insurance contracts are accounted for under IAS 39, which delays recognition of profit on these contracts. ‘Embedded value’ (EV) is a voluntary method of accounting for insurance contracts which has been developed in Europe by banks and insurance companies. Under ‘embedded value’ reporting, firms recognise new business on point of sale, with the contribution of existing business only including changes in the value of future cash flows compared to predictions. The embedded value approach allows earlier recognition of revenue; revenue which is expected over the life of the insurance contract but cannot be recognised under IAS 39. HBOS profit under EV was GBP 262m higher than under IFRS. The contribution of new business was GBP 474 million higher under EV than IFRS. 3. What do you consider are the incentives to report embedded value results? To what extent are managers likely to manipulate embedded value results? Managers of growing firms want to report results using the ‘embedded value’ approach to provide information about the value of new business being written by the firm. This allows analysts and investors to make a more accurate assessment of firm value and to price the firm’s shares accordingly. Without embedded value results, a growing firm could be undervalued by investors and ranked less favourably than a more mature firm. Under IFRS, the value of new business is not captured and mature firms look more profitable compared to young firms. Therefore, mature firms would not have the same incentive to provide embedded value results. The embedded value measures are estimates of the present value of insurance contracts which have been written and will earn revenue in the future. They are based on managers’ estimates of future cash flows and discount factors. Nevertheless, managers providing embedded value information have an incentive to provide accurate information because the information is used to value the firm. There will be ex-post settling up in the market (i.e. analysts will downgrade stocks for which embedded value estimates prove inaccurate) if managers’ estimates are inaccurate. Theory in Action 9.4 EPG’s auditor queried on sales AFR 9 May 2008 by Ashley Midalia 1. Contracts for the sale of the two properties were initially exchanged during the year ended 30 June 2005, and eventually were finalised before the end of 2005, so why were the auditors criticised for allowing the revenue to appear in the 2004/2005 accounts? It is argued that the revenue should not be recognised in the accounts until ‘control’ of the properties had passed to the purchaser. Although contracts were initially exchanged in June 2005, these contracts were replaced by new contracts which were signed on October 28 2005. It is argued that the rescission of the original contracts meant that control did not exist until the later date. The article does not explain when the rescission took place. A counter-argument that the auditors could make is that as at 30 June 2005 it appeared that the exchange of contracts was final. However, auditors are required by ASA 560 Subsequent Events to consider the effect of subsequent events on the financial report and on the auditor’s report (paragraph 5). Auditors are required to perform audit procedures during the period after 30 June and up to the date the audit report is signed to detect subsequent events (paragraph 8). If the rescission took place before the auditor signed the audit report, then these procedures should have provided evidence that the contracts were not final on 30 June 2005. 2. Why is there doubt over whether the revenue should have been recognised at all? The article mentions ‘vendor financing arrangements’ between the parties to the contract. Although these arrangements are not detailed in the article, it appears that the contracts allow the EPG companies to retain ‘effective control of the development of the properties’. In addition, the EPG companies could have received a share of the profits from the development. It appears that the contracts of sale may have given legal ownership to the purchaser, but did not give the purchaser true control over the properties. ‘Control’ of an asset is not synonymous with legal ownership, the test is related to the eventual disposition of the benefits that flow from an asset (see paragraph 58, AASB Framework). The form of the contract was that legal ownership passed, but the substance was that the ‘vendor’ retained an element of control over the property development and its benefits. CASE STUDIES Case Study 9.1 Property development companies: When to recognise revenue? 1. For companies which construct and sell residential property units, what would be the conservative accounting treatment for revenue under IFRS? Identify the sections of IAS 18 which support this treatment. The conservative treatment would be to record all revenue when the property is sold. If the transaction is classified as sale of goods (rather than provision of services) under IAS 18, the following will apply: IAS 18 para 14 states that revenue arising from the sale of goods shall be recognised when all the following conditions have been satisfied: (a) the entity has transferred to the buyer the significant risks and rewards of the ownership of the goods; (b) the entity retains neither continuing managerial involvement in the degree usually associated with ownership nor effective control over the goods sold; (c) the amount of revenue can be measured reliably; (d) it is probable that the economic benefits associated with the transaction will flow to the entity; and (e) the costs incurred or to be incurred in respect of the transaction can be measured reliably. Recognition of revenue when the residential units are completed satisfies these conditions. Further guidance is provided in the IAS Appendix for situations where title passes before completion and where the seller has continuing obligations after title has passed. 2. Emaar Properties uses the percentage of completion method under IAS 11. Explain when revenue is recognised under this method. Why would a company want to use the percentage of completion method? If IAS 11 applies, revenue is recognised on a percentage-of-completion basis provided that reliable estimates of construction progress and future costs can be made. Revenue is recognised in proportion with the amount of work which has been completed compared to the amount required under the contract. A company may want to use percentage of completion to enable it to recognise revenue earlier in the business cycle. Jose (2008) quotes a spokesperson from Emaar Properties as saying ‘Companies would always want to be liquid right from the beginning and the cash flow to start early.’ This statement implies that companies set up their contracts to ensure progress payments are received in relation to the stage of completion of the project. As cash is received, it may be appropriate to recognise revenue. Percentage of completion provides for more even recognition of revenue and profit for projects which continue over more than one financial year because recognition of revenue is spread out over the lifetime of the project. Some argue that revenue recognition in stages is a more accurate reflection of the progress of construction and provides for better matching of revenue and expenses. 3. How does the IFRIC 15 affect revenue recognition for property development companies? IFRIC 15 requires property developers to follow certain conditions which make applying the percentage of completion method under IAS 11 difficult. The main change will be to prevent some companies from recognising revenue as construction progresses. Instead they will recognise revenue at a single time, at completion upon or after delivery. IASB (2008) states that agreements that will be affected will be mainly those currently accounted for in accordance with IAS 11 that do not meet the definition of a construction contract as interpreted by the IFRIC and do not transfer to the buyer control and the significant risks and rewards of ownership of the work in progress in its current state as construction progresses. 