History and Recognition issues around securitised assets

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According to the FASB, and specifically the Statement of Financial Accounting Concepts No. 5, "Recognition is the process of formally incorporating an item into the financial statements of an entity as an asset, liability, revenue, expense, or the like" (FASB, 2008). Once this item has been formally incorporated into the financial statements, it is then "measured by different attributes, depending on the nature of the item and the relevance and reliability of the attribute measured" (FASB, 2008). As a result, it is clear that the process of recognition involves recognising that an item belongs on the financial statements, as well as recognising that it can actually be reliably and relevantly measured for the purposes of reporting to investors and stakeholders in the company. Unfortunately, this concept comes with significant issues. In particular, the point at which various items are recognised is not very well defined, and is somewhat open to interpretation by managers and accountants, as are the values that a can be recognised under standards such as IAS 40 investment property (IFRS, 2010). Whilst this issue has been addressed, to some extent, in the wake of the Enron and Worldcom scandals, it still remains tricky, particularly when considering revenue recognition. In addition to this, there can be issues with recognising and accounting for securitised assets, such as mortgage backed securities, which it can be difficult to formally recognise as an asset with a definite economic value. There are also some other recognition issues involving different accounting standards and recognition of intangible assets. As such, this essay will discuss and explore these and other issues surrounding the recognition of elements in the financial statements, in the context of accounting theory and its relevance to practices in financial reporting.

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Revenue recognition issues

Revenue recognition is one of the most important recognition issues, because revenue is generally the largest single recurring item in most financial statements. In addition to this, "issues involving revenue recognition are among the most difficult that standard setters and accountants deal with regularly" (Schipper et al, 2009, p. 55). Also, IAS 18 Revenue states that "The primary issue in accounting for revenue is determining when to recognise revenue" (IFRS, 2010). The recognition of revenue also influences other factors such as the recognition of inventory costs as an expense under IAS 2 (IFRS, 2010). Unfortunately, whilst the FASB's Concepts Statements offer conceptual guidance on the nature and importance of revenue recognition, there is no overarching and authoritative revenue recognition standard in most financial reporting standards or in accounting theory in general. Whilst most Accounting Standards Board, including the FASB and the IASB, offer detailed guidance on recognition, most of this guidance only focuses on specific industry or transaction related issues, and has been mainly developed on an ad hoc basis as new business models and forms of earnings arise (Schipper et al, 2009, p. 55). This can be seen in the annual report of Pearson, which states "Revenue from the sale of books is recognised when title passes. A provision for anticipated returns is made based primarily on historical return rates. If these estimates do not reflect actual returns in future periods then revenues could be understated or overstated for a particular period" (Pearson, 2009).

As a result of the lack of proactive guidance in accounting theory and reporting standards, corporate revenue recognition is regularly identified as one of the top practical financial reporting issues, and the most important recognition issue facing contemporary companies. Indeed, "according to a 2005 study revenue recognition was the accounting issue responsible for over 60% of restatements" (de Mesa Graziano, 2005, p. 28). Among the most common revenue recognition issues encountered are a failure by companies to determine the degree of accounting risk posed by their business models; a failure to establish sound credit and receivable management systems; and a failure to understand the implications of the cash flow statement on revenue recognition. This ultimately resulted in issues when the level of cash collection failed to match the growth in revenues, and bad debt allowances turned out to be inadequate (de Mesa Graziano,, 2005).

This problem is increasingly being exacerbated by the growth of electronic commerce in developed nations. This causes its own revenue recognition issues, particularly due to the practice of bundling electronic goods with subscriptions or other goods. Identifying the individual products or services in such multiple element arrangements can cause significant issues for revenue recognition. Whilst the accounting standard setters have again provided guidance on dealing with specific multiple element arrangements, there is no overarching guidance for electronic commerce in general (DeMark, 2004). With such confusing issues, it is perhaps unsurprising that "a substantial portion of litigation against accounting firms involves revenue recognition issues" (Miller, 2003, p. 1). Whilst many of these issues "result from what appears to be improper accounting treatment of sales recorded in the ordinary course of a client's business" (Miller, 2003, p. 1), implying a degree of falsification, some of them are simply due to misunderstanding the available guidelines, or businesses exercising their ability to stretch the uncertainty in the accounting rules to their own ends.

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In order to attempt to address some of these issues, the International Accounting Standards Board, the IASB, has considered numerous new approaches to revenue recognition, including using the application of assets and liabilities based accounting to determine the recognition of any given revenue (Accountancy, 2003). Specifically, the assets and liabilities approach would focus on the extent to which revenue affected the company's recognised assets and liabilities, on the basis that changes to these are easier to interpret and understand. However, some accountancy practitioners continue to focus on using the point when revenue is earned as the recognition point, despite the confusion that this can cause when multiple streams of revenue are involved. Fortunately, in most cases these different approaches will produce similar results and recognitions, however their different approaches mean that some differences are inevitable, which obviously leaves scope for errors and manipulation. In addition, "both the assets and liabilities approach and the [revenue] approach are dependent on the availability of reliable information about the fair values of assets and liabilities" (Accountancy, 2003, p. 101). Without such information, revenue recognition will continue to be complex, and affected by numerous issues.

