The substance behind the sale

The general principle of revenue recognition under UK GAAP is that the buyer assumes from the seller the significant risk and rewards of ownership of the assets sold, and that the revenue must be reliably measurable and certain. In other words, you can’t recognise revenue unless you have an asset as a result of a transaction or, at least, a smaller liability to show for it.

Much of the recent focus on revenue recognition is a reaction to various accounting incidents, where companies were exaggerating turnover. The classic example is the dotcom sector, where bartered advertising between two websites would be treated by both as turnover. Under the Urgent Issues Taskforce Ruling, such a transaction couldn’t be recognised as increasing a company’s sales unless it could have been made for cash.

While the ASB was itching to lay down the law on this, it was hamstrung by the fact that the IASB and the US FASB have a major project on the go. Having said that, it is establishing principles which UK businesses need to follow in deciding how to recognise revenue. It has done this in the form of an exposure draft (ED), recognising the substance of transactions.

Revenue recognition will enter UK accounting standards as an amendment to Financial Reporting Standard 5. And while we can shake our heads at the dotcom barter approach to revenue recognition, it shows the complexity of business activity that has given rise to different types of revenue-earning transaction.

The ASB has laid out basic principles. The key one states: “At the time of performance of its contractual obligations, a seller typically recognises a new asset, its right to be paid. The gross amount of this asset is simultaneously reported as revenue.”

The ED sets out further principles. If a seller receives payment in advance, it recognises a liability equal to the consideration received that represents the obligation to fulfil its contractual obligations. When performance takes place, the reduction in the value of the liability is simultaneously reported as revenue.

Revenue should be measured as the fair value of the consideration receivable, and turnover is the revenue that results from the transfer to customers.

However, this ED is meant to be less concerned with the theory of revenue recognition and more to do with providing specific guidance on transactions which companies have, in practice, treated in different ways.

The main focus is on long-term contractual performance, the separation and linking of contractual arrangements, bill and hold arrangement, sales with right of return, and presentation of turnover as principal or as agent. All of this illustrates the fact that the complexity and diversity of business activity means there are revenue-earning transactions that were never thought of when the point of sale was first established.

Revenue recognition questions have most often been concerned with the when of revenue recognition rather than asking what revenue is for any business. For most, revenue is seen to equal what you get paid for selling things. However, this approach to revenue needs to be redefined in order to be workable in less straightforward transactions. For example, the answer is not so obvious when applying a commonsense approach to barter transactions or to transactions that go over more than one accounting period. The ASB is suggesting that where contractual performance is incomplete, revenue should be recognised to the extent that the seller has performed and that the performance has resulted in some benefit to the customer.

Accounting for partly performed contracts is the most difficult aspect of revenue recognition to deal with. Businesses need to develop techniques for estimating the value transferred to a customer. The ED talks about three possible approaches – unbundling, value-to-date assessment and value-outstanding assessment.

The ASB’s Statement of Principles is an attempt to link revenue recognition and changes in balance sheet assets and liabilities. In this approach – strongly opposed by some – gains and losses are defined as increases and decreases in net assets.

Will it make a great deal of difference to the way companies report their results? Probably not, especially as the ASB knows this is only an interim measure. But it will help as a reminder to FDs to curb some of the more enthusiastic revenue reporting practices. And it also fits in with these more downbeat times.