4. Why do you think the IFRIC issued IFRIC 15? IFRIC’s principal role is to consider accounting issues that are likely to receive divergent or unacceptable treatment in the absence of authoritative guidance (IASB 2008). The case study material suggests that there was diversity in practice. Improving consistency is one reason why an interpretation may be issued. Another reason is because a standard is not being applied correctly. IFRIC was of the view that under IAS 11 property developers were recognising revenue when the risks and rewards of ownership had not transferred to the buyer but remained with the seller. IFRIC 15 seeks to improve comparability in practice of real estate companies. Introducing IFRIC 15, Robert Garnett, IFRIC Chairman and IASB member, said: The real estate industry is an important sector across countries and, especially in times of volatile markets, transparency and comparability of the accounting are important. However, at present there is widespread divergence in practice when accounting for the recognition of revenue for ‘off plan’ contracts. IFRIC 15 clarifies how the existing principles in IAS 11 and IAS 18 apply for the revenue recognition in the real estate sector and by doing so will ensure consistent accounting. Case Study 9.2 Improper revenue recognition The violations outlined involve techniques to boost revenue, including: • improper sales cut-off • consignment sales recorded as revenue • parking, bill and hold and channel stuffing • back-to-back swaps • fictitious sales. Describe each of these techniques and explain whether they would be in breach of Australian accounting standards. In your answer, refer to the recognition criteria of IAS 18/AASB 118 Revenue presented in figure 9.3. Improper sales cut-off US GAAP requires a firm to record sales in the period the goods are shipped or services performed. Intentionally holding open the books of account beyond the end of the period is a violation of GAAP. Although sale or delivery is an accepted point for revenue recognition, this has not occurred at the period end date. AASB 118 para 14 (a) requires risks and rewards of ownership to be transferred to the buyer. Tranfer of title for sale of goods did not occur within the period, so a sale should not be recorded. Although sale or delivery is an accepted point for revenue recognition, this has not occurred at the period end date. For a service transaction, the transaction was not complete at the reporting date (AASB 118 para 20). The transaction should not be included in revenue. Consignment sales recorded as revenue Consignment sales usually feature an agreement whereby the buyer (consignee) has the unconditional right to return the merchandise to the seller (consignor). Title does not pass. AASB 118 para 14 (a) requires risks and rewards of ownership to be transferred to the buyer. Tranfer of title for consigned goods did not pass, so the transaction should not be recorded as a sale. Appendix para 2(c) states that a sale should be recognised by the seller (consignor) in a consignment sale when the consignee sells the goods to a third party. Parking, bill and hold and channel stuffing Premature revenue recognition by negotiating sales with customers who do not need, or cannot take delivery, of goods in the period. The goods are held with an intermediary (parking), left in seller’s inventory (bill and hold), or shipped to the buyer (channel stuffing). Deferred payment terms are included in the agreement. The guidance of AASB 118 para 14 (a) requires that risks and rewards of ownership to be transferred to the buyer. In the cases descibed above, ownership of the goods remains with the seller. The risks and rewards of ownership have not passed, irrespective of the location of the goods. Therefore a sale should not be recorded. Appendix to AASB 118 provides further guidance in relation to the above situations. For example, bill and hold sales can be recognised when the buyer takes title and accepts billing, subject to additional conditions (delivery is probable; item is ready for delivery; buyer acknowledges deferred delivery instructions and usual payment terms apply). Under these conditions, sales such as those in item 3 would not be recorded as revenue. Back-to-back swaps Firm A sells assets to Firm B at a gain, and in turn agrees to buy assets from Firm B in the same or subsequent period, also at a gain. These transactions may appear to be within the revenue recognition guidelines of AASB 118 para 14. However, Appendix to AASB 118 provides further guidance. Para 5 states that sales and repurchase agreements need to be analysed to determine whether there is an in substance transfer of the risks and rewards of ownership. If not, despite the fact of legal transfer of title, a sale should not be recorded. Fictitious sales Company goods may be ordered, but not shipped; shipped but not ordered; or never ordered or shipped. The company may fabricate purchase orders or shipping records (fictitious customers), or not produce any records. These transactions cannot be recorded as revenue because it is not probable that economic benefits associated with the transaction will flow to the entity (AASB 118, para 14c) Case Study 9.3 New research finds red flags to uncover accounting fraud 1. What is meant by the term ‘earning management’? What are the incentives for managers to manage earnings? Earnings management occurs when managers use judgment or discretion within GAAP, or structure transactions, to affect the information in financial reports. The purpose of earnings management is to influence users’ perceptions of financial statements about the firm’s underlying economic performance or to influence outcomes that contractually depend on reported accounting numbers. For example, if financial information is used in determining bonus payments as part of executive remuneration, managers may have an incentive to arrive at the financial results necessary to achieve the bonus. Another example relates to debt covenants. A firm at risk of breaching a loan covenant has an incentive to manipulate financial information to avoid the breach and thus avoid cost of refinancing the loan. Earnings management may be undertaken so that a firm reports a smooth income stream rather than a volatile one. The practice of earnings management may potentially affect transparency of the underlying economic reality of a firm’s financial performance or position. Consequently, investors’ decisions with respect to the allocation of resources may be affected, with adverse consequences. The authors note that earnings management may be used to disguise declining operating performance to protect share price to ‘ensure their stock based compensation remains valuable’ and to allow capital raising on favourable terms. 2. What types of firm score poorly on the F score? The researchers found that growing firms with deteriorating operating performance are the firms most likely to score poorly. The researchers suggest that manipulations could reflect managers’ desire to disguise moderating operating performance in these firms. Manipulating firms are more likely to be large firms. They were more likely to be in the computer industry, followed by retail and service industries, and to relate to the period 1999 and 2000. The results are consistent with UK research related to firms subject to action by the Financial Reporting Review Panel (FRRP) in the 1990s. Peasnell, Pope and Young (2001) report that UK companies subject to adverse rulings were average performers experiencing temporary performance difficulties, rather than being perennial underachievers. [Peasnell K., Pope P. and Young, S. (2001), “The characteristics of firms subject to adverse rulings by the Financial Reporting Review Panel”, Accounting and Business Research vol. 31, pp. 291-306.] Students should note that the results are specific to the period studied. The tech stock bubble ended early in 2001. During the prior years, managers with stock compensation had incentives to ensure share prices continued to increase, giving rise to the manipulations observed in the study. Thus the findings reflect the conditions during the latter years of the study. A study of a different period may capture different economic conditions and incentives. 