There are different accounting principles that have risen over the years to cater for different accounting needs. This paper is more concerned with the principle of revenue recognition, which forms the basis of accrual accounting. This principle forms the cornerstone of what is known as accrual accounting as well as the matching principle. They are used as determinants of the accounting period, during which expenses and revenues can be recognized in an organization. The principle argues that revenues should be recognized when they are earned and realized. The principle does not take into account when cash will be received. It is important to have a brief look at other accounting principles before going into detail analysis of the subject of this research. The first accounting principle is the principle on economic entity. The principle argues that an accountant tends to keep records of business transactions separately from personal transactions of the business owner. When it comes to legal issues a sole proprietorship is the same entity as the owner, but when it comes to accounting the two tend to be considered as separate entities. The second principle is on monetary unit assumption. This principle argues that economic activities of an entity are measured in terms of monetary value, and only those transactions that can be recorded can be expressed monetary. Because of this assumption, it is assumed that the purchasing power, for instance, of a dollar, has not changed with time; thus the accountants do not take into account the effect of inflation on the amount being recorded.
Additionally, time period is another principle of accounting. It assumes that there is a possibility of accountant recording/reporting on-going as well as complex activities of an entity within intervals of a short period. Cost principle is also applicable when it comes to accounting activities of an entity. From the accounting point of view, cost tends to refer to the amount that is usually spent when originally obtaining a certain item. Therefore, the principle argues that an accountant should show the amount of various items on the financial statements based on their historical cost. On the other hand, full disclosure is another important accounting principle. The principle states that any information that is important to investor should be disclosed fully in the financial statements of the company or on the notes made on financial statements. Going concern is another principle of accounting that is applicable when it comes to preparation of financial statements. This principle allows an organization to defer prepaid expenses until forthcoming accounting dates.
In addition, matching is another crucial principle of accounting. The principle argues that an entity should use the accrual basis of accounting whereby expenses are matched with revenues. Finally, revenue principle of accounting usually states that an organization accountant should recognize a transaction immediately when it is made without taking into account when the payment of the said transaction will take place. The above principles are used in conjunction with the principle of accrual basis which forms the basis of revenue recognition.
Revenue recognition is an important principle, and there are different methods of revenue recognition that are applied in organizations when it comes to accounting processes. This paper explains different methods of revenue recognition and their implications on financial statements of business organization. The paper will provide a brief description of history of the accounting financial theory and at the same time compare GAAP and IFRS policies in relation to revenue recognition. The paper will also look at the conceptual framework in relation to revenue recognition and the impact they will have on accounting practices in the future. This paper seeks to bring changes in the way organization treats revenue recognition and adopts the best method that suits their needs.
Historical Development of Financial Accounting Theory
Record keeping of business transaction can be traced as early as 4500 BC where Babylonians used to record these transactions for future references. The first complete system of double entry can be traced back in 1340 BC at the City of Genoa, which is found in Italy. During the 11th and 13th century trade activities, as well as other business related activities increased leading to the development of partnership. This permitted business owners with a concept of sharing risks, capital and labor. These developments helped in shaping the concept of a separate entity, which is widely applied in modern accounting activities, especially in financial accounting of partnership business activities. The first book on the concept of double entry was written in 1494 BC by Paciolo; it was a mathematical related book though the author included the concept related to bookkeeping which was in its early stages of development.
Before 16th century, accounting was characterized with a number of issues. First, accounting information was prepared with an aim of providing information to business owners. Secondly, there was no separation between the owners and the business itself. The concept changed with years and acquired separation of business and their owners. On the other hand, accounting period concept used not to exist. Furthermore, it lacked business continuity concept. Finally, there were descriptions in accounting records due to lack of the monetary unit that was common during the period.
