Slide 5.

Chapter 5: Revenue (IAS 18) and

construction contracts (IAS 11)
MMPA -501
Financial Accounting

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Slide 5.2

Objectives

When you have completed this chapter you should be able to:
• Explain what revenue is and how it relates to net income.
• Distinguish between revenue and income.
• Explain how to measure revenue.
• Determine when revenue from sale of goods and from rendering of
services is normally recognized.
• Understand exceptions to these normal revenue-recognition principles.

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Slide 5.3

Why Revenue is important?

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Slide 5.4

Why Revenue is important?

• # Single largest item reported in an entity’s financial

statements.
• # Important measure of size and hence growth of an entity
• #Key variables for calculating important ratios
• # Key items for restatements of financial statements

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Slide 5.5

Restatement by Reason

Figure 5.1 Restatement by reason: January 1997–June 2002 and July 2002–September 2005
Source: US GAO (2006)

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Slide 5.6

What IAS 18 & 11deals?

• # Sale of goods
• # The rendering of services;
• # The use by others of assets belonging to the entity and
giving rise to interest, royalties and dividends (this goes
beyond the scope of this book and we will not deal with
it);
• # A number of specific transactions.

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Slide 5.7

Definition of revenue and income

The IASB’s Framework defines ‘income’ as:

…increases in economic benefits during the accounting
period in the form 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.

Revenue, a subset of income, is defined in IAS 18 as:

…the gross inflow of economic benefits during the period
arising in the course of the ordinary activities or an entity
when those inflows result in increases in equity, other than
increases relating to contributions from equity participants.
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Slide 5.8

‘Revenue’ vs. ‘income’

• A car dealer, who sells both new and used cars, has
demonstration cars available that can be used by
potential customers for test drives. The cars are used for
more than one year and then sold as used.
• Does the sale represent the sale of a fixed asset, as the
car was used by the dealer for the purpose of securing
sales, or is the sale of the car the sale of an item of
inventory resulting in the recording of revenue, as the
dealer is in the business of selling new and used cars?

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Slide 5.9

‘Revenue’ vs. ‘income’

• The car dealer is in the business of selling new and used
cars. As selling used cars is part of his ordinary revenue
generating activities, the sale of such used cars would
represent revenue.

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Slide 5.10

How to identify a transaction in order to recognize revenue

Revenue from the sale of goods should be recognized 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;
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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Slide 5.11

How to identify a transaction in order to recognize

revenue (cont’d)
According to IAS 18 para 20, revenue from the rendering of
services, should be recognised when all the following conditions
have been satisfied:
a) the amount of revenue can be measured reliably;
b) it is probable that the economic benefits associated with the
transaction will flow to the entity;
c) the stage of completion of the transaction at the end of the
reporting period can be measured reliably;
d) the costs incurred for the transaction and the costs to complete
the transaction can be measured reliably.

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Slide 5.12

How to identify a transaction in order to recognize

revenue (cont’d)
Sale of goods and rendering of services have the
following conditions in common:
• reliable measurement of consideration;
• reliable measurement of costs;
• probability that the economic benefits from the
transactions will flow to the entity.

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Slide 5.13

Reliable measurement of consideration

• (a) each party’s enforceable rights regarding the

service to be provided and received by the parties;
• (b) the consideration to be exchanged;
• (c) the manner and terms of settlement.

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Slide 5.14

Reliable measurement of costs

• Sale of goods: Manufacturing costs

• Rendering of services: Costs of service

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Slide 5.15

Probability that the economic benefits from the

transactions will flow to the entity.

• For example, it may be uncertain that a foreign

governmental authority will grant permission to remit
the sales consideration from that foreign country.

• When an uncertainty arises about the collectability of

an amount already included in revenue, the
uncollectible amount is recognised as an expense,
rather than as an adjustment of the amount of revenue
originally recognised (IAS 18 para 18).

