Chapter 9

Revenue Recognition and Recognition of Expenses

OBJECTIVE 1: DEFINITION OF REVENUE

1.1 Meaning

The Institute of Chartered Accountants of India (ICAI) defines revenue as “the gross inflow of cash, receivables, or other consideration, arising out of activities of an enterprise from the sale of goods, from the rendering of services and from the use by others, of enterprise resources yielding interest, royalties, and dividends.”

OBJECTIVE 2: FACTORS DERIVED FROM THE DEFINITION

• Revenues are the gross inflow of cash from the following activities of a business enterprise.
  1. Sale of goods, i.e. selling of products or raw materials.
  2. Rendering of services.
  3. From the use by others, i.e. permitting others to use enterprise resources which will yield interest, royalties, dividends and so on.
• In addition, the following may also be taken into consideration for recognition of revenues:
  1. Selling of assets other than goods.
  2. Receiving the amount of commission in an agency relationship.

Here it is to be noted that in case a fixed asset is sold, only the difference between sale price and the book value is recognised as revenue (i.e., profit amount in sale of fixed assets – net receipts). For example, if a building with a book value of Rs 5,00,000 is sold for Rs 5,50,000 only (Rs 5,50,000 – 5,00,000) = Rs 50,000 is to be recognised as revenue and not the entire sale proceeds. Similarly, revenue is the amount of commission received and not the gross receipts in an agency relationship.

• Flow of revenue may relate either to one accounting period or may spread over more than one accounting period. Revenues do not include assets or resources acquired by purchases, proceeds from borrowings, or capital by owners or adjustments of revenues of earlier periods.

OBJECTIVE 3: TIMING OF REVENUE RECOGNITION

3.1 Recognition of Revenue

Revenue recognition is mainly concerned with the timing of recognition of revenue in the income statement or for income determination. There are two views relating to timing of recognition of revenue. First view is that revenue has to be recognised as and when the transaction takes place without waiting for the receipt of cash. This view is based on accrual concept. The second view is that revenue is to be recognised when cash is received. This is based on cash concept or cash accounting.

Business enterprises adopt accrual accounting. Certain professions use cash accounting (doctors, lawyers and chartered accountants).

OBJECTIVE 4: GUIDELINES FOR REVENUE RECOGNITION

The following guidelines have been adopted to recognise revenues in the books of account as soon as

• the business enterprise has performed substantial portion of its duty in the form of transfer of goods to the buyer or performance of service as the case may be,
• the revenue can be objectively measured,
• the earning process has been substantially completed in the sense that the major portion of costs has been incurred and the remaining costs can be estimated with reasonable accuracy,
• the amount ultimately collectable on bills is realisable or from debtors has been received and estimate can be made of the bad debts or unrecoverable amount.

OBJECTIVE 5: REVENUE RECOGNITION AT THE POINT OF SALE

“Revenue recognition” is ascertained at the time of sale of products or performance of the services. This method is used by most of the business entities. This method of revenue recognition is known as the complete “Sale or Market Test.” The reasons for the use of “Sale or Market Test” are as follows:

• It is in conformity with the tests of objectivity and definiteness.
• Goods are transferred to the buyer and thereby the buyer attains title to the goods.
• Amount of revenue is measured objectively and precisely.
• Most of the costs have been incurred.
• If collection from the customers is unknown, such amount can be estimated easily.

Even though the AS–9 sets out certain guidelines on this aspect, sales should be in accordance with the provisions of the Sale of Goods Act. As such agreement to sell, goods sent on consignment basis and sale on approved basis do not constitute legal sales.

OBJECTIVE 6: A METHOD TO ASCERTAIN RECOGNITION OF REVENUE

6.1 Proportionate or Percentage of Completion Method

AS–9 recognises this method and for long-term contracts this method is adopted. According to this method, revenue is recognised in the Statement of Profit and Loss proportionately with the degree of services under a contract. Instead of waiting for a few years for completion of project to recognise revenue, this method aims at recognising revenues on yearly basis. Accordingly, percentage of completion method is used by which a portion of total contract price is recognised as revenues of each accounting period, on the basis of the reasonable estimate of the work completed. This is explained by way of an illustration as follows: (figures are imaginary)

A construction company engaged in the construction of a bridge, incurs costs of Rs 30,00,000 in 2007, Rs 40,00,000 in 2008 and Rs 30,00,000 in 2009. Revenue recognised during 2007, 2008 and 2009 are as follows:

The Gross Profit recognised for 2007 is (Rs 33,00,000 – Rs 30,00,000) = Rs 3,00,000 and for 2008 is (Rs 44,00,000 – Rs 40,00,000) = Rs 4,00,000 and for 2009 is (Rs 33,00,000 – Rs 30,00,000) = Rs 3,00,000. It should be noted that all the remaining revenues are recognised and no percentage of work completed (estimate) is calculated.