The theory of financial accounting did develop greatly during the industrial revolution period in 17th and 18th century, where a number of concepts were introduced. The period had a number of impacts on the accounting practices in the world. This period leads to the development of cost accounting and at the same time depreciation concept, an important concept that is widely used in modern financial accounting. It is during this period that distinction between income and capital was developed when preparation of accounting information was concerned. Additionally, the concept of going concern was developed during the period of the industrial revolution. Finally, cost adherence, as a basis for carrying out asset evaluation, was put into use during this period.
Accounting theory has seen a rapid development in 19th and 20th century with the introduction of international bodies which develop and regulate accounting standards in the world. Today accountants have to work within generally accepted accounting standards when preparing financial statements. Over the years, the concept of accounting ethics and principles has been developed as a mean of introducing professionalism in accounting. The main bodies that deal with accounting related issues in the world include CPA, IFRS, GAAP and others.
Revenue Recognition Methods
There are different methods that are used by organizations in revenue recognition. This section discusses the various methods of revenue recognition and their implications on financial statements.
Sales basis approach is one of the revenue recognition methods. In this method, revenue tends to be recognized when sales are made. In other words, when goods are transferred from the seller to the buyer and their title of ownership is given to the buyer (Briner, 2001). It is necessary to note that sales can be made either through credit or cash but under this approach revenue cannot be recognized when even cash has been received before the actual transaction takes place. Therefore, under this approach revenue is recognized once the transaction has been completed. For instance, a book publisher who receives annual subscriptions amounting to $ 240 will tend to recognize only $ 20 as the revenue each and every month as far as this method is concerned. This method implies that the information that is contained in financial statements tends to be accurate as the method is one of the most accurate methods of revenue recognition.
Percentage of completion approach is used as another basis of revenue recognition. This method is widely used in engineering and construction companies who usually take years before they make delivery of the product to the intended customer. The company developing the product uses this method to show shareholders that it is making a profit and generating income even though the project in question is not completed yet (Briner, 2001). The method will be applied as a basis for revenue recognition if two circumstances are met. First, the company should be performing a long-term contract that is legally enforceable. Secondly, a situation where it is possible to make estimation on the percentage of the work that is completed within the project and at the same time costs and revenues can be easily estimated. Revenue can be recognized using two different ways as far as this approach is concerned. Milestones can be used where one basis the number of miles completed as the basis of revenue recognition. On the other hand, cost incurred in relation to estimated total cost of the project. This method may have negative impacts on the financial statement of the companies involved whereby overstatement of gross profit, as well as revenue, may be realized before they make a contribution to the completion of the work in question.
Additionally, cost recoverability approach is another important concept of revenue recognition widely used in financial accounting. In this approach, profit is not recognized till all expenses related to the project in question have been incurred and recorded. This means that income will only be recognized until cost related to develop a given product has been fully met. The implication of this method is understatement of gross profit in the initial stages of the product cycle and overstatement of the same in the late years of the product cycle.
Finally, installation method is an approach that can be used in revenue recognition by organization. This method can be best applied in areas where the collections from customers are not reliable. In this case, profit is calculated in relation to the cash that has been received by the company. Therefore, this company recognizes revenue once cash has been received. This method has one implication on company financial statement where profit maybe overstated in situations where the last payment from the customer is not received.
The adoption of the revenue recognition method largely depends on the nature of business activity being carried out and at the same time the accounting policies that have been adopted by the company in question. These methods are vital in revenue recognition, and it is upon the management of a given organization to ensure that it adopts a method that is accurate so as to reduce chances of overstated or understated figures in the financial statements of the organization under consideration (Briner, 2001).
