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ACCOUNTING STANDARDS BOARD JULY 2001 DISCUSSION PAPER RECOGNITION ACCOUNTING STANDARDS BOARD DISCUSSION PAPER REVENUE For the convenience of respondents, the text of the Invitation to Comment section of this Discussion Paper can be downloaded (in Word format) from the Revenue Recognition page in the Current Projects section of the ASB Website (www.asb.org.uk). Comments should be addressed to: Phil Barden ACCOUNTING STANDARDS BOARD Holborn Hall 100 Gray’s Inn Road London WC1X 8AL or sent by email to: [email protected] and should be dispatched so as to be received not later than 31 October 2001. All replies will be regarded as on the public record unless confidentiality is requested by the commentator. RECOGNITION ACCOUNTING STANDARDS BOARD DISCUSSION PAPER REVENUE ©The Accounting Standards Board Limited 2001 ISBN 1 85712 105 8 REVENUE RECOGNITION CONTENTS page Summary 2 Preface and invitation to comment 8 Chapter 1 What should ‘revenue’ represent? 22 Chapter 2 Revenue and contractual performance 45 Chapter 3 Accounting for incomplete contractual performance 54 Rights of return and post-performance options 70 Chapter 5 Measuring consideration 92 Chapter 6 Other issues relating to contracts and performance 117 Agency 135 Chapter 4 Chapter 7 Appendix A: Deep and liquid markets 140 Appendix B: Accounting for ‘points schemes’ 144 Appendix C: FRS 5 and rights of return 147 REVENUE RECOGNITION SUMMARY At present in the UK and the Republic of Ireland, there is no accounting standard governing the recognition and measurement of revenue. Different entities and industries follow practices that are in some respects inconsistent with one another; more generally, there are different views of what revenue is or represents, and of how financial statements should portray a business’s operating activities. In the longer term, it will be possible to agree on consistent solutions to the many and varied revenue problems and issues that arise in practice only if there is consensus on the overall objectives. Accordingly, this Discussion Paper examines revenue recognition and measurement from first principles. It sets out proposals intended to provoke discussion, with the longer-term aim of establishing a framework within which to address consistently revenue issues that arise in different contexts. The Paper asks first, in Chapter , what ‘revenue’—which may be referred to by various names, including sales, fees, interest, dividends and royalties—should represent in financial statements. It proposes the following definitions: In the context of a business operating cycle, revenue is the class of gains, before deduction of associated costs, arising as a result of benefit being transferred to a customer in an exchange transaction (ie under a contract). An operating cycle is a sequence of business activities, carried out with a view to profit, which involves the transfer of benefit to customers in exchange for consideration (ie payment). 2 SUMMARY Chapter develops this definition of revenue, by exploring how benefit is transferred to customers in exchange transactions. It concludes that benefit is transferred when the seller honours the promises it has made under the contract—in other words, ‘performs’ its contractual obligations. In that light, the chapter builds on the definition of revenue from Chapter : In the context of a business operating cycle, revenue arises as a result of benefit being transferred to a customer through the seller’s performance under a contract. Chapter extends this discussion of performance to contracts where the seller’s contractual performance is incomplete. It concludes that full performance is only sometimes necessary for revenue to arise, and suggests the following general principle for determining the extent to which revenue should be recognised on the basis of partial performance: Where contractual performance is incomplete, revenue should be recognised to the extent that the seller has performed and that performance has resulted in benefit accruing to the customer. Chapter then considers, at a very high level, various techniques by which this general principle might be applied in practice. It acknowledges, however, that dealing with incomplete performance is likely to be the biggest single difficulty arising in practice, and that the application of the above proposal to specific industries will be an important part of the next stage of this project. 3 REVENUE RECOGNITION Chapter considers how the approach developed above is affected by customer rights of return, which in effect give a customer the ability to unwind a contract after performance by the supplier has occurred. The chapter proposes the following two possible approaches to accounting for rights of return and asks for views on which is more appropriate: Expected sale approach: Where goods are transferred along with a right of return, revenue should be recognised on the transfer of benefit, with an appropriate adjustment to reflect the risk of returns. Accounting policy approach: Where goods are transferred along with a right of return, an entity should select and consistently apply whichever of the following accounting policies is most appropriate to its circumstances: • either revenue should be recognised on the transfer of benefit, with an appropriate adjustment to reflect the risk of returns • or revenue should be recognised on the expiry of the right to return. The most appropriate accounting policy should be judged by reference to the objectives and constraints set out in ‘Accounting Policies’, giving due weight to the objective of comparability between entities operating within the same industry. SUMMARY Whereas earlier chapters have been concerned primarily with the recognition of revenue, Chapter discusses measurement principles and associated issues. It makes the following proposal for the measurement of revenue: Revenue should be measured as the change in fair value, arising from the seller’s performance, of (i) assets representing rights or other access to consideration and (ii) liabilities in respect of consideration received in advance of performance. By restricting revenue to gains that arise from the seller’s performance, the Paper avoids the measurement of revenue being distorted by the timing of payment from a customer. Chapter spells out in more detail that changes to the value of consideration arising from factors other than performance—for example, the time value of money where a customer pays a long time in advance—do not form part of the measurement of revenue: Assets representing rights or other access to consideration should be remeasured to reflect the effect of the time value of money, where this effect is significant. Such remeasurement does not arise from performance and does not, therefore, give rise to revenue. Liabilities in respect of consideration received in advance of performance should not be remeasured to reflect changes in the fair value of performance that has not yet occurred. They should, however, be remeasured to reflect the effect of the time value of money, where this effect is significant. Such remeasurement does not arise from performance and does not, therefore, give rise to revenue. REVENUE RECOGNITION Chapter also considers different types of barter transaction, and asks which of them should give rise to revenue. Referring back to the discussion in Chapter , the chapter proposes that what is important is the role that the transaction has in the entity’s operating cycle: A transaction is with a customer—and hence gives rise to revenue—if, on its completion, the entity has been rewarded for eliminating the risks previously outstanding in the relevant operating cycle. Chapter draws together some other issues relating to contracts and performance. It first asks how, in the light of Chapter , customer payments for options should be dealt with, setting out the following proposals: Where a customer pays for an option to require future performance from a seller, that payment gives rise to a liability, which should be released as revenue only when the future performance to which it relates occurs. Because the number of options that will lapse unexercised cannot be known with certainty, the relationship between proceeds and performance should be estimated at the outset, and estimates should be revised over the period of performance. The chapter next considers which activities of a seller should be taken into account when assessing the extent to which performance has occurred: An activity will constitute part of the performance of a contract only if it is a necessary part of the contract, in that it is specific to the customer and would not have taken place had the contract not existed. SUMMARY Chapter concludes with a discussion of some issues that arise when two parties each provide goods or services to the other: Two contracts should be accounted for separately if they are genuinely independent of one another, but should be treated as one larger contract if, either legally or economically, one is conditional or dependent on the other. Such economic dependence may arise if, for example, contract prices are set so far from fair value that there is no realistic prospect that the second contract will not follow from the first. Finally, Chapter considers the recognition of revenue in the context of agency agreements, making the following proposals: When a principal transacts with a customer through a disclosed agent, the pr incipal’s revenue should reflect the full consideration payable by the customer in the transaction. The principal should treat any commission or other amounts payable to the agent separately as an expense and not as a reduction of revenue. When an entity acts as a disclosed agent, its revenue should reflect the amount of commission or other income receivable from its principal. When an entity acts as an undisclosed agent, it should account for revenue in the same way as a principal. REVENUE RECOGNITION Preface and invitation to comment PREFACE Revenue and financial statements Introduction This Discussion Paper is being published by the Accounting Standards Board as a first step towards the development of an accounting standard. It is expected that such development will be conducted in consultation with the International Accounting Standards Board and other standard-setters, and comments from those bodies and their constituents will be particularly welcome. For most businesses, the recognition of revenue is what triggers the recognition of profits in financial statements. It is unsur pr ising therefore that, in many industr ies, issues surrounding the recognition of revenue and profit are amongst the most important—and sometimes the most difficult—facing accountants. Different approaches to revenue In the absence, in the UK and the Republic of Ireland, of an accounting standard dealing comprehensively with revenue,1 preparers of financial statements have looked to var ious notions—such as ‘earning’, realisation, accruals/matching and prudence—in order to develop suitable approaches to the recognition of revenue and, hence, profits. Unfortunately, these notions sometimes point in opposite directions: different entities and industries have found different solutions, and this has led to practices that are in some respects inconsistent with one another. 1 SSAP 9 ‘Stocks and long-term contracts’ discusses the recognition of revenue for long-term contracts, but not other contracts. PREFACE AND INVITATION TO COMMENT This inconsistency is not merely a practical problem. It reflects different views of what revenue is or represents, and of how financial statements should portray a business’s operating activities. Moreover, the range of different views on these matters is likely to increase as business activities become more complex and financial reporting develops. In the longer term, it will be possible to agree on consistent solutions to the many and varied revenue problems and issues that arise in practice only if there is consensus on the overall objectives. The objective and structure of this Paper Accordingly, this Paper examines revenue recognition and measurement from first principles, with the aim of establishing a framework within which to address consistently revenue issues that arise in different contexts. It does this by considering the following questions in turn. • Chapter asks what ‘revenue’—which may be referred to by a variety of names, including sales, fees, interest, dividends and royalties—should represent in financial statements. It proposes that, although gains may in principle arise, and perhaps be recognised, at various stages in an entity’s operating cycle, ‘revenue’ arises only when benefit is transferred to a customer under a contract—ie in an exchange transaction. • Chapter develops the proposal from Chapter , by considering how benefit is transferred to customers in exchange transactions. It proposes that revenue arises as a result of a seller’s performance of its obligations under a contract—ie contractual performance. • Chapter extends the discussion from Chapter to contracts where the seller’s contractual performance is incomplete. It proposes that, in such circumstances, revenue should be recognised to the extent that the seller has performed and that performance has resulted in benefit REVENUE RECOGNITION accruing to the customer. It acknowledges that dealing with incomplete performance is likely to be difficult in practice, and that the application of this proposal to specific industries will be an important part of the next stage of this project. • Chapter considers the impact of the preceding discussion on customer r ights of retur n, which in effect give a customer the ability to unwind a contract after performance by the supplier has occurred. The chapter proposes two possible approaches to accounting for rights of return and asks for views on which is more appropriate. • Whereas earlier chapters have been concerned primarily with the recognition of revenue, Chapter discusses measurement principles and associated issues. It proposes that revenue should be measured as the change in fair value, arising from the seller’s contractual performance, of (i) the seller’s assets representing rights or other access to consideration and (ii) its liabilities in respect of consideration received in advance of performance. • Chapter considers other issues relating to contracts and performance. • Finally, Chapter considers the recognition of revenue in the context of agency agreements. Matters not addressed in this Paper Although revenue recognition is often closely linked with profit recognition, this Paper makes proposals only in respect of revenue, and not for profit recognition in itself. This is mainly to prevent the project becoming unmanageably large and to ensure that the debate focuses, for the time being, exclusively on revenue. PREFACE AND INVITATION TO COMMENT Similarly, although it draws on examples, the Paper does not address revenue issues that have arisen in specific industries. This is because the objective at this stage is to develop consistent general principles, rather than to consider their application to specific circumstances. In some contexts, applying the general principles proposed in the Paper is likely to require careful and detailed consideration of associated industry issues. Accordingly, the Board is asking respondents for their views at this stage on the application of the principles to industries with which they are familiar. Such views will be valuable to the Board when refining the Paper’s proposals. Existing approaches to revenue recognition The accruals concept and realisation Existing approaches to revenue recognition in the UK and the Republic of Ireland tend to draw on notions such as the accruals concept and realisation. The discussion below explains why, in the light of the Board’s Statement of Principles for Financial Reporting,2 this Paper is driven primarily by the former and not at all by the latter.3 The accruals concept requires the effects of transactions and other events to be reflected, as far as is possible, in the financial statements for the accounting period in which they occur. This means that, where an entity trades for profit, the financial reporting objective is for that profit to be recognised—providing it can be measured reliably—in the period in which it arises, not before and not after. 2 for convenience, hereafter abbreviated to the ‘Statement of Principles’. 3 In the UK and the Republic of Ireland, companies legislation includes requirements based on the notion of realisation. Legal issues are discussed later in this Preface. REVENUE RECOGNITION It is not always easy to determine precisely when profit arises, and the recognition of profit has, historically, been based on additional criteria. Profits have been recognised only when realised in the form either of cash or of other assets the ultimate cash realisation of which can be assessed with reasonable certainty. In other words, the notion of realisation has been used to ensure that only profits that are reasonably certain and unlikely to reverse are included in the profit and loss account.4 The use of realisation as a basis for revenue recognition is not without difficulties. The notion can be difficult to interpret, which increases the risk that it may be inconsistently applied, particularly in complex situations. Moreover, use of the notion does not always avoid difficult questions about when revenues arise—for example, where goods or services are paid for in advance under a binding contract. Difficulties in applying the notion are exacerbated by the increasing use in business transactions of consideration other than cash—such as shares and share options—and the development of new markets. The difficulties in understanding and applying the notion of realisation, and the developments that call into question its appropriateness in some circumstances, make it worth revisiting the basis on which revenues and profits are recognised. Rather than adopting the notion of realisation, the Statement of Principles states that assets and liabilities—and hence gains, which result from changes to assets and liabilities—should be recognised when they exist and are capable of being measured reliably. Accordingly, the main focus of this Paper is on the process that brings revenues into existence, rather than on when they become realised. 4 This Paper refers to the ‘profit and loss account’ to be consistent with present generally accepted accounting practice. If proposals set out in FRED 22 ‘Revision of FRS 3 “Reporting Financial Performance”’ (published in December 2000) are implemented, the profit and loss account will be replaced by a statement of financial performance. However, the only effect on this Paper would be to change the name used to refer to that primary statement. PREFACE AND INVITATION TO COMMENT The Statement of Principles also reflects developments in the accruals concept that have occurred since it was discussed in ‘Disclosure of accounting policies’.5 In describing the accruals concept, referred to revenue and costs being “matched with one another so far as their relationship can be established or justifiably assumed, and dealt with in the profit and loss account of the period to which they relate”. The Statement of Principles does not refer to matching, but instead focuses on reflecting the effects of transactions and other events in the period in which they occur. This change of focus directly affects the way that profits are recognised, but primarily in terms of when expenses are recognised rather than revenues. As such, it has rather less impact on this Paper than does the change in the role played by the notion of realisation. Revenue recognition outside the UK and the Republic of Ireland Although there is much accounting literature outside the UK and the Republic of Ireland dealing with revenue recognition, it may be particularly helpful to draw attention to the positions under International Accounting Standards (IASs) and in the USA. International Accounting Standards The main body of IAS (revised ) ‘Revenue’ includes both a revenue recognition objective and detailed application rules, and an appendix illustrates the application of the standard to a number of commercial situations. In the absence of a relevant accounting standard in the UK and the Republic of Ireland, IAS has often been used as a source of guidance. 5 SSAP 2 has since been superseded by FRS 18 ‘Accounting Policies’. The discussion of the accruals concept in FRS 18 is based on that in the Statement of Principles. REVENUE RECOGNITION The discussion in this Paper is broadly consistent with the objective descr ibed in IAS . However, although the application rules in IAS reflect generally accepted accounting practice, the mechanism by which they were derived from IAS ’s objective is not always precisely clear. Accordingly, this Paper focuses on underlying principles, seeking to demonstrate how its proposals are built up from them. As noted earlier, this Paper is intended to contribute to an international debate, which may involve a revision of IAS . Revenue recognition in the USA Although revenue is defined in a concepts statement ,6 revenue recognition in the USA is governed primarily by a number of accounting standards, most of which are industry-specific. In contrast, the Board’s preference at this stage is to seek to develop a single accounting standard setting out general principles for revenue recognition; if necessary, industry-specific issues can be dealt with in Application Notes or industry guidance. In addition to the accounting standards mentioned above, SEC Staff Accounting Bulletin No. ‘Revenue Recognition in Financial Statements’ (SAB ) identifies four criteria for the recognition of revenue. “The staff believes that revenue generally is realized or realizable and earned when all of the following criteria are met: • Persuasive evidence of an arrangement exists, • Delivery has occurred or services have been rendered, • The seller’s price to the buyer is fixed or determinable, and • Collectibility is reasonably assured.” 6 The US Financial Accounting Standards Board’s Statement of Financial Accounting Concepts No. 6 ‘Elements of Financial Statements’. PREFACE AND INVITATION TO COMMENT The principles underlying these criteria are discussed in this Paper, though it approaches some of them in a slightly different way. The Paper proposes that a contract must exist before revenue can be recognised—and generally a contract is not enforceable in law unless it specifies a price that is either fixed or determinable. The Paper also links the recognition of revenue to contractual performance, which will generally encompass delivery or the rendering of services. Finally, collectability is implicitly a factor in the proposal in Chapter that consideration receivable should be measured at fair value.7 It should, however, be emphasised that, although the Paper focuses on pr inciples that are in essence similar to those identified in SAB , the two documents will not always be consistent in their detailed application. Other matters Terminology In the Statement of Principles, the terms ‘gains’ and ‘losses’ refer, broadly speaking, to inflows and outflows of economic benefit. Thus, in the context of the sale of an item of stock, the Statement of Principles refers to the sale proceeds and the cost of the item sold as a gain and a loss respectively. In other contexts, however, ‘gain’ is commonly used to refer to a net increase in total assets less total liabilities; for example, in a contractual exchange, ‘gain’ is often used to refer to the net of the sale proceeds and the cost of the item sold. Generally this Paper uses ‘gain’ (or ‘profit’, where that term is more comfortable) to mean a net increase in total assets less total liabilities. In other words, ‘gain’ is most often used to mean either the net of sale proceeds and the cost of an item sold or, where operating activities increase the value of an asset still held, 7 The term ‘fair value’ is discussed later in this Preface. REVENUE RECOGNITION the excess of that increase over associated expenses. However, in the Paper’s proposed definition of ‘revenue’, ‘gain’ should be understood in the ‘gross’ sense of the Statement of Principles, eg before deducting the cost of the item sold. The Paper uses the term ‘fair value’ when discussing both the measurement of incomplete contractual performance (in Chapter ) and the measurement of consideration (in Chapter ). However, it does not enter into a detailed discussion of the meaning of the term. This is in part because the Board does not think such a discussion necessary for the Paper’s examination of general principles; moreover, the interpretation of ‘fair value’ is still a matter for discussion between standard-setters. Accordingly, for the purposes of this Paper, the term ‘fair value’ should be understood in the sense in which it is defined in ‘Derivatives and other Financial Instruments: Disclosures’: “The amount at which an asset or liability could be exchanged in an arm’s length transaction between informed and willing parties, other than in a forced or liquidation sale.” FRS 5 ‘Reporting the Substance of Transactions’ Some of the discussion in this Paper, particularly that in Chapter dealing with rights of return, is concerned with matters also falling within the scope of ‘Reporting the Substance of Transactions’. The approach taken in the Paper, like that in , is to ask what effect a transaction has had on assets and liabilities. Generally, however, the Paper does not draw in more detail on the analysis in . Appendix C briefly summarises how deals with rights of return. PREFACE AND INVITATION TO COMMENT Reliable measurement A necessary condition for the recognition of revenue and/or profit is that reliable measurement is possible. Reliable measurement is discussed in Chapter , but the condition that reliable measurement is possible should be taken as applying throughout the Paper, including where, for ease of reading, it is not made explicit. Legal issues The Paper is concerned primarily with the principles underlying revenue recognition, rather than their detailed application, and its proposals have been developed with an international context in mind. Accordingly, the Paper does not consider legal issues that might arise if its proposals were to be implemented as a standard in the UK and the Republic of Ireland. Such issues will be addressed in a future exposure draft of a standard dealing with revenue recognition. Not-for-profit entities The Paper discusses revenue recognition in the context of entities trading for profit. It does not focus directly on not-forprofit entities, and in particular it does not consider nonreciprocal transactions, such as donations. Nevertheless, the discussion in the Paper may have some relevance for not-forprofit entities. INVITATION TO COMMENT The Board would welcome comments on any aspect of the Discussion Paper. Respondents’ views are especially sought on the matters set out below. It would be helpful if respondents could support their views with reasons and, where applicable, preferred alternatives. REVENUE RECOGNITION Chapter 1: What should ‘revenue’ represent? Q1 Do you agree that revenue should be a measure of exchanges with customers, irrespective of the extent to which gains may be recognised in advance of such exchanges? (If not, and if you would favour a wider ‘value added’ definition of revenue, how would you respond to the associated difficulties highlighted under paragraph .?) Q2 Do you agree that revenue should be defined in the context of the business operating cycle being presented? Chapter 2: Revenue and contractual performance Q3 Do you agree that revenue recognition should be driven by a seller’s performance under a contract in transferring benefits to a customer? Chapter 3: Accounting for incomplete contractual performance Q4 Do you agree that, where contractual performance is incomplete, revenue should be recognised to the extent that the performance has resulted in benefit accruing to the customer? Q5 The Board envisages that measur ing incomplete performance will be one of the most difficult issues arising. What practical problems do you foresee with the approaches to measuring incomplete performance, such as unbundling, proposed in Chapter ? Could these approaches be amended or refined in order to deal with any difficulties that you foresee? PREFACE AND INVITATION TO COMMENT Chapter 4: Rights of return and post-performance options Q6 When discussing how to account for goods transferred with a right of return, Chapter considers and rejects an approach that would never recognise revenue until the option to return lapses. Do you agree that this approach should be rejected? Q7 Chapter suggests two approaches that might be acceptable where goods are transferred with a right of return—an expected sale approach and an accounting policy approach. Which of these approaches, if either, do you favour? If you favour neither approach, how would you account where goods are transferred with a right of return? Chapter 5: Measuring consideration Q8 Do you agree that revenue should reflect the amount to which a seller becomes entitled under a contract as a result of perfor mance, rather than the fair value of that performance? If so, do you agree that revenue should be measured as the change in fair value, arising from the seller’s contractual performance, of (i) the seller’s assets representing rights or other access to consideration and (ii) its liabilities in respect of consideration received in advance of performance? Q9 Do you agree that revenue should not include changes in the fair values described in question 8 above arising from the time value of money rather than from performance? Q10 Chapter proposes two possible approaches—an expected sale approach and an accounting policy approach—where the amount of revenue is determinable by a factor within the control of a customer. These alternative approaches are based on those discussed in Chapter (see question above). Which of these approaches do you favour, if either? If your answer to question was different, what are the important aspects of each scenario that led you to different conclusions? REVENUE RECOGNITION Q11 Do you agree with the analysis of the principles applicable to barter transactions in Chapter ? In particular, do you ag ree that whether a transaction (such as a barter transaction) forms part of revenue should depend on whether, on its completion, the seller has been rewarded for eliminating the risks previously outstanding in the relevant operating cycle? Chapter 6: Other issues relating to contracts and performance Q12 Do you agree with the proposal in Chapter that, where a customer pays for an option to require future performance from a seller, revenue relating to that payment should be recognised only when that future performance occurs? If so, do you also agree that, because the level of future option lapses cannot be known with certainty, the relationship between proceeds and performance should be estimated at the outset and revised over the period of performance? Q13 Do you agree that an activity should constitute part of the performance of a contract only if it is a necessary part of the contract, in that it is specific to the customer and would not have taken place had the contract not existed? Q14 Do you agree with the proposal that two contracts should be accounted for separately if they are genuinely independent of one another, but should be treated as one larger contract if, either legally or economically, one is conditional or dependent on the other? Chapter 7: Agency Q15 Where a principal transacts with a customer through a disclosed agent, do you agree that the principal’s revenue should reflect the full consideration payable by the customer, with any commission or other amounts payable to the agent being treated as an expense and not as a reduction of revenue? PREFACE AND INVITATION TO COMMENT Q16 Where an entity acts as a disclosed agent, do you agree that its revenue should reflect the amount of commission or other income receivable from its principal? Q17 Where an entity acts as an undisclosed agent, do you agree that it should account for revenue in the same way as a principal? Other matters Q18 The objective of this Paper is to explore general principles of revenue recognition, which can be refined and applied to a variety of specific industry issues. Do you have any comments at this stage on difficulties that may be encountered in applying this Paper’s proposals to specific industry issues? Q19 The Board would welcome examples illustrating particular problems of revenue recognition that may or may not be dealt with by the proposals set out in this Paper. Could you provide the Board with examples that you believe it would be useful to consider? REVENUE RECOGNITION Chapter 1 What should ‘revenue’ represent? Summary 1.1 This chapter asks what ‘revenue’—which may be referred to by various names, including sales, fees, interest, dividends and royalties—should represent in financial statements. In discussing this question, the Paper considers how revenue, which is generally reported gross (ie before deducting associated expenses), might be distinguished from other gains, which are often reported net. Before this, however, the chapter considers: • how revenue has been seen in a historical cost context, and the role it plays within financial statements • when and how gains associated with operating activities come into existence • how gains generally are recognised under current value and historical cost principles • two different views of how gains arising from operating activities should be reported. 