Recognition issues around securitised assets

Another major area where recognition issues have been encountered in recent years is in the process of securitisation, particularly the securitisation of various corporate finance assets. In this context, "securitisation involves the carving out of identifiable cash-flows receivable from financial assets of the "originator" and selling the right to receive those cash flows on to a new entity, typically a special purpose vehicle" (White and Hodgkins, 2004, p. 63). In practice, this generally involves a bank securitising the loans it has made to its customers, turning them into a financial instrument in which other parties can invest. These other parties can then purchase parts of these instruments, effectively buying the right to the revenue streams made by the originating company. This has numerous benefits for the originating company, in that it rapidly reduces its own liabilities in the case of defaults, and also helps provide an additional source of finance for the company to invest in more products and financial services provision.

However, for many years now it has been acknowledged that this process of securitisation creates its own specific issues around the recognition and measurement of the assets, liabilities and revenue streams that result from them. Even as early as the 1980s, millions of loans that had previously been recognised as assets and liabilities on the balance sheets of major banks had been converted into securities and sold to other parties (Swieringa, 1989). Initially, this process focused on residential mortgage backed securities, which were relatively liquid and easy to understand. However, in more recent years other types of loans, "including car loans, commercial mortgages, credit cards, lease receivables and even insurance policy loans have been securitized" (Swieringa, 1989, p. 169). Such a wide range of securitised assets are in circulation in global financial markets that they have raised many accounting recognition and measurement issues. As with revenue recognition for complex and multi stream sources of revenue, many of the issues arise because the numerous ways of structuring transactions to securitize assets are not covered in existing accounting literature or accounting standards, whilst others occur because the literature and standards have conflicting guidance when applied to securitisation. Indeed, this is further complications by the fact that some securitisation can actually be used to raise cash from loans which have a cost higher than their market value without a loss being recognised under standard accounting conventions (Swieringa, 1989). As such, whilst securitisation doesn't create as many issues as revenue recognition, these issues can arguably be more serious, as reflected in the numerous changes and amendments to IAS 23, IAS 36 and IAS 39 over the years, largely in response to the recent issues around securitisation (IFRS, 2010).

Indeed, in recent years the issue of the accounting recognition of securitised assets has come to the forefront of contemporary attention, with the impact of securitisation on the global financial crisis. During the financial crisis, systemic risk elements led to a crisis in the subprime mortgage backed securities market in the United States into a major worldwide financial crisis, in spite of the fact that accounting conventions and systems should have acted to prevent this (Hellwig, 2009). Two main recognition issues emerged from this system. Firstly, the accounting system did not include any methods for recognising the maturity transformation impact of these securities. In particular, many banks and businesses relies on being able to continually roll over their loans, whilst recognising them on their balance sheets as less risky long term assets and liabilities, due to the flexibility allowed when making provisions under IAS 37. As such, when the maturity transformation conduits broke down in August 2007, large amounts of what were reported as long term liabilities rapidly turned into short term liabilities that banks were unable to honour, necessitating huge government bailouts. In addition to this, "as the financial system adjusted to the recognition of delinquencies and defaults in US mortgages and to the breakdown of maturity transformation of conduits and SIVs" (Hellwig, 2009, p. 129), current recognition practices forced the banks to recognise massive losses from marking their products to market, i.e. to the current market price. This meant that banks had to recognise large paper losses without actually losing significant amounts of money, thus harming their balance sheets significantly and making it harder for them to lend, causing the so called 'credit crunch' (Hellwig, 2009). Whilst the case of the recognition of securitised assets is somewhat unique due to its severity and the global impact it has caused, it nevertheless aptly demonstrates the range of issues that can be encountered when attempting to recognise transactions which have no well defined recognition basis in accounting. Indeed, similar issues can exist when using derivative financial instruments, which Thomas Cook (2009, p. 74) recognises as a source of accounting risk.

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Other recognition issues

Another important recognition issue, and one which ties into the discussion above about a lack of clarity around the basis for recognition, is that different financial reporting standards and accounting principles often imply different recognition bases. For example, Iatridis (2010, p. 193) discusses the impact of "the adoption of the International Financial Reporting Standards (IFRSs) in the UK and concentrates in the switch from the UK GAAP to IFRSs". According to the results of this study, switching to IFRS helps to reinforce accounting quality partly due to the need for more timely revenue and loss recognition than GAAP. However, whilst the UK has switched to IFRS, many other countries including the US continue to use their own GAAP. This implies that not only is there always likely to be the potential for earnings manipulation through different recognition methods, but also that the potential for manipulation is likely to vary across countries (Iatridis, 2010), particularly for international companies such as BP (2009, p. 59) which discusses the "Non-GAAP information on fair value accounting effects". This can also be seen in the case of IAS 12, which has been amended to allow recognition of tax losses as an asset, in contrast to financial reporting standards in other nations, and IAS 19 which has very specific requirements for the recognition of employee benefits (IFRS, 2010), thus causing British American Tobacco to restate some of its 2008 accounts. This obviously raises the question of how comparable financial accounts can be across different countries, when there is different potential for manipulation and different recognition standards across these countries. For example, the change to IFRS in the UK allowed WM Morrison to state that "Current tax is charged in the income statement, except when it relates to items charged or credited directly in equity in which case the current tax is reflected in equity" (WM Morrison, 2010).

