Due to emerging of various new sales patterns and payment terms in recent years, the current revenue principle seems a bit insufficient in reporting information about revenue, which is always an important part of the business, to the readers of the financial statements. To address this issue, new accounting principle for revenue (“new principle”) is generated by Ministry of Finance in 2017 and all Chinese non-listing companies applying the accounting principles in preparing the financial statements shall start to implement from 2021.
The purpose of the new principle is to report the nature, amount, timing and the uncertainty of revenue and cash flow from a contract with a customer. For this purpose, new principle requires apply a 5-step model, which include:
1) Identify the contract with the customer;
2) Identify the performance obligation contained in the contract;
3) Determine the transaction price;
4) Allocate the transaction price to the performance obligation; and
5) Recognize revenue when the entity completes a performance obligation
Below, we will briefly explain the 5 steps one by one.
Step 1: Identify the contract with the customer
The new principle can be applied when the contract meets the following conditions:
1) Both parties have approved and committed the implementation to the contract.
2) The contract shall explicitly state the obligation and responsibilities of both parties and payment term.
3) The transaction in the contract shall have commercial substance.
4) The consideration in exchange of goods or service can most likely be collected.
Of course, contract shall be legal. If the above conditions are satisfied, other than written form, oral or other forms of contracts can also be accepted.
According to the new principal, two or more contracts might be combined as one for accounting treatment and the modification to the original contract might be regarded as a separate contract. For example, if the amount of one contract is decided by the amount or the implementation of another contract, these two contracts are treated as one. If goods or service in the modification contract can be distinct from those in the original contact, the modification contract shall be regarded as a new contract
Step 2: Identify the performance obligations in the contract
After the contract is identified, the entity shall further identify each separate performance obligation contained in the contract as well as the way of completion, at a point of time or over time.
The performance obligation is the commitment of transferring distinct goods or service, or transferring a series of distinct goods or service which has the same substance and the same pattern of transfer.
For example, a sales contract signed between an air-conditioner manufacturer with a customer. The contract includes 3 performance obligations, sales of goods, installation service and 6-year maintenance service. Since the installation service is often priced in the contract and can be purchased separately from the manufacturer, this service is regarded as a distinct performance obligation. The legal requirement for quality guarantee period for the overall set of air-conditioner is 1 year, but the manufacturer’s maintenance service is 6 years. It seems that the manufacturer offers extra service to the customer other than just guaranteeing the quality of the machine meets the standard requirement committed in the contract. The extra period maintenance service is a distinct performance obligation.
For sales of contract, sales shall be recognized at the point of time when the control to the goods is transferred.
For installation service, since the installation work can be completed within short time, revenue can be recognized after the completion of the work.
For maintenance service, since the customer consumes the benefits at the same time of service provision, and the customer can control the air-conditioner over the time of service provision and service fee can be collected periodically for a period of time’s service provision, the revenue is recognized over time. For the regulation required guarantee period service, the contingency liability standard is followed for accounting treatment and for the extra service, contract liability is booked when sales of goods is recognized, and service revenue is recognized over the maintenance period.
Step 3: Determine the transaction price
Under new principle, the transaction price recognized as revenue is not just the contract amount, but an amount the seller expects to receive from the customer according to the contract. The transaction price does not include the amount collected on behalf of the third parties. When deciding the transaction amount, the following main elements shall be considered:
1) Variable consideration
The variable consideration includes discount, refund, rebate, bonus, fines, etc.. When it is highly probable that you can keep the amount, you shall include the amount in the transaction price.
For example, after you sell air-conditioners, based on previous experience or other factors, you estimate that no goods return will happen. Then you can recognize 100% of contract amount as revenue. But if you estimate that it is highly probable that 10% of sales would return, you can only recognize 90% of contract amount as revenue, and 10% shall be recognized as goods return liability, instead of revenue when recognizing sales revenue. This means that this 10% of the contract amount might be repaid to customer in the future. After the expiring of the goods return period as stated in the contract, the balance of the liability, if there is, can be recognized as revenue.
2) Significant financing component
If the payment term in the sales contract is not to pay the contract amount shortly after the transfer of control on goods or services, but 1 year later, or make down payment 1 year earlier, time value of money shall be considered in deciding the transaction price. The contract including significant financing component shall divide the contract amount, i.e. the accounts receivable, into transaction price and lending for accounting treatment.
3) Non-monetary consideration
When the customer pays non-monetary items, the transaction price is decided by the fair value of the non-monetary item. If the fair value of the non-monetary item cannot be reasonably estimated, the selling price you promise to your costumer in return for the goods or services shall be used to decide the transaction price.
4) Consideration payables to customers
Consideration payables to customers may include the amount you shall pay to your customers according to the contract. For example, you may give coupons to customers, or you may agree to pay your customer for special arrangement on goods display in their shops or warehouse. This kind of amount shall be deducted from the transaction price.
Step 4: Allocate the transaction price to the performance obligation
The transaction price shall be allocated to each performance obligation identified in a contract. In allocation, if stand-alone selling price, which is applied to sell to similar customer under the similar conditions, is available, this stand-alone selling price is the best evidence, i.e. the direct observable price, in deciding the allocated price. Otherwise, the entity shall analyze all information which can reasonably obtained and utilize the methods such as marketing adjustment, cost plus or residual value to make estimation in allocation.
Step 5: Recognize revenue
After the entity satisfies the performance obligation, revenue shall be recognized either over time or at the point of time.
According to the new principle, revenue shall be recognized over time if one of the following criteria is met. Otherwise, revenue shall be recognized at the point of time.
1) The customer obtains and consumes the benefits at the same time you satisfy the performance obligation.
2) The customer can control the goods in construction in the process of satisfying the performance obligation
3) The goods or services created by the entity in satisfying the performance obligation do not have alternative use and the entity has enforceable right to receive the amount for the accumulated work completed up to date.
For revenue recognized at the point of time, the new principle stipulates that the point is just the moment when the control is passed to customer. The new principle gives a list of indications for the transfer of control.
1) The entity has the present right to collect the amount and the customer has the present right to make payment
2) The entity has transferred the legal ownership to the customer
3) The entity has transferred the physical goods to the customer
4) The entity has transferred the main risks and rewards related to the goods or services to the customer
5) The customer has accepted the goods or services
Compared with the current one, the theories in the new principle is more comprehensive but also more complicated for understanding and practical implementation. Normally, Ministry of Finance would provide with further clarification by issuing a detailed guidance for accounting treatment. But before that, we still recommend the entity to make sufficient preparation by being familiar with the new principle, analyzing contracts by going through the 5 steps, identifying the difference you would have in complying with the new principle, and measuring the necessary update on contracts and accounting systems or even internal procedures when necessary.
Regarding the above, if you need further assistance, please contact us.
Please note that the article only represents the opinion of the writer. Regarding the implementation of the tax treatment, the consultation with the local in-charge tax authority is required.