1.2 Based on the discussion of these matters, the chapter puts forward the following proposals, which are developed in subsequent chapters. CHAPTER 1: WHAT SHOULD ‘REVENUE’ REPRESENT? In the context of a business operating cycle, revenue is the class of gains, before deduction of associated costs, arising as a result of benefit being transferred to a customer in an exchange transaction (ie under a contract). An operating cycle is a sequence of business activities, carried out with a view to profit, which involves the transfer of benefit to customers in exchange for consideration (ie payment). 1.3 Although this Paper is concerned with the recognition of revenue rather than gains generally, much of this chapter focuses on gain recognition. This is necessary because one of the most important aspects of revenue, at least under historical cost accounting, is as a potential trigger for gain recognition. 1.4 Although the discussion considers how both revenues and gains generally might be recognised under current value principles,8 this does not imply that the Board favours requiring entities to report using such an approach. The discussion of current value principles is included for the light it casts on how revenue should be recognised under historical cost principles. The Board expects that, as at present, most entities will continue to report revenues, and associated net gains, under historical cost principles. 8 For the avoidance of doubt, the current value principles discussed are not those of current cost accounting (CCA). Whereas CCA, in essence, updates a historical cost framework for changing prices (holding gains and losses), the current value principles discussed in this Paper are concerned with how gains arise from an entity’s activities. REVENUE RECOGNITION What should ‘revenue’ represent? How has revenue been seen in a historical cost context? Revenue and exchange 1.5 In the past, revenue recognition questions have most often been concerned with when to recognise revenue, rather than asking what revenue is for a particular business. This is because for most businesses the answer to the second question has appeared obvious—indeed, often so obvious that the question has not even needed asking. Nevertheless, it might be suggested, rather crudely, that revenue has been seen in terms of ‘what you get paid for selling things’. Identifying revenue often seems obvious, in that the ‘what’ is usually cash, and ‘selling things’ is easily distinguished from ‘buying things’ because in the latter case a business usually parts with cash rather than receiving it. 1.6 Later, this chapter will consider why and how such an approach to revenue would need to be refined in order to be workable in less straightforward transactions.9 At this stage, the main point to observe is that revenue recognition has been seen as linked to a process of exchange. The seller gives something to the customer (goods, services, rights) and, in exchange, becomes entitled to consideration, triggering the recognition of revenue. 9 For example, the answers may not always seem so obvious when attempting to apply such a ‘commonsense’ approach to barter transactions. CHAPTER 1: WHAT SHOULD ‘REVENUE’ REPRESENT? 1.7 This notion of exchange has also been reflected in the balance sheet, in that the event of exchange has caused new assets to be recognised. For example, on the sale of goods a company has ceased to recognise stocks as an asset and has instead recognised cash or a debtor. Similarly, on the supply of services, although there was no asset in the balance sheet to derecognise, the supplier has nevertheless recognised a new asset: cash or a right to cash (ie a debtor) from the customer. Revenue and profit recognition 1.8 In a histor ical cost context, 10 the point of revenue recognition has also been the earliest point at which profits arising from the transaction have been recognised. In effect, before revenue has been recognised, any costs associated with the transaction have either been accumulated (as part of the cost of the asset to be exchanged) or charged as an expense; but because the carrying amount of the asset has not been remeasured, no profits have been recognised. For example, a manufacturer producing goods for stock has valued that stock by reference to historical costs associated with it, but has not recorded any ‘gain’ arising from manufacturing activities until such time as the goods are exchanged. 10 References in this Paper to the recognition of revenues and profits in a historical cost context mean, in particular, a context in which stocks are carried at their historical cost and are not remeasured except to net realisable value, if lower. This is the norm for most businesses in the UK and the Republic of Ireland. REVENUE RECOGNITION 1.9 Another way of thinking about this is to say that, in a historical cost context, profits have not arisen before the point of revenue recognition because this is the first point at which asset measurement may cease to be ‘backward-looking’ and instead become ‘forward-looking’. Thus, stocks have been valued by reference to outflows (usually of cash) that have occurred in the past;11 however, debtors have usually been valued by reference to inflows to be received in the future. In a sense, therefore, debtors have ‘included profits’ whereas stocks have not.12 The role of revenue in financial statements 1.10 The significance of revenue recognition is not limited to asset classification and the timing of profit recognition. In particular, when revenues and associated profits are reported under historical cost principles, the presentation of a revenue figure (such as sales or turnover) in the profit and loss account can help users of financial statements in two ways. 11 or outflows to which the business has become committed as a result of a past event. 12 For completeness, it should be noted that stock valuation in a historical cost context is not purely ‘backward-looking’, in that a ‘forward-looking’ measure (net realisable value) is substituted if lower. This does not detract from the main point, however, which is that in a historical cost context the point of revenue recognition is the first point at which profits may be recognised. The inclusion of ‘profit’ in the valuation of debtors is so generally accepted as to appear entirely obvious. Nevertheless, it should be noted that, in principle, historical cost accounting could have developed in a way that would have required cash to be received before profits could be recognised. Under such an approach, debtors would be measured at the historical cost (if any) of goods or services supplied, and asset measurement would cease to be ‘backward-looking’ only on the receipt of cash. Equally, historical cost accounting could in principle have developed so that profits would be recognised on entering into a contract with a customer (though some strong arguments against this are discussed in Chapter 2). Under such an approach, the measurement of stocks would, like debtors, become ‘forward-looking’ when a customer entered into a binding agreement to buy them. These points are picked up in the discussion of revenue and unexpired risk in Chapter 2. CHAPTER 1: WHAT SHOULD ‘REVENUE’ REPRESENT? • For many businesses, the revenue figure is a key measure of economic activity during the period, in that it reflects the extent to which the business has supplied goods or services to customers. Revenue for a period can be compared with that for earlier periods, and with that of competitors, as part of an assessment of the business’s performance. • The separate disclosure of revenue and of costs enables users to compare a business’s g ross marg in in percentage terms with that in earlier periods, and with that of competitors, and also to assess the sensitivity of gross profits to volume and price changes. 1.11 The usefulness of revenue information will of course vary from business to business. Nevertheless, to summarise the preceding discussion, it has been noted that in a historical cost context: • revenue has traditionally been associated with ‘exchanges’ with customers • the point of revenue recognition is also the earliest point at which profits may be recognised • the gross revenue figure presented in the profit and loss account may be useful as a measure of economic activity • the separate g ross presentation of revenue and associated costs may be useful when assessing trends in, and the quality of, profitability. REVENUE RECOGNITION How and when do gains come into existence? 1.12 So far, this chapter has summarised how revenue has traditionally been seen in a historical cost context. Accordingly, the focus has been on how and when revenues and associated profits have been recognised in financial statements, but has not been on how and when gains may be thought to arise in the underlying business. The following paragraphs are therefore concerned with how and when gains come into existence.13 1.13 Accountants are not accustomed to distinguishing existence from recognition in the context of revenue, but such a distinction is familiar for another class of gains. Specifically, where a tangible fixed asset such as a building increases in value, the gain will be recognised only if the business has a policy of revaluing such assets. Nevertheless, the gain exists irrespective of whether it is recognised. 1.14 It may of course be argued that there is an important difference between such a gain and a trading profit. Where a building increases in value, the gain will often be unrelated to any activity of the owner; it will simply reflect changing prices in the property market. It may therefore be described as a holding gain, in the sense that the property is still the same asset after the gain has arisen: it simply has a different value. 1.15 The gains that arise in a revenue context, however, are not for the most part holding gains. They are operating gains, in the sense that they arise as a result of the business’s activities, rather than external price changes. Accordingly, in order to determine when gains arise in the operating cycle, it will be necessary to consider more carefully the factors that br ing them into existence. 13 Although assets and liabilities can be said to ‘exist’ in time, gains arise from changes to assets and liabilities and are by their nature of the instant. Nevertheless, for the sake of brevity, the following discussion refers to gains coming into existence, rather than referring always to changes in existing assets and liabilities. CHAPTER 1: WHAT SHOULD ‘REVENUE’ REPRESENT? The role of risk 1.16 The view outlined below, which is drawn on later in this Paper, is that in principle profits (ie operating gains) can be expected to come into existence only as a result of taking and eliminating risk. 1.17 This is of course a very imprecise statement, and there is much about it that must immediately be clarified. It is not the case that a business should, except by chance, expect to earn profits by taking unnecessary risks. Furthermore, a business that takes only necessary risks may still not be rewarded with profit. The following example may help to illustrate what is meant. Example 1.17: a component-testing business Suppose that the most efficient manufacturing process for a particular type of component results in a relatively high proportion that do not work—on average, about per cent. Suppose also that history has shown the skills needed to test such components are very different from those needed to be a manufacturer, so that manufacturers choose only to sell untested components. Thus separate businesses buy untested components, test them, throw away those that do not work and sell those that do. How does such a component-testing business make profits? To answer this question, it is necessary to consider how much someone will rationally pay for a tested component. The component-tester’s potential customers have two choices; they can either buy untested components and do the testing themselves, or they can buy working components from a component-tester. REVENUE RECOGNITION Suppose a potential customer chooses the former option. If the price of untested components is £., and the failure rate is on average per cent, then over the longer term the average cost per working tested component will be £. plus the cost (say a further £.) of testing two components—a total of £.. However, if the potential customer chooses to buy tested components rather than test them itself, it will rationally pay more than £. for a tested component. This is because the two situations are not directly comparable. If it tests the components itself, it is still bearing the risk that the failure rate will be higher (or lower) than the average of per cent; if it buys tested components, it is not bearing that risk.14 There is an analogy here with the rate of return that will be required on a risky investment. If an entity is choosing between two investments that are expected to generate the same rate of return, and one is more risky than the other, the entity will rationally choose the less risky investment. In order to choose the more risky investment, it will need to be offered a higher rate of return. Accordingly, the component-testing business can expect to receive more than £. for each tested component it sells. Over the longer term, however, its costs per tested component should not exceed £..15 It is making profits by taking and eliminating risks—one of those risks being that the component failure rate will deviate from expectations. 14 In other words, the price that a customer will pay for tested components is the ‘certainty equivalent’ that adjusts the expected failure rate for risk. 15 Economies of scale may mean that its testing costs are less than the £1.00 that the potential customer would incur, but this does not detract from the rest of the argument. CHAPTER 1: WHAT SHOULD ‘REVENUE’ REPRESENT? 1.18 Accordingly, this Paper argues that gains arise over a business’s operating cycle, as it takes and eliminates necessary risks. Of course, those necessary risks may fall at different stages of the operating cycle for different entities. For some entities, such as pharmaceutical companies perhaps, a large element of risk may be concentrated at the development and trial stage. For others, predicting levels of demand may be one of the chief risks. Nevertheless, to the extent that an entity has eliminated necessary risks before entering into an exchange transaction, gains associated with those risks may be said to have come into existence, even if they have not yet been recognised. How might gains be recognised under current value and historical cost principles? 1.19 The following discussion is intended only as a very broad outline of how gain recognition might operate under current value principles. In practice, many difficult issues might be expected to arise over how to apply current value principles, not least because of differing views of how current value and fair value should be defined.16 1.20 Rather than dealing with those issues, the discussion below illustrates the broad differences that might be expected between gain recognition under histor ical cost and cur rent value principles. Thus, purely for the sake of illustration, it is assumed that gain recognition under current value principles would be broadly equivalent to the continuous remeasurement of assets and liabilities to ‘fair value’, in the sense in which that term is described in the Preface. 16 The Statement of Principles explains the Board’s view that the deprival value model provides the most relevant measure of current value. Under that model, current value is the lower of replacement cost and recoverable amount, which is itself the higher of value in use and net realisable value. REVENUE RECOGNITION Gain recognition under current value principles 1.21 Paragraph . discussed how, at the point of revenue recognition, asset measurement ceases to be ‘backward-looking’ and instead becomes ‘forward-looking’, so that debtors, for example, are valued by reference to future cash inflows. No matter how it is defined, fair value is inherently a ‘forwardlooking’ measure. For example, where an asset’s fair value is determined by reference to a market, the market price will reflect market participants’ assessments of the uses to which the asset can be put (and, ultimately, the cash flows associated with those uses) and the degree of risk associated with those uses. 1.22 Thus, although there may be different views as to which future cash flows to include and the appropriate perspective from which those cash flows and risks should be assessed,17 fair value may in principle be thought of as equivalent to the value of future cash flows discounted for risk. 1.23 When an entity carries out operating activities, thereby taking and eliminating necessary risks, the risks associated with future cash flows will have reduced, no matter whose perspective they are judged from. Thus if assets and liabilities are continuously remeasured to fair value, gains will be recognised as the entity moves through its operating cycle. 17 for example, a market perspective or the perspective of the transacting entity. CHAPTER 1: WHAT SHOULD ‘REVENUE’ REPRESENT? 1.24 This can be illustrated by continuing the example from paragraph .. Example 1.24: manufacturers using components Suppose the facts about component testing are the same as in Example ., and that A and B both use components in their manufacturing processes; however, A buys tested components whereas B buys untested components and tests them itself. Thus B incurs average expenditure of £. per tested component whereas the market price paid by A for a tested component is higher than this—say £.—for the reasons explained in Example .. Ultimately, therefore, A makes £. less profit than B, and we can say that this is because it is exposed to less risk in its operations. Suppose A and B both value stocks at current value, rather than at historical cost. If A has tested components in stock, they will be included in A’s balance sheet at their current value of £.—and the same is true for B, in respect of those components that it has successfully tested, even though B’s expenditure will be lower than this (on average, £.). Unlike A, B has taken and eliminated component-testing risk, and the gain of £. is its reward. (It is perhaps worth emphasising that this is not a holding gain, in the sense discussed in paragraph .. Rather, it is an operating gain, in that it arises as a result of B’s activities, ie testing components, rather than external price changes.)18 18 Another way of thinking about this is to say that A and B have precisely the same core operations, but that B has, in addition, a component-testing business. Although the component-testing business does not sell to third parties, it is nevertheless profitable. REVENUE RECOGNITION 1.25 The kind of approach illustrated in the preceding example is also required, for entities complying with International Accounting Standards, by IAS ‘Agriculture’. IAS requires both biological assets and agricultural produce (ie biological assets that have been harvested) to be measured at fair value (less estimated point-of-sale costs), except where it is not possible to measure fair value reliably. Thus entities complying with IAS will recognise gains over the period that biological assets are growing, rather than deferring gain recognition until those assets have been sold. 1.26 It is worth emphasising that gain recognition under current value principles does not result in all stocks being valued at expected selling price, because that ignores selling risk, which is usually an important risk. Thus, except where a deep and liquid market exists for a product (so that there is, in effect, no selling risk), an element of profit would still be recognised on sale under current value principles. Gain recognition under historical cost principles 1.27 The recognition of gains under historical cost principles has already been discussed under paragraph .. As noted there, the earliest point at which profits will be recognised under such principles is on an exchange with a customer. Before that, measurement will be ‘backward-looking’, in that assets (such as stocks) will be measured at amounts not exceeding the costs actually incurred to date. (Thus in Example ., B will record tested components in stock at £., and will recognise the associated gain of £. only on sale of the items into which the components are installed.) 1.28 When an exchange with a customer occurs, the consideration received or receivable from the customer will be measured at its fair value, just as it would be under current value principles. Accordingly, the profit recognised on the exchange will be equal to the cumulative gains that have arisen to date but CHAPTER 1: WHAT SHOULD ‘REVENUE’ REPRESENT? have not previously been recognised. In effect, therefore, whereas current value gains may be recognised for various activities in the operating cycle, no historical cost gains will be recognised until there is an exchange with a customer, at which point the historical cost gains will ‘catch up’. 1.29 Thus, although this is not how it actually developed, this type of historical cost accounting can be seen as a simplification of its current value equivalent. Instead of recognising gains (and sometimes losses) over various activities in the operating cycle, historical cost accounting in effect recognises cumulative profit at a particular point in that cycle—namely, on exchange with a customer. This idea of historical cost as a simplification of current value gain recognition principles is discussed further in the following paragraphs. Different views of how profits should be reported 1.30 The historical cost and current value approaches to gain recognition discussed in the preceding paragraphs correspond reasonably well to two different (and in essence incompatible) views of how profits should be recognised in accounts. These views differ primarily over how unexpired risk should affect the recognition of profit. • Many believe that no profit should be recognised until the risks in the operating cycle have been substantially eliminated. (This might broadly correspond to gain recognition under historical cost principles.) • Others believe that profits should be recognised as risk is reduced over the various stages of a business’s operating cycle—including stages that precede a contract with a customer—reflecting the ‘value added’ by the business’s activities. (This might broadly correspond to gain recognition under current value principles.) REVENUE RECOGNITION 1.31 The former approach is more familiar to accountants in the UK and the Republic of Ireland. Supporters might argue that it is more prudent—and conversely that it is imprudent to recognise profits before the operating cycle is substantially complete. They might note that, if substantial operating risks remain, there is a substantial risk that profits recognised under current value principles may subsequently have to be reversed. They might also argue that profits reported under historical cost principles are more reliable, because they are measured by reference to a value established in an exchange with a third party, namely the agreed sale proceeds. By contrast, profits measured under current value principles will not generally be based on such an exchange and may therefore involve more subjective judgements about future cash flows and unexpired risks. 1.32 On the other hand, supporters of a ‘value added’ approach might argue that, as outlined earlier in this chapter, such an approach better reflects how gains arise as a result of a business’s activities. In particular, they might argue that a historical cost approach, which arguably ignores profits until they are ‘in the bag’, has more to do with issues of solvency and paying dividends than with a business’s performance. Turning to the detailed arguments from the preceding paragraph, they might agree that there is more chance under a ‘value added’ approach that profits recognised will subsequently reverse; however, they will not see this as a flaw if it in fact reflects what is happening within the business. In support of this, they might note that, even under historical cost principles, bad debts will cause the reversal of profits previously recognised. They might also reject the argument that historical cost profits are necessarily more reliable, noting for example that significant subjective judgements can be involved when recognising revenues and profits for an incomplete long-term contract under . CHAPTER 1: WHAT SHOULD ‘REVENUE’ REPRESENT? 1.33 It is not the objective of this Paper to choose between these two approaches. Moreover, although this chapter has suggested that a current value approach might better reflect how profits ar ise in a business’s operating cycle, it does not automatically follow that it is always appropriate to recognise profits on this basis in financial statements.19 As illustrated in the preceding discussion, any approach to profit recognition will need to balance issues of relevance and reliability, and the appropriate balance is likely to vary depending on the nature of the underlying business. What should ‘revenue’ represent? 1.34 Earlier in this chapter it was noted that, historically, the recognition of revenue has been linked to the recognition of an asset receivable from a customer in the context of an exchange transaction. This approach works well when a business reports under historical cost principles and, as noted earlier, the presentation of a revenue figure may enable some information to be derived about: • the scale of economic activity during the period (at least insofar as that activity relates to supplying goods or services to customers) • gross margins (if associated costs are also presented gross). 19 That said, certain circumstances in which a current value approach is clearly preferable are discussed in Appendix A. REVENUE RECOGNITION 1.35 However, where an entity reports under current value principles, it may recognise some (or indeed all) of its profits before an exchange transaction has taken place. As a result, the information that can be derived from an ‘exchange-based’ revenue figure (called ‘turnover’ below, for convenience 20) is arguably less useful when an entity reports under current value principles. • It might be argued that the most useful measures of economic activity will have some relationship with profit, but whereas profit and turnover are recognised simultaneously under historical cost principles, this is not the case under current value principles. • To the extent that profits are recognised before an exchange transaction occurs, they will not give rise to turnover and will instead be reported net, making sensitivity analysis more difficult. Conversely, to the extent that profits are reported when an exchange transaction occurs, the costs reported will include some ‘mark-up’ for the profits already recognised, so that the gross margin shown will be less than that made overall from activities. 20 In Great Britain, the Companies Act 1985 defines ‘turnover’ as “the amounts derived from the provision of goods and services falling within the company’s ordinary activities, after deduction of(i) trade discounts, (ii) value added tax, and (iii) any other taxes based on the amounts so derived.” CHAPTER 1: WHAT SHOULD ‘REVENUE’ REPRESENT? 1.36 These shortcomings are highlighted most clearly in the case of assets, such as some commodities, for which a deep and liquid market exists.21 Under current value principles, all profits relating to such assets will have been recognised before an exchange transaction occurs, so there need be no direct relationship between turnover and profit: production and sale could fall into different periods. Moreover, the problem is likely to be exacerbated in industries where the same production may change hands more than once. For example, in the oil industry it is not uncommon for a cargo of oil to be sold many times while in transit. Such buying and selling is essentially a shortterm investment type of activity but, if reflected in turnover, it could lead to a huge disparity in reported turnover between entities that are essentially similar, at least insofar as production levels are concerned. Should ‘revenue’ mean something wider than turnover? 1.37 These problems with turnover arise because, under current value principles, gains arise over various economic activities of an entity, but turnover is traditionally reported only on the economic activity of exchange with a customer. This begs the question of whether revenue might be defined more widely, so as to encompass gains on all economic activities in the operating cycle, rather than just exchange. 1.38 One obvious way to do this might be to focus on the assets that are remeasured when profits are recognised under current value principles. Specifically, revenue could be derived from the amounts to which those assets are remeasured. However, such an approach would seem to have serious flaws, as illustrated by the following example. 