Revenue Recognition under International Accounting Standard 18 - “Revenue” with Comparisons to US GAAP

- RevenueRecognition.com Contributor

International Accounting Standard (“IAS”) 18 applies to revenue arising from:

a) The sale of goods
b) The rendering of services, other than construction contracts (1) and
c) The use by others of entity assets yielding interest, royalties and dividends.

IAS 18 contains high-level general principles applicable to different industries and transactions. While US GAAP is based on the same principles, it contains more detailed implementation guidance and includes industry specific guidance, such as software, which results in more consistent revenue recognition.

This article covers the revenue recognition process for the sale of goods and services which can be broken down into the following steps:

1) Identify the Transaction
2) Identify the Components to be Accounted for Separately
3) Allocate the Consideration to the Components
4) Assess the Revenue Recognition Criteria

Step 1 - Identify the Transaction

As part of identifying the transaction it is necessary to determine whether two or more transactions should be linked and accounted for as one arrangement. IAS 18.13 states that revenue recognition criteria are applied to two or more transactions together when they are linked in such a way that the commercial effect cannot be understood without reference to the series of transactions as a whole. However, the standard does not provide any factors to consider in determining whether transactions should be accounted for together. From April 2002 to February 2003 IFRIC discussed the issue of Reporting of Linked Transactions (2), but the factors to consider were never finalized and the project was dropped in November 2006. At that time IFRIC tentatively agreed to the following indicators that transactions should be accounted for together:

• The transactions are entered into at the same time or as part of a continuous sequence and in contemplation of one another.
• The transactions, in substance, form a single arrangement that achieves or is designed to achieve an overall commercial effect.
• One or more of the transactions, considered on its own, does not make commercial sense, but they do when considered together.
• The contracts include one or more options or conditional provisions for which there is no genuine commercial possibility that the option(s) or conditional provision(s) will, or alternatively will not, be exercised or fulfilled.
• The occurrence (or non-reversal) of one transaction is dependent on the other transaction(s) occurring.

While IAS 18 does not contain indicators to consider in determining whether multiple transactions should be accounted for together, the US GAAP software guidance in 985-605-55-4 does provide indicators that are used for both software and non-software transactions. Those US GAAP indicators, in addition to the non-finalized IFRIC indicators, may be referenced when determining whether multiple transactions should be accounted for together.

Step 2 – Identify the Components to be Accounted for Separately

IAS 18.13 indicates that where there are multiple components in a single transaction, the revenue recognition criteria should be applied to the separately identifiable components in order to reflect the substance of the transaction. While US GAAP has specific guidance on how to determine whether separately identifiable components exist, IAS18 does not. As a result, under IFRS, assessing whether the components can be separately accounted for is determined by analogy to Paragraph 15 of IFRIC 18 – Transfers of Assets from Customers, which indicates that a separate component exists when:

i) The component has stand-alone value to the customer
• This is also a requirement under US GAAP along with the requirement that if there is a right of return associated with the delivered item that delivery or performance of the undelivered item is considered probable and substantially in the control of the vendor.
ii) The fair value of the component can be measured reliably
• Discussed in Step 3.

Step 3 – Allocate the Consideration to the Components

IAS 18.9 states that revenue should be measured at the fair value of the consideration received. Where multiple components exist it is necessary to allocate the consideration to the individual components; however unlike US GAAP, IAS 18 does not address the allocation of revenue to the separate components. Once again, analogy to other IFRS standards such as the following is required:

a) IFRIC 12, Service Concession Arrangements which requires the use of the relative fair value method as noted in Paragraph 13
• US GAAP (Accounting Standards Codification (“ASC”) 605-25) similarly refers to the use of the relative selling price method where Vendor Specific Objective Evidence (“VSOE”) is the preferred measure and third-party evidence is the alternative measure if VSOE does not exist.
b) Paragraph 11 to the appendix (3) to IAS 18 which permits allocation of the expected cost plus reasonable profit to the undelivered item
• For non-software transactions, US GAAP (ASC 605-25) permits the use of management’s best estimate of selling price when VSOE or third party evidence of fair value does not exist, which would include this method.
c) IFRIC 13, which permits the use of the residual value method (i.e. fair value of the undelivered item) as noted in the Basis for Conclusions to IFRIC 13, Paragraph 14
• The residual method is no longer permitted under US GAAP as per Accounting Standards Update 2009-13 codified in ASC 605-25. Note that as IFRS does not include software industry guidance, VSOE of fair value is not a requirement for allocating consideration to multiple software components, as is the case under US GAAP software revenue recognition guidance.

