need 2 annotated bibliography single space each one need one paragaph

Paper ‘Preliminary Views on

Revenue Recognition in Contracts

with Customers’

JAN MARTON & ALFRED WAGENHOFER ON BEHALF OF

THE EUROPEAN ACCOUNTING ASSOCIATION’S FINANCIAL

REPORTING STANDARDS COMMITTEE

1

Gothenburg University, Sweden and University of Graz, Austria

The joint IASB and FASB Discussion Paper ‘Preliminary Views on Revenue

Recognition in Contracts with Customers’ from December 2008 proposes a

single standard for the accounting of contracts with customers. It aims to elimin-

ate inconsistencies in current IFRSs and US GAAP. A contract with customers

consists of performance obligations, which are dened as a promise to transfer

an asset (good or service) to the customer. The contract is recognized as a

(net) contract asset or contract liability. Revenue is recognized when the entity

satises a performance obligation. The key criterion is the transfer of control

of the asset to the customer (rather than the entity’s activities to satisfy the obli-

gation). Measurement of the performance obligation and the contractual rights

would be based on the transaction price, which is allocated to the performance

obligations based on their stand-alone selling prices. A performance obligation

should not be adjusted subsequently except if it is deemed onerous. The proposed

revenue recognition principle is conceptually signicantly different from the

current rules, and it would change accounting practice particularly for construc-

tion contracts and for multi-element contracts. The preliminary views of IASB

and FASB stated in the Discussion Paper contain a number of fundamental

issues, on which the boards invite views from their constituencies.

Accounting in Europe

Vol. 7, No. 1, 3 – 13, June 2010

Correspondence

Address:

Jan

Marton,

Gothenburg

University,

Sweden.

Email:

[email protected]

Accounting in Europe

Vol. 7, No. 1, 3 – 13, June 2010

1744-9480 Print/1744-9499 Online/10/010003– 11 # 2010 European Accounting Association

DOI: 10.1080/17449480.2010.485386

Published by Routledge Journals, Taylor & Francis Ltd on behalf of the EAA

In line with the EAA Financial Reporting Standards Committee’s mission

statement, the objective of this paper is to collate and bring to the IASB’s atten-

tion research that is relevant to the deliberations and to point out research needs

for an adequate way forward to the issues the IASB aims at resolving. The

accounting for revenue recognition is clearly an international issue and, hence,

our review includes research from all over the world. Our emphasis is on research

from European countries, although we note at the outset that there is relatively

little European research that studies this issue. The papers we survey give a

sense for the broad methodological approaches and results in the area.

However, we do not claim that they represent a comprehensive list of work in

this area.

Our comment is organized as follows: in the next section, we present prior

research according to the methodology used, namely, theoretical (a priori)

research, then analytical research and nally empirical research. In the sub-

sequent section, we respond to the main questions of the Discussion Paper.

1.

Prior Research

1.1. Theoretical (a priori) Research

Theoretical (a priori) research uses logical arguments and conceptual thinking to

derive solutions to a problem, based on normative theory. In the following, we

discuss two themes that are related to the themes in the Discussion Paper.

The Discussion Paper is based on the asset – liability model that is favoured by

the boards. While this model does have some merits, the alternative revenue –

expense model that was the conceptual basis of accounting standards for many

decades also has merits. Dichev (2008) lists three of them: (i) the revenue –

expense model follows the underlying business process of earnings generation

and reects business reality; (ii) conceptually, income determination is clearer

and more useful than assets and liabilities; and (iii) earnings is the most important

output of the accounting system. In a long-term empirical analysis Dichev and

Tang (2008) nd that the increased use of the asset – liability model in the

USA had negative effects on the quality of accounting earnings.

Despite the emphasis on the asset – liability model, the revenue recognition

concept in the Discussion Paper is mixed and includes elements of a revenue –

expense model. For example, the proposed relative stand-alone price allocation

of the contract transaction price is an allocation (of the difference between

stand-alone prices and the contract price) rather than an individual measurement

of the respective performance obligations or any group of such obligations. A

similar observation holds for the continuous recognition of, say, a warranty obli-

gation (as discussed in paragraph A28 of the Discussion Paper), which is another

allocation.