21 As explained in Appendix A, the absence of selling risk for such assets means that their current value will be the same as their expected selling price. Thus the sale of such an asset will never of itself generate a profit; it will merely crystallise a gain that already exists and would already have been recognised under current value principles. REVENUE RECOGNITION Example 1.38: can revenue be defined more widely? Suppose that C manufactures a product with a selling price of £, and associated costs of £; however, when the product is part-complete and costs of £ have been incurred, its value can be measured under current value principles at £. 22 Accordingly, if C reports under current value principles, £ of profit will be recognised when the product is part-complete, with the balance of £ being recognised on sale. If revenue of £ were to be reported when the product is part-complete, with associated costs of £, the revenue figure would provide a measure of economic activity linked to the recognition of profit. In addition, it would be possible to consider sensitivities associated both with revenue and with costs: margin information would be available. This might seem, therefore, to be an improvement on the information given by turnover in the same situation. However, some difficulties with this approach come into focus when attempting to account for the subsequent sale. If revenue on the subsequent sale were still reported as £, then C would in due course report total revenue of £ relating to the product—a number with no apparent meaning. Moreover, if C subsequently concluded that reliable measurement was also possible at a second intermediate stage, say when the product had a value of £, it would instead report total revenue of £ in respect of exactly the same activities. 22 An example might be a business that grows coffee beans, which it uses to make instant coffee. When the beans are harvested it will be possible to measure their market value (assumed in the numerical example to be £75, though of course this figure would fluctuate). CHAPTER 1: WHAT SHOULD ‘REVENUE’ REPRESENT? For this sort of approach to be workable, therefore, it would be necessary instead to measure revenue incrementally at each stage. In the original example discussed above, revenue of £ would be recognised when the product was part-complete, with the balance of £ (ie £ - £) being recognised on sale. If the example is modified, so that profit is also measured at the second intermediate stage, the revenue recognised at each stage would instead be £, £ and £. Nevertheless, such an approach would still lead to some strange-looking results. For example, suppose D sells the same product as C, but car r ies out only the second stage of manufacturing itself; in other words, it buys part-complete products (for £ each), finishes them off (at a cost of £) and sells them (for £). If C and D start a period with the same number of part-complete units in stock, finish them all off and sell them all, they will have had exactly the same economic activity as each other in the period. Yet C will report revenue of £ for each unit sold,23 while D will report four times that figure. This is an unattractive result, and it seems doubtful that it would help users to compare the activities of C and D. 1.39 IASC faced essentially this problem when developing IAS , which, as mentioned earlier, requires gains to be recognised over the period that biological assets are growing. However, the approach taken by IAS does not involve widening the definition of revenue; although the standard requires the increase in the fair value of biological assets to be reported separately on the face of the income statement, it is not described as revenue. 23 having already reported the first £75 of revenue in previous periods, when the stock was manufactured. REVENUE RECOGNITION 1.40 Certainly it would be possible to widen the meaning of ‘revenue’ (at least for the purpose of financial statements) so as to include gains—such as gains from remeasuring assets—that do not result from an exchange with a third party. However, as argued below, this seems on balance to be both unwise and unnecessary. 1.41 Dictionary definitions of revenue refer to ‘receipts’ or ‘income’, with a clear implication that revenue is ‘something coming into a business from outside’. In addition, revenue is widely understood by users of financial statements, internationally as well as in the UK and the Republic of Ireland, to involve a ‘sale’ or exchange rather than merely the remeasurement of an existing asset. 24 Accordingly, it is questionable whether any benefits associated with a wider meaning for revenue would outweigh the confusion that might result. 1.42 Moreover, even if there would be benefits in defining revenue more widely, there must be some doubt whether a definition could be found that would be robust and would cater adequately for all situations, for the reasons illustrated in Example .. Finally, as IAS shows, it is not necessary to widen the definition of revenue to give useful information about economic activity in financial statements. Remeasurement gains (and losses) could be presented gross on the face of the profit and loss account, where this would be useful, without having to be reported as revenue. 1.43 For these reasons, this Paper proposes that the meaning of revenue should not be widened to encompass the remeasurement of assets and liabilities, but should continue to relate to exchange transactions. 24 For example, although the definitions of revenue used in IAS 18 and in FASB Concepts Statement 6 do not refer to an exchange, the conditions for recognising revenue in effect require an exchange to have taken place. CHAPTER 1: WHAT SHOULD ‘REVENUE’ REPRESENT? Which exchange transactions give rise to ‘revenue’? 1.44 It was suggested above that a ‘commonsense’ view might, rather crudely, describe revenue in terms of ‘what you get paid for selling things’. But if the presentation of revenue in the profit and loss account is to be of most value to users of financial statements, care is needed in developing this approach. 1.45 First, it does not seem appropriate to limit a definition of revenue by reference to the nature of ‘what you get paid’. Although most revenue transactions give rise either to cash or to the promise of cash, it is generally accepted that barter transactions can g ive r ise to revenue, at least in some circumstances.25 1.46 Secondly, it is common for businesses to sell fixed assets once they are no longer required. For most businesses, however, it is generally accepted that the income from such sales is not revenue. Accordingly, a definition of revenue should not simply focus on the fact of a sale, but will also need to take account of what is sold. Moreover, income that is largely incidental to one entity may be the main type of revenue for another. Thus if revenue is to be defined in terms of ‘what is sold’, such a definition must be capable of varying from entity to entity, in that it will depend upon the nature of the business concerned. It should therefore be based on the sequence of activities—the operating cycle—that an entity undertakes with a view to profit. 25 The subject of barter is discussed later in this Paper in Chapter 5. Without anticipating that discussion, the Paper is at this stage merely looking for a revenue definition that will not necessarily exclude barter transactions. REVENUE RECOGNITION 1.47 In the light of these points, this Paper makes the following proposals, which will be developed further in subsequent chapters. In the context of a business operating cycle, revenue is the class of gains, before deduction of associated costs, arising as a result of benefit being transferred to a customer in an exchange transaction (ie under a contract). An operating cycle is a sequence of business activities, carried out with a view to profit, which involves the transfer of benefit to customers in exchange for consideration (ie payment). 1.48 In the preceding definition, ‘gains’ should be understood in the sense of the Statement of Principles, which refers, in the context of the sale of an item of stock, to the sale proceeds and the cost of the item sold as a gain and a loss respectively. CHAPTER 2: REVENUE AND CONTRACTUAL PERFORMANCE Chapter 2 Revenue and contractual performance Summary 2.1 This chapter develops the proposal from Chapter that, although gains may arise over various activities that a business undertakes, revenue should be defined in relation to exchange transactions with customers. It examines exchange transactions in more detail, with the aim of identifying which events within such transactions should cause revenue to be recognised. 2.2 The chapter makes the following proposal, which is built upon in subsequent chapters. In the context of a business operating cycle, revenue arises as a result of benefit being transferred to a customer through the seller’s performance under a contract. Revenue and exchange transactions 2.3 Although the buyer and seller will not always think of them in so formal a way, the exchange transactions that give rise to revenue are, legally speaking, contracts. Thus it is helpful to consider the various stages involved in a contract. These can be broken down as follows. REVENUE RECOGNITION Pre-contract stage The seller and customer may discuss contract terms, but no binding agreement exists between them. Formation The seller and customer enter into a contract, which is a binding agreement.26 For a contract to be enforceable, there must be agreement over what each party will do (or, failing that, about how what each party will do is to be determined). In the context of a revenue transaction, the seller will usually agree to supply goods, rights or services, and the customer will agree to provide consideration (generally cash) in return. Although many contracts are documented in writing, this is not a necessary feature of a contract.27 26 Some contracts allow the customer the option to withdraw at some time after formation, usually returning the assets of both parties to the position before the contract existed; for example, a customer paying for goods may be entitled to return them and claim a full refund. Contracts lacking such an option are sometimes described as ‘binding contracts’, in the sense that the customer is unable to back out. However, it is perhaps worth emphasising that, in a legal sense, all contracts are binding on both parties. Where a customer has the ability to return goods, that is a term of the contract: it does not demonstrate that no contract exists. Rights of return make the analysis of revenue transactions more complicated. For this reason, they are discussed separately, in Chapter 4, while the material in the rest of this chapter and in Chapter 3 is concerned with contracts where no such option exists. 27 The extent to which a contract is documented in writing will vary greatly depending on the nature of the contract. A large construction contract is likely to be documented in some detail and signed by each party; a large retailer may display terms of trade in its stores, without explicitly agreeing them with each customer; and there is unlikely to be any written documentation where a customer buys a newspaper from a newsagent. Nevertheless, all are valid contracts. CHAPTER 2: REVENUE AND CONTRACTUAL PERFORMANCE Performance The seller and customer fulfil their promises: for example, the seller delivers goods, rights or services and the customer pays for them. Note that, for each party, performance may be instantaneous or may occur over a period of time. In addition, depending upon what has been agreed, the customer may pay in advance or in arrears, or may make stage payments at various times. Completion Once the seller and customer have fulfilled their promises, the contract is complete. Note, however, that it will not always be apparent to either party whether a seller has in fact fulfilled its promises. For example, goods sold may later transpire to have been faulty, demonstrating with hindsight that, although neither party was aware of this at the time of delivery, the seller had not fulfilled its promises and thus the contract was not complete. 2.4 The following paragraphs consider how the rights and obligations of customer and seller change as a contract progresses, based on the simple example of a seller supplying sports equipment to a customer. Before formation of a contract, the seller has an asset of sports equipment, while the customer has no r ights whatsoever in respect of that equipment. After completion of the contract, the customer has an asset of sports equipment, while the seller has no rights whatsoever in respect of that equipment; instead, the seller has an asset of, say, cash received from the customer. REVENUE RECOGNITION 2.5 Thus between formation and completion of the contract, the seller and customer have exchanged assets. To determine when this exchange took place, it is helpful to think about the nature of the seller’s and the customer’s assets at each stage—and to be able to do this, it is necessary to assume that formation and completion are not simultaneous.28 Does exchange occur on formation? 2.6 Before formation of the contract, the seller has an item of property, namely sports equipment; however, the rights that make this property an asset of the seller are, primarily, the rights to offer the property to a third party in exchange for cash. When does the seller give up these rights? 2.7 Certainly, the position of seller and customer is different after formation of the contract, as discussed below. However, despite the promises each has made, the seller has not at this point given up its ability to sell the equipment to someone else. The seller could still sell the equipment to someone other than the customer; if as a result it was unable to fulfil its promise to the customer, it would be in breach of contract, and the customer might be able to claim compensation in the form of damages.29 But the customer could not, in general, insist on delivery of the equipment, because for most contracts a court will not insist on specific performance by the seller as a remedy for breach of contract.30 28 A situation in which formation and completion are simultaneous is then just a simplification of that discussed below. 29 It may be unlikely that the seller would wish to breach the contract in this way, but there might be circumstances in which it would choose to do so, perhaps because a third party was prepared to offer a significantly higher price. The objective of this discussion is to identify at what point rights change, rather than how likely they are to change. 30 Where a contract is of a type for which a court is prepared to order specific performance, the effect may be that the customer receives certain rights on formation of the contract. However, the transfer of those rights would itself be an act of contractual performance in the sense discussed later in this chapter (and elsewhere in the Paper). Thus such contracts would not be exceptions to the proposals discussed below. CHAPTER 2: REVENUE AND CONTRACTUAL PERFORMANCE 2.8 Formation of the contract does not in general give the seller the right to insist that the customer takes and pays for the equipment. If the customer refuses to honour its promise, it will be in breach of contract and the seller may be able to claim compensation in the for m of damages. As noted above, however, a court will not usually insist on specific performance. Thus, although the seller may be compensated for lost profits, it will retain the equipment and will not therefore have given up the right to offer it to a third party in exchange for cash. 2.9 Moreover, any damages that a court might be prepared to award to the seller may fall some way short of the profit that the seller would have recognised on the transaction. This is because the court will, in awarding damages, take into account what the seller could have done to mitigate its loss. For example, if the equipment could be sold to someone other than the customer at the same price, no (or only nominal) damages may be awarded— irrespective of whether the equipment is, in fact, subsequently sold to a third party. 31 2.10 To summarise, although formation of a contract changes the position of both seller and customer, it does not in itself mean that exchange has occurred. Remedies may be available to each party if the other does not honour promises made, but the equipment has not yet become an asset of the customer; it remains an asset of the seller. 31 The underlying principle here, which is sometimes referred to as the ‘plaintiff’s duty to mitigate’, is also referred to in paragraph 6.28. REVENUE RECOGNITION Does exchange occur if and when the customer pays in advance of delivery? 2.11 Suppose that, immediately after formation of the contract but before delivery by the seller, the customer pays in full (perhaps because, by agreeing to do so, it was able to secure a better price from the seller) but does not obtain any form of title in return.32 Has exchange occurred at this point? 2.12 The answer is again no, because the analysis in paragraphs .-. still applies. The seller has not given up its ability to sell the equipment to a third party, nor has the customer yet obtained the right to insist on delivery. All that has changed is that any damages the customer could claim would be at least equal to the amount paid in advance.33 Exchange and performance by the seller 2.13 The position changes as the seller delivers the equipment to the customer, irrespective of whether the customer has paid in advance. Generally, on delivery the seller ceases to have access to the economic benefits inherent in the equipment; the seller cannot reclaim the equipment from the customer in order to sell it to a third party. Instead, the customer now generally has full access to the economic benefits inherent in the equipment. 2.14 Accordingly, following performance by the seller, the seller’s assets are different. It no longer has the ability to sell equipment to a third party; instead, it has the right (usually unconditional) to receive consideration from the customer. 32 If title did pass on payment, this would instead be a ‘bill and hold’ transaction, as discussed under paragraph 3.30 below. 33 This is not to suggest that the timing of payment by a customer is of no significance in a revenue context. However, its significance lies in determining the amount at which revenue is measured, rather than in determining the point at which revenue is recognised. A promise of cash (ie payment in arrears) is worth less than the same amount of cash already held (ie payment in advance), because of credit risk and because of the time value of money. CHAPTER 2: REVENUE AND CONTRACTUAL PERFORMANCE 2.15 Thus, the exchange of assets described in paragraph . occurs when the seller honours its promises—ie performs— under the contract; this is the point at which benefits are transferred from the seller to the customer. The first proposal under paragraph . can therefore be developed as follows. In the context of a business operating cycle, revenue arises as a result of benefit being transferred to a customer through the seller’s performance under a contract. 2.16 Chapter considers the position where a seller has only partly performed under a contract. However, before addressing that issue, it is helpful to develop further the discussion begun under paragraph .. In particular, it is now possible to say more about how the recognition of revenue by reference to a seller’s performance fits in with the idea of risks in the operating cycle being substantially eliminated. Revenue and unexpired risk 2.17 Chapter acknowledged that, although revenue recognition has historically been linked to a notion of exchange, it could in principle have been linked either to formation or to completion of a contract.34 Given the wide range of contracts that arise in different businesses and the very different risks associated with each, it is possible to make only general statements about how the different stages of a contract relate to risk. Nevertheless, the following analysis is possible for contracts that do not give the customer a right of return.35 34 See footnote 12. 35 Customer rights of return are discussed in Chapter 4. REVENUE RECOGNITION Stage of contract: Seller’s unexpired risks: On formation Credit risk (including default risk and the risk that payment will not be received on time). Performance risk (including the risk that the seller will fail to become entitled to payment from the customer on time, as a result of failing to honour its promises either in the agreed way or on time). After performance by the seller Credit risk (as above) if customer payment is in arrears, otherwise none. On completion (ie after full performance by both parties) None. (Note that warranty risk is not a post-completion risk; rather, a valid warranty claim indicates that the seller has not fully performed and that the contract is not therefore complete.) 2.18 As mentioned above, a decision for the generality of businesses on when in this process to recognise revenue would involve balancing relevance and reliability. Recognising revenue only on completion of a contract would mean complete reliability, but would be unacceptably late in many circumstances, because it is generally possible to allow for the impact of credit risk in measuring future cash flows. 2.19 On the other hand, recognising revenue on formation of a contract would involve adjusting future cash flows for the impact of performance risk. The extent of performance risk is likely to vary far more from business to business than the extent of credit risk; it is correspondingly likely to be much harder to assess. Moreover, whereas it might be argued that for the generality of businesses, credit risk is not substantial, the same cannot be true of performance risk; for many businesses performance risk will be the most significant risk. CHAPTER 2: REVENUE AND CONTRACTUAL PERFORMANCE 2.20 To summarise, it may be argued that for businesses in general the earliest point at which risks in the operating cycle have been substantially eliminated is after performance by the seller in a contractual exchange with a third party. This analysis of revenue and r isk will be relevant in Chapter when considering customers’ rights of return. REVENUE RECOGNITION Chapter 3 Accounting for incomplete contractual performance Summary 3.1 Chapter proposes that revenue should be recognised when a seller performs under a contract. This chapter considers how to account for revenue when the seller’s contractual performance is incomplete, for example over a period-end. Although the chapter discusses principles concerning how revenue should be recognised, the measurement of revenue is discussed in Chapter . 3.2 The chapter first considers, and rejects, the possibility that revenue should always be recognised only on full performance. It then suggests a principle for determining the extent to which revenue should be recognised on the basis of par tial performance, and considers various techniques by which that principle might be applied in practice.36 Finally, it considers the application of the principle to full performance contracts and to ‘bill and hold’ sales. 3.3 The main proposal discussed in this chapter is set out below. Where contractual performance is incomplete, revenue should be recognised to the extent that the seller has performed and that performance has resulted in benefit accruing to the customer. 36 It acknowledges, however, that dealing with incomplete performance is likely to be the biggest single difficulty arising in practice, and that the application of this principle to specific industries will be an important part of the next stage of this project. CHAPTER 3: ACCOUNTING FOR INCOMPLETE CONTRACTUAL PERFORMANCE General principle in respect of incomplete contractual performance Is full performance always necessary? 3.4 The first possibility to consider is that, as a general principle, revenue should not be recognised until a business has fully performed all of its promises under a contract. This would be a major change from existing practice. For example, ‘Stocks and long-term contracts’ requires that for long-term contracts turnover is recognised as contract activity progresses. 3.5 Paragraph . of the Statement of Principles comments on this subject, using the term ‘critical event’ to refer to an event that causes a gain (ie revenue) to be recognised: “For many types of transaction, the critical event in the operating cycle is synonymous with full performance. In such cases a gain will be recognised when the entity providing the service or goods has fully performed. That need not, however, be the case: the critical event could occur at other times in the cycle and there could be more than one critical event in the cycle.” 3.6 Several arguments may be made against a full performance approach. It may be argued, as in , that turnover should reflect contract activity rather than contract completion. In addition, a full performance approach will sometimes seem excessively prudent in that, for example, it is the norm in longterm construction contracts for work to be certified, invoiced and settled as activity progresses. REVENUE RECOGNITION 3.7 Probably the strongest argument against a full performance approach is that it places undue weight on the legal form of a transaction and insufficient weight on its economic substance. To illustrate this, suppose a household wishes, like many others in the same street, to have a newspaper delivered daily for a month, and suppose also that there are several newsagents already delivering to that street. The household and newsagent could, in theory, at the start of the month enter into separate contracts—one for each day—or into one contract covering the entire month.37 If the former, the newsagent would recognise revenue daily; if the latter, only at the end of the month. Yet, economically speaking, any differences between the two situations may be very slight indeed.38 As discussed later in this chapter, the single monthly contract is, in substance, daily contracts ‘bundled’ together. How should incomplete contractual performance be accounted for? 3.8 If an approach always requiring full performance of a contract is to be rejected, it is necessary to identify how revenue should be recognised in respect of part-performance. is not specific on this point, but seems to imply that, providing estimates are made on a prudent basis and the contract outcome can be assessed with reasonable certainty, revenue should be recognised by reference to the work done, or costs incurred, on the contract to date. 3.9 However, it is argued in Chapters and that revenue should be a measure of exchange with a customer. In particular, for the reasons discussed in those chapters, revenue is defined by reference to the transfer of benefit to customers. For consistency with this 37 In practice, it is of course unlikely that there would be any written documentation of the arrangement, but this does not alter the underlying principle. 38 If after, say, 20 days of supply, either party refused to continue with the contract(s), this would be a breach. Nevertheless, for the reasons discussed in paragraph 2.9, it seems unlikely that a court would order anything other than nominal damages for such a breach, because the newsagent can find other customers, while the household can find other suppliers. CHAPTER 3: ACCOUNTING FOR INCOMPLETE CONTRACTUAL PERFORMANCE approach, it seems appropriate, rather than focusing on the costs incurred by the seller, to focus on the extent to which benefit has accrued to the customer as a result of the seller’s performance. The following general principle is therefore proposed. Where contractual performance is incomplete, revenue should be recognised to the extent that the seller has performed and that performance has resulted in benefit accruing to the customer. Applying the principle in practice 3.10 Accounting for partly performed contracts is one of the trickiest aspects of revenue recognition arising in practice. Accordingly, although the principle above is more specific than , it would be foolish to imagine that this will of itself reduce the many practical difficulties that arise in connection with incomplete performance: having a more precise goal does not necessarily make it easier to achieve the goal. 3.11 Nevertheless, before discussing how the principle might be applied in practice, it is worth clarifying some aspects of what is proposed. The reference to benefit accruing should not be taken to mean that the customer must necessarily have title to, or physical custody of, any property involved in the contract. It is well established that benefits can be received by a customer without title passing at any stage, as in the case of an asset held under a finance lease.39 In addition, the discussion of ‘bill and hold’ sales later in this chapter 40 suggests that benefits can pass with title to goods, before a customer has obtained possession of them. 39 or before title has passed, where goods are supplied with a retention of title clause (ie title does not pass until the goods are paid for). 40 under paragraph 3.30. REVENUE RECOGNITION 3.12 Rather than necessarily involving either a physical event (eg delivery) or a legal event (eg transfer of title), the accruing of benefit to a customer is in essence an economic event. To take an example familiar from , if a seller is constructing a building to a customer’s design, the customer may gain neither title nor physical custody until construction is complete; nevertheless, the benefit of construction activity is accruing to the customer. The main change of emphasis arising from the principle proposed in this Paper is that, in assessing the extent of contract activity, the focus would be not on the cost of work done to date, but rather on the value to the customer of what has been done.41 Different approaches to measuring benefit transferred 3.13 To measure incomplete contractual performance, entities will need to develop suitable techniques for estimating value transferred to a customer. Three possible techniques are discussed below, in decreasing order of preference: • unbundling • value to date assessment • value outstanding assessment. 3.14 In the following discussion, it is important to note that values are measured by reference to prices and circumstances prevailing at the time the contract was originally formed; otherwise, changed prices may distort the allocation of overall revenue from the contract.42 41 Thus a distinction that will be drawn later is whether the benefit from a particular activity of a seller accrues to the customer or to the seller. (See the discussion of generic products and specificity under paragraph 6.26.) 