The main concerns with the accounting policies of revenue recognition

Published:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

This assignment explores the main concerns related to the accounting policies of revenue recognition, regulated by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), as well as their subsequent efforts to adopt a joint approach towards a more consistent accounting treatment. The IASB, founded in 2001 as the standard-setting successor of the International Accounting Standards Committee (IASC), is responsible for ''developing, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require transparent and comparable information in general purpose financial statements'' [1] . These accounting standards are designated International Financial Reporting Standards (IFRS). The FASB, on the other hand, established in 1973, is the respective U.S. private, not-for-profit organisation committed to generating Generally Accepted Accounting Principles (GAAP) used for financial reporting purposes. Both regulatory bodies are cooperating closely and have, in many instances, designed an agenda of convergence in order to solve the discrepancies inherent in their accounting standards, as in the case of revenue recognition which will be examined in the course of the assignment.

Revenue recognition refers to the process a company uses to record its revenues and match them to the related expenses. This process, although it is easy to implement in simple transactions that involve customers buying goods or services using cash or credit, it often becomes complex depending on the terms of payment, e.g. a construction company working on a project that will take more than one years to complete. The existing accounting standards, IAS 18 Revenue under IFRS and Accounting Standards Codification (ASC) 605 Revenue Recognition of the FASB are trying to address these issues.

Under IAS 18, revenue is ''the gross inflow of economic benefits (cash, receivables, other assets) arising from the ordinary operating activities of an entity (such as sales of goods, sales of services, interest, royalties, and dividends)''2. Any item considered revenue should be added in the income statement if it satisfies the following conditions:

Its amount as well as the associated costs (incurred and remaining) can be reliably measured

It is probable that it will be received by the firm

The stage of completion can be determined

In general, under US GAAP, revenue must be both earned and ''realised'' (or ''realisable'') before incorporated in the financial statements and this happens when the following criteria are met:

There is persuasive evidence of the transaction

Delivery of goods or services has taken place

The sale price is fixed or determinable

Payment is assured (or there is ability to estimate its probability)

Despite the fact that both FASB and IASB use similar accounting standards that involve specific criteria needed to be met for an item to be recognised as revenue, they present significant differences making revenue recognition an ambiguous process.

One of the main problems of the FASB ASC is the content and complexity of the guidance. US GAAP still includes many different revenue rules, many of which are industry specific. Therefore, it is not rare for a firm to refer to different sections of the code in order to determine the revenue principle that should be applied to a transaction; a problem exacerbated when conflicting results arise from economically similar transactions. Furthermore, apart from the real estate and financial services industries which are specifically regulated, others lack specific guidance. As a result, entities have difficulties in choosing between the rules that should be applied in each case of revenue recognition.

Conversely, IFRS provide a single standard containing general principles, IAS 18, making it, theoretically, easier for the firms to put it into use. Nevertheless, in practice many users have experienced problems in its implementation to more complex transactions involving multiple components. The source of the problem lies in the fact that, even though the standard requires from a component to have a commercial substance in order for its revenue to be recognised (otherwise all components are recorded as a single transaction), it does not specify the criteria for making such a determination.

Moreover, analysing the differences between the two aforementioned accounting standards and the subsequent problems created, it is worth to mention the deviating approaches they follow in cases where construction contracts are used. Under both standards, if certain conditions are met, the percentage-of-completion method is applied, that is revenues and expenses are recorded each year based on the degree of the work performed. Alternatively, US GAAP necessitate the use of the completed contract method, not permitted by IFRS (IAS 11) stating that only recoverable costs should be considered. The complete contract method implies that revenues and expenses from a contract cannot be reported in any other year apart from the one the contract is concluded.

The ambiguity associated with the use of the existing standards underlined the need for a more robust framework, designed to surpass all weaknesses and inconsistencies and bring clarity in the field of revenue recognition. In pursuit of this objective, in October 2002, FASB and IASB decided to cooperate towards the delivery of a single revenue recognition model. As a result, in December 2008 they issued discussion papers with the title "Preliminary Views on Revenue Recognition in Contracts with Customers" to make an introduction of the approach they intended to follow and, eight years after, they presented a draft of their project and held a period, during which the draft was subject to comments and discussion that ended in October 22, 2010.