There are alternative revenue recognition concepts that have not been dis-

cussed in the Discussion Paper. For example, Wu¨stemann and Kierzek (2005)

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J. Marton and A. Wagenhofer

propose an asset and liability transaction approach that is derived from an appeal

to the legal existence of the entity’s right of obtaining consideration. They

suggest that ‘revenue should be recognized when the enterprise obtains the

right to consideration in exchange for the substantive fullment of its perform-

ance obligation’ (Wu¨stemann and Kierzek, 2005, p. 95). The difference to the

proposed revenue recognition model in the Discussion Paper that is based on

the satisfaction of performance obligations is gradual and based on legal

claims rather than economic criteria. Wu¨stemann and Kierzek (2007) discuss

their approach for construction contracts and Wu¨stemann and Kierzek (2008)

for service contracts. In many cases, their approach would imply later revenue

recognition than under the Discussion Paper’s model.

However, Nobes (2006) and Alexander (2006) argue against Wu¨stemann and

Kierzek in support of an approach that is more similar to the Discussion Paper. A

PAAinE (2007) Discussion Paper favours a continuous approach in contrast to a

critical events approach taken by the Discussion Paper.

We conclude that the revenue recognition approach in the Discussion Paper

attempts to achieve conceptual consistency, and it clearly increases consistency

relative to the existing set of standards. However, the literature casts some

doubt that their appeal to the asset – liability model as the consistent concept is

the best way to regulate revenue recognition.

1.2. Analytical Research

Analytical research stresses the fact that accounting provides additional infor-

mation for specic purposes. Revenue recognition rules inuence the information

content in the accounting system (see, e.g. Christensen and Demski, 2003, par-

ticularly chap. 14; see also Liang, 2001). In essence, revenue recognition rules

determine the timing when new information is recorded in the accounting

system. Most of the literature deals with stewardship issues and potential

welfare effects of early or late recognition for that objective.

2 Accounting

systems aggregate individual information into earnings, which makes it difcult

or impossible to disentangle the individual information, and reduces the compar-

ability of the information produced by applying different methods. It is not sur-

prising that most of the literature nds ambiguous results about the preferability

of certain revenue recognition methods, thus, opposing the idea of a single con-

sistent concept that is the best for all situations.

Antle and Demski (1989) study revenue recognition from an information (con-

sumption smoothing of risk averse agents) and a stewardship (providing incen-

tives to agents) perspective. They show that the preferability of early or late

recognition depends on the time in which the risk of the outcome of the pro-

duction process is resolved. The situation becomes more complicated if earnings

management is considered as well (see Christensen and Demski, 2003, chap. 14).

Antle and Demski stress the trade-offs that are incurred and that prohibit an easy

solution to any revenue recognition discussion.

Comment on ‘Preliminary Views on Revenue Recognition in Contracts with

Customers’

5

completion is more neutral, but at the cost of a higher opportunity for earnings

management.

Although the models focus on a variety of economic effects, they generally

support the percentage-of-completion method over the completed-contract

method for long-term contracts. If the revenue recognition criteria suggested in

the Discussion Paper lead to an increase in the use of the completed-contract

method, for example, in the construction industry, the effects may be negative.

However, earnings management opportunities are greater under the percentage-

of-completion method and should be considered as well.

1.3. Empirical Research

In this section we cover empirical literature related to revenue recognition. There

are several strains of research covered. We start with accounting choice, that is,

how reporting entities tend to make choices on reporting revenue in different situ-

ations and what factors may determine these choices. Next, we survey studies on

the quality of accounting information, in which the focus shifts from the produ-

cers to the users of nancial statements. The last part of this section covers mis-

cellaneous issues, such as how accounting standards should be written.

Starting with accounting choice, there are several studies that have focused on

Internet and other IT companies. This is because many issues in reporting

revenue have been especially important in this industry. Many new accounting

pronouncements pertaining to this industry have been issued, especially in the

USA. Both Altamuro et al. (2005) and Srivastava (2008) study the effects of

new accounting pronouncements that decreased discretion in reporting revenues.

While Altamuro et al. found a reduction in earnings management following the

new pronouncement, Srivastava identied no such effect. Both studies indicate a

decrease in usefulness of revenue numbers after the introduction of less discre-

tion. Bowen et al. (2002) nd that earnings management is stronger for Internet

rms with higher cash burn rate (indicating a high need for external nancing).

Chamberlain (2002), however, suggests caution in interpreting these results.