42 This follows from the view, supported by this Paper, that, although revenue is recognised when benefits are transferred to a customer, the amount at which revenue is measured relates to the consideration received or receivable from a customer, rather than the benefits transferred. The discussion under paragraph 5.6 below is concerned with this issue. CHAPTER 3: ACCOUNTING FOR INCOMPLETE CONTRACTUAL PERFORMANCE Unbundling 3.15 Where practical, the best technique to use in measuring incomplete contractual performance is that of unbundling. This in effect reverses the process discussed in paragraph .; it asks whether the value of a large incompletely performed contract can be broken down into smaller stages or elements that might otherwise have been contracted for separately. Where this can be done, those elements will often be either complete or wholly unperformed, so that the revenue allocated to them is recognised in full or not at all. Assigning fair values to elements 3.16 Two key issues tend to arise in the unbundling process. The first is the assignment of fair values to the elements identified. The aim should be to use prices for those elements that have been agreed in similar transactions, but this may still involve a degree of estimation. Further, a measurement issue may arise if the sum of estimated element fair values does not equal the total value of the contract. In this situation, the following approaches may be considered: • If the contract value exceeds the total of the elements, this may suggest that a fair value should be attributed to the activity of managing the other elements. (An example of this will arise if a building contractor delegates all the physical work to subcontractors. The amount charged by the building contractor to its customer will exceed the amount paid to subcontractors, because the building contractor is being paid to manage the contract.) • If the contract value is less than the total of the elements, it may be that an element of performance has been double-counted. For example, there may be economies of scale that arise from combining elements, such as set-up time that does not need to be duplicated. However, a discount may remain after any REVENUE RECOGNITION double-counting has been eliminated. As a purely practical approach, it may be sensible to allocate such a discount between the various elements in proportion to the revenue estimated for each element. Example 3.16: a mobile phone package A mobile phone retailer may package within a single contract supply of a handset, some line rental and some prepaid calls. If those three elements are also available separately, their standalone prices will be the starting point for allocating the total contract value between them. At the very beginning of the contract, the handset will have been delivered to the customer, but provision of a line and calls will still be outstanding. Thus, no revenue will be recognised in respect of the latter elements.43 Are elements independent? 3.17 The second issue arising in the unbundling process, which is related to the first, lies in determining whether elements are in fact independent of one another. The unbundling process is based on the idea that elements are substantially independent of one another, so that there is no significance in the fact that they have been contracted for together. Thus, in the example discussed in paragraph ., it was implicitly assumed that the value each day of having a newspaper delivered was not affected by whether another would be delivered the next day. However, if elements are not entirely independent, some care will be needed when allocating fair values to them. 43 The extent to which revenue is recognised in respect of the handset will depend on its value when separated from the associated provision of line rental and calls. If the handset is capable of being used with more than one network, it has a value to the customer when separated from the associated line rental; the customer could reasonably have bought just the handset. However, if the handset could be used only in conjunction with the associated line rental, it would have no stand-alone value. (See also Example 3.17 below.) CHAPTER 3: ACCOUNTING FOR INCOMPLETE CONTRACTUAL PERFORMANCE Example 3.17: computer hardware and software If a customer contracts with a computer supplier to have delivered both a personal computer and certain games to be run on it, it may be reasonable to assume that these two elements are substantially independent. Having many other uses, the computer will have significant value when separated from those games; moreover, the customer would probably have little difficulty obtaining them elsewhere. On the other hand, if a business contracts with a computer supplier to develop a combined package of hardware and software to perform a specialised task, it may be much less likely that the hardware and software can be seen as substantially independent elements. The hardware may in fact have little or no use other than in conjunction with the software. 3.18 Unbundling will often help in assessing the extent to which revenue should be recognised in respect of incomplete contractual performance, but it may not provide all the answers. It may be that some material elements of a contract (or indeed a contract itself) cannot be broken into smaller elements. In that case, it will be necessary to consider the alternative techniques discussed below. Value to date assessment 3.19 If (further) unbundling is not possible, the best alternative is to attempt to assess directly the value 44 that has accrued to a customer in respect of a seller’s performance to date. 44 measured by reference to prices and circumstances prevailing at the time the contract was originally formed. REVENUE RECOGNITION 3.20 In some industries, such as construction, an independent third party periodically assesses the value of contract work performed. Where such an assessment corresponds to a fair and realistic assessment of the benefit accruing to the customer, it will provide suitable evidence of the extent to which revenue should be recognised.45 3.21 The main practical problem with this approach will arise where no such independent assessment is available. In these circumstances, there may be little reliable evidence from which to estimate the value accruing to the customer, and it may be necessary to consider the third technique below. Value outstanding assessment 3.22 The third technique available when dealing with incomplete contractual performance is to assess the value of benefit that has not yet accrued to a customer. In effect, this asks the question: if there was no further performance from the seller, what value would the customer have to pay a third party in order to take over and complete the contract? 3.23 Once again, when making this assessment, it is important that it is based on prices and circumstances that would have prevailed at the time the contract was originally formed; otherwise, changed prices may distort the allocation of overall revenue from the contract. 3.24 A difficulty with this approach arises where a third party taking over the contract would have to duplicate some of the work already done by the seller, for example in terms of familiarisation. There is a risk, therefore, that it will tend to overstate the revenue relating to unperformed activities and hence to understate the revenue that should be recognised. 45 Of course, if the independent assessment preceded the period-end and further work had been performed in the interim, this would not preclude the recognition of the appropriate amount of additional revenue as a result of that further work. CHAPTER 3: ACCOUNTING FOR INCOMPLETE CONTRACTUAL PERFORMANCE Applying these techniques in practice 3.25 In practice, a combination of these techniques may be used as appropriate. In addition, once a reasonable population of similar revenue transactions is established, it may be practical to develop specific estimation techniques that approximate the results from using those described above. For example, many industries already use percentage of completion methods when accounting for incomplete contracts; such methods would continue to be appropriate providing they are properly weighted to the fair values of different parts of a contract and reasonably reflect how benefits are received by customers.46 Full performance contracts and ‘trigger events’ 3.26 Although the preceding paragraphs discuss var ious techniques that may be used when accounting for incomplete contractual performance, it must be emphasised that, under some contracts, revenue should be recognised only on full performance. This is unlikely to be a significant issue where performance takes little time, such as in most retail transactions, but there may also be longer-term contracts for which full perfor mance will be a necessar y condition for revenue recognition. Such contracts will be those under which no benefit (or none of any significance) accrues to the customer until full performance has occurred. They may be structured so that, unless and until full performance occurs, the customer will pay nothing. 46 Percentage of completion methods often assess the costs incurred by a business as a proportion of the total costs expected on a contract. Such methods will remain appropriate where it is reasonable to assume a correlation between the costs incurred by the business and the benefits received by the customer. REVENUE RECOGNITION 3.27 More generally, there may be contracts under which no benefit of any significance accrues to the customer until an identified significant act of performance has occurred. For convenience, the specified act of performance (which may, as above, be full performance) is referred to below as a ‘trigger event’. Under such contracts, no revenue will be recognised until the trigger event occurs. In addition, the contract may often specify that the customer pays nothing unless and until the trigger event occurs. Trigger events and payment terms 3.28 Many contracts specify a payment schedule, sometimes linked to acts of performance. This does not imply that all such contracts contain trigger events, because trigger events relate to how benefit accrues to the customer, rather than the customer’s payment obligations. To identify trigger events, it may be helpful to consider whether, before a particular event in a contract, a seller’s activity accrues benefit not to the customer, but rather to the seller—primarily in that it contributes to the likelihood that the contract will ultimately be successfully performed. 3.29 As a general comment, a contract is perhaps more likely to contain trigger events where there is a high level of risk that the contract will not be successfully performed. Such risks may be present if there is a significant element of contract performance that is exposed to circumstances outside the control of either party. CHAPTER 3: ACCOUNTING FOR INCOMPLETE CONTRACTUAL PERFORMANCE ‘Bill and hold’ sales 47 3.30 ‘Bill and hold’ sales are sales in which a customer takes title to goods but the seller continues to hold them, 48 at the customer’s request, for later delivery or collection. They are incompletely performed contracts because the seller still has outstanding contractual promises—namely to retain custody of the goods for a specified period and, perhaps, to deliver them. For the purposes of the following discussion, it is assumed that the goods in question are not made to the customer’s order.49 3.31 Care is needed when deter mining the appropr iate accounting for bill and hold sales, because it is not always clear whether revenue should be recognised. To illustrate this, suppose that, before a seller’s year-end, a customer places an order for goods to be delivered in the next accounting period, with payment to be made some time after delivery. At the yearend, this contract will be executory, and no revenue will be recognised. However, if all the facts are unchanged except that the customer agrees to take title before the year-end, the contract may be described as a bill and hold sale. Should this necessarily make the accounting different? 3.32 At this stage, two factors may be identified that are necessary (but not automatically sufficient) for a bill and hold sale to be distinguished from an executory contract. 47 Although the analysis in this section is not drawn from FRS 5, it has broadly the same objective in that it focuses on the extent to which benefits (and the risks underlying those benefits) have accrued to the customer and, hence, the extent to which the customer has an asset. 48 Some transactions in which title passes but not possession are not sales at all but are simply financing arrangements. They are not considered here. 49 See paragraph 6.26 below for a discussion of specificity. REVENUE RECOGNITION • The seller must, before the transaction, have held title to the goods—otherwise title could not validly have been transferred to the customer. The goods must therefore exist and be in stock. • The arrangement to retain stocks after they have been sold must have been at the customer’s request, and must not simply reflect the seller’s inability to deliver. 3.33 The second factor is necessary because, under the proposals in this Paper, revenue will be recognised only where a customer receives benefit as a result of a seller’s contractual performance. Thus the transfer of title to goods before delivery will need to be an agreed element of the contract, and the customer will need to obtain benefit from it; it must be a contract term and must have economic substance. 3.34 If these conditions are met, revenue will be recognised to the extent that benefits have been received by the customer as a result of the seller’s incomplete performance. The customer has received title to the goods but not possession. Accordingly, the question to consider is which economic benefits, if any, the customer has received—and, correspondingly, to which risks of variation in those economic benefits the customer is exposed—as a result of the seller’s incomplete performance. 3.35 One possibility to consider is that, through the bill and hold transaction, the price of the goods has been fixed,50 thus relieving the seller of price risk. However, if benefits are to be attributed to the seller’s incomplete performance, it must be shown that they were not already present before that performance took place. Generally, a price will be fixed not on performance but rather on formation of a contract, so that the benefit of a fixed price cannot be attributed to performance. 50 This may not be the case; it is possible to transfer title without having fixed a price so long as the contract specifies how the price is to be determined. CHAPTER 3: ACCOUNTING FOR INCOMPLETE CONTRACTUAL PERFORMANCE 3.36 Another possibility is that the customer may have agreed to bear the risk that the goods will become damaged. In practice it may be difficult to determine whether this should be regarded as persuasive, since it may be difficult to ascertain the real economic effect of such an agreement. For example, because the seller has contracted to retain custody of the goods, it will probably have a duty to ensure that they are not damaged, and might therefore have to reimburse the seller anyway if damage occurred as a result of its negligence. Benefits of title—risks relating to future possession 3.37 One benefit that may pass with title relates to the risk that the customer will not ultimately obtain possession of the goods. It would be simplistic to relate this ‘possession risk’ entirely to transfer of title—because before title has passed under a contract, the seller has nevertheless promised to transfer possession. Thus, even in a non-bill and hold sale (ie one in which title passes only on delivery), the customer’s ‘possession risk’ is reduced greatly on formation of a contract. 3.38 Nevertheless, the transfer of title may in some circumstances affect the risks associated with the customer’s future possession. Suppose a customer enters into an executory contract to have product X delivered in one month’s time. The seller may or may not have product X in stock at the time the contract is made, but if it does it is still entitled to sell any such stocks to someone else; it can honour its contractual promises by obtaining replacements. However, there remains a risk that the contract may subsequently become frustrated if the seller is unable to obtain replacement supplies of product X. 3.39 Accordingly, in some circumstances, a customer may receive benefit as a result of obtaining title, in the form of greater assurance that possession will ultimately be achieved. However, the value of this benefit will be significant only where there is a significant risk that goods could not be replaced—for example, because they are unique or because supply may be restricted. REVENUE RECOGNITION Benefits of title—ability to control 3.40 The other respect in which benefits may pass with title is if the transfer of title gives the customer effective control of the goods. This will be the case where the goods are held to the customer’s order, unless the contract restricts the customer’s ability to obtain access to the goods. An example of such a restriction might arise if the contract would not allow the customer to collect or request delivery of the goods before a specified later date. 3.41 In practice, it may be very difficult to distinguish bill and hold sales from executory contracts, and careful attention will need to be paid to the facts in each case. However, the overall principle should be that revenue is recognised in respect of bill and hold sales only to the extent that the customer has received benefits—and, correspondingly, accepted risks—as a result of the transfer of title. The preceding discussion suggests that this will be the case if • without transfer of title there would be a significant risk that the customer might not ultimately obtain possession—ie either the goods are unique or replacements may not be available within the relevant timescale—or • the transfer of title gives the customer effective control of the goods, so that there are no significant restrictions on its access to them. Applying the principle in practice—summary 3.42 This chapter has proposed as a principle that, where contractual performance is incomplete, revenue should be recognised to the extent that the seller has performed and that performance has resulted in benefit accruing to the customer. The chapter has then considered different approaches whereby that principle might be applied in practice, and the implications of the principle for full performance contracts and bill and hold sales. CHAPTER 3: ACCOUNTING FOR INCOMPLETE CONTRACTUAL PERFORMANCE 3.43 As this Paper has already acknowledged, dealing with incomplete performance is likely to be the biggest single difficulty arising in practice, and the application of the Paper’s proposals to specific industries will be an important part of the next stage of this project. Nevertheless, the Board encourages respondents to consider now how the proposals might be applied to industries with which they are familiar. Views on difficulties that may arise will be valuable to the Board when refining the Paper’s proposals. REVENUE RECOGNITION Chapter 4 Rights of return and post-performance options Summary 4.1 The preceding chapters have considered how revenue arises as a result of a seller’s performance under a contract. In particular, they have focused on how that performance enables the seller to recognise rights in respect of the consideration specified in the contract. This chapter considers the impact on the preceding discussion of customer rights of return, which in effect give a customer the ability to unwind a contract after performance by the supplier has occurred. 4.2 The chapter proposes two possible approaches to accounting for rights of return, summarised below, and asks for views on which is more appropriate. Expected sale approach: Where goods are transferred along with a right of return, revenue should be recognised on the transfer of benefit, with an appropriate adjustment to reflect the risk of returns. Accounting policy approach: Where goods are transferred along with a right of return, an entity should select and consistently apply whichever of the following accounting policies is most appropriate to its circumstances: CHAPTER 4: RIGHTS OF RETURN AND POST-PERFORMANCE OPTIONS • either revenue should be recognised on the transfer of benefit, with an appropriate adjustment to reflect the risk of returns • or revenue should be recognised on the expiry of the right to return. The most appropriate accounting policy should be judged by reference to the objectives and constraints set out in ‘Accounting Policies’, giving due weight to the objective of comparability between entities operating within the same industry. Post-performance options 4.3 Under some contracts, a customer can choose not to proceed even after performance has occurred, thereby becoming entitled to a refund of all or part of any consideration already paid (or ceasing to have an obligation in respect of some or all of any consideration not yet paid). 4.4 Sometimes contract terms with this effect are required by statute, but often they are intended as an incentive to potential customers who might not otherwise have chosen to contract. Some common examples arise: • in the financial services industry, where customers are allowed a ‘cooling off ’ period (eg days) in which to revoke an agreement • where retailers sell goods with a right of return, enabling customers to reclaim in full any amounts paid • where goods are supplied on a sale or return basis (for example by manufacturers to dealers), so that the receiving party may avoid paying for the goods by instead returning them. REVENUE RECOGNITION 4.5 This chapter considers how the analysis in earlier chapters is affected by the existence of such customer options.51 Which options is this chapter concerned with? 4.6 Options are implicit in most contracts. For example, in most cases both parties to a contract that is still executory can in principle decline to proceed with it, even though no such option is explicitly acknowledged in the contract. 52 The price of exercising this option will be the damages, if any, payable to the other party for breach of contract (see paragraph .). 4.7 The options with which this section is concer ned, however, are contract terms that, in effect, allow one or other party to ‘reverse’ the contracted transaction, such as: • a customer’s option to return goods supplied and claim a refund of amounts paid (or the discharge of a liability to pay) • a supplier’s option to require the return of goods supplied. 4.8 The existence of such options can make it difficult to determine how a transaction should be accounted for. The effects of options held by a supplier are discussed under paragraph . below, but this chapter considers first the more difficult issues that arise from customers’ options. The example in paragraph . below may help to demonstrate the potential difficulties, and will also be referred to when further analysing the effects of such options. 51 Note that the chapter is concerned only with customer options that exist after performance has occurred. Thus it is not concerned with, for example, a customer’s ability to return a faulty product, because the fact that the product is faulty means that the supplier has not properly performed. 52 An exception is the limited range of contracts for which a court is prepared to order specific performance. CHAPTER 4: RIGHTS OF RETURN AND POST-PERFORMANCE OPTIONS ‘Sale’ with right of return 4.9 Suppose that X transfers a number of assets to Y in exchange for cash, but the terms of the deal allow Y to return as many (or as few) of those assets as Y wishes within seven days and claim a refund of the cash paid for each. Should X account for a sale at the initial point of exchange—and if so, precisely what has been sold? 4.10 If X is a retailer, and the assets are items of clothing, then under present accounting practice it would be common to treat a sale as having occurred, making provision for the expected level of returns.53 In effect, the transaction is regarded as a sale but with a return option attached. 4.11 Present accounting practice may be different, however, if X is a wine merchant and the assets are wineglasses. It is common for wine merchants to provide a free glass loan service to customers, with both parties expecting that most (if not all) of the glasses will be returned. The transaction may be given the legal form of a sale (with a guaranteed offer to ‘repurchase’), but under present accounting practice it may be more likely that X will initially account for it as a loan, recognising sales (if any) only at the point that glasses are not returned. In effect, the transaction is regarded as a loan with an option to buy attached.54 53 Indeed, Example 4 in Appendix III to FRS 12 ‘Provisions, Contingent Liabilities and Contingent Assets’ proposes accounting in this way for a very similar transaction. 54 It is important to note at the outset that although the wine merchant expects very few of the wineglasses to be ‘sold’, this does not imply that such sales will be unprofitable. The wine merchant will set the deposit/sale price at a level high enough to provide adequate recompense in the minority of cases in which glasses are not returned. REVENUE RECOGNITION 4.12 The fact that the two transactions are accounted for differently, even though they are both based on the contract terms described in paragraph ., suggests that either • the present accounting is inappropriate for at least one of them, or • there is a difference between the two that justifies the different accounting. 4.13 The first of these possibilities is considered below; the second under paragraph .. Is the present accounting inappropriate? 4.14 To assess whether the present accounting is inappropriate, it seems sensible to consider the consequences of accounting for both transactions in the same way, ie either • as a sale with an option to return attached, or • as a loan with an option to buy attached. Sale with an option to return 4.15 What if the wine merchant accounted for its transaction as a sale of wineglasses with an option to return attached? The change from the wine merchant’s present accounting might be quite small, because the likelihood of the return option being exercised would be very high. Only a very small level of revenue would be recognised, reflecting the small proportion of glasses not expected to be returned. Almost all of the ‘deposit’ received from the customer would give rise to a liability, reflecting the amount to be paid out under the option. This possibility is considered again later.55 55 as approach (b) under paragraph 4.49. CHAPTER 4: RIGHTS OF RETURN AND POST-PERFORMANCE OPTIONS Loan with an option to buy 4.16 What if the clothing retailer accounted for its transaction as a loan of items of clothing with an option to buy attached? Under this approach, it would not account for any revenue until the customer ‘exercised the option’. This would be at the point when the customer lost the ability to return the clothing and claim a refund, and this point would vary depending on what had been agreed between the retailer and the customer. Often the option would lapse when the customer ‘adopted’ the clothing by wearing it. In some cases there might be a limited period—say, one month—in which returns could be made; in others, the return period might be open-ended. Thus the impact of this accounting would vary from retailer to retailer, but it might be rather more pronounced than the impact described in paragraph .. 4.17 There are some who believe that, in principle, all sales with a right of return should be regarded as loans until the return option lapses, because they believe that such an approach reflects how the seller’s liabilities are extinguished. They believe that, where a customer pays in advance, the seller has a liability—an obligation to transfer economic benefits—and that this liability is extinguished only when the customer loses the ability to claim a refund. They would in principle always measure a seller’s liabilities in respect of customer return options at the maximum amount that customers could reclaim. The likelihood of that happening is not, in their view, relevant. 4.18 Others argue that the amount at which the seller’s liability should be measured changes as a result of the seller’s performance. They believe that once the seller has supplied clothing, its liability in respect of customer return options should be measured at fair value, taking account of how likely it is that customers will seek refunds. In support of this view, they argue that from the perspective of the seller there is no inherent difference between the risk that a customer will seek a refund and the risk that goods supplied will prove, with hindsight, to have been faulty. They believe that both risks should give rise to a liability reflected at fair value. REVENUE RECOGNITION 4.19 This Paper does not support the view that all sales with a right of return should be accounted for as ‘loans with an option to buy’, in part because of the arguments in the preceding paragraph and in part because of the discussion in the rest of this chapter. Accordingly, it is appropriate next to consider whether there are differences between the clothing retailer and wine merchant examples that justify their being accounted for differently. Is the present accounting justified? 4.20 If the two transactions are properly accounted for differently, what is the difference that justifies this? An initial reaction may be to say that, ignoring the legal form of each, the substance of the former is a sale whereas the substance of the latter is a loan. However, there are differences between these transactions and ‘normal’ sales and loans that appear, at least at first glance, not insignificant. • In a ‘normal’ sale, unless the goods sold are defective, a customer cannot insist on a refund—but the clothing retailer’s customer can insist on one here. Although, at the initial point of exchange, the recognition of sales reflects the extent to which goods are expected to be returned, until the option expires (which will be later than that initial exchange) the customer can demand a refund in respect of all items. • In a ‘normal’ loan, the lender can insist on the return of the item loaned at the end of the loan period—but the wine merchant cannot do so here. The wine merchant expects the glasses to be returned, but has no right to insist on it; the customer can instead give up his right to a refund. 4.21 Accordingly, when looking at the substance of each transaction, it is not true that the former is just like a sale and the latter is just like a loan; both transactions have elements that are not necessarily consistent with that substance. CHAPTER 4: RIGHTS OF RETURN AND POST-PERFORMANCE OPTIONS 4.22 Nevertheless, many might see the clothing retailer’s transaction as having more in common with a sale than it does with a loan, and the wine merchant’s as having more in common with a loan than it does with a sale. In both cases this may be because they do not see the existence of the option as fundamentally changing what the character of the transaction would have been without it: • the clothing retailer expects customers to exercise the return option only in a minority of cases—it is seen as a remedy for the small number of customers who may subsequently regret their purchases, rather than as a feature regarded as essential by all customers; • the wine merchant expects most glasses to be returned, with the option to buy being exercised only in a small number of cases (primarily as a result of breakages). 4.23 If it is right, however, that the two situations can be distinguished by focusing on the character of the transaction, it is necessar y to consider how the different aspects of each transaction enable its character to be determined. Certainly, the two transactions have many aspects in common, because each is based on the example in paragraph .. For example, in both cases the customer is entitled to claim a refund on any (or all) of the assets if he wishes, but is not obliged to return any of the assets. There are no restrictions on what the customer can do with the assets, but he is exposed to any risk of damage while they are in his custody. What then are the differences between the two transactions? 