Essentials of FA_Chapter 13_Income

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CHAPTER 13

INCOME

Chapter Objective

The objective of this chapter is to provide understanding of accounting principles and

methods for accounting for incomes. Incomes include revenue from sale of goods,

revenue from sale of services, royalty, interest and dividend income and income from

sale and construction of real estate.

13.1 DEFINITION

Income is defined as “increases in economic benefits during the accounting period in theform of inflows or enhancements of assets or decreases of liabilities that result in

increases in equity, other than those relating to contributions from equity participants”

In accordance with the above definition income arises from:

(i) Inflow of economic benefits (e.g. receipts from customers, return on investment, and

government grants); or

(ii) Enhancement of assets (e.g. increase due to revaluation of assets, and change in thefair value of held for trading and available for sale investments); or

(iii) Decrease of liabilities (e.g. waver of outstanding interest due on a loan by a bank

under the corporate debt restructuring scheme and final settlement with a trade creditor at

an amount lower than the outstanding liability).

In this chapter we shall discuss the principles and methods for accounting for income

arising from inflow of economic benefits.

Exhibit 13.1 presents classification of income arising from inflow of economic benefits:

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Exhibit 13.1: Classification of income arising from inflow of economic benefits

Revenue

Revenue is the gross inflow of economic benefits during the period arising in the course

of the ordinary activities of an entity when those inflows result in increases in equity,

other than increases relating to contributions from equity participants.

Revenue includes only the gross inflows of economic benefits received and receivable by

the entity on its own account . Amounts collected on behalf of third parties such as sales

taxes, goods and services taxes and value added taxes are not economic benefits which

flow to the entity and do not result in increases in equity. Therefore, they are excluded

from revenue. Similarly, in an agency relationship, the gross inflows of economic

benefits include amounts collected on behalf of the principal and which do not result in

increases in equity for the entity. The amounts collected on behalf of the principal are not

revenue. Instead, revenue is the amount of commission.

Examples of revenue are income from sales of goods by an entity engaged in

merchandising business, income from sales of goods by an entity engaged in

manufacturing of goods, export incentives received or receivable by an entity engaged in

the export of goods, income from sales of services by an entity engaged in selling

Inflow of economic benefits

RevenueIncome from

ordinary

activities

Other incomeIncome from

peripheral

activities

Government

grantsOthers

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services, interest income of an entity engaged in the banking business, fees earned by a

investment banker and fees earned by a professional accountant.

Revenue is measured at the gross amount received or receivable by the entity.

Illustration 13.1

A company is in crude oil business. It sells crude oil and gas produced from exploratory

wells in progress in exploratory areas.

Required

Explain how the company should account for the income from the sale of crude oil

produced during exploration.

Solution

The amount realized/realizable from such sale should not be recognized as revenue

because it is not arising from the ordinary activities of the company. It should be

deducted from expenses incurred to explore oil wells.

Other income

Income, other than those arising from activities other than ordinary activities are

classified as other income. For a non-finance entity, interest and dividend income are

classified as other income. Similarly, profit from sale of fixed assets is classified as other

income. Other income is recognised at the net amount that is net of expenses.

Government grant

Government grants are assistance by government in the form of transfers of resources to

an entity in return for past or future compliance with certain conditions relating to the

operating activities of the entity. Financial assistance to companies which invest in

pollution control equipment is an example of government grant.

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13.2 REVENUE: GENERAL PRINCIPLES

13.2.1 Recognition Principles

In accrual accounting, the timing for the recognition income does not coincide with the

timing of receipt and payment of cash. Recognition and measurement of revenue or

expenses involve judgement. Therefore, recognition and measurement of revenue has

significant potential for earnings management. An entity may overstate profit and asset

by recognising income before the earning process is complete and can understate profit

and asset by not recognising income even after the earning process is complete. Most

accounting fraud involves violation of the revenue recognition principles. Therefore,

managers should understand principles for recognising income and expenses.

Revenue recognition at the point of saleUsually revenue is recognised at the point of sale.

An entity should recognise revenue when the earning process is complete and it is

reasonably certain that it will be able to collect the amount from the customer.

Staff Accounting Bulletin (SAB)-101 issued by the Securities and Exchange Commission

(SEC) of USA describes the conceptual foundation for revenue recognition. It says that

revenue is generally realised or realisable and earned when all of the following criteria

are met:

(a) There is persuasive evidence that an arrangement exists.

(b) Delivery has occurred or services have been rendered.

(c) The sellers’ price to the buyer is fixed or determinable.

(d) Collectibility is reasonably assured.

Inappropriate application of the rule results in premature recognition of revenue or

recognition of fictitious revenue. For example, In order to boost sales, near the end of the

reporting period, an enterprise may allow buyers (e.g. dealers) rights of return and other

privileges that violate the realization principle. Similarly, an enterprise may record

license fees or membership fees when an agreement is signed, rather that over the term of

the agreement. A company that provides mobile telephony services may recognize the

initial fixed charges received from customers as revenue at the time of agreement rather

than allocating it over the period for which the company, on an average, retains

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customers. This violates the fundamental principle that ‘revenue should be recognized

only on completion of the earning processes’.

Indian GAAP comparison

Principles stipulated in the Indian GAAP as well as those stipulated in the IFRS for therecognition of revenue are based on the general principles discussed above.

Illustration 13.2

Himani Wines Limited (HWL) harvests grapes every year and processes them into

various types of wines. HWL enters into contracts with customers at the beginning of the

aging process, which takes several years to complete. Each customer pays 30% of the

selling price at the beginning of the aging process and the balance when it takes delivery

after aging.

Required

Explain when HWL should recognise the revenue from the sale of wines.

Solution

HWL should recognize revenue when the wine is delivered, that is, when the earning

process is complete. The 30 percent of the selling price received at the beginning of

aging process should be recognised as a liability (advance received from customers).

Illustration 13.3Urvashi Camera Limited (UCL) enters into an agreement with Trident Limited, which

runs the West-Side chain of family stores, to place cameras in West Side stores. As per

the agreement West Side receives the cameras on consignment basis and makes best

efforts to sell the cameras at the best price depending upon the competition and new

offerings by competitors. UCL maintains title to cameras until West Side sells them.

When West Side sells the cameras, it remits the selling price minus a fee to UCL. UCL

takes back any damaged or defective cameras.

Required

Explain when UCL should recognise the revenue from the sale of cameras.

Solution

The transaction is in the nature of consignment sale. UCL should recognize revenue when

West Side confirms the sale. It is inappropriate for UCL to recognise revenue when it

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initially ships the cameras to West Side, because it maintains titles to cameras until West

Side sells them and also because the price at which West Side will sell the cameras is not

determined until the sales takes place.

Revenue recognition at the point of production

In some situations, revenue or profit is recognised during the production process or on

completion of production but before the occurrence of sale. Examples are revenue/profit

from agricultural activity, revenue/profit from construction contracts and revenue/profit

from service contracts.

13.2.2 Measurement of Revenue

Revenue should be measured at the fair value (FV) of the consideration received. The

difference between the nominal amount of the consideration and the fair value of the

same, if any, is accounted for as interest income using the effective interest rate method.


Revenue is measured by the charges made to customers or clients for goods supplied and

services rendered to them. Therefore, in no situation, except in case of installment sales,

the nominal consideration is allocated between sales revenue and interest income.

Consideration in the Form of CashWhen the consideration received is in the form of cash or cash-equivalents, the amount of

revenue is the amount of cash or cash-equivalents received or receivable. However, when

the inflow of cash or cash equivalents is deferred, the FV of the consideration may be less

than the nominal amount of cash received or receivable.

A sales transaction that allows credit for a significant period (usually longer than six

months) is in ‘substance’ a combination of sales transaction and financing transaction.

Therefore, the amount receivable from the customer should be apportioned between

revenue and interest income. Usually when an entity grants credit for a significant period,

it obtains an instrument such as ‘promissory note’ from the customer to protect its claim.

When the transaction is identified as a composite transaction constituted of sales and

financing, the FV of the consideration is determined by discounting all future receipts

using an imputed rate of interest .

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Imputed rate of interest

The imputed rate of interest is the more clearly determinable of either

(a) The prevailing rate for a similar instrument of an issuer with a similar credit rating

(b) A rate of interest that discounts the nominal amount of the instrument to the current

cash sales price of the goods or services

The imputed rate of interest is the market interest rate. Therefore, when an entity offers

credit at an interest rate below the market interest rate, it should apportion the amount

receivable between revenue and interest income using the market interest rate.

Illustration 13.4

Golden Tribute Limited (GTL) is engaged in manufacturing and selling designer

furniture. It allows three months credit to its customers, which is normal in the industry in

which the firm operates. GTL sold furniture for Rs. 2,000,000 to Ms. Mona Lisa. The

market interest rate on the date of the transaction was 10% per annum.

