Revenue Recognition

Abstract

Revenue recognition is a concept in the financial accounting theory that involves the inflow or revenue that comes to an entity as a result of its operational activities. The concept of revenue recognition is defined and guided by different sets of standards including the US GAAP and the IFRS. This report discusses the concept of revenue recognition by discussing the historical development if the financial accounting theory, the concept of revenue recognition, biblical application, US GAAP and IFRS reporting standards and the impact of the Sarbanes Oxley act on the concept. The report will demonstrate the differences between the two sets of standards when it comes to revenue recognition. 

 

Table of Contents

Historical development of financial accounting theory 4

The concept of revenue recognition 7

Financial accounting and revenue recognition in relation to the bible 8

Current GAAP 9

U.S. GAAP and IFRS in revenue recognition 11

Problem areas 13

Appropriate courses of action 14

The Impact of Sarbanes-Oxley on Revenue Recognition 14

Conclusion 15

References 16

 

Revenue Recognition

Revenue recognition is an important element of financial statements that forms the basis of investment decisions. It is part of the general financial accounting theory that is the material basis of accounting and dates back to the barter trade era. This paper discusses revenue recognition in respect to the financial accounting theory. The report will analyze the topic through different sections that will discuss several elements including the historical development of financial accounting theory, current GAAP, how US GAAP and IFRS differ in revenue recognition, identifying problem areas in these differences, suggesting appropriate courses of action, analyzing the impact of Sarbanes-Oxley on revenue recognition, and providing a biblical application of revenue recognition. 

Historical development of financial accounting theory

The history of the financial accounting theory dates back to 1494 when a Luca Pacioli who was a Franciscan Monk introduced the concept of double entry in a mathematics book publication. According to Pacioli, any successful businessman or merchant would require three things: enough operating cash, an accounting system and a good book keeper to run the accounting system (Geijsbeek, 1914). This concept still applies in today’s accounting theory as entities continue to do formal book keeping and have an accounting system. However, the history of accounting dates back centuries before the publication by Pacioli as research has found that even farmers in ancient Mesopotamia (7500-3350) had a way of calculating and counting their farm produce (Berisha & Asllanaj, 2017). During this time, accountants were referred to as scribes and their main duty was to record transactions on clay tablets. Book keeping has also been found in ancient Egypt, Rome, China and Greece whereby accounting records were recorded in papyrus and clay tablets. These ancient civilizations had government accounting and banking systems that involves managing government property in terms of recording daily cash receipts as well as outflows. However, the double accounting method came into existence after it was introduced by Pacioli in 1494. In this accounting system, all the debit transactions are recorded in the left side while credit transactions are listed on the right. Pacioli introduced the idea of keeping journals and using ledgers to record financial transactions. When these records were closed after an accounting period, merchants recorded their profits or loss to get a balance and giving rise to the balance sheet. The same concept influences modern day accounting and are recommended by professional bodies that set accounting standards. 

After the double entry method, companies and businesses took the lead in further developing financial accounting by focusing on providing clearer and more reliable financial information and this was mainly influenced by unprecedented economic times. For instance, during the 1772 depression, the need to go beyond general book keeping arose when businesses saw the need for using the transaction information to assess whether a business is using resources or operating efficiently. In the US, a government accounting system was established in 1789 and in Britain, professional accountants to help manage state and court affairs were introduced in 1850. The first professional organization of accountants was founded in1887 when some accountant migrants formed an organization whereby they developed accounting standards and the certified processes on how people could become accountants (Berisha & Asllanaj, 2017). 

This organization is what is currently known as the American Institute of Certified Public Accountants (AICPA).  Further development of the financial accounting theory occurred when the Securities Act and the Securities Exchange Act were passed in 1933 and 1934 to establish requirements for stock offerings and how to report these market offerings. The US government established the Securities and Exchange Commission (SEC) in 1934 to help set the formal standards of financial reporting and accounting for public companies. However, the private sector still develops accounting standards and the SEC responds by accepting or changing that standard. In addition, the commission makes financial accounting and reporting announcements known as Financial Reporting Releases (FRRs) (Schroeder,  Clark & Cathey, 2016).

Another critical development in the financial accounting theory is the development of financial accounting regulation in the US. Between 1938 and 1959, the Committee on Accounting Procedure (CAP) played the role of developing accounting standards. This body was replaced by the Accounting Principles Board (APB) that developed conceptual accounting framework and it performed this function between 1959 and 1973. In attempts to establish a more independent financial accounting regulation body, the APB was reorganized into the Financial Accounting Standards Board (FASB). Later, the US government established the Government Accounting Standards Board (GASB) to help the government in developing financial accounting standards as part of GAAP (FASB, 2014). 