4.24 An initial reaction may be to say that the two main differences lie first in the intentions of the transacting parties and secondly in their expectations of what will occur. It is worth considering this more carefully if these apparent differences are to be used to determine the appropriate accounting in each case. REVENUE RECOGNITION Distinguishing between transactions on the basis of intent 4.25 Standard-setters are generally reluctant to distinguish between transactions purely on the basis of intent, because they believe that intent does not alter the underlying economic position that financial statements should report. 4.26 Leaving this concern to one side, in the examples discussed above it is true that both the clothing retailer and the wine merchant will know what their intent is in entering into the transaction. The clothing retailer intends to sell goods to the customer, thereby making a profit. By contrast, the wine merchant intends to lend wineglasses to the customer, expecting to make no profit on that particular transaction but to generate goodwill that may result in sales of wine. 4.27 However, because the options are exercisable by the customer, the intentions of the seller are not directly relevant. Having entered into the transaction, the seller is not in a position to influence its final outcome. If any intentions are relevant, it is those of the customer—but the seller will not usually know what the customer’s intentions are. For example, the clothing retailer’s customer may have bought several items as alternatives, with the intention of choosing one and retur ning the others. Alternatively, the customer may have bought items speculatively for someone else, knowing that they can be returned if they are not suitable. Similarly, the wine merchant’s customer may intend from the outset to retain the glasses; if so, there is no particular reason why the wine merchant should be aware of this. 4.28 The seller may be able to make a reasonable guess about the intentions of buyers when considered in aggregate, by considering the outcomes of previous similar transactions. In that case, however, he is no longer concerned with intent as such, but is instead considering the second difference identified in paragraph ., being the parties’ expectations of what will occur. This is discussed below. CHAPTER 4: RIGHTS OF RETURN AND POST-PERFORMANCE OPTIONS Distinguishing between transactions on the basis of expected outcomes 4.29 It must of course be acknowledged that the seller is no more able to assess the buyer’s expectations about the transaction’s final outcome than he is the buyer’s intentions when entering into the transaction. Nevertheless, where the seller has entered into similar transactions in the past, it is certainly true that he may be able to make an assessment of the expected outcome of a current transaction. Indeed, in the clothing retailer’s case, this assessment is already made under present practice and used to determine the extent to which a provision is required. 4.30 How might expected outcomes be used to determine whether a particular transaction should be treated as a sale with a right of return or as a loan? The expected outcome will suggest an estimate of the percentage of assets that will be returned. Where this is very low (as may be the case for the clothing retailer) it does not seem unreasonable to treat transactions as sales with a right of return. Where this is very high (as may be the case for the wine merchant’s glasses) it does not seem unreasonable to treat transactions as loans. 4.31 However, to be able to classify all transactions either as sales or as loans, it will be necessary to specify a threshold at which one is distinguished from the other. Although in practice this could be done, as an approach it has a number of undesirable qualities: • any such threshold will be somewhat arbitrary • transactions that are very similar to one another and have very similar expected outcomes will nevertheless be accounted for quite differently if those outcomes fall either side of the arbitrary threshold • as a consequence, given the potential degree of subjectivity involved in assessing expected outcomes, there may be scope for sellers to achieve significantly different accounting simply by making small changes to estimates of expected outcome. REVENUE RECOGNITION 4.32 To sum up, customers’ options to return goods are at present accounted for differently (ie as sales or as loans) in different circumstances. However, the preceding discussion has not identified a principle capable of objective application that would enable all transactions to be allocated to one or other of those categories. It therefore seems appropriate to consider the problem from another perspective. What is the nature of the seller’s asset? 4.33 The discussion above sought to identify criteria that would determine whether particular transactions should be classified either as sales or as loans. Nevertheless, it was acknowledged earlier (in paragraph .) that these transactions do not have precisely the same characteristics as ‘normal’ sales or loans. It may therefore be helpful to give more thought to the asset that the seller has as a result of entering into such transactions. 4.34 Suppose the transaction described in paragraph . is modified, so that X transfers a number of articles to Y in exchange for Y’s promise to pay cash in seven days. Once again, the terms of the deal allow Y to return as many (or as few) of those articles as Y wishes within seven days, so that at the end of that period Y will pay only for those articles that have not been returned.56 4.35 Clearly, before X contracts with Y, all the articles belong to X. At the end of seven days, X may once again have all the articles (if Y returns all of them), or X may just have cash (if Y returns none of them) or X may have some articles and some cash. 56 This example differs from that in paragraph 4.9 only with regard to the timing of payment. This Paper proposes that the recognition of revenue should not, in general, be affected by the timing of cash flows, except to the (generally relatively small) extent that credit risk affects measurement and except for the impact of the time value of money. In this example, the timing of payment has been varied primarily to make the discussion more straightforward. CHAPTER 4: RIGHTS OF RETURN AND POST-PERFORMANCE OPTIONS 4.36 But what are X’s assets at the point immediately after the initial exchange (ie before any articles have been returned by Y)? X physically holds neither articles nor cash. Does X have a claim against Y for articles? No, because X cannot insist that Y returns any of them. Does X have a claim against Y for cash? No, because X cannot insist that Y buys any of the articles. 4.37 Nevertheless, X does have a claim against Y, because X can insist that at the end of seven days Y returns either articles or cash. It is simply the case that X cannot specify which; that choice lies with Y. X’s asset does not therefore fall naturally under either of the headings ‘stocks’ or ‘trade debtors’. It is a hybrid of the two, and X does not control its make-up. (For convenience, this asset is referred to below as X’s ‘either/or’ asset.) 4.38 Now that X’s asset has been identified, it is helpful briefly to step aside from a historical cost framework and to consider how the either/or asset’s fair value is related both to the fair values of unsold articles and to the selling price agreed with Y.57 If the selling price agreed with Y is the fair value of the articles, the future cash flows to be discounted will be the same for: • unsold articles • the either/or asset • debtors in respect of articles sold. 4.39 What will vary is the extent to which risk is associated with those cash flows. The following table illustrates some of those risks (but does not claim to be comprehensive). 57 This discussion takes the same broad approach to measurement as the current value approach discussed in Chapter 1. In other words, it focuses on the future cash flows expected to be associated with an asset and, in particular, on the risks associated with those cash flows. REVENUE RECOGNITION Asset held: Expected future cash flows to be adjusted for: Debtors in respect of articles sold Credit risk (including default risk and the risk that payment will not be received on time) Unsold articles Credit risk (as above), plus Selling/performance risk (including the risk that articles will be sold for a price other than that expected and the risk that sales will not occur when forecast, or at all) 4.40 Where does the fair value of the either/or asset fall? It can be seen that, broadly speaking, it depends on the proportion of articles expected to be returned. In particular, • if almost all of the articles are expected to be returned, the fair value will tend to be close to that of unsold articles,58 whereas • if very few of the articles are expected to be returned, the fair value will tend to be close to that of debtors in respect of articles sold. 4.41 Thus if assets were being measured on the fair value basis described above, then gains (or perhaps losses) might in principle be recognised on entering into any transaction of the type described in paragraph .. Moreover, the extent of the gain or loss would depend on the likelihood that articles would be returned. 58 It could in principle be lower, because all the time that Y is holding the articles, X will be unable to sell them to someone else. If in fact there is more chance that X will sell the articles by keeping them in stock, then X could make a loss (in fair value terms) by transferring them to Y. However, it seems rather unlikely that X would in that case enter into the transaction described. CHAPTER 4: RIGHTS OF RETURN AND POST-PERFORMANCE OPTIONS 4.42 Of course, the fact that gains or losses might in principle be recognised does not indicate whether revenue should be recognised. But it is now possible to ask what effect the existence of customer return options has in the context of the discussion of revenue and unexpired risk under paragraph .. The discussion notes that under historical cost accounting the point of revenue recognition broadly corresponds, for businesses in general, to the point at which the risks associated with future cash flows have been substantially eliminated (ie reduced to an acceptable level). The way that historical cost accounting has evolved suggests that credit risk is generally seen as sufficiently low to be ‘acceptable’, but that selling/performance risk is generally seen as too high. 4.43 As noted in paragraph ., the degree of risk remaining where customer return options exist is related to the likelihood that those options will be exercised. Broadly speaking, where most return options are not exercised (as in the clothing retailer example), the degree of risk remaining for the seller is only slightly higher than credit risk; thus it might reasonably be argued that risks have been substantially eliminated. In contrast, where the level of returns is expected to be significant, the degree of risk remaining for the seller is much higher; a significant element of selling/performance risk may remain. Thus it might reasonably be argued that risks have not yet been substantially eliminated. 4.44 If the view described above is taken, it suggests that where customer return options exist no general statement can be made about when risks will have been substantially eliminated. Rather, the degree of risk associated with those options will be a relevant factor. REVENUE RECOGNITION Three possible approaches 4.45 The preceding discussion has illustrated the difficulties that arise when dealing with customer return options in a historical cost framework. This final section discusses three possible approaches that could be taken, under the headings of: (a) a threshold approach, (b) an expected sale approach, and (c) an accounting policy approach. (a) A threshold approach 4.46 This approach has already been discussed under paragraph .. As explained earlier, it would involve specifying a threshold at which sales are distinguished from loans. Thus if the threshold was set at per cent, say, a company supplying goods with a customer return option would record a sale (and a return provision) if the expected level of returns was less than per cent, but would record a loan if it was more than per cent. 59 4.47 This approach would maintain present accounting practice for the clothing retailer and wine merchant examples described earlier in this chapter. It also has the advantage of consistency between entities, in that all entities would apply the same criteria (which would not be the case for approach (c) described below). Nevertheless it has significant disadvantages, as described under paragraph .. In particular, where an entity’s expected level of returns was close to the threshold, there would be a lack of consistency in reporting very similar transactions, and the approach might also give scope for manipulating reported sales. 59 The choice of 20 per cent in this example is for illustration only, and should not be taken to imply that this is necessarily thought an appropriate level. CHAPTER 4: RIGHTS OF RETURN AND POST-PERFORMANCE OPTIONS 4.48 On balance, therefore, the Paper does not favour this approach. (b) An expected sale approach 4.49 A second option is to require the ‘sale with an option to return’ treatment (as described in Appendix III to and in the clothing retailer example in paragraph .) to be applied in all circumstances. Thus, in the wine merchant example, the wine merchant would provide for the amount of cash likely to be refunded for glass returns and would treat the balance as a sale of the proportion of glasses not expected to be returned. 4.50 Like approach (a), this has the advantage that all entities would apply the same criteria. It also has the benefit that it seeks to reflect the fair values of the assets and liabilities resulting from the initial exchange. 4.51 On the other hand, the approach would probably represent a change to present accounting practice. In addition, some may dislike the fact that under this approach an entity may book ‘sales’ that are subsequently reversed. This is of course already the case for the clothing retailer accounting under , in that the level of returns may be higher than forecast. Nevertheless, to apply this approach in situations where the expected level of returns is both relatively high and relatively uncertain increases the risk that a subsequent ‘reversal of sales’ may be significant when compared with the level of sales originally booked. REVENUE RECOGNITION (c) An accounting policy approach 4.52 A third approach is to permit two different accounting policies: sales could be recognised either on initial exchange (as for the clothing retailer) or on exercise/lapse of the customer option (as for the wine merchant). Entities would then be required to assess which of these policies was most appropriate to their particular circumstances, and to apply that policy consistently to all similar transactions.60 The expected level of returns would be a very significant factor in determining the appropriate policy and it seems likely that, in practice, the choice would often be clear-cut. 4.53 This approach would allow present accounting practice to be maintained in the clothing retailer and wine merchant examples described earlier in this chapter. It does not, however, have the disadvantages associated with a threshold approach. 4.54 The main risk with approach (c) is that different entities with similar transactions might choose different policies, thus reducing comparability. However, this risk should be largely mitigated if entities give due weight to the objective of comparability when making that choice, as required by .61 Choosing between these three approaches 4.55 This Paper does not favour approach (a), for the reasons already set out above. However, approaches (b) and (c) both appear to have merits, and this Paper does not favour one over the other. Thus the Board would particularly welcome views on which of the following approaches is thought more appropriate. 60 Where an entity had two different types of transaction, with different characteristics, it might be necessary to choose a different policy for each. 61 FRS 18 requires entities to adopt, from the range of acceptable accounting policies, those most appropriate to their particular circumstances, based on objectives of relevance, reliability, comparability and understandability. The standard notes that, in selecting accounting policies, an entity will assess whether accepted industry practices are appropriate to its particular circumstances. CHAPTER 4: RIGHTS OF RETURN AND POST-PERFORMANCE OPTIONS Expected sale approach: Where goods are transferred along with a right of return, revenue should be recognised on the transfer of benefit, with an appropriate adjustment to reflect the risk of returns. Accounting policy approach: Where goods are transferred along with a right of return, an entity should select and consistently apply whichever of the following accounting policies is most appropriate to its circumstances: • either revenue should be recognised on the transfer of benefit, with an appropriate adjustment to reflect the risk of returns • or revenue should be recognised on the expiry of the right to return. The most appropriate accounting policy should be judged by reference to the objectives and constraints set out in ‘Accounting Policies’, giving due weight to the objective of comparability between entities operating within the same industry. Suppliers’ call options 4.56 The issues of principle surrounding suppliers’ rights to require the return of goods supplied (suppliers’ call options) are not as complex as those relating to customer options, discussed above. Nevertheless, care is required when analysing suppliers’ call options, for the reasons considered below. REVENUE RECOGNITION 4.57 At the outset, it is worth noting an important difference between suppliers’ call options in a revenue context and in the context of financial instruments. In a revenue context, a supplier’s right to demand the return of an item supplied is generally specific to the thing sold.62 This need not, however, be the case in a financial instruments context. For example, a call option over a share in a listed company can generally be satisfied by buying the appropriate type of share in the market; it is not necessary to return the same share as was originally transferred, because all shares of the same class are identical. 4.58 It is also helpful to adopt some terminology to distinguish between different types of call option. Accordingly, for the purposes of the discussion below: • a call option is described as ‘unconditional’ if the supplier is entitled to exercise it irrespective of whether certain conditions are met • a call option is described as ‘conditional’ if the supplier is entitled to exercise it only if certain conditions are met • a call option is described as ‘fixed’ if, at the time the option is created, the assets to which it will apply can be known with certainty • a call option is described as ‘determinable’ if, at the time the option is created, the assets to which it will apply will not be known until some later determining event occurs. 62 and for this reason, it will be assumed to be specific to the thing sold throughout the discussion in this section. CHAPTER 4: RIGHTS OF RETURN AND POST-PERFORMANCE OPTIONS Unconditional fixed call options 4.59 An item of property, such as a car, is for accounting purposes seen as consisting of rights or other access to future economic benefits. Where an entity has custody of an item of property, however, it does not follow that it has rights or other access to all—or even any—of the economic benefits inherent in that property. 4.60 Consider a car on short-term hire. The customer may be severely restricted in terms of the future economic benefits to which he has access. Generally, he will be able, under the terms of the lease, neither to sell the car to someone else nor to carry on using it beyond the agreed hire period, and he may also be restricted in how he uses the car during the hire period. In these circumstances, it would be wrong to say that the customer has an asset of the car; rather, the customer’s asset is restricted to certain of the future economic benefits inherent in the car. 4.61 Similarly, where a supplier has an unconditional fixed call option over part of an item of property, the effect of the option is to restrict the receiving party’s access to some of the benefits inherent in the item.63 Thus, if the short-term hire agreement described above had instead taken the legal form of a sale, giving both supplier and customer the unconditional right to insist on a repurchase after a specified period, the customer would not at the outset have an asset of the car. Rather, the customer’s asset would be the right to use the car for that specified period. By the same logic, therefore, the supplier would not have disposed of the car, but would have disposed only of the right to use the car for that specified period. 63 unless either (i) there is no realistic prospect that the option will be exercised or (ii) any penalties payable by the receiving party would be insufficient to compel it to honour the option if exercised. For the purposes of the discussion in this section, these exceptions are assumed not to apply. REVENUE RECOGNITION 4.62 Thus, where a supplier has an unconditional fixed call option over part of a non-fungible item of property passed to another party, and thereby denies that party access to the associated future economic benefits, that part of the item remains the supplier’s asset and has not, therefore, been sold. Other supplier call options 4.63 Other supplier call options may not be so straightforward, as shown by the examples below. • A manufacturer may supply goods to a dealer on a sale or return basis, with the manufacturer retaining a conditional call option over the goods. If to exercise the call option the supplier must first offer the dealer unconditional rights to the goods, it may be argued that this negates the effect of the call option—because the dealer’s access to the future economic benefits in the goods is not restricted. • Similarly, the manufacturer may have a call option over any goods that have been neither sold nor otherwise disposed of by the dealer at a specified date. The subject of the option is determinable rather than fixed, because it will not be possible to know at the outset which goods will remain. Moreover, the subject of the option is largely determinable by the dealer rather than the manufacturer; the dealer, rather than the manufacturer, has the ability to determine whether goods are sold or otherwise disposed of. In this case, therefore, the dealer’s access to future economic benefits is restricted (in that it cannot choose to hold the goods beyond the specified date), but this restriction may be of little significance if, for example, the dealer is likely to have sold the goods by then anyway. CHAPTER 4: RIGHTS OF RETURN AND POST-PERFORMANCE OPTIONS 4.64 To sum up, in a revenue context the effect of a supplier retaining a call option is to restr ict what has been sold. However, care is needed when determining the effect of such a restriction, particularly where a supplier’s call option is either conditional or determinable, as is illustrated above. REVENUE RECOGNITION Chapter 5 Measuring consideration Summary 5.1 Whereas earlier chapters have been concerned primarily with the recognition of revenue, this chapter first considers the general principles of how revenue should be measured, and then discusses particular measurement issues under the headings of: • reliable measurement • consideration that is determinable rather than fixed • barter transactions. 5.2 The main proposals discussed in this chapter are set out below. Revenue should be measured as the change in fair value, arising from the seller’s performance, of (i) assets representing rights or other access to consideration and (ii) liabilities in respect of consideration received in advance of performance. Assets representing rights or other access to consideration should be remeasured to reflect the effect of the time value of money, where this effect is significant. Such remeasurement does not arise from performance and does not, therefore, give rise to revenue. CHAPTER 5: MEASURING CONSIDERATION Liabilities in respect of consideration received in advance of performance should not be remeasured to reflect changes in the fair value of performance that has not yet occurred. They should, however, be remeasured to reflect the effect of the time value of money, where this effect is significant. Such remeasurement does not arise from performance and does not, therefore, give rise to revenue. A transaction is with a customer—and hence gives rise to revenue—if, on its completion, the entity has been rewarded for eliminating the risks previously outstanding in the relevant operating cycle. General principles for measuring revenue 5.3 Earlier chapters have discussed how revenue arises as part of a process of exchange with a customer, with revenue being the class of gains arising under a contract as a result of a seller’s performance. In a very simple example, the process of exchange can be nearly instantaneous; for example, a newsagent hands over a newspaper and immediately receives cash in return. 5.4 In such a straightforward example, the appropriate measure of revenue is obvious—it is the value of the cash received. The seller’s contractual performance gives rise to an asset, namely cash, and revenue is the gain, before deduction of associated costs, arising from recognition of that asset. 5.5 The measurement of revenue, and of the assets and liabilities arising from the contract, can be more difficult where exchange is not instantaneous. Accordingly, the discussion below considers together the measurement of revenue and the measurement of related assets and liabilities. REVENUE RECOGNITION Benefits transferred or consideration accruing? 5.6 When a transaction at fair value is entered into, it is to be expected that the fair value of goods or services to be supplied will be the same as the fair value of consideration receivable. But if there is a delay between entering into the contract and its performance, these values may move out of line with each other because of changing prices. It is therefore fundamental to ask which aspect of the exchange revenue is measuring: the benefit being transferred to the customer, or the consideration accruing to the seller as a result of that performance. 5.7 This issue is perhaps best illustrated with an example. Example 5.7: measuring revenue Suppose that a company contracts to supply services in exchange for consideration of £, being the fair value of those services at the time. However, in the interval between entering into the contract and its performance, the normal selling price for those services (which is the same as fair value) falls to £. From a purely arithmetical point of view, there are two different ways in which the revenue side of the transaction might be presented in the profit and loss account: • revenue might be presented as £ (the fair value of the consideration) • revenue might be presented as £ (the fair value of the services), with a separate gain of £ recorded in relation to the executory contract. CHAPTER 5: MEASURING CONSIDERATION Which of these is correct? Another way of expressing exactly the same issue is to focus on the balance sheet. Suppose the consideration of £ was received at the outset, giving rise to a liability of that amount. Will that liability change in value in the interval between formation and performance? The answer seems to depend on precisely what the liability is seen as representing: • if it is a liability to refund amounts paid in advance (‘on deposit against future performance’) then it will remain at £ (except for effects due to the time value of money, which are discussed under paragraph . below) • if it is a liability to provide specified services, then presumably its value will change (to £) with the fair value of those services. 5.8 This Paper favours the view that revenue reflects the amount to which a seller becomes entitled under a contract as a result of performance, rather than the fair value of that performance. Certainly this view is more consistent with the natural meaning of ‘revenue’; as noted in Chapter , dictionary definitions have a clear implication that revenue is ‘something coming into a business from outside’. In addition, this view seems more consistent with the whole focus on exchange, discussed earlier in the Paper, in that the alternative view seems implicitly to assume that exchange has already occurred. REVENUE RECOGNITION 5.9 It follows from this that a payment in advance by a customer gives rise to a liability in respect of the amount received, rather than in respect of the goods or services to be provided. That liability will generally be extinguished by subsequent performance, but will not be remeasured for changing prices of goods or services in the interval before performance occurs.64 General principles for revenue measurement 5.10 In the light of the preceding discussion, proposals for measuring revenue can now be set out. Revenue should be measured as the change in fair value, arising from the seller’s performance, of (i) assets representing rights or other access to consideration and (ii) liabilities in respect of consideration received in advance of performance. 5.11 These proposals are developed further below. Some of their implications are discussed in later sections of this chapter. Fair value of rights or other access to consideration 5.12 Contracts will usually specify, at least in broad terms, when payments are to be made by a customer. Often, as in many construction contracts, those payments will be timed to coincide with performance, but this need not be the case; payments may fall entirely before or after performance. 64 Of course, a contract may specify that consideration is to be denominated in a currency other than the seller’s reporting currency; for example, an entity reporting in sterling may enter into a contract to sell a product for US$10,000. In this situation, any payment in advance will give rise to a monetary liability denominated in a foreign currency. Although that liability will not be remeasured in dollar terms, the sterling amount to which it is translated will need to be remeasured in order to be kept up to date for changes in the exchange rate. CHAPTER 5: MEASURING CONSIDERATION 5.13 Rights or other access to consideration are not restricted to, and should not be confused with, a seller’s rights to raise invoices in accordance with a contract-specified payment schedule. The latter will reflect only the agreed timing of payment, whereas this Paper proposes that the former should arise as benefit accrues to a customer through a seller’s contractual performance. Where a contract allows invoices to be raised only on full performance, but a seller’s incomplete performance has resulted in benefit accruing to a customer, the bridge between revenue and invoice will be an asset of accrued income. 