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  • Munich Business Research Münchner Betriebswirtschaftliche Beiträge

    Rethinking Revenue Recognition – Critical Perspectives on the IASB’s Current Proposals –

    Michael Dobler & Silvia Hettich

    # 2006-03

    First Draft: December 2005

  • Rethinking Revenue Recognition – Critical Perspectives on the IASB’s Current Proposals –

    Michael Dobler* and Silvia Hettich**


    Acknowledging deficiencies in current regulations and aiming at convergence, the IASB is conducting a joint project with the FASB to develop a principle-based standard on revenue recognition. The tentative proposals feature an asset-liability approach relying on measurement at fair values or at allocated consideration amounts. Based on conceptual, analytical, and empirical evidence, this paper finds that the current proposals conflict with (i) qualitative characteristics of information, (ii) objectives of financial reporting, and (iii) current and emerging regulatory framework. Main results show that the fair value approach yields more severe conflicts than the allocated consideration amount approach. The proposals ambivalently prefer relevance over reliability and can give rise to adverse incentives for investment decisions and earnings management. While both approaches comprise inconsistencies with existing IASB/IASCF regulations and developments in other projects of the IASB, our results particularly question whether the current proposals meet the endorsement criteria of Art. 3(2) of Regulation (EC) 1606/2002.

    Keywords: Decision Usefulness; IFRSs; Income Concept; Revenue Recognition; Stewardship. JEL-Classification: K22; M41.

    * Dr. Michael Dobler, MBR, Chair for Accounting and Auditing, Ludwig-Maximilians-University

    Munich, Ludwigstr. 28/RG IV, D-80539 Munich, Germany; e-mail: ** Dipl.-Kffr. Silvia Hettich, MBA, MBR, Chair for Accounting and Auditing, Ludwig-Maximilians-

    University Munich, Ludwigstr. 28/RG IV, D-80539 Munich, Germany; e-mail: hettich@bwl.uni-

  • 1

    1 Introduction

    IFRSs are known to lack a well-founded concept of income (Haller and Schloßgangl,

    2005; Hettich, 2006). Particularly, regulations on revenue recognition show

    inconsistencies, e.g., between IAS 18 and the Framework, and loopholes, e.g.,

    concerning multi-element arrangements (IASB, 2005e; Wüstemann and Kierzek, 2005).

    Under US-GAAP, revenue recognition is addressed by almost 200 references which are

    not fully consistent. Particularly, given recent accounting scandals in the USA, revenue

    recognition is considered to be the most urgent topic to be dealt with by the FASB

    (FASAC, 2005b; FASB, 2005b; GAO, 2002).

    Given (i) deficiencies in both IFRSs and US-GAAP and (ii) the aim of convergence, the

    IASB and the FASB have been rethinking revenue recognition in a joint project since

    2002. Aiming at a general and comprehensive standard, the project Revenue

    Recognition develops a conceptual revenue recognition model largely independent from

    existing standards. The tentative proposals feature a valuation-based asset-liability

    approach measuring liabilities arising from enforceable performance obligations at their

    fair value or at an allocated consideration amount (FASB, 2005a; 2005b; IASB, 2005b,

    2005c, 2005e; 2005h, 2005i). While all decisions and proposals made to date are

    tentative and a discussion paper is scheduled for the second half of 2006, the proposals

    take shape and imply far reaching changes in revenue recognition compared to current

    IFRSs particularly relevant for IFRSs-users in the EU (Ernstberger, 2005; Wüstemann

    and Kierzek, 2005; Dobler, 2006).

    This paper is among the first to investigate the proposals of the project Revenue

    Recognition, thereby considering developments up to December 2005. Unlike other

    papers which discuss accounting differences between the proposals and current IFRSs,

    i.e., IAS 11 and IAS 18, we aim at evaluating the proposals from overriding

    perspectives based on conceptual, analytical, and empirical findings. Particularly, we

    take (i) an informational perspective referring to qualitative characteristics of financial

    information, (ii) an objectives-based perspective linked to decision-usefulness and

    stewardship purposes of financial reporting, and (iii) a regulative perspective

    considering compatibility with recent and emerging regulations.

