Most revenue transactions—those initiated and completed almost at the same time—pose few problems for revenue recognition. However, not all transactions are that simple. For example, customers might pay at a time different from that when they receive goods or services, and an entity might provide the promised goods and services over many reporting periods.
To account for those transactions, accountants have developed a model in which an entity recognizes revenue when payment is received or receivable from a customer and the entity “earns” that revenue by providing the goods or services promised to the customer. In other words, entities recognize revenue when payment is realized or realizable and the “earnings process” is substantially complete.
As straightforward as that earnings process approach may appear, it sometimes provides users of financial statements with information that is not the most useful for making economic decisions. Moreover, it has created problems for financial statement preparers, auditors, regulators, and standard setters. The first section of this post considers some of the problems in U.S. GAAP and IFRSs and how FASB-IASB will address these issues. Read on…
Problems in U.S. GAAP
Numerous Standards That Define An Earnings Process Inconsistently
The application of the earnings process approach has led to more than 100 standards on revenue and gain recognition in U.S. GAAP—many of which are industry-specific and some of which can produce conflicting results for economically similar transactions. That is largely because the notion of an earnings process is not precisely defined and people often disagree on how it applies to particular situations.
For example: Consider a cable television provider:
- Does its earnings process involve only the provision of a cable signal to the customer over the subscription period? Or;
- Is the service of connecting the customer to the cable network an additional earnings process?
In accordance with FASB Statement No. 51, Financial Reporting by Cable Television Companies, an entity accounts for connection services as a separate earnings process and recognizes revenue for them when rendered (but only in an amount equal to direct costs).
As described in FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, and, to a lesser extent, in the IASB’s Framework for the Preparation and Presentation of Financial Statements.
In contrast, consider a telecommunications provider that requires a customer to pay an upfront, nonrefundable “activation fee” plus regular monthly fees for telephone usage:
- Does the provider’s earnings process involve only the provision of access to the telecommunication network during the contract period?; Or
- Is the service of connecting the customer’s telephone to the network a separate earnings process?
That service is similar to the connection services provided by a cable television provider. However, in accordance with SEC SAB 104, Revenue Recognition, a telecommunication provider does not account for that service as a separate earnings process. As a result, a telecommunication provider does not recognize revenue for nonrefundable activation fees when the activation services are rendered (not even in an amount equal to direct costs).
Many more examples like this exist in U.S. GAAP. The fact that entities apply the earnings process approach differently to economically similar transactions calls into question the usefulness of that approach. Moreover, the existence of different requirements for economically similar transactions reduces the comparability of revenue across entities and industries.
Gaps In Guidance And Conflicts With Asset And Liability Definitions
Despite the numerous standards in U.S. GAAP, gaps in guidance still exist. For example: there is no general standard on recognizing revenue for services. Moreover, as evidenced by topics recently on the agenda of the FASB’s Emerging Issues Task Force (EITF), revenue recognition questions continue to arise. That continuing need for guidance suggests that more robust revenue recognition guidance is needed in U.S. GAAP.
Guidance also is needed because the earnings process approach sometimes leads to a misrepresentation of an entity’s contractual rights and obligations in financial statements. In other words, an earnings process approach accounts for revenue with little consideration of how assets and liabilities arise and change over the life of a contract.
Assets and liabilities are the cornerstone elements in the FASB’s and IASB’s conceptual frameworks—indeed, the definition of revenue depends on changes in assets and liabilities. Therefore, some think that the earnings process approach could be improved by focusing on changes in specified assets or liabilities.
Problems In IFRSs
IFRSs have fewer standards on revenue recognition than U.S. GAAP. However, those standards also need improvement.
Inconsistency With Asset And Liability Definitions
Similarly to U.S. GAAP, some criticize revenue recognition standards in IFRSs because an entity applying those standards might recognize amounts in the financial statements that do not faithfully represent economic phenomena. That can happen because revenue recognition for the sale of a good depends largely on when the risks and rewards of ownership of the good are transferred to a customer.
Therefore, an entity might recognize a good as inventory (because a preponderance of risks and rewards may not have passed yet to the customer) even after the customer has obtained control over the good. That 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.