5.14 Accrued income does not represent a contractual right to demand payment from a customer. Seller and customer are free to agree whatever payment schedule they wish, and to allow this to dictate the recognition of revenue would lead to a lack of comparability and allow wide discretion over reporting revenues. Rather, in accordance with this Paper’s principles, accrued income is a measure of the extent to which performance has occurred in advance of contractual rights to payment. It may therefore be better understood as a conditional right to payment from a customer,65 but—importantly—for benefits that have already been transferred. 5.15 Where there is a significant interval between performance and a customer being required to pay, the contract pricing will in principle reflect not only the fair value of benefits transferred but also the time value of money. Thus, where the effect of the time value of money is significant, this should be taken into account in measuring rights or other access to consideration and, hence, revenue. 65 It will most often be conditional on further performance under the contract. REVENUE RECOGNITION 5.16 Accordingly, the following principle is proposed. Assets representing rights or other access to consideration should be remeasured to reflect the effect of the time value of money, where this effect is significant. Such remeasurement does not arise from performance and does not, therefore, give rise to revenue. Fair value of liabilities where consideration is received in advance of performance 5.17 As explained under paragraph ., the approach to revenue proposed in this Paper means that liabilities for customer payments in advance will not be remeasured for changing prices; rather, they will generally be released when performance occurs. Nevertheless, a customer paying significantly in advance of performance should be able to negotiate a lower price than would have been payable at the time of performance, because of the time value of money. It would seem wrong to ignore this effect when accounting for revenue. 5.18 Accordingly, the following principles are proposed. Liabilities in respect of consideration received in advance of performance should not be remeasured to reflect changes in the fair value of performance that has not yet occurred. They should, however, be remeasured to reflect the effect of the time value of money, where this effect is significant. Such remeasurement does not arise from performance and does not, therefore, give rise to revenue. CHAPTER 5: MEASURING CONSIDERATION Reliable measurement 5.19 The discussion above and in earlier chapters has concluded that a seller should recognise revenue as a result of performing its contractual promises. However, like other assets and liabilities, assets and liabilities relating to consideration will be recognised in financial statements only if they can be measured with sufficient reliability. 5.20 At this point, it is worth noting paragraph . of the Statement of Principles, which suggests that, where measurement uncertainty exists, there will in almost all cases be a minimum amount for an asset or liability that is reasonably assured. Therefore, it will be very rare for measurement uncertainty to be so significant as to prevent the recognition of revenue. Rather, an asset relating to consideration will be stated at no less than the minimum amount (which in some cases may be nil), with a higher amount being used if that is a better estimate. Consideration that is determinable rather than fixed 5.21 For a contract to be effective, there must be agreement between the seller and the customer concer ning the consideration. Usually, a contract will specify a fixed price, but this is not always necessary. For example, fees for professional services are sometimes agreed by specifying that the hours worked—which may be highly uncertain—will be charged at particular rates. The important point is that the amount of the consideration is determinable. 5.22 In principle, there is nothing to prevent the seller and customer agreeing that the consideration shall be whatever one of the parties subsequently decides. However, such an agreement exposes the other party to significant risk. It is more common, therefore, where consideration is not a fixed amount, for the parties to have less discretion than this. REVENUE RECOGNITION 5.23 If consideration is to be determinable, it follows that a contract must specify what is to determine it. For the purposes of the following discussion, the determining factor or factors specified can be divided into three classes: • determining factors that are within the control of neither seller nor customer • determining factors that are within the control of the seller • determining factors that are within the control of the customer. Determining factors within the control of neither seller nor customer 5.24 The following paragraphs discuss how to measure revenue where the amount of consideration is uncertain, but will be determined by factors that are external to the seller and the customer. At the outset, it is worth emphasising that the degree of uncertainty might be very small or very large. For example, if the consideration is to be a fixed amount adjusted by reference to an index, such as the retail price index, the degree of uncertainty may be relatively small. On the other hand, the consideration might be ‘all or nothing’ depending on whether a particular event 66 occurs, in which case the degree of uncertainty may be very large—particularly if the two possible outcomes are roughly equally likely. 5.25 Three possible approaches are discussed below. 66 that is not under the control of either the seller or the customer. CHAPTER 5: MEASURING CONSIDERATION Approach (1): defer revenue recognition until the amount is determined (the ‘deferral’ approach) 5.26 One approach is to wait until the amount payable is determined before recognising a consideration asset. In effect, this is to recognise revenue not on performance but rather when the amount payable is determined (for convenience, this is called the ‘determining event’ below). 5.27 However, such an approach does not seem to cope well where only a little uncertainty exists (eg the retail price index example in paragraph .). In addition, it is inconsistent in principle with the arguments expressed earlier in this Paper; once a seller has fully performed its contractual promises, it is entitled to receive the consideration specified in the contract. This is no less true where the amount specified in the contract is determinable rather than fixed, even if it has not yet been determined. The seller is entitled to whatever that amount turns out to be. In other words, the seller has a consideration asset and, although there is uncertainty over the amount at which that asset should be measured, there is no uncertainty over its existence. 5.28 If full performance occurs before the determining event, and if reliable measurement is possible at the time of full performance,67 then the ‘deferral’ approach will result in revenue being recognised later than it should be. Accordingly, the Paper rejects this approach. 5.29 Unlike the ‘defer ral’ approach, the two remaining approaches (which are discussed below) both acknowledge that once the seller has fully performed it is entitled to receive consideration. However, they differ in the extent to which they would reflect that entitlement as an asset. To illustrate how these approaches work, it may be helpful to refer to an example. 67 As noted in paragraph 5.20, based on discussion in the Statement of Principles, it will be very rare for measurement uncertainty to prevent the recognition of consideration. REVENUE RECOGNITION Example 5.29: determinable consideration Suppose that a seller has fully performed under a contract and as a result is entitled to receive consideration. That consideration will be determined by a future event outside the control of the seller and the customer. There are four possible outcomes,68 and their associated probabilities are as follows: Outcome Probability Consideration I 1% £1,000 II 9% £10,000 III 10% £20,000 IV 80% £50,000 100% In this example, the most likely outcome is that the seller will receive £,, but there is a one in five chance that the amount received will be less than this. Nevertheless, the seller is certain to receive at least £, and per cent certain to receive at least £,. 68 This example is of course artificial, but its aim is to illustrate the underlying principles. For the sake of simplicity, it is assumed that consideration will be received in the near future, so that the effect of the time value of money is not significant. CHAPTER 5: MEASURING CONSIDERATION Approach (2): recognise whatever element of consideration is virtually certain (the ‘virtually certain’ approach) 5.30 This approach is similar to the approach taken to the recognition of contingent assets in .69 Under the ‘virtually certain’ approach, the seller would recognise consideration only to the extent that it is virtually certain to be received. 5.31 If this approach is applied to the example, consideration of either £, or £, will probably be recorded, depending on whether the threshold corresponding to ‘virtual certainty’ is judged to be above or below per cent (the probability that at least £, will be received). Approach (3): recognise a fair value for the consideration asset (the ‘fair value’ approach) 5.32 Under this approach, the consideration asset would be measured on recognition at fair value. It might sometimes be possible to measure this fair value directly (if, for example, the consideration is linked directly to a quoted index or share price). Otherwise, fair value would be determined by reference to expected future cash flows, discounted so as to take account of associated risks. 5.33 In the example, the fair value cannot be determined directly. The weighted average of all possible outcomes is approximately £,, but the fair value will be less than this because it will reflect risk. Nevertheless, fair value will exceed the figure that is judged ‘virtually certain’, probably by a significant amount. 69 FRS 12 defines a contingent asset in terms of uncertainty over its existence rather than over the amount at which it should be measured. Technically, therefore, a consideration asset is not within the FRS 12 definition of a contingent asset because, although the amount of consideration is uncertain, the existence of the consideration asset is not. REVENUE RECOGNITION Advantages and disadvantages of the ‘virtually certain’ and ‘fair value’ approaches 5.34 Some may be attracted to the ‘virtually certain’ approach because under that approach it is always virtually certain that the amount of consideration actually received will not fall short of the amount recorded. By contrast, although the fair value will reflect the risk of variation in outcome, there will be more chance under the ‘fair value’ approach that consideration may need to be adjusted downwards. 5.35 However, this is not a particularly powerful criticism of the ‘fair value’ approach, because consideration is likely to need subsequent adjustment under both approaches (in that the estimate made at the outset will usually differ from the amount subsequently received). On the other hand, there are two quite strong criticisms of the ‘virtually certain’ approach, which suggest that it could often produce results that are misleading. 5.36 The first criticism is that the ‘virtually certain’ approach acknowledges no possibility that the seller may be able to close out some or all of the risks associated with fair value. For example, suppose that a seller of goods will receive consideration in one month’s time, equal to the value at that time of a specified number of shares in a quoted company. The fair value of that consideration at present will be very close to whatever is the present quoted price for that number of shares—say, £,. Moreover, irrespective of how volatile the share price is, the seller can close out the risks of variation by ‘going short’ in the shares; in effect, the seller freezes the consideration at its present fair value of £,. However, under the ‘virtually certain’ approach the seller might find it very difficult to estimate an amount below which the share price would be virtually certain not to fall, particularly if the price is volatile. CHAPTER 5: MEASURING CONSIDERATION 5.37 The second criticism of the ‘virtually certain’ approach stems from the first. If the seller in the above example knows that it can close out the risks of variation in share price, this will influence its agreement with the buyer over the consideration. For example, the goods being sold in the preceding paragraph’s example might have cost the seller £,, resulting in a profit of £, which can be frozen by going short in the shares. Under the ‘virtually certain’ approach, however, unless the seller can be virtually certain that the share price will stay above £,— which may be very unlikely—the seller will report a loss that need not in fact be incurred. 5.38 Although these criticisms are particularly powerful where consideration is linked directly to a quoted index or share price, they point up a more general failing inherent in the ‘virtually certain’ approach. A seller is not compelled to enter into a contract with determinable rather than fixed consideration: even where determinable consideration is the norm for a particular transaction, a customer should rationally be prepared to agree to a fixed price if that price is set appropriately. Therefore, a seller should take on the r isks associated with deter minable consideration only if it is rational to do so. The ‘virtually certain’ approach distorts the economic reality by reducing the ‘real’ gain associated with the seller’s perfor mance and, conversely, by pretending that any subsequent upside associated with the determinable consideration comes at no cost. By contrast, the ‘fair value’ approach better depicts the underlying economic position. 5.39 For these reasons, this Paper favours the ‘fair value’ approach. When, as a result of contractual performance, a seller becomes entitled to receive an uncertain amount of consideration, to be determined by factors outside the control of both the seller and the customer, the consideration asset arising should be recorded at its fair value. REVENUE RECOGNITION Determining factors within the control of the seller 5.40 The second category to consider is where consideration will be determined by factors within the control of the seller. Before going further, however, it is worth clarifying the position where the parties to a contract do not specify how a price is to be determined. In effect, for such a contract to be valid, it must have an implied term that the price is to be fair; otherwise, there is no valid contract. The effect of the implied term is that consideration is not determinable but rather is fixed at whatever that fair price should be.70 Accordingly, such situations do not fall into this second category. 5.41 The aspect of perfor mance used to deter mine consideration is usually time of completion. This is common in construction contracts, where the price that the seller will receive often depends on when work is completed. The different outcomes may be characterised as penalties for late completion and/or bonuses for early completion; nevertheless, from the seller’s point of view, some work is to be done and the consideration to be received will depend on when it is completed. 5.42 Where consideration depends on when performance is completed, the accounting issue that arises is how to measure the amount of consideration to be recognised when performance is incomplete. Once again, it may be helpful to refer to an example. 70 In practice, of course, the ‘fair price’ may be arrived at by subsequent negotiation between the parties. CHAPTER 5: MEASURING CONSIDERATION Example 5.42: construction of a hospital A company is constructing a new hospital. The first stage of work is now complete, and it has been determined that the value to date of the work represents per cent of the total contract value. However, the amount that will be payable for the hospital as a whole will depend on when it is completed: 71 Date of completion Consideration Before 30 September 2001 £45 million 1-31 October 2001 £40 million After 31 October 2001 Subtract £500,000 for each extra day 5.43 Several different approaches might be taken, and these are considered below. (a) ‘Contract price’: the amount of consideration to be recognised should be based on the ‘contract price’. Bonuses for early completion should be recognised only if and when early completion is achieved; similarly, penalties for late completion should be recognised only to the extent that they become unavoidable. (b) ‘Best outcome’: since the time of completion is within the builder’s control, the amount of consideration to be recognised should be based on the best outcome that the builder can achieve. If the builder subsequently fails to meet this timetable, the losses associated with that failure should be reported in the periods in which the failure occurs. 71 Once again, a somewhat artificial example has been chosen in order to illustrate the principles involved. For simplicity, assume that no stage payments are made and, hence, that such payments cannot be used to estimate the value of the consideration asset. REVENUE RECOGNITION (c) ‘Worst outcome’: the amount of consideration to be recognised should be based on the lowest amount that is virtually certain to be received. Any excess over this amount is achieved only when the builder performs better than this, and should be reported at that time. (d) ‘Fair estimate’: the amount of consideration to be recognised should be arrived at by reviewing the various possible outcomes, assessing the most likely and adjusting it for the risk of variations from it. 5.44 The ‘contract price’ approach is unsatisfactory because contracts that are economically identical may be drafted in different ways and would then lead to different amounts of revenue being reported. In the example, the ‘contract price’ might have been specified as £ million, with a bonus of £ million for early completion and penalties of £, per day for late completion. However, the ‘contract price’ might equally have been specified as £ million, with penalties of £ million for the first days of late completion and £, per day after that. 5.45 Most will probably find the ‘best outcome’ approach unattractive in that it involves recognising consideration that will very often subsequently be written back and, as such, seems both biased and imprudent. However, it is also based on questionable logic. Just because the builder has the ability to control the outcome, it does not follow that it will necessarily choose to exercise control so as to achieve the highest amount of consideration; for example, it may be that the incremental costs associated with early completion exceed the incremental revenues. CHAPTER 5: MEASURING CONSIDERATION 5.46 At the other extreme, the ‘worst outcome’ approach is also unattractive. There is always some risk associated with contracts and, accordingly, there may be relatively few in respect of which it is virtually certain that no loss can arise. Under the ‘worst outcome’ approach, it seems likely that losses would be reported on most incomplete contracts, even though it might be unlikely that such losses would be sustained. (In the example, there is no minimum amount of consideration specified; the penalties are open-ended.) 5.47 Consequently, the ‘fair estimate’ approach seems to lead to the most appropriate accounting. To arrive at a fair value for the consideration asset to be recognised in respect of performance to date, the builder should first realistically assess when the remaining performance is most likely to be completed. The consideration associated with that timescale then represents the most likely outcome for the contract as a whole, but this needs to be adjusted to reflect any risk that the actual outcome will be different. The consideration asset to be recognised for incomplete performance is then derived from this risk-adjusted, most likely outcome. 5.48 This can be illustrated by reference to the example. Suppose that the builder’s best estimate is that the work will be finished on or around October. In that case, the most likely consideration is £ million. The builder then needs to assess the effect on this amount of any delay in completion. If the builder thinks it unlikely that any delay beyond October will be more than days, then the amount of £ million could be reduced by up to £ million (four days beyond October at £, per day). Therefore the r isk-adjusted total consideration will probably lie somewhere between £ million and £ million; since in the example the work is per cent complete, the amount to be recognised will lie between £ million and £ million. REVENUE RECOGNITION Determining factors within the control of the customer 5.49 The final category to examine is where consideration will be determined by factors within the control of the customer. For the purposes of the following discussion, such consideration can be seen as consisting of two elements: a fixed element, which is the minimum that is certain to be paid (but which may be nil), and a further variable element. Accounting for the former is relatively straightforward. Following the principles discussed elsewhere in this Paper, the fixed element of consideration will be reflected as revenue when the seller performs the contractual promises to which it relates.72 5.50 As regards the variable element, the position is more difficult. From an perspective, the customer has no obligation in respect of any variable element (which may be the entire fee) until he becomes committed to paying it. Some might suggest therefore that no revenue should be recognised in respect of the variable element until such time as the customer ceases to control the amount, if any, that will be paid. However, this would not necessarily be consistent with Chapter , which suggests that revenue recognition is sometimes possible in circumstances where the customer nevertheless still has the right not to proceed. Moreover, although the fair value of a consideration asset relating to a variable element may sometimes be small, it will not be zero; the seller is better off with such an asset than without it. 72 As discussed in Chapter 3, revenue will be recognised for some contracts only on full performance. When dealing with consideration to be determined by factors within the control of a customer, particular care should be taken to ensure that revenue is recognised only to the extent that performance has already occurred. CHAPTER 5: MEASURING CONSIDERATION 5.51 The discussion in Chapter suggests that, where performance by a seller has taken place but the customer still has discretion over whether to proceed, the likelihood of consideration being received is relevant in determining the treatment. In some circumstances it may be very likely that the customer will proceed; in others, there may be much uncertainty. Chapter favours one of two possible approaches to such situations: • an expected sale approach (discussed under paragraph .) • an accounting policy approach (discussed under paragraph .). 5.52 It therefore seems sensible to consider similar approaches where, following performance by a seller, factors determining the amount of consideration remain within the control of a customer. The Board would again particularly welcome views on which approach is the more appropriate. Barter transactions 5.53 Although the consideration receivable by a seller is usually cash, entities sometimes enter into barter transactions, where the consideration receivable is something other than cash—for example, the right to receive goods or services. 5.54 Two particular issues of pr inciple ar ise with barter transactions and are discussed below: • should they be treated as giving rise to revenue? • how is consideration to be measured? REVENUE RECOGNITION Should barter transactions be treated as giving rise to revenue? 5.55 If a gas producer wishes to buy steel and a steel producer wishes to buy gas, they may enter into separate transactions with one another for cash. In such circumstances, each will record revenue as a result of the transaction. Equally, however, they might agree to swap gas for steel. From a legal perspective, this may raise a question of whether any profit arising from the barter transaction can be regarded as realised; nevertheless, there seems no reason in principle to account differently depending on whether there is legally one transaction or two. 5.56 On the other hand, suppose two gas producers enter into a transaction. One has surplus gas stocks in North America, but needs gas in Europe; the other has surplus gas stocks in Europe, but needs gas in North America. They therefore agree to swap gas in one location for gas in the other. This may seem rather less like a revenue transaction; in particular, it may seem more akin to a transaction with a supplier—such as exchanging unwanted goods for others—than a transaction with a customer. 5.57 The main difference between these examples lies in the effect that each transaction has within the entities’ operating cycles. In the first example, each entity has, as a result of the transaction, reached the end of its operating cycle, in the sense that it has been rewarded for eliminating risks previously outstanding in that cycle. For both producers, a sale transaction has simply been bundled with a purchase having nothing to do with that operating cycle. This is not the case in the second example; the position of both suppliers is substantially unchanged as a result of the transaction. 5.58 The definition of revenue in Chapter is linked to an idea of business activities carried out with a view to profit, but it does not focus on the nature of the consideration received from a CHAPTER 5: MEASURING CONSIDERATION customer. Thus, where a barter transaction involves a seller providing goods or services that would, if sold for cash, give rise to revenue, the fact that the consideration is other than cash need not of itself prevent revenue from arising. Rather it will be necessary to consider the substance of the transaction and, in particular, its role in the entity’s relevant operating cycle—ie the cycle that involves providing the goods or services in question. 5.59 Where the consideration receivable by a seller is not directly connected with that operating cycle, the view supported by this Paper is that revenue should arise. The consideration receivable may be intended for general use in the entity’s business—for example a fixed asset or consumable; it may be an input to a different operating cycle; or it may be a surplus asset, which the business will then seek to realise. Nevertheless, in all such cases the transaction is in substance a revenue transaction, in the sense that the seller has been rewarded for eliminating the outstanding risks in its operating cycle: it has provided goods to a customer and been rewarded for that activity. 5.60 The position is more difficult where the consideration receivable by a seller is directly connected with its operating cycle, because the substance of the transaction may be different. • Where a seller exchanges goods with a supplier or competitor, and receives in return goods having a similar role in its operating cycle, the transaction may not put the entity in a substantially different position. Afterwards, the entity continues to have goods on which outstanding operating cycle risks have not been eliminated. Moreover, because of the nature of the other party involved, the transaction is unlikely to be undertaken directly with a view to profit. Thus the entity has neither eliminated risks nor been rewarded. REVENUE RECOGNITION • Where a seller supplies goods in exchange for goods at a later stage in its operating cycle, the transaction may in substance be the outsourcing, or subcontracting, of part of the seller’s production process. To take a somewhat artificial example, a coffee supplier wishing to outsource the manufacture of instant coffee from coffee beans might also pay for that manufacturing service with coffee beans. The transaction would then be a barter transaction; the coffee supplier would deliver beans to the other party, some would be returned in the form of instant coffee, and others would be retained as payment. 5.61 Nevertheless, transactions in which the consideration receivable by a seller is directly connected with its operating cycle may in some circumstances have the substance of revenue transactions. This will most often be the case where the other party does not have the same access to markets as the seller, and will therefore be prepared to barter on terms more favourable to the seller. For example, a dealer in second-hand compact discs may be prepared to enter into a barter transaction with an individual who has received a gift of unwanted compact discs. That transaction may involve exchanging second-hand compact discs for other second-hand compact discs, but the exchange will take place only on terms favourable to the dealer. The dealer will require a reward—an increase in the value of assets—just as in a sale for cash. 5.62 Thus, where the consideration receivable in a barter transaction is directly connected with the operating cycle in question, it will be necessary, as illustrated above, to consider the substance of the transaction in order to determine whether revenue has arisen. In that light, the following development of the definitions from Chapter is proposed. A transaction is with a customer—and hence gives rise to revenue—if, on its completion, the entity has been rewarded for eliminating the risks previously outstanding in the relevant operating cycle. CHAPTER 5: MEASURING CONSIDERATION How is consideration in a barter transaction to be measured? 5.63 From the discussions earlier in this chapter, it seems reasonable to conclude that consideration in a barter transaction should be measured at fair value, just as it would be in a nonbarter transaction. 5.64 In principle at least, fair value may sometimes be easy to assess. For example, where an entity receives as consideration assets that it would otherwise have bought, it may be relatively straightforward to determine the fair value by reference to the price that would otherwise have been paid. 5.65 Rather more difficulty may arise however where, in the absence of the associated sale transaction, the entity would not have chosen to purchase the assets received as consideration. This may be the case, for example, where trade with a third party is subject to currency restrictions, so that consideration must be other than in cash. If an entity supplies machinery and receives shoes in return then, assuming it is not in the business of selling shoes, it will upon supplying the machinery recognise revenue at the fair value of the shoes it has received. However, in the absence of a reliable external measure of that fair value, it may be necessary to assess the amount for which it may be able to sell the shoes and to discount this for associated risks, including selling risk. When it subsequently disposes of the shoes, that disposal may give rise to a gain but not to revenue, because the sale of shoes is not part of an operating cycle for the entity. UITF Abstract 26 ‘Barter transactions for advertising’ 5.66 UITF Abstract 73 is concerned with the amount of tur nover, and expense, that should be recognised when advertising is exchanged in a barter transaction. It reflects the consensus of the UITF that turnover and costs should not be recognised unless there is persuasive evidence of the value at which, if the advertising had not been exchanged, it would have been sold for cash in a similar transaction. 