Sample Disclosure – Revenue Recognition (2 December 2008)
Revenue recognition
Revenue is recognised to the extent that it is probable that the economic benefits will flow to the Group and the revenue can be reliably measured. The following specific recognition criteria must also be met before revenue is recognised:
i. Sale of goods
Revenue is recognised net of sales taxes and upon transfer of significant risks and rewards of ownership to the buyer. Revenue is not recognised to the extent where there are significant uncertainties regarding recovery of the consideration due, associated costs or the possible return of goods.
ii. Project management fees
Management fees are recognised when the services are rendered.
iii. Rental income
Rental income from operating leases and investment properties is recognised on a straight-line basis over the term of the lease. The aggregate cost of incentives provided to lessees is recognised as a reduction of rental income over the lease term on a straight-line basis.
iv. Interest income
Interest income is recognised on an accrual basis using the effective interest method.
v. Dividend income
Dividend income is recognised when the Group’s right to receive payment is established.
Various Types of Transactions – Collection from Other Source of Revenue and Income, Dividend Income (Part 4b)
For those business entities who have invested in shares of another company, dividends may be received by these business entities as a way of distributing the earnings or profits made by the investee companies to the shareholders. Dividends could take the form of cash or non-cash (e.g. bonus shares, property etc.). I will only discuss the recording of cash dividend income in this post.
Whenever dividends are distributed to the shareholders, enclosed together with the cheques to the shareholders are dividend warrants or vouchers. The dividend warrants or vouchers show the details of the dividends payments.
Dividends are classified into two types: 1. Interim dividends, and; 2. Final dividends. It should be noted that it is the Board of Directors of companies that has the power to determine how frequent to declare and how much to declare interim dividends, NOT the shareholders. However, when interim dividends are paid during the financial year, there is a general expectation that final dividends will be proposed by the Board of Directors in the coming Annual General Meeting of members and subject to approval by the shareholders.
When a company declares and pays dividends, the relevant financial period would be mentioned in the warrant or voucher and usually, the dividends are declared and paid depending on the profits that have been generated during this financial period. However, the Board of Directors of a company making losses in the current financial year could still declare and paid dividends out of the profits retained or accumulated in the previous financial year.
According to International Accounting Standards (IAS) 18, dividends (income) shall be recognised when the shareholders’ right to receive payment is established. This is usually easy to identify as the date of the dividend entitlement is stated clearly on the dividend warrants or vouchers.
Many small businesses record dividend income on cash basis, i.e. upon receipt. The double entry for recording dividend income is:-
Balance Sheet | Income Statement | |||
DR | CR | DR | CR | |
Cash at bank* | XXXX | |||
Dividend income | XXXX |
*Business entities usually receive dividend income by way of cheques and not “hard cash”. Therefore only the cash at bank account is debited and not petty cash.
Example
The financial period of ABC Co. Ltd. is from 1 January to 31 December. On 10 January 2007, ABC Co. Ltd. received $5,000 dividend from XYZ Co. Ltd., a company in which ABC Co. Ltd; paid $80,000 to acquire 80,000 ordinary shares of $1.00 each on 1 January 2006. ABC Co. Ltd. records its transactions using cash basis of accounting, the dividend voucher received:-
XYX CO. LTD. | |||||
DIVIDEND NO. | TYPE OF DIVIDEND | FOR YEAR ENDED | ENTITLEMENT DATE | DATE OF PAYMENT | |