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Slide 5.16

How to identify a transaction in order to recognize

revenue (cont’d)

Figure 5.2 Recognition of sales revenue

Source: adidas Group Annual Report 2008

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Slide 5.17

Measurement of revenue

Revenue should be measured at the fair value of the

consideration received or receivable, taking into account
the amount of any trade discounts and volume rebates
allowed by the entity.

The consideration is in the form of cash or cash

equivalents and the amount of revenue is the amount of
cash or cash equivalents received or receivable.

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Slide 5.18

Measurement of revenue

Example 5.2

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Slide 5.19

Measurement of revenue
(Continued)

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Slide 5.20

Transfer of significant risks and rewards of

ownership
Where the transfer of significant risks and rewards has not
taken place include the following (IAS 18 para 15):
* Unsatisfactory performance not covered by normal
warranty provisions.
* Particular sale is contingent on the buyer deriving
revenue from its sale of the goods.
* Shipped subject to installation and the installation is a
significant part of the contract which has not yet been
completed by the entity.
* Buyer has the right to cancel the purchase for a reason
specified in the sales contract and the entity is uncertain
about the probability of return.
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Slide 5.21

Recognition of revenue from sale of goods

Table 5.1 Sale of goods

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Slide 5.22

Recognition of revenue from sale of goods

(Continued)

Table 5.1 Sale of goods

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Slide 5.23

Recognition of revenue from rendering of

services and from construction contracts
Construction contracts
• 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.
• Two groups:
– Fixed price contracts are construction contracts 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.
– Cost plus contracts are construction contracts in which the contractor
is reimbursed for allowable or otherwise defined costs, plus a
percentage of these costs or a fixed fee.

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Slide 5.24

Recognition of revenue from rendering of

services and from construction contracts
(Continued)
Construction contracts (cont’d)
• Single asset such as a bridge, building, dam, pipeline, road,
ship or tunnel.
• A number of assets which are closely interrelated or
interdependent.

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Slide 5.25

Recognition of revenue from rendering of

services and from construction contracts
(Continued)
Combining and segmenting construction contracts
When a contract covers a number of assets, the construction of
each asset shall be treated as a separate construction contract
when:
• separate proposals have been submitted for each asset
• each asset has been subject to separate negotiation and the
contractor and customer have been able to accept or reject
that part of the contract relating to each asset;
• the costs and revenues of each asset can be identified.

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Slide 5.26

Recognition of revenue from rendering of

services and from construction contracts
(Continued)
Combining and segmenting construction contracts (cont’d)

A group of contracts, whether with a single customer or with

several customers, should be treated as a single construction
contract when:
• the group of contracts is negotiated as a single package;
• the contracts are so closely interrelated that they are, in
effect, part of a single project with an overall profit margin;
• the contracts are performed concurrently or in a continuous
sequence.

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Slide 5.27

Recognition of revenue from rendering of

services and from construction contracts
(Continued)
How to determine a stage of completion
• The ‘percentage of completion’ method is used.
• Depending on the nature of the transaction, the methods
may include:
– surveys of work performed method;
– services/works performed to date as a percentage of total
services/work to be performed (also called units-of-work-
performed method);
– the proportion that costs incurred to date bear to the
estimated total contract costs (also referred to as the cost-
to-cost method). Jagdish Kothari and Elisabetta Barone, Advanced Financial Accounting, 1st Edition, © Pearson Education Limited 2011
Slide 5.28

Recognition of revenue from rendering of

services and from construction contracts
(Continued)
Examples of contract costs which are excluded

– (a) Contract costs that relate to future activity on the contract

– Payments made to subcontractors in advance of work
performed under the subcontract (IAS 11 para 31).

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Slide 5.29

Recognition of revenue from rendering of

services and from construction contracts
(Continued)
When the outcome of the transaction involving the
rendering of services cannot be estimated reliably?
• (a) revenue should be recognised only to the extent of
contract costs incurred that it is probable will be
recoverable; and
• (b) contract costs should be recognised as an expense
in the period in which they are incurred.