73 issued on 9 November 2000. REVENUE RECOGNITION 5.67 In the advertising exchanges considered in the Abstract, each party will generally consume the benefits of the advertising received, rather than selling the advertising space provided by the other party on to someone else. In other words, although each party will generally be in the business of selling its own advertising space, it will not be in the business of selling others’ advertising space. Thus, in the context of the discussion above, such exchanges will in principle give rise to revenue. 5.68 Nevertheless, although the Abstract discusses whether revenue should be recognised, it may equally be seen as asking what reliable evidence exists to support the value at which revenue should be measured. Since advertising space expires without value unless it is sold before the time at which it will be used, an entity will rationally accept any amount, no matter how small, in exchange for space that will not otherwise be sold. In effect, therefore, the approach taken in the Abstract may be reconciled to that proposed above by returning to a point made earlier in this chapter. Paragraph . notes that, where measurement uncertainty exists, revenue will be stated at no less than the minimum amount that is assured (which in some cases may be nil), with a higher amount being used if that is a better estimate. CHAPTER 6: OTHER ISSUES RELATING TO CONTRACTS AND PERFORMANCE Chapter 6 Other issues relating to contracts and performance Summary 6.1 This chapter considers various other issues relating to contracts and performance. In particular, it discusses: • pre-performance options • which activities constitute performance • ‘two-way’ trading arrangements. 6.2 The main proposals discussed in this chapter are set out below. Where a customer pays for an option to require future performance from a seller, that payment gives rise to a liability, which should be released as revenue only when the future performance to which it relates occurs. Because the number of options that will lapse unexercised cannot be known with certainty, the relationship between proceeds and performance should be estimated at the outset, and estimates should be revised over the period of performance. An activity will constitute part of the performance of a contract only if it is a necessary part of the contract, in that it is specific to the customer and would not have taken place had the contract not existed. REVENUE RECOGNITION Two contracts should be accounted for separately if they are genuinely independent of one another, but should be treated as one larger contract if, either legally or economically, one is conditional or dependent on the other. Such economic dependence may arise if, for example, contract prices are set so far from fair value that there is no realistic prospect that the second contract will not follow from the first. Pre-performance options 6.3 Whereas Chapter was concerned with options giving either the customer or the seller the right to reverse a transaction after performance has occurred, the following paragraphs are concerned with options giving a customer the right to enter into a transaction on particular terms. 6.4 Options ar ise in a number of different revenue transactions, although they are not always explicitly so described. For example, if a customer cannot yet decide whether to buy a particular item, the seller may agree for a time not to sell it to anyone else providing the customer pays a non-refundable deposit. That deposit is in effect an option to purchase the item.74 6.5 In the preceding example the customer paid for the option, but that need not always be the case. A supermarket may distribute money-off coupons that customers can use towards the price of particular items; if so, those coupons may, in effect, also be options to purchase those items at a reduced price.75 The following paragraphs consider the appropriate accounting where 74 The term ‘layaway sales’ is used to describe some transactions meeting this description. 75 Though they may not be legally binding, as discussed under paragraph 6.21 below, and they may not guarantee availability. CHAPTER 6: OTHER ISSUES RELATING TO CONTRACTS AND PERFORMANCE an entity issues options, first for consideration and secondly free of charge. (Unless stated otherwise, the discussion assumes prices are set so that the exercise of the option will not give rise to a loss; for example, where money-off coupons are issued, the product is still being sold for more than its previous carrying value.) Options granted in exchange for consideration 6.6 If a customer pays for an option to buy a product, this gives rise to a contract under which the seller must supply the product at the customer’s request. The seller has not yet performed its potential obligations under that contract, and if it subsequently failed to supply the specified product, the customer would be entitled to a refund of the option price.76 Accordingly, the option payment is not yet revenue, but instead gives rise to a liability.77 It may be seen as equivalent to a payment in advance. 6.7 In a sense, this is the opposite of unbundling. Whereas the discussion in Chapter is concerned with whether a contract may be broken down into smaller independent elements, the sale of an option must be considered together with the further contract to which it will give rise if exercised; the two are not independent. Thus revenue from the sale of an option will generally arise when the seller performs under the further contract—ie supplies goods or services on exercise of the option. 76 Although the option payment/deposit is ‘non-refundable’, this usually means only that the customer cannot subsequently cancel the contract and ask for a refund; it does not mean that there are no circumstances in which a refund would have to be given. For example, a refund would certainly have to be provided if the seller failed to honour its contractual promises. 77 Paragraph 6.10 below discusses how this liability is affected by expectations that options will lapse unexercised. REVENUE RECOGNITION 6.8 Two particular questions arise from this. • If options lapse unexercised, how should this affect accounting for revenue? • Will it always be possible to determine the extent to which a supplier’s performance has taken place? 6.9 The first of these questions is considered below, the second under paragraph .. Options lapsing unexercised 6.10 The proportion of options that will lapse unexercised will vary significantly depending on the situation; nevertheless, it is in the nature of options that they may not be exercised. Some might argue, therefore, that the receipt of option proceeds should give rise to a gain, rather than a liability, to the extent that options may be expected to lapse. However, if options have been granted at fair value, that fair value should already reflect the possibility of lapse, and the fair value of the seller’s liability at the date of grant should still be the same as the option proceeds. 6.11 If the rate of lapse could be known with certainty—which will not be the case—accounting for the option proceeds would be straightforward. The proceeds would be attributed to the proportion of options expected to be exercised, and would be recognised as revenue when, following exercise, the seller’s performance occurred. The following example illustrates this entirely hypothetical situation. CHAPTER 6: OTHER ISSUES RELATING TO CONTRACTS AND PERFORMANCE Example 6.11: options lapsing (1) A sells , options for £ each, which enable the optionholder on exercise to buy product X for £. Accordingly, A will recognise a liability of £, on receipt of the option proceeds, and no gain will arise at this point. If A could know with certainty that precisely per cent of the options would be exercised and per cent would lapse, it would reduce the option liability by £ (being £ divided by per cent) each time an option was exercised and product X was sold. Thus it would recognise total revenue of £ for each sale of product X. 6.12 In practice, it will never be possible to know with certainty the rate of lapse that will occur, though it may be possible to estimate it with a greater or lesser degree of confidence. It will therefore be necessary to consider how to deal with variations from the expected rate of lapse. In particular, should the liability in respect of unexercised options be remeasured—and if so, how should gains and losses arising be treated? 6.13 A first reaction may be to say that remeasurement seems appropriate, because the seller’s position is clearly different if the rate of lapse is different. However, it is proposed in Chapter that where consideration is received in advance of performance, the resulting liability should not be remeasured to reflect changes in the fair value of performance that has not yet occurred. The following paragraphs illustrate why remeasurement is generally inappropriate for pre-performance options. 6.14 Although the seller’s position is different if the rate of lapse is different, the seller will not necessarily be worse off in the longer term if more options are exercised than originally expected. Rather, this will depend on whether any additional outflows of benefit arising from the higher exercise rate are covered by any additional inflows also arising. This can be illustrated by returning to the example under paragraph .. REVENUE RECOGNITION Example 6.14: options lapsing (2) As before, A sold , options for £ each, enabling the option-holder on exercise to buy product X for £, and recognised a liability of £, on receipt of the option proceeds. Estimating that per cent of the options would be exercised (ie in total) and per cent would lapse, A reduced its option liability by £ (being £ divided by per cent) each time an option was exercised and product X was sold. However, after options had been exercised (and the option liability stood at £,), A revised its estimates and concluded that a further options (rather than ) would be exercised. What effect will this have on A, and should it record a loss on revising this estimate? Certainly, when the additional options are exercised A will incur higher costs in respect of product X, because it will have to supply a further products. However, it will also receive an additional £, of sale proceeds. Thus it will only be worse off in the long run if the cost of product X exceeds £; otherwise it should be pleased that more options will be exercised. Moreover, even if the cost of product X exceeds £, A will first be affected only by recognising lower profits on future sales. If A could now know with certainty that no more than a further options would be exercised, it would have to provide for expected future losses only if the cost of product X exceeded £ (being £ further proceeds per item plus £, allocated over options). CHAPTER 6: OTHER ISSUES RELATING TO CONTRACTS AND PERFORMANCE 6.15 If all the options are considered together, they are rather like a long-term contract under . Uncertainty over the number of options that will be exercised means that neither total revenues nor total costs can be predicted with certainty. Nevertheless, revised estimates of those total amounts do not crystallise a gain or loss in respect of performance to date; rather, they are taken into account over the remaining performance of the contract. 6.16 A similar approach is proposed here. Like payments in advance, liabilities in respect of option proceeds should be recognised as revenue only when the future performance to which they relate occurs. The relationship between proceeds and performance cannot be known with certainty, because of the unknown level of future option lapses; thus it should be estimated at the outset and estimates should be revised over the period of performance. Example 6.16: options lapsing (3) Using the same facts as in Example ., upon issuing options A estimates that per cent will be exercised (ie in total) and per cent will lapse. Accordingly, as the first options are exercised A reduces its option liability by £ (being £ divided by per cent) each time an option is exercised and product X is sold. As a result it records revenue as £ for each of the first sales. After options have been exercised (and the option liability stands at £,), A revises its estimates and concludes that a further options (rather than ) will be exercised. Accordingly, as the remaining options are exercised A reduces its option liability by £ (being £, divided by ) each time an option is exercised and product X is sold. It therefore records revenue as £ for each of the last sales. REVENUE RECOGNITION ‘Open-ended’ options 6.17 The second question under paragraph . asks whether it will always be possible to determine the extent to which a supplier’s performance has taken place. To illustrate the problem, consider an option that is not described as such. A nonrefundable joining fee for a sports club is in effect the sale of an option: it gives a member the option to pay regular membership fees and thereby obtain rights of access to the club’s facilities. When should the joining fee be recognised as revenue? 6.18 Applying the same principles as discussed above, the sports club should recognise the joining fee as income when it performs by providing access to its facilities. 78 However, a practical issue arises if membership is open-ended (ie it does not have a fixed expir y date): how is the extent to which performance has occurred to be assessed? 6.19 The problem here is in essence the same as that discussed above in the context of options lapsing unexercised; 79 accordingly, this Paper favours the same approach. Liabilities in respect of joining fees should be recognised as revenue only when the future performance to which they relate occurs, which will be over the period of membership. The relationship between proceeds and performance cannot be known with certainty, because the period of membership cannot be known; thus it should be estimated for members in aggregate at the outset and estimates should be revised over the period of performance. 6.20 In the light of the preceding discussions, this Paper makes the following proposals. 78 The discussion in paragraphs 6.37-6.43 is also relevant to a club that makes facilities available to members over time. 79 The difference is merely that in the preceding discussion an option would either be exercised or lapse, whereas the issue here is the extent to which an option will be exercised. CHAPTER 6: OTHER ISSUES RELATING TO CONTRACTS AND PERFORMANCE Where a customer pays for an option to require future performance from a seller, that payment gives rise to a liability, which should be released as revenue only when the future performance to which it relates occurs. Because the number of options that will lapse unexercised cannot be known with certainty, the relationship between proceeds and performance should be estimated at the outset, and estimates should be revised over the period of performance. Options granted without consideration 6.21 The preceding paragraphs have considered options granted in exchange for consideration but, as noted earlier, some options—such as super market money-off coupons—are distributed free of charge. In legal terms these options may be somewhat different, because a contract requires consideration in order to be binding. Accordingly, these options may merely constitute an invitation to tender for a product at a reduced price; in the absence of consideration, the supermarket may have no obligation, because such an invitation is not binding.80 6.22 If the transaction will be profitable, the appropriate accounting is the same irrespective of whether distributing the coupons gives rise to an obligation towards the coupon-holders. From the supermarket’s perspective, an obligation to reduce the price of a future transaction is not an obligation to transfer economic benefits; on the contrary, there will be a net inflow of economic benefits if the option is exercised. Accordingly, no liability is recognised in respect of the coupons. If and when a transaction occurs, the revenue recorded will be the amount that is actually paid for the product (ie after deducting the discount set out on the coupon). This is of course consistent with the treatment of options issued for consideration, where the consideration received is recorded as a liability—it is simply the case that the consideration (and hence the liability) is nil. 80 though it may have a constructive obligation, as discussed below. REVENUE RECOGNITION 6.23 The situation is different if exercise of the coupons will result in products being sold at a loss. Where this is the case, it will be necessary to consider further whether the coupons actually give rise to an obligation on the part of the supermarket, which might be the case if, for example, the supermarket has a constructive obligation not to withdraw the offer.81 Where an entity becomes obliged to supply goods or services at a loss, that is an onerous contract and provision will need to be made in accordance with . Nevertheless, the revenue recorded will still be the amount that is actually paid for the product (ie after deducting the coupon discount). 6.24 Of course, it is important to distinguish options that are genuinely granted free of charge from those that are granted as part of another transaction. If, by buying a packet of cereal, a customer becomes entitled to buy another at a reduced price, that option is not free of charge; rather, part of the amount paid for the first packet represents the price of the option. If the effect was material, it would be necessary to allocate the consideration between the packet of cereal and the option. The allocation of consideration between contract elements is discussed further in Chapter . 6.25 One common way in which options are sold with other goods or services is in the form of ‘points schemes’. Such schemes are operated by many airlines (in the form of air miles) and by credit card companies and supermarkets. Although they do not give rise to separate issues of principle, such schemes raise practical accounting issues, and these are discussed further in Appendix B. 81 If the supermarket does not guarantee that the products will be available, it might be argued that the obligating event is putting the product on the shelf. On the other hand, if the supermarket does have a constructive obligation not to withdraw its offer, it may also have a constructive obligation to make the product available where possible. CHAPTER 6: OTHER ISSUES RELATING TO CONTRACTS AND PERFORMANCE Which activities constitute performance? Generic products/specificity 6.26 This Paper argues that an entity should recognise revenue as it performs its contractual promises and, as a result, accrues benefit to its customers. Accordingly, it is appropriate to consider which of the business’s activities are part of that contractual performance, particularly if revenue is to be recognised using an estimation method based on that performance, such as percentage of completion. 6.27 To highlight why this may be an issue, contrast two different contracts: • a stationer y supplier contracts with a paper manufacturer for the manufacture and delivery of a lorryload of plain white photocopier paper. (This is one of the paper manufacturer’s main product lines.) • a firm of accountants contracts with a stationery supplier to have the accountants’ address and logo printed on fifty reams of paper, which are then to be delivered. (For simplicity, assume that the stationery supplier performs this printing in-house, using plain paper that it would otherwise sell.) 6.28 In both cases, a manufacturing process (printing in the second example) precedes delivery. However, is that process to be regarded as part of the performance of the contract? To answer this question, it is necessary to return to a concept mentioned in paragraph .—that of the ‘duty to mitigate’. 6.29 If the stationer y supplier cancelled its order for photocopier paper immediately before delivery was due, it would be in breach of contract. However, it is likely that the paper manufacturer would be entitled only to nominal damages, because it could mitigate its loss by selling the photocopier paper to someone else. REVENUE RECOGNITION 6.30 By contrast, if the accountants cancel the order for headed paper immediately before delivery is due, the stationery supplier will be unable to mitigate its loss by selling the headed paper to someone else. It will be entitled to seek damages from the accountants for the full value of the order. 6.31 The difference between these examples is that the paper manufacturer would have manufactured photocopier paper irrespective of whether the particular contract with the stationery supplier existed. Without the contract with the accountants, the stationery supplier would not have arranged for the headed paper to be printed. 6.32 Accordingly, this Paper makes the following proposal. An activity will constitute part of the performance of a contract only if it is a necessary part of the contract, in that it is specific to the customer and would not have taken place had the contract not existed. 6.33 This means, in particular, that where a business produces generic products not specific to a customer, that manufacturing activity will not be regarded as part of its contractual performance. 6.34 A manufacturing activity specific to a customer should be distinguished from one that is merely specified by a customer. For example, when a customer orders a new car, there are typically many choices available in respect of colour, optional extras and accessories. These choices are specified by the customer, but they are not specific to the customer; the customer is selecting from a standard range of choices, and the car could still be sold to someone else. However, if a customer required a special purpose vehicle to be built to its specifications, that activity would be specific to the customer. CHAPTER 6: OTHER ISSUES RELATING TO CONTRACTS AND PERFORMANCE Other activities that are not specific to a contract 6.35 From the proposal set out under paragraph ., it follows that administrative, indirect and pre-contract activities and expenditure do not form part of the performance of a contract. They will not, therefore, be taken into account when determining the extent to which revenue should be recognised. 6.36 This is not to imply that associated costs must be written off as expenses as they are incurred; they may be recognised as assets if they satisfy the necessary recognition criteria. The most obvious example arises where an entity manufactures generic products. For the reasons outlined above, that manufacturing will not form part of contractual performance; nevertheless, the goods so manufactured will be recognised as assets until such time as they are disposed of or otherwise appropriated to a particular contract. Contractual performance: transfer and consumption of benefits 6.37 Under many contracts, particularly those for the provision of services, a supplier’s performance takes place over time. Nevertheless, it should not be assumed that this is true for all contracts with an apparent time element. To illustrate this, consider two examples. (a) A business that has developed some proprietary software sells to X for £, the right to use it, with payment to be made immediately in full. The business does not undertake to upgrade the software or to provide any further services or support whatsoever. REVENUE RECOGNITION (b) The same business sells to Y for £, the right to use the same software, but only for a period of five years.82 Once again, payment is to be made immediately in full and the business does not undertake to upgrade the software or to provide any further services or support whatsoever. 6.38 No element of time is involved in example (a), and many would accept that revenue should be recognised in full when the business has installed the software and, hence, fulfilled its promises.83 However, example (b) appears to involve a time element. Does this mean that the recognition of revenue should be different? 6.39 Some might argue that the revenue in example (b) should be recognised over the period of five years specified in the contract. But this seems to produce a strange result when example (b) is compared with example (a). Immediately after delivery, the business will have recognised £, of revenue in example (a) but almost nothing in example (b); yet it might be argued that there is no difference between the two examples in terms of what the business is required to do under the contracts. 6.40 On that basis, some might argue that the treatment of example (a) should be modified, so that the revenue of £, is spread over the software’s expected useful life. However, it is not only software that has an expected useful life; applying such an approach elsewhere would apparently mean that car dealers, builders of hospitals and many other suppliers would also have to spread revenue, sometimes over very long periods. 82 The very small difference in price between examples (a) and (b) reflects that the software is expected to have little value in five years’ time. 83 If the software is faulty in some way, the supplier will not have fully performed its promises in either example. However, for the sake of illustration, assume that there is no such fault. CHAPTER 6: OTHER ISSUES RELATING TO CONTRACTS AND PERFORMANCE 6.41 This Paper rejects an approach that spreads revenue over time without considering whether the deferred element can be considered a liability. Such a liability exists where a business has been paid in advance for performance that has not yet taken place; however, in these examples there is no performance outstanding. If the business chose to wind itself up immediately after successfully installing the software, neither X nor Y could have grounds to object. Following the principles set out in this Paper, the business would recognise revenue in full on successfully installing the software, because that is when full performance has occurred. 6.42 What these examples highlight is that, in some circumstances, a time element in a contract may not relate to the supplier’s performance. In example (b) the time element relates to when Y will get benefit from using the software—but this is inherently no different from a buyer of a car getting benefits over the car’s life. It does not alter the fact that the seller fully performed its obligations at the outset and that, as a result, Y obtained full access to the software from the outset and was from that point on required to pay for it in full. 84 6.43 The previous paragraphs have illustrated that care is needed when considering any time element of a contract. A focus on two questions should now help to identify when the supplier’s performance occurs and when revenue should be recognised. • What is the subject of the contract? In example (b) the subject of the contract was the right to use the software for five years, and the customer was obliged to pay for this irrespective of whether it actually used the software for five years. However, if the contract gave the customer the r ight to cancel after, say, two years and receive a proportionate refund, the subject of the contract, and 84 The analysis might of course be different if Y could stop using the software at any point and claim a refund in proportion to the time not yet elapsed, but the contract does not allow this option. REVENUE RECOGNITION hence the customer’s asset, might be different as a result of the customer’s right of return. It would then be necessary to consider the issues discussed in Chapter in order to determine the extent to which the transaction should be treated as a sale. • Now that the economic benefits that are the subject of the contract have been identified, to what extent have they been transferred to the customer and, conversely, to what extent does the customer’s access to them depend upon the supplier’s future performance? In both the software examples discussed above, full access is provided to the customer at the outset and hence there is no outstanding performance. However, a customer paying for one year’s use of a bank safety deposit box remains dependent on the bank for access; if the bank closes down, he cannot get to the box. In this situation, access to economic benefits depends upon the bank’s future performance, so the bank will recognise revenue over the period of the contract (as performance occurs) rather than at the outset.85 ‘Two-way’ trading arrangements 6.44 It is not uncommon for two entities to trade so that each sells to the other in separate transactions. For example, an electricity company may supply power to a wholesaler from which it also buys stationery. 6.45 Where the two transactions are unconnected, they give rise to no accounting difficulties. Issues can arise, however, where the transactions may be connected. For example: • A may sell components to B and then purchase manufactured goods incorporating those components. 85 Another way of looking at this is to say that the bank still has unfulfilled promises under the contract. It will breach those promises if, for example, it fails to grant the customer access at the times specified in the contract. CHAPTER 6: OTHER ISSUES RELATING TO CONTRACTS AND PERFORMANCE • A retailer that buys products from a manufacturer may be paid by the manufacturer to promote those products, for example by displaying advertisements around its store. 6.46 Under the first of these examples, the goods manufactured by B might use components from many other suppliers apart from A, and B might sell those goods to many customers other than A. On the other hand, the two parties might agree that A must supply all the components from which the goods are manufactured, and must buy all the goods manufactured by B. In the latter circumstances, there may be some doubt whether A should treat the transfer of components to B as a sale. 6.47 The appropriate accounting in situations like this will depend upon the precise circumstances, but the important question to address is whether the arrangements should be accounted for as two separate contracts, or bundled together as one larger contract. If the former, then both parties will account for a sale; if the latter, it will be necessary to consider the terms of the combined contract to determine whether this is still true, or whether only one party should record a sale. 6.48 Accordingly, this Paper proposes the following. Two contracts should be accounted for separately if they are genuinely independent of one another, but should be treated as one larger contract if, either legally or economically, one is conditional or dependent on the other. Such economic dependence may arise if, for example, contract prices are set so far from fair value that there is no realistic prospect that the second contract will not follow from the first. 6.49 To take again the first example under paragraph ., A will treat components transferred to B as sold only if it is neither contractually nor economically obliged to repurchase them as part of the finished goods. REVENUE RECOGNITION 6.50 Similarly, to take the second example under parag raph ., the ‘promotion contract’ will not be independent of the supply of products if it is conditional on a minimum level of purchases by the retailer. However, this second example is more complex than the first, because even if the two contracts are to be treated as one, there is still an element of non-cash consideration involved (ie barter). Specifically, there will be an extent to which the retailer is providing a promotional service in exchange for products. It will therefore be necessary to assess the fair value to the manufacturer of this promotional service in order to determine • the extent, if any, to which promotional activity should be treated as giving rise to service revenue for the retailer, and • the extent to which the promotional payment should be treated as a reduction in the price of the products bought by the retailer. 