Besides the studies that focus on Internet and the IT industry, there are some

more general studies on accounting choice. Larson and Brown (2004) show

that there is diversity in practice for reporting revenue on long-term contracts,

suggesting the need for stricter regulation. Marquardt and Wiedman (2004)

study in what situations different income statement items are used for earnings

management. They nd that revenues are accelerated especially for rms that

are in the process of issuing equity. Choi (2007) shows that rms that are more

dependent on banks tend to recognize losses earlier (i.e. exhibit more conserva-

tive accounting), which also leads to an increase in value relevance of the income

statement. Nelson et al. (2003) show that revenue is a nancial statement item

that is subject to substantial earnings management.

Next, we focus on research on the quality of accounting, that is, how different

ways of reporting revenue affects the quality of accounting. Zhang (2004) studies

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J. Marton and A. Wagenhofer

the adoption of new regulation for the software industry reporting of revenues,

and nds that a lower level of discretion leads to an increase in the timeliness

and relevance of reported revenue, but reduces the reliability and time-series

predictability. Cerf (1975) argues that discretion in reporting revenues relating

to long-term contracts is positive and improves the quality of accounting. The

same argument is made by Baker and Hayes (2004) relating to the Enron case.

These ndings suggest that allowing more discretion in revenue recognition

should be avoided, although the literature is not unanimous on the issue

because the effects may be context-dependent. In industries with stronger incen-

tives (such as the IT industry, where public offerings may cause strong incentives

and high pressure for growth) stricter accounting standards appear advantageous.

In construction, an industry characterized by a higher long-term stability (albeit

cyclical variation), more discretion may be useful. These observations suggest

that a uniform and consistent revenue recognition model may be inferior to indus-

try-specic revenue recognition rules.

Apart from the debate on the level of discretion, there is a host of papers that

cover other quality issues. Barley (1995) suggests a probability-based model that

would yield better results than a model based on transfer of control. Samuelson

(1993) shows that the transaction price is not a good basis for the measurement

of performance obligations. Based on a similar reasoning, Friedman (1978)

suggests that an entire income statement based on exit prices is preferable.

Davis (2002) focuses on Internet rms and nds that rms that report grossed-

up or barter revenue exhibit a lower value relevance of earnings. Ball and Shiva-

kumar (2006) nd that an asymmetric recognition of losses is relevant. In an

earlier study, however, Ball and Shivakumar (2005) show that the quality of

early loss recognition depends on the market context of reporting entities.

It is probably difcult to directly apply these studies in practice. What we can

conclude, however, is that it could be relevant to recognize unrealized losses

earlier than gains, which is similar to what the boards suggest for onerous

contracts.

Another effect from revenue recognition comes from deferred taxes. Guenther

and Sansing (2000) study the effect of differences in nancial reporting and tax

for income statement items, including revenue. They nd that such differences

can affect the quality of accounting, an issue that may be especially relevant in

Europe, where there is a multitude of tax regimes. Any revenue recognition

accounting standard promulgated by the IASB is likely to differ from revenue

recognized for tax purposes in many jurisdictions. Even though the IASB does

not (and should not) consider local tax regulation, Guenther and Sansing’s nd-

ings imply that the magnitude of nancial reporting and tax differences could

have an impact on the quality of accounting.

Other studies focus on how users treat accounting information related to

revenue. In an experimental study, Trotman and Zimmer (1986) nd that subjects

are functionally xated and, generally, do not make adjustments for alternative

revenue recognition methods when analysing nancial statements. This evidence

Comment on ‘Preliminary Views on Revenue Recognition in Contracts with

Customers’

9

suggests that (contrary to ndings we discuss above) having a single, consistent

model of revenue recognition for all transactions is useful. It can be expected to

lead to similar transactions being treated in a similar manner, regardless of in

which circumstance the transaction occurs, which is an advantage for function-

ally xated investors.

Prakash and Sinha (2009) argue that standards that require deferring the recog-

nition of revenue, but the corresponding expenses are not deferred, for example,

because those expenses include a large portion of general indirect costs, introduce

a mismatch of revenues and expenses. They nd that if changes in deferred rev-

enues in two periods are signicant, investors and analysts have difculty in fore-

casting future prot margins, so that analysts’ forecast errors increase and prices

do not fully incorporate the implications of the changes in deferred revenues.

