The most misused accounting rule is the rule for revenue recognition. There are two reasons for this. The first reason is that increase in revenue increases the reported operating and net profits because expenses recognised in the income statement, except a few like cost of goods sold and distribution expenses, do not have a direct cause and effect relationship with revenue.
For example, depreciation, administrative expenses, advertisement expenses, research expenses, training expenses, expenses on repairs and maintenance and interest have no cause and effect relationship with revenue. The second reason is that increase in revenue improves many financial ratios commonly used by financial analysts. For example, increase in revenue increases the turnover ratios.
The most misused rule is quite straight forward. Revenue is recognised when the earning process is complete and cash collection is reasonable likely. Staff Accounting Bulletin (SAB)-101 issued by the Securities and Exchange Commission (SEC) of the USA describes the conceptual foundation for revenue recognition.
It says that revenue is generally realised or realisable and earned when all of the following criteria are met: There is persuasive evidence that an arrangement exists; delivery has occurred or services have been rendered; sellers price to the buyer is fixed or determinable; and collectibility is reasonably assured.
Inappropriate application of accounting principles and methods for revenue recognition might result in premature recognition of revenue or even recognition