6.51 Barter transactions are considered in more detail in Chapter under paragraph .. CHAPTER 7: AGENCY Chapter 7 Agency Summary 7.1 This chapter considers certain aspects of agency arrangements. The main proposals discussed are set out below. When a principal transacts with a customer through a disclosed agent, the pr incipal’s revenue should reflect the full consideration payable by the customer in the transaction. The principal should treat any commission or other amounts payable to the agent separately as an expense and not as a reduction of revenue. When an entity acts as a disclosed agent, its revenue should reflect the amount of commission or other income receivable from its principal. When an entity acts as an undisclosed agent, it should account for revenue in the same way as a principal. Introduction 7.2 Sometimes, rather than transacting directly with a customer, a seller transacts through an agent. In such a transaction, the seller is known as the principal and, although all the customer’s dealings are with the agent, the transaction is legally between the customer and the principal. The agent is providing a service to the principal, and any remuneration for that service is a matter to be agreed between the principal and the agent. That remuneration could be a flat fee, unconnected with any transactions the agent enters into on the principal’s behalf. Often, however, the agent’s remuneration is linked in some way to the transactions entered into, for example as a flat rate per transaction or as a percentage of the value of each transaction. In these circumstances, the agent’s remuneration is often referred to as commission. REVENUE RECOGNITION 7.3 Agency is a complex subject, in part because it may take many forms. • It is possible for an agent to transact with a customer without disclosing that it is doing so in its capacity as an agent. This does not alter the fact that the agent is acting on behalf of the pr incipal, but in such circumstances an agent will have the same liabilities as a principal in respect of any obligations to the customer ar ising out of the transaction. This situation is described as an ‘undisclosed agency’.86 • Although the risks and rewards arising directly from an agency transaction will, in the first instance, lie with the principal and the customer, there is nothing to stop the agent and principal agreeing that the agent shall be exposed to some of the principal’s risks and rewards. One example of this is a ‘del credere’ agent, where the agent accepts any credit r isk associated with a transaction; however, at the extreme, there seems nothing to prevent an agent agreeing to be exposed to all the risks and rewards associated with a transaction. Exposure to risks and rewards 7.4 Although, as explained above, agency takes many forms, one common form is a disclosed agency in which the agent’s exposure to risks and rewards is limited to the amount of its commission. The agent will receive or retain its full commission if the transaction proceeds successfully; it may receive or retain a lesser amount or nothing if something goes wrong; but whatever happens the agent’s maximum potential liability arising from the transaction is to refund to the principal any commission received. 86 This should be distinguished from the situation where a customer transacts, via an agent, with a principal whose identity is not disclosed. CHAPTER 7: AGENCY 7.5 An accepted way of accounting in such circumstances is for the agent to record as revenue the amount of its commission, rather than any gross amount received from the customer. Such a treatment appears consistent with the principles discussed in this Paper. Although the cash flows may follow a slightly different route, both the legal position and the economic substance are that the principal has sold goods or services to the customer for the full contract price, and the agent has sold agency services to the principal for the amount of commission. Thus the following principles are proposed. When a principal transacts with a customer through a disclosed agent, the pr incipal’s revenue should reflect the full consideration payable by the customer in the transaction. The principal should treat any commission or other amounts payable to the agent separately as an expense and not as a reduction of revenue. When an entity acts as a disclosed agent, its revenue should reflect the amount of commission or other income receivable from its principal. Accounting by entities other than disclosed agents 7.6 Sometimes, an entity that is not legally a disclosed agent appears nevertheless to have much in common with such an agent. For example, a retailer may hold goods on sale or return from a manufacturer, having agreed that per cent of the price paid by a customer will be passed to the manufacturer. Such a retailer will not be exposed to obsolescence risk or to selling risk and, correspondingly, its rewards from a sale will be limited to ‘commission’ of per cent. This prompts the question: if an entity that is not legally a disclosed agent is nevertheless exposed in a transaction to the same risks and rewards that such an agent would be, how should it account? REVENUE RECOGNITION 7.7 However, it is important to note that it is unusual for an entity other than a disclosed agent to be exposed to precisely the same risks and rewards as such an agent. To demonstrate why, consider the retailer described above. The arrangement with the manufacturer has a number of similarities with a disclosed agency arrangement, but it has one significant difference. If the goods turn out to be faulty, the customer will seek redress from the retailer, not the manufacturer—and for the full price, not just the per cent ‘commission’. The retailer may then seek reimbursement from the manufacturer, but that will not alter the existence of the retailer’s liability to the customer.87 7.8 Accordingly, to have precisely the same risks and rewards as a disclosed agency arrangement, it appears necessary for the sales contract to be between three parties—the supplier, the retailer and the customer—and for the contract explicitly to limit the retailer’s liability. Provided that (i) the customer has no right of action against the retailer and (ii) the retailer’s liability to the supplier is limited to its per cent ‘commission’, it would seem appropriate for the retailer to account as a disclosed agent, because that is the economic substance of its role. 7.9 These conditions will not be met, however, in an undisclosed agency. Such an agency differs from a disclosed agency in that the customer is not made aware of the agreement between the principal and its agent. Thus the principal is not a party to the sales contract between the undisclosed agent and the customer; so far as the customer is concerned, the agent is acting as a principal. This has an important effect on the legal position, in that the agent’s exposure to risks and rewards is not limited to the amount of its commission. Although it will receive or retain no more than its commission if the transaction proceeds successfully, it is potentially exposed to the full amount paid by the customer. 87 It follows that, where a retailer charges a customer for delivery but subcontracts that delivery to a third party, the retailer will treat delivery charged to the customer as part of its revenue except where it is acting as the third party’s disclosed agent. CHAPTER 7: AGENCY 7.10 An accepted way of accounting in such circumstances is to treat the undisclosed agent as a principal, and such a treatment appears consistent with the principles discussed in this Paper. Thus the following principle is proposed. When an entity acts as an undisclosed agent, it should account for revenue in the same way as a principal. REVENUE RECOGNITION Appendix A Deep and liquid markets Balancing relevance and reliability A1 The discussion under paragraph . in Chapter contrasts historical cost and current value approaches to profit recognition and notes that any approach to profit recognition will need to balance issues of relevance and reliability. A2 The appropriate balance is likely to vary according to the nature of the underlying business. However, there are certain circumstances in which this balance will clearly favour a current value approach. They are where a deep and liquid market exists for an entity’s products. What is a deep and liquid market? A3 This appendix does not seek to define a deep and liquid market. Nevertheless, such a market is likely to possess the following characteristics: • the assets in question (ie the products) will be homogeneous • there will be frequent trading in those assets • the quoted market price will be a reliable indicator of the price that would be achieved were assets to be bought or sold • there will be willing buyers and sellers at all times during normal business hours at the quoted market price.88 88 Similar criteria are already reflected in FRSs 10, 11 and 13. APPENDIX A: DEEP AND LIQUID MARKETS A4 Where an entity holds an asset, such as a commodity, for which a deep and liquid market exists, its current value can be determined by reference to the quoted market price. The characteristics set out above ensure that the quoted price is reliable; ie where a deep and liquid market exists, it is always possible to measure the current value of the asset reliably. A5 Accordingly, where an entity’s business is to produce 89 (and in due course sell) assets for which a deep and liquid market exists, the current value of those assets can be measured reliably as soon as they are ready for market. It is not necessary for an exchange transaction to occur. Under current value principles, the entity will always be able to measure reliably the profits or losses that have arisen in making the asset ready for market. A6 In effect, this is the case because there is no selling risk for such assets; the existence of a deep and liquid market means they can always be sold at the market price. In other words, no profit arises from selling such assets (as distinct from producing or holding them) because there is no risk. A7 Of course, an entity may choose to hold the assets that it has produced in the hope that the market price will improve. However, this is an investment decision, unconnected with production activities; a non-producer could do exactly the same thing by buying assets and holding them. Therefore, although any holding gains or losses should be reported as and when they arise, there is no argument to support deferring the recognition of the gains or losses that have arisen from production. 89 In this context, production is intended to cover any and all activities that result in an asset for which a deep and liquid market exists, such as growing, harvesting, extracting, refining, distilling, cultivating, originating and other such processes. REVENUE RECOGNITION A8 Accordingly, this Paper’s conclusion is that, where a deep and liquid market exists for an entity’s products, those products should be remeasured at market price, and any production gains or losses recognised, as soon as they are ready for market.90 When is an asset ‘ready for market’? A9 Many activities may be necessary in making an asset ready for market, some significant and others trivial. An asset will not be ready for market if significant business risks remain to be eliminated.91 However, sometimes an asset may be ready for market in all but a trivial respect. An example might arise where the market requires the asset to be stored in a particular location, such as an approved warehouse; if in fact the asset is at present stored nearby, any time and risk involved in moving it may be quite insignificant. A10 Accordingly, this Paper proposes that an asset should be regarded as ‘ready for market’ once any risks attaching to the activities still necessary to bring it to market are insignificant. A11 Such risks will be significant if they bring into doubt the entity’s ability to obtain the quoted market price for the asset. Accordingly, two particular risks may be singled out. One is the risk that the asset will not satisfy the standards set by the market; this would be the case if, for example, an outstanding activity involved a significant risk of damage to the asset. The other is the risk that the market price could move significantly in the time required for any remaining activities to be performed; it is therefore necessary that the time needed for such activities is not significant. 90 This is not to argue that revenue should be recognised when products are ready for market; as explained in Chapter 1, this Paper proposes that revenue should continue to arise from exchange transactions. Where an entity’s main activity is to produce an asset for which a deep and liquid market exists, however, revenue may not be a particularly useful figure to report, and an alternative presentation in the profit and loss account may be more appropriate, as discussed in paragraph 1.42 in Chapter 1. 91 The fact that an asset is not ready for market does not imply that a current value approach should not be used; rather, it will be necessary to consider the balance between relevance and reliability, as discussed in Chapter 1. APPENDIX A: DEEP AND LIQUID MARKETS A12 One of the outstanding activities may be some form of inspection or certification. Where an entity has, at its periodend, assets that have not yet been inspected and/or certified, those assets will nevertheless be of either an adequate or inadequate standard for the market. Subsequent inspection and/or certification will merely confirm the condition of those assets at the period-end, and the fact that assets have not been inspected and/or certified will not necessarily prevent assets of an adequate standard from being ready for market. A13 Nevertheless, if the process of inspection and/or certification will necessarily take a significant amount of time,92 so that market prices could move significantly before the process can be completed, the assets will not be ready for market. Applying a current value approach in other circumstances A14 At present, most entities report operating gains under a historical cost approach, but the appropriate balance between relevance and reliability may change over time, both as markets develop and as the requirements of users of financial statements change. A15 One situation in which a current value approach is adopted has already been discussed in Chapter . IAS requires both biological assets and agricultural produce (ie biological assets that have been harvested) to be measured at fair value (less estimated point-of-sale costs), except where it is not possible to measure fair value reliably. Although deep and liquid markets may exist for some biological assets, IAS acknowledges that such markets do not exist for all biological assets. Nevertheless, it is clear that a significant element of the profit (or loss) that ultimately arises on agricultural produce is attributable to the growing process, rather than to the activity of selling. 92 This might be the case, for example, where inspection/certification is available only at certain specified times. REVENUE RECOGNITION Appendix B Accounting for ‘points schemes’ B1 As mentioned in paragraph . in Chapter , ‘points schemes’ are commonly operated by airlines (in the form of air miles) and by credit card companies and supermarkets. When purchasing goods or services, customers become entitled to ‘points’ which, depending on the scheme, can be used towards part or all of the cost of future purchases or can in due course be redeemed for cash. This appendix briefly discusses how the proposals set out in this Paper might be applied to such schemes. Arriving at a value for points B2 When a customer purchases goods or services in a transaction that also entitles him to points, the amount paid by the customer needs to be allocated between an amount paid for the goods or services and the amount paid for the points. Using the unbundling principles discussed in Chapter , the total consideration will be allocated by reference to the fair values to the customer of the goods/services and the points.93 B3 Of course, the amount that the customer would be prepared to pay for the points will depend upon what they can be exchanged for (and, perhaps, when they can be exchanged if they cannot be redeemed immediately). Under many points schemes, quite a wide range of goods and services is available, and it would not be practical to assess on a customer-bycustomer basis what value should be attributed to the points. Instead, it may be better to derive a fair value for the points by 93 This fair value will be affected by how likely it is that points will lapse without being used, but it is nevertheless a measure of the fair value to the customer. It will not, therefore, be measured by reference to the expected cost to the entity of supplying goods or services. APPENDIX B: ACCOUNTING FOR ‘POINTS SCHEMES’ considering, as a starting point, the fair values of the goods or services for which points can be exchanged. This can be used to deduce an ‘exchange rate’ for each of the goods or services, from which an average exchange rate can be derived. 94 (In effect, the points can be thought of as analogous to a foreign currency.) Points schemes run by third parties B4 Often, the points scheme will not be run by the entity with which the customer transacts but will instead be operated by a third party; the transacting entity will make a payment to that third party in respect of points issued. In this situation, the transacting entity is acting as agent for the points scheme operator when it ‘sells’ points to a customer. B5 This should not in principle alter the way in which the transacting entity measures the proportion of income attributable to the ‘sale’ of points; it should continue to measure them by reference to their fair value to the customer. However, if that fair value is very close to the amount that the transacting entity must pay the operator, it may be simpler to use the latter as a surrogate. 95 B6 If the agency arrangement is disclosed, the customer will not have recourse to the transacting entity in respect of unredeemed points, and the transacting entity’s only liability will be to make the necessary payment to the operator. In this situation, the proportion of income attributable to the ‘sale’ of points will not be revenue in the hands of the transacting entity, because it belongs instead to the principal. The transacting entity’s revenue in respect of points will be the commission it receives from the principal. 94 If a scheme is properly designed, it seems likely that most of the individual exchange rates will be close to the average. If an individual exchange rate deviates significantly, it suggests that the associated goods or services are either underpriced or overpriced, and the demand for them is likely to be affected accordingly. 95 In the hands of the operator, of course, the proceeds in respect of the points will be treated as a payment in advance. REVENUE RECOGNITION B7 It may be rather more likely, however, that the agency arrangement is undisclosed. In this situation, income attributable to the ‘sale’ of points will be revenue in the hands of the transacting entity. However, the customer will also have recourse to the transacting entity in respect of unredeemed points, and the transacting entity’s liabilities will therefore need to be considered carefully. Benefit schemes other than points schemes B8 A scheme that is similar to a points scheme in many ways arises where a customer can become entitled to benefits (such as free products) as a result of satisfying certain criteria. Those criteria may involve exceeding a cumulative level of purchases. Alternatively, they may be time-based—for example, a customer may become entitled to benefits simply by continuing to be a member of a scheme for a specified period. B9 Criteria based on a cumulative level of purchases may be seen as directly analogous to points, and it is therefore argued that they should be accounted for in the same way: the benefit to which a customer can become entitled should be recognised incrementally as purchases occur. B10 Where criteria are based on continuing to be a ‘member’ for a specified period, it will be necessary to consider whether these require any act of ‘performance’ by a customer or whether they are purely time-based. Criteria that are purely time-based might be expected to arise infrequently, and they may often be more properly regarded as linked to some other act by the customer, such as payment of a membership fee or subscription. However, where benefits genuinely arise only as a result of time, so that the customer is not required to spend money or perform any other act in order to achieve entitlement, the obligation to the customer arises in full at the outset and should be recorded at that point.96 96 It may need to be discounted, however, to reflect the fact that benefits cannot be claimed until some time in the future. APPENDIX C: FRS 5 AND RIGHTS OF RETURN Appendix C FRS 5 and rights of return C1 Chapter , which is concerned primarily with customer rights of return, considers issues also touched upon in two Application Notes to ‘Reporting the Substance of Transactions’. Application Note A to deals with consignment stock, while Application Note B is concerned with sale and repurchase agreements. C2 The transactions discussed in Chapter have important elements in common with those discussed in the Application Notes, and this appendix considers how the former would be dealt with under those Application Notes. Nevertheless, it should be emphasised that, although there are important common elements, there may also be differences, both in terms of which r isks are significant and where those r isks lie. Accordingly, this appendix does not represent a comprehensive analysis of the transactions from the perspective of , and is intended only for the purposes of illustrating the issues involved. Application Note A—Consignment Stock C3 Application Note A describes consignment stock in the following terms. “Consignment stock is stock held by one party (the ‘dealer’) but legally owned by another (the ‘manufacturer’), on terms that give the dealer the right to sell the stock in the normal course of its business or, at its option, to return it unsold to the legal owner.” C4 The Application Note explains that the various features of a consignment stock agreement will determine where the associated benefits and risks lie. It concludes that consignment stock should be included on the dealer’s balance sheet if it is in substance an asset of the dealer, ie where the dealer has access to its principal benefits and bears the principal risks inherent in those benefits. A table, reproduced below, summarises how the different characteristics of a consignment stock agreement will influence the required accounting. REVENUE RECOGNITION Indications that the stock is not an asset of the dealer at delivery Indications that the stock is an asset of the dealer at delivery Manufacturer can require the dealer to return stock (or transfer stock to another dealer) without compensation, or Manufacturer cannot require dealer to return or transfer stock, or Penalty paid by the dealer to prevent returns/transfers of stock at the manufacturer’s request. Financial incentives given to persuade dealer to transfer stock at manufacturer’s request. Dealer has unfettered right to return stock to the manufacturer without penalty and actually exercises the right in practice. Dealer has no right to return stock or is commercially compelled not to exercise its right of return. Manufacturer bears obsolescence risk, eg: Dealer bears obsolescence risk, eg: - obsolete stock is returned to the manufacturer without penalty; or - penalty charged if dealer returns stock to manufacturer; or - financial incentives given by manufacturer to prevent stock being returned to it (eg on a model change or if it becomes obsolete). - obsolete stock cannot be returned to the manufacturer and no compensation is paid by manufacturer for losses due to obsolescence. Stock transfer price charged by manufacturer is based on manufacturer’s list price at date of transfer of legal title. Stock transfer price charged by manufacturer is based on manufacturer’s list price at date of delivery. APPENDIX C: FRS 5 AND RIGHTS OF RETURN Manufacturer bears slow movement risk, eg: Dealer bears slow movement risk, eg: - transfer price set independently of time for which dealer holds stock, and there is no deposit. - dealer is effectively charged interest as transfer price or other payments to manufacturer vary with time for which dealer holds stock; or - dealer makes a substantial interest-free deposit that varies with the levels of stock held. C5 The paragraphs below summarise how these characteristics are reflected in Chapter . Manufacturer’s ability to secure return of goods (suppliers’ call options) C6 The discussion under paragraph . concludes that, in a revenue context, the effect of a supplier retaining a call option is to restrict what has been sold. It notes, however, that care is needed when determining the effect of such a restriction, particularly where a supplier’s call option is either conditional or determinable. C7 In most of the situations discussed in Chapter the seller will not have the right to insist on the return of goods sold. Dealer’s ability to return goods C8 The situations discussed in Chapter are those where a customer can, without penalty, return goods received. Thus in all the situations discussed there will be a right of return without penalty that is actually exercised in practice from time to time. REVENUE RECOGNITION Obsolescence risk C9 Because Chapter is concerned only with situations where a customer can without penalty return goods received, it follows that the supplier will in all the situations discussed bear any obsolescence risk. Date on which transfer price is set C10 Chapter is concerned only with situations where delivery of goods by a supplier constitutes performance under a contract—and in order for a contract to exist, a price must have been agreed that is either fixed or determinable. In most of the situations discussed in Chapter the price will have been fixed at or before the point of delivery. Slow movement risk C11 In terms of the discussion in Chapter , slow movement risk is concerned with whether the fair value of consideration received or receivable by the supplier is affected by the length of time that elapses before a customer gives up a right of return. Generally, this will not be the case for the situations discussed in Chapter , because in most of those situations the customer will pay either on delivery or within an agreed period after delivery. Summarising benefits and risks C12 To summarise the preceding paragraphs, the situations discussed in Chapter would generally be analysed under Application Note A as follows: APPENDIX C: FRS 5 AND RIGHTS OF RETURN Indications that the stock is not an asset of the customer at delivery Supplier unable to secure return of goods Indications that the stock is an asset of the customer at delivery ✔ Customer able to return goods ✔ Obsolescence risk with supplier ✔ Transfer price set at delivery ✔ Slow movement risk with customer ✔ C13 Application Note A includes further guidance where, as above, different features of an agreement point to different conclusions. It makes clear that it will be necessary to look at all the features of an agreement, giving greater weight to those that are more likely to have a commercial effect in practice. The interaction between the features will also need to be considered, and the arrangement will need to be evaluated as a whole. Application Note B—Sale and Repurchase Agreements C14 In the context of a sale and repurchase agreement, the purpose of the analysis in Application Note B is “... to determine both whether the seller has an asset (and what is the nature of that asset), and whether the seller has a liability to repay the buyer some or all of the amounts received from the latter.” REVENUE RECOGNITION C15 In effect, the approach taken in the Application Note is to ask whether the agreement is in substance a secured loan, or whether it results in the seller having a different asset. The Application Note identifies benefits and risks that may be relevant in determining the appropriate accounting. A table, reproduced below, summarises how the different characteristics of a sale and repurchase agreement will influence the required accounting. Indications of sale of original asset to buyer (nevertheless, the seller may retain a different asset) Indications of no sale of original asset to buyer (secured loan) Sale price does not equal market value at date of sale. No commitment for seller to repurchase asset, eg: Commitment for seller to repurchase asset, eg: - call option where there is a real possibility the option will fail to be exercised. - put and call option with the same exercise price; - either a put or a call option with no genuine commercial possibility that the option will fail to be exercised; or - seller requires asset back to use in its business, or asset is in effect the only source of seller’s future sales. APPENDIX C: FRS 5 AND RIGHTS OF RETURN Risk of changes in asset value borne by buyer such that buyer does not receive solely a lender’s return, eg: Risk of changes in asset value borne by seller such that buyer receives solely a lender’s return, eg: - both sale and repurchase price equal market value at date of sale/purchase. - repurchase price equals sale price plus costs plus interest; - original purchase price adjusted retrospectively to pass variations in the value of the asset to the seller; - seller provides residual value guarantee to buyer or subordinated debt to protect buyer from falls in the value of the asset. Nature of the asset is such that it will be used over the life of the agreement, and the seller has no rights to determine its use. Seller has no rights to determine asset’s development or future sale. Seller retains right to determine asset’s use, development or sale, or rights to profits therefrom. REVENUE RECOGNITION C16 When the analysis above is applied to the transactions with a right of return discussed in Chapter , the majority of factors indicate, not surprisingly, that the transactions are not in substance simply secured loans.97 However, to the extent that the transaction has given rise to new assets and liabilities of the seller, Application Note B requires them to be recognised on a prudent basis. Where doubts exist regarding the amount of any gain or loss arising, the Application Note requires full provision to be made for any expected loss but recognition of any gain, to the extent that it is in doubt, to be deferred until it is realised. 97 In the wine merchant example from Chapter 4, it is possible that the ‘deposit’ paid for wineglasses may exceed their market value. All the other factors, however, will tend to indicate that the original asset has been sold to the buyer. 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