01 | INTERIM | 31 DECEMBER 2006 | 31 DECEMBER 2006 | 10 JANUARY 2007 | |
VOUCHER NO. | NUMBER OF SHARES HELD OF $1.00 EACH | DIVIDEND RATE | GROSS DIVIDEND | INCOME TAX @ 30% | NET DIVIDEND |
003 | 80,000 | 6.25 CENTS PER SHARE | $5,000 | TAX EXEMPT | $5,000 |
ABC CO. LTD. | |||||
123, GOODLUCK STREET | |||||
5678 PROSPER LAND |
For the financial year ended 31 December 2006, ABC Co. Ltd. would not have recorded the dividend income because this transaction will be recorded in the accounts of ABC Co. Ltd. upon receiving the income on 10 January 2007. In respect of the $80,000 investment in shares of XYZ Co. Ltd. the double entry is:-
Balance Sheet | Income Statement | |||
DR | CR | DR | CR | |
Investment in XYZ | 80,000 | |||
Cash at bank | 80,000 |
The journal adjustment to recognise the dividend income (ABC Co. has the right to receive this dividend on 31 December 2006) is:-
Balance Sheet | Income Statement | |||
DR | CR | DR | CR | |
Dividend receivable | 5,000 | |||
Dividend income | 5,000 |
The income statement and balance sheet of ABC Co. Ltd. before and after this adjustment for dividend income recognition are shown below to illustrate the impact of this adjustment: –
Example of Income Statement and Balance Sheet of ABC Co. Ltd. | ||||
Income Statement for the year ended 31 December 2006 | ||||
BEFORE | Adjustment | AFTER | ||
DR | CR | |||
$ | $ | |||
Sales | 109,270 | 109,270 | ||
Cost of Sales | – 40,875 | – 40,875 | ||
Gross profit | 68,395 | 68,395 | ||
Other income: – | ||||
Dividend income | – | 5,000 | 5,000 | |
Operating expenses: – | ||||
Accountancy fee | – 800 | – 800 | ||
Depreciation of property, plant and equipment | – 2,500 | – 2,500 | ||
Donation | – 500 | – 500 | ||
Electricity & water | – 3,340 | – 3,340 | ||
Insurance premium | – 200 | – 200 | ||
Printing & stationery | – 1,697 | – 1,697 | ||
Rental of premises | – 12,000 | – 12,000 | ||
Salaries | – 27,865 | – 27,865 | ||
Upkeep of office | – 3,547 | – 3,547 | ||
Telephone charges | – 1,285 | – 1,285 | ||
Travelling, petrol & toll charges | – 2,648 | – 2,648 | ||
– 56,382 | – 56,382 | |||
Net profit for the year | 12,013 | 17,013 | ||
Retained profits B/F | 27,654 | 27,654 | ||
Retained profits C/F | 39,667 | 44,667 | ||
Balance Sheet as at 31 December 2006 | ||||
$ | $ | |||
Non-current assets | ||||
Property, plant and equipment | 12,500 | 12,500 | ||
Investment in XYZ | 80,000 | 80,000 | ||
Current assets | ||||
Inventories | 5,000 | 5,000 | ||
Trade receivables | 17,030 | 17,030 | ||
Other receivables, deposits & prepayments: | ||||
Dividend receivable | – | 5,000 | 5,000 | |
Deposits | 14,077 | 14,077 | ||
Prepayments | 2,200 | 2,200 | ||
Cash and bank balances | 30,023 | 30,023 | ||
68,330 | 73,330 | |||
Current liabilities | ||||
Trade payables | – 3,588 | – 3,588 | ||
Other payables and accruals | – 102,575 | – 102,575 | ||
– 106,163 | – 106,163 | |||
Net current assets | – 37,833 | – 32,833 | ||
54,667 | 59,667 | |||
Financed by: – | ||||
Share capital | 15,000 | 15,000 | ||
Retained profits | 39,667 | 44,667 | ||
54,667 | 59,667 |
For the financial year ended 31 December 2007, ABC Co. Ltd. would have recorded the $5,000 dividend received on 10 January 2007 as follow: –
Balance Sheet | Income Statement | |||
DR | CR | DR | CR | |
Cash at bank | 5,000 | |||
Dividend income | 5,000 |
As the dividend income should be recognised in the financial year ended 31 December 2006 and not 31 December 2007, the following correction journal adjustments are required:-
1. Correction of dividend incorrectly recognised during the financial year ended 31 December 2007
Balance Sheet | Income Statement | |||
DR | CR | DR | CR | |
Dividend receivable | 5,000 | |||
Retained profits | 5,000 |
Note: This journal entry is actually the same as the journal entry shown earlier to recognise the dividend income in the financial year ended 31 December 2006. In the context of the financial statements of ABC Co. Ltd. for the year ended 31 December 2007, any adjustments made that affect the profit in earlier years, are now required to be adjusted to the retained profits brought forward.
