Not all revenue is this year’s income!

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As IFRS develop, we are told that they are becoming increasingly complex and difficult to understand. But is that really the case?

The new IFRS simply require what they always required, i.e., to reflect the true intention behind a transaction, to show the economic reality of the transaction and to relate both of these to what the client expects from the seller. Stick to these key principles, and things are not that complicated.

How does this relate to revenue? 

Let’s have a look at some short examples first:

  • A company by chance makes revenue and profits from the scrapping of raw materials which were bought by mistake in large quantities. Suddenly, prices went up and the company took advantage of that. 

    Was the original intention to trade in these raw materials? Can it be claimed that these are operating profits to be compared against those of a similar company?

  • You rent on a monthly basis an expensive piece of machinery and you are responsible for its maintenance and upkeep for most of its useful life and you insure it against fire and other damage. 
    Can you deny that effectively this asset is “owned” by the company despite the legal form of ownership? 

  • You had agreed in a contract to deliver to a client an asset without further obligation in case the asset is not performing as per expectations. The client knows that you always replace the asset if it proves faulty without asking questions. 
    Can you show the whole contract price as income without any provisions made? Your behavior makes the client expect that your obligation extends beyond the delivery point. 

 

There are very few managers in business that are not evaluated by the revenue they mobilise. It is probably one of the most important financial measures of a business’s size, strength, growth and prospects. 

I am sure you also look at revenue as a starting point when you want to get an idea about the strength of a company or you want to impress your stakeholders with your performance.

So how would you treat this simple example?

D Limited buys and sells plots of land to make a profit. D Limited agrees to sell one plot of land on 1 April 20X6 to FinCo Limited for $9.5m. This plot had cost $6m when purchased some time ago. 

The contract provides that D Limited agrees to purchase the plot back on 31 March 20X8 for $9.9m. Very interesting!

Can you guess why D Limited would want to do this? i.e. what the intention is and what the economic reality is behind this intention? 

Have a quick think before you read on! 

Moreover, in the contract, D Limited retains rights of access and supervision over the plot and the right to build on this land up until 31 March 20X8. 

On 1 March 20X6 the plot was valued at $12.5m.

How should this sale and repurchase agreement be reflected in the financial statements on 31 March 20X7? 

I imagine that the management would want to show income of $9.5m as per contract.


Have a think, but to help you let us look at what the new IFRS 15 requires us to do:

This transaction is effectively a Sale and Repurchase agreement. Such agreements arise when an entity (the seller) enters into an agreement to sell goods to a buyer and concurrently: 

  • agrees to repurchase the same goods at a later date; or 
  • the seller has an option to repurchase the goods, referred to as a 'call option', at a later date; or 
  • the buyer has an option to require the repurchase, by the seller, of the goods, referred to as a 'put option', at a later date.

If the transaction is recognized as revenue of $9.5m, the impact on the financial statements would be to increase profits, increase equity and reduce the gearing level of the company. If it is a listed company, then the net impact would be an increase in the value of its shares.

In order to cover such possibilities IFRS 15 requires that revenue must only be recognised when the entity:

  • Can show that there is a relevant contract (written or oral or by implication);
  • Has performance obligations which are identifiable in the contract 
  • Can determine a price in this contract for each obligation 
  • Can show that the performance obligation is satisfied 

Do you think that in the case of D Limited, the above are met? And can the $9.5 be shown as Revenue in the Year Ended 31 March 20X7?

Or do you think that we should actually not show any Revenue at all and, on the contrary, show some costs in each year until 31 March 20X8?

Let us know what you think in the Comments below!

For a full model solution to the above case study, including double entry, please consult the i-learning IFRS Enabler, where you will find this and much more on Revenue Recognition and all other IFRS Standards. 

You can also purchase the CPD-certified Module on Revenue Recognition to access this full case study and many more + 15 CPD credit hours on successful completion. Order here or contact us now.


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