Revenue Recognition and Earnings Management - Essay Example

?Ibi Ryan Plc: Revenue Recognition and Earnings Management Revenue Recognition under IAS 18 The emphasis in auditing is not restricted to arithmetical accuracy. Appropriate application of accounting principles and disclosures is necessary for forming a correct view of the state of affairs. Therefore, meaning of ‘income’, ‘revenue’ and ‘profit (gain)’ in terms of IAS 18 is important in understanding the principle of revenue recognition. “Income is defined in the Framework for the Preparation and Presentation of Financial Statements as increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. Income encompasses both revenue and gains.” (ec.europa.eu, p. 2) Revenue: “IAS 18 defines revenue 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” (ACCA, 2013.) Gain: “An increase in the value of an asset or property. A gain arises if the selling or disposition price of the asset is higher than the original purchase or acquisition price” (Investopedia, n.d.) Normally the word ‘profit’ is used in business context in the place of gain. It is also very important that that revenue and the related expenses should be matched with the accounting period, and this is called matching principle. “When the selling price of a product includes an identifiable amount for subsequent servicing that amount is deferred and recognised as revenue over the period during which the service is performed. The amount deferred is that which will cover the expected costs of the services, together with a reasonable profit on those services” (ACCA 2013). Construction of certain long term projects spans over more than a year. In those cases, revenue recognition is based on stage or percentage of completion. Only when the economic benefits associated with the transaction flows to the entity, corresponding revenue could be recognized. When two or more transactions are linked as in the case of repurchase agreement, both the transactions i.e. sale and repurchase should be dealt with together. Section 14 of IAS 18 stipulates the conditions for revenue recognition in respect of sale of goods. These following two conditions are relevant for discussion in respect of accounting of transaction related to Witney. (a) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods; (b) the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; Section 20 states “When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognised by reference to the stage of completion of the transaction at the end of the reporting period.” This principle is relevant for discussion in respect of support services to PC4U. Case Study Sale of electrical goods When sale has been accounted properly, the goods covered should not be treated as stock; and the sale is not treated as stock by the company. Snowfall and delay in delivery cannot alter the position. Once the goods are despatched to the buyer, the seller has no control over the same. The following conditions u/s 18 are important in this respect (a) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods and (b) the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold. Therefore, no adjustment is required on account of this transaction. Contract with Witney The total amount owing to Ibi Ryan from Witney is ?600,000 at 31st March. It is assumed that includes the sum relating to the Liverpool transaction also. The terms of the company’s contract with Witney specify that the goods remain the property of Ibi Ryan until they are paid for by Witney. As in the previous case, the following points are relevant in deciding the ownership. (a) The entity has not transferred to the buyer the significant risks and rewards of ownership of the goods; (b) The entity retains continuing managerial involvement to the degree usually associated with ownership or effective control over the goods sold; The title to the goods worth has not passed on from Ibi Ryan from Witney ?600,000 as per the terms of contract. Therefore, inclusion of this amount under sale during the year is not correct. This sale worth ?600,000 should be reversed in the books of accounts of Ibi Ryan and treated as stock. Profit of the company is overstated by ? 300,000 i.e. 50% of sales. Support services in respect of sale of laptops to PC4U IAS 18 states: “when the selling price of a product includes an identifiable amount for subsequent servicing, that amount is deferred and recognised as revenue over the period during which the service is performed.” In this case, support services for thirty three months relating to the subsequent period up to 31st December 2015 have been included in the current year. This should be reversed and the corresponding profit works out to 165000 at 25% of the charges. in ? Full price for the contract - Sale of laptops to PC4U and support services 2720000 Price for 10000 laptops @ ? 200 2000000 ----------- The cost of the support services 720000 Support services for 2 years and 9 months (to be reversed) 660000 Profit included on the above (to be reversed) 165000 Adjustments required in accounts Revenue (? in millions) Profit (? in millions) Reported revenue and profit 4003.00 51.00 Less Reversal in respect of Witney ( 6.00) (3.00) Excess incl. for support services ( 6.60) (1.65) -------------------------- ---------------------- Revised revenue and profit 3990.40 46.35 ================ ============== Incentive bonus payable based on price of the company’s shares The incentive bonus payable to the directors is not linked to performance of the company. IAS 18 stipulates the following conditions for estimating the outcome of a transaction: (a) The amount of revenue can be measured reliably; (b) It is probable that the economic benefits associated with the transaction will flow to the entity; (c) The stage of completion of the transaction at the end of the reporting period can be measured reliably; and (d) The costs incurred for the transaction and the costs to complete the transaction can be measured reliably. Also, we cannot treat this payment in terms of section 29 of IAS 18 which is related to interest, royalties or dividends. Therefore, there is no question of restating revenue or operating profit. Creative Accounting and Earnings Management Earnings management is used generally to exercise conservatism and prudence. Companies adopt this technique to smooth out the fluctuations in earnings. It will provide stability and allow the company to maintain continuity in declaring dividends to the shareholders. But, unscrupulous managements use earnings management to manipulate the financial results through creative accounting by adopting questionable accounting and reporting practices. Earnings management is also carried out to rig up the stock prices or improve the incentives or commissions of the managerial people. Levitt, A. (1998) stated “Flexibility in accounting allows it to keep pace with business innovations. Abuses such as earnings management occur when people exploit this pliancy. Trickery is employed to obscure actual financial volatility. This, in turn, masks the true consequences of management's decisions.” In the case of Ibi Ryan our analysis reveals that the following transactions raise the question of earnings management. 1. As per the contract between the company and Witney, till the payment is not received the transaction cannot be treated as sales. However, the company has treated goods worth 600,000 as sold, for which payment has not been received. 2. In the transaction relating to PC4U, the company has included the entire support services for the period up to 31st December 2015 (for 3years) in the accounts during current year. This could be considered as a clear case of earnings management since treatment of the above transactions distorts true and fair view of the accounts. References ACCA, 2013. Revenue Recognition. Available at: [Accessed 23 November 2013]. ec.europa.eu, 2009. International Accounting Standard 18 Revenue. 16 September 2009. Available at: [Accessed on 23 November 2013]. Investopedia, n.d. Definition of ‘Gain.’ Available at: [Accessed on 23 November 2013]. Levitt, A., 1988. REMARKS BY CHAIRMAN ARTHUR LEVITT SECURITIES AND EXCHANGE COMMISSION THE "NUMBERS GAME," NYU CENTER FOR LAW AND BUSINESS, NEW YORK, N.Y. SEPTEMBER 28, 1998. Available at: [Accessed 23 November 2013]. Read More