The role of revenue recognition in performance reporting

Abstract

This paper examines revenue and profit or loss recognition and how these measures provide financial information about companies' performance. First, I review academic literature that examines the importance of revenue in informing capital markets and in performance evaluation and discuss findings on revenue management. Second, I describe fundamental revenue recognition concepts developed in the academic literature based on the economics of risks involved in the earnings cycle. Third, I evaluate the new revenue recognition standard of the International Accounting Standards Board, which aims to state a single consistent criterion for revenue recognition. I argue that striving for a conceptually consistent standard is undesirable because the economic characteristics of earnings cycles differ across firms and so does the usefulness of information. Consistent with that, the new standard actually contains different recognition criteria, does not fully follow the asset–liability approach and, although the Conceptual Framework favours neutrality over conservatism, includes several instances of conservatism.

Keywords:

• asset–liability approach
• conservatism
• earnings cycle
• performance measurement
• revenue–expense approach
• revenue recognition

Acknowledgements

This paper was prepared as a basis for a presentation at the ICAEW's Information for Better Markets Conference, held in December 2013 in London. I thank an anonymous reviewer, John Christensen, Ralf Ewert, Christian Groß, Richard Macve, Aleš Novak, Stefan Schantl, and Brian Singleton-Green for helpful comments.

Notes

1. The IASB Framework (1989) used the term ‘prudence’, whereas most academic literature uses ‘conservatism’. I acknowledge that some commentators distinguish between prudence, conservatism, and caution. In this paper, I follow the academic literature and use ‘conservatism’ regardless of the reason for a deviation from a neutral depiction required in the Conceptual Framework (IASB 2010b, QC14).

2. In particular, the exposure draft on insurance contracts (IASB 2013b) contains principles that are similar to those for revenue from customer contracts. See Horton et al. (2011) for a discussion.

3. Separate presentation, disclosure of disaggregated items, or disclosure of alternative measurement effects provides additional information resulting from the application of a particular revenue recognition principle. For example, discussion papers on performance reporting by PAAinE (2006, 2009) and the IASB (2013a) focus on the presentation of income and expenses either in profit or loss or in other comprehensive income.

4. See, for example, Penman (2012, Chapter 15).

5. For example, economic value added and other residual-income based measures are value-based measures and capture part of the value that has been added through operations in the period. Together with the change in market value added (expected future economic value-added amounts), it captures value generated or destroyed in the period. See, for example, O'Hanlon and Peasnell (1998).

6. While there is little research on the effects of revenue recognition on debt covenants, many findings of conservatism in debt contract settings carry over to revenue recognition. See, for example, Ewert and Wagenhofer (2012) for a survey.

7. IAS 11 and IAS 18 provide criteria for which method is required.

8. See also Mohnen and Bareket (2007).

9. Eichenwald (2005, Chapter 3), describes several projects in detail. It should be noted that this example is not primarily a revenue recognition theme, but more one of an ill-designed internal performance evaluation system.

10. This is usually the case, as managers have limited liability or can resign early, rendering bonus banks that serve as ‘collateral’ for compensation ineffective. Moreover, claw-back clauses in compensation contracts are usually tied to clear wrong-doing by the manager.

11. The leading cases are business combinations and financial instruments. See the reports of the German Financial Reporting Enforcement Panel (http://www.frep.info/presse/taetigkeitsberichte.php).

12. I use the term ‘earnings cycle’ to avoid the term ‘earnings process’ that is often used in relation with the revenue–expense approach.

13. Watts (2006, p. 53), reproduces an operating cycle taken from the Australian Accounting Research Foundation, which starts even earlier. Glover and Ijiri (2002) list additional stages for e-commerce activities.

14. If expenses that are not recognised as assets according to other standards arise and they directly relate to the contract, they are recognised as a contract asset (work-in-progress, inventory).

15. Demski (2004) labels exclusion as ‘truncation’.

16. Sorter (1969) discusses an ‘events’ approach, which focuses on the ability to reconstruct events aggregated in the financial statements. See also Johnson (1970). Much of such a disaggregation can be done by presentation and disclosures and by complementing financial information with non-financial information. More recently, the developments in information technology would make it easy to provide raw data and let users manipulate the data.

17. Conceptually, one could even consider the time an entrepreneur has the idea of a profitable project (see Watts 2006, p. 53).

18. IAS 1 distinguishes profit and loss from other comprehensive income, which can be used to portray the consequences of two different realisation principles for earnings. The IASB uses this approach in the measurement of particular financial instruments to separate realised and unrealised changes in value. See also IASB (2013a, Chapter 8) for a discussion of principles that may guide what items are included in other comprehensive income.

19. See, for example, Kothari et al. (2010) and Ball et al. (2012). The Conceptual Framework (IASB 2010b, QC8–10) discusses predictive and confirmatory values, albeit not in a stewardship context.

20. It should be noted that this statement depends on the content of the information. For example, in an management performance context, later information may comprise volatility that is uninformative about the manager's actions and, hence, not useful but even costly in terms that the manager must be compensated for taking additional risk.

21. This principle does not consider the cumulative risks that have been resolved as important even though such a view would often result in similar outcomes. A cumulative view is embedded in a principle that revenue should be sufficiently ensured so that there is no significant probability of a reversal of cumulative revenue recognised previously.