Required

(a) Explain whether GTL should allocate total amount realisable from the transaction

between revenue and interest.

(b) Will your answer be different if GTL uses the Indian GAAP for the preparation of

financial statements?

Solution(a) GTL would recognise the total amount of the consideration as revenue because the

credit period is short (less than six months) and consequently the time value of money is

not material. However, if GTL sells goods on cash basis, and the cash price is different

from the price to be realised from Mona Lisa, there is a case of apportioning the amount

realisable between revenue and interest income. The revenue should be recognised at the

cash sale price and the difference between the cash price and the considerations to be

realised from the customer should be recognised as interest income.

(b) If GTL uses the Indian GAAP for the preparation of financial statements, it should

measure the revenue at the total amount of the consideration even if the cash price is

different from the price at which the furniture is sold to Mona Lisa.

Illustration 13.5

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On January 1, 2010, Mohini Limited (ML) sold Cleopatra Furniture for Rs. 5,000,000

with a credit arrangement. Under this arrangement, Cleopatra would pay the

consideration (sale value) after twelve months with interest at the rate of 2% per annum.

The market interest rate on the date of the transaction is 12% per annum. ML closes its

financial year on December 31.

Required

(a) Explain how ML should account for the sale transaction.

(b) Explain how ML should account for the sale transaction if it uses the Indian GAAP

for the preparation of financial statements.

Solution

(a) The market interest rate is determined with reference to the credit risk, which depends

on the credit period, the amount of receivables, and credit rating (credit worthiness) of the

customer.

ML allowed credit to Cleopatra at a concessional rate of 2 per cent. The credit period is

longer than six months. Therefore, the time value of money is material. ML should

recognise the revenue and interest income as follows:

(i) Total amount receivable = (Rs. 5,000,000 × 1.02) = Rs. 5,100,000

(ii) PV of receivable (Revenue) = Rs. 5,100,000/ (1.12) = 4,553,571

(iii) Interest income = (Rs. 5,100,000 – 4,553,571) = Rs. 546,429

In substance ML granted a loan to Cleopatra on which it earned interest income at the

rate of 12% per annum. Therefore, in substance, ML allowed a discount on the list price.

Thus, it sold goods to Cleopatra below the list price.

(b) If ML uses the Indian GAAP for the preparation of financial statements, it should not

allocate the consideration received from Cleopatra between revenue and interest income.

It should recognise the revenue at Rs. 5,000,000. The interest of Rs. 100,000 receivedfrom the customers should be recognised as interest income. Indian GAAP does not

require the use of effective interest rate method to recognise the interest income.

Consideration other than in the Form of Cash

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When a firm receives consideration in a form other than cash or cash-equivalent, revenue

is recognised at the fair value (FV) of the consideration received or receivable. For

example, if the entity receives equity shares issued by the buyer as consideration, revenue

should be recognised at the FV of equity shares received by the seller. The FV should be

measured using the share price and measurement assumption at the earlier of the two

dates - grant date and vesting date. Grant date is the date on which the equity shares are

granted to the seller. Vesting date is the date on which the performance necessary to earn

the equity is completed by the seller and seller’s rights have vested.

FV cannot be measured reliably

In a situation when the FV of the consideration received cannot be measured reliably, the

entity should apply the well accepted accounting principle that a transaction involving

exchange of non-monetary considerations should be recorded at the FV of the

consideration given or consideration received, whichever is more clearly evident.

Therefore, in a sale transaction, if the FV of the consideration received cannot be

measured reliably, revenue should be measured based on the FV of the goods or services

sold.

Inability to measure outcome

If, the outcome of a transaction involving the rendering of services cannot be estimated

reliably (that is, the amount of revenue cannot be measured reliably), revenue should berecognised only to the extent of expenses recognised that are recoverable.

As a general principle, if FV of both the goods (services) sold and consideration received

cannot be determined reliably, no profit should be recognised.

Illustration 13.6

Namrata, a management graduate from a reputed business school, immediately after

graduation, started hospitality business in the name of ‘Namrata recreation and tourism’

(NRT). She purchased equipment from Allahabad Machineries Limited (AML) in

exchange of a haveli (private mansion), now abandoned, owned by her in a remote

village in UP. The village is in the development map of the UP government.

Required

Explain at what amount the revenue should be measured by AML.

Solution

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AML should recognize revenue at the fair value of the haveli determined by appraisal

method. However, if the fair value of the haveli cannot be determined reliably, AML

should recognize the revenue at the normal selling price of equipment sold to Namrata.

Barter Transactions

When goods or services are exchanged or swapped for goods or services, which are of a

similar nature or value, the exchange is not regarded as a transaction which generates

revenue. Therefore, exchange of similar items does not result in recognition of revenue.

Illustration 13.7

“Evening News” (EN), a very popular evening newspaper, under an arrangement swaps

advertising space with “Morning News” (MN).

Required

Explain how EN and MN should account for the transaction.

Solution

In absence of evidence to the contrary, it may be assumed that advertising spaces are of a

similar nature and value. Therefore, neither EN nor MN should recognise revenue and

corresponding expenses. Although recognition of revenue and corresponding expense

does not change the operating result presented in the profit and loss account, it misleads

users of financial statements and distorts analysis.

Illustration 13.8 Digital.Com Limited (DCL) provides services for advertising on Internet. Under an

arrangement with Champion Club Limited (CCL), DCL advertises the football, cricket

and rugby tournaments of CCL in exchange of CCL advertising the services of DCL in

all its correspondence to members. No other consideration flows between DCL and CCL.

DCL, as a part of its regular business, provides services similar to those being provided to

CCL to other clients on payment of cash. CCL does not provide any advertising services

to any client other than DCL.

Required

Explain whether DCL and CCL should recognise revenue.

Solution

Standard Interpretation Committee (SIC) of IASB issued SIC-31, which discusses barter

transactions involving advertising services. It concludes that revenue from a barter

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transaction involving advertisement cannot be measured at the FV of advertising services

received. However, a seller can determine the FV of services provided reliably with

reference to non-barter transactions. In identifying non-barter transactions, the seller must

ensure that those transactions:

(a) Involve advertising similar to the advertising in the barter transaction.

(b) Occur frequently.

(c) Represent a predominant number of transactions and amount when compared to all

transactions to provide advertising that is similar to the advertising in the barter

transaction.

(d) Involve cash and/or other form of consideration that has a reliably measurable FV.

(e) Do not involve the same counterparty as in the barter transaction.

In accordance with SIC-31, DCL should recognise revenue and expenses at FV of

services provided to CCL. It should determine the FV with reference to transactions

involving advertising similar to advertising in the barter transaction. However, CCL

should recognise neither revenue nor expenses, because it does not provide any

advertising services to any other client. There are no transactions that can be used as

benchmark transactions for determining the FV of services provided to DCL.

CCL may put forward an argument that it should be allowed to recognise the revenue and

expenses at FV determined with reference to advertising services received from DCL.SIC-31 concludes that measuring revenue at the FV of advertising services received from

the customer in a barter transaction is impractical, because reliable information that is

required to support the measurement is not available to the seller . In view of the

conclusions in SIC-31, CCL should not recognise the revenue.

Illustration 13.9

New Age Airlines Limited (NAAL) has an arrangement with Women’s Collections

Limited (WCL) to advertise ‘designer apparels’, being designed, produced and sold by

WCL. Under the arrangement, NAAL allots vacant seats in flights in metro sectors to

fashion models of WCL after the ticket window is closed and the boarding is announced.

WCL in return advertises the services of NAAL in its fashion shows. It does not provide

advertising services to any other customer.

Required

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Explain whether NAAL and WCL should recognise revenue.

Solution

Neither NAAL nor WCL should recognise revenue, because FV of considerations cannot be measured reliably. It is not appropriate for NAAL to measure revenue with reference

to normal fare being charged to customers, because only vacant seats are allotted to WCL

after the boarding is announced. In other words, NAAL sells only those assets (services)

whose FV is zero in the market for airlines services. It is impractical to determine the FV

of services being provided to WCL, which is unique. Similarly, in absence of benchmark

transaction, it is impracticable for WCL to measure the FV of advertising services being

provided to NAAL.

13.2.3 Collectibility

Reasonable assurance of collectibility implies that the entity is able to estimate the

uncollectible receivables with reasonable accuracy. In absence of reasonable assurance of

collectibility, an entity defers recognition of revenue. It recognises revenue when

uncertainties surrounding collectibility are resolved or the amount is collected. For

example, if it is uncertain whether a foreign government authority will grant permission

to remit the consideration from a sale in a foreign country, the recognition of the revenue

should be deferred. When the permission is granted, the uncertainty is resolved and

revenue should be recognised. However, when uncertainty arises about the collectibility

of revenue already recognised, the uncollectible amount is recognised as expense (bad

debt). Revenue already recognised is not adjusted. For example, in the year 2009 goods

sold to Ms. Nancy on credit for Rs. 10,000 were recognised as sales and debtors was

recognised in the balance sheet. In 2010, Ms. Nancy becomes bankrupt and collectibility

ceases to be probable. The asset, that is, debtors, should be de-recognised and the amount

should be recognised as an expense as bad debt in the profit and loss account for the year

2010.

