Revenue Recognition and Financial Accounting Theory - Research Paper Example

Revenue recognition of Table of Contents Historical development of financial accounting theory 3 Current Generally Accepted Accounting Principles 5 Compare and contrast U.S. GAAP and IFRS in respect to revenue recognition 7 Identification of problem areas and requisite changes 8 Conceptual framework for financial reporting and qualitative characteristics of useful information 10 1.Relevance 10 2.Faithful representation 11 3.Comparability and consistency 11 4.Understandability 11 Recommended course of action 11 References 13 Bibliography 14 Historical development of financial accounting theory Prior achieving a clear understanding and meaningful insight in the historical development of financial accounting theory, it is important to understand the need of financial accounting in the business world. Financial accounting is an important operation within an economy. Financial markets are responsible for allocation of capital resources and this process involves a large of decisions taken by fund providers (investors, lenders and financial institutions). Since most of these decisions involve financial information, they are presented in financial statements. Modern financial accounting is highly dependent on double entry bookkeeping. However, the origin of double entry bookkeeping is not clearly known of yet literatures suggest that in almost every civilization, financial record keeping was followed. Franciscan Friar, Luca Pacioli is often associated with double entry bookkeeping because he published a book on the same in 1494. In the book, he spoke of debit and credit as well as of liabilities and assets. Pacioli also advised in the book about periodic profit calculation and yearly closing of books (Previts, Parker & Coffman, 1990). Around sixteenth century, noticeable changes were proposed and incorporated in the bookkeeping techniques for the purpose of recording various kinds of transactions. During this period, usage of specialized subsidiary books such as separate cash book increased greatly. By the end of seventeenth century, evolution of periodic preparation of financial statements was witnessed. Additionally, the eighteenth century marked personification of different accounts and transactions for rationalizing debit and credit rules that were applicable to abstract and impersonal accounts (Jones & Riahi-Belkaoui, 2010; Previts, Parker & Coffman, 1990). The period also pointed at evolution of three methods of treating fixed assets. Firstly, assets were carried forward in financial statements at original cost and difference between revenue payments and receipts was shown in profit and loss account. Secondly, fixed asset accounts were closed on the balancing date and the difference between debit and credit balance due to original cost and other expenditures was carried forward. The third method was to evaluate appreciation and/or depreciation in the asset value and the difference was reflected in profit and loss account. However, it was only around 1930s, the depreciation charges and methods became more evident in practice (Edwards, 2013). Post industrial revolution in nineteenth century, cost accounting came in existence. In the latter half of nineteenth century and twentieth century, accounting theories and principles were critically examined and analyzed by different groups in Australia, the United States of America (USA) and other countries. The overall process can be classified in four phases. The first phase witnessed complete managerial control over financial disclosures in annual reports. In this era, another development was observed, that is, taxation of business income. In the second phase, role of various institutions in development of accounting principles was observed. For instance, in the USA, the Securities and Exchange Commission (SEC) was established in 1933 under Securities Act as a result of 1929 stock market crash. During that period, the primary purpose of the SEC was to protect investors and regulation of accounting rules (Jones & Riahi-Belkaoui, 2010). As a part of the third phase, the Committee of Accounting Procedure was empowered by the SEC for issuance of pronouncements in 1938. However, the committee faced severe criticism between 1957 and 1959 regarding failure to develop comprehensive statement based on basic accounting principles and failure to resolve certain unpopular issues. The fourth phase was introduced in 1973 and it continues to exist till present day. During this period, organizations such as Financial Accounting Standards Board (FASB), International Accounting Standards Board (IASB) and Australian Accounting Standards Board in Australia (AASB) came in existence. The FASB is held responsible for establishment and improvement of Generally Accepted Accounting Principles for public interest in the USA. The prime development in the history of financial accounting theory is introduction of standards and the GAAP were the first to gain substantial degree of authoritative support (Jones & Riahi-Belkaoui, 2010). In 2002, the Sarbanes-Oxley Act was passed, which is also known as Public Company Accounting Reform and Investor Protection Act. This act was passed as a result of growing recognition and importance of accounting and auditing in the political arena. Furthermore, the act was also enacted as a result major corporate accounting scandals such as Enron and WorldCom. The act comprised 11 sections that were approved by the SEC for the purpose of implementation and compliance of regulations. These sections include corporate responsibility, public company accounting oversight board (PCAOB), auditor independence, enhanced financial disclosure, conflicts of interest, corporate fraud accountability, criminal fraud accountability, commission resources and authority, white-collar crime penalty enhancement, corporate tax return and studies and reports (Edwards, 2013). The international accounting standards board was established in 2001 and is solely responsible for setting