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?

  1. Instead of showing a tax recoverable of $1,250, a tax payable of $1,000 is shown.
  1. Taxation amount shown in the income statement of $1,000 instead of $1,250
  1. The tax of $1,000 not set off against the tax credit of $2,500.
  1. 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.