2. Reversal of dividend income incorrectly recognised in the income statement of ABC Co. Ltd. for the year ended 31 December 2007 and dividend receivable
Balance Sheet | Income Statement | |||
DR | CR | DR | CR | |
Dividend income | 5,000 | |||
Dividend receivable | 5,000 |
The income statement and balance sheet of ABC Co. Ltd. before and after adjustment No. 1 & 2 are shown below to illustrate the impact of these adjustments: –
Example of Income Statement and Balance Sheet of ABC Co. Ltd. | |||||||
Income Statement for the year ended 31 December 2007 | |||||||
BEFORE | Adjustment | AFTER | |||||
No. | DR | No. | CR | ||||
$ | $ | ||||||
Sales | 159,270 | 159,270 | |||||
Cost of Sales | – 90,875 | – 90,875 | |||||
Gross profit | 68,395 | 68,395 | |||||
Other income: – | |||||||
Dividend income | 5,000 | 2 | 5,000 | – | |||
Operating expenses: – | |||||||
Accountancy fee | – 800 | – 800 | |||||
Depreciation of property, plant and equipment | – 2,500 | – 2,500 | |||||
Donation | – 500 | – 500 | |||||
Electricity & water | – 3,340 | – 3,340 | |||||
Insurance premium | – 200 | – 200 | |||||
Printing & stationery | – 1,697 | – 1,697 | |||||
Rental of premises | – 12,000 | – 12,000 | |||||
Salaries | – 35,579 | – 35,579 | |||||
Upkeep of office | – 3,547 | – 3,547 | |||||
Telephone charges | – 1,285 | – 1,285 | |||||
Travelling, petrol & toll charges | – 2,648 | – 2,648 | |||||
– 64,096 | – 64,096 | ||||||
Net profit for the year | 9,299 | 4,299 | |||||
Retained profits B/F | 39,667 | 1 | 5,000 | 44,667 | |||
Retained profits C/F | 48,966 | 48,966 | |||||
Balance Sheet as at 31 December 2007 | |||||||
$ | $ | ||||||
Non-current assets | |||||||
Property, plant and equipment | 10,000 | 10,000 | |||||
Investment in XYZ | 80,000 | 80,000 | |||||
Current assets | |||||||
Inventories | 5,200 | 5,200 | |||||
Trade receivables | 6,000 | 6,000 | |||||
Other receivables, deposits & prepayments: | |||||||
Dividend receivable | – | 1 | 5,000 | 2 | 5,000 | – | |
Deposits | 14,077 | 14,077 | |||||
Prepayments | 2,200 | 2,200 | |||||
Cash and bank balances | 52,652 | 52,652 | |||||
80,129 | 80,129 | ||||||
Current liabilities | |||||||
Trade payables | – 3,588 | – 3,588 | |||||
Other payables and accruals | – 102,575 | – 102,575 | |||||
– 106,163 | – 106,163 | ||||||
Net current assets | – 26,034 | – 26,034 | |||||
63,966 | 63,966 | ||||||
Financed by: – | |||||||
Share capital | 15,000 | 15,000 | |||||
Retained profits | 48,966 | 2 | 5,000 | 1 | 5,000 | 48,966 | Note 1 |
63,966 | 63,966 |
Note 1:
All adjustments affecting the income statements have to be repeated again and shown as adjustments to the retained profits account in the balance sheet. This is because all adjustments affecting any income statement items and the retained profits brought forward will eventually be included in the retained profits carried forward to the next financial year.
The discussions in this post do not include the explanations on the effect of tax on dividends and the dividend imputation system imposed in some countries. Please refer to my post: Dividend Imputation for further details.
Dividend Imputation
In some countries, dividends are distributed to shareholders under dividend imputation system. The purpose of this system is to avoid imposing tax “2 times” on the same income is first generated by companies (taxed the first time when the income is reported by companies), which is then distributed to shareholders as dividends (taxed the second time when the dividend income is reported by individual shareholders).
Example
Company A has 2 shareholders – Mr Big and Mr Small, each holding 50% of the shares in Company A. The details of the share capital of Company A are shown below: –
$ | |
Authorised Share Capital: | |
100,000 ordinary shares or $1.00 each | 100,000 |
Issued and Fully Paid-up Share Capital: | |
100,000 ordinary shares or $1.00 each | 100,000 |
For the financial year ended 31 December 2007, Company A made $25,000 profit before taxation and declared and paid a dividend of 25 cents per share to its shareholders.