Step 4 – Assess the Revenue Recognition Criteria

The final step is to determine when revenue can be recognized. IAS 18 indicates that revenue is recognized when it is probable that the economic benefits will flow to the entity and these benefits can be measured reliably. The standard outlines specific revenue recognition criteria for the sale of goods (sections 14 through 19) as well as the sale of services (sections 20 through 28).

Revenue Recognition Criteria - Sale of Goods:

Revenue may be recognized when:
a) The entity has transferred to the buyer the significant risks and rewards of ownership of the goods
b) The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold
• Criteria A and B are similar to the US GAAP requirement that delivery has occurred.
c) The amount of revenue can be measured reliably
• This criterion is similar to the US GAAP requirement that the seller’s price is fixed or determinable.
d) It is probable that the economic benefits associated with the transaction will flow to the entity
• This criterion is similar to the US GAAP requirement that collectability is reasonably assured.
e)The costs incurred or to be incurred in respect of the transaction can be measured reliably.
• Although not noted as one of the four US GAAP criteria for revenue recognition, when costs cannot be reliably estimated, such as for warranties (ASC 460-10-25-6) revenue recognition is precluded.

As can be seen from the above, the IFRS and US GAAP criteria for revenue recognition are similar; however US GAAP has an additional requirement that persuasive evidence of an arrangement exist.

Revenue Recognition Criteria – Rendering of Services

For services, when the outcome of a transaction can be estimated reliably, revenue should be recognized by reference to the stage of completion of the transaction (the percentage of completion method) at the end of the reporting period. The outcome of a transaction can be estimated reliably when all the following conditions are satisfied:

a) The amount of revenue can be measured reliably
b) It is probable that the economic benefits associated with the transaction will flow to the entity
c) The stage of completion of the transaction at the end of the reporting period can be measured reliably
• The stage of completion of a transaction may be determined by various methods such as the cost to cost method (i.e. the proportion that costs incurred to date bear to the estimated total costs of the transaction).
d) The costs incurred for the transaction and the costs to complete the transaction can be measured reliably

Under the percentage of completion method, revenue is recognized in the accounting periods in which the services are rendered (4). Revisions to estimates of revenue are made when necessary as the service is performed. Note that when the service to be performed consists of an indeterminate number of acts over a specified period of time, rather than the percentage of completion method, revenue is recognized on a straight-line basis over the specified period unless there is evidence that some other method better represents the stage of completion. Also, if the service contains a significant act which is much more significant than any other acts, the recognition of revenue is deferred until the significant act is executed.

When the outcome of a transaction cannot be estimated reliably, revenue should be recognized only to the extent of the expenses recognized that are recoverable (i.e. zero profit model). If it is not probable that the costs incurred will be recovered, the costs are recognized as an expense while revenue is not recognized.

Under US GAAP the accounting for services is addressed in the SEC materials (SAB Topic 13) in ASC 605. Unlike IFRS, the use of the cost-to-cost percentage of completion method is not permitted under US GAAP for transactions outside the scope of ASC 605-35-Construction-Type and Production-Type Contracts. Service revenue should instead be recognized on a straight-line basis, unless evidence suggests that revenue is earned or obligations are fulfilled in a different pattern. Since the cost-to-cost percentage of completion method is not permitted for services, there would be no use of the zero profit model in accounting for services under US GAAP. ________________________________________________________________________

(1) Revenue from construction contracts is outlined in IAS 11 Construction Contracts

(2) As noted in an IASB and FASB Staff Paper, Appendix A: http://www.iasb.org/NR/rdonlyres/E94EC516-8794-430B-9911-40749197DD13/0/RR0906b07Bobs.pdf

(3) The appendix accompanies, but is not part of IAS 18.

(4) IAS 11 – Construction Contracts, also requires the recognition of revenue on this basis. The requirements of IAS 11 are generally applicable to the recognition of revenue and the associated expenses for a transaction involving the rendering of services.