In the UK and Europe, the International Accounting Standards Committee (IASC) was established in 1973 to deal with accounting issues and to offer guidance on accounting standards and practices. The IASC was reorganized into the International Accounting Standards Board (IASB) whose main function is to develop accounting standards that are referred to as the International Financial Reporting Standards (IFRS). However, the board has no right to force companies and business entities to comply with these IFRS. However, there are still major differences between the standards set by the US FASB and the IASB and in October 2002, the two bodies have been working together to develop a more common set of accounting reporting standards. The two boards have successfully developed accounting standards for fair value measurement, revenue recognition, leases, among other sets of standards. It is expected that the two boards will continue to develop accounting standards that will be adopted globally. 

The concept of revenue recognition 

Revenue is also known as income and it is the most reported item by organizations in their financial statements. It involves the inflow of cash or assets enhancements or even liabilities settlements or any other income that comes in through the main activities or operations of an organization. Revenue is also what an entity or organization earns after performing its role of specific activities that allow the entity to receive revenue and enjoy its benefits. Revenue is an important part of an organization and its operations as it brings in cash or material resources to the organization and it also forms a critical element in investors’ decision making (FASB, 2014).

Revenue recognition is a common concept in the accounting theory and different accounting standard setters and accountants have different ways of defining it. These different parties define revenue and specify when entities should recognize them. For instance, the US GAAP, FASB Concepts Statement No. 5, revenue is recognized when an entity realizes or earns revenue or income. In contrast, under the IFRSs, revenue recognition is guided by IAS 18 and IAS 11. These standards define revenue as income from the sake of goods, from rendering of services and from the use of assets by third parties resulting in income in form of royalties, interest and dividends. None of these definitions are specific or comprehensive enough in defining revenue recognition. For instance, the FASB statement number 6 requires revenue to be recognized only when goods are produced and when operational activities are in place thereby allowing revenue to be recognized. On the other hand, the IFRS has different definitions of revenue recognition whereby IAS 18 recognizes the sales of goods, rendering of services and hiring out assets as the key activities that can bring in income and IAS 11 specifies the financial circumstances of construction contracts (Lemus, 2014).

However, these differences in defining and recognizing revenue have been converged through a joint effort of the FASB and the IFRS. Through the ASU 2014-09 statement issued by the FASB and the IFRS 15 statement issued by the IFRS, there is now a more general and comprehensive revenue recognition standard taking effect from 2017 that guides all industries including the real estate, construction, among other industries. According to the new standard, an entity should recognize revenue when the correct amounts of goods and services are delivered to a customer and this amount reflects the income that the entity expects to receive from the delivery of these items.

Financial accounting and revenue recognition in relation to the bible 

The theory of financial accounting and the concepts of revenue recognition can be found in different parts of the bible where they are mentioned. While the main purpose of financial accounting is to manage business activities and finances, some bible verses are against the whole concept. For instance, in 2 Kings 12:16, it is mentioned that, “The trespass money and sin money was not brought into the house of the LORD: it was the priests’.” Similarly, 2 Kings 22:7 mentions that, “Howbeit there was no reckoning made with them of the money that was delivered into their hand, because they dealt faithfully.” This implies that financial accounting is only necessary when contractors and business partners are not honest or faithful.

However, some parts of the bible recognize the importance of financial accounting. For instance, 2 Chronicles 24:11 states that, “Now it came to pass, that at what time the chest was brought unto the king’s office by the hand of the Levites, and when they saw that there was much money, the king’s scribe and the high priest’s officer came and emptied the chest, and took it, and carried it to his place again. Thus they did day by day, and gathered money in abundance.” In addition, in the new testament, 2 Corinthians 8:16-21, when Paul was sending Titus to collect offerings from the church in Corinth, Paul stresses on the importance of accounting for the money collected. In verses 20 to 21, it states, “20Avoiding this, that no man should blame us in this abundance which is administered by us: 21Providing for honest things, not only in the sight of the Lord, but also in the sight of men”. Here, the bible implies that those managing funds should practice integrity and should account for all the funds. This is the basis of accounting as the theory involves managing and accounting for transactions and finances in an honest manner. 

Current GAAP

In the previous US, GAAP, revenue recognition was guided by FASB statement number 6 and FASB statements number 5 that provided standards of how revenues are treated and recognized. Both statements indicate that revenue is recognized when an entity earns or realizes income. However, these guidelines were used until December 2017 when the FASB and the IASB converged their revenue recognition standards into ASU 2014-09 and IFRS 15 that provide a comprehensive and common revenue recognition definition. Since 2017, the new standards now guide revenue recognition by entities across different industries.

