THE IMPACT OF IFRS ON
REVENUE RECOGNITION ISSUE
CHAPTER TWO
LITERATURE REVIEW
2.0 INTRODUCTION
International
Financial Reporting Standards (IFRS) are designed as a common global language
for business affairs so that company accounts are understandable and comparable
across international boundaries. They are a consequence of growing
international shareholding and trade and are particularly important for
companies that have dealings in several countries. They are progressively
replacing the many different national accounting standards. They are the rules
to be followed by accountants to maintain books of accounts which are
comparable, understandable, reliable and relevant as per the users internal or
external. IFRS, with the exception of IAS 29 Financial Reporting in
Hyperinflationary Economies and IFRIC 7 Applying the Restatement Approach under
IAS 29, are authorized in terms of the historical cost paradigm. IAS 29 and
IFRIC 7 are authorized in terms of the units of constant purchasing power
paradigm.
2.1 OVERVIEW OF IFRS
IFRS
began as an attempt to harmonize accounting across the European Union but the
value of harmonization quickly made the concept attractive around the world.
However, it has been debated whether or not de facto harmonization has
occurred. Standards that were issued by IASC (the predecessor of IASB) and are
still within use today go by the name International Accounting Standards (IAS),
while standards issued by IASB are called IFRS. IAS were issued between 1973
and 2001 by the Board of the International Accounting Standards Committee (IASC).
On 1 April 2001, the new International Accounting Standards Board (IASB) took
over from the IASC the responsibility for setting International Accounting
Standards. During its first meeting the new Board adopted existing IAS and
Standing Interpretations Committee standards (SICs). The IASB has continued to
develop standards calling the new standards “International Financial
Reporting Standards”.
In
the absence of a Standard or an Interpretation that specifically applies to a
transaction, management must use its judgment in developing and applying an
accounting policy that results in information that is relevant and reliable. In
making that judgment, IAS requires management of companies to consider the
definitions, revenue recognition criteria, and measurement concepts for assets,
liabilities, income, and expenses in the Framework.
Criticisms
of IFRS are:
–
that they are not
being adopted in the US
–
a number of
criticisms from France and
–
that IAS 29 Financial
Reporting in Hyperinflationary Economies had no positive effect at all during 6
years in Zimbabwe’s hyperinflationary economy.
The
IASB offered responses to the first two criticisms, but has offered no response
to the last.
Financial
statements are a structured representation of the financial positions and
financial performance of an entity. The objective of financial statements is to
provide information about the financial position, financial performance and
cash flows of an entity that is useful to a wide range of users in making
economic decisions. Financial statements also show the results of the
management’s stewardship of the resources entrusted to it.
To
meet this objective, financial statements provide information about an entity’s
assets, liabilities, equity, income and expenses, including gains and losses,
contributions by and distributions to owners in their capacity as owners and
cash flows.
This
information, along with other information in the notes, assists users of
financial statements in predicting the entity’s future cash flows and, in particular,
their timing and certainty in a bid to enhance revenue recognition.
The
following are the general features in IFRS:
–
Fair presentation and
compliance with IFRS: Fair presentation requires the faithful representation of
the effects of the transactions, other events and conditions in accordance with
the definitions and recognition criteria for assets, liabilities, income and
expenses set out in the Framework of IFRS.
–
Going concern:
Financial statements are present on a going concern basis unless management
either intends to liquidate the entity or to cease trading, or has no realistic
alternative but to do so.
–
Accrual basis of
accounting: An entity shall recognize items as assets, liabilities, equity,
income and expenses when they satisfy the definition and recognition criteria
for those elements in the Framework of IFRS.
–
Materiality and
aggregation: Every material class of similar items has to be presented
separately. Items that are of a dissimilar nature or function shall be
presented separately unless they are immaterial.
–
Offsetting:
Offsetting is generally forbidden in IFRS. However certain standards require
offsetting when specific conditions are satisfied (such as in case of the
accounting for defined benefit liabilities in IAS and the net presentation of
deferred tax liabilities and deferred tax assets in IAS).
–
Frequency of
reporting: IFRS requires that at least annually a complete set of financial
statements is presented. However listed companies generally also publish
interim financial statements (for which the accounting is fully IFRS compliant)
for which the presentation is in accordance with IAS Interim Financing
Reporting.