Illustration 13.10

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Indian Thermal Power Corporation (ITPC) sells electricity to State Electricity Boards

(SEB). As per the agreement, penal interest at the rate of 11% is payable on amount

overdue for more than one year. Accordingly, in the year 2010, ITPC invoiced Rs. 10

million on various SEBs towards penal interest on claims overdue for more than three

years.

Required

Explain whether ITPC should recognise Rs. 10 million as income.

Solution

ITPC should not recognise the interest income of Rs. 10 million, because of theuncertainty surrounding its collectibility. The collectibility of the interest from SEBs is

not reasonable certain because of the inability of ITPC to collect its dues on account of

supply of electricity.

Illustration 13.11

Millennium Equipment Ltd. (MEL) operates as the distributor for Boston Equipment

Ltd. (BEL). MEL supplies imported equipment to various universities and researchinstitutions. As per the original agreement, equipment is to be supplied at the quoted price

without any provision for escalation claim. While renewing the contract in 2010, some

universities agreed to compensate MEL for the additional cost that might arise due to

exchange rate fluctuations, provided it managed exchange risks to their satisfaction. MEL

submitted an escalation claim to National University of India (NUI) for Rs. 50,000 for

equipment supplied in 2010.

Required

Explain when MEL should recognise the escalation claim as revenue.

Solution

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MEL should not recognise Rs. 50,000 as revenue until the claim is accepted by the

university, because the amount that would be accepted by the university cannot be

estimated reliably. However, if NUI agrees to compensate MEL for the additional cost

arising due to exchange fluctuation unconditionally, the escalation claim should be

recognised as revenue immediately on submission of the claim.

13.2.4 Matching Principle

Revenue and expenses that relate to the same transaction or other event are recognised

simultaneously. Therefore, revenue should not be recognised when the related expenses

cannot be measured reliably. In such circumstances, any consideration already received

for the sale of goods or rendering of services is recognised as a liability. If an entity

recognises revenue without recognising related expenses, it overstates profit.

Summary

Usually revenue is recognised at the point of sale. An entity should recognise revenue

when the earning process is complete and it is reasonably certain that it will be able to

collect the amount from the customer. Revenue should be measured at the fair value (FV)

of the consideration received. The difference between the nominal amount of the

consideration and the fair value of the same, if any, is accounted for as interest income

using the effective interest rate method.

In some situations, revenue or profit is recognised during the production process or on

completion of production but before the occurrence of sale.

13.3 SALE OF GOODS

Revenue from the sale of goods should be recognised when all the following conditions

have been satisfied:

(a) The entity has transferred to the buyer the significant risks and rewards of ownership

of the goods;

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(b) The entity retains neither continuing managerial involvement to the degree usually

associated with ownership nor effective control over the goods sold;

(c) The amount of revenue can be measured reliably;

(d) It is probable that the economic benefits associated with the transaction will flow to

the entity; and

(e) The costs incurred or to be incurred in respect of the transaction can be measured

reliably.


Revenue from sales should be recognised when requirements as to performance are

satisfied, provided that at the time of performance it is not unreasonable to expect

ultimate collection.

In a transaction involving sale of goods, performance should be regarded as being

achieved when the following conditions have been fulfilled:

(i) The seller of goods has transferred to the buyer the property in the goods for a price or

all significant risks and rewards of ownership has been transferred to the buyer and the

seller retains no effective control of the goods transferred to a degree usually associated

with ownership; and

(b) No significant uncertainty exists regarding the amount of the consideration that will

be derived from the sale of goods. In most situations, application of the principles stipulated in the Indian GAAP will give

the same results that will be applied by applying principles stipulated in the IFRS.

13.3.1 Transfer of Significant Risks and Rewards

An entity should assess the point in time when significant risks and rewards of ownership

have transferred to the buyer taking into account the terms of contract and circumstances

of each transaction. In most cases, risks and rewards get transferred to the buyer with the

transfer of the legal title or passing of possession to the buyer. This is the case for most

retail sales. For example, in ex-factory sales, risks and rewards of ownership are

transferred when goods are delivered to the buyer at the factory or to the transporter who

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acts as an agent of the buyer. In a Free on Board (FOB) contract, risks and rewards get

transferred to the buyer when goods have been delivered to the shipping agent.

There are circumstances in which risks and rewards do not get transferred to the buyer

with the transfer of the legal title or passing of possession. IAS-18 provides the following

examples of those situations:

(a) When the entity retains an obligation for unsatisfactory performance not covered by

normal warranty provisions.

(b) When the receipt of the revenue from a particular sale is contingent on derivation of

revenue by the buyer from its sale of the goods.

(c) When goods are shipped subject to installation and the installation is a significant part

of the contract which has not yet been completed by the entity.

(d) When the buyer has the right to rescind the purchase for a reason specified in the sales

contract and the entity is uncertain about the probability of return.

If an entity retains only an insignificant risk of ownership, the transaction is a sale and

revenue is recognised. For example, an entity retains only an insignificant risk of ownership in a retail sale when a refund is offered if the customer is not satisfied.

Revenue in such cases is recognised at the time of sale provided the seller can reliably

estimate future returns and recognises a liability for returns based on previous experience

and other relevant factors.

Illustration 13.12

Aviana Electricals Limited (AEL) has sold five high pressure boilers to a public utilityfirm for Rs. 50 lakhs each. The contract includes delivery and installation of boilers. The

customer will accept the boilers only after final inspection of boilers after installation.

Required

Explain when AEL should recognise the revenue from the sale of boilers.

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Solution

AEL should recognise the revenue only when the delivery is accepted by the customer

after installation and inspection. Risks and rewards of ownership will be transferred to the

buyer only on acceptance of the boilers by the buyer after installation and inspection.

Installation is a significant activity and therefore, until inspection AEL retains risks of

ownership, which are not immaterial.

Illustration 13.13

Sony Mony Limited (SML) sells branded TV sets which are tested and certified by the

manufacturer. As a practice, SML installs the TV set sold in the location decided by the

customer.

Required

Explain when SML should recognise the revenue from the sale of TV sets.

Solution

SML should recognise the revenue immediately on delivery of the TV set to the

customer. The installation process is simple and it is almost certain that the installation

will be complete to the satisfaction of the customer. Therefore, until installation, SML

retains risks, which are immaterial.

Illustration 10.14

Genuine Ores Limited (GOL), a mining company, exports zinc raw ore to various firms

on FOB contract basis. Contracts with different firms establish prices for different grades

of the ore. GOL determines the sale value of each consignment and prefers invoice based

on test results in its own laboratory. However, the final price is determined by the

customer after inspection and test of the ore in its laboratory. The customer does not

reject the ore unless it is below the acceptable grade. GOL, while dispatching a

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consignment, ensures that the ore is of such a quality that the consignment would not be

rejected by the customer.

Required

Explain when GOL should recognise the revenue from the sale of ore.

Solution

GOL should recognise revenue when the consignment is delivered to the shipping

company. Risks and rewards of ownership are substantially transferred at that point in

time. Inspection and testing for determining the price do not defer the transfer of risk and

rewards of ownership. GOL should estimate the reduction in price and should provide for the same.

Illustration 10.15

Neo machines Limited (NML) manufactures equipment for the production of innovative

electric ICMIC cookers. An ICMIC cooker is a steam cooker. It cooks several items

simultaneously. It calls for slow cooking, as a result of which many foods taste better. No

attention is needed during cooking. The demand for this product has not yet picked up inthe market. NML promotes this product as a strategy to achieve target growth. It sells the

equipment that it manufactures with a condition that if the customer fails to achieve target

revenue by selling ICMIC cookers in the first full year after the purchase of the

equipment, NML will take back the equipment and will refund the full amount received

as consideration.

Required

Explain when GOL should recognise the revenue from the sale of ore.

Solution

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NML should recognise the revenue from the sale of the equipment after the expiry of the

period within which the customer can claim refund of the sale consideration. By

guaranteeing the target revenue from the sale of ICMIC cookers by the buyer of the

equipment, NML retains significant risks. Risks and rewards of ownership of the

equipment get transferred only when the buyer’s right to return the equipment ceases.

13.3.2 Bill and Hold Sales

‘Bill and hold sales’ refers to a situation when an entity holds goods on behalf of a

customer. For example, an entity manufacturing and selling equipment against firm

orders, holds finished goods ready for dispatch on behalf of a customer, if the site for

installation is not ready. The accounting principle is that the entity should recognise the

revenue when the buyer takes the title provided:

(a) It is probable that the delivery will be made.