Based on the profit of $25,000, assume a corporate income tax rate of 20%, and there are no adjustments required to be made to the $25,000 accounting profit to arrive at the taxable profit, the corporate income tax paid by Company A is therefore $5,000 ($25,000 x 20%).
The summarised income statement of Company A for the year ended 31 December 2007 is shown below:-
$ | |
Profit before taxation | 25,000 |
Taxation | -5,000 |
Profit after taxation | 20,000 |
Retained profits brought forward (Assume $10,000) | 10,000 |
Profits available for appropriation | 30,000 |
Dividends | -25,000 |
Retained profits carried forward | 5,000 |
The $25,000 is the dividend distributed to both Mr Big and Mr Small in the following manner:-
$ | |
Mr Big – 50% | 12,500 |
Mr Small – 50% | 12,500 |
TOTAL | 25,000 |
In a simplified scenario and assuming there is no dividend imputation, both Mr Big and Mr Small would need to declare this dividend received as a source of income to the tax authority and be taxed accordingly. Assuming a personal income tax rate of 10%, and no other source of income, and no other deductions or rebates, Mr Big and Mr Small would need to pay $1,250 each as income tax to the tax authority.
The following table shows clearly that based on the same source of profit, originally the $25,000 profit before taxation made by Company A, and subsequently distributed to the shareholders as dividends – $12,500 to Mr Big and $12,500 to Mr Small, the total amount of income tax collected by the tax authority is $7,500 ($5,000 from Company A, $1,250 from Mr Big and $1,250 from Mr Small):-
$5,000 | —–> | on $25,000 profit reported by Company A | |
+ | |||
$1,250 | —–> | on $1,250 profit reported by Mr Big | |
+ | |||
$1,250 | —–> | on $1,250 profit reported by Mr Small | |
TOTAL TAX COLLECTED | $7,500 |
There is an argument that it is unfair for the tax authority to impose tax twice on the same income and therefore the dividend imputation system is introduced.
Under the dividend imputation system, the amount of tax paid by companies, in this example, the $5,000 tax charged on Company A, will be recorded in a tax credit account. This tax credit account is not an account created and maintained in the general ledger, it is just a memorandum account used to keep track of the income tax on companies which can be used to frank the payment of dividends to shareholders.
Based on the $5,000 tax charged on Company A (some countries require that the tax must be paid by companies before it is eligible to be used as tax credit to frank the payment of dividends), and assume it is eligible to be used as tax credit to frank the dividends, Company A would need to perform a calculation check to know the maximum amount of profits that can be distributed to its shareholders, WITHOUT additional tax to be paid as follows:-
Tax credit | = $5,000 | |
Maximum amount of profit that Company A can declare as dividend without incurring additional tax | ||
= $5,000 X | (100% – income tax rate) | |
income tax rate | ||
= $5,000 X | (100% – 20%) | |
20% | ||
= $5,000 X | 80% | |
20% | ||
= $20,000 |
This $20,000 represents the profit of Company A that can be distributed as net dividend to that shareholders without paying additional tax and if Company A were to decide to declare its profit to the maximum without paying additional tax, the dividend is usually described as follows: –
“Company A declared and paid a gross dividend of $25,000 less tax of $5,000 (tax rate at 20%) amounted to $20,000 to its shareholders”.
Refer to the summarised income statement of Company A:-
$ | |||
Profit before taxation | 25,000 | > | This is NOT the maximum amount of profit that Company A can distribute as dividends without incurring additional tax |
Taxation | -5,000 | > | This is the tax credit available to be utilised to frank the payment of dividends |
Profit after taxation | 20,000 | > | This IS the maximum amount of profit that Company A can distribute as dividends without incurring additional tax |
Assume now Company decided to declare $20,000 net dividends to its shareholders, instead of $25,000 (as described earlier where there is no dividend imputation)
In the books of Company A
The double entry for the recording of the dividends paid is:-
Balance Sheet | Income Statement | |||
DR | CR | DR | CR | |
Retained profits – dividend* | 20,000 | |||
Cash at bank | 20,000 |
*Take note that dividend is not an expense. It is a distribution of profits to shareholders and therefore is shown as a deduction against retained profits.