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Slide 5.30

Recognition of revenue from rendering of

services and from construction contracts
(Continued)
Where the outcome of a transaction cannot be reliably estimated and
costs already incurred are not expected to be recoverable?

• (a) that are not fully enforceable, i.e. their validity is seriously in
question;
• (b) the completion of which is subject to the outcome of pending
litigation or legislation;
• (c) relating to properties that are likely to be condemned or
expropriated;
• (d) where the customer is unable to meet its obligations; or
• (e) where the contractor is unable to complete the contract or
otherwise meet its obligations under the contract.
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Slide 5.31

Recognition of revenue from rendering of

services and from construction contracts
(Continued)

Table 5.2 Rendering of services

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Slide 5.32

Recognition of revenue from rendering of

services and from construction contracts
(Continued)

Table 5.2 Rendering of services

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Slide 5.33

Recognition of revenue from rendering of

services and from construction contracts
(Continued)

Table 5.2 Rendering of services

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Slide 5.34

Recognition of revenue from rendering of

services and from construction contracts
(Continued)

Table 5.3 Revenue recognition for construction contracts: the effect of variations and claims

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Slide 5.35

Recognition of revenue from rendering of

services and from construction contracts
(Continued)

Figure 5.3 Accounting policy for construction contracts

Source: Aker ASA Annual Report 2008

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Slide 5.36

Recognition of revenue from rendering of

services and from construction contracts
(Continued)
Construction contracts: calculation of gross amount due
from customers

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Slide 5.37

Recognition of revenue from rendering of

services and from construction contracts
(Continued)
Construction contracts: calculation of gross amount due
from customers

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Slide 5.38

Recognition of revenue from rendering of

services and from construction contracts
(Continued)

Table 5.4 Gross amount due from customer

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Slide 5.39

Recognition of revenue from rendering of

services and from construction contracts
(Continued)
Construction contracts: revision of estimates. An example

A construction contractor has a fixed price contract for

EUR 23,000. The initial estimate of costs is EUR 15,000
and the contract is expected to take four years (2006–9).
In 2007 the contractor’s estimate of total costs increases
by EUR 1,000 to EUR 16,000. Of the EUR 1,000
increase, EUR 600 is to be incurred in 2008 and EUR
400 in 2008.

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Slide 5.40

Recognition of revenue from rendering of

services and from construction contracts
(Continued)

Table 5.5 Stage of completion of the contract

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Slide 5.41

Recognition of revenue from rendering of

services and from construction contracts
(Continued)

Table 5.6 Revenue, costs and profit recognised for the construction contract

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Slide 5.42

Recognition of revenue from rendering of

services and from construction contracts
(Continued)
Construction contracts: inefficiencies. An example
A construction contractor has a fixed price contract for
EUR 23,000. The initial estimate of costs is EUR 15,000
and the contract is expected to take four years (2006–9).
In 2007 the contractor’s estimate of total costs increases
by EUR 1,000 to EUR 16,000 as a result of
inefficiencies in 2007.

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Slide 5.43

Recognition of revenue from rendering of

services and from construction contracts
(Continued)

Table 5.7 Stage of completion of the contract – first method

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Slide 5.44

Recognition of revenue from rendering of

services and from construction contracts
(Continued)

Table 5.8 Revenue, costs and profit recognized for the construction contract – first method

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Slide 5.45

Recognition of revenue from rendering of

services and from construction contracts
(Continued)

Table 5.9 Stage of completion of the contract – second method

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Slide 5.46

Recognition of revenue from rendering of

services and from construction contracts
(Continued)

Table 5.10 Revenue, costs and profit recognized for the construction contract – second method

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Slide 5.47

Recognition of revenue from multiple-

element transactions

Figure 5.4 Recognition of revenue from multiple-element transactions

Source: Vodafone Group Plc Annual Report 2008

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Slide 5.48

Case study: 1 (The Australian Financial Review by Garry West)