global accounting standards. The IASB is also responsible for approving and developing the International Financial Reporting Standards (IFRS). The IFRS is also known as international GAAP and require approval of at least nine members out of every twelve members of IASB for its issuance. The framework regarding preparation and presentation of financial statement is developed by IASB so that it can evaluate existing IFRSs in a better manner as well as provide superior assistance in development of future IFRSs (Jones & Riahi-Belkaoui, 2010). Since 2002, IASB and FASB have been working simultaneously towards international convergence in context of accounting standards. The aim of this convergence is to create a group of high quality internationally approved accounting standards which companies can implement for domestic as well as international financial reporting. The reason behind this decision is that it was observed that a financial reporting system induces economic development through corporate governance, high quality of standards and sound regulations. In the present environment, financial reporting has become very important for organizations and stakeholders but as businesses are taking a globalised shape, a common reporting structure will ensure clarity and easy understanding of the information. Another important effort of the IASB is the conceptual framework or the conceptual framework of Financial Accounting. The framework is a set of various fundamental concepts that assists in preparing and presenting financial statements. The conceptual framework recognizes various concepts that IASB can consistently use for revising and developing IFRSs (Jones & Riahi-Belkaoui, 2010; Edwards, 2013; Previts, Parker & Coffman, 1990). Current Generally Accepted Accounting Principles The GAAP is generally referred to a standard framework of regulations related to financial accounting used within a particular jurisdiction. The GAAP mainly comprises of standards, rules and conventions that are implemented by accountants for the purpose of recording, summarizing and preparation of financial statements. The US GAAP is one of the largely recognized principles of accounting all over the world. The importance of assimilating US GAAP in various national accounting standards have increased significantly with the advent of globalization and increased access to global securities markets and capital. A number of foreign companies need to publish their financial reports in accordance with the US GAAP for getting listed at USA based stock exchanges such as NASDAQ and New York Stock Exchange for the purpose of easy consolidation (Ernst & Young, 2013). The financial statements that are considered under the US GAAP are consolidated balance sheet showing comparatives for two years, consolidated income statement showing comparatives for three years, consolidated statement of stockholders’ equity and comprehensive incomes presenting comparatives for three years, consolidated cash flow statement presenting comparatives for three years, a summary of important accounting principles as required by Accounting Principles Board, forward looking statement that complies with section 27A of the Securities Act, 1933 and section 21E of the Securities Act, 1934 and Certification by CFO and CEO as necessary under section 302 and section 906 of Sarbanes Oxley Act, 2002 in annual report as well as quarterly report (Jones & Riahi-Belkaoui, 2010). Under the US GAAP, the accounting policies that are needed to be disclosed include revenue recognition, fixed assets, investment, goodwill and intangible assets, derivatives instrument, foreign currency translation, stock based compensation and retirement benefits. The revenue recognition in US GAAP considers sale of goods as well as that of services. Additionally, each interim period under the US GAAP is considered as an important part of the annual period. Consequently, a number of costs that generate benefit in more than one interim period are allocated accordingly causing deferral or accrual of those costs (Ernst & Young, 2013, Jones & Riahi-Belkaoui, 2010). The US GAAP is important because it provides a standard way of profit or loss accounting in public businesses. Thereby, it provides investor an opportunity to clearly understand fund management in a company. Studies suggest that most organizations in the USA are privately owned and most groups are owned by the government. For attracting greater share of investment in the public sector, investors require a number of financial information so that they can assess the risk associated with these investments. The US GAAP helps investor gaining all the necessary information regarding an organization and related investment. Additionally, reporting through gap also provide information about financial health of a company and its future prospects. The USA is a capitalist economy and its existence lies solely in the number of industries operating therein. The US GAAP helps investors from all over the world in investing in the economy by providing them credible information regarding the various industries (Ernst & Young, 2013, Jones & Riahi-Belkaoui, 2010). Compare and contrast U.S. GAAP and IFRS in respect to revenue recognition The US GAAP pronouncements regarding revenue recognition is very broad and involves a number of standards that have been issued by the FASB, the SEC, the Emerging Issues Task Force and the American Institute of Certified Public Accountants. The guidance provided by the US GAAP is generally industry specific and extremely elaborate. Contrastingly, IFRS has only two standards for revenue recognition and four interpretations for the same. Additionally, in IFRS the principles have been laid out in a broad manner and it does not cover any kind of industry specific regulations. In a number of industries, significant difference in outcomes can be observed due to certain difference in US GAAP and IFRS. For instance, revenue recognition in context of software products requires vendor specific objective evidence of