FinancialReporting
GET IT RIGHT
Revenue recognition
Revenue recognition is a complex area of accounting that can have a material impact on a company’s financial statements
Words: Steve Collings Illustration: Michał Bednarski
Revenue is often the largest number in a set of financial statements and often the most material. This article considers some of the key technical concepts where FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland and FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime are concerned and what preparers need to know in terms of revenue recognition.
FRS 102, Section 23 Revenue and FRS 105, Section 18 Revenue apply to the accounting for revenue arising from:
· the sale of goods;
· the rendering of services;
· construction contracts where the reporting entity is the contractor; and
· the use by others of entity assets which yield interest, royalties or dividends.
While UK and Ireland accounting standards deal with the sale of goods and the rendering of services, some entities undertake a combination of both in a single contract with a customer. For example, a company may sell software and then provide a support service that is renewable by the customer on a periodic basis. Neither FRS 102 nor FRS 105 provide guidance on how to distinguish between a contract for goods and a contract for services. However, IFRS 15 Revenue from Contracts with Customers does deal with this issue and it may be that some entities preparing financial statements under FRS 102 choose to refer to that standard for guidance in this area, although they are not required to do this.
Defining terms
Revenue is defined as:
‘The gross inflow of economic benefits during the period arising in the ordinary course of activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.’
Company law uses the term ‘turnover’ (see Companies Act 2006, Section 474) and defines this term as:
‘Turnover, in relation to a company, means the amounts derived from the provision of goods and services after deduction of:
(a) trade discounts,
(b) value added tax, and
(c) any other taxes based on the amounts so derived.’
Revenue is not the same as income. Income refers to anything that is credited to profit or loss and hence is a much broader term.
Measurement
An entity measures revenue at the fair value of the consideration received or receivable. The fair value of the consideration received or receivable takes into account the amount of any trade discounts, prompt settlement discounts and volume rebates allowed to customers by the entity.
Revenue is initially recognised at the price of the sale, net of value added tax (VAT) where the business is registered for VAT.
>EXAMPLE
Settlement discount
Sunnie Ltd offers its customer, Ratchford Enterprises Ltd, a settlement discount of 2% if an invoice for £650 plus VAT is paid within 15 days. Ratchford Enterprises Ltd has a credit account with Sunnie Ltd and the terms are 30 days from date of invoice.
The sale should be recorded at £650 if the discount is not taken and £637 (£650 – (£650 x 2%)) if the customer will take the discount. Sunnie Ltd recognises revenue at either amount depending on whether it is likely the discount will be taken. If this is a new customer, and there are uncertainties as to whether the discount will be taken, the entity can assume the discount will be taken. If it turns out the customer has not paid promptly (hence forfeiting the cash discount), the entity adjusts revenue in the next accounting period.
While UK and Ireland accounting standards deal with the sale of goods and the rendering of services, some entities undertake a combination of both in a single contract with a customer.
Agent vs principal relationships
Both FRS 102 and FRS 105 state that an agent must only recognise revenue to the extent of its commission. Amounts collected on behalf of the principal are not revenue of the agent. Amounts collected on behalf of the principal are recognised as a liability in the financial statements of the agent if they are not paid over to the principal by the reporting date.
>EXAMPLE
Solicitor’s debt recovery commission
Stephanie is a solicitor specialising in debt recovery. She has agreed to take on a case where the client is owed an amount of £20,000 from one of its contractors who has refused to pay, claiming defective work has been carried out. The matter was taken to court and the court found that no defective work had, in fact, been carried out and ordered the contractor to make payment. Stephanie has been instructed by the client and they have agreed that she will charge a 5% commission for any monies she recovers.
The contractor eventually paid the solicitor following a threat to issue a winding-up petition in the court.
Of the £20,000 (ignoring any VAT implications), 5% will be deducted by Stephanie for her agreed commission, hence £1,000 will be recognised as revenue. The remaining £19,000 will be recognised in Stephanie’s books as a liability owed to the client and will be held in the client account until the funds are remitted. If they are not remitted by the reporting date, the proceeds payable to the client are recognised in the balance sheet as a liability.