In the books of Mr Big
The double entry for the recording of the dividend income is:-
Balance Sheet | Income Statement | |||
DR | CR | DR | CR | |
Cash at bank | 10,000 | |||
Tax recoverable | 2,500 | |||
Dividend income | 12,500 |
In the books of Mr Small
The double entry for the recording of the dividend income is:-
Balance Sheet | Income Statement | |||
DR | CR | DR | CR | |
Cash at bank | 10,000 | |||
Tax recoverable | 2,500 | |||
Dividend income | 12,500 |
Assume a personal income tax rate of 10% and both Mr Big and Mr Small have no other source of income, no other deductions and rebates, the tax computation prepared for tax purposes is as follows:-
Mr Big | Mr Small | ||
$ | $ | ||
Dividend income | 12,500 | 12,500 | A |
Tax @ 10% | 1,250 | 1,250 | B = A X 10% |
Tax credit available for set-off | -2,500 | -2,500 | C = from the $5,000 tax credit in Company A split into 50% for Mr Big and 50% for Mr Small |
Tax recoverable | -1,250 | -1,250 | D = B + C |
As shown above, the $5,000 ($2,500 each for Mr Big and Mr Small) tax credit available for Mr Big and Mr Small to set off against the tax payable calculated on the dividend income, is from the tax credit of Company A on the $25,000 profit reported to the tax authority.
In the hand of the shareholders, Mr Big and Mr Small, as the amount of tax on the dividend income is only $1,250 each for Mr Big and Mr Small, both Mr Big and Mr Small are eligible to apply to the tax authority for the refund of the “excess” tax paid amounted to $1,250 each for Mr Big and Mr Small. This $1,250 of “excess” tax paid is therefore shown as tax recoverable.
The double entry to record the amount of tax payable of $1,250 calculated above is:-
In the books of Mr Big
Balance Sheet | Income Statement | |||
DR | CR | DR | CR | |
Taxation | 1,250 | |||
Tax recoverable | 1,250 |
In the books of Mr Small
Balance Sheet | Income Statement | |||
DR | CR | DR | CR | |
Taxation | 1,250 | |||
Tax recoverable | 1,250 |
The income statement of Mr Big and Mr Small after taken into account of the two adjustments is as follow:-
Mr Big | Mr Small | |
$ | $ | |
Profit before taxation (Assume only dividend income. No other income or expenses) | 12,500 | 12,500 |
Taxation | -1,250 | -1,250 |
Profit after taxation | 11,250 | 11,250 |
The extract of the balance sheet of Mr Big and Mr Small showing the tax recoverable is as follow:-
Mr Big | Mr Small | |
$ | $ | |
Current Assets | ||
Inventories | xxxx | xxxx |
Trade receivables | xxxx | xxxx |
Other receivables, deposits and prepayments | xxxx | xxxx |
Tax recoverable ($2,500 – $1,250) | 1,250 | 1,250 |
Cash at bank | xxxx | xxxx |
A word of caution, I have seen many mistakes on the recording of dividend income in the books of the recipients when the dividend imputation system is applied. The mistakes done usually is because the following double entry is used to record the dividend income:-
Balance Sheet | Income Statement | |||
DR | CR | DR | CR | |
Cash at bank | 10,000 | |||
Dividend income | 10,000 |
The tax computation prepared is as follows:-
$ | |
Dividend income | 10,000 |
Tax @ 10% | 1,000 |
The journal adjustment to record the tax payable is:-
Balance Sheet | Income Statement | |||
DR | CR | DR | CR | |
Taxation | 1,000 | |||
Tax payable | 1,000 |
Can you see the mistakes made?
Instead of showing a tax recoverable of $1,250, a tax payable of $1,000 is shown.
Taxation amount shown in the income statement of $1,000 instead of $1,250
The tax of $1,000 not set off against the tax credit of $2,500.
Dividend income shown in the income statement is $10,000 instead of $12,500
What if Company A decided to declare a net dividend of $25,000 to its shareholders?(i.e. $5,000 in excess of the $20,000 calculated where no additional tax liability required). Under the tax law and regulations in respect of dividend imputation, Company A is required to pay the tax on the excess of $5,000 ($25,000 – $20,000) for distributing the profit as dividend to its shareholders, i.e. $1,000 ($5,000 x 20%). I have seen many companies declared and paid dividends to the shareholders in excess of the maximum amount without realising that this is the case and attracted unnecessary tax penalties.