Accounting standards for corporate recognition of revenue from the sale of products and services need an extreme makeover, and American and international standard setters are asking for long-range help. On Friday, the Financial Accounting Standards Board and the International Accounting Standards Board issued a joint discussion paper on revenue recognition rules, asking constituents for comments by June 19, 2009.
The six-month review period, and the fact that the boards issued a discussion paper ahead of a draft rule proposal, indicates that the issues to be debated are complex.
A major cause of the complexity appears to be an overabundance of FASB revenue-rec rules in comparison to a sparseness of detail in the IASB standards, critics suggest. Indeed, the number of FASB’s revenue-recognition rules has mushroomed to more than 100 standards, plus rule exceptions addressing about 25 different industries. In contrast, some say, IASB revenue-rec rules often lack precision, leaving preparers confused as to what overriding principle to apply. Both extremes have led to a diversity in practical application and a skewing of economic reality, many observe.
Revenue recognition is, after all, an area greatly susceptible to a range of errors, from simple blunders to outright fraud. Companies caught in a web of complex rules, may, for example, make honest mistakes. On the other hand companies scheming to game the accounting system are able to hide losses and fudge results. In fact, the most common types of fraud for both bankrupt and non-bankrupt companies involved revenue recognition, manipulation of expense, and improper disclosures, according to a study conducted by the Deloitte Forensic Center and released in November. Revenue recognition also tops the list of reasons for restatements, according to several other studies.
The FASB-IASB discussion paper focuses on customer contracts for products and services, rather than contracts for financial instruments — which will be handled as part of separate projects on lease, hedging, and pension accounting. Whittling down U.S. generally accepted accounting standards and beefing up International Financial Reporting Standards likely will change the way companies think about revenue and, in some cases, book it, a reading of the discussion paper suggests.
Broadly, the paper discusses the lack of a general standard in U.S. GAAP for recognizing revenue for services. Further, the paper points to a slack linkage between the income statement and the balance sheet. Under American rules, the process for reporting net income “accounts for revenue with little consideration of how assets and liabilities arise and change over the life of a contract.”
That’s a problem, say the boards. Assets and liabilities are, after all, “cornerstone elements” in their joint conceptual framework project, so the definition of revenue depends on changes in assets and liabilities. As a result, the approach to reporting earnings could be improved by focusing on changes in specified assets or liabilities,” notes the paper.
Meanwhile, IFRS, which includes just two main revenue-rec standards, faces a different type of problem. For example, IAS 18 — the principle governing the sale of goods — is at odds with the definition of an asset. That is, the definition of a sale under IAS 18 depends on when the risks and rewards of ownership of the product are transferred to a customer. So, a company might recognize a product as inventory even after the customer has obtained control over the good, states the paper. Such an “outcome is inconsistent with the IASB’s definition of an asset, which depends on control of the good, not the risks and rewards of owning the good,” it continues.
Accounting for bundled products and services is “another deficiency” within IFRS singled out in the discussion paper. According to IAS 18, “in certain circumstances, it is necessary to apply the [revenue] recognition criteria to the separately identifiable components of a single transaction.” However, the principle says little more about when or how a company should separate a single transaction into components or units of accounts.
There is also a lack of guidance in IFRS about how to measure the elements in a multiple-element arrangement — a situation which has led to the application of different measurement approaches by different companies. What’s more, IASB believes that accounting for transactions in the construction industry is problematic and that a basic tenet will likely be revised in this area.
Specifically, IFRS provides no clear distinction between goods and services. That has led some builders to account for real estate contracts as construction-service contracts, recognizing revenue throughout the construction process. Meanwhile, other builders account for similar contracts as goods, recognizing revenue when the risks and rewards of owning the real estate are transferred to the customer. The discussion paper leans toward delaying revenue recognition until a builder hits a milestone or finishes the contract work completely.
The boards also pose questions about whether an obligation to accept a returned good and refund from a customer is considered a performance obligation, and whether sales incentives give rise to performance obligations if they are provided in a contract with a customer. Further, the boards ask whether it makes sense to measure performance obligations at the original transaction price and update the price only if the obligation is deemed onerous.