Under the Percentage of Completion Method, degree of completion consists of both the amount of revenues and the amount of expenses.

6.2 Installment Method of Revenue Recognition

Detailed procedure is explained in the chapter “Hire Purchase.” Under this method, one makes the down payment at the time of signing the agreement for installment sale and promises to pay the remaining in installments over a period. Revenue is recognised only when the installments are collected in cash. Every installment comprises of two components:

1. a part of the cost of goods (expenses recovered) and
2. a part of the gross profit on sale.

Let us illustrate:    (based on assumptions)

    Sale price of a motor cycle is Rs 35,000

    Cost of motor cycle is Rs 26,250

The collection of installments is as:

 

    Gross Profit to sale

Hence, each installment consists of 75% recovery of the cost of goods sold and 25% of gross profit which is shown in the tabular column as follows:

6.3 Recognition at Completion of Production Process

Under this method, revenues are recognised when the goods are produced. Sale is not considered as a deciding factor.

For example, extraction of precious metals from mines, agriculture products and so on.

In mining enterprises, revenues can be determined at the stage of production itself. Similarly, the sale of agricultural products is estimated objectively at the stage of harvest (end stage of production process) itself.

6.4 Revenue Recognition on Holding of Assets

On investments, both short- and long-term, interest earned, dividend received and capital gains on sale are recognised as revenues. In case of leasing, revenue is recognised when others hold the assets of the business.

6.5 On Service Contracts

Service charges are recognised only at the time when the work is completed.

OBJECTIVE 7: CONCEPT OF RECOGNITION OF EXPENSES (COSTS)

Here, cost is always treated as an expired cost (expense). Expired cost represents the cost that has been used to earn revenues. It may also be said that costs are the resources to earn revenue. Fixed assets such as land, buildings, plant, machinery and the like are termed as unexpired costs (expenses) or used assets as depreciation.

Examples of expired costs:

1. Cost of Goods Sold
2. Wages and Salaries
3. Interest Expenses and
4. Selling Costs and so on

7.1 Guidelines for Expense Recognition

The matching principle is the main concept to determine expenses for a period, which requires perfect association of expenses with revenues.

The methods to determine expense recognition are as follows:

1. direct identification of expenses with revenues and
2. identification with the accounting period

Expenses that can be readily identified by knowing its association with revenues may be determined in the first method. For example, commission to salesmen with sales, cost of goods sold with sales of goods. Simply saying by matching revenues with respective associated and related expenses, expense recognition is determined at ease by the first method.

Expenses are determined mainly relating to the period for which they were spent. For example, insurance premiums are written off pro rata over the period, spreading over a few accounting years.

Expense portion of the cost of a fixed asset is recognised by matching the revenues of the period with the total revenue that the asset will help produce over its useful life. The important factors to be considered while assessing expense recognition under the second method are

1. objectivity
2. passage of time and
3. convenience

After explaining these basic concepts, the need arises to discuss the salient features of AS–9.

OBJECTIVE 8: AS–9 REVENUE RECOGNITION

Accounting Standard comprises paragraphs 10–14 of this statement. The Standard should be read in the context of paragraphs 1–9 of this statement and of the preface to the Statements of Accounting Standards.

8.1 Introduction: Salient Features of AS–9

1. This statement deals with the bases for recognition of revenue in the Statement of Profit and Loss of an enterprise. The statement is concerned with the recognition of revenue arising in the course of ordinary activities of the enterprise from
   1. the sale of goods,
   2. the rendering of services,
   3. the use by others of enterprises resources yielding interest and
   4. royalties and dividends.
2. This statement does not deal with the following aspects of revenue recognition to which special considerations apply:
   1. revenue arising from construction contracts,
   2. revenue arising from hire purchase and lease agreements,
   3. revenue arising from government grants and other similar subsidies,
   4. revenue of insurance companies arising from insurance contracts.
3. Examples of items not included within the definition of “revenue” for the purpose of the statement are as follows:
   1. Realised gains from the disposal of and unrealised gains resulting from holding of noncurrent assets, e.g. appreciation in the value of fixed assets.
   2. Unrealised holding gains resulting from the change in the value of current assets and the natural increases in herds and agricultural and forest products.
   3. Realised or unrealised gains resulting from change in foreign exchange rates and adjustments arising on the translation of foreign currency financial statements.
   4. Realised gains resulting from the discharge of an obligation at less than its carrying amount.
   5. Unrealised gains resulting from the carrying amount of an obligation.