(b) The item is on hand, identified, and ready for delivery.

(c) The buyer specifically acknowledges the deferred delivery instructions.

(d) The usual payment terms apply.

Illustration 13.16

Happy Home Furniture Limited (HHFL) manufactures standard teak wood furniture for use in home. However, it modifies standard furniture according to interior decoration

plan of the customer. It receives full payment with the firm order. On 15 December 2010,

it received an order from Ms. Lovely for Rs. 500,000. Execution of the order will require

modification of standard furniture. The modification would be completed by 15 January

2011.

Required

Explain whether HHFL should recognise revenue in the profit and loss account for the

year 2010.

Solution

HHFL should not recognise the revenue in the year 2010, because on 31 December 2010,

furniture were not ready for delivery and the buyer did not accept the title, although she

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paid the full amount. HHFL should recognise the amount received as a liability (advance

from customers) in the balance sheet as at 31 December 2010.

13.3.3 Lay Away Sales

‘Lay away sales’ are similar to ‘bill and hold sales’. In lay away sales, the goods and

equipment are on hand, identified and ready for delivery to the buyer, but delivery is

deferred until final payment is received. Usually, sufficient payment is received to

support commitment of the buyer and consequently the collectibility of the sale value. An

entity recognises the lay away sales as revenue for the period in which the sales occurred.

Illustration 13.17

Sun Sports Limited (SSL) manufactures and sells sports equipment. It normally allows

30 days credit. At the request of a local club it agreed to special terms of payment. Under

the arrangement, the club identified sports goods and equipment worth Rs. 500,000. The

club would make payment for those items in a series of installment. SSL would deliver

the items only on receipt of final payment. On 31 December 2010, Rs. 150,000 was due

from the club.

Required

Explain whether SSL should recognise the revenue in the year 2010.

Solution

SSL should recognise the revenue in the year 2010, because it has received significantdeposit, and the goods and equipment are on hand, identified and ready for delivery to the

buyer. Although physical delivery is not complete as on 31 December 2010 sales are

consummated and it is probable that delivery will be made. It is assumed that the seller is

holding goods for the buyer.

13.3.4 Sales and Repurchase of Goods

Accounting for a sales and repurchase transaction depends on the substance of the

transaction. If the seller transfers the risks and rewards of ownership to the buyer,

revenue is recognised. If, in substance, the seller transfers the legal title, but retains the

risks and rewards of ownership through a repurchase arrangement, the transaction is a

financing arrangement and does not give rise to revenue.

If the product or good is readily available in the market (e.g. securities being traded in the

capital market) and the seller has the option to buy back the same at a specified date at

20



the then prevailing market price, the seller transfers the risk and reward of ownership to

the buyer. If, the price of the good sold increases during the intervening period, the gain

due to increase in the price goes to the buyer. Similarly, if, the price of the good sold goes

down during the intervening period, the resultant loss is borne by the buyer.

Illustration 13.18

Sujal Limited (SL) sold 10,000 shares of Castrol Limited, which is a listed company, to

Kangna Limited (KL) on June 11, 2010 at the rate of Rs. 400.10 per share. As per the

arrangement, SL will buy back the shares on June 11, 2011 at the closing price of the

share in BSE at that date.

Required

Explain whether SL should recognise the transaction as a sale transaction.Solution

SL should recognise the transaction as a sale transaction as it has passed the risk and

reward of ownership of the shares to KL. For example, if the closing price on June 11,

2011 is higher than Rs. 400.10 per share, KL will benefit from the increase as SL will

buy back the shares at that increased price. On the other hand, if the closing price on June

11, 2011 is lower than Rs. 400.10 per share, KL will suffer a loss due to decrease in the

share price as SL will buy back the shares at that reduced price. We have assumed thatKL holds the shares in stock. But, it is quite possible that KL might have sold the shares

during the intervening period and booked profit. It will purchase the shares from the

market on June 11, 2011 and will return the shares to SL. This shows that if the item is

readily available in the market, the buyer can take advantage of intervening changes in

the price of the item. The seller cannot take the benefits of intervening changes in the

price of the item.

If the product or good is readily available in the market (e.g. securities being traded in the

capital market) and the seller has the option to buy back the same at a specified date and

at a specified price, the seller does not transfer the risk and reward of ownership to the

buyer. If, the price of the good sold increases during the intervening period, the gain due

21



to increase in the price goes to the seller. Similarly, if, the price of the good sold goes

down during the intervening period, the resultant loss is borne by the seller.

Illustration 13.19

Sudipti Limited (SL) sold 10,000 shares of Castrol Limited, which is a listed company, to

Kanti Limited (KL) on June 11, 2010 at the rate of Rs. 400.10 per share. As per the

arrangement, SL will buy back the shares on June 11, 2011 at the rate of Rs.450 per

share.

Required

Explain whether SL should recognise the transaction as a sale transaction.

SolutionSL should recognise the transaction as a financing transaction as it has retained the risk

and reward of ownership of the shares. For example, if the closing price on June 11, 2011

is lower than Rs. 450 per share, SL will lose as it will buy back the shares at the pre-

specified price of Rs. 450.00 per share. On the other hand, if the closing price on June 11,

2011 is higher than Rs. 450.00 per share, SL will gain as it will buy back the shares at the

pre-specified price of Rs. 450.00 per share. It is quite possible that KL would book profit

taking advantage of intervening changes in the price of the shares. But, by specifying thebuyback price, SL has retained the risk, which is not immaterial.

If the product or good is not readily available in the market (e.g. special equipment) and

the seller has the option to buy back the same at a specified date, the seller does not

transfer the risk and reward of ownership to the buyer, because non-availability of the

product in the market restrains the buyer to sell or mortgage the good.

Illustration 13.20

Sunshine Limited (SL) sold goods to Moonlight Limited (ML) on 15 December 2010 for

Rs. 5,000,000 with an arrangement that SL would repurchase the goods from ML on 15

January 2011 for Rs. 5,050,000.

22



Required

Explain whether SL should recognise the transaction as a sale transaction.

Solution

SL and ML should recognise the transaction as a financing transaction. SL shouldrecognise Rs. 5,000,000 as loan (asset) in the balance sheet as at 31 December 2010 and

should recognise Rs. 25,000 as interest income in the profit and loss account for the year

2010. ML should recognise Rs. 5,000,000 as borrowing in its balance sheet as at 31

December 2010 and Rs. 25,000 as interest expense for the year 2010.

13.3.5 Goods Shipped Subject to Approval

If, there is uncertainty about the possibility of return, revenue should not be recogniseduntil the goods have been formally accepted by the buyer or the time period for rejection

has elapsed. Although not explicitly provided, IAS-18 does not preclude recognition of

revenue at the time of sale, if there is no significant uncertainty about the possibility of

return. In other words, if the seller can reasonably estimate the amount of future return, it

should recognise the revenue at the time of sale and provide for estimated return.


Indian GAAP requires that revenue should not be recognised until the goods have been

formally accepted by the buyer or the time period for rejection has elapsed.

13.3.6 Installment Sales

When the consideration is receivable in installments, revenue attributable to the sales

price, exclusive of interest , is recognised at the date of sale. Sale price is the present value

of the consideration, determined by discounting the installments receivable at the imputed

rate of interest. The interest element is recognised using the effective interest rate

method.

13.3.7 Subscriptions to publications and similar items

When the items involved are of similar value in each time period, revenue is recognised

on a straight-line basis over the period in which the items are despatched. When the items

23



vary in value from period to period, revenue is recognised on the basis of the sales value

of the item despatched in relation to the total estimated sales value of all items covered by

the subscription.

Illustration 13.21

Sarthak Publications Limited (SPL) publishes a monthly magazine targeted to youth in

the age group of 25 to 30 years. The yearly subscription is Rs. 1,300. A subscriber

receives 13 issues, which include one annual number, which is issued in January. The

annual number is a special issue and the management estimates that its sale value should

be four times of the sale value of monthly issues. SPL closes its financial year on

December 31.

RequiredIf SPL receives subscription from a subscriber on July1, 2010, how much of the annual

subscription it should recognise in the year 2010.

Solution

During the full year a subscriber receives equivalent to 16 (12 + 4) issues in terms of sale

value. The subscriber in consideration will receive only six issues during the year 2010.

Therefore, SPL should recognise only Rs. 487 .50 [(1,300/16) × 6] as revenue for the

year 2010.

13.3.8 Servicing Fees Included in the Price of the product

When the selling price of a product includes an identifiable amount for subsequent

servicing (for example, after sales support and product enhancement on the sale of

software), that amount is deferred and recognised as revenue over the period during

which the service is performed. The amount deferred is that which will cover the

expected costs of the services under the agreement, together with a reasonable profit on

those services.

