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Revenue Recognition
The higher the quality of financial reporting, the more useful the information will be for
business decision making. Qualitative as well as quantitative components should be considered
when analyzing earnings for an accounting period. An earnings figure should be developed in
order to reflect the future ongoing development of a firm. “This process requires a consideration
of qualitative factors and necessitates in some cases, an actual adjustment of the reported
earnings figure” (Giordano, 2011).
The quality of financial reporting issues often affects more than one financial statement.
Therefore, the quality of the information on the Balance Sheet and the Statement of Cash Flow’s
is equally important. Some items that affect earnings quality are:
Sales = Premature revenue recognition, Allowance for doubtful accounts
COGS = Cost flow assumption for inventory, Loss recognition on write downs of
inventories
Operating expenses = Discretionary expenses, Depreciation, Reserves
Non-operating Revenue & Expenses = Gains (losses) on sale of assets, interest income,
income taxes
Other Issues = Material changes in number of shares outstanding, operating earnings-aka
EBITDA
This list does not include everything that effects earnings quality. These examples are
qualitative issues most commonly encountered in financial statement data. When it comes to
premature revenue recognition, Generally Accepted Accounting Principles (GAAP) says
“revenue should not be recognized until there is evidence a true sale has taken place” (PWC,
2011). This evidence would include delivery of the product, title being passed to the buyer,
services were rendered, the price was determined, and collection expired. Firms violate this
policy by booking revenue before any of these examples have occurred (PWC, 2011).
A clue to a violation may be a change in the revenue recognition policy which can be found
in the financial statement notes. Analyzing the relationship among sales, accounts receivable
and inventory can be a way of ensuring revenue has been reported in a timely fashion. If the
three do not move in comparable patterns, there may be a possibility the booking of revenue has
not been reported correctly. “Another issue that could be a miss-representation and a sign that
premature revenue has been booked could be a firm who reports fourth quarter spikes in sales.
Another tactic to boost revenue is to record sales at the gross rather than the net price. “Gross”
refers to the total amount the final customer pays for an item. “Net” refers to the gross amount
less the cost of the sale, which equals the fee that is paid to the reseller of the item” (Giordano,
2011).
There are many things that could affect revenue. For example, “accounting choices and
estimates have a significant impact on the financial statement numbers” (NASBA). The
valuation of inventory and whether they use first in first out (FIFO) or last in first out (LIFO)
affects both the amount of inventory on the balance sheet and the associated cost of selling
inventory in the income statement. “Comparability can be affected with companies in the same
industry because of these different choices. The quality of financial reporting can also be
impacted if the choice does not reflect economic reality” (Giordano, 2011).
GAAP based financial statements are based on accrual rather than the cash basis. Revenue is
recognized in the accounting period when the sale is made rather than when the cash is received.
The expense associated with the product may occur before or after the cash is paid out. The
accrual method attempts to match the revenue with the expenses in the appropriate accounting
periods which require estimation and judgment. Like inventory, this affects the financial
statement numbers. According to Professor Giordano, “A firm has a continuous life but financial
statements are prepared on certain dates at the end of accounting periods, such as year or quarter
and the financial data must be appropriated to particular time periods” (Giordano, 2011).
The future of Financial Statements is unknown for the US. “US rules are more complex than
international rules developed by the International Accounting Standards Board (IASB)” (PWC,
2011). IASB tends to develop rules with a significant amount of detail, whereas the Financial
Accounting Standards Board (FASB) has a broader principles approach. GAAP and IASB have
agreed on some rule changes but there are still controversial issues that are not resolved.
Changes include lease accounting, classification of financial instruments, inventory accounting
and revenue recognition. An important project also consists of reforming the financial
statements. A proposal has been made public but nothing has been decided yet. If changes are
implemented the financial statements will look different than current GAAP. According to the
Revenue Recognition article, “Management has considerable discretion within GAAP. Potential
exists for manipulation to the bottom line and other accounts. Financial statements should reflect
an accurate picture of a company’s financial condition and performance in order to assess the
past and predict the future. Many opportunities exist to affect the quality of financial statements”
(Revenue Recognition, 2011).
