What is REVENUE?
Any income or consideration received in return of providing goods or services to your customer. Revenue can be defined as the total amount of income generated by the sale of goods or services that are related to the company’s primary operations. It can also be termed as gross sales or simply sales and is always on top of the statement of profit or loss.
Revenue and Income
Many people think that revenue and income both terminologies have the same meanings. But it’s better to understand that revenue always refers to the money generated from sales of goods and services including all the expenses but income refers to the amount of money after deducting expenses that occur in the course of trading.
Examples:
Revenue: In a book shop, money received from a customer by selling a book to him.
Income: The amount left when the expenses (purchase costs, admin costs, selling costs, etc…) are deducted from the total revenue figure.
Revenue recognition
Whenever an entity makes a sale, it does not directly record it in its books of accounts or in its financial statements. First, an entity has to make sure whether the sales amount really needs to be put in the revenue head, but the question is at what point the management would need to record it as a sale? What makes a transaction eligible for becoming part of the business’ revenue? Here comes the perks of the 5-step Revenue Recognition Model.
Sales are sometimes in cash and often in credit, so management has to decide when should they recognize the revenue. The answer to the above questions is the revenue recognition model that outlines the minimum requirements that must be met in order to record a transaction as a “sale” in the business’ books.
The 5 Steps of the revenue recognition model are as follows:
- Identify the contract
- Identify the performance obligation
- Determine transaction price
- Allocate transaction price
- Recognize revenue
1. Identify the contract
Firstly, what is a contract? A contract is an agreement between two or more parties that create a legal binding for them and which also creates some rights and obligation for the parties involved in the contract. It might be oral, written or implied.
So the first step is identifying a contract. If the commitment of parties lies in that criteria, we will call it a contract.
The criteria to identify a contract in the revenue recognition model is:
- A contract has to be approved by all the parties involved in it.
- Rights over the goods or services should be clearly recognized.
- Payments terms and modes should be clear and understandable by all parties.
- It should have a commercial substance. (commercial substance means that through this particular contract, the future cash flows of the company will change)
- Consideration should be fixed at the time of the contract.
2. Identifying the performance obligation
What is a performance obligation? it is a promise of one party to another of giving some particular goods or services mentioned in the contract. Performance obligations can be one or more for a single contract.
The most important part of this step is that a performance obligation should be distinct in a way that:
- Goods or services can be transferred independently regardless of other performance obligations
- Customer can take benefits on their own or with their own other resources
Performance obligations are not only those goods or services which are explicit in nature but they can be in the form of policy, any statement or any other business practice.
Before completing the performance obligation, the entity must decide the nature of the obligation which it is going to perform. Maybe an entity has to provide the goods or services (performance obligation) by itself or it has to hire an agent or a third party to provide that particular goods or services mentioned in the contract as performance obligations.
In circumstances where the entity is an agent who is just providing goods or services (performance obligation) on the behalf of another entity, it should recognize its revenue on the basis of the fee or commission which it is charging.
3. Determining the transaction price
The transaction price is the amount paid as a consideration in exchange for the performance obligation. It is the amount of consideration to which an entity expects to be entitled in exchange for transferring goods or services to a customer.
Transaction price can consist of both variable and fixed amounts. While determining the transaction price one should be aware of
- Variable consideration: Variable Considerations come in many forms including discounts, refunds, credits, price concessions, right of returns, penalties etc…
- A financing component in consideration: A financing component can be expressed as the consideration which is payable in the future, should be discounted back on its present value while taking good care of its financing rate. A financing component always considers the time value of money in the transaction price.
- Non-cash consideration: Sometimes a customer wants to pay in the form of stocks, or other goods or services then we must consider the fair value of that non-cash consideration.
- The consideration payable to a customer: These are considerations that are payable to a customer or other parties that purchase the entity’s services or goods. IFRS 15 makes it clear that this requirement not only applies to a direct customer but also to a distribution or supply further down.
4. Allocate the transaction price
Most probably, a contract always contains more than one performance obligation, so the total transaction price should be allocated to each performance obligation fairly. You have to be sure that the stand-alone price of the performance obligation is satisfied. It should not be over or underpriced. If identifying the stand-alone price is not possible, then fair estimations and judgments should be used in determining the overall transaction price.
Sometimes. discounts are also offered on some of the performance obligations, in which case discount should only be allocated to that particular obligation on which discount is being offered.
5. Recognize revenue
It is not necessary that when a sale is made, management will recognize the revenue immediately after the sale. This whole 5 step revenue recognition process is required. Once all of the above steps of the revenue recognition model are followed, it’s time to recognize the revenue. There is a little complication in the final stage that is; performance obligations are either completed at once or gradually over time. So, when does the management record the revenue?
Revenue is recognized once the performance obligations or a performance obligation is satisfied. If all of the performance obligations have been satisfied, the whole amount should be recorded. If performance obligations are completed over time, an amount should be recorded after the completion of each performance obligation.
Summary of the IFRS 15 5-Step Model
The 5-step model is a model that is followed to record revenue. There are complications like credit terms, performance fulfillments, the time span of transactions and other industry-specific issues in businesses which could create problems in recording the revenue figure in an appropriate manner. To solve this issue and create harmony in recording transactions, there is a 5-step model that lets businesses record revenue accurately.
ILLUSTRATION: Throughout this illustration, I’ll be using an example of a car dealership to make it easier for you to understand how the 5-step revenue recognition model works.
Whenever a transaction takes place, the first thing to do is to identify a contract. A contract could be oral, written or implied. In our example, when a customer finalizes a vehicle and accepts the terms including warranty, payment method etc…
The next step, identifying the performance obligation, is to identify what the dealer needs to do in order to fulfill the requirements of the customer. That could be delivering the vehicle to the customer’s address or completing the customizations, if included in the contract.
Next we have to determine the transaction price. This could be as simple as adding taxes with the selling price of the vehicle but could get complicated in cases where things like discounts, right to returns and finance costs are involved.
Once the overall transaction price is determined, a price will be allocated to each of the performance obligation (if more than one). The prices allocated to each performance obligation should match the total transaction price. In our example, it could be allocating the overall transaction price to the free maintenance service, delivery costs etc…
Lastly, the revenue is recognized once the performance obligations are satisfied. If the obligations are satisfied at once, the total revenue is recognized. If the performance obligations are completed in parts, revenue for the of the completed performance obligation is recognized in the books.