The main principle underlying the proposed joint revenue recognition model is that a firm should recognise the revenue on transfer of goods and services to clients at a transaction price reflecting the amount the firm receives (or expects to receive) for the goods or services provided. In other words, the principal questions the boards are trying to answer concern the timing and amount of revenue recognition that should take place in each case and, thus, they identify a set of specific steps that every entity using this model should follow:

Determine the contract(s) it has concluded with every client

Determine and segregate performance obligations in the contract

Decide upon a transaction price and assign it to the distinct performance obligations

Record revenue when each performance obligation is satisfied

This new joint approach differentiates itself from the current rules in that revenue recognition is based on changes in the balance sheet, i.e. increases in an entity's net position arising from the satisfaction of contractual obligations, -not on the income statement- and, if adopted, it will impact several industries. For example in the case of construction contracts, as long as there is continuous transfer of goods on which customers have control, continuous revenue recognition policies will have to be followed. Otherwise, the complete contract method will be applied. Apart from the construction industry, agriculture will also be influenced, as, in contrast to today's standards, an increase in the inventory value, even without a contract, will not be considered a source of revenue anymore. Revenue will be recognised only when the firm has met its contractual obligations with its customers. Regarding the transactions affected, the revenue from post-delivery services such as warranties is deferred and recorded only after the entity's performance obligations are met. Also, under the new rules, enhanced separation of multiple elements can be achieved.

Developing a model that could be consistently applied across all entities, industries and geographical areas and therefore improve comparability was the principal boards' objective. Also, the project would simplify the preparation of financial statements, enhancing at the same time the understandability of the revenue recognition process for the financial statement users. Commenting on the draft, Sir David Tweedie, chairman of the IASB, affirmed that comparability of the financial statements and clarity regarding the revenue recognition process are what the project attempts to achieve and invited every party affected by the new guidance to express its views. He appeared confident that, although not all details and answers are sorted out completely, the board is following the right path. On the other side of the deal, Robert Herz, chairman of the FASB, in his announcement pointed out the importance of the new standards in resolving existing inconsistencies and reducing complexity and stressed out the boards' unanimous agreement to proceed with the project.

I believe that the introduction of a single revenue recognition model is the first step towards overcoming most of the inefficiencies related to the current standards. The universal character of the model is undeniable, as it incorporates all contracts with customers, even though the inclusion of leasing, insurance and financial contracts is still being considered. However, these new measures are not without cost. The proposed amendments require a high degree of detailed information to be incorporated in the revenue recognition process; information which might often seem incomprehensible to the financial statement users. Moreover, preparing its financial statements according to the new guidance might be time-consuming for an entity and therefore costly. Also, even though calculating a price based on the probability of the transaction to be performed is sound, however, other alternatives e.g. the Best Execution Methodology might produce better results if applied under certain scenarios. At last, a ''one size fits all'' approach might not represent the best policy to be followed taking into account that, after all, entities operate in very complex global markets and that generalisations of this kind are impossible to prove completely effective.

To sum up, revenue is a crucial figure used by the financial statement users to assess a company's performance. This is why an accurate revenue recognition process is of significant importance. The boards' efforts to come up with a common approach are a critical first move towards the achievement of this objective. Yet, despite their claim that the similarity of the proposed model to many of the existing rules will facilitate its implementation as some transactions are not affected by its proposals, there are lots of details needed to be arranged for the project to be finalised. Ultimately, we should not forget that revenue is the number one element of the financial statements susceptible to manipulation and, therefore, both IASB and FASB should be extra cautious when dealing with the sensitive issue of revenue recognition.

Writing Services

Essay Writing
Service

Find out how the very best essay writing service can help you accomplish more and achieve higher marks today.

Assignment Writing Service

From complicated assignments to tricky tasks, our experts can tackle virtually any question thrown at them.

Dissertation Writing Service

A dissertation (also known as a thesis or research project) is probably the most important piece of work for any student! From full dissertations to individual chapters, we’re on hand to support you.

Coursework Writing Service

Our expert qualified writers can help you get your coursework right first time, every time.

Dissertation Proposal Service

The first step to completing a dissertation is to create a proposal that talks about what you wish to do. Our experts can design suitable methodologies - perfect to help you get started with a dissertation.

Report Writing
Service

Reports for any audience. Perfectly structured, professionally written, and tailored to suit your exact requirements.

Essay Skeleton Answer Service

If you’re just looking for some help to get started on an essay, our outline service provides you with a perfect essay plan.

Marking & Proofreading Service

Not sure if your work is hitting the mark? Struggling to get feedback from your lecturer? Our premium marking service was created just for you - get the feedback you deserve now.

Exam Revision
Service

Exams can be one of the most stressful experiences you’ll ever have! Revision is key, and we’re here to help. With custom created revision notes and exam answers, you’ll never feel underprepared again.