They attribute their ndings to the increased complexity of predicting future per-

formance. Since the Discussion Paper does not alter the matching of costs, such

negative consequences are likely to continue to exist.

A different issue is studied by Clor-Proell and Nelson (2007), namely, how

accounting standards should be written. They nd that producers of accounting

base their interpretation of standards on examples rather than the text per se.

Thus, standard-setters should provide relevant examples, especially for areas

that are conceptually new. This would particularly apply to the Discussion

Paper on revenue recognition.

2.

Response to the Main Questions

We organize our responses to the questions in the Discussion Paper along the fun-

damental issues addressed in the research surveyed.

One question is whether it is preferable to have a single revenue recognition

principle that is based on the entity’s contract asset or liability. From the research

it is not obvious that the asset – liability model dominates the revenue – expense

model, as the Discussion Paper claims. Moreover, it is not obvious if inconsisten-

cies (e.g. those in existing standards) are really undesirable. There may well exist

a higher level principle the seemingly inconsistent revenue recognition rules obey

or could obey. In addition, the proposal to net the liability arising from the per-

formance obligation and the right for consideration is an aggregation of infor-

mation, which inevitably destroys information that may be useful. Finally,

empirical research suggests that nancial reporting is contingent on the situation,

in that information based on a certain principle may be more or less useful in

different situations. Together, this research suggests a need for a diversity of

approaches to revenue recognition.

Another question is concerned with the satisfaction of performance obli-

gations. We note that the legal enforcement of seemingly similar claims for con-

sideration may differ across jurisdictions. It is not obvious whether the economic

substance or the legal existence of a claim is the better criterion for revenue rec-

ognition to produce decision-useful information.

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J. Marton and A. Wagenhofer

A fundamental (and open) question is the measurement of performance obli-

gations. The Discussion Paper includes two approaches, the transaction price

approach and the current exit price approach. Analytical research suggests that

the transaction price approach has benets (at least for performance evaluation)

over the current exit price approach, which includes more market risk or more

judgment. Moreover, recognizing day-1 gains and losses as in the current exit

price anticipates future performance, which can be detrimental to providing

incentives for management to perform. Empirical research suggests that early

recognition of losses of onerous performance obligations provides useful infor-

mation. Also, research suggests that a more timely recognition of bad news

than good news is a desirable characteristic of nancial reporting.

A further question is the allocation of the transaction price to the performance

obligations and the fact that contract origination costs are not included in per-

formance obligations. Such ancillary costs are expensed when they occur

rather than allocated to the performance obligations they help to generate.

Analytical research suggests that all costs should be matched to the revenues

they relate to, in order to mitigate incentives for sub-optimal management

decisions and, thus, to serve the stewardship objective. In addition, a mismatch

of revenues and costs recognition may impede the predictability of earnings.

A more general question relates to the level of discretion in revenue recog-

nition provided to reporting entities. Research suggests that discretion can be

benecial as a means of providing information. To the extent that discretion

increases with the principles suggested in the Discussion Paper, this would

have a benet. The allocation of transaction price to different performance obli-

gations may be an example.

Research indicates a functional xation in the interpretation of revenue-related

transactions. Then the control model may not be optimal from a user perspective,

especially as it pertains to construction contracts. If the control model results in

revenue recognized when a contract is completed, it would be difcult for

nancial reporting users to see through to the economic substance of the transaction.

Notes

1Other members are: Graeme Dean, University of Sydney; Lisa Evans, University of Edinburgh;

Gu¨nther Gebhardt, Johann-Wolfgang-Goethe Universita¨t (Chair); Martin Hoogendoorn, Erasmus

Universiteit Rotterdam; Araceli Mora, Universidad de Valencia; Ken Peasnell, Lancaster Univer-

sity; Roberto Di Pietra, Universita` degli Studi Siena; and Frank Thinggaard, Aalborg University.

2We note that the IASB tends to focus on decision usefulness and to consider stewardship objectives

as secondary (see the Exposure Draft of an Improved Conceptual Framework for Financial Report-

ing – Chapter 1: The Objective of Financial Reporting, Chapter 2: Qualitative Characteristics and

Constraints of Decision-Useful Financial Reporting Information from May 2008).

References

Alexander, D. (2006) Legal certainty, European-ness and Realpolitik, Accounting in Europe, 3, pp.

65–80.

Comment on ‘Preliminary Views on Revenue Recognition in Contracts with

Customers’

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