Issues surrounding recognition of elements in financial statements

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In this essay I will discusses and explores the issues surrounding the recognition of elements in the financial statements, in the context of accounting theory and its relevance to practices in financial reporting. Recognition is defined in the IASB framework as "the process of incorporating in the balance sheet or income statement, an item that meets the definition of an element and satisfies the criteria for recognition" (Alan Melville 2009). According to the FASB, Statement of Financial Accounting Concepts No. 5 Recognition and Measurement in Financial Statements of Business Enterprises, "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. Recognized item is depicted in both words and numbers, with the amount included in the statement totals" (FASB, 2008). After it has been correctly incorporated into the financial statement, then it will be measure against the four different measurement bases to get a value for the item. "Measurement is the process of determining the monetary amount at which an element is to be recognised and shown in the financial statements" (Alan Melville 2009). Therefore, during the process of recognition, first the item will be recognised which part of the financial statement it belong to and then, it will be reliably and relevantly measured for the purpose of reporting to all users of that financial statement. Unfortunately, this concept has a massive drawback, when some of the items are being recognised are not well defined enough to give a clear instruction on the recognition, and which will lead to interpretation by managers and accountants. After the Enron scandal, it still remains uncertain, especially considering revenue recognition.

Revenue recognition

First of all, what is revenue? Revenue is "the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants", according to IAS18 (IFRS 2010). "Issues involving revenue recognition are among the most difficult that standard setters and accountants deal with regularly" (Schipper et al, 2009). Out of all recognitions, revenue is one of the most important recognition; due to it is the largest amount item on most financial statements.

IAS18 shall be applied in accounting for revenue arising from the following transactions and events: sale of good, rendering of services and interest, royalties and dividends. "The primary issue in accounting for revenue is determining when to recognise revenue" IAS 18 Revenue stated (IFRS, 2010). Different recognition criteria will apply depending on the transactions.

Tesco is a well known Retail Company, we can see from the Annual report of Tesco, which states for retail (sale of good) "Revenue consists of sales through retail outlets. Revenue is recorded net of returns, relevant vouchers/offers and value-added taxes, when the significant risks and rewards of ownership have been transferred to the buyer. Relevant vouchers/offers include: money-off coupons, conditional spend vouchers and offers such as buy one get one free (BOGOF) and 3 for 2" (Tesco 2010). As you can see from above, recognising revenue at the point of sale of goods is very straight forward. As for rendering of service, revenue can be recognise when the service have been performed by the end of reporting period and also can be reliably measure. Here is an example, as Thomas Cook annual report states "Revenue represents the aggregate amount of gross revenue receivable from inclusive tours, travel agency commissions receivable and other services supplied to customers in the ordinary course of business. Revenue and direct expenses relating to inclusive tours arranged by the Group's leisure travel providers, including travel agency commission, insurance and other incentives, are taken to the income statement on holiday departure. Revenue relating to travel agency commission on third party leisure travel products is also recognised on holiday departure. Other revenue and associated expenses are taken to the income statement as earned or incurred. Revenue and expenses exclude intra-group transactions" (Thomas Cook 2009). Lastly, when recognising revenue for interest, royalties and dividends, IAS18 states there are three bases need following; "interest is recognised using the "effective interest method", royalties are recognised on the accruals basis and dividends are recognised when the shareholder's right to receive payment is establish" (IFRS 2010). This can be seen in the annual report of Lloyds TSB, which states "Interest income and expense are recognised in the income statement for all interest-bearing financial instruments, except for those classified at fair value through profit or loss, using the effective interest method. The effective interest method is a method of calculating the amortised cost of a financial asset or liability and of allocating the interest income or interest expense over the expected life of the financial instrument. The effective interest rate is the rate that exactly discounts the estimated future cash payments or receipts over the expected life of the financial instrument or, when appropriate, a shorter period, to the net carrying amount of the financial asset or financial liability" (Lloyds TSB 2009)

