Revenue Recognition And Theories of Accounting free essay sample

The Joint Project Revenue recognition requirements in US generally accepted accounting principles (GAAP) differ from those in International Financial Reporting Standards (IFRSs); the former consists of broad concepts whereas IFRSs contain fewer standards, but applying the two main standards to complex transactions were difficult and needed improvement (Australian Accounting Standards Board, 2010). Accordingly, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) initiated a joint project to clarify the revenue recognising principles and to establish a common revenue standard that would: (a)remove inconsistencies in existing standards; (b)provide a sturdier framework for addressing revenue recognition issues; (c)improve comparability across entities, industries, and capital markets; and (d) require enhanced disclosures (IFRS Foundation, 2010). The proposed new standard would clarify recognition, measurement and disclosure of revenue. If adopted, revenue would be recognised when goods or services, or both, are transferred to the customer (IFRS Foundation, 2011). In contrast, current approach to earning revenue is based on the income statement. We will write a custom essay sample on Revenue Recognition And Theories of Accounting or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page Impact of Revenue Recognition Revenue reporting directly  impacts an entitys results of operations and financial position, therefore any changes in the revenue recognition model can have a fundamental consequence on a company’s results. Accordingly, the proposed model could have a significant impact on several industries. For example, the recognition of revenue for the licence of intellectual property is dependant upon the customer obtaining control of the asset. The proposals may result in some entities recognising revenue over the term of the licence instead of upon the granting of it, thereby delaying its recognition (PricewaterhouseCoopers, 2010). Importance of Revenue It is widely recognised that revenue is one of the most important items in financial statements and that revenue recognition is one of the toughest issues standard-setters and accountants face. Apart from its monetary importance, users of financial statements attach great value to revenue in making investment decisions on the basis of its trends and growth, evaluating the companys past performance and making predictions about its ability to generate cash flows in the future. Why has revenue been given such significance? Reflecting on this, the work of Hines (1988, 1991) can be considered. Hines stresses a perspective that ‘financial accounting practices are implicated in the construction and reproduction of the social world’, arguing that emphasising particular performance attributes such as profits, or elements like revenue which determine profits, gives legitimacy to organisations. Furthermore, Hines also adopted the view that accountants create the impression that things like revenue only exist once we decide to recognise them, thereby making them real-ised. Essentially it is we who have created revenue to be associated with transactions and events holding such significance and subsequently defining it as crucial in assessing performance. The Development of Models amp; Theories As for revenue recognition models, its development is supposedly grounded in the principles in the existing Conceptual Framework (CF) (Wustemann amp; Kierzek, 2005). The CF sets out major accounting objectives with concepts and general principles specified in the standards for particular types of transactions and events. The interaction of these and professional judgement can well be demonstrated in the area of revenue recognition, discussed later below. Although CFs are defined by the FASB as ‘a coherent system of interrelated objectives and fundamentals that can lead to consistent standards’, Hines (1989) suggested CFs are merely ‘a strategic manoeuvre for providing legitimacy to standard-setting boards and the accounting profession’. She believed the qualitative characteristics of comparability, completeness and consistency of accounting information could not be achieved due to the CF’s lack of theoretical foundation. The CF is an example of a normative theory of accounting because it prescribes guidance such as the qualitative characteristics financial information should possess, as contrasted with positive theories, which seek to explain and/or predict particular phenomena (Deegan, 2009). Both theories are developed on the basis of deductive reasoning, which relies upon the use of logic to develop arguments and related theory. Although typically all research and theories are value-laden, the prescriptive nature of normative theories means more value judgement and social biasness is involved in its development, which may be a reason for the apparent functional failure of CFs. Raymond Chambers (1957) was a distinguished contributor to normative theory; he developed the Continuously Contemporary Accounting theory that describes how financial accounting should be undertaken, suggesting that the most useful information about an organisation’s assets for the purposes of economic decision-making is information about their ‘current cash equivalents’. Alternatively, positive theories begin with some assumptions and, through logical deduction, enable explanations or predictions to be made, typically evaluated by considering how well these relate to actual observations. Watts and Zimmerman (1978) developed the Positive Accounting Theory, which seeks to predict and explain why managers prefer adopting particular accounting methods, but neither