8.2 Definitions

The following terms are used in the statement with the meaning specified.

Revenue is the gross inflow of cash receivables or other considerations in the course of the ordinary activities of an enterprise from the sale of goods, from the rendering of services, and from the use by others of enterprise resources yielding interest, royalties and dividend. Revenue is measured by the charges made to customers or clients for goods supplied and services rendered to them and by the charges and rewards arising from the use of resources by them. In an agency relationship, the revenue is the amount of commission and not the gross inflow of cash, receivables or other consideration.

Completed Service Contract Method is a method of accounting which recognises revenue in the Statement of Profit and Loss only when the rendering of services under a contract is completed or substantially completed.

Proportionate Completion Method is a method of accounting which recognises revenue in the Statement of Profit and Loss proportionately with the degree of completion of services under a contract.

8.3 Explanation

Revenue recognition is mainly concerned with the timing of recognition of revenue in the Statement of Profit and Loss of an enterprise. The amount of revenue arising on a transaction is usually determined by agreement between the parties involved in the transaction. When uncertainties exist regarding the determination of the amount or its associated costs, these uncertainties may influence the timing of revenue recognition.

8.4 Sale of Goods

A key criterion for determining when to recognise revenue from a transaction involving the sale of goods is that the seller has transferred the property in the goods to the buyer for a consideration. The transfer of property in the goods, in most cases, results in or coincides with the transfer of significant risks and rewards of ownership to the buyer. However, there may be situations where transfer of property in goods does not coincide with the transfer of significant risks and rewards of ownership to the buyer. Such cases may arise when delivery has been delayed through the fault of either the buyer or seller and the goods at the risk of the party at fault as regards any loss which might not have occurred but for such fault. Further, sometimes the parties may agree that the risk will pass at a time different from the time when ownership passes.

At certain stages in specific industries, such as when agricultural crops have been harvested or mineral ores have been extracted, performance may be substantially complete prior to the execution of the transaction generating revenue. In such cases, when sale is assured under a forward contract or a government guarantee or where market exists and there is a negligible risk of failure to sell; the goods involved are often valued at net realisable value. Such amounts while not revenue as defined in this statement are sometimes recognised in the Statement of Profit and Loss and appropriately described.

8.5 Rendering of Services

Revenue from service transactions is usually recognised as the service is performed either by the Proportionate Completion Method or by the Completed Service Contract Method.

Proportionate Completion Method: Performance consists of the execution of more than one act. Revenue is recognised proportionately by reference to the performance of each act. The revenue recognized under this method would be determined on the basis of contract value, associated costs, number of acts or other suitable basis. For practical purposes, when services are provided by an indeterminate number of acts over a specific period of time, revenue is recognised on a straight line basis over the specific period unless there is evidence that some other method better represents the pattern of performance.

Completed Service Contract Method: Performance consists of the execution of a single act. Alternatively, services are performed in more than a single act, and the services yet to be performed are significant in relation to the transaction taken as a whole that performance cannot be deemed to have been completed until the execution of those acts. The Completed Service Contract Method is relevant to these patterns of performance and accordingly revenue is recognised when the sole or final act takes place and the service becomes chargeable.

The use by others of enterprise resources yielding interest, royalties and dividends:

1. The use by others of such enterprise resources gives rise to
   1. interest – charges for the use of cash resources or amounts due to the enterprise
   2. royalties – charges for the use of such assets as know-how, patents, trade marks and copyrights
   3. dividends – rewards from the holding of investments in shares
2. Interest accrues, in most circumstances, on the time basis determined by the amount outstanding and the rate applicable. Usually, discount or premium on debt securities held is treated as though it were accruing over the period to maturity.
3. Royalties accrue in accordance with the terms of relevant agreement and are usually recognised on that basis unless, having regard to the substance of the transactions, it is more appropriate to recognize revenue on some other systematic and rational basis.
4. Dividends from investments in shares are not recognised in the Statement of Profit and Loss until a right to receive payment is established.
5. When interest, royalties and dividends from foreign countries require exchange permission and uncertainty in remittance is anticipated, revenue recognition may need to be postponed.

