Revenue Recognition: New Standards versus Old Standards - Essay Example

Revenue Recognition: New Standards versus Old Standards Introduction The new revenue recognition rules are meant to improve the current accounting guidelines. The guidelines are used in United States Generally Accepted Accounting Principles. The new standards impact the organizations in three different ways; organizations incur implementation costs; they restructure their practices in response to the new standards and; financial statements are expected to change for some organizations. The new standards have a material impact on the financial statements of organizations. This paper is going to examine the old rules along with the analysis of the current standards, and determine the changes that are likely to be witnessed with the adoption of the new rules with emphasis on revenue recognition. FASB & IASB define revenue as the “inflow or other improvement of assets of a unit or completion of its liabilities from conveying or producing goods, offering services, or other issues that comprise the entity’s continuing chief or central operations” (www.fasb.org). This paper simplifies the definition; revenue is the amount received by an organization in the payment for goods and services. Revenue if therefore considered as one of the most important components in organization’s accounting practices. Revenue recognition that is at the center of this paper is an accounting principle that determines the requirements of a firm to realize income as revenue. Firms’ accountants are under a duty to comply with U.S. GAAP guidelines and adjust accordingly to changes in guidelines. Revenue guidelines have evolved over time. The guidance on revenue recognition had a relatively simple beginning. However, the guidance has grown larger and more complex with time. Though the new guidelines are complex, they are a step towards the right direction. Background/history Topic sentence: The concept of revenue recognition is currently one of the most complex areas of accounting. Nevertheless there is need for continuous review of rules and adoption of the same. The late 1990s became a period when the Securities and Exchange Commission (SEC) became concerned about the quality of revenue recognition. These concerns were specifically raised by the former Chief Accountant of SEC, Lynn Turner, who argued that recognition of revenue prematurely has made investors lose millions of dollars. These concerns made SEC make a number of attempts to elevate the quality of financial reporting. This move attracted criticism from many quarters pressuring the SEC into diminishing the guidance that it had offered completely. Whereas the new standards attracted a lot of criticism, it also attracted support from shareholders who perceived this move as a step towards the right direction and fairness within the organization. a. There is lack of fair value measurements under the old rules Although the fair value principles were present under the old rule, the process of applying these principles was very complex and they often brought controversies. b. The cases of revenue fraud are increasing at a high rate. There are increasing calls for more stringent guidelines. Revenue frauds have been found to be increasing at a very high rate especially within the large companies. In the period 1998-2007, 60 percent of accounting fraud cases were revenue fraud cases, which was an increase from the period 1987-1997 accounting for 50 percent (Beasley 2). There are many publications that have been issued by the governing bodies such as FASB, APB, and SEC among many others seeking to ensure the accuracy of revenue recognition. Though the cases of revenue fraud increased from the period 1987-1997 to 1998-2007, the current standards are fairer than the old standards. Concluding sentence: There is a need for stringent revenue recognition guidelines. New accounting rule Topic sentence: Different standards have been developed by both the FASB and IASB on how revenue should be recognized a. Accounting standards have changed over a period A historical examination shows FAS 141 (R) superseding the earlier authoritative FAS 141 and FAS 142 in December 2007 (www.fasb.org). This shows the dedication that is in FASB in improving the financial reports’ quality. In May 2014, the Accounting Standards were further updated by FASB. The document (FASB ASU No. 2014-09) was issued for guidance. The standards that govern Accountants in the US are the Generally Accepted Accounting Principles (U.S. GAAP), developed by FASB. Currently, revenue recognition has proved to be one of the most important financial reporting areas. As a result, it has received constant attention by investors and regulatory agencies. c. Fair Value Measurements New rules on revenue recognition require the use of seller-specific objective evidence of fair value in determining an approximation of the selling price. In 2006, FASB issued a new rule that was aimed at providing a single, consistent definition of fair value. FAS 157, “Fair Value Measurement” standard laid down a common framework for development of fair