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>.