fair value for determination of selling price under US GAAP. However, there is no such provision for such transaction under IFRS. It was observed that activation services provided by telecommunication companies are largely similar but their reporting differs under US GAAP while IFRS does not follow equivalent requirements (PWC, 2013; Ernst & Young, 2013; Yoon, 2009). Contingent pricing and its role in the revenue recognition model differs to a great extent between US GAAP and IFRS. The criterion for revenue recognition is generally based on fixed or determinable pricing under US GAAP causing the contingent amount to be ignored in the revenue till the contingency is resolved. IFRS on the other hand has a different timing of revenue recognition because it compares and weighs probability of potential economic benefits from the revenue source and ability of measuring the same in a credible manner. Under US GAAP, revenue arrangements in context of multiple deliverables are classified in different units of accounting when the deliverables meet various criteria as per the guidance. Additionally, revenue recognition is conducted in an independent manner for each accounting unit. Under IFRS, transactions are either separated or grouped as per the requirement for having a better understanding of revenue recognition. The residual method for allocation of arrangement considerations is not pursued any more under US GAAP but continues to be one of the options under IFRS (PWC, 2013; Ernst & Young, 2013; Yoon, 2009). Studies suggest that fundamentally different outcomes can be observed between both the standards in context of accounting for customer loyalty programs. The IFRS treats customer loyalty programs as multiple element arrangements where consideration is provided to goods and services. US GAAP companies, on the other hand, generally employ the incremental cost model. It was observed that method of IFRS generally leads to deferral of revenue. Additionally, it was ascertained that cost to cost percentage of completion method is prohibited for service transactions under the US GAAP unless the same qualifies as production or construction contracts. Since most service transactions are not accounted under construction or production contract therefore are reported using proportional performance model. On the other hand, percentage of completion model is preferred in IFRS unless the progress in the project cannot be accurately measured. In such situations, the zero profit approach is adopted under IFRS (PWC, 2013; Ernst & Young, 2013; Yoon, 2009). Identification of problem areas and requisite changes In recent year, IFRS has gained a great degree of significance as a set of reporting standards in various nations. Till date, US GAAP has been the most acceptable accounting standards and was followed not only in the USA but also in a number of foreign companies who were interested in being listed in stock exchanges of the USA. Though US GAAP AND IFRS followed same conceptual framework and general principles, US GAAP was found to be more inclined towards rules while IFRS is more focused on principles. Since IFRS is principle focused, it explains economics of a transaction in a better manner compared to the US GAAP. One of the major problems that was noticed in the US GAAP is it is highly detailed and complex. The IFRS was introduced primarily to mitigate the problem related to elaborated information and complicated structure of US GAAP. However, there are certain disadvantages of convergence of US GAAP to IFRS. According to a number of investors, principle based system such as the IFRS would result in excessive management discretion. Additionally, it was ascertained by certain researchers that the IFRS is comparatively less robust in areas such as lease accounting, accounting in context of insurance industry and accounting regarding revenue recognition (Elena, et al., 2009; Ball, 2006). It was also ascertained that convergence of standards may confuse investors who are used to of one particular system. The SEC allowed in its proposal, implementation of either IFRS or GAAP or both. Consequently, it forces investors and accountants to learn and apply both the standards simultaneously. Convergence of US GAAP to IFRS is useful because IFRS is being practiced in about 100 nations worldwide and implementation of IFRS in the USA will ensure uniformity in accounting practices. The importance of global standards has increased recently because it presents investors the opportunity to compare company’s performance at international level (Elena, et al., 2009; Ball, 2006). Some of the benefits of the IFRS over US GAAP are discussed as follows. IFRS is highly focused on requirements of investors; consequently, the harmonization of accounting standards eliminates the processing and adjustment fees related to financial statements that are paid by investors to analysts. As globalization is an important agenda in modern day business world, IFRS reduces international differences in context of cross border acquisitions and mergers. Additionally, it was ascertained that IFRS enhances the quality of information available even though it streamlines the reports compared to US GAAP. Under the IFRS, loss is recognized immediately which benefits investors as well as lenders and other stakeholders of a company. Furthermore, convergence to IFRS will also ensure that the consistency and transparency is maintained in financial reporting. Adoption of IFRS will also improve the credibility of financial markets and provide better access to foreign capital markets and investments. In context of foreign competitors, IFRS will make it easy to compare performance and resource conversion to revenue. However, there are certain criticalities that can be recognized in this context. Comparability of financial statements can take adverse shape if the same company adopts two different reporting styles, namely, IFRS and national reporting standards (Elena, et al., 2009; Ball, 2006). Conceptual framework for financial reporting and qualitative