Income statements are of crucial importance to users of financial statements The WritePass Journal

Income statements are of crucial importance to users of financial statements INTRODUCTION Income statements are of crucial importance to users of financial statements INTRODUCTIONTHE MAIN PROBLEMS ASSOCIATED WITH REVENUE RECOGNITIONVIEWS TAKEN BY THE TWO BOARDSREASONED CRITIQUE OF THEIR THINKINGCONCLUSION Related INTRODUCTION Income statements are of crucial importance to users of financial statements, particularly investors. It is vital that revenues are properly recognized when preparing income statements to give a fair view of profitability of the associated company/firm. Thus investors are not misled while making decisions and undertaking risks involved with the concerned company. The International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) joint project tries to remedy such problems, by eliminating inconsistencies and developing coherent conceptual guidance for revenue recognition. Both boards consist of professional accountants that aim to develop high quality/understandable accounting standards and principles to ensure a more accurate and consistent reporting. The IASB deals with the development, promotion and application of International Financial Reporting Standards (IFRS). The FASB develops generally accepted accounting principles (GAAP) in the interest of the public. Moving on, the main concerns of this report are problems involved in revenue recognition, views taken by the two boards and a reasoned thinking of their critique. THE MAIN PROBLEMS ASSOCIATED WITH REVENUE RECOGNITION When it comes to revenue recognition transactions that begin and are completed in the same time period, cause considerably few problems. Real obstacles arise when customers prefer paying later on than when receiving the product or in cases where supplier might provide the promised good over several reporting periods. This earning process approach has led to problems for financial statements’ users and problems with GAAP and IFRSs. Building on the earnings approach, too many standards evolving revenue recognition has been formed by GAAP. The application of some of those standards by entities can produce inconsistencies for economically similar purposes. This can be a result of lacking a clearly identified earning process as well as people’s disagreements on how it applies in certain occasions. For instance think of a service provider that requires customers to pay an upfront fee plus monthly charges. In accordance with the SEC SAB 104, the provider does not account for the service as a separate earnings process and therefore does not recognize revenue for activation fees when the activation services are rendered. The fact that entities apply different earning process approaches to economically similar transactions reduces the comparability of revenue across entities and industries. In addition by applying revenue recognition standards designed by IFRS one can clearly observe that amounts in the financial statements might not correctly correspond to real economic phenomena. The underlying skepticism of this assumption is that revenue recognition of a product/service sale largely depends on when the rewards as well as risks associated with them are transferred from the owner to the client. Considering the IAS 18, circumstances can get even worse when goods and services are interrelated with the good transaction thus the entity views the transaction as a whole. Such circumstances involve recognizing all the revenue on the delivery of the good before the entity has fulfilled all of its obligations for the services like warranty. As a result revenue does not represent the delivery of all goods and services as stated in the contract. Additionally, IFRS lacks guidance on transactions involving delivery of more than one good or service also known as multiple element arrangement. IAS 18 does not clearly state whether an entity should recognize all the revenue for a multiple element arrangement by the time the first element is distributed or until the last element is distributed. IFRS also lacks guidance on how to measure the elements in a multiple element arrangement. According to IFRS another problem is created with revenue recognition because of the application of different approaches by entities when accounting for goods and services. Without any clear division between goods and services some entities undertaking service contracts were recognizing revenue throughout the service process. Some others though contracting for goods tended to recognize revenue by the time that risks and rewards related to the product were transferred to customer. Such gaps in guidance could be eliminated with the existence of clear principles; but principles of IAS 11 and IAS 18 are inconsistent. The first principle implies that revenue should be recognized while the activity of the contract still takes place and the customer does not have the risks and rewards of owning the product. On the contrary IAS 18 principle states that revenue should be recognized when the customer controls and undertakes risks and rewards of the ownership of the product. VIEWS TAKEN BY THE TWO BOARDS According to the board’s last meeting IASB and FASB discussed about 6 major topics involving revenue recognition. The first one involves identification of separate performance obligations. Under this topic the boards have decided that an entity should account for a collection of goods and services as one performance obligation in cases where the entity provides a service combining both goods and services into a single item. Conversely an entity should account for goods and services as different performance obligations when: the good or service is sold apart or when the client can use a good/service individually or with existing resources available to