Illustration 13.22

Hansa Limited (HL) sells water purifiers, primary for use in offices and factories. The

selling price is Rs. 25,000 per unit. HL provides four free after sales service at the end of

each three-month period from the date of sale. Service includes replacement of parts. HL

24



earns a gross profit of 25 per cent on the product. The management estimates that the cost

of each service comes to Rs. 1,000. HL closes its financial year on December 31.

In October 2010 HL sold four purifiers.

Required

Explain how HL should account for the revenue earned on the sale of the purifiers on

October 2010.

Solution

We may assume that HL completed on free service during the year 2010.

The selling price of Rs. 25,000 includes servicing fees of Rs. 5,000 [(1,000 × 1.25) × 4].

Immediately on sale, HL should recognise revenue of Rs, 20,000 (25,000 – 5,000) per

purifier. Recognition of fees for Identifiable services at Rs. 5,000 per purifier should be

deferred.

In the year 2010, one service on the four purifier sold was complete. Therefore, HL

should recognise Rs. 85,000 [(20,000 × 4) + (5,000/4) × 4] as revenue for the year 2010

from the transaction of selling four purifiers in October 2010.

Summary

Revenue from the sale of goods should be recognised when all the following conditionshave been satisfied:

(a) The entity has transferred to the buyer the significant risks and rewards of ownership

of the goods;

(b) The entity retains neither continuing managerial involvement to the degree usually

associated with ownership nor effective control over the goods sold;

(c) The amount of revenue can be measured reliably;

(d) It is probable that the economic benefits associated with the transaction will flow to

the entity; and

(e) The costs incurred or to be incurred in respect of the transaction can be measured

reliably.

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In most cases, risks and rewards get transferred to the buyer with the transfer of the legal

title or passing of possession to the buyer. This is the case for most retail sales.

Accounting for a sales and repurchase transaction depends on the substance of the

transaction. If the seller transfers the risks and rewards of ownership to the buyer,

revenue is recognised. If, in substance, the seller transfers the legal title, but retains the

risks and rewards of ownership through a repurchase arrangement, the transaction is a

financing arrangement and does not give rise to revenue.

When the selling price of a product includes an identifiable amount for subsequent

servicing, that amount is deferred and recognised as revenue over the period during

which the service is performed.

13.4 SERVICE REVENUES

13.4.1 General Principles

Outcome can be measured reliably

Usually service contracts cover more than one accounting period. Therefore, revenue is

recognised with reference to the stage of completion of the transaction on the balancesheet date. The same rule is followed in the case of construction contracts, which are also

multi-period contracts. However, the rule can be applied only if the outcome of the

transaction can be measured reliably.

The outcome of a transaction can be estimated reliably when all the following conditions

are satisfied:

(a) The amount of revenue can be measured reliably;(b) It is probable that economic benefits arising from the transaction will flow to the

entity;

(c) The stage of completion at the balance sheet date can be measured reliably; and

(d) The costs incurred for the transaction and the costs to complete the transaction can be

measured reliably.

26



Measurement of the stage of completion

The stage of completion can be determined in a variety of ways such as survey of the

work performed and services rendered till the balance sheet date as a percentage of total

services to be performed. Depending on the nature of the transaction, the methods may

include:

(a) Surveys of work performed;

(b) Services performed to date as a percentage of total services to be performed; or

(c) The proportion that costs incurred to date bear to the estimated total costs of the

transaction. Only costs that reflect services performed to date are included in costs

incurred to date. Only costs that reflect services performed or to be performed are

included in the estimated total costs of the transaction.

Progress payments and advances received from customers often do not reflect the

services performed.

Illustration 13.23

Krittika IT Solutions Limited (KITSL) develops and implements IT systems for large

companies. Average cycle time for the completion of a contract is about three years. On

January 1, 2010 it initiated work on a contract for a client operating in the automobile

sector. Total cost to complete the contract is estimated at Rs. 100 million. The contract

price is Rs. 130 million. Costs incurred till the end of the year 2010 amounted to Rs. 25

million.

Required

Estimate the amount of revenue to be recognised by KITSL in the profit and loss account

for the year 2010 against the subject contract.

Solution

27



The total revenue and the total costs to completion are measured reliably by the

management. Therefore, we can conclude that the outcome of the contract can be

measured reliably. The revenue from the contract should be measured using the stage of

completion method.

The stage of completion as at December 31, 2010 was 25 per cent (25/100). Therefore, 25

per cent of the total revenue should be recognised in the profit and loss account for the

year 2010. Accordingly revenue for the year 2010 should be recognised at Rs. 32.50

million.

Outcome cannot be measured reliably

When the outcome of the transaction involving the rendering of services cannot be

estimated reliably, the entity recognises revenue only to the extent of the expenses

recognised that are recoverable.

Usually, during the early stages of the transaction, the outcome of the transaction cannot

be measured reliably. However, it is probable that the entity will be able to recover the

costs incurred. Therefore, the entity does not recognise profit from the transaction and

recognise revenue only to the extent of expenses recognised in the profit and loss

account. As a practice, entities do not recognise any profit until more than 20 per cent of

the work is completed.

When the outcome of a transaction cannot be estimated reliably and it is not probable that

the costs incurred will be recovered, revenue is not recognised and the costs incurred are

recognised as an expense.

Illustration 13.24

Sangeeta IT Solutions Limited (SITSL) develops and implements IT systems for large

companies. Average cycle time for the completion of a contract is about three years. On

May 1, 2010 it initiated work on a contract for a client operating in the automobile sector.

28



Total cost to complete the contract is estimated at Rs. 100 million. The contract price is

Rs. 130 million. Costs incurred till the end of the year 2010 amounted to Rs. 15 million.

Required

Estimate the amount of revenue to be recognised by KITSL in the profit and loss account

for the year 2010 against the subject contract.

Solution

Although the total revenue and the total costs to completion are measured reliably by the

management, it is incorrect to conclude that the outcome of the contract can be measured

reliably because only 15 per cent (15/100) of the transaction is complete as at the end of the year 2010. Therefore, revenue for the year 2010 from the subject transaction should

be recognised only to the extent of expenses recognised for the year 2010. Accordingly,

only Rs. 15 million should be recognises as revenue for the year 2010.

13.4.2 Application of General Principles

Indeterminate number of acts

For practical purposes, when services are performed by an indeterminate number of acts

over a specified period of time, revenue is recognised on a straight line basis over the

specified period, unless there is evidence that some other method better represents the

stage of completion.

When a specific act is much more significant than any other act, the recognition of

revenue is postponed until the significant act is executed. For example, revenue from

artistic performance, banquets and other special events is recognised when the eventtakes place.

Subscription

29



When subscription to a number of events is sold, the fee is allocated to each event on a

basis that reflects the extent to which services are performed at each event.

Customized software

Fees for the development of customized software are recognised as revenue by reference

to the stage of completion of the development, including completion of services provided

for post-delivery service support. Usually, the service provider establishes milestones in

consultation with the customer for transfer of sales consideration. Sometimes revenue

from incomplete contracts is recognised as and when the milestones are achieved.

Advertising Commission

The general principle is that revenue should be recognised when the service is completed.

Media commission is normally recognised when the related advertisement or commercial

appears before the public and the necessary intimation is received by the agency.

Production commission should be recognised when the project is completed.

Insurance Agency Commission

Insurance agency commissions received or receivable which do not require the agent torender further service are recognised as revenue by the agent on the effective

commencement or renewal dates of the related policies. However, when it is probable

that the agent will be required to render further services during the life of the policy, the

commission, or part thereof, is deferred and recognised as revenue over the period during

which the policy is in force.

Admission Fee

Admission fee that relates to a number of events sold is allocated to each event on a

systematic and rational basis.

Tuitions Fee

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Revenue is recognised over the period of instruction.

Institution Entrance and Membership Fees

Entrance fee received is generally capitalised.

Revenue recognition from membership fees depends on the nature of services provided.

If the fee permits only membership, the fee should be recognised as revenue when no

significant uncertainty as to its collectibility exists. If the membership fee entitles the

member to service or publications to be provided during the membership period or to

purchase goods or services at prices lower than those charged to non-members, it is

recognised on the basis that reflects the timing, nature and value of the benefits provided.

Illustration 13.25

Divya Limited (DL) maintains an auction site on its web. It charges customers an upfrontfee to list products for sale and a transaction fee when a sale takes place. The transaction

fee is refundable if the auction winner fails to honour its commitment to purchase the

product.

Required

Explain the appropriate revenue recognition principles to be followed by DL in

recognising revenue from transactions mentioned in the illustration.

Solution

DL should recognize the upfront fee as revenue on time proportion basis over the average

period over which it retains its customers and recognize the transaction fee when the

buyer of the customer’s product honours the commitment. It will be inappropriate for DL

to recognise the upfront fee as revenue immediately because, its contract with a customer

is a multi-period contract and it cannot be said that the delivery is complete immediately

on receipt of the fee.