characteristics of useful information The Conceptual Framework for Financial Reporting is responsible for establishing and defining various concepts that contribute towards formation of financial reporting. The framework is often considered as a coherent system of various accounting concepts developed with an objective. This object further recognizes the main purpose of financial reporting. The various concepts are responsible for providing guidance regarding identification of boundaries of financial reporting, selection of transactions and representation of various circumstances. Additionally, the conceptual framework also determines the manner, in which the information are to be recognized and measured, disclosed, summarized and reported (IFRS, 2013; Financial Accounting Standards Board, 2006). According to the framework, while setting various accounting standards, it is presumed that individuals who will have access to these reports will have reasonable amount of knowledge regarding business and economic activities so as to interpret a financial report. Additionally, it is also presumed that financial reporting information users will be reviewing and analyzing the available information diligently. The other presumptions include exercise of care while obliging financial reporting requirements by accountants. Due care in reporting include appropriate analysis and application of reporting requirements while presenting the resultant information in a clear and concise manner. There are four qualitative characteristics that are addressed in financial reporting as per the conceptual framework. These are relevance, faithful representation, comparability and consistency and understandability (IFRS, 2013; Financial Accounting Standards Board, 2006). 1. Relevance Decision pertaining to investment, credit and other resource allocation require information that are contextual and relevant. Relevant information is valuable because it is capable of creating difference in decisions of individuals through evaluation of potential impact of past, present and future transactions or other factors on future cash flow. Another important aspect of relevant information is timeliness. Timeliness ensures that a piece of information is available to investors and other decision makers before it loses its abilities to influence the particular decision. 2. Faithful representation Faithful representation in financial reporting involves information to be verifiable, complete and neutral in nature. Verifiability implies that different individuals who are expert in their respective fields will be able to reach a general consensus if not a complete agreement regarding the information presented in the reports. Neutrality focuses on absence of biasness in the information. In other words, the information should be factual and under no circumstance should have undergone manipulation. Completeness indicates that in financial reporting for faithful representation, information should be complete and serve the purpose of incorporation. 3. Comparability and consistency Comparability and consistency are some of the important qualitative characteristics of financial reporting that enhance credibility and usability of the same for various purpose of decision making. Comparability ensures that certain information in financial report of a company can be compared with that of other by users considering two set of economic factors. On the other hand, consistency focuses on following same accounting policies and procedures for financial reporting for a long period of time. 4. Understandability Understandability is a prime quality of information that ensures that users with basic knowledge of economic and business activities and financial accounting will be able to comprehend the same. However, it is noteworthy that relevant information should not be neglected or rejected because some users are unable to interpret the same. Instead, understandability can be enhanced through information classification and presentation of the same in a concise manner (IFRS, 2013; Financial Accounting Standards Board, 2006). Recommended course of action It was ascertain in the paper that the financial sector has undergone several changes since the introduction of double entry system in financial accounting. Presently, the debate is mainly focused in US GAAP and IFRS. After complete assessment of both the accounting standards, IFRS can be recommended as global accounting standards. The primary reason for this recommendation is that IFRS is highly focused on stakeholders’ requirements which should be the main aim of financial reporting. However, it was gathered that US GAAP is considered more robust compared to IFRS. The solution to this problem is that to enhance effectiveness of IFRS, modifications can be proposed under conceptual framework. Lastly, it was observed that in a number of organizations dual reporting practices are being followed which can be confusing to information allocator as well as user. In this context, it is recommended that organizations should focus on only one reporting style and take measures to converge towards IFRS. References Ball, R. (2006). International Financial Reporting Standards (IFRS): pros and cons for investors. Accounting and business research, 36(1), 5-63. Edwards, J. R. (2013). A history of financial accounting. London: Routledge. Elena, H., Catalina, M. C., Stefana, C. I. & Niculina, A. A. (2009). Some issues about the transition from US generally accepted accounting principles (GAAP) to international financial reporting standards (IFRS). Annales Universitatis Apulensis Series Oeconomica, 1(11), 275-289. Ernst & Young. (2013). US GAAP versus IFRS: the basic. 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(1994). Accounting history: some British contributions. Oxford: Oxford University Press. Van der Meulen, S., Gaeremynck, A. & Willekens, M. (2007). Attribute differences between US GAAP and IFRS earnings: An exploratory study. The International Journal of Accounting, 42(2), 123-142. Read More