The Basic Purpose Of Accounting Standards Accounting Essay

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Revenue recognition is one of the most debated issues in the context of Financial Reporting. Revenue is the proceeds that a business generates by selling goods or providing services. It is the first figure that appears in the income statement of a company. This is also one of those figures whose manipulation can dramatically change the outlook of the company's performance during the year. Before going into the details of Revenue recognition and the limitations of accounting standards in this regard, it is essential to identify the basic purpose of accounting standards. According to Mohapatra (2007), accounting standards serve the purpose of internationally reducing the differencing in treatment of financial transactions and their reporting in financial reports. Therefore, it is established that accounting standards aim to create uniformity in accounting treatment around the globe. Another purpose of these standards as per Walton and Aerts (2006) is the role that ensures the true and fair view of the financial statements as per the requirements of International Accounting Standard Board's Framework for Internal Accounting Standards.

The standard addressing the measurement and recognition criteria of revenue is IAS 18 (Revenue). This standard was effectively applied from 1st January 1984 as a result of exposure draft issued during 1982. The standard was revised during 1995 and ever since it is in effect with some later minor changes. (IASPLUS 2011) According to this standard, revenue is recognized on the matching or accrual concept. This means that income is recognized n the period in which it is earned regardless of when the cash is received. According to IAS 18, revenue is only recognized when the following conditions are met;

The selling party transfers all the risks and rewards associated with an item to the buying party.

The selling party loses control and managerial involvement in the item.

The sum of revenue can be determined dependably.

There is a probability that the economic benefits attached to the transactions will stream towards the selling party.

The cost of selling the item can be measured with reliability.

The same rules are applied to recognize revenue associated with the provision of services, however, with one extra consideration as follows;

At the date of balance sheet, the stage of completion of the service contract can be reliably estimated.

(IASPLUS 2011)

The Limitations of IAS 18

The essence of revenue recognition and IAS 18 in particular, nourished during the era of 1950 to 2000 during which time the financial reporting was majorly profit focused. After IASB took over the responsibility of formulation of standards, the focus shifted to positional reporting, i.e. Assets and Liabilities. Beside such a change in approach of IASB, the recognition of revenue and hence IAS 18 remained to be on performance basis.

Interpretative Nature of IAS 18

The recognition of revenue causes issues due to the timing difference of initiating the sale agreement and its termination. This difference of time, requires the seller to apply the provisions of IAS 18 in order to decide the time and amount of revenue to be recognized. The basic principle followed by IAS 18 is that revenue should be recognized when it is earned, and receiving cash does not simply represent the revenue is earned. Therefore for many organizations, the recognition of revenue becomes a major issue. An example can be of a telecom company providing mobile telecom services. The company only provides prepaid services, which means that the consumers have to purchase and load a card into their SIM to use the services. Now the problem for this telecom company is, "when the revenue should be recognized?" There are three instances which might confuse the company in this regard, which include the time when the customer purchases the card, the time when the customer loads the card, or the time when customer uses the balance loaded. Following the rules of IAS 18, revenue should be recognized when it is earned, i.e. when the risks and rewards of ownership are transferred to the buyer and there is no managerial control left on the asset. Considering this principle, the risk and rewards are transferred when the customer buys the card if the card is not refundable. However, it can also be argued that revenue is earned when the customer loads the card. Another argument can be that revenue should be recognized when the customer actually uses the balance loaded through the card as this the time when the revenue is practically earned. Therefore, the seller has to interpret the provisions of IAS 18 and recognize revenue based on that interpretation. This leads to differences as every decision maker can conclude on a different time out of the above three options to recognize the revenue. This interpretative nature of IAS 18 is considered to be a limitation of this standard. (Jones 2010)

Limitations in US GAAP

Due to the interpretative nature of IAS 18 and the differences in the nature of revenue transaction in every industry, US GAAP provides more than 100 standards and principals on the recognition of gains and revenue. The major reason for such large number of standards related to revenue is the fact already stated that every industry has a different nature of revenue transaction. For example for the telecom companies such as mentioned above, US GAAP provides a different standard for the recognition of revenue whereas for a company providing broadcast services, the standard to recognize revenue is different. However the dilemma is that besides such a diverse number of standards on revenue, there remain many gaps in the guidance of these standards particularly related to the recognition of revenue associated with provision of services (Sunil and Xiao-Jun 2002)

Limitations in UK GAAP

Although, IFRSs have quite fewer standards on Revenue as compared to US GAAP, but there is still great room for improvement in them. The major issue with UK GAAP same as US GAAP is that the users of the financial statements cannot be ensured that the Revenue presented in the financials of the company is representing the true economic performance. The huge potential for manipulation in this area is also considered to be due to the fact that the standards have not yet been able to come up with a good solution for revenue recognition.