Illustration 13.26

Priyanka Software Limited (PSL) develops software and sells it to customers for an

upfront fee. PSL provides its customers with password-protected access to its website for

31



two years after delivery of the software. With this access, customers can download

updates to the software. PSL has an obligation to provide update on the website.

Required

Explain how PSL should account for the upfront fee received from customers.

Solution

PSL should recognize the total upfront fee as revenue on receipt of the amount and

should simultaneously recognise a provision for the estimated costs of providing updates.

It is not appropriate for PSL to recognize the total upfront fee as revenue on time

proportion basis over a period of two years, because the earning process is substantiallycomplete when the software is sold and the add-on service is only a small part of the total

contract.

Illustration 13.27

Zee Tele films Limited sells advertisement space to its customer.

Required

Explain when Zee should recognise the commission earned by selling the advertising

space.

Solution

It recognizes the advertising space selling commission when the related advertisement or

commercial appears before the public i.e. on telecast.

Illustration 13.28

Balaji Tele-films Limited produces television programmes. It earns revenue by selling the

programme produced by it.

32



Required

Explain the appropriate accounting policy for the recognition of revenue.

Solution

In respect of sponsored programs, revenue should be recognised as and when the relevant

episodes of the programs are telecast. In respect of commissioned programs, revenue is

recognised as and when the relevant episodes of the programs are delivered to the

channels.

Illustration13.29

UPS Limited provides courier services. It collects fees from customers while collecting

letters and other packages. The delivery time and costs depend on locations, distance

between locations, mode of transport and types of packages.

Required

Explain the appropriate accounting policy for the recognition of revenue.

Solution

Revenue should be recognized upon delivery of a letter or package because the earning

process completes only on delivery.

Summary

Revenue is recognised with reference to the stage of completion of the transaction on the

balance sheet date if, the outcome of the transaction can be measured reliably. When theoutcome cannot be estimated reliably, the entity recognises revenue only to the extent of

the expenses recognised that are recoverable. Usually, during the early stages of the

transaction, the outcome of the transaction cannot be measured reliably. When the

outcome of a transaction cannot be estimated reliably and it is not probable that the costs

incurred will be recovered, revenue is not recognised and the costs incurred are

33



recognised as an expense. For practical purposes, when services are performed by an

indeterminate number of acts over a specified period of time, revenue is recognised on a

straight line basis over the specified period When a specific act is much more significant

than any other act, the recognition of revenue is postponed until the significant act is

executed.

13.5 ROYALTY, INTEREST AND DIVIDEND

13.5.1 Royalties and License Fees

Entities allow others to use its assets such as trademarks, patents, software, music

copyright, record masters and motion picture films on payment of fees or royalties. Fees

and royalties received for such an arrangement are recognised as revenue in accordance

with the substance of the agreement. In practice revenue from such an arrangement is

recognised on a straight line basis over the life of the agreement.

Sometimes, an entity assigns rights for use of its assets for a fixed fee or non-refundable

guarantee under a non-cancellable contract which permits the licensee to exploit those

rights freely and the licensor has no remaining obligations to perform. Such an

arrangement is in substance a sale, and revenue is recognised at the time of sale.

Examples of such transactions are:

(a) A licensing agreement for use of software when the licensor has no obligations

subsequent to delivery.

(b) Assignment of rights to exhibit a motion picture film in markets where the enterprise

has no control over the distributor and it does not expect to receive further revenues from

the box-office receipts.

If the receipt of fees or royalties is contingent on the occurrence of a future event, theenterprise recognises the revenue when the event has occurred.

Interests and dividends

Revenue from interests and dividends should be recognised on the following bases:

(a) Interest: Interest income is recognised using the effective interest method.

34



(b) Dividends ( from investment in shares): When the owner’s right to receive payment

is established.

The effective interest method is discussed in chapters 11 and 12. When unpaid interest

has accrued before the acquisition of an interest-bearing security, the subsequent receipt

of interest is allocated between pre-acquisition and post-acquisition periods. Only post-

acquisition period interest is recognised as revenue, and pre-acquisition period interest is

reduced from the cost of investment as a part recovery of the cost. Similarly, dividend

declared from pre-acquisition net income is reduced from the cost of investment as a part

recovery of the cost.


Interest income is recognised on a time proportion basis taking into account the amount

outstanding and the rate applicable.

The principles for the recognition of royalty and dividend are the same as those stipulated

in IFRS.

13.6 FINANCIAL SERVICE FEES

The recognition of revenue for financial service fees depends on the purposes for which

the fees are assessed and the basis of accounting for any associated financial instrument.

It is necessary to distinguish between fees that are an integral part of the effective interest

rate of a financial instrument, fees that are earned as services are provided, and fees that

are earned on the execution of a significant act.

13.6.1 Fees that are Integral Part of the Interest

Fees that are integral part of the interest are generally treated as an adjustment to the

effective interest rate. However, when the financial instrument is measured at fair value

with the change in fair value recognised in profit or loss, the fees are recognised as

revenue when the instrument is initially recognised. Accounting for financial assets and

financial liabilities is discussed in chapters 11 and 12.

Origination fees in creating a financial asset

35



Origination fees may include compensation for activities such as evaluating the

borrower’s financial condition, evaluating and recording guarantees, collateral and other

security arrangements, negotiating the terms of the instrument, preparing and processing

documents and closing the transaction. These fees are an integral part of generating an

involvement with the resulting financial instrument and, together with the related

transaction costs are deferred and recognised as an adjustment to the effective interest

rate.

Illustration 13.30

National Bank Limited (NBL) provides housing finance to buyers of new apartments in

bank approved projects. It charges a flat amount of Rs. 10,000 for each loan application.

The only cost that is directly attributable to the processing, approving and sanctioning of

loan is the amount that it pays to an analytic firm to assess the risk of the loan. In a

particular case the bank received an application for a loan of Rs. 2 million (20 lakhs). It

paid Rs. 2,000 to the analytic firm to assess the risk of the loan. After due assessment of

the risk the bank has sanctioned the loan at an interest rate of 10 per cent per annum. The

loan will be repaid in equal instalments over a period of 120 months.

Required

Explain how the bank should account for the origination fee of Rs. 10,000.

Solution

The origination fee (Rs. 10,000) adjusted for the transaction cost (Rs. 2,000) should be

considered as cash inflow at the date of disbursement of loan to calculate the effective

interest rate. Thus the cash outflow at the date of disbursal should be taken at Rs.

1,992,000 (2,000,000 – 10,000 + 2,000).

Commitment fee

If it is probable that the entity will enter into a specific lending arrangement, the

commitment fee received is regarded as compensation for an ongoing involvement with

36



the acquisition of a financial instrument and, together with the related transaction costs is

deferred and recognised as an adjustment to the effective interest rate. If the commitment

expires without the entity making the loan, the fee is recognised as revenue on expiry.

13.6.2 Fees Earned as Services are Provided

Fees charged for servicing a loan

Fees charged by an entity for servicing a loan are recognised as revenue as the services

are provided.

Commitment fees to originate a loan

If it is unlikely that a specific lending arrangement will be entered into, the commitment

fee is recognised as revenue on a time proportion basis over the commitment period.

Investment management fees

Fees charged for managing investments are recognised as revenue as the services are

provided. Incremental costs that are directly attributable to securing an investment

management contract are recognised as an asset if they can be identified separately and

measured reliably and if it is probable that they will be recovered. The asset represents

the entity’s contractual right to benefit from providing investment management services,

and is amortised as the entity recognises the related revenue. If the entity has a portfolio

of investment management contracts, it may assess their recoverability on a portfolio

basis.

13.6.3 Fees that are Earned on the Execution of a Significant Act

The fees are recognised as revenue when the significant act has been completed.

Commission on the allotment of shares to a client

The commission is recognised as revenue when the shares have been allotted.

Placement fees for arranging a loan between a borrower and an investor

37



The fee is recognised as revenue when the loan has been arranged.

Loan syndication fees

A syndication fee received by an entity that arranges a loan and retains no part of the loan package for itself (or retains a part at the same effective interest rate for comparable risk

as other participants) is compensation for the service of syndication. Such a fee is

recognised as revenue when the syndication has been completed.

13.7 FRANCHISE FEES

Franchise fees may cover the supply of initial and subsequent services, equipment and

other tangible assets, and know-how. Accordingly, franchise fees are recognised asrevenue on a basis that reflects the purpose for which the fees were charged.

Supplies of equipment and other tangible assets

The amount, based on the fair value of the assets sold, is recognised as revenue when the

items are delivered or title passes.

Supplies of initial and subsequent services

Fees for the provision of continuing services, whether part of the initial fee or a separate

fee, are recognised as revenue as the services are rendered.

When the separate fee does not cover the cost of continuing services together with a

reasonable profit, part of the initial fee, sufficient to cover the costs of continuing services

and to provide a reasonable profit on those services is deferred and recognised as revenue

as the services are rendered.

