Revenue - the question of recognition
'The most common fraud technique involved improper revenue recognition'
A strong and provocative statement, the above is taken from a recently released report by the U.S Committee of Sponsoring Organisations of the Treadway Commission (COSO), based on a comprehensive analysis of fraudulent financial reporting occurrences investigated by the U.S. Securities and Exchange Commission (SEC) between January 1998 and December 2007.
The SEC investigation and COSO report are based on U.S. GAAP reports. It is noteworthy that the U.K. Financial Reporting Review Panel (FRRP) in its yearly report, based on findings from its review of published financial statements under IFRS, draws attention to concerns it has regarding revenue recognition and its financial reporting.
Matters of concern
The COSO report states that over 60 percent of the 347 alleged cases of public company fraudulent financial reporting from 1998 to 2007 involved an overstatement of revenues. The revenue misstatements were primarily due to recording revenues fictitiously or prematurely by employing a variety of techniques, many of which involved such obvious fraud as the falsifying of records. However, some were in relation to the mistiming of recognition, which may have been due to inappropriate interpretation of accounting requirements.
The FRRP report published in July 2009 and based on financial statements mainly for financial periods ending from December 2007 to June 2008 questioned the adequacy of the stated accounting policies for revenue recognition. The FRRP was concerned as to whether the policies were adequate to enable users to understand the basis on which management recognises its significant revenue streams, with specific examples including rebates and discounts in the retail trade, and part exchange arrangements in the accounts of house-builders. The FRRP also asked questions of companies that derive substantial revenue from the provision of services but did not explain how they establish the stage of completion according to which revenue is measured, with the concern that revenue may be recognised too early. The FRRP encouraged companies to keep their revenue recognition policies and practices under review, particularly given changes and uncertainties in the market which may affect their ability to measure revenue reliably.
While the intensity of language used in both reports may differ, it is clear that they both share some common concerns.
They serve to underline the major need identified by both the IASB and the U.S. FASB to treat the development of a new and converged standard for revenue recognition as a high priority project.
Current accounting position - a problem?
IFRS and U.S. GAAP currently find themselves at opposite ends of the spectrum with regard to the level of development of standards, and there are substantial differences.
IFRS has two main revenue recognition standards, IAS 18 'Revenue' and IAS 11 'Construction Contracts'. Both standards are many years old and while there has been some tinkering around the edges, it is little more than that, leaving them difficult to apply to transactions which have in many industries become more complex over the years, examples of which are multiple-element arrangements with customers.
U.S GAAP comprises broad revenue recognition concepts and numerous requirements for particular industries or transactions that can result in different accounting for economically similar transactions. A comment that has often been made about U.S. GAAP and its multiplicity of rules is that it is a 'cookery book' approach and the topic of revenue recognition is a prime example of this. There is a fear that such an approach has led to many situations where getting around the rules in order to achieve a better presentation of results became the end-game rather than adhering to the principles and reporting based on the substance of the transactions.
Two different approaches, neither of which are fulfilling the objectives in an adequate and consistent manner.
The quest for a solution
The first IASB meeting at which the development of a new standard was discussed was in June 2002 with the first joint meeting of the IASB and FASB at which it was discussed being in October 2005. It has been on the agenda at over 50 meetings during the period from June 2002 to date.
All of this is an indication of the complexities involved and the divergence of views that had to be grappled with in order to achieve a meeting of minds. Little wonder given that in the early stages there were four widely different approaches to a topic which many outside the accounting profession may believe should be relatively straightforward but it is clear that it is deeply complex.
After an eight-year gestation period, the major question is whether an acceptable solution has yet been found.
The proposed solution
In June, the IASB and the FASB published a draft standard to prepare and align the financial reporting of revenue from contracts with customers and related costs, with the IASB chairman commenting that 'it is an important step towards a single global principle based standard that should make it absolutely clear when revenue is recognised .... and why'.
The core principle of the draft standard is that an entity should recognise revenue from contracts with customers when it transfers goods or services to the customer in the amount of consideration the entity receives or expects to receive from the customer.
Under the proposals an entity should:
- Identify the contract(s) with the customer
- Identify the separate performance obligations in a contract
- Determine the transaction price
- Allocate the transaction price to the separate performance obligations
- Recognise the allocated revenue when the entity satisfies each performance obligation
Impact on reporting by entities
The recognition of revenue should be on a consistent basis for all entities adopting either IFRS or US GAAP when the new standard is implemented. Profit recognition may continue to differ, however, because of differences in other standards relating to accounting for the costs of fulfilling a contract. A prime example of this is that under US GAAP LIFO (Last In First Out) may be used for inventory valuation but it is prohibited under IFRS.
For some contracts (e.g. many retail transactions) the proposed requirements are not likely to have any significant effect on current practice. For many others there is potential for the new proposals to have a significant impact on the amounts reported in the financial statements primarily with regard to the timing of recognition.
Some of the potential areas in which fundamental differences to current practice may arise are as follows:
- Some entities that apply a percentage of completion method may be required to only recognise revenue when the final product is delivered to a customer
- The allocation of the transaction price to the elements in a multiple element arrangement may change
- A loss may be recognised at contract inception on specific elements of a contract even though the overall contract is profitable
- Entities that provide warranties could be required to defer some revenue at inception of the contract
- The effect of a customer's credit risk (ie collectability) could affect how much revenue an entity recognises rather than whether an entity recognises revenue
- The proposed requirements specify which contract costs an entity should recognise as expenses when incurred and which costs should be capitalised because they give rise to an asset
All entities would be required to disclose more information about their contracts with customers than is currently required including more disaggregated information about recognised revenue and more information about performance obligations remaining at the end of the reporting period. Such disclosures would include a reconciliation from the opening to the closing balance of contract assets and liabilities.
Revenue recognition is considered by the IASB and the FASB under their memorandum of understanding as being a high priority project for improvement of standards and convergence. While the June 2011 timeline has been deferred for a number of projects, revenue recognition remains high on the agenda and on track for publication of a final standard in the second quarter of 2011. The draft standard is open for comment until 22 October 2010.
It is proposed that the standard would apply to all contracts other than lease contracts, insurance contracts and contracts within the scope of IFRS 9 on financial instruments. While the majority of entities in the financial services industry are scoped out of the proposed new standard it is important for many of them to gain an understanding of it given the fundamental importance of revenue recognition to the financial statements of customers with whom they are entering into lending or other financial transactions.
The proposed new standard is expected to become effective for accounting periods beginning 1 January 2013 with full retrospective application. Entities to whom it will apply would be well advised to commit resources to becoming familiar with the proposed standard and evaluating how the proposals could affect the structuring of customer contracts, performance measurements used, debt covenants, accounting policies and systems. If the new requirements are to give rise to significant changes, entities should be aware of these at an early stage and manage the change process to avoid unwanted surprises in the marketplace.
First published in Finance Dublin online