–
Comparative
information: IFRS requires entities to present comparative information in
respect of the preceding period for all amounts reported in the current
period’s financial statements. In addition comparative information shall also
be provided for narrative and descriptive information if it is relevant to
understanding the current period’s financial statements. The standard IAS also
requires an additional statement of financial position (also called a third
balance sheet) when an entity applies an accounting policy retrospectively or
makes a retrospective restatement of items in its financial statements, or when
it reclassifies items in its financial statements. This for example occurred
with the adoption of the revised standard IAS 19 (as of 1 January 2013) or when
the new consolidation standards IFRS 10-11-12 were adopted (as of 1 January
2013 or 2014 for companies in the European Union).
–
Consistency of
presentation: IFRS requires that the presentation and classification of items
in the financial statements is retained from one period to the next unless:
a.
it is apparent,
following a significant change in the nature of the entity’s operations or a
review of its financial statements, that another presentation or classification
would be more appropriate having regard to the criteria for the selection and
application of accounting policies in IAS 8; or
b. an
IFRS standard requires a change in presentation.
2.2 DEFINITION OF REVENUE RECOGNITION
The Financial Accounting Standards
Board (FASB) and the International Accounting Standards Board (IASB) both use a
different definition concerning revenue: “Revenues are inflows or other
enhancements of assets of an entity or settlements of its liabilities (or a
combination of both) from delivering or producing goods, rendering services, or
other activities that constitute the entity’s ongoing major or central
operations.” (FASB Concepts Statement No. 6 Elements of Financial Statements,
paragraph 78), and “Revenue is 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.”
In the FASB Concepts Statement number
5, paragraph 58 you can read that “Recognition is the process of formally
recording or incorporating an item in the financial statements of an entity as
an asset, liability, revenue, expense, or the like. Recognition includes
depiction of an item in both words and numbers, with the amount included in the
totals of the financial statements.” Mentioned in the IAS 18 standard about
recognition is: “Recognition means incorporating an item that meets the
definition of revenue in the income statement when it meets certain criteria”
So, according to the concepts and
standards mentioned above, revenue recognition is recording revenue, which
suffices certain conditions, in the financial statements.
Although these standards and definitions
are notable dated (1984 and 1993), they are still applicable. Only concerning
the implementation of the revenue recognition process some discussion is
possible. As an addition to the FASB Concepts Statement, the Securities and
Exchange Committee (SEC) published in the end of 1999 some detailed rules on
the area of revenue recognition, in the Staff Accounting Bulletin 101 (SAB
101). The SAB 101 was revised in 2003 and the SAB 104 was published as its
substitute. The reason of publishing more detailed rules was that the SEC
expressed in public their concern about the big amount of points of controversy
and the problems that companies experience concerning the current revenue
recognition.
Schipper
et al. (2009) describes some different conceptual models for revenue
recognition: the customer consideration model and the measurement model. These
models were proposed at an AAA/FASB Financial Reporting Issues Conference, in
order to replace the current revenue recognition models. Some participants
believe that the notion of an earnings process is insufficiently precise, to
provide a sound conceptual basis for revenue recognition standards. Therefore
two new models were presented at that conference. Both models are based on
contract asset and contract liability, so they both recognize revenue when
contract asset increases or contract liability decreases. The difference
between the two proposed models were that, at the customer consideration model
revenue is recognized based on the prices that are mentioned in the contract,
while at the measurement model recognized revenue is based on what really is
paid.
2.2.1 TIMING OF REVENUE RECOGNITION
Accrual accounting distinguishes cash
inflows from revenues and cash out-flows from expenses, recognizing the
differences between cash flows and income as liabilities or assets.
The principles which govern the
recognition of revenues (and expenses) are the key determinants of the
properties of accrual accounting information (Dhutta and Zhang, 2002). The
recognition of economic events in accounting revenues tends to lag that of the
market. An informed market recognizes the effects of economic events when they
occur, but revenue recognition must await compliance with formal accounting
recognition criteria. The application of these criteria involves basic concepts
as reliability, objectivity, conservatism, and verifiability. It affects
earnings in two ways:
–
current earnings will
include recognition of certain prior periods’ economic events, and
–
current earnings do
not recognize all of the current period’s economic events until future periods.
(Warfield and Wild, 1992)
The reason that this is a big issue is
because events occur now, they are recognized over some time and therefore
future periods’ earnings possess explanatory power for current returns. The
incremental explanatory power of future periods’ earnings varies inversely with
the length of the reporting period. Warfield and Wild (1992) indicated that in
certain instances, the recognition lag is of such magnitude that the explanatory
power of future periods’ earnings for current returns more than triples that of
current earnings.
For investors and other stakeholders it
is sometimes hard to say what the explanatory power of current returns and
earnings is. It is unclear in which period current returns will lead to future
earnings. And what the influence of previous returns on current earnings is.
Therefore
it is important that there are good rules to determine when revenue and some
item should be recognized.