For example, the timing of reporting revenue and expense recognition could affect the quality
of financial statements. “The matching principle is where expenses are matched with the
generation of revenues to determine net income for an accounting period” (Revenue
Recognition, 2011). Like accrual, revenues are recognized when earned and expenses are
recognized when incurred. According to Professor Giordano, “Judgments are made by
management regarding the timing of expense and revenue recognition since the accounting rules
are not always precise. For example, when will an uncollectible accounts receivable or obsolete
inventory be written off? The more conservative management is in making these decisions, the
higher the quality of earnings resulting from the matching of revenues and expenses in a given
time period” (Giordano, 2011).
Another example of where the quality of the financial statements can be manipulated could
be discretionary items. Expenditures are discretionary in nature. Management controls the
budget level and timing of expenditures such as repair and maintenance of machinery and
equipment, marketing and advertising, research and development (R&D) and capital expansion.
Policies are flexible when replacing plant assets, development of new product lines, and the
disposal of an operating division. These discretionary items have an immediate and long term
impact on profitability perhaps not in the same direction. Such as, a company may defer
maintenance to boost current period earnings. Advertising, marketing expenditures and R&D are
essential to gaining and maintaining market share in some industries. (Computers, electronics,
health and auto.) “These policies should be scrutinized by the analyst with respect to
discretionary items through an examination of expenditure trends as well as the industry
competitors. The analyst can provide insight to a company’s existing strengths or weaknesses
and assess its ability to perform successfully in the future” (Giordano, 2011).
As far as the definition of revenue recognition, International Financial Reporting Standards
(IFRS) and GAAP agree that it is “tied to the completion of the earnings process and the
realization of assets from such completion” (Ernest & Young, 2011). Other similarities
according to Earnest & Young are as follows,
”Under IAS 18 Revenue, revenue is defined as 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” (Ernest
& Young, 2011).
“Under US GAAP (which is primarily included in ASC 605 Revenue Recognition),
revenues represent actual or expected cash inflows that have occurred or will result from the
entity’s ongoing major operations.” Under both US GAAP and IFRS, “revenue is not recognized
until it is both realized (or realizable) and earned” (Ernest & Young, 2011).
“Ultimately, both GAAP and IFRS base revenue recognition on the transfer of risks and
both attempt to determine when the earnings process is complete. Both GAAP and IFRS contain
revenue recognition criteria that, while not identical, are similar. For example, under IFRS, one
recognition criteria is that the amount of revenue can be measured reliably, while US GAAP
requires that the consideration to be received from the buyer is fixed or determinable” (Ernest &
Young, 2011).
Even though there are some similarities, it seems as though there is a larger amount of
significant differences. According to Earnest & Young,
“There is extensive guidance under US GAAP, which can be very prescriptive and often
applies only to specific industries. For example, under US GAAP there are specific rules for the
recognition of software revenue and sales of real estate, while comparable guidance does not
exist under IFRS” (Ernest & Young, 2011)
In addition, the detailed US rules often contain exceptions for particular types of
transactions. Further, public companies in the US must follow additional guidance provided by
the SEC staff.
Conversely, a single standard (IAS 18) exists under IFRS, which contains general
principles and illustrative examples of specific transactions. Exclusive of the industry-specific
differences between the two GAAPs, following are the major differences in revenue recognition”
(Revenue Recognition, 2011).
Sale of goods:
GAAP - Public companies must follow SAB 104 Revenue Recognition, which requires that delivery has occurred (the risks and rewards of ownership have been transferred), there is persuasive evidence of the sale, the fee is fixed or determinable, and collectability is reasonably assured.
IFRS - Revenue is recognized only when risks and rewards of ownership have been transferred, the buyer has control of the goods, revenues can be measured reliably, and it is probable that the economic benefits will flow to the company.
Rendering of services:
GAAP - Certain types of service revenue, primarily relating to services sold with software, have been addressed separately in US GAAP literature. All other service revenue should follow SAB Topic 13. Application of long-term contract accounting ASC 605-35 Construction-Type and Production-Type Contracts, (formerly SOP 81-1), is not permitted for non-construction services.
IFRS - Revenue may be recognized in accordance with long-term contract accounting, including considering the stage of completion, whenever revenues and costs can be measured reliably, and it is probable that economic benefits will flow to the company.
Deferred receipt of receivables:
GAAP - Discounting to present value is required only in limited situations.
IFRS - Considered to be a financing agreement. Value of revenue to be recognized is determined by discounting all future receipts using an imputed rate of interest.
