Is it a bird, is it a plane – no its superman!
To be or not to be, that is the question.
Or, how is it possible to enter into a sales contract but the business not to recognise any revenue?
It is indeed possible to sell something but not to record the transaction as a sale. This is because it is necessary to faithfully represent the economic reality of transactions and to report substance over form. In short, we should be reporting the truth.
Let me take you through an example with a sales contract but where it would be wrong to report any revenue.
A timber merchant has inventory that takes one year to mature before it can be used. The inventory cost $100,000 and is sold for $150,000. The buyer is a bank. As part of the sale agreement the timber merchant has agreed to repurchase the inventory in 12 months’ time for $165,000. In the meantime, the timber merchant continues to be responsible for the timber’s storage.
The Wrong Answer:
If the timber merchant records the receipt of $150,000 as revenue (and therefore reports a profit of $50,000 on the transaction) then that is just plain wrong.
Whilst legally there has been a passage of title, in reality, the timber merchant has not sold the inventory – after all, the bank never takes delivery of the timber and the timber merchant has an obligation to pay the money back (with interest!). There is no performance obligation to deliver the timber.
To record the transaction this way would be unethical and it would overstate profit and understate liabilities.
The Correct Answer:
Where there are two linked transactions, it raises suspicions that there might be a conflict between the legal contract and the economic reality. It is necessary to consider the two transactions in the round to arrive at the truth.
The timber merchant should reflect that the receipt of $150,000 from a bank is really a loan secured on the asset: as under the arrangement $150,000 cash comes in and then 12 months’ later goes out again with an extra 10%.
The timber merchant is under no performance obligation to deliver any timber to the bank. The bank does not want the timber as such and does not carry any risk or reward associated with owning the timber. The bank merely has legal title as a form of security in the event the timber merchant defaults on the loan.
This type of transaction is known as a sale and repurchase arrangement.