8.6 Effect of Uncertainties on Revenue Recognition

1. Recognition of revenue requires that revenue is measurable and that at the time of sale or the rendering of the service, it would not be unreasonable to expect ultimate collection.
2. Where the ability to assess the ultimate collection with reasonable certainty is lacking at the time of raising any claim, e.g. for escalation of price export incentives, interest, etc. revenue recognition is postponed to the extent of uncertainty involved. In such cases it may be appropriate to recognize revenue only when it is reasonably certain that the ultimate collection will be made. When there is no uncertainty as to the ultimate collection, revenue is recognised at the time of sale or rendering of service even though payments are made by installments.
3. When the uncertainty relating to collectability arises subsequent to the time of sale or the rendering of service, it is more appropriate to make a separate provision to reflect the uncertainty rather than to adjust the amount of revenue originally recorded.
4. An essential criterion for the recognition of revenue is that the consideration receivable for the sale of goods, the rendering of services form the use by others of enterprise resources is reasonably determinable when such consideration is not determinable within reasonable limits and the recognition of revenue is postponed.
5. When recognition of revenue is postponed due to the effect of uncertainties, it is considered as revenue of the period in which it is properly recognised.

8.7 Accounting Standard

1. Revenue sales or service transactions should be recognised when the requirements as to performance set out in paragraphs 11 and 12 are satisfied, provided that at the time of performance it is not unreasonable to expect ultimate collection. If at the time of raising of any claim it is unreasonable to expect ultimate collection, revenue recognition should be postponed.
2. In a transaction involving the sale of goods, performance should be regarded as being achieved when the following conditions have been fulfilled:
   1. the seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and
   2. no significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods.
3. In a transaction involving the rendering of services, performance should be measured either under the Completed Service Contract Method or under the Proportionate Completion Method, whichever relates the revenue to the work accomplished. Such performance should be regarded as being achieved when no significant uncertainty exists regarding the amount of the consideration that will be derived from rendering the service.
4. Revenue arising from the use by others of enterprise resources yielding interest, royalties and dividends should only be recognised when no significant uncertainty as to measurability or collectability exists. These revenues are recognised on the following basis:
   1. Interest: On a time proportionate basis taking into account the amount outstanding and the rate applicable.
   2. Royalties: On an accrual basis in accordance with the terms of the relevant agreement.
   3. Dividends from investment in shares: When the owner’s right to receive payment is established.

   Disclosure

5. In addition to the disclosures required by AS–1 on Disclosure of Accounting Policies (AS–1), an enterprise should also disclose the circumstances in which revenue recognition has been postponed pending the resolution of significant uncertainties.

OBJECTIVE 9: APPENDIX

Appendix is given here to illustrate the application of AS–9 to a number of commercial transactions. Following are some special commercial situations to illustrate as to how the revenue is to be recognised:

1. Sale of Goods: Delivery is delayed at buyer’s request and buyer takes title and accepts billing Revenue is to be recognised even if the delivery is yet to be made. But the item sold should be in stock, identified and ready for delivery.

2. Delivery Subject to Conditions – Installation and Inspection: Under such conditions, revenue should be recognised only after the customer accepts delivery and installation is done completely. Where the installation does not require much cost, it is recognised at the time of sale itself.

3. Sale on Approval: Revenue should not be recognised until the goods are formally accepted by the buyer or the time period for rejection has been elapsed or where no time has been fixed, a reasonable time has elapsed.

4. Guaranteed Sales: Delivery is made giving the buyer an unlimited right of return. Revenue recognition depends on the substance of agreement. In the case of retail sales offering a guarantee of “money back if not completely satisfied” it may be appropriate to recognise the sale but to make a suitable provision for revenues based on previous experience. In other cases, the agreement may amount to a sale on consignment.

5. Consignment Sales: Revenue should not be recognised until the goods are sold to a third party.

6. Cash on Delivery Sales: Revenue should not be recognised until cash is received by the seller or his agent.

7. Sales on Installment Payments and Delivery to be made after the Receipt of Final Installment: Revenue is recognised after effecting the delivery of goods.

8. Special Order and Shipments: Revenue from such sales should not be recognised until goods are manufactured, identified and ready for delivery to the buyer by the third party.

9. Sale/Repurchase Agreements: It is a method of obtaining finance and the resulting cash flow is not revenue as defined and should not be recognised as revenue.

10. Sales to Intermediate Parties: Goods are sold to distributors, dealers or intermediaries for resale. Revenue from such sales may be recognised if significant risk of ownership has passed; in some situations the buyer may in substance be an agent and in such cases the sale may be treated as a consignment sale.