Construction contracts:
GAAP - Construction contracts are accounted for using the percentage-of-completion method if certain criteria are met. Otherwise completed contract method is used.
IFRS - Construction contracts are accounted for using the percentage-of-completion method if certain criteria are met. Otherwise, revenue recognition is limited to recoverable costs incurred. The completed contract method is not permitted. Construction contracts may be, but are not required to be, combined or segmented if certain criteria are met. Construction contracts are combined or segmented if certain criteria are met. Criteria under IFRS differ from those in US GAAP. (Revenue Recognition, 2011)
Ernest &Young also report “In October 2009, the FASB issued ASU 2009-13 Multiple-
Deliverable Revenue Arrangements. This revised guidance is effective for revenue arrangements
entered into or materially modified in fiscal years beginning on or after 15 June 2010. Early
adoption is permitted. The new guidance more closely aligns the accounting requirements for
multiple-element arrangements in US GAAP and IFRS by eliminating the requirement for the
undelivered elements to have reliable and objective evidence of fair value in order to treat the
delivered elements as separate units of accounting” (Revenue Recognition, 2010).
When the conversion to IFRS comes into play, it will mean different things for different
industries when accounting for revenue recognition. For example, “if the exposure draft based
on revenue from Contracts with Customers published between IASB and FASB is implemented,
the building and construction industry will feel a tremendous impact” (Gunderson, 2011). The
efforts to converge the revenue from contracts are part of a continuous project between the
FASB/IASB implemented in 2002. Revenue recognition for GAAP and IFRS has hundreds of
standards amongst the two that generate contradictory outcomes when it compares congruent
economical transactions. Beyond simple transactions, revenue recognition standards between the
two can be considered vague and inconsistent. According to Gunderson, “The objective of the
project has been to develop a single, contract-based revenue recognition standard that:
Eliminates inconsistencies and weaknesses in the current standard
Converges GAAP and IFRS on revenue recognition
Establishes a clear set of principles to address revenue recognition issues as they arise
The standard-setting boards believe that a consistent standard and principles for recognition of
revenue should improve comparability and understanding of revenue reported on financial
statements.” For example, in the construction industry on the basis of segmenting a contract, the
wording was somewhat disconcerting to those affected. For this reason, the requirement will be
eliminated and replaced with separation of a contract (Gunderson, 2010). This is just one of
many compromises the standard setting boards has had to make.
There are many factors that will affect revenue in the construction and building industry but
two that I find of particular interest. One being the collectability of promised consideration.
According to Gunderson, “Firms must take into account the credit status of their customers, and
report as revenue only what they expect to collect, on a probability-weighted basis – another
break from current practice. If a contract price is $1 million and the seller considers the customer
to be a bad credit risk at the outset, expecting to collect only $975,000, then $975,000 is the price
to be used.” The other interesting twist is the use of the time value of money. Gunderson also
states, “While the time value of money does not matter to many contracts, there could be cases
where payment from the customer is due either significantly before or after goods or services
have been transferred by the seller. In those cases, the sales consideration is discounted at the
rate that would be used in separate financing between the seller and customer, and separate
recognition of financing income is shown” (Gunderson, 2010).
In a recent update dated September 21, 2011, a joint project between FASB and the IASB
has made a decision on how time value of money should be adjusted. “The Boards tentatively
decided that an entity should adjust the promised amount of consideration to reflect the time
value of money if the contract includes a financing component that is significant to that contract”
(Project Updates, 2011). In assessing whether a contract has a significant financing component,
an entity should consider various factors, including the following:
1. Whether the amount of customer consideration would be substantially different if the customer paid in cash at the time of transfer of the goods or service
2. Whether there is a significant timing difference between when the entity transfers the promised goods or services to the customer and when the customer pays for those goods or services
3. Whether the interest rate that is explicit or implicit within the contract is significant.
The Boards also tentatively decided that, as a practical expedient, an entity should not be
required to assess whether a contract has a significant financing component if the period between
payment by the customer and the transfer of the promised goods or services to the customer is
one year or less” (Project Updates, 2011).
As the changes in revenue recognition continue to evolve like the examples given above, it
will be important as ever for each individual entity to pay close attention to what will affect them
personally. Even though there was no intent to republish revised proposals, on June 15, 2011the
IASB and FASB agreed to publish the common revenue recognition standard. The two boards
will allow feedback from the affected parties since the reporting of revenue recognition is an
important factor on how a company will operate in the future. The thought of the two boards is
to avoid any unplanned consequences they may have overlooked (Press Releases, 2011).