"According to a 2005 study revenue recognition was the accounting issue responsible for over 60% of restatements" (de Mesa Graziano, 2005). Due to the lack of clear instructive guidance in financial report standards, revenue recognition is always knows as one of the biggest financial reporting problems, and also the biggest financial reporting problem that business and companies are facing nowadays. With the growth of technology and new business models entering the economy, it causes revenue recognition issue in the digital business. Especially when company bundles multiple revenue-generating activities into a single transaction, when it comes to unbundle each of the product or service in the multiple items transaction can cause a major issues in revenue recognition. (DeMark, 2004)

Other recognition issues

Across the globe, companies in different countries use different financial standards and accounting principles, which often have different recognition bases. This is a major issue where users of the financial statements often will not be able to compare the accounts against other businesses' accounts. For example," with the UK switching from UK GAAP to IFRS, meanwhile other countries like the US who still carry on use their own accounting standards and principles. Iatridis (2010) 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". From the result of the study, it was shown that changing from UK GAAP to IFRS helps to improve the quality of accounting and recognition because of the extra time that is needed is far more than the UK GAAP. With the companies switching to IFRS, there are some major changes in the standard, for example we look at Deloitte an international accounting and consulting firm, which states "the change of GAAP may result in changes in the timing and amounts of cash tax payable" (Deloitte) For example, "the default useful economic life for goodwill is 10 years within IFRS for SMEs this could accelerate tax deductions compared to existing UK GAAP and IFRS". Under the provisions of IAS 38 Intangible assets "amortisation is prohibited and the directors must undertake an impairment review on an annual basis."(IFRS 2010). Under SSAP 9 Stock and long term contract companies can adopt the use of last in first out (LIFO) for stock valuation, whereas IAS 2 inventories states LIFO is not permitted. As for operating profit, under IAS 1 presentation of financial statement operating profit is not required in the financial statement, but the entity may choose to report it. In the cash flow statement, due to the switch to IFRS there are few notable changes between the two. It used to prepare under eight heading, whereas under IAS 7 Cash flow statement, it only needs to prepare under three heading: operating activities, investing activities and financing activities, and states "reconciliation of movements in cash flows to movements in net debt' is not required". Another major change is deferred taxation, under IAS 12 Income taxes a company cannot discount its deferred tax to present day values and deferred tax is recognised on the basis of 'taxable temporary differences." (IFRS 2010) Here is an example of what happened to WM Morrison with the switch to IFRS, which allowed WM Morrison to state "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). Another example, British American Tobacco has to adjust their 2008 report due to the switch of accounting standard.

Securitisation is another major recognition issue that occur in recent years. "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). Never the less, it is well known for this process of securitisation over the years, it creates its own recognition and measurement issues in the financial statements. Comparing to revenue recognition, securitisation has not got as much issues, but the issues are far more serious than the revenue recognition, due to the numerous amendments and adjustments to IAS 39 Financial Instruments: Recognition and Measurement, IAS 36 Impairment of Assets and IAS 23 Borrowing Costs through the years (IFRS 2010)

The last issue that will be discussing in this essay is the difference between disclosure and recognition. First of all, recognition involves the reporting of an element in the context of financial statements; on the other hand, disclosure reports that exact same element in the footnote of the financial statements, which seems to be less useful and important to the end users of those statements. Under IAS 16 Property, Plant and Equipment and IAS 20

Accounting for Government Grants and Disclosure of Government Assistance, (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. Therefore, "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)


In conclusion, the major issue in the recognition of elements in financial statements is the revenue recognition, with 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, which means there are always loopholes in the standard because it is only a guidance not a clear definite rule of the standard, it will keep being change and adjust in the fore coming years. Other issues include a lack of consistency in recognition across different reporting standards and countries, the recognition of intangible assets, securitisation, and conflict between recognition and disclosure in the financial statements.