Salomon Smith Barney Australian Corporate Finance is claiming $ 2.5 million from Allgas for
Investment banking services provided in 1997 and 1998. Allgas was taken over by the Queensland
Government-owned power supplier Energex for $ 250 million in August 1998.
SSB’s counsel, Mr Peter Dunning, told the Queensland Supreme court that in June 1997, When Allgas
engaged SSB to find a strategic investor; it set the banks’ fee at 1% of the equity value. He said Allgas
ideally sought an international utility to take a 40% to 50% stake to provide financial strength and
technical expertise.
Mr Phillip Morrison QC, who is representing Allgas, said the fee was not payable because the original
contact with SSB ended when the Allgas board decided in January 1998 it wanted a 100% takeover.
‘From that point of view it was a new transaction. The features of it were quite different,’ Mr Morrison
Said.
Energex outbid US group Texas Utilities and Boral Ltd.
But Mr Dunning said the decision was part of a ‘settlement development’ of the transaction and that
the fee was never revised. He said the board elected at a meeting in July 1998 not to pay the $2.5
million because the Energex bid had ‘come from the clouds’. It decided instead to negotiate a lower
fee, but no payment was made.
• Required: Whether Salomon Smith Barney Australian Corporate Finance should recognise the $
2.5 million as revenue?

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Slide 5.49

Case study: 2 (The Australian by Georgina Safe)

A million dollar painting, one of the most reproduced works in the country and due to be
auctioned at Sotheby’s tonight, has been withdrawn and donated to the National Gallery of
Victoria.
The portrait Jeanne, by Australian artist Hugh Ramsay, was on show at Sotheby’s
Melbourne auction house yesterday morning before its scheduled sale for an estimated $ 1
million. But by 3 p.m. the painting one of Ramsay’s best known works, had been delivered
to the gallery’s doorstep as a surprise gift from its owner, John Wicking.
The 1901 painting of Jeanne Garreau, a six-years-old French girl, had previously been on
show at the gallery for 40 years.
It was lent to the gallery in 1947 by Ramsay’s niece, the late Janet Wicking, but by the
1980s she had become unhappy that the work was hung in a gloomy corridor and she
withdrew it.
The painting was put up for sale, at a Sotheby’s auction of Australian and International
Painting, by John Wicking on behalf of his wife, who died last year.
But Mr Wicking has second thoughts after the catalogue was printed and resolved to
donate the painting to the gallery, fearing that it might otherwise leave Australia.
‘I am honouring my wife’s ambition that the painting should go to a great public institution
to ensure that this masterpiece.... is enjoyed by the widest possible audience,’ Mr Wicking
said in a statement.
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Slide 5.50

Case study: 2 (The Australian by Georgina Safe)

Gallery director Gerard Vaughan said yesterday his limited acquisitions budget meant the
gallery would not have been able to afford the ‘staggeringly generous’ gift at auction.
We have made it very clear to Mr Wicking that Jeanne will take pride of place,’ Dr Vaughn
said.
The gallery’s senior curator of Australian Art, Terence Lane, said Jeanne was a masterwork
that would complement the gallery’s existing collection of 10 paintings by the artist, who
died of tuberculosis in Melbourne in 1906, aged 28.
Thirteen of Ramsay’s paintings have been offered at auction over the past 10 years, with
the highest price begin being $ 28750 for a Portrait of a Young Girl, achieved in August
1994.
The Australian Market analyst, Michael Reid, said Sotheby’s had placed an ambitious
value on the work and it may have been passed at auction. ‘The asking price of $1 million
to $1.2 million was exceptionally strong given the track record of Ramsay over the past
decade,’ Mr Reid said.
Sotheby’s managing director Paul Summer said he was delighted the painting had gone to
a public gallery where it could be seen by all Australians.
• Required: Whether the Gallery should treat the donation is treated as revenue? If the
donation is treated revenue, how would that revenue be measured?
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