Along those same lines, PricewaterhouseCoopers (PWC) is allowing any individual to
complete a survey that covers the following, “Ahead of any SEC decision, we would like to
canvass a broader range of constituents' views on similar topics – in short, what you think would
best serve the interests of preparers, investors and other users of financial statements. We will
share survey results with the standard setters and regulators (e.g. SEC, FASB, and IASB), so this
is an opportunity to join the debate. We will also share survey results through an upcoming
webcast and publication, which will be announced via our website (www.pwc.com/usifrs) and e-
newsletter updates” (PWC, 2011).
There are many concerns amongst the experts when it comes to converting to IFRS
standards. In an interview with PWC’s Jim Kaiser, US Convergence & IFRS leader he states
that “one of the concerns with the new revenue recognition policy will be sometimes companies
will receive greater revenue than the cash they receive in a transaction. Jim explains in the past
we have also recognized revenue and expenses associated with a transaction. For instance, with
warranty costs if a company has to provide warranty services in the future they may also have to
defer warranty recognition or a portion of the revenue until the warranty expense is incurred.”
(PWC, 2011) So basically this isn’t just revenue recognition they are talking about it is also
about the cost associated with those revenue recognition streams (PWC, 2011).
According to an article written by PWC, “In May 2011, the SEC staff released a paper
that invites dialogue as to how an endorsement mechanism for IFRS incorporation might work in
the US. First, it describes a slower process of incorporating IFRS into the US financial reporting
system, with an ultimate objective of US standards being compliant with IFRS. The FASB
would change US GAAP over a defined period perhaps 5-7 years by endorsing, and thereby
incorporating, individual IFRS standards into US GAAP” (PWC, 2011).
PWC explains, “Existing IFRSs would be categorized into three groups for incorporation,
with the goal of minimizing the transition impact to US issuers while providing useful
information to investors.”
The categories are:
Standards subject to current convergence projects, such as revenue and leasing;
Standards that are expected to change in the near future; and
All other standards including those that are not anticipated to undergo significant change.
In PWC’s article they noted “The SEC held an IFRS roundtable in Washington, DC, on July
7, 2011, to discuss the benefits and challenges of potentially incorporating IFRS revenue
recognition into the US financial reporting system” (PWC, 2011). “At the event, SEC Chairman
Mary Schapiro called the idea of IFRS in the US a major decision for this agency, and not one to
be taken lightly” (PWC, 2011).
In preparation of the transition to IFRS, there are training courses available now that are
offered through GAAP. “GAAP Seminars offers a wide range of IFRS courses to meet our
clients’ training needs. In addition to our existing standard courses, we offer specifically tailored
courses as well. By tailoring a course specifically for our audience and integrating real-life
examples taken from your financial statements, we ensure that the information delivered is
relevant to your business issues and resonates with your personnel. Regardless of your needs or
time restraints, we will work to effectively convey to your personnel the IFRS knowledge that is
important to your business” (NASBA, 2011).
The GAAP Website also offers the following, “Using our vast library of IFRS training
materials, we assemble a tailored, modular training designed to teach participants the
requirements of IFRS based on their individual needs. This includes recognition and
measurement of key financial statement line items, as well as presentation and disclosure
requirements, to ensure that the financial statements are in accordance with IFRS. Depending on
time and/or cost constraints, we tailor courses by adding case studies and illustrations, usually
taken from your annual report, that reflect the accounting issues impacting your company. We
can even add excerpts of accounting policies and/or journal entries to the training to ensure that
key areas important to your company are emphasized” (NASBA, 2011).
