Internal Audit

Guide to Audit of Revenue from Operations as per AS 9

Revenue from operations is a critical metric that reflects a business’s financial health, and its accurate reporting is crucial for stakeholders. Accounting Standard (AS) 9, which governs the recognition and presentation of revenue, provides a framework for recognizing revenue when it is earned and realizable. Auditing revenue from operations as per AS 9 involves a comprehensive evaluation of a company’s financial records, ensuring that revenue has been accounted for in compliance with these standards.

This guide offers an in-depth understanding of the audit process for revenue from operations, focusing on key principles outlined in AS 9. It will delve into various aspects, such as revenue recognition, disclosures, and common issues that auditors may encounter. Understanding these elements is essential for ensuring transparency and accuracy in financial reporting and fostering trust among investors, regulators, and other stakeholders.

Understanding Revenue Recognition

Revenue is the gross inflow of cash, receivables as well as other considerations emerging in the course of the ordinary or normal activities of an enterprise from the sale of goods, from the delivery of services, and from the use by others, resources generating good interest, royalties along with healthy dividends.

Revenue is estimated and assessed by the charges made to clients for goods supplied as well as services rendered to them & by the charges and rewards arising from their use of resources. In an agency relationship, revenue is the amount of commission. It’s not the gross inflow of cash, receivables, or even other considerations.

AS 9 focuses on the criteria for revenue recognition in the financial statement of a company. The Standard acknowledges revenue from the sale of goods, provision of services, along with the utilization of enterprise resources for royalties, interests, and dividends during regular business operations. Significant factors to consider when recognizing revenue in the income statement include:

• The timing of recognition of revenue.
• The amount of revenue. It is generally determined by agreement between the parties involved in the transaction.
• Uncertainties regarding the determination of the amount or its associated costs may influence the timing of revenue.

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How Do you Recognize Revenue from the Sale of Goods?

Revenue from the sale of goods is recognized when:

• The seller has passed on ownership of the goods to the buyer in exchange for payment.
• The buyer has assumed major risks and rewards of ownership.
• As is typically seen with ownership, The seller does not exert significant control over the goods they transfer.
• There is no notable doubt about the amount of consideration that will come from the sale of goods.

When property in goods is transferred, substantial ownership risks and rewards are transferred to the buyer. Nevertheless, there might be cases in which the transfer of goods does not align with the transfer of ownership risks and rewards.

In these instances, revenue is acknowledged when substantial risks and rewards of ownership are transferred to the purchaser. Instances can occur when a delay in delivery is caused by either the buyer or the seller, resulting in the party at fault being responsible for any potential loss related to the delay.

How Do you Recognize Revenue from the Sale of Services?

Revenue from service transactions is generally recognized:

• As the service is performed, follow either the ‘Proportionate Completion Method’ or ‘Completed Service Contract Method’.
• There is no significant uncertainty regarding the amount of consideration derived from service rendering.

Proportionate Completion Method

When a service involves multiple actions, revenue is recognized proportionately based on the completion of each action. The proportionate completion method calculates revenue based on contract value, costs, acts, or another suitable basis.

Nevertheless, in practical terms, if services are delivered through various acts over a designated timeframe, revenue is recorded evenly over that period unless a different approach more accurately reflects the performance pattern.

For instance, a yearly maintenance agreement for a machine requires the service provider to check and clean the machine every three months. In this scenario, the revenue received from the customer is recognized quarterly, with 25% of maintenance fees recognized as revenue each quarter.

Completed Service Contract Method

This approach accounts for revenue earned through services when the services are either done in one or multiple acts. The remaining services are crucial to the overall transaction and are not considered complete until those acts are carried out. The finished service contract approach pertains to these performance patterns. Thus, revenue is acknowledged when the last act occurs, and the service becomes billable.

For instance, a contract mandates the installation of wooden benches in multiple parks maintained by the city’s municipal corporation. The agreement specifies that payment will only be made once all benches are installed throughout the city, and the payment is a fixed amount for the whole contract.

The municipal corporation will only recognize the completion of services after all benches have been installed. In this scenario, revenue will be acknowledged once the contract is finished, meaning when all the benches are installed throughout the city.

Revenue Arising from The Use by Others

This consists of interest, royalties, and dividends. Revenue should only be recognized when there is no substantial doubt regarding its measurability or collectability. These profits are acknowledged based on the following criteria:

• Interest: It is calculated based on the remaining balance and the interest rate proportionate to the amount of time that has passed.
• Royalties: They will be calculated based on the terms of the agreement in effect at the time.
• Dividends: They are received by shareholders when their entitlement to payment is confirmed.

Uncertainties in Revenue Recognition

Accounting Standard (AS) 9 guides managing uncertainties affecting revenue recognition. According to AS 9, two essential prerequisites for revenue recognition are:

• Revenue is measurable.
• An ultimate collection is reasonably expected during the sale or service rendering.