Indeed, some of these issues were seen in the UK's Financial Reporting Exposure Draft, issued as part of the attempt to converge UK accounting standards with International Financial Reporting Standards. This draft specifically commented on the need to revise IAS 39 "Financial Instruments: Recognition and Measurement" in order to ensure that UK companies would continue to account for their recognition in a consistent way after the implementation of the IFRS in the UK (Accountancy, 2002). The lack of consistency is also shown in the accounts of Berkeley (2009, p. 82) which state that "Note ii: 2005 is presented under UK GAAP for comparison purposes. The main adjustments that would be required to comply with FRS would be those set out in Note 29 to the Group Financial Statements in the 2006 Annual Report, including the impact of IAS 18 "Revenue recognition"". The fact that the company's entire accounts had to be restated and adjusted to comply with different accounting standards and revenue recognition requirements implies that there are significant differences in the recognition bases of both sets of accounting standards, and this will cause issues for people looking to compare revenues from companies using the different standards.

Another important issue is the fact that, in order to ensure that their annual report and accounts more fully represent their current financial situation, companies are increasingly looking to measure and disclose the value of their intangible assets on their balance sheets, such as the value of Unilever's (2009) numerous brands. In particular, companies generally look to recognise the goodwill them acquire from purchasing companies, as well as to capitalise some of their major expenses such as research and development expenditure. In the case of, Berkeley (2009, p. 64), goodwill is the main intangible asset which the company has reported: "The goodwill balance relates to the acquisition of the 50% of the ordinary share capital of St James Group Limited that was not already owned by the Group. The acquisition was completed on 7 November 2006 and resulted in the recognition of goodwill of £17,159,000. The goodwill balance is tested annually for impairment". Similarly, Rio Tinto (2009, p. 19) notes that "The Group will continue to test goodwill and may, in the future, record additional impairment charges. This could result in the recognition of impairment provisions (which are non cash items) that could be significant and could have an adverse effect on the Group's reported results". The recognition and annual impairment of goodwill is another recognition issues that can be highly controversial, with AOL Time Warner famously having to report a goodwill impairment of $54 billion in 2002, having failed to recognise the impairment of this goodwill in previous years (Shook, 2002). Similar issues could occur when companies look to capitalise the research and development expenditures, as GlaxoSmithKline (2009) and AstraZeneca (2009) attempt to do; or capitalise the value of long term construction contracts under IAS 11 (IFRS, 2010) and often recognising too high an amount in an attempt to avoid reporting large losses. Whilst official regulation and voluntary self regulation have helped to address many of these issues, and prevent them from recurring, the recognition of intangibles is another area that includes plenty of scope for recognition issues (Dedman et al, 2009, p. 312).

The final issue that this essay will discuss is the difference between recognition and disclosure, and the implications of this for financial reporting. Whilst recognition involves the formal reporting of an item in the main body of the financial statements, disclosure involves reporting the same information in the footnotes to the financial statements, where it is less likely to be seen as important by users of the information. Under IAS 16 and IAS 20, this can be used to account for any government grants that may reduce the carrying value of a property asset (IFRS, 2010). According to Beattie et al (2000) the main issue in this area is that, as the rules around recognition are progressively tightened, more and more companies look to get around the rules by relying on disclosures instead of recognition. As a result, "The sheer volume of disclosures found in modern financial reports has resulted in concern being expressed that disclosure overload is occurring, whereby critical disclosure information is being obscured" (Beattie et al, 2000, p. 1185). This primarily occurs when dealing with intangible assets and liabilities such as operating leases, as discussed under IAS 17 Leases, but also when disclosing accounting methods used to value joint ventures under IAS 31 (IFRS, 2010). As these represent a significant financial obligation for a large proportion of companies, by disclosing them in the footnotes rather than recognising them in the accounts, companies can avoid revealing quite how large their liabilities are. This in turn can help improve the balance sheet and boost the apparent value of the company.

Conclusion

In conclusion, the main contemporary issues surrounding the recognition of elements in the financial statements focus on the recognition of revenue, and the recognition of securitised assets. Whilst the recognition of securitised assets is only a main issue at the moment due to its role in the credit crunch, it could potentially relate to the recognition of any asset or set of cash flows where the accounting theory and practice does not require the company to consider all details. In the case of the securitised assets, the duration of the securitisation, and the need for regular maturity transformations, caused many of the issues. In terms of revenue recognition, the nature of revenue, its importance to the company and the numerous ways in which it can be achieved means that there is scope for companies to either make genuine mistakes, or to deliberately over or under report their revenue in certain periods. Other issues include a lack of consistency in recognition across different reporting standards, the recognition of intangible assets, and conflict between recognition and disclosure in the financial statements.