>EXAMPLE
Carrier bag sales
Salinger’s Supermarkets Ltd is required to charge customers for plastic carrier bags. Legislation states that the proceeds from carrier bag sales must be donated to a good cause. The financial controller has queried why the proceeds from carrier bag sales are recognised as revenue as the law states they must be paid to a good cause.
Salinger’s Supermarkets is acting in the capacity of principal where the carrier bag sales are concerned. This is because:
· the supermarket is not required to notify the customers which causes will receive the donations from the carrier bag sales;
· there are risks associated with the carrier bags – for example, if the bag breaks while the customer is packing their shopping, the supermarket will have to replace the bag;
· the supermarket receives a reward from the sale of the carrier bag because the proceeds are donated to a good cause, hence the Salinger’s Supermarkets brand will be associated with good causes; and
· the customer receives a benefit in the form of a carrier bag that can be reused by the customer if they wish.
An entity must apply the recognition criteria to the separately identifiable components of a single transaction when doing so is necessary to reflect the substance of the transaction.
Identifying a revenue transaction
FRS 102, paragraph 23.8 acknowledges that an entity will usually apply the revenue recognition criteria separately to each transaction. However, an entity must apply the recognition criteria to the separately identifiable components of a single transaction when doing so is necessary to reflect the substance of the transaction. For example, a company could sell a machine but include servicing at periodic intervals. While the two elements of the sale may take place in a single transaction, the recognition criteria must be applied to the sale of the machine and the servicing element separately. Conversely, an entity applies the recognition criteria to two, or more, transactions together when they are linked in such a way that the commercial effect cannot be understood without reference to the series of transactions as a whole.
Care will be needed when assessing whether a component can be separately identifiable. In the example of King Software below, the customer could have purchased the software but chosen not to take up the software support. This is common where software is concerned. In some instances, a seller may choose to sell a product as part of a ‘bundle’. This does not mean that the component cannot be separately identifiable because the customer could obtain the product on its own from a different supplier.
>EXAMPLE
Software company
King Software Ltd sells bookkeeping software to its clients, consisting primarily of accountancy firms, and the entity has a reporting date of 31 August. On 1 August 2024, the company sold a piece of software to its customer for £5,000 plus VAT. Included in this transaction is one year’s software support that was charged at £1,200.
This single transaction has two components to it: the software product and the software support, and both components must be accounted for separately. The sale of software can be recognised as revenue at an amount of £3,800 (£5,000–£1,200), but the software support is for one year, hence only 1/12 should be recognised as a sale. The total sale will be recognised in profit or loss at £3,900, being £3,800 worth of software plus one month’s software support at £100 (£1,200/12). The remaining £1,100 is presented as deferred income in the balance sheet within current liabilities and is recognised in revenue over the term of the support agreement.
>EXAMPLE
Membership fees
Joe’s Gyms Ltd offers memberships to the general public where members can pay monthly or they can pay for the full year (or more) upfront if they wish.
A total of 40% of the members pay one year’s fee upfront with the remaining 60% paying on a monthly Direct Debit.
Revenue should only be recognised in respect of the 40% upfront fees as the members use the facility. In practice, this would be over a 12-month period. If the upfront fee straddles two accounting periods, there will be an element of deferred income recognised in the financial statements under current liabilities. This will be released to profit or loss in the next accounting period as the member uses their membership.
Periodic review amendments
As part of the periodic review amendments, the FRC has redrafted both revenue sections in FRS 102 and FRS 105. Both sections have been renamed Revenue from Contracts with Customers and incorporate a single, comprehensive five-step model for revenue recognition. The FRC states that this will be easier for entities to account for revenue transactions correctly and consistently across all sizes of entity and all contract types.
The new revenue recognition rules apply mandatorily for accounting periods commencing on or after 1 January 2026. Earlier adoption is permissible, provided that all the periodic review amendments are applied at the same time.
Conclusion
It is fundamentally important that revenue is recognised correctly at an appropriate time to avoid the financial statements from becoming misleading. The new revenue sections in FRS 102 and FRS 105 that have been introduced following the FRC’s periodic review will help to strengthen requirements in this area and provide additional clarity to reporting entities.