3. Explain the relationship of cash flow and earnings management. Is it possible for managers to ‘manage’ cash flows? One way to achieve earnings management is through the use of accruals. Recall that accruals are period end adjustments to financial accounts which do not involve cash. Managers have discretion about the amount and timing of accrual adjustments and thus can use them to manage earnings. For example, an adjusting entry to record sales for which cash is not yet received (accrued revenue) increases revenue and boosts earnings. Managers seeking to increase earnings can increase revenue or decrease expenses by using accruals. The study reported that most manipulations related to revenue and many of these involved accruals e.g. front loading sales from future quarters and creating fictitious sales. It is more difficult to manage earnings using cash flows since they reflect actual cash received or paid by the business. While accrual accounting information is useful for investors, analysts also keep a close watch on cash flows because they are harder to manipulate and thus are used for predicting the firm’s future cash flows. However, cash flows can be manipulated through such techniques as improper sales cut-off (including next period sales in the current period) and back to back swaps with cash transfers (see Case Study 9.2 for further discussion). 4. What are the practical applications of the F score? In what ways can the F score assist auditors? The F score provides an indicator that there are inconsistencies in the firm’s accounts. It is an objective measure that can be used by investors, auditors and regulators as a ‘red flag’, that is, a suggestion that there are possible inconsistencies in the firm’s actual and reported financial performance and position that warrants further investigation. The authors note that the manipulating firms have abnormally low free cash flows and that many firms were seeking new financing to cover negative operating and investing cash flows. The low free cash flows and high accruals can be seen as a ‘red flags’ for investors because of the difficulty of manipulating cash flows and the ease of manipulating accruals. The article notes that Enron had an F score more than twice that of an average firm, indicating it was a high risk firm. Auditors could use the F score to highlight risky firms and suggest that additional testing be carried out. QUESTIONS 1. What is revenue? Is it an object or an event? Revenue is defined in AASB 118 (paragraph 7) as follows: Revenue is the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants. The definition implies that revenue is an event (an increase or flow), not an object. Revenue applies definitely to value, which is monetary. Although assets are economic objects, revenue relates to enhancement in value of the assets. .. 2. What is the difference between revenue and gains? How does the Framework definition of ‘income’ treat revenue and gains? The AASB framework defines income as including both revenue and gains (para 74). Thus the Framework makes no conceptual distinction between revenue and gain. Both are consistent with the concept of income as something which increase assets (an inflow or enhancement) or decreases liabilities with a resulting increases in equity (para 70(a)). Gains are included in income because they represent future economic benefits flowing to the entity. They may or may not arise from ordinary operations of the entity, while revenue is defined as arising from ordinary operations. It should be noted that gains may also include unrealised gains. 3. Explain the ‘earning process’. How does the earning process concept relate to the operational view of revenue? Accounting theory assumes that revenue (and income) cannot arise unless the firm performs — that is, it must do something to make revenue happen. The earning process consists of the activities that cause revenue to occur. For a manufacturing firm, the sequence of events is typically the following: • purchase of service inputs (labour, materials, etc.) • production • storage of product • sale of product (on credit) • collection of cash (from customers) • warranty service. The operational view is essentially the same as the view expressed above, except that revenues (and income) are defined more explicitly in terms of the particular operations that generate revenues (and income). Professor Bedford, who stresses this viewpoint, lists the following business operations: • acquisition of money resources • acquisition of services • utilisation of services • recombination of acquired services • disposition of services • distribution of money resources. 4. What are the differences between general criteria for revenue recognition and revenue recognition principles contained in AASB 118 Revenue? The general criteria for revenue recognition are: • measurability of asset value • existence of a transaction • substantial completion of the earning process. The revenue recognition principles contained in IAS 18/AASB 118 are stated in Figure 9.3. They do not state the criteria in the above form. IAS 18/AASB 118 recognition rules are formulated around the concept of a probable inflow of future economic benefits and reliable measurement of such an inflow. Therefore, the first general criterion (measurability of asset value) forms part of IAS 18/AASB 118 as reliable measurement is a recognition criterion. The existence of a transaction (second criterion) is specifically mentioned in para 20 and forms part of the discussion in IAS 18/AASB 118. Substantial completion of the earning process is not specifically mentioned in para 14, 20 and 29. However, completion of the earnings process underpins these paragraphs. For example, a sale occurs when the significant risks and rewards of ownership have transferred. This implies substantial completion of the earnings process. Similarly in the rendering of services, recognition depends on the extent to which the transaction is complete. Also for interest royalties and dividends, the process of earning the item is discussed. For example, interest is recorded as it is earned based on the effective interest method. 5. Why are revenue recognition principles needed? Does it matter which principles are adopted, as long as they are applied consistently across time? Discuss. Revenue recognition principles emerged in GAAP because prior to specific standards (such as IAS 18/AASB 118) the definition of revenue was too general and did not provide sufficient guidance. Rules were needed about when to identify (recognise) revenue and to ensure that the revenue figure was reliable. It does matter which principles are adopted because they affect the reliability of the figure presented. The use of wrong principles, even if they are consistent over time, can lead to misleading information that has adverse economic effects. For example, recognition rules which permitted overstatement of revenue could prevent investors from making efficient resource allocation decisions. 6. What is the significance of the criterion of measurability of the consideration received? AASB 118 para. 9 states that revenue shall be measured at the fair value of the consideration received or receivable. Measurability of the consideration (whether in cash or another form) is therefore required before revenue can be recognised. It should be noted that para. 12 of AASB 118 states that if goods or services are exchanged for goods or services of a dissimilar nature, the fair value of the goods or services received establishes the amount of revenue. Where it is not possible to reliably measure this fair value, the revenue will be measured at the fair value of the goods or services given up, adjusted by any cash or cash equivalent transferred. 7. Explain the concepts of realisation and recognition as they relate to the measurement and disclosure of revenues under the historical cost system and under a system of mark-to-market or fair value for financial instruments. See discussion in text as follows: Recognition requires an inflow of assets or a measurable (quantifiable) change in the value of an asset, whereas realisation requires an inflow of liquid assets. For example, a bank that holds shares in public companies can mark the investment to market and recognise any gain or loss at balance date (that is, use fair value accounting). This is an example of revenue being recognised before it has been realised. As an example of a financial instrument, let’s say that a bank holds 1 000 shares in B Limited, which were purchased at the beginning of the financial year for $1 per share. At balance date, they have a value of $1.20 per share. Under historical cost accounting, the gain or loss on the shares would not be recognised until realised. That is, in the increase or decrease in value would not be recorded in the accounts (recognised) until the shares were sold and the gain/loss was realised. Under fair value or mark-to-market accounting the assets are valued at $1 200 at balance date and revenues increase by the incremental gain of $200. If the year-end value was 80 cents per share, then the incremental expense of holding the shares of $200 would be recognised in the statement of financial performance. The gain/loss has not been realised, but is recognised each accounting period. When a gain or loss is realised through the sale of the shares then the adjustment is directly against the asset, to remove it from the books, and to cash (or whatever asset is received for the shares). So, in the example, if the balance date assets are valued and recognised at $1 200, and they are subsequently sold for $1 200 cash, then the journal entry would be a debit to cash and a credit to ‘shares in B Ltd’ of $1 200. No gain or loss would be recognised at the point of realisation. 