value estimates. FAS 157 defines fair value as the price received after selling an asset or the one paid in transfer of a liability in an arranged deal (www.fasb.org). The new standard FASB ASU No. 2014-09 requires the firms to use a principle-based approach for determining revenue recognition (AICPA 1). Under this principle, revenue is recognized after a firm is in line with a performance requirement by conveying a promised good or service to the purchaser. Revenue is recognized after control of good or service is transferred to the customer. Works by McEnroe and Sullivan have showed that an investigation done by SEC after Enron’s scandal recommended accounting standards be developed on a principle-based approach. d. Introduction of comprehensive income concept and the model for the measurement Comprehensive income comprises all revenues and gains, expenses and losses, and other gains and losses that bypass net income but have effects on the stockholders’ equity. Under the new rule of fair value accounting, the income statement is considered as residual to balance sheet measurement. Under the new rules, the income statement was found to provide information about risk exposure and management performance (Penman 39). FASB ASU No. 2014-09 provides a model for measuring and recognizing gains and losses on the sale of certain non-financial assets. The new standards for revenue recognition have removed inconsistencies and weaknesses in the old standards requirements. Comparison between new revenue recognition rule and the old revenue recognition rule Topic sentence: There are three areas of differences between the old revenue recognition method and the new revenue recognition method. a. Old standards versus New standards Under old standards revenue was recognized before the transfer of goods or services to the customer whereas under the new rules revenue is recognized only after goods and/or services are transferred to the customer. Previously, the firms were not required to account for all distinct goods but under the new standards firms are required to account for these goods. Under new rules, in order to determine the amount to allocate and the basis for that allocation, the firm will require to use greater estimates (Lamoreaux and Nilsen 27). b. The new standards are more beneficial than old standards in many ways. The new standards provide more useful information to users because they have established new disclosure requirements. They have also removed inconsistencies and weaknesses in the old standards. These standards specify the accounting treatment for all revenues that arise from contracts with customers. The major changes in this rule will impact many companies and various stakeholders have commented on this issue. Changes that have been witnessed have dramatically improved the quality of financial reports and this change has been received well by various stakeholders. News and discussion Topic sentence: New rules have a large number of supporters as well as detractors. Most investors, analysts and other stakeholders like this new rule for various reasons a. Support and detraction Analysts like this because it provides a better value for the acquisition. Under new standards, there are more fair value measurements. During their analysis, the analysts consider their forecasts to be more accurate (AAAFASC 12). On the other hand, many accountants criticized the old method and hailed the move to change the rules arguing that the old rules allowed the firms to make overpriced acquisitions without suffering consequences in their earnings. The supporters of fair value accounting rise in defense of new rules arguing that it is more relevant than the old rule because it provides up-to-date information concerning revenue recognition, thereby increasing transparency. The new rules have discouraged cases of fraud which were found to be on the rise (Beasley 2). As it was observed earlier in this paper, there is a rapid change in the business environment; therefore, the income statements should reflect the true values of revenue rather than a summary of past transactions. In addition, failure to recognize revenues at their fair value only lays a foundation for manipulation of financial reports. However, critics too point out that fair values based on models are not reliable and can be easily manipulated by the management. Another criticism involves its high implementation costs. b. There are various reasons why investors, creditors and other stakeholders like the new revenue recognition rule. Owners, shareholders, and potential investors are more interested in profitability. The most interested party in the area of revenue recognition is the investors because they look for a high payout ratio. Investors and creditors find a fair value measurement more pertinent to them since it replicates the current value as well as timeliness. Under the old standards, the information about revenue was not relevant because it was always out-of-date. They also like the new rule because the earnings are measured more continually, and they are always based on changes in the economic values of