Revenue Recognition and the Planned Convergence with IFRS
In a recent article in Accounting Today (http://www.accountingtoday.com/news/FASB-Ease-Revenue-Recognition-Standards-66581-1.html), they discuss an aspect of the ongoing work between the Financial Accounting Standards Board’s (FASB) work and its international counterpart, the International Accounting Standards Board (IASB) on the convergence of US-GAAP and IFRS. This particular article is about one of the more challenging aspects of the convergence: revenue recognition standards. Though there is still much work to be done and when adopted, the conversion will be phased in over a long transition period, it brings potentially major changes to how US-based firms conduct revenue accounting, primarily in the change to principles-based interpretation of the rules versus the prescriptive methods contained in the Financial Accounting Standards.
This blog is designed to help non-financial managers and IT professionals understand what’s being proposed so they can be ready to implement the new standards when they arrive. This blog is not intended for accounting and finance professionals who are already well ahead of the curve, although I’d highly recommend reading the Accounting Today article referenced above.
First, a little review. Accounting uses a guideline called the “matching principle” which attempts to align a company’s revenues to the costs that were incurred to generate them. This is the basis for accrual accounting. As simple as that seems, there’s a lot of work that goes in to determining the amount of revenue to allocate to a particular accounting period and for a minority of firms, is an opportunity for accounting fraud. According to the matching principle, revenue should be recognized when it is earned, that is when all goods and services are delivered and no obligations to perform remain.
In the US, the FASB has gone to great lengths to keep up with emerging issues in company business models to ensure that revenue recognition stays true to the intent of the matching principle. In recent years complications arising from certain business agreements where contracts with multiple elements—such as software licenses and support services—were entered into. This caused a lot of ambiguity because while the cost of the software license can be recognized when the system goes live, the related support services are delivered (and recognized) over the period of the contract. The problem was how to “break out” the license from the services so that the license revenue could be recognized early on—rather that recognized ratably, along with the services, over subsequent accounting periods. This all changed with FASB enacted a new standard which went into effect in 2011. This standard, known as Accounting Standards Update (ASU) 2009-13 allowed the “breaking apart” of multi-element agreements and set out strict rules for how each of the elements would be recognized and valued (the term VSOE should ring a bell). This may all change depending on how much of the convergence project balances IFRS vs. US-GAAP methods.
Differences and Similarities
Both IFRS and US-GAAP use the similar conceptual frameworks. For example, US GAAP states that to recognize revenue, the following standards must be met: there must be persuasive evidence of an agreement between the parties, delivery has occurred or services rendered, the seller’s price is fixed or determinable and collectability of the amount due is assured. IFRS uses similar language: a transfer of ownership has occurred, the amount of revenue can be reliably measured, there is a strong likelihood that the economic benefits will flow to the seller and the costs of the transaction can be reliably measured. However, the differences appear in how the two standards implement these frameworks. While IFRS has a single standard (IAS 18) US GAAP has multiple standards that deal with revenue recognition. Moreover, IFRS uses a very broad, principles-based approach that leave interpretation to up to accounting practitioners and auditors while US-GAAP is very prescriptive with detailed rules in how accounting for revenue must be applied. I’ve talked to CFOs who say there is a certain comfort in the US Financial Accounting Standards (FAS) in that there’s not a lot of ambiguity in how to apply them. European CFOs often become frustrated with the IAS because it places much of the burden on them to get it right. They often turn to the US standards for explicit guidance.
Based on what’s reported in the article, the FASB and IASB, along with the US. Securities and Exchange Commission are thoughtfully weighing the pros and cons of principles vs. prescription and much work remains to be done. However, for managers and IT professionals, forewarned is forearmed and this will have a significant impact on your accounting operations and the software vendors you count on.