The franchise agreement may provide for the franchisor to supply equipment, inventories,

or other tangible assets, at a price lower than that charged to others or a price that does

not provide a reasonable profit on those sales. In these circumstances, part of the initial

fee, sufficient to cover estimated costs in excess of that price and to provide a reasonable

38



profit on those sales, is deferred and recognised over the period the goods are likely to be

sold to the franchisee. The balance of an initial fee is recognised as revenue when

performance of all the initial services and other obligations required of the franchisor

(such as assistance with site selection, staff training, financing and advertising) has been

substantially accomplished.

The initial services and other obligations under an area franchise agreement may depend

on the number of individual outlets established in the area. In this case, the fees

attributable to the initial services are recognised as revenue in proportion to the number

of outlets for which the initial services have been substantially completed.

If the initial fee is collectible over an extended period and there is a significant

uncertainty that it will be collected in full, the fee is recognised as cash instalments are

received.

Continuing franchise fees

Fees charged for the use of continuing rights granted by the agreement, or for other

services provided during the period of the agreement, are recognised as revenue as the

services are provided or the rights used.

Agency transactions

Transactions may take place between the franchisor and the franchisee which, in

substance, involve the franchisor acting as agent for the franchisee. For example, the

franchisor may order supplies and arrange for their delivery to the franchisee at no profit.

Such transactions do not give rise to revenue.

13.8 REAL ESTATE

Agreement for the construction of real estate

Real estate developers undertake the construction of real estate directly or through

subcontractors. They usually enter into agreements with one or more buyers before

construction is complete. Such agreements take diverse forms. For example, entities that

39



undertake the construction of residential real estate often start to market individual units

(apartments or houses) ‘off plan’, i.e. while construction is still in progress, or even

before it has begun. Each Buyer enters into an agreement with the entity to acquire a

specified unit when it is ready for occupation. Typically, buyers make progress payments.

Entities that undertake the construction of commercial or industrial real estate enter into

an agreement with a single buyer. The buyer may be required to make progress payments

between the time of the initial agreement and contractual completion. Construction may

take

Within a single agreement, an entity may contract to deliver goods or services in addition

to the construction of real estate (e.g. a sale of land or provision of property management

services). Such an agreement may need to be split into separately identifiable components

including one for the construction of real estate. The fair value of the total consideration

received or receivable for the agreement shall be allocated to each component.

Nature of the agreement

Determining whether the transaction is to be accounted for as a construction contract (see

section 13.8 below) or as a sale of goods or services, needs consideration of the terms of

the agreement and all the surrounding facts and circumstances. Such a determination

requires judgement with respect to each agreement.

The agreement is in the nature of a construction contract when the agreement meets the

definition of a construction contract. Construction contract is defined as ‘a contract

specifically negotiated for the construction of an asset or a combination of assets’. An

agreement for the construction of real estate meets the definition of a construction

contract when the buyer is able to specify the major structural elements of the design of the real estate before construction begins and/or specify major structural changes once

construction is in progress (whether or not it exercises that ability).

In contrast, an agreement for the construction of real estate in which buyers have only

limited ability to influence the design of the real estate, e.g. to select a design from a

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range of options specified by the entity, or to specify only minor variations to the basic

design, is an agreement for the sale of goods.

Accounting for revenue from the construction of real estate

When the agreement is a construction contract, the transaction is to be accounted for as

per the principles and methods described in section 13.8.

If the agreement does not meet the definition of a construction contract, the entity

determines whether the agreement is for the rendering of services or for the sale of goods.

If the entity is not required to acquire and supply construction materials, the agreement

may be only an agreement for the rendering of services In this case, if the outcome can

be estimated reliably, revenue to be recognised by reference to the stage of completion of

the transaction using the percentage of completion method.

If the entity is required to provide services together with construction materials in order

to perform its contractual obligation to deliver the real estate to the buyer, the agreement

is an agreement for the sale of goods.

Usually an entity transfers to the buyer control and the significant risks and rewards of

ownership of the real estate in its entirety at a single time (e.g. at completion, upon or

after delivery). In this case, the entity recognises revenue only when all the criteria of

revenue recognition, including the delivery of goods, are satisfied.

Revenue is normally recognised when legal title passes to the buyer. However, in many

situations the equitable interest in a property vests in the buyer before legal title passes

and, therefore, the risks and rewards of ownership get transferred at that stage. In such

cases, provided that the seller has no further substantial acts to complete under the

contract, it is appropriate to recognise revenue. If the seller is obliged to perform any

significant acts after the transfer of the equitable and/ or legal title, revenue is recognised

as acts are performed.

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The entity may transfer to the buyer control and the significant risks and rewards of

ownership of the work in progress in its current state as construction progresses. In this

case, if all the criteria of revenue recognition are met continuously as construction

progresses, the entity recognises revenue by reference to the stage of completion using

the percentage of completion method.


Under the Indian GAAP, real estate developers recognise revenue by reference to the

stage of completion using the percentage of completion method irrespective of the nature

of contract.

13.9 CONSTRUCTION CONTRACTS

13.9.1 Characteristics of Construction Contracts

Definition

A construction contract is a contract specifically negotiated for the construction of an

asset or a combination of assets that are closely interrelated or interdependent in terms of

their design, technology and function or their ultimate purpose or use.

Characteristics

The unique feature of construction contracts is that the date at which the contract activity

is entered into and the date when the activity is completed usually fall into the different

accounting periods. Therefore, the primary issue in accounting for construction contracts

is the allocation of contract revenue and contract costs to the accounting periods in which

the construction work is performed.

Although, usually contracts are carried at the job site, accounting principles for

accounting for construction contracts are applicable in appropriate cases to the

manufacturing or building of special items on a contract basis in a contractor’s own plant.

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Examples of construction contracts are civil construction contracts and contracts for

shipbuilding.

As earned approach

‘As earned’ approach is adopted to recognise revenue from a construction contract. ‘As

earned’ approach is justified, because in most situations both the buyer and the contractor

obtain legally enforceable rights. The buyer has the legal right to enforce specific

performance and, in effect, has ownership claim to the contractor’s work-in-progress. The

contractor usually has the right to require the buyer to make progress payments during the

construction period. Therefore, in substance, continuous sale occurs as the work

progresses.

13.9.2 Types of Contracts

A fixed price contract is a construction contract in which the contractor agrees to a fixed

contract price, or a fixed rate per unit of output, which in some cases is subject to cost

escalation clauses.

A cost plus contract is a construction contract in which the contractor is reimbursed for

allowable or otherwise defined costs, plus a percentage of these costs or a fixed fee.

Construction contracts include:

(a) Contracts for the rendering of services which are directly related to the construction of

the asset, for example, those for the services of project managers and architects.(b) Contracts for the destruction or restoration of assets, and the restoration of the

environment following the demolition of assets.

13.9.3 Recognition of Contract Revenue and Expenses

Outcome can be estimated reliably

When the outcome of a construction contract can be estimated reliably, contract revenue

and contract costs associated with the construction contract should be recognised using

the ‘percentage-of-completion’ method.

Outcome cannot be estimated reliably

When the outcome of a construction contract cannot be estimated reliably:

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(a) Revenue is recognised only to the extent of contract costs incurred that it is probable

will be recoverable; and

(b) Contract costs are recognised as an expense in the period in which they are incurred.

An expected loss on the construction contract should be recognised as an expense.

immediately. During the early stages of a contract it is often the case that the outcome of

the contract cannot be estimated reliably. Nevertheless, it may be probable that the entity

will recover the contract costs incurred. Therefore, contract revenue is recognised only to

the extent of costs incurred that are expected to be recoverable. As the outcome of the

contract cannot be estimated reliably, no profit is recognised. However, even though the

outcome of the contract cannot be estimated reliably, it may be probable that total

contract costs will exceed total contract revenues. In such cases, any expected excess of total contract costs over total contract revenue for the contract is recognised as an

expense immediately.

Recovery of costs is not probable

Contract costs recovery of which is not probable are recognised as an expense

immediately. Following are examples of circumstances in which the recoverability of contract costs incurred may not be probable:

(a) Contracts which are not fully enforceable, that is, their validity is seriously in question

(b) Contracts the completion of which is subject to outcome of pending litigation or

legislation

(c) Contracts relating to properties that are likely to be condemned or expropriated

(d) Contracts where the customer is unable to meet its obligations

(e) Contracts where the contractor is unable to complete the contract or otherwise meet its

obligations under the contract

When the uncertainties that prevented the outcome of the contract being estimated no

longer exist, revenue and contract costs should be recognised using the percentage-of-

completion method.

13.9.4 Reliability of Estimates

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A contractor should be able to estimate the outcome of a contract reliably, if the contract

establishes:

(a) Each party’s enforceable rights.