The risks and rewards notion in IAS 18 can also cause problems when a transaction involves both a good and services related to that good. To determine when the risks and rewards of ownership of the good are transferred, an entity often considers the transaction as a whole. That can result in an entity recognizing all of the revenue on delivery of a good, even though it has remaining contractual obligations for the services related to the good (for example, a warranty). As a result, revenue does not represent the pattern of the transfer to the customer of all of the goods and services in the contract. In addition, depending on how the accruals for the services are measured, an entity might recognize all of the profit in the contract before the entity has fulfilled all of its obligations.
Lack Of Guidance
Another deficiency in IFRSs relates to the lack of guidance for transactions involving the delivery of more than one good or service (that is, a multiple-element arrangement). For example: consider the guidance for multiple-element arrangements in IAS 18:
. . . in certain circumstances, it is necessary to apply the [revenue] recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction.
Although there are a few more sentences on the topic, IAS 18 does not state clearly when or how an entity should separate a single transaction into components (or units of account). Some interpret paragraphs 17 and 19 of IAS 18 as permitting the recognition of all the revenue for a multiple-element arrangement upon delivery of the first element if all the elements are sold together. Others, however, interpret the same paragraphs to require deferral of revenue for all the elements until delivery of the final element.
IFRSs also lack guidance on how to measure the elements in a multiple-element arrangement. Without a specified measurement objective for the remaining elements in such an arrangement, entities apply different measurement approaches to similar transactions, which reduces the comparability of revenue across entities.
Distinguishing between goods and services is another problem in IFRSs. The International Financial Reporting Interpretations Committee (IFRIC) recently dealt with this question in IFRIC 15, Agreements for the Construction of Real Estate.
Without a clear distinction between goods and services, some entities were accounting for real estate contracts as construction (service) contracts, recognizing revenue throughout the construction process. Other entities were accounting for similar contracts as contracts for goods, recognizing revenue when the risks and rewards of owning the real estate were transferred to the customer. The lack of a clear distinction between goods and services reduced the comparability of revenue across entities.
Gaps in guidance would not be as problematic if there was a clear principle to apply to ever-changing and increasingly complex transactions. However, the principles of IAS 11 and IAS 18 are inconsistent. For instance: the principle of IAS 11 (which applies only to construction contracts that meet specified requirements) appears to be that an entity should recognize revenue as the activities required to complete a contract take place (even if the customer does not control and have the risks and rewards of ownership of the item being constructed). In contrast, the principle of IAS 18 for the sale of goods is that revenue should be recognized only when an entity transfers control and the risks and rewards of ownership of the goods to the customer.
How FASB-IASB Will Address Those Issues [Focus On Assets And Liabilities!]
To address the problems in U.S. GAAP and IFRSs, the FASB-IASB propose to develop a single revenue recognition model using a recognition principle that can be applied consistently to various transactions.
In developing this principle, the Boards considered the following existing definitions of revenue in both U.S. GAAP and IFRSs:
- 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]
- 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. [IAS 18, paragraph 7].
In both definitions, revenue is an increase in assets, a decrease in liabilities, or some combination of the two. Using those definitions, FASB-IASB propose to focus the recognition principle on changes in assets and liabilities. By focusing on changes in assets and liabilities, the Boards do not intend to abandon the earnings process approach. On the contrary, the Boards think that focusing on changes in assets and liabilities will bring discipline to the earnings process approach so that entities can recognize revenue more consistently. In other words, the Boards think there will be more agreement on whether an asset has increased or a liability has decreased than there is currently on what an earnings process is and whether it is complete. This does not mean that judgments will be easy; however, a focus on assets and liabilities provides a clearer objective for making those judgments.
A focus on changes in assets and liabilities should not fundamentally change current practice for most transactions. But it should provide a set of principles that could simplify U.S. GAAP and provide the guidance lacking in IFRSs. Moreover, that set of principles should assist in addressing future revenue recognition questions and, therefore, should benefit preparers, auditors, regulators, and standard setters. In turn, users of financial statements should benefit because economically similar transactions would be reported similarly.