The following can be considered in tailoring the needs to a specific industry:
Overview of IFRS and related framework
Presentation of financial statements, including discontinued operations
First-time adoption of IFRS
Business combinations
Goodwill and other intangible assets, including related impairment issues
Consolidation requirements under IFRS, including for special purpose entities
Share-based payment, including issues relating to stand-alone entities
Investments, including IFRS 9: Financial Instruments - Classification and
measurement
Derecognition of financial assets and financial liabilities
Derivatives and embedded derivatives
Hedging
Fair value
IFRS 7: Financial Instrument Disclosures
Segment reporting
Accounts receivable, loans and the related allowances
Investments in associates, joint ventures and subsidiaries
Inventories
Property, plant and equipment, including related impairment issues, investment properties
and assets held for sale
Provisions and termination benefits
Pensions and other post-retirement benefits
Debt and equity classification, including instruments with characteristics of both
liabilities and equity
Leasing
Current and deferred income taxes
Revenue recognition, including loyalty programs, service concession arrangements and
government grants
Accounting for foreign currency issues
Insurance contracts
Earnings per share
(NASBA, 2011)
In a recent a recent update from PWC, “the FASB and IASB are about to issue a revised
exposure draft on their revenue recognition proposal. PWC will hold a discussion on their
webcast scheduled for Thursday, November 17 at 1:00 to 2:30 PM (ET). Kenny Bement,
FASB project manager and lead FASB staff member on the joint FASB-IASB Revenue
Recognition project, will join their panel of revenue recognition specialists to provide his
perspective” (PWC, 2011).
Overview of the Webcast:
“Revenue is a key metric subject to considerable focus by investors and other
stakeholders. Proposed changes will impact key financial measures and ratios. Companies
may need to change information technology systems to capture different information and
develop new processes for estimates that aren’t required today. Adopting the new guidance
may require adjusting prior period financial statements. Understanding the effect of this
change on your business will help you inform your key stakeholders, prepare internally, and
limit surprises down the road” (PWC, 2011).
Speakers on our webcast panel will:
Summarize key aspects of the revised revenue recognition exposure draft
Highlight changes from today's accounting
Discuss business impacts and recommended next steps; and
Answer as many of your questions as possible during a Q&A session
Participants will gain a heightened understanding of recent developments on the revenue
recognition proposal, along with what their companies should be doing as a result (PWC,
2011).
As we move forward in anticipation of GAAP moving towards IFRS, we must stay
focused and up to date on the ever changing rules that affect our specific industry. There are
experts such as PWC that offer training solutions in finance as well as accounting training as
noted above. The costs that may need to be incurred to implement the rules must also be a
focus as this may be a constraint on a company’s net income as they work through the
conversion. As we are all well aware, everything comes at a cost when change is
implemented whether it is for the good or the bad.
Works Cited
"Share Your Photos." Clock Image. Loadtr, 2009. Web. 16 Oct. 2011.
<http://en.loadtr.com/ clock_-394568.htm>.
Giordano, Thomas J. CPA Assistant Professor of Accounting UMA. "Topics in Business."
University of Maine. Randall Student Center. June 2011. Class presentation.
"Revenue Recognition." US GAAP vs. IFRS: the basics, March 2010. Ernest &
Young, 15 Oct. 2001. Web. 20 Oct. 2011. http://www.ey.com/
Gunderson, Clifton. "Impact of the Proposed Changes in Accounting for Revenue Recognition in
Building and Construction." Recognizing Change. Clifton Gunderson LLP, 2010. Web.
23 Oct. 2011. <http://www.cliftoncpa.com>.
"Project Updates." FASB Technical Plan and Project. Financial Accounting Standards Board, 21
Sept. 2011. Web. 24 Oct. 2011.
<http://www.fasb.org/revenue_recognition.shtml#decisions>.
"Press Releases." IASB and FASB to re-expose revenue recognition proposals. IFRS
Foundation, 15 June 2011. Web. 29 Oct. 2011.
<http://www.ifrs.org/News/Press+Releases/re-expose+rev+rec+June+2011.htm>.
PricewaterhouseCoopers LLP. "US GAAP convergence & IFRS." US financial an reporting
will undergo unprecedented level of change within the next several years.
PricewaterhouseCoopers LLP, 2011. Web. 30 Oct. 2011.
<http://www.pwc.com/us/en/issues/ifrs-reporting/index.jhtml>.
PricewaterhouseCoopers LLP. "US GAAP convergence & IFRS." Current situation and
next steps. PricewaterhouseCoopers LLP, 2011. Web. 30 Oct. 2011.
<http://www.pwc.com/us/en/issues/ifrs-reporting/index.jhtml>.
National Association of State Boards of Accountancy (NASBA). "GAAP Seminars-Bridging the
GAAP." IFRS Offerings. National Association of State Boards of Accountancy
(NASBA), 2011. Web. 30 Oct. 2011. <http://www.gaapseminars.com
/course2.htm?gclid=CPeKx8mMkawCFeQ65QodLB11nQ>.
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