(b) The consideration to be exchanged.

(c) The manner and terms of settlement.

In case of a fixed price contract, the contractor can estimate the outcome reliably when all

the following conditions are satisfied:

(a) The contract revenue can be measured reliably.

(b) It is probable that the economic benefits associated with the contract will flow to the

enterprise.

(c) Both the contract costs to complete the contract and the stage of completion at the

balance sheet date can be measured reliably.

(d) The contract costs attributable to the contract can be clearly identified and measured

reliably so that the actual contract costs incurred can be compared with prior estimates.

In case of cost plus contract, the outcome can be measured reliably when all the

following conditions are satisfied:

(a) It is probable that the economic benefits associated with the contract will flow to the

enterprise.

(b) The contract costs attributable to the contract, whether or not specificallyreimbursable, can be clearly identified and measured reliably.

13.9.5 Percentage-of-Completion Method

Under percentage-of-completion method, contract revenue and contract costs (expenses)

are recognised in the profit and loss account for the accounting periods in which the work

is performed.

The stage of completion of a contract may be determined in a variety of ways, including:

(a) The proportion that the contract costs incurred for work performed to date bear to the

estimated total contract costs

(b) Surveys of work performed

(c) Completion of a physical proportion of the contract work

Progress payments and advances received from customers often do not reflect the work

performed .

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Cost to cost method

Cost-to-cost method is commonly used to measure the percentage-of-completion of the

contract. Costs incurred to the balance sheet date should include only those contract costs

that reflect work performed to that date. Total costs should be adjusted based upon most

recent information. The following steps are involved in determining the revenue for the

current period:

(a) Determine the contract accosts incurred to the balance sheet date from the

commencement of activities associated with the contract.

(b) Estimate the total contract costs for completing the contract based on most recent

information.

(c) Determine the ratio of (a) to (b).

(d) Apply the ratio at (c) to the contract price to determine the amount of revenue earned

to the balance sheet date.

(e) Deduct from (d) above the revenue previously recognised to determine the current

Illustration 13.31

Amishi Construction Limited (ACL) constructs commercial spaces in Kolkata. It

involves the buyer in planning and designing the space. The buyer has the right to advice

ACL on construction activities during the construction of the contract. ACL started

construction of a commercial building for one of its esteemed client on the land provided

by the client in the year 2009. By the end of the year 2010, ACL incurred Rs. 50 million

towards construction costs. As per the latest estimate prepared by the management of

ACL, total construction cost comes to Rs. 100 million. The selling price is Rs. 130

million. In the year 2009, ACL recognised revenue from the contract at Rs. 30 million.

Required

(a) Explain the principles of accounting to be applied in accounting for the transaction.

(b) Calculate the amount of revenue to be recognised in the profit and loss account for the

year 2010.

Solution

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(a) The nature of the contract is that of construction contract because of buyer’s

involvement in planning, designing and during the construction of the commercial

building. Therefore, principles of contract accounting should be applied to account for the

transaction.

(b) The percentage completion at the end of the year 2010 was 50 per cent (50/100).

Therefore, cumulative revenue of Rs. 65 million (.50 × 130) should be recognises.

Revenue of Rs. 30 million was reognised in the profit and loss account for the year 2009.

Therefore, revenue for the year 2010 should be recognised at Rs. 35 million (65 – 30).

13.10 BUNDLED OFFERS

The recognition criteria for revenue recognition are usually applied separately to each

transaction. However, in certain circumstances, it is necessary to apply the recognition

criteria to the separately identifiable components of a single transaction in order to reflect

the substance of the transaction. For example, when the selling price of a product

includes an identifiable amount for subsequent servicing, that amount is deferred and

recognised as revenue over the period during which the service is performed.

Usually the total selling price is allocated to different components based in fair values of

different components which constitute the transaction. However, some times, allocation

becomes too complicated. For example, in case of accounting for revenue in the

telecommunication sector, large are large number of issues involved in allocating the

selling price to different components. In most situations, different entities provide

different components (e.g. hand set and contents), which are delivered by the mobile

service providers. This makes the accounting for revenue a complex issue.

Loyalty programmes

Customer loyalty programmes are used by entities to provide customers with incentives

to buy their goods or services. If a customer buys goods or services, the entity grants the

customer award credits (often described as ‘points’). The customer can redeem the award

credits for awards such as free or discounted goods or services.

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An entity accounts for the award credits as a separately identifiable component of the

sales transaction(s) in which they are granted (the ‘initial sale’). The fair value of the

consideration received or receivable in respect of the initial sale is allocated between the

award credits and the other components of the sale.

The consideration allocated to the award credits is measured by reference to their fair

value, i.e. the amount for which the award credits could be sold separately.

If the entity supplies the awards itself, it shall recognise the consideration allocated to

award credits as revenue when award credits are redeemed and it fulfils its obligations to

supply awards. The amount of revenue recognised is based on the number of award

credits that have been redeemed in exchange for awards, relative to the total number

expected to be redeemed.

If a third party supplies the awards, the entity assesses whether it is collecting the

consideration allocated to the award credits on its own account (i.e. as the principal in the

transaction) or on behalf of the third party (i.e. as an agent for the third party).

If the entity is collecting the consideration on behalf of the third party, it measures its

revenue as the net amount retained on its own account, i.e. the difference between the

consideration allocated to the award credits and the amount payable to the third party for

supplying the awards; and recognises this net amount as revenue when the third party

becomes obliged to supply the awards and entitled to receive consideration for doing so.

If the entity is collecting the consideration on its own account, it measures its revenue as

the gross consideration allocated to the award credits and recognises the revenue when it

fulfils its obligations in respect of the awards.

13.11 GOVERNMENT GRANTS

Government grants or other types of government assistance are usually provided to

enterprises to encourage certain types of activities. Perhaps in the absence of government

grants, enterprises would not have undertaken such activities.

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13.11.1 Accounting Principles

No government grant should be recognised until there is a reasonable assurance that: (a)

the enterprise will comply with the conditions attached to them; and (b) the grants will be

received.

Government grants should be recognised in profit or loss on a systematic basis over the

periods in which the entity recognises as expenses the related costs for which the grants

are intended to compensate.

13.11.2 Application of Accounting Principles

Grants related to specific expenses

In most cases the periods over which an entity recognises the costs or expenses related to

a government grant are readily ascertainable. Thus grants in recognition of specific

expenses are recognised in profit or loss in the same period as the relevant expenses.

Grants related to depreciable assets

Grants related to depreciable assets are usually recognised in profit or loss over the

periods and in the proportions in which depreciation expense on those assets is

recognised.

Grants related to non-depreciable assets

Grants related to non-depreciable assets may also require the fulfilment of certain

obligations and would then be recognised in profit or loss over the periods that bear the

cost of meeting the obligations. As an example, a grant of land may be conditional upon

the erection of a building on the site and it may be appropriate to recognise the grant in

profit or loss over the life of the building.

Grants for immediate financial assistance

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In some circumstances, a government grant may be awarded for the purpose of giving

immediate financial support to an entity rather than as an incentive to undertake specific

expenditures. Such grants may be confined to a particular entity and may not be available

to a whole class of beneficiaries. These circumstances may warrant recognising a grant in

profit or loss of the period in which the entity qualifies to receive it, with disclosure to

ensure that its effect is clearly understood.

A government grant may become receivable by an entity as compensation for expenses or

losses incurred in a previous period. Such a grant is recognised in profit or loss of the

period in which it becomes receivable, with disclosure to ensure that its effect is clearly

understood.

Non-monetary grants

Non-monetary grants should be recognised at fair value. For example, if an asset, such as

land, is received free of cost from the government towards a government grant, both the

grant and the asset are recognised at the fair value of the asset. Alternatively, both the

grant and the asset are recognised at a nominal amount.

There are two alternative acceptable methods for presentation of grants related to assets.

Under the first method, the government grant is recognised as deferred income. The

deferred income is recognised as income over the period and in the proportion in which

depreciation on the asset is charged. Under the second method, the government grant is

deducted in arriving at the carrying amount of the asset. The net carrying amount is

allocated over the useful life of the asset by way of depreciation.

Repayment of grants

A government grant becomes repayable due to non-compliance of stipulated conditions

or due to disbursement of excess grant by mistake. A government grant that becomes

repayable should be accounted for as a revision to an accounting estimate. Repayment of

a grant related to income should first be adjusted against the unamortized balance of

deferred income set up against the grant. The balance amount, that is, the excess of

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amount repayable over the unamortized balance of the related deferred income, should

immediately be recognised as an expense in the profit and loss account. Repayment of

grant related to an asset, should be recorded by increasing the carrying amount of the

asset, or by reducing the deferred income balance by the amount repayable. The

cumulative additional depreciation that would have been recognised to date as an expense

in the absence of the grant should be recognised immediately as an expense.

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Essentials of FA_Chapter 13_Income

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