However, there may be situations where assessing ultimate collection with reasonable certainty is not feasible, such as in cases involving insurance claims or price escalation claims. In such scenarios, AS 9 recommends postponing revenue recognition to the extent of uncertainty. Revenue is only recognized when it is reasonably certain that collection will be made.

When there is no uncertainty about collection, revenue is recognized at the time of sale or service rendering, even if payments are made in instalments. AS 9 also states that revenue recognition should be postponed when the consideration receivable for sales, services, or use of enterprise resources is not determinable within reasonable limits. Once the uncertainties cease to exist, revenue is recognized when the collection becomes certain.

Example: For instance, if an insurance claim raised in the financial year ending March 31, 2021, faced uncertainties, it would not be recognized as revenue. If these uncertainties were resolved and the insurance surveyor approved the claim during the financial year ending March 31, 2022, the revenue would be recognized later.

In cases where uncertainty arises after the sale or service (e.g., customer insolvency), AS 9 advises creating a provision for doubtful receivables instead of adjusting previously recognized revenue. AS 9 provides various illustrations of revenue recognition scenarios, including:

• “Bill and Hold” sales
• Delivery is subject to conditions
• On approval sales
• Guaranteed sales
• Consignment sales
• Principal-agent relationships

What is the Objective of the Audit of Revenue?

The primary objective of auditing revenue is to validate the following assertions:

• Existence: The recorded revenue corresponds to goods shipped or services rendered during the period without overstatement.
• Completeness: All sales made during the period are recorded, avoiding understatement.
• Accuracy: All revenue transactions are recorded correctly.
• Presentation and Disclosure: Proper disclosures are made in accordance with Schedule III and AS 9.

Potential Risks of Material Misstatements in Revenue

Revenue misstatements are often driven by a desire to present better financial performance. Senior management may use grey areas in revenue recognition regulations to accelerate revenue reporting, as businesses are often judged based on their reported revenue.

The Institute of Chartered Accountants of India (ICAI), in its Standard on Auditing (SA 240), presumes risks of fraud in revenue recognition and mandates auditors to evaluate types of revenue and assertions that may present such risks. Common revenue misstatement methods include:

• Fictitious sales, where goods or services are not provided.
• Manipulating sales to meet revenue targets or earn commissions.
• Premature recognition of revenue before fulfilment of sales terms.
• Overstating sales through side agreements or consignment sales without actual delivery.

Auditors should also be aware of risks like early recognition of sales after the period’s end, failure to account for sales returns, or channel-stuffing to inflate sales figures.

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What is the Procedure of Audit?

Auditors should follow the below procedures:

• Understand the nature of products or services, including the entity’s sales processes and pricing policies.
• Ensure the entity’s revenue recognition policies are consistent with AS 9.
• Verify the consistency of recorded sales with supporting documents (e.g., sales orders, invoices, delivery notes).
• Verify whether the deferred portion is accounted for properly in cases of deferred revenue.
• Test “bill and hold” and consignment sales to confirm compliance with AS 9’s recognition criteria.
• Review discount and pricing policies to ensure authorizations are in place.

Auditors must also ensure cash sales are reconciled with bank deposits, export sales are recorded according to AS 11, and related-party transactions occur at arm’s length.

The policy must be reviewed for sales returns, and corresponding credits should be verified with return notes and inspection reports. Additionally, revenue cut-off procedures ensure that the correct accounting periods are followed.

Auditors can use external data for further assurance, such as reconciling revenue with e-way bills or bank realization certificates (e-BRC) to verify export sales.

Know about the Reporting Requirements

Under the Companies (Auditor’s Report) Order, 2020, the auditor must report on revenue-related matters, specifically if any income not recorded in the books has been surrendered or disclosed in tax assessments under the Income-tax Act, 1961.

Disclosure Requirements as per Schedule III and AS 9

Schedule III of the Companies Act 2013 mandates the disclosure of revenue in the profit and loss statement under specific categories, including sales of products and services. Additionally, companies must present net revenue of goods and services tax (GST) collected in compliance with the Guidance Note on Schedule III issued by ICAI. For finance companies, revenue disclosures must include interest and financial services revenue, separately disclosed in the notes to the accounts.

Conclusion

In conclusion, auditing revenue from operations as per AS 9 is fundamental to ensuring accurate and transparent financial reporting. AS 9 provides clear guidelines on recognizing revenue from the sale of goods, rendering of services, and income generated from using enterprise resources.  Auditors play a crucial role in validating that companies adhere to these guidelines, verifying that revenue is recognized only when earned, measurable, and collectable.

By following these principles, businesses can provide stakeholders with a true reflection of their financial health, fostering trust and confidence among investors, regulators, and other key parties. Moreover, the audit process helps identify and mitigate risks of revenue misstatement, which is often driven by pressures to enhance financial performance.

By understanding the nature of the company’s operations, reviewing its revenue recognition policies, and conducting thorough checks on supporting documents, auditors ensure compliance with AS 9 and guard against fraud or errors. Proper revenue recognition is essential for compliance and the overall credibility of a company’s financial statements, ultimately impacting its reputation and market stability.

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