8. What do we mean when we suggest that applying the principles adopted in accounting standards which make use of fair value measurement, such as IAS 39, 40 and 41 (AASB 139, 140 and 141), lead to an even greater mix of values presented in a company’s balance sheet? Current accounting standards require/allow that a mixed attribute measurement model be used in the financial statements. That is, some items are valued at historical cost while others are measured at fair value. Initially, historical cost represents fair value. However, over time the two values may diverge. Current accounting standards require/allow a range of measurement methods to be used. For example, fixed/capital assets are held at cost and systematically depreciated in value over their expected useful life. They may or may not be systematically revalued (by independent or directors’ valuation). Intangible assets such as goodwill and brand names are valued at cost. Amortisation or impairment testing may reduce their reported value. Other assets, such as some financial instruments, investment properties and biological assets are revalued each accounting period to reflect current net market value. This means a variety of measurement methods are reflected in the financial statements, without any conceptual basis for doing so. Measurement methods reflect more the politics of standard setting than they do sound conceptual reasons for adopting a particular approach. 9. Suppose you are a manufacturer of plastic products. A new customer, X Ltd, has purchased a large quantity and gives you a note as payment. The note requires X Ltd to make four equal instalments over a period of 2 years. How do you determine the collectability of the note? When should revenue be recognised? The collectability of the note is determined be assessing the ability of X Ltd to pay. One would analyse its financial statements for liquidity and solvency, and consider the customer’s credit rating (Information can be gained from credit rating agencies.) Presumably this would have been done before the sale was finalised. If so, it would be reasonable to assume that, once accepted, the collectability of the note is considered to be reasonably assured. The transaction meets the criteria for revenue recognition under AASB 118 para 14 (see text, figure 17.3). As soon as the company considers that it is probable that economic benefits will result, i.e. the amount outstanding will probably be collected, then revenue should be recognised. This assumes that the significant risks and rewards of ownership have been transferred from the manufacturer to X Ltd. 10. Should accountants insist that revenue be recognised by a firm only on receipt of a liquid asset in a sale transaction? Why or why not? NO! For revenue to be recognised it has to be earned, be capable of reliable measurement and it must further meet the requirement that the ‘inflow or other enhancement or saving in outflows of service potential or future economic benefits’ will occur. That is, revenue must be realisable to be recognised, rather than realised. The term ‘realised’ refers to the inflow of liquid assets, which, if revenue were only recognised when realised, would imply that only sales would be recorded as revenue. For example, suppose Company X sold a machine to Mr Y on ‘net 30’ terms. Revenue should be recognised when earned (the goods have been provided) and the inflow will probably occur. If revenue has to be realised before it were recognised, then Company X would have to wait until Mr Y paid cash under the strictest interpretation of ‘realised’, or when the sale occurred and the firm acquired an account receivable under a less stringent interpretation of ‘realised’. Generally, revenue recognition requires that the resulting inflow (or saving in outflow) be probable — the amount owed represents a valid claim or is collectable. However, some circumstances exist where collectability of an inflow is not assured — for example, where a creditor forgives a debt the entity owes. Under the Framework this forgiven liability would contribute revenue (being a saving in future outflows of assets), although no amount will even be ‘realised’ in the form of a physical inflow. The accounting profession has abandoned the position of insistence of receipt of a liquid asset before revenue can be recorded. The basis of insisting on the receipt of a liquid asset is to protect the working capital position of the firm. But accountants now believe that this is a managerial function. Revenue may be recognised even though a non-monetary asset is received. However, the first criterion of measurability is important — that the non-monetary asset be subject to reasonable valuation. 11. Is it important to have an external transaction to support the amount of revenue recorded? Name a case in present accounting practice where revenue or gain is not directly based on an external transaction and state the reasons for this exception. An external transaction is one with an outside party on an arm’s length basis. Such a transaction provides objective evidence of the value of the firm’s product or service. Many accountants believe that such objective evidence can be obtained without an external transaction. Where, for example, units are interchangeable and have an immediate marketability at quoted prices, it would seem reasonable to assume that the amount of revenue can be objectively determined. The requirement for an external transaction may be seen as a necessary but not a sufficient condition to establish revenue. Exceptions that are acceptable today are: • short-term investments — recovery to original cost may be recorded as a gain. The gain is permitted because it is an increase of a previously recorded decrease (loss). • accrued revenue, such as interest revenue. For accruals, the revenue is earned continuously as time passes, rather than at a specific point in time. For instance, interest revenue denotes the sale of a service, the use of money. • an exchange gain may be recorded based on the difference in exchange rates for relevant assets or liabilities on the original transaction date and the financial statement date. The change in exchange rate connected to the relevant asset or liability is considered an important economic event. 12. If the criterion of ‘existence of a transaction’ is relaxed so that the firms involved need not be direct participants in the transaction, what are the implications? If the firms involved need not be direct participants in the transaction, then objective evidence to support the amount of revenue would be obtained through observation of a market transaction. Providing the output is practically guaranteed to be sold, the objective evidence to measure the amount of revenue and the probability may be significantly assured, and thus revenue can be recognised. The implications would be that a sales transaction would not always be required before revenue could be recognised – i.e. revenue could be recognised before it is realised. The instructor may wish to discuss with students whether, in their opinion, the criterion should be relaxed. 