rights and obligations. Under the new rules, revenue is recognized when it is realized and earned. These rules also require that the consideration be received from the buyer, and it should be fixed or determinable. The old method used the matching principle to measure expenses whereas earnings were measured at discrete points when the revenue recognition criteria were met. Many academic researchers have highlighted the advantages and benefits of the new rules. Academic research Topic sentence: Academic researchers have highlighted both the advantages and disadvantages of revenue recognition. a. Revenue recognition may be used by the management in earnings management Accruals management is one of the two broad categories of earnings management. The most popular method of accounting accruals is when a firm accounts for earnings before cash is received. This is an improper revenue recognition action, and it has received criticism from different academic quarters. Improper revenue recognition increases earnings for a period making the firm look better. Chiou and Tsai suggest that the most probable reason behind improper revenue recognition is that it is difficult to detect, less costly, and it is easily manipulated (1783). Loomis observes that almost all firms use earnings management to some degree (74). However, using improper revenue recognition to fix small organizational problems through manipulating earnings can cause a continuous downhill spiral effect. This could end up plunging the firm into an abyss where no kind of earnings management will do the trick anymore. For example, Enron is one of the companies that used earnings management and ended up spiraling it out of control. Enron crossed the line through the use of earning management resulting in the largest U.S. bankruptcy of all time. Enron used earnings management to fallaciously create revenues. Accounting decisions have to be in coherence with the new rules or not. Earnings management that violates the new rules is probably intended to mislead the stakeholders. Earnings management that is intended to inform stakeholders is considered to be incoherent with the new rules. The new rules influence relevance and reliability of the information disseminated to the stakeholders. Own Opinion In spite of the complexity of revenue recognition guidelines and the possibility management manipulation, the new rule is better because it increases transparency and relevance. The new rules have had dramatic changes in the way firms recognize their revenues. Substantial progress has been achieved by FASB in addressing the revenue recognition issues that affect investors, stakeholders, and shareholders. The new revenue recognition rules have provided greater transparency for investors and the all the other users of financial statements. However, some positive factors in revenue recognition have partially been obtained or discontinued. There is a need for even further updates on the current revenue recognition standards. Conclusion A shift from old revenue recognition standards to new ones has been received well by various stakeholders, and they find the new method more useful because it addresses their interests. Armstrong, Guay, and Weber suggest that there is a difference of interests, risk attitudes, and time horizons between managers and shareholders (185). The new standards tend to put more weight on the shareholders’ side. The new rules lay a good foundation for better revenue recognition, at fair values. The new standards can prevent cases such an Enron’s one because of their insistence on fair value recognition. Bufklins and Dharan establish the link between improper revenues and executive compensation as the leading factor in Enron’s focus on boosting its total revenue figures (101). References Armstrong, C., Guay, W. and Weber, J. The Role of Information and Financial Reporting in Corporate Governance and Debt Contracting. Journal of Accounting and Economics. 50 (2-3): 179-234, 2010. Print Bufkins, William. and Dharan, Bala. Red Flags in Enron’s Reporting of Revenues and Key Financial Measures. Enron: Corporate Fiascos and Their Implications. 97-110 Beasley, Mark., Carcello, Joseph, Hermanson, Dana and Neal, Terry. Fraudulent Financial Reporting 1998-2007. Committee of Sponsoring Organizations of the Treadway Commission, 2010. Web. Chiou, Yen-Jiun and Tsai, Chih-Fong. Earnings Management Prediction: A Pilot Study of Combining Neural Networks and Decision Trees. Expert Systems with Applications, 3 (36): 7183-7191.print Financial Accounting Standards Board, News Release 6/10/97. FASB Issues Special Report on Business Combinations. Norwalk, CT. Web. Lamoreaux, M. and Nilsen, K. Convergence milestone. Journal of Accountancy. 210 (2), 26-31: 10.Print Loomis, Carol. Lies, Damned Lies, and Managed Earnings. Fortune. 140 (3): 74-92. 1999. Web. McEnroe, J. and Sullivan, M. The Rise and Stall the U.S. GAAP and IFRS convergence movement. ProQuest: The CPA Journal. 84 (1), 14-19. 2014. Print. Penman, S. Financial Reporting Quality: Is fair Value a Plus or a Minus? Accounting and Business Research. 33-44. 2007. Print. Read More