According to the new GAAP standards on revenue recognition, revenue is recognized when an entity transfers goods and services to another entity in the agreed amount that reflects the amount of income that the entity selling should receive. To be able to do this, businesses should be able to follow a certain procedure that includes having a contract with a customer in place, specifying the obligations of the contract, specifying the price, allocating the price for the transaction and recognizing the revenue as soon as entity meets its contract obligations. These steps can be discussed as follows:

  1. Identify the contract with the customer – a contract occurs when two or more parties define and agree to certain rights and obligations. A contract is enforceable when there is approval from all parties, when rights of the different parties are identified, when payment terms are specified, when the contract had commercial terms, and when an entity collects a specified amount of money after delivering goods and services of a certain value to a customer.
  2. Specifying the performance obligation of the contract – this is a promise to deliver goods and services to a customer through a contract. The goods and services delivered should be distinct in that the customer can benefit from the items directly or when used with other resources accessible to the customer. The goods and services should also be distinct according to the contract implying that a certain clause in the contract exists to show that an entity is required to deliver the items.
  3. Determining the contract price – this is the amount in monetary terms that an entity expects to receive after delivering the promised goods and services. The transaction price is determined by multiple factors including variable consideration, estimates of the variable consideration, financial component existence, non-cash consideration, and the consideration that is payable to the customer (FASB, 2014). 
  4. Allocating the price for the transaction – every contract should consist of obligations for each party and each performance obligation should have a transaction price that matches the amount of money that matches the goods and services delivered as agreed. Any amount that is allocated after performance obligations have been met is recognized as revenue.
  5. Recognizing revenue when contract obligations are met – FASB requires organizations or entities to recognize revenue only when a performance obligation of delivering goods and services to a customer has been met. A delivered good or service is that item that the customer can control as a result of the transfer. While some payments or revenue is not paid in time, the customer will satisfy their performance obligation at a point in time.

 U.S. GAAP and IFRS in revenue recognition 

While the convergence of the US GAAP and IFRS standards on revenue recognition aim at establishing a common set of guidelines, not all entities are reporting revenue according to ASU 2014-09 and IFRS 15 guidelines that became effective in December 2017 (Deloitte, 2017). Most entities still use either US GAAP or IFRS as guidelines on revenue recognition. Each of these set of guidelines differ in different ways as discussed below:

  1. Revenue recognition criteria

Under the US GAAP, revenue is recognized when it is earned or realized after the sale of goods or services. This occurs when the following has occurred: proof that an arrangement to deliver goods and services was in place, services have been delivered, the price is determined, and the collection of payment is assured. Under the IFRS, revenue is recognized when there is an identifiable outcome of a transaction after these conditions have been met: the amount of revenue can be identified, the economic benefits or revenue will flow to an entity, the transaction has been completed by the end of the reporting period, and the cost of the transaction can be measured.

  1. Defining revenue

Under the current US GAAP, FASB concept statement 6 defines revenue as the inflows or enhancements that arise when an entity produces goods, delivers goods, provide services, or engage in any other operational activity that results in the entity receiving the inflows (FASB, 2008). In contrast, the IFRS defines revenue as the income or gains that arise from the activity of an organization or entity. Paragraph 74 of the IASB Framework also states that the income or revenue might flow into an entity through different forms including sale, dividends, interests, royalties, rent, or even fees. In addition IAS 18 considers revenue to be any economic benefits that arise from the ordinary activities of an entity and these benefits result in increased equity (IFRS, 2012). Both the US GAAP and the IFRS consider revenue to be the cash inflows that arise from the action of delivering goods or rendering services.

  1. Sales of goods and services

Another point of comparison between the US GAAP and the IFRS is the sale of goods and services. In the US, SAB topic 13 provides guidelines on when to recognize revenue from the sale of goods and services. According to the guideline, revenue from the sale of goods and services are recognized only when the income is realizable or when there is an arrangement between an entity and its customers, when an entity has delivered the items, when there is a fixed price for the goods and the collection of the agreed amount is assured. Similarly, under the IFRS, IAS 18 paragraph 14 recognizes revenue from the sale of goods and services when an entity has delivered good as services together with their benefits and risks, when an entity no longer owns or control the goods, when the income from the transaction can be measured, when the economic benefits will flow to the entity, and when the cost of delivering the goods and services can be determined (Deloitte, 2017).

