THE IMPACT OF IFRS ON REVENUE RECOGNITION ISSUE

CHAPTER TWO

LITERATURE REVIEW

2.0   INTRODUCTION

International Financial Reporting Standards (IFRS) are designed as a common global language for business affairs so that company accounts are understandable and comparable across international boundaries. They are a consequence of growing international shareholding and trade and are particularly important for companies that have dealings in several countries. They are progressively replacing the many different national accounting standards. They are the rules to be followed by accountants to maintain books of accounts which are comparable, understandable, reliable and relevant as per the users internal or external. IFRS, with the exception of IAS 29 Financial Reporting in Hyperinflationary Economies and IFRIC 7 Applying the Restatement Approach under IAS 29, are authorized in terms of the historical cost paradigm. IAS 29 and IFRIC 7 are authorized in terms of the units of constant purchasing power paradigm.

2.1   OVERVIEW OF IFRS

IFRS began as an attempt to harmonize accounting across the European Union but the value of harmonization quickly made the concept attractive around the world. However, it has been debated whether or not de facto harmonization has occurred. Standards that were issued by IASC (the predecessor of IASB) and are still within use today go by the name International Accounting Standards (IAS), while standards issued by IASB are called IFRS. IAS were issued between 1973 and 2001 by the Board of the International Accounting Standards Committee (IASC). On 1 April 2001, the new International Accounting Standards Board (IASB) took over from the IASC the responsibility for setting International Accounting Standards. During its first meeting the new Board adopted existing IAS and Standing Interpretations Committee standards (SICs). The IASB has continued to develop standards calling the new standards "International Financial Reporting Standards".

In the absence of a Standard or an Interpretation that specifically applies to a transaction, management must use its judgment in developing and applying an accounting policy that results in information that is relevant and reliable. In making that judgment, IAS requires management of companies to consider the definitions, revenue recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the Framework.

Criticisms of IFRS are:

-      that they are not being adopted in the US

-      a number of criticisms from France and

-      that IAS 29 Financial Reporting in Hyperinflationary Economies had no positive effect at all during 6 years in Zimbabwe's hyperinflationary economy.

The IASB offered responses to the first two criticisms, but has offered no response to the last.

Financial statements are a structured representation of the financial positions and financial performance of an entity. The objective of financial statements is to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions. Financial statements also show the results of the management's stewardship of the resources entrusted to it.

To meet this objective, financial statements provide information about an entity's assets, liabilities, equity, income and expenses, including gains and losses, contributions by and distributions to owners in their capacity as owners and cash flows.

This information, along with other information in the notes, assists users of financial statements in predicting the entity's future cash flows and, in particular, their timing and certainty in a bid to enhance revenue recognition.

The following are the general features in IFRS:

-      Fair presentation and compliance with IFRS: Fair presentation requires the faithful representation of the effects of the transactions, other events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework of IFRS.

-      Going concern: Financial statements are present on a going concern basis unless management either intends to liquidate the entity or to cease trading, or has no realistic alternative but to do so.

-      Accrual basis of accounting: An entity shall recognize items as assets, liabilities, equity, income and expenses when they satisfy the definition and recognition criteria for those elements in the Framework of IFRS.

-      Materiality and aggregation: Every material class of similar items has to be presented separately. Items that are of a dissimilar nature or function shall be presented separately unless they are immaterial.

-      Offsetting: Offsetting is generally forbidden in IFRS. However certain standards require offsetting when specific conditions are satisfied (such as in case of the accounting for defined benefit liabilities in IAS and the net presentation of deferred tax liabilities and deferred tax assets in IAS).

-      Frequency of reporting: IFRS requires that at least annually a complete set of financial statements is presented. However listed companies generally also publish interim financial statements (for which the accounting is fully IFRS compliant) for which the presentation is in accordance with IAS Interim Financing Reporting.