Current GAAP Policies in Relation to Revenue Recognition
Currently, GAAP policies in relation to revenue recognition are based on two principles of accounting that are matching principle and accrual principle. The two principles tend to give different notations on how revenue can be treated within a given accounting period of a company. The accrual principle tends to argue that revenue should be recognized once they are realized. This means that a company will recognize revenue before even the actual cash related to the transaction has not been received. On the other hand, the matching principle argues that revenue should be recognized in the books of accounts of the company once cash has been received in relation to the transaction in question. The principles make the company prone to a number of problems. If a company uses accrual principle as it basis for revenue recognition, wrong figures may be entered in the balance sheet given that some customers may not honor their promises to pay their debt on a future date. This means that company’s profits may be overstated resulting to figures that are misleading the users of accounting information for decision making purposes. On the other, the matching principle makes the company prone to the problem of some transaction not being recorded in it books of account if the transaction involves goods sold on credit. This means that the company may not be able to follow up those transactions in the future. Therefore, for the international bodies that set standards in the field of accounting it helps to come up with a solution in relation to revenue recognition given that the current principles are not adequate to address the problem in question.
Current GAAP and IFRS Policies in the US
There are notable differences and similarities as far as IFRS and US GAAP guidelines are concerned in areas of presentation of financial statements. Under the both sets of standards the main form of financial statements is the same. Therefore, under the standards, the number of financial statements that an organization is supposed to prepare for the accounting information users is the same. In addition, two sets of standards usually require a company to present changes in shareholders’ equity. When it comes to US GAAP, this statement can be presented as a note within the company financial statements while IFRS provide an opportunity for the statement of shareholders equity to be presented differently from other statements. The two bodies require financial statements to be prepared on the accrual accounting basis though they allow exemptions to this requirement. On the other hand, two sets of standards tend to make use of similar concepts as far as consistency and materiality of the financial statements are concerned (IASB, 2001). Differences in the two sets of standards usually come in the specific level of guidance as provided by the bodies to cater for different accounting and reporting needs.
One of the main differences is in the area of the financial period where US GAAP is not strict on the need for comparative statements to be disclosed, but IFRS requires comparative statements of the previous period to be presented when reporting the current period statements of financial performance. When it comes to income and balance sheet layout US GAAP does not set general requirements that need to be contained in the two statements. On the other hand, IFRS sets a number of minimum items that must be contained in the financial statements.
In the area of revenue recognition there is a number of differences that exist between US GAAP and IFRS. There is a significant difference in the area of guidelines issued by the two bodies when it comes to revenue recognition, where US GAAP gives a more detailed guidance than IFRS. When it comes to IFRS, it usually deals with the issue of revenue recognition in two particular standards. They include IAS 18 revenue as well as IAS 11 Construction contracts. As far as US GAAP is concerned it gives detailed concepts and at the same time provides extensive rules on how revenue should be recognized in various industries within an economy. Due to this reason, it is difficult to mention differences that exist in revenue recognition as far as the two standard bodies are concerned. Timing in the area of revenue recognition tends to be different when contingencies in prices are involved. It is easier to recognize revenue in cases where prices are not fixed in IFRS in comparison to US GAAP. It is essential to note that in IFRS revenue recognition takes place when the economic benefits that are associated with a given transaction will be realized by the entity in question. For the revenue to be recognized its measurability must be reliable. This means that for the revenue involving contingencies, it can only be recognized when the two conditions have been met.
On the other hand, US GAAP has outlined a set of rules that must be followed when it comes to revenue recognition as far as contingencies are concerned. This means that where prices have not been fixed revenue cannot be recognized as far as US GAAP standards are concerned. Therefore, it is essential for the issues to do with contingencies to be resolved before they are recognized. Thus, when it comes to IFRS revenue relating to questionable amount or contingencies can be recognized earlier as far as IFRS standards are concerned than when US GAAP are involved.
Other notable differences when it comes to revenue recognition include cases when transactions with multiple deliverables are involved, approaches revenue allocation to the different items in the balance sheet, loyalty programs involving multi-features arrangements, contracts involving construction, discount revenue and value which are related to a transaction involving barter trade.
There also a number of similarities that exist as far as US GAAP and IFRS standards on revenue recognition are concerned. Revenues are measured in both bodies using the notion of fair value. Exchanges related to non-monetary exchanges are treated the same way as far as the two sets of standards are concerned (IASB, 2001). The exchanges are usually recognized at the fair value with which they were incurred at.