guides us nor tells us anything about current practice’s efficiency. Contrastingly, going backwards, early development of accounting theory relied on descriptive research based on the process of induction, which is the development of ideas or theories by codifying common accounting practices based on observation. Paton and Littleton (1940) were two notable theorists who supported this form of research. They introduced the revenue and expense view, which proposed recognising revenue when it is earned or realised and matching the related costs with those revenues, assuming profit accrues throughout the entire earnings process. As a result, accounting income does not have an intrinsic definition and is operationally defined as the result of applying those principles. However, standard-setters have since proposed changing from the revenue and expense view to the asset and liability view, which somewhat restricts the application of the realisation principle and the matching principle, in order to curb arbitrary judgements and to achieve a more consistent income determination (American Accounting Association). Shifts in Theory Evidently over several decades there have been shifts from one theory to another, such as from early positive theories to normative theories of accounting, and more specifically, from an income statement approach to that of a balance sheet-driven model for revenue recognition. In explaining the reason for this, consider Kuhn’s (1962) explanation of how knowledge development is revolutionary, whereby one theory is replaced by another as particular researchers denigrate an existing paradigm and advance an improved alternative. Principal to this conversion is the role of value judgements and the individual value systems they are founded on. Different researchers work from different paradigms that provide greatly distinct perspectives on the topic of research, based on their respective value judgements. Thus, any changes in their value judgements alter their paradigm, enabling them to gain insight into and possibly become proponents of newer concepts that they see as superior. The role of value judgements is pervasive in all choices and conclusions. In accounting for organisations, since many transactions and events are incomprehensively addressed in the standards, managers and accountants must often use judgement when applying accounting standards. The reliance on principles over rules results in an inconsistent application because it allows management to exert judgement differently in identical cases through the choice of dissimilar accounting methods (Wustemann, 2010). Another reason for the shift from different accounting models could be to improve accounting standards and the credibility of accounting itself (Heffes amp; Orenstein, 2005). Accounting standards and measurement principles, and hence financial statements, are full of management estimates that are the result of differing value judgements or attempts to structure transactions to attain a specific accounting result rather than properly reflecting its economic substance. This has led to accounting losing its integrity and true purpose of communicating relevant and reliable information. In the case of sub-prime mortgage loans and the sale of their cash flows through collateralised debt obligations (CDOs), the assumption that real estate prices would continue to rise was shown to be a false assumption, estimates of default rates were too low, and the adequacy of credit enhancements was overestimated (Walters, 2008). Financial statement information, based on these flawed estimates and assumptions, was only proven to be wrong when real estate prices began falling, leading to the collapse of the sub-prime mortgage market. Thus, the development of newer accounting models and standards aim for the specification of particular accounting treatment resulting in financial information that more accurately reflects a company’s position and performance. It aspires to increase the efficacy of the accounting function and prevent the occurrence of similar crises. Conclusion This essay explored the reasons for the emergence of the IASB-FASB joint project on revenue recognition as an attempt to improve financial reporting by clarifying the principles for recognising revenue and creating a single joint revenue recognition standard that companies can apply consistently. The proposed revenue recognition model could have a significant accounting impact for several industries because of revenue being one of the most important indicators of a successful business, which directly affects financial results. The reason for revenue being pivotal may be merely due to the emphasis given to it as a key performance attribute that signals justification of support for particular organisations, as suggested by Hines. Concerning revenue recognition models, their development is apparently based on the essential elements of the CF, which are thoroughly discussed by standard-setting constituents, broadly understood and generally agreed upon before issuance of related standards. However, the CF has been viewed as failing technically and functionally, its purpose seemingly ‘to assist in socially constructing the appearance of a coherent differentiated knowledge base for accounting standard’ (Hines). Revenue recognition models have thus gone through several changes due to ongoing discussions surrounding the appropriate accounting treatment of revenue and the value judgements underlying those dialogues. Such modifications endeavour to promote accounting standards’ and principles’ credibility, to assist the accounting profession recover from scandals that have led to its reputation being questioned.