13. What is meant by ‘substantial completion of the earning process’? What is the significance of this criterion? How is the criterion incorporated into IAS18/AASB 118? The meaning of the phrase is that the activities that generate revenue have been mostly undertaken. Usually, substantial completion of the earning process indicates sale or production has occurred. The significance of the criterion is that there is sufficient performance by the company to say it has ‘earned’ the revenue. In other words, the company has done enough to warrant the recording of revenue. Another reason that the recording of revenue may be justified at this point is that uncertainty of the costs to match against revenue is minimised, since most of the costs have already been incurred and whatever remains is predictable and estimable. This ‘substantial completion of the earnings process’ criterion, not explicitly stated in the AASB Framework, focuses on the notion that revenue is not generated (earned) until the firm has performed most of the activities for which the firm earns revenue. For this criterion to be applicable, revenue is not regarded as having been earned until the firm has done something. For example, the signing of a contract in most cases does not create revenue because there is no performance by the seller at that point. The criterion is not specifically stated in para 14, 20 and 29 of AASB 118 (see text figure 17.1). But completion of the earnings process underpins these paragraphs. For example, a sale occurs when substantially all the risks and rewards of ownership have transferred. This implies substantial completion of the earnings process. Similarly in the rendering of services, recognition depends on the extent to which the transaction is complete. Also for interest royalties and dividends, the process of earning the item is discussed. For example, interest is recorded as it is earned based on the effective interest method. 14. Does the percentage-of-completion method meet the criterion of substantial completion of the earning process? Explain. If the earning process is considered complete only when the project is finished, then the criterion is not met by the percentage-of-completion method. But if the intent of the criterion is considered, which is to ensure that revenue is recorded when there is sufficient performance by the firm, then it is met. Each period is a definable, separate segment of the total performance. Since revenue is based on the performance by the firm, then it is met. Since revenue is based on the performance of a given period, there is completion of the earning process for that period. Revenue is not recorded for any performance not yet undertaken. 15. What are the reasons for selecting the point of sale as the general revenue recognition principle? The point of sale basis is selected, because it is the earliest time when the three criteria for revenue recognition are met. The three criteria are: receipt of a measurable asset, existence of a transaction, and substantial completion of the earning process. At the point of sale, there is sufficient, objective evidence to support the amount of revenue. 16. What is the significance of ‘title passing’ in determining whether a sale has taken place? Legally, title passing is part of the meaning of a sale of a good. In accounting, we use this aspect of a sale to determine in many cases that a sale has taken place. But it is used as a guideline only, not a requirement. For example, in a sale-type capital lease, sales revenue is recorded by the lessor although title has not passed. Economic substance is more important than legal form. For this reason, accounting looks more at the transfer of significant risks and rewards of ownership in the sale of goods rather than the passing of legal title. 17. What are the reasons proposed for recognising revenue at the end of production? Objective evidence is the primary concern in revenue recognition. Certain companies can recognise revenue at the end of production (before sale), because there is sufficient evidence of the increase in value without the confirming evidence provided by a sale transaction. This will be the case for firms with forward contracts or a guaranteed buyer, such as gold to the Australian government. In these cases, production, rather than sale, is the ‘critical’ event. Once produced, the output is guaranteed to be sold, at least at the price specified by the contract or government. 18. ‘Revenue should be recognised only where it is supported by the existence of an external transaction.’ Discuss. While the existence of an arm’s-length external transaction provides objective evidence that revenue has been earned, revenue can still be earned without the existence of an external transaction. In certain circumstances standards allow revenue to be recognised other than the time of sale. These include: • during production AASB 111 Construction Contracts • end of production and AASB 6 Exploration for and Evaluation of Mineral Resources (provided there is a legally binding contract which establishes sales price) • unrealised foreign exchange gains AASB 121 The Effects of Changes in Foreign Exchange Rates The Framework criteria for revenue recognition are that it must be probable and measured reliably, this is generally consistent with the existence of an external transaction. However, the criteria are broad enough to encompass revenue recognition in certain situations without the requirement of an external transaction (provided there is sufficient objective evidence). 19. Explain how Myers’ concept of ‘critical event’ can influence the point at which revenue is recognised. Myers suggests that profits are earned (and therefore revenue can be recognised) upon the happening of the ‘critical event’ in the earnings process. This critical event differs from one business to the next and is the most critical decision or task within the transaction cycle. So, for example, in a service based business the critical event may be the delivery of a substantial portion of the service, in a retailer it may be the delivery of the goods, in a financial institution it may be the advance of a loan. Although this leads to inconsistent revenue recognition points, it can be useful in assisting accountants to identify when it may be appropriate to recognise revenue. 20. What are the conditions for use of the ‘cash received’ basis for revenue recognition? The ‘cash received’ basis of revenue recognition leads to revenue being recognised only when cash has been received, even though the sale had occurred prior to that. On the one hand, companies are encouraged to employ the sales basis for revenue recognition unless there is great uncertainty about the collectability of the periodic payments in an instalment sale. Then the instalment or cost recovery method is recommended. On the other hand, companies are forbidden to use the sales basis for revenue recognition and are required to use the instalment or cost recovery method if collectability is very uncertain, or if performance is not substantially complete. For example, retail land sales and construction contracts fall in this second category. The position of the profession at present appears to be this: • For instalment sales for typical retail and manufacturing companies, use the sales basis for revenue recognition, unless there is evidence of great uncertainty about collecting the payments — then use the instalment or cost recovery method. • For certain other industries, such as retail land sales and construction contracts, where it is typical for customers to give a long-term note in a sale, use the instalment or cost recovery method unless there is evidence of substantial performance by the seller and collectability of the note is assured — then the company may use the sale basis for revenue recognition. In some cases, the AASB has spelled out rules to determine collectability e.g. AASB 118. 