There are a number of areas that remain a problem in revenue recognition. Areas of what should be done to revenue, which has not yet been realized but the sale has been made, remain a challenge when preparing final financial reports. Furthermore, issues related to treatment of contingencies and questionable transactions remain a challenge when it comes to recognition of revenue in such kind of circumstances. On the other hand, issues related to differences in the area of accounting standards in the area of revenue recognition remains a challenge to many industries. Lack of standardized ways to treat revenue received from different nature of transaction remains a major issue when it comes to revenue recognition. One of the ways to overcome this problem is the body involved in the formulation of policies and accounting standards to come up with conceptual framework that will help minimize differences when it comes to revenue recognition.
There is a number of weaknesses that are related to treatment of revenue recognition as far as accounting standards bodies are concerned. To deal with these differences IFRS and US GAAP has come together and formulated a conceptual framework providing guidelines to deal with problems of revenue recognition experienced by different players in various industries. The conceptual framework addresses a number of issues related to revenue recognition. First, the conceptual framework seeks to remove weaknesses and inconsistencies in existing revenue recognition requirements related to standards of IFRS and US GAAP. Secondly, the framework provides a comprehensive framework that seeks to address revenue recognition related issues that remain to be a problem to this day (James, 2011). Additionally, the conceptual frameworks are aimed at improving the comparability of issues related to revenue recognition practices as carried out in different business entities, jurisdictions, capital markets and industries. Finally, the framework seeks to provide more helpful information to those who uses financial statements by improving disclosure requirements.
In order to address the problem of revenue recognition, two probable approaches may be adopted in helping the entire process. To start with the joint board from the two bodies may adopt an asset-liability approach whereby revenue will be measured indirectly by focusing on changes in liabilities and assets with an aim of identifying the revenue earned from those changes. Secondly, they can adopt earning process method. In this approach revenue will be recognized once a transaction is completed. Given that this approach does not take into account changes in assets as well as liabilities it may result to problems in preparations of balance sheets whereby there will be deferred debits and credits which are not in line with a definition of assets and liabilities. Therefore, the only option that remains is for the board to adopt revenue recognition approach that caters for issue related to assets and liabilities to avoid problems that may arise in the process of preparation of the balance sheet, where figures may be understated or overstated. Thus, it is the role of the joint board to ensure the aim of the new conceptual framework on revenue recognition is attained. This will go a long way in reducing problems related to revenue recognition experienced by players in different economic sectors. In addition, the new principle should be based on promoting the principle of prudence whereby revenue or gain should only be recognized whereby the probability of receiving the income in question is high (Lamoreaux, 2012). The prudence principle will be useful in reducing problems which rises due to recognition of revenue, which end up to being deferred debit when preparing financial statements. Despite the bodies, dropping prudence principle, when it comes to revenue recognition with an argument that it brings in bias, will be vital in reducing problem related to revenue overstatement or understatement in financial statements.
Biblical Application of Revenue Recognition
The concept of revenue recognition can be applied in areas of tax payment and debt payment as described in the scriptures. The scriptures in Roman 13: “6 this is also why you pay taxes, for the authorities are God’s servants, who give their full time to governing. 7 Give to everyone what you owe them: If you owe taxes, pay taxes; if revenue, then revenue; if respect, then respect; if honor, then honor.” Therefore, revenue should be recognized in relation to the teaching of the bible where it should only be recognized when the one who owes an organization pays the debt in question. This will ensure that problems related to treatment of revenue when preparing financial statement are fully addressed.
Coming up with integrated reporting standards in the area of revenue recognition will be an important milestone in resolving the current differences as far as US GAAP and IFRS standards are concerned. The resolution of differences will ensure that information from various industries can be compared to see their performance. Therefore, I believe that my research has provided vital information on revenue recognition concepts and the areas that need to be addressed through international accounting standards.
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