-      Comparative information: IFRS requires entities to present comparative information in respect of the preceding period for all amounts reported in the current period's financial statements. In addition comparative information shall also be provided for narrative and descriptive information if it is relevant to understanding the current period's financial statements. The standard IAS also requires an additional statement of financial position (also called a third balance sheet) when an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements. This for example occurred with the adoption of the revised standard IAS 19 (as of 1 January 2013) or when the new consolidation standards IFRS 10-11-12 were adopted (as of 1 January 2013 or 2014 for companies in the European Union).

-      Consistency of presentation: IFRS requires that the presentation and classification of items in the financial statements is retained from one period to the next unless:

a.   it is apparent, following a significant change in the nature of the entity's operations or a review of its financial statements, that another presentation or classification would be more appropriate having regard to the criteria for the selection and application of accounting policies in IAS 8; or

b.  an IFRS standard requires a change in presentation.

2.2   DEFINITION OF REVENUE RECOGNITION

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) both use a different definition concerning revenue: “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), and “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.”

In the FASB Concepts Statement number 5, paragraph 58 you can read that “Recognition is the process of formally recording or incorporating an item in the financial statements of an entity as an asset, liability, revenue, expense, or the like. Recognition includes depiction of an item in both words and numbers, with the amount included in the totals of the financial statements.” Mentioned in the IAS 18 standard about recognition is: “Recognition means incorporating an item that meets the definition of revenue in the income statement when it meets certain criteria”

So, according to the concepts and standards mentioned above, revenue recognition is recording revenue, which suffices certain conditions, in the financial statements.

Although these standards and definitions are notable dated (1984 and 1993), they are still applicable. Only concerning the implementation of the revenue recognition process some discussion is possible. As an addition to the FASB Concepts Statement, the Securities and Exchange Committee (SEC) published in the end of 1999 some detailed rules on the area of revenue recognition, in the Staff Accounting Bulletin 101 (SAB 101). The SAB 101 was revised in 2003 and the SAB 104 was published as its substitute. The reason of publishing more detailed rules was that the SEC expressed in public their concern about the big amount of points of controversy and the problems that companies experience concerning the current revenue recognition.

Schipper et al. (2009) describes some different conceptual models for revenue recognition: the customer consideration model and the measurement model. These models were proposed at an AAA/FASB Financial Reporting Issues Conference, in order to replace the current revenue recognition models. Some participants believe that the notion of an earnings process is insufficiently precise, to provide a sound conceptual basis for revenue recognition standards. Therefore two new models were presented at that conference. Both models are based on contract asset and contract liability, so they both recognize revenue when contract asset increases or contract liability decreases. The difference between the two proposed models were that, at the customer consideration model revenue is recognized based on the prices that are mentioned in the contract, while at the measurement model recognized revenue is based on what really is paid.

2.2.1        TIMING OF REVENUE RECOGNITION

Accrual accounting distinguishes cash inflows from revenues and cash out-flows from expenses, recognizing the differences between cash flows and income as liabilities or assets.

The principles which govern the recognition of revenues (and expenses) are the key determinants of the properties of accrual accounting information (Dhutta and Zhang, 2002). The recognition of economic events in accounting revenues tends to lag that of the market. An informed market recognizes the effects of economic events when they occur, but revenue recognition must await compliance with formal accounting recognition criteria. The application of these criteria involves basic concepts as reliability, objectivity, conservatism, and verifiability. It affects earnings in two ways:

-      current earnings will include recognition of certain prior periods' economic events, and

-      current earnings do not recognize all of the current period's economic events until future periods. (Warfield and Wild, 1992)

The reason that this is a big issue is because events occur now, they are recognized over some time and therefore future periods' earnings possess explanatory power for current returns. The incremental explanatory power of future periods' earnings varies inversely with the length of the reporting period. Warfield and Wild (1992) indicated that in certain instances, the recognition lag is of such magnitude that the explanatory power of future periods' earnings for current returns more than triples that of current earnings.

For investors and other stakeholders it is sometimes hard to say what the explanatory power of current returns and earnings is. It is unclear in which period current returns will lead to future earnings. And what the influence of previous returns on current earnings is.

Therefore it is important that there are good rules to determine when revenue and some item should be recognized.