21. When should revenue be recognised for the following businesses? (a) a soft-drink manufacturer (b) a legal firm (c) a theatre that sells season tickets to musical productions (d) a magazine publisher producing monthly titles (e) a gold-mining company (f) a farmer who grows wheat (g) a company which sells houses on an instalment plan; term of payment extending to 20 years; buyers assume all risks of ownership; buyers pay a deposit of 25% of the sales price (h) a contractor building a bridge for the government (a) When the soft drinks are delivered to the customers (b) When services are rendered (after the last act is performed) (c) After the musical production is performed. In most cases, refunds are not given to those who do not show up (no-shows). (d) When the magazines are delivered. For advertising revenue, when the advertising appears in the magazine. (e) Either at end of production (after the gold is mined) or at time of sale. A gold mining company has a choice of using end of production or sale basis for revenue recognition. (f) Sale as in (e) above. A wheat farmer has a choice between end of production or sale basis for revenue recognition because the wheat board guarantees prices. (g) It seems the full accrual method (sales basis) can be used. The main points are collectability and the degree of continuing involvement of the seller. (h) Percentage of completion method or completed contract method can be used. 22. On 20 December, E Ltd sold a portion of its inventory to W Ltd for $200 000 cash. The cost of the inventory was $80 000. In a related transaction, E Ltd agreed to repurchase the inventory from W Ltd 2 months later for $200 000, to be paid in four equal monthly instalments at 10% interest. What transactions should be recorded by E Ltd? According to AASB 118 para. 13, when an entity sells goods and, at the same time, enters into a separate agreement to repurchase the goods at a later date, the substantive effect of the transaction is negated, and the two transactions are dealt with together. The transaction will not give rise to revenue, even though legal title has passed. When repayment of the loan commences, the capital portion of the loan will be offset against liability, and the relevant interest expense on the outstanding balance will be recorded each month until it is repaid in full. 23. Lee Ltd agreed to manufacture Product A according to Smith Ltd’s specifications over a 2-year period. Because special machinery is needed to produce Product A, Smith Ltd is to pay for it. Lee Ltd purchased the machinery for $1 000 000. It debited Machinery and credited Cash. A month later, Lee Ltd received $1 000 000 from Smith Ltd as reimbursement of the cost. What entry should Lee Ltd make for the cash received? When Lee Ltd uses the machinery each year, what entry should be made? This is what Lee has done: Machinery $1 000 000 Cash $1 000 000 This agreement specifies that Smith is to pay for the machinery. The contract is only for two years. The problem does not state what will happen to the machinery at the end of the 2-year period. Will Lee keep it or will Smith expect to receive it? The assumption made here is that it does not appear that Smith intends this to be a donation to Lee (there is no information to support the view that it may be a donation). Probably, Lee did not want to take the risk of purchasing the special machinery for the sole purpose of making this product for Lee for only two years. Lee should not show the machinery in its statement of financial position as an asset and should not be depreciating it. Based on the fact that the original entry processed by Lee was incorrect, Lee should now record the following: Cash $1 000 000 Machinery $1 000 000 Presumably, the agreement specifies a certain (lower) price that Smith will pay for product A, which considered the fact that the special equipment will be purchased by Smith. When Lee uses the machinery, it will make no entry. When Smith purchases the product from Lee, it should increase the pertinent amount of depreciation expense. Smith should record the depreciation expense, and then, if considered appropriate, allocate the expense to the cost of its products through an overhead recovery account. 24. If revenue is recognised, does that mean that the revenue has been realised? Explain your answer and provide an example to support your view. If revenue is recognised that does not mean necessarily that the revenue has been realised. Recognising revenue is the process of including the earning activities conducted by the entity into the financial performance and position of the entity. Recognising that the earning activity has taken place, it therefore must be recorded. Realisation is the conversion of assets into cash or cash equivalence (such as a receivable). It can be said recognition requires an inflow of assets whereas realisation requires an inflow of liquid assets. There are many examples of revenues being recognised without being realised such as when a firm sells its product and receives raw materials or a fixed asset in return (bartering). Revenue can also be in the form of increases in the fair value of biological assets — whereas the revenue has been earned, a cash benefit associated with the revenue may not be realised for several reporting periods in the future. 25. Kalbarri Ltd began operations on 1 January 2008 by purchasing 3 000 orange tree saplings at a cost of $4 per sapling. Delivery charges were $500 and it cost $1 200 to plant the trees on Kalbarri Ltd’s land, which 2 years earlier cost $60 000. During 2008, the saplings produced fruit that was used to generate 1 000 seedlings. The only other expense during the year was herbicidal spraying, which cost $400. At the end of the year the saplings had a market value of $4 per sapling and the seedlings $1 per seedling. Show all journal entries for the calendar year 2008 and the calculation of profit for the year. Entries for the Year 2008: 01.01.2008 Dr Biological assets — Saplings $13 700 Cr Cash $13 700 Purchase of 3 000 orange tree saplings (incl. transport & planting costs) 01.01.2008 Dr Decrement in market value account $1 700 Cr Biological assets — Saplings $1 700 To recognise net market value of orange trees at $4 per tree. 31.12.2008 Dr Spraying Costs $400 Cr Cash $400 31.12.2008 Dr Biological assets — Seedlings $1 000 Cr Revenue — Increment Account $1 000 1 000 seedlings at a current market value of $1. We do not have sufficient information to calculate net value as we do not have an estimate of the costs associated with the sale of the seedlings. So record at $1 each and assume this is the net value. Calculation of profit/loss for 2008: Seedlings Increment $1 000 Saplings Decrement ($1 700) Net decrease in Market Value ($ 700) Add: Operating expenses ($ 400) Net Loss for 2008 ($1 100) 26. Why have the IASB and FASB begun a project to reconsider revenue recognition and measurement? What apects of their approach in this project may cause changes to the way companies recognise and measure revenue? The IASB and FASB have both admitted that there are inconsistencies between their conceptual framework and some standards. For example, the IASB has stated the application of recognition criteria in the Framework and IAS 18 may create deferred assets and liabilities which do not accord with the Framework’s definition of assets and liabilities. A similar situation occurs in the US, based on SFAC 5 and 6. Current guidance does not deal well with transactions involving components (multi-element revenue arrangements). Revenue recognition guidance is incomplete. There is diversity in current practice and revenue recognition policies of US companies have been the subject of the majority of the SEC’s requests for restatement of financial statements. Thus, standard setters have turned their attention to revenue recognition. Their approach is to focus on changes in assets and liabilities rather than the notions of realisation and earned (such as those contained in SFAC 5). This approach is consistent with SFAC 6 and avoids the problem of recognising debits and credits which do not meet the definitions of assets and liabilities. In addition, it avoids problems arising because notions of realised and earned are not precisely defined. However, the asset-and-liability approach represents a change from current practice, which may not be accepted by preparers and users of financial statements. The proposed measurement criterion requires that the change in assets or liabilities can be appropriately measured. Specifically, (1) assets or liabilities are measured by means of a relevant attribute; and (2) the increase in assets or decrease in liabilities is measurable with sufficient reliability. A relevant attribute suggest consideration of fair value measurement. The criterion does not refer to probability which was used in the past, eg AASB Framework para 83 (probable that future economic benefits associated with the item will flow to or from the entity). The measurement criterion places less emphasis on substantial completion of the earnings process. 