22. The prime proponents of the revenue–expense approach are Schmalenbach (1919) and Paton and Littleton (1940). Early proponents of the asset–liability approach are Hatfield (1909) and Simon (1886), but there are many others that distinguish themselves by what measurement concept they favoured. See, for example, Mattessich (2008), particularly Chapters 3 and 11. Beaver and Demski (1979) and Beaver (1998) show that the two approaches are not fundamentally different in a world of perfect and complete markets and that in incomplete markets, the preference for one approach depends on the decision context. Bromwich et al. (2010) also discuss their close relation. Brief summaries of the antecedents relating to revenue recognition can be found in Liang (2001) and Zülch et al. (2006).

23. If revenue is recognised based on the progress of production and, in particular, progress measured by incurred costs, then the expenses in fact determine revenue recognition.

24. This statement received the most agreement in the questionnaire, followed – interestingly – by policies that use conservative accounting principles (75%).

25. See SFAC 5, para. 83–84. Recently, the ASBJ (2013) suggests that to measure financial performance, profit or loss should result from transactions and that other comprehensive income (OCI) is the linkage factor between financial performance and changes in the financial position.

26. For example, Sprouse (1966) labels deferrals in the balance sheet very descriptively as ‘What-You-May-Call-Its’. However, whether the asset–liability approach avoids such deferrals would seem to depend on the definition of assets and liabilities.

27. The new standard conceptually changes the linkage between receivables and revenue recognition by assuming that performance obligations and a contract asset arise with contract inception and revenue arises if the contract liability is satisfied. However, assuming netting of contract assets and liabilities, revenue is recognised when a (net) contract asset increases, which produces an equivalent outcome as the traditional understanding.

28. See the discussion in the Discussion Paper on the Conceptual Framework (IASB 2013, para. 3.16–38).

29. See also Wüstemann and Kierzek (2005).

30. For a discussion, see Ordelheide (1988).

31. Subsequent fair value measurement can also lead to ‘day-2’ profit if the firm's credit rating worsens after contract inception because the fair value of the contract liability falls (see Macve forthcoming). This effect is more general as it occurs under fair value measurement of any of the firm's own liabilities.

32. Section 2 discusses undesirable effects of unreliable performance measures. See also Dobler (2008).

33. See also the summary of discussions in Schipper et al. (2009).

34. Of course, this effect depends on the continuity with which companies invest in intangibles and fulfil customer contracts. In a steady-state situation, there is no effect on profit but on net assets that increase if investment expenditures are recognised.

35. There are differences between the stipulated amount of consideration and the transaction price, so the model does not necessarily allocate contractual cash flows to the periods of performance. An example is a financing component in the contract, which is discussed later.

36. On the other hand, unconditional conservatism does not include additional information. An example is not recognising research expenditures as an asset, which leads to an expense in that period.

37. An argument is that conservative accounting would have disappeared over time if it was not economically beneficial. For surveys, see, for example, Watts (2003a,b), Kothari et al. (2010), and Shivakumar (2013). Macve (forthcoming) provides a critical discussion of this view.

38. For more instances of conservative accounting in current and newly developed IFRSs, see Barker and McGeachin (2013).

39. See IASB (2008, para. S2) and Schipper et al. (2009). One may question whether developing detailed rules-based standards is a meaningful objective after all. For example, Sunder (2005) argues that detailed codification of financial reporting will always lead to undesirable outcomes and suggests that a balance between rules and social norms is preferable.

40. See the definitions in the revised exposure draft (IASB 2011) and in the Conceptual Framework (IASB 2010b, para. 4.29), which the IASB intends to leave largely unchanged in the new Framework (IASB 2013a, para. 2.46). For a critical analysis of this definition, see Nobes (2012).

41. See also the alternative view of Linsmeier in the revised US exposure draft (IASB 2011, para. AV7).

42. The basis for conclusions in IASB (2011, para. BC24 and BC103) discusses the relation between the core principle, transfer of the asset, with a principle based on a right to payment and finds that they are not the same.

43. The revised exposure draft provides guidance on which costs satisfy this criterion and which do not. The direct costs need not match the costs defined in a cost-plus contract to be refundable (plus a profit margin). Hence, even though such a contract is a prime example for an economic matching, it is unlikely to be accounted for as such.

44. In particular, costs incurred before contract inception are unlikely to meet the recognition criteria for assets. The first exposure draft of revenue recognition prohibited recognition of costs to obtain a contract (IASB 2010a, para. BC158).

45. Current US GAAP contains a similar method.

46. Note that these effects are a consequence of not following a fair value measurement approach and recognising a ‘day-1’ profit.

47. Determination of the financing component can be difficult because it requires anticipation of when the performance obligations are satisfied.

48. A similar diversification argument would apply to a group of similar performance obligations, regardless of whether they are bundled in the same contract or not.

49. Interestingly, in its discussion paper on the Conceptual Framework (IASB 2013a, sec. 2–4) the IASB proposes to eliminate any reference to probability thresholds for recognition of assets and liabilities.

50. The standard does not contain a revenue cap that was contained in US GAAP, which would limit the transaction price allocated to a satisfied performance obligation to the amount that is not contingent on the satisfaction of performance obligations in future periods.