  1. Providing services

Similar to the sale of goods, the US GAAP recognizes revenue from rendering services when the income is realizable. This implies that revenue is recognized when there is proof that an arrangement exists, when services have been provided, when the services have a fixed price and when an entity is assured of the collectability of revenue. However, the US GAAP does not have specific guidelines or recognizing revenue from services rendered and the recognition criteria is only guided by ASC 605-35. Under the IFRS, revenue from services rendered is recognized when the outcome of services delivered can be identified. This occurs when the amount of revenue can be measured, when the economic benefits from the transaction will flow into the entity, when the transaction can be measured and when the cost of delivering the service can be measured. Both US GAAP and IFRS recognize revenue from services when the services have been provided as agreed.

  1. Construction services

The US GAAP and IFRS also differ in the way revenue from construction services is recognized. Under the US GAAP, ASC 605-35 states that the percentage of completion method or the completed contract method could be used for construction contracts. Revenue is recognized using the revenue approach or the gross profit approach. Under the IFRS, the completed contract method is not used and revenue from the contract is identified through the gross profit approach. When the percentage of completion method cannot be used, the revenue is recognized through the recoverable costs.

Problem areas 

The US GAAP and the IFRS differ in different ways when it comes to revenue recognition and when an entity can recognize revenue. To address the differences, the two different bodies introduced GAAP ASU 2014-09 guidelines and IFRS 15 guidelines that converged the revenue recognition standards. These standards were to take effect as from December 2017. However, in 2018, there were still entities recognizing revenue using the old FASB or IFRS standards. Since the two bodies have no right to force companies to adhere to the new guidelines, it appears as if it will take longer for entities to use new guideline. Another problem area that could result from the differences in the US GAAP and IFRS and the two guidelines ASU 2014-09 and IFRS 15 guidelines that were introduced by the bodies is creating a framework to identify and define customer contracts. For instance, it might be difficult for an entity to make decisions on whether they should renew customer contracts using the old framework or new framework. This is because new contracts using the new guidelines will be accounted for differently than contracts using the older guidelines. However, the new sets of revenue recognition guidelines are meant to eliminate the differences in revenue recognition between the US GAAP and the IFRS (Fangshu, 2015).

Appropriate courses of action

To address the above problems, the US GAAP and IFRS should encourage entities to use the new guidelines by pointing out the benefits of the new standards. The two bodies should also demonstrate the ease of making the transition and offer to assist entities who are struggling to implement the new guidelines. For entities having trouble to develop a framework for defining new customer contracts, the IFRS and the FASB should assist by helping develop a transitioning framework. For instance, there should be guidelines on when an entity should shift from the old guidelines to the new guidelines. In addition, both bodies should provide enough timeframe for when all entities will be able to use the new guidelines for new customer contracts. The bodies should also be able to demonstrate that the revenue that entities expect should not be affected by the new guidelines for ease in transition. 

The Impact of Sarbanes-Oxley on Revenue Recognition

The Sarbanes Oxley act of 2002 was passed to reduce fraudulent activity by entities and corporations and improve the way in which financial reporting is done. A key role of the act is to ensure that entities report accurate revenue and the end of each reporting period. Whereas the US GAAP and the IFRS provide guidelines on how and when entities should recognize revenue, the Sarbanes Oxley Act ensures that entities report the correct amounts of revenue. Consequently, the act requires entities to engage five processes to ensure compliance with revenue reporting. These include:

  1. Revenue allocation – entities are required to follow GAAP guidelines while allocating revenue to the goods and services that they sell. Automation and transaction tracking is recommended for this process.
  2. Revenue scheduling – entities are advised to schedule revenue at as they transact to help in managing transaction data.
  3. Revenue recognition – entities are required to follow the GAAP guidelines in revenue recognition to know when revenue should be recognized.
  4. Revenue accounting – this is when an entity records receivables against expected revenue.
  5. Revenue compliance – entities have to demonstrate compliance with the revenue recognition process and should have internal controls to ensure that revenue is accurately reported (Bloch, 2003).

Conclusion

In conclusion, revenue recognition is a critical part of the financial accounting theory as it forms the basis in which an entity receives economic benefits as a result of its operational activities. Both the US GAAP and the IFRS provide guidelines on how entities should report guidelines. An effort to converge the two guidelines when it comes to revenue recognition gave rise to the ASU 2014-09 and IFRS 15 guidelines that came effective in 2017. The new guidelines might present a few challenges to entities and organizations but with proper guidelines from the FASB and the IFRS, the transition should be smooth.

 

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