27. What is meant by ‘revenue cut-off’? Why do auditors verify the date of sales transactions around the end of a financial period? The revenue cut-off assertion is that revenue transactions have been recorded in the correct accounting period. If sales transactions that occur in the first few days of an accounting period are backdated to the final days of the previous accounting period, revenue for the earlier period is overstated and revenue for the later period is understated. Auditors will perform procedures to test whether revenue transactions are recorded in the correct accounting period. These procedures include matching the date of the transaction recorded on the sales invoice or cash sales receipt to the date under which the transactions is recorded in the journals and ledgers. The procedures are designed to provide evidence to support the conclusion that the revenue for the period is fairly stated. 28. Explain why an auditor would be interested in the terms of the senior executives’ remuneration contracts, in particular, how bonuses for outstanding performance are calculated. An auditor would be interested in the terms of senior executives’ remuneration contracts because such contracts potentially create incentives for accounting misstatements. For example, if the contract specifies that the executive is paid a bonus based on revenue growth, auditors need to be alert to the possibility that revenue is overstated. If the bonus is based on profit growth, there are incentives to misstate both revenue and expense transactions. However if the contracts specify bonuses based on other performance targets, for example, share price increase or opening new branches, the incentives to overstate revenue are likely to be less. Problems 9.1 In the following examples, indicate whether it was proper for X to record the particular amount of revenue according to accepted recognition principles (accrual system). Your answer should be ‘yes’ or ‘no’. Give reasons for your answers. 1. No. The common carrier is the agent of X and it still has possession of the goods. There is no sale, because delivery has not been made, not until the point of destination. 2. Yes. For the sake of convenience to the customer, delivery has not been made. In such a case, delivery is not insisted upon in order to record revenue. If X wished to, X could wait until delivery to record the sale. 3. No. Since Y’s credit rating is good, there is no basis for belief that collectability is very uncertain; therefore, X should not use the instalment method. This assumes that delivery of the vehicle has been taken by X, and that there is nothing in the sale agreement which would vary the point at which control passes from seller to buyer. 4. No. There is also accrued interest for the four months from September 1 to December 31. 5. No. X should have recorded the $600 as revenue last year when the repair service was rendered. 6. No. The consignee is, in effect, an agent of X. Until the consignee sells the goods, there is no sale. 7. No. Until the study is completed, there is no sale of services. The completion of the study is necessary to the meaningfulness of the study. The last act must be performed before there is recognition of revenue. 9.2 State whether revenue (or gain) is to be recorded in the following cases: 1. Yes. In this case, the orchard is a biological asset, and according to AASB 141, changes in the fair value of biological assets are taken to profit or loss at the end of each accounting period. The trees will be measured at fair value less estimated costs to sell. 2. Yes. The tax refund qualifies as ‘other income’. It is not extraordinary and it is not a prior period adjustment. There is a realised increase in assets (increase in wealth) and the transaction is not a capital or financing one. 3. Yes. The cash from the lawsuit qualifies as ‘other income’. It is not a prior period adjustment. There is a realised increase in assets and the transaction is not a capital or financing one. 4. No. Production of paper does not qualify for the end of production revenue recognition principle, unless the firm has a financial contract. 5. Yes. There is a gain of $10 000. Since the amount of recovery from the insurance company exceeds the carrying value, a gain will be recorded. 6. Yes. An exchange of non-monetary dissimilar assets completes the earning process, and therefore a gain of $10 000 is to be recorded. 7. The receipt of a cash dividend is usually treated as income. Where a dividend is not received in cash, but rather in shares, the decision of whether it is income or not depends on how the market views the share dividend. If the market value of the shares drops, so that in total Company X’s investment value (and therefore net asset base) has not changed as a result of the share dividend, then there would be no income. However, if the overall value of the assets has increased by the receipt of the additional shares, then the definition of revenue is met and the dividend would be treated as income. There is insufficient information here to give a definitive answer, but students should be encouraged to discuss the issues around this. 8. Yes. An inflow of economic benefits has occurred and can be measured reliably. 9.3 Required: Calculate the amount of revenue for each year under each of the following recognition principles: (a) sales recognition principle (completed contract method) (b) production recognition principle (percentage-of-completion method) (c) instalment recognition principle (cash received method). (a) Completed contract method: 2005 2006 2007 2008 2009 Revenue 0 0 0 $600 000 0 The project was completed in 2008, and therefore the ‘sale’ is consummated in that year. (b) Percentage-of-completion method: 2006 2007 2008 Revenue $150 000 $375 000 $75 000 For 2006: $100 000/$400 000 = 25% 25% $600 000 = $150 000 For 2007: $350 000/$400 000 = 87½% less 25% = 62½% 62½ $600 000 = $375 000 For 2008: $400 000/$400 000 = 100% less 87½ = 12½% 12½% $600 000 = $75 000 (c) Cash received method: 2006 2007 2008 2009 Revenue 0 $100 000 $200 000 $300 000 9.4 Revenue was recognised when the events below occurred (accrual system). State whether it was proper or improper according to accepted recognition principles. 1. No. There is no sale – there was no transfer of significant risks and rewards of ownership. 2. No. Revenue should have been recorded a year ago when the repair was done. 3. Yes. There is a credit sale. The transfer of goods and the risks and rewards of ownership have passed. 4. No. Title does not pass until the common carrier has possession of the goods. The common carrier is the agent of the buyer in this case, and the goods have not been delivered to the agent yet. 5. No. Title passes at point of destination, and presumably the goods are still in transit. 6. Yes. The sale has occurred for two reasons. First, delivery is delayed at the convenience and request of the buyer. Second, the item is unique and costly, and therefore, legally, the sale is made when the buyer agrees to purchase the 1912 automobile. The presumption here is that delivery is the only outstanding action, and that the significant risks and rewards of ownership have passed to the buyer. 7. No. This is cash received in advance of the sale of the service. This is unearned revenue. 8. It depends on whether the conditions specified in AASB 118 are met. If significant risks and rewards of ownership have passed to the buyer and the seller effectively no longer controls the goods and it is probable that the sale will take place, they could recognise the revenue now. If not, recognition should be delayed. 9. No. This is a consignment, not a sale. 10. No. There is no performance yet. If the company had already begun to construct the yacht, then it could record the full amount as revenue. If there is performance, then a sale has been made. This assumes that the contract is not cancellable and that costs to be incurred can be measured reliably. 11. Yes. The sale was made because the truck was delivered. This is not an instalment sale, since there will be no periodic payments. Despite the fact that legal title has not passed, this is simply a credit sale. 12. Yes. Although this is an instalment sale, the sales basis should be used, because there is no evidence of great uncertainty in collecting the payments. 9.5 Required: According to generally accepted accounting principles, determine the total amount of sales revenue Steele Ltd should report on its statement of financial performance for 2008. 1. There is no sale. 2. Sale made for $300 000. Risks and rewards of ownership pass when the goods are shipped (EXW shipping point), which has occurred. 3. Sale of $12 000 000 made. It does not matter that $200 000 has not been received in cash, since the accrual method is used. 4. This is a consignment, not a sale. 5. The sales basis should be used, since there is no great uncertainty of collecting the payments. Sales of $150 000 to be recorded. There is interest income of $3 000. 