11. Subscriptions for Publications: Revenue bill will be allocated to different periods on a straight line basis over time. However, where the items delivered vary in value from period to period, revenue should be based on the sales value of items delivered in relation to total sales value of all items covered by the subscription.

12. Trade Discounts and Volume Rebates: They are a reduction in cost. They should be deducted in determining revenue. They do not constitute revenue.

13. Rendering of Services:

1. Installation fees: Revenue is recognised only after the installation is completed and accepted by customer.
2. Advertising and insurance agency commissions: Revenue should be recognised when the service is completed. For advertising agencies, media commissions will normally be recognised when the related advertisement appears before the public and production commissions only when the project is completed.

   Insurance agency commissions should be recognised on the effective commencement or renewal dates of related policies.

3. Financial services commissions: A financial service may be rendered as a single act or may be spread over a period of time. The recognition of such revenue should have regard to:
   1. whether the service has been provided “once and for all” or is on a “continuing basis”
   2. the incidence of the costs relating to the service
   3. when the payment for the service will be received
4. Admission fees: Revenue should be recognised when the events take place.
5. Consultancy and maintenance contracts are recognised on completed contract method.
6. Tuition fees: Revenue should be recognised over the period of tution.
7. Entrance and membership fees: Entrance fee is to be capitalised. Membership fees depend on the nature of services provided. If it pertains to membership only, the fee should be recognised when received.

• “Revenue” may be defined as “the gross inflow of cash or other consideration, arising out of activities of an enterprise from the sale of goods, from the rendering of services and from the use by others, of enterprise resources yielding interest, royalties and dividends.”
• Revenues are gross inflow of cash, selling of assets other than goods and receiving commission in an agency type business.
• Flow of revenue relates to even more than one accounting period.
• Revenues do not include assets acquired by purchases, proceeds from borrowings, capital by owners and adjustment of revenues for earlier period.
• Revenue is recognised on accrual as well as cash concepts.
• Revenue recognition at point of sale: Revenue is recognised at the time of sale of products: A “Sale or Market” Test.
• Revenue is recognised in the statement of profit and loss proportionately with the degree of services under a contract. AS–9 recognises this method.
• Revenue is recognised under installment method also. Revenue is recognised only when the installments are collected in cash.
• Recognition of expenses: Cost is always treated as an expired cost – the cost that has been used to earn revenues.
• The methods to determine expense recognition are (i) direct identification of expenses with revenues and (ii) identification with the accounting period.
• Accounting Standard–9 (AS–9): Salient provisions with Appendix (refer the main part of the text).

Accounting Standard (AS–9): AS–9 deals with how revenue is to be recognised in profit and loss account of a business entity.

Revenue: It may defined as “the gross inflow of cash, receivables or other consideration, arising out of activities of an enterprise from the sale of goods, from the rendering of services and from the use by others, of enterprise resources, yielding interest, royalties and dividends.”

Recognition of Expenses: To recognise costs that has been used to earn revenues during a specified period.

Recognition of Revenue: To recognise revenue in the form of an inflow of assets resulting from the profit. Revenue may be recognised when transaction takes place (accrual) or when cash is received (cash basis).

 

“Compendium of Statements and Standards of Accounting” – The Institute of Chartered Accountant of India, New Delhi.

 

I. State whether the following statements are True or False

1. Revenue is the gross inflow of cash.
2. Net receipts are recognised as revenue.
3. Flow of revenue must be related to a particular specific period only.
4. Revenue includes capital introduced by the owner.
5. Professionals follow accrual accounting basis only.
6. Revenue is recognised only at the time of sale of products or performance of services.
7. AS–9 deals with valuation of inventories.
8. Appreciation in the value of fixed assets is an important item for revenue recognition.
9. Revenue recognition is mainly concerned with the timing of recognition of revenue in the profit and loss account.
10. Revenue should be recognised when the equipment is installed and accepted by the customer.
11. Realisation principle is applicable to the recognition of expenses also.
12. Direct identification of expenses with revenues is essential in recognition of expenses.

Answers

 

1. True	2. True	3. False	4. False	5. False
6. True	7. False	8. False	9. True	10. True
11. False	12. True

1. What do you mean by “revenue” in accounting?
2. How is revenue recognised in respect of sale of goods?
3. How is revenue recognised in respect of rendering of services?
4. Explain revenue recognition with respect to “use by others of enterprise resources.”

1. Explain the guidelines to be followed to recognize revenues with suitable illustrations and exceptions.
2. What are the guidelines to be followed to recognize expenses (costs)?
3. Explain in detail the salient features of AS–9?