  • 2

    Main results cast doubt on the reliability and the relevance of the proposed concepts

    particularly concerning initial and subsequent measurement of performance obligations.

    Recognising revenue and expense with reference to (hypothetical) market prices (in the

    fair value approach) or with reference to (modified) estimated sales prices (in the

    allocated consideration amount approach) incorporates managerial judgement and can

    provide a misleading indicator for future performance. Specifically, when applying the

    fair value approach, a loss can occur at contract inception although performing the

    contract is expected to yield profit and vice versa. While challenging decision

    usefulness, we argue that the fair value approach provokes accounting and real earnings

    management, yields adverse incentives for investment decisions and is inappropriate for

    stewardship purposes. These concerns are partially mitigated in the allocated

    consideration amount approach. Based on the findings we detect incompatibilities with

    both current IASB/IASCF regulations and developments in other projects conducted by

    the IASB. We conclude that the current proposals of the project Revenue Recognition do

    not comply with EU endorsement requirements set out in Art. 3(2) of Regulation

    1606/2002 which is likely to impact the further proceeding of the project.

    The remainder of the paper is organised as follows. The next section surveys research

    background. Section 3 presents the current proposals of the project Revenue

    Recognition, which we discuss in Section 4. Section 5 concludes.

    2 Theoretical Background 2.1 Conceptual Findings

    Financial statements are (i) to provide information for decision making purposes (F.12)

    and (ii) to show the results of stewardship of the management (F.14). Both objectives

    can not be achieved by using the same set of standards (Gjesdal, 1981). Likewise, not

    all concepts of income do equally fit to deliver the information necessary (Baetge, 1970:


    Decision usefulness requires relevance and reliability of information (Barth, Beaver,

    and Landsman, 2001: 80). The concept of economic income defines income as the

    increase in wealth (Smith, 1890). Fisher (1906) and Lindahl (1919) show that under

    certain conditions income equals the interest on wealth at the beginning of the period.

  • 3

    For an entity, wealth is derived by discounting future cash flows (Solomons, 1961).

    Economic income is ideal for decision making purposes since future developments are

    considered and changes therein are recognised immediately (Franke and Hax, 2004).

    But when lifting the condition of a perfect capital market, economic income is no longer

    well-defined. The necessary assumptions about the future undermine the reliability of

    the income figure. The manager can influence income without detection by investors

    because the figure can neither be verified nor falsified. An auditor is only able to check

    for plausibility (Dobler, 2004).

    Accounting profit results from the difference between realised income and expense

    which follow from transactions and events in the corresponding period (Belkaoui,

    2000). Assets and liabilities are carried at historical cost until they are used up or sold;

    revenues and expenses are matched (revenue-expense approach) (Paton and Littleton,

    1955). For decision making purposes, accounting income delivers reliable information.

    As it results from past transactions and events and is well documented, it can relatively

    easily be verified. As accounting profit anticipates future losses but not future gains

    (i.e., conservative accounting), the income figure is biased. Nevertheless, assets and

    liabilities carried at historical cost can be interpreted as a set of resources generating

    future profit and can, thus, serve as an indicator for users (Leuz, 1998).

    While the revenue-expense approach focuses on the recognition criteria for income and

    expenses to compute profit, the asset-liability approach defines profit as changes in

    values of assets and liabilities. These values can be historical values, current or market

    values, values in use or other. Accounting profit uses historical costs for assets and

    liabilities, whereas the current value concept of income uses current values.1 Current or

    market values are not well-defined because they can either be entry or exit values. If

    market prices don’t exist, the values have to be estimated. The profit consists of a

    realised and an unrealised component (Edwards and Bell, 1961). The change in value

    constitutes relevant information for users and impedes a biased income figure. Market

    values can be interpreted as the best e