6. There is no sale. Paper products do not qualify for the revenue recognition exception of recording revenue at end of production. $ 300 000 12 000 000 150 000 $12 450 000 Sales revenue for 2008 The interest income is not sales revenue. 9.6 Required: Prepare entries to record the sale of the franchise to T under each of the following assumptions: (a) The deposit is not refundable, no future services are required by the franchisor and collection of the note is reasonably assured. (b) The franchisor has substantial services to perform and the collection of the note is very uncertain. D Ltd will charge an annual fee of $4 000 for services rendered. (c) The deposit is not refundable, collection of the note is reasonably certain, the franchisor has yet to perform substantial services and the deposit represents services already performed. (a) Cash $150 000 Notes Receivable (at present value) 128 855 Revenue from Franchise Fees $278 855 It is possible to record the note at $150 000 and credit a discount account for the difference (150 000 – 128 855 = 21 145) Present value of ordinary annuity, 3 periods, 8% 2.5770 $50 000 = $128 855 (b) Cash 150 000 Unearned Franchise Fees 150 000 (c) Cash 150 000 Notes Receivable (at present value) 128 855 Revenue from Franchise Fees 150 000 Unearned Franchise Fees 128 855 9.7 Required: Prepare separate statements of financial performance for Divisions A and B for Year 1. For Division B, use the end of production revenue recognition principle. For Division A, using the percentage-of-completion method: $190 000 materials used 350 000 direct labour 100 000 overhead 80 000 administrative expenses (to be used because there is only one project) $720 000 total costs to date 720 000 additional costs to complete, including administrative expenses $1 440 000 total costs $720 000/$1 440 00 = 50%, percentage of completion 50% $2 000 000 = $1 000 000 revenue Statement of Financial Performance For the Year Ended December 31, Year 1 Revenue $1 000 000 Cost of construction 640 000 Gross profit $ 360 000 Administrative expenses 80 000 $ 280 000 For Division B, using the end of production method: Statement of Financial Performance For the Year Ended December 31, Year 1 Sales revenue: Barley (8 000 m3 $5.00) $40 000 Rye (12 000 m3 $3.00) 36 000 Total $76 000 NRV of ending inventory: Barley (2 000 m3 $5.00) $10 000 Rye (8 000 m3 $2.70) 21 600 31 600 Total revenues $107 600 Less operating expenses 50 000 Operating income $57 600 Other items: Loss on sale of beginning inventory of barley (1000 m3 $0.40) -400 Gain on sale of beginning inventory of rye (2 000 m3 $0.10) 200 -200 Net income $57 400 The NRV for ending inventory was calculated as follows: Barley: $5.50 expected sale price less $0.50 expected cost of disposition = $5.00 Rye: $3.20 expected sale price less $0.50 expected cost of disposition = $2.70 The sale of the beginning inventory is made for speculative profit. The beginning inventory was considered revenue in the previous year at NRV. Any difference between the NRV of the previous year and the net realised amount this year is gain or loss. The NRV for the previous year was: Barley: $5.40 less $0.50 = $4.90 Rye: $2.90 less $0.50 = $2.40 The net amount realised this year was: Barley: $5.00 less $0.50 = $4.50. Therefore a loss of $0.40 was realised when sold ($4.90 –$4.50) Rye: $3.00 less $0.50 = $2.50. Therefore a gin of $0.10 was realised when sold ($2.40 - $2.50) The expenses related to the sale of the beginning inventory were deducted in the previous year, since NRV was taken. 9.8 Required: A. Record the journal entries relating to the instalment sales, using a deferred gross profit account. B. Calculate the realised gross profit, showing it as the difference between revenue and cost of goods sold. A. (a) Instalment accounts receivable $700 000 Instalment sales $700 000 (b) Cost of instalment sales 420 000 Inventory 420 000 (c) Cash 300 000 Instalment accounts receivable 300 000 (d) General — administrative expenses 70 000 Cash or Accounts payable 70 000 (e) (At end of period) Instalment sales 700 000 Cost of instalment sales 420 000 Deferred gross profit 280 000 (f) Deferred gross profit 120 000 Realised gross profit 120 000 $280 000/$700 000 = 40%, gross profit rate 40% $300 000 (cash received) = $120 000 or $300 000/$700 000 = 42.857% 42.875% $280 000 = $120 000 (g) Realised gross profit 120 000 General — administrative expenses 70 000 Income summary 50 000 B. Revenue (cash received) $300 000 Cost of goods sold 180 000 Realised gross profit $120 000 As can be seen in the entries above, Revenue and Cost of goods sold are not recorded as accounts. Instead, the realised gross profit is an account from the ledger. They are put in this format so that the student can see that the cash received is actually the revenue, when the instalment method is used. Cost of goods sold is 60% of revenue or it can be calculated as 42.857% of $420 000 = $180 000. 9.9 Required: A. Prepare all journal entries to record the establishment of Brockelsby Station Ltd. B. Prepare journal entries to reflect the change in net market value of cattle at 30 June 2008 and the sale of calves during the period. C. Assume the only transaction was veterinary fees of $20 000. Show the calculation of reported profit/loss for Brockelsby Station Ltd at 30 June 2008. (Note: All transactions are cash transactions. Brockelsby Station Ltd has been established to buy, breed, sell or slaughter and process cattle for sale at retail outlets.) A. Prepare all journal entries to record establishment of Brockelsby Station: Note: Cannot record purchase of land as we do not know the purchase price. 01.01.2008 Dr Biological assets — livestock $1 115 000 Cr Cash $1 115 000 Purchase and transport of livestock Dr Decrement in value of Biological assets (Recognised as expenses) $120 600 Cr Biological assets — livestock $120 600 Cost of purchase, transport costs to buy, point of sale costs, and 1% auction fee ($55 000 + $55 000 + $10 600) B. 30.06.2008 Dr Cash $8 000 Cr Sales $8 000 Sale of livestock Dr Biological assets - livestock $225 600 Cr Net Increment in value (Revenue) $225 600 Net increment in market value of livestock Net value start of year ($1 115 000 – $120 600) is $994 400. Net change is $1 220 000 – $994 400 = $225 600. C. Calculation of profit for period: Sales $ 8 000 Market increment $225 600 $233 600 Decrement expense $120 600 $113 000 less: Expenses $ 20 000 Profit $ 93 000 9.10 See Pty Ltd began operations on 1 January 2008 by purchasing 5 000 apple tree saplings at a cost of $2 per sapling. It costs $3 600 to transport and plant the trees on land purchased 3 years earlier for $100 000. During 2008, the only expenses were insecticide spraying and pruning costs totalling $8 000. On 15 August an additional 1 000 saplings were purchased for $3 each (with transport and planting costs of $1 800). In November a bushfire destroyed 25% of the planted trees. The year-end market valuation of the remaining trees was $11 000. Show all journal entries for the calendar year 2008 and the calculation of profit/loss for the year. Assume all transactions are cash-based. 01.01.2008 Dr Biological assets $13 600 Cr Cash $13 600 Purchase of saplings including transport and planting costs Dr Decrement in fair value —Expense $3 600 Cr Biological assets $3 600 To recognise net market value (assume net market value would be $2 per sapling) 15.08.08 Dr Biological assets $4 800 Cr Cash $4 800 Purchase of saplings including transport and planting costs Dr Decrement in fair value —Expense $1 800 Cr Biological assets $1 800 Recognise net market value (assume net market value would be $3 per sapling) 31.12.2008 Dr Spraying & Pruning Costs $8 000 Cr Cash $8 000 Operating expenses Dr Natural disaster expense $3 250 Cr Biological assets $3 250 Loss of 25% of trees (25% $10 0000; 25% $3 000) Dr Biological assets $1 250 Cr Market Value Increment Revenue $1 250 Net value at year of saplings was $9 750 and market value was $11 000 difference is a gain. Calculation of profit/loss: Net Increment $1 250 Less: Loss of Biological assets ($3 250) ($2 000) Operating Expenses ($8 000) Net Loss ($10 000) Solution Manual for Accounting Theory Jayne Godfrey, Allan Hodgson, Ann Tarca, Jane Hamilton, Scott Holmes 9780470818152
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