the customer and when the pattern of transferring the good or service is diverse from the pattern of transferring other goods and services in the contract. The second one is about combining contracts. The boards decided that two or more contracts that are placed at closely related times with the same customers can be merged and accounted as one when contracts are offered as a package, when the amount of consideration of a contract depends on the other and when the design, technology and function of goods and services are interconnected. The next topic involves contract modifications. The boards concluded that if a contract is modified in such a way that it results to a separate performance obligation with a price matching the obligation, the entity should regard the contract as a separate one. Otherwise, the performance obligation should be reconsidered and the transaction price of each separate performance obligation should be reallocated. Moving on the next topic engages the breakage and prepayments of future goods and services. The boards decided that where it would be reasonable for the entity to estimate the amount of expected breakage, the effects should be recognized as revenue along with the rights exercised by the customer. Another discussed topic is burdensome performance obligations. The boards decided that in order to find out whether the performance obligations are heavy there should be a test, the onerous test which will be defined by the remaining obligations of the contract. Finally the last topic includes revenue recognition for services. The Boards concluded that in order to recognize the revenue of a service the entity must go through two steps; first it must determine that a performance obligation is assured continuously and secondly it must then choose a method of measuring progress in order to completely satisfy that performance obligation. The Boards have furthered their discussions into issues which arise when an entity uses an input method for the measurement progress to complete satisfaction of a performance obligation. The entity, in some instances will only obtain goods which are transferred at another time from related services. In such cases, the Boards decided that the entity should measure the progress for the transfer of such goods should be equal to the costs of the transferred goods. REASONED CRITIQUE OF THEIR THINKING The technical director of Shumate Mechanical, LLC strongly supports that segmented performance obligation approach will increase costs and result in unclear accounting information. This is due to changes of revenue from period to period, violation of costs and revenue matching principles, lack of clear information making it difficult to understand performance to total product and uninformed transfer of revenue to performance obligations. The application of this model of revenue recognition according to the construction industry will lead to more inconsistencies, unreliable financial information as well as difficulties in their preparation. Furthermore under the agreement where a service provider transfers services to a customer, the proposed standard revenue is recognized by the time services are provided, depending on the provider’s estimation on progress of the performance obligation. Thus revenue cost is recognized as it occurs. David P.Bohn, partner of LARSON, LUDWIG and STROKES LLP, correctly mentions that the proposed standard does not set any requirements that the recognized percentage of total revenue matches the recognized percentage of total cost of revenue, which some service providers would prefer to maintain. Recognizing different percentages of revenue would lead to misrepresentation of gross margin. Deloitte Touche Tohmatsu finds the principle of combining two or more contracts really useful. But some concerns still exist according to the guidance around price interdependence which seems confusing. As mentioned in FASB and IASB’s exposure draft an entity should combine two or more contracts if the price of goods and services bought in a contract is dependent on the price of goods and services of another contract. Moving on it also states that in cases where a customer can benefit from discount on goods and services due to existing customer relationship mostly arrived from other purchases, then the price of the contract is not said to be interrelated with the price of another contract. These two paragraphs seem to contradict to each other. Therefore entities with similar types of revenue streams will arise. PricewaterhouseCoopers agree with board’s proposal that an entity should identify performance obligations differently in case that goods and services are distinctive. But they mention that it requires judgment and may be difficult to determine. Incomplete guidance is also given on identifying different performance obligations. Moreover they report that the boards omit distinct profit margin. Finally based on the exposure draft all performance obligations are identified first and separated into distinct performance obligations at a later stage making it difficult to reflect the economics of transactions. CONCLUSION Revenue recognition is a great issue and one can say that it might be unsolved. Because of many inconsistencies associated with it, FASB and IASB together have tried through their joint project to eliminate such inconsistencies. All the users of this standard have now come to criticize some of its principles even though they might be satisfied with the majority of other principles stated. There are still others that continue to believe that a lot of inconsistencies and omissions still exist. Some believe if the existing work done by the boards is furthered developed and modified through the publication of a comprehensive standard on revenue recognition, a clear and robust standard on revenue recognition can be formed.