UK GAAP allows a company to continue recognizing its inventory as its asset even after the control associated with them is transferred to the buyer. The ground for such a treatment is provided by the standard itself which says that an inventory is not sold unless the risk and rewards are transferred. This statement and treatment is not consistent with the definition if asset given in the Framework. An asset as pre the definition in the framework is only recognized when the control is present on it; however in a scenario when the control is transferred to the buyer but still the company is recognizing the inventory as its assets, the treatment is totally against the recognition criteria of asset.

Another area where the limitations of UK GAAP and IFRSs are identified is where the transaction involves the selling of goods and the associated provision of services. An example can be a case when the company sells a plant and agrees to provide the services of its installation. In this scenario, there are two streams giving rise to revenue and therefore the revenue should be recognized when it is earned from each stream. However, it is quite possible that the seller might recognize the total revenue when the contractual part of selling the plant is realized even though the services are yet to be provided. Again the timing difference is the causing the anomaly by creating room for manipulation (Axel and Maria 2005).

Another area, where there is a lack of guidance is related to transactions involving the transfer of more than one item or service. Although IAS 18 recognizes this situation and states that such transactions should be dealt according to economic substance of them, but the statement remains very general. Therefore, IAS 18 again leaves the decision to be made by the companies to interpret the standard and recognize revenue in transactions involving multiple commodities. Furthermore, the standard fails to provide guidance regarding the measurement criteria of items in a multiple commodity transaction. Therefore the officials of the company have to adopt a measurement criterion themselves and value the items which lead to differences and decrease the comparability of the financial statements (Axel and Maria 2005)

Distinction between IAS 18 and IAS 11

IAS 11 Construction Contract is related to the recognition of revenue and gain associate with the provision of construction services. There is a significant clash within the criteria of recognizing the revenue between IAS 11 and IAS 18. As per IAS 11, revenue can be recognized as and when a particular activity is performed. This is regardless of the provision of IAS 18, according to which revenue is recognized when the entity transfers risks and rewards of ownership. Therefore IAS 11 does not require the company to ensure the provision of transfer of risk and rewards of ownership as according to it, revenue is recognized when the company fulfills a particular activity as per the contract. This difference in the two revenue standards highlights the weakness of UK GAAP and US GAAP to standardize the revenue recognition criteria (Jürgen 2005)

A solution for the Problem

The basic purpose of accounting standards as identified earlier is to harmonize the accounting environment and increase the comparability feature of the financial statements. Another purpose of these standards is to ensure that the companies present in different jurisdictions and under different regulations, prepare their financial reports based on a uniform set of standards so that the reporting of individual as well as consolidated financial statements becomes easy. Moreover, the increasing concept of global village and globalization move of the enterprises makes these standards the need of time.

However, IAS 18 has been seen to be unable to meet the basic purpose of creating the uniformity as there are considerable differences it the recognition of revenue according to this standard and other revenue standards and moreover, IAS 18 fails to provide enough guidance on several areas. Another weakness of IAS 18 identified is the inability to be in consistence with the guidance in framework.

The solution for the problem is that FASB and IASB should devise a revenue recognition method that can act as a main principle for recognizing the different revenue transactions. For this purpose the first step that the two boards should take is to introduce the performance based approach in recognizing the revenue. The performance based approach means that revenue should be linked with the concept of assets and liabilities. According to this concept, every sale transaction gives rise to an asset as well as a liability. The asset is the right to receive cash and the liability is to comply with the contract and provide goods or services. As per the performance based approach to revenue recognition, the company should only recognize the revenue when the asset i.e. the cash is realized and it happens when the associated liability is settled i.e. the goods or services are transferred. The realizing of asset and the discharge of liability is an inter-bundled concept and the revenue should be recognized when both are settled. Similarly the standard should provide guidance on every aspect of the transaction to make it less interpretive and more practical.

IASB and FASB should try to unite all the revenue standards into a single set of guidance that provides a comprehensive solution to all the different sorts of revenue streams. This will solve the comparability problems for the company and their auditors and enhance the true and fair presentation of financial performance and position of a company to its stakeholders. The investors' confidence will increase in the financial statements as there will be lesser rooms for manipulation.