FRS 115: Introductory Guide to New Revenue Recognition Standards
In light of the new FRS 115 revenue recognition standard that takes effect from this year onwards, practically every company, big or small, are affected in their operations and revenue reporting. Still, not everyone may not be familiar with the new standards. in 2017, less than 10% of companies are ready for the FRS 115, while 60% are undecided on approaching these changes. To prepare ourselves for the incoming changes from the new revenue recognition standard, we offer a series of articles to inform you in navigating through these huge changes. This is...the introductory guide to the new revenue recognition standards.
What is Revenue?
Under Financial Reporting Standard, Revenue is sated as the gross inflow of economic benefits (received and receivable by an organisation)during the period arising in the course of the ordinary activities of an organisation (such as sales of goods, rendering of services, interest, royalties, and dividends) when those inflows result in increases in equity, other than increases relating to contributions from equity participants.
In layman terms, Revenue means sales or income that is derived from a company’s core business (principal) activities.
For example, if the company’s core activities are of importing and exporting of timber, scrap metal and spices, then the company’s Revenue will include sales from timber, scrap metal and spices. Note any contribution from or to shareholders are not considered Revenue.
What is the difference between Revenue and other Income?
Revenue includes only the economic benefits arising in the ordinary course of the company’s activities, whereas income includes such benefits that arise from all activities whether ordinary or otherwise.
Thus, those income derived outside of the company’s core activities are usually classified as other income. With reference to example above, if the company receives interest or dividends which are not part of the company’s core activities, these will be classified as other income.
What is the distinction between Capital and Revenue?
Capital are the funds received by the company which is non-recurring in nature. They are generally part of financing and investing activities rather than operating activities. Some sources of capital receipts are; issue of shares,issue of debt instruments such as debentures’ loan taken from a bank or financial institution, government grants, insurance claim, additional capital from shareholders etc. Whereas Revenue arises through the core business activities of a company.
How do you distinguish Revenue from gains?
Revenue arises from an entity’s ordinary business activities.
Gains are increments in business’s financial holdings that resulted from external events unrelated to the main operations. Gains include such non-routine items such as profit from disposal of non-current assets, retranslating balances in foreign currencies, fair value adjustments to financial and non-financial assets etc.
Why is Revenue so important?
Revenue is the economic engine of any organization and is the basic financial component of operating a business.
The most basic point about the importance of revenue is that without it, a company cannot earn a profit and stay viable in the long run. You need to collect revenue to justify the fixed and variable expenses you pay just to operate a business and to continue as an ongoing entity, a company must generate sufficient revenue to cover its cost and earn profits. Without which, your company will have to use other financing sources, including equity issuance or loans, to fund its activities.
1. A successful business
Revenue typically drives the success of most businesses, as it is a means of generating profits and increasing equity. Revenue can be compared as an engine that drives the company to earn a profit and stay viable in the long run. Hence, it is crucial to attain proper revenue recognition.
Revenue creates critical internal and external psychological impact for your business. Employees desire to have confidence in their employer’s ability to provide security and stability in their jobs. Strong revenue production drives this sense of confidence. Revenue affords similar comfort to business partners, suppliers, shareholders and other stakeholders impacted by your business. Increase in stakeholders’ confidence enables them to take more risks and make decisions in line with the company’s direction.
2. Investors and shareholders
Investors or shareholders want to see that a business is able to perpetually generate more Revenue over time as the company is promoted to expanding markets. Also, from an investors’ perspective, it could mean the difference between investing into or holding a stake in a company and from shareholder perspective a large dividend and whether to investor further in the company.
It is the key variable in a number of calculations and ratios that management and others may consider to be important indicators of its financial performance by investors and creditors.
3. Bankers and providers of credit
To qualify for loans and favourable interest rates on credit accounts, lenders need to see that you are able to generate steady revenue from regular business activities. Coupled with assessments of existing debt structure aid in their analysis to your favor. Poor revenue and weak attractiveness to lenders become unfavourable for company who’s looking to fund new business activities and projects.
Banks and providers of credit use revenue as a benchmark to measure the size, growth pattern, gross margin and operating profits of an entity, as well as the calculation of earning per shares and range of ratios including EBITA of an entity. Bankers use these yardsticks to whether to provide loans, favourable interest rates and other terms on the loan.
Bankers and providers of credit assess the Company’s ability to generate steady stream of Revenue from regular business activities and assess the Company’s ability to repay their interest and principle. As a result, it can be argued that the amount shown as revenue is the single most important item to the users of financial statements.
Why the need for a change in Revenue recognition policy?
The update is in response to increasing concern in the financial industry related to inconsistencies across companies and industries regarding revenue recognition. There was a need to clarify the differences in the accounting principles generally accepted in the United States of America (US GAAP) and International Financial Reporting Standards (IFRS) and to harmonise Revenue recognition principles and develop a common revenue standard for accounting principles. This way investors can compare companies’ financial performance across the world.
Thus, the new standard eliminates the numerous inconsistencies introduced by industry-specific guidance, particularly on the revenue generation from contracts with customers. It serves as a cohesive standard that will supersede most of the previous FRS and layout a framework for all industries to follow.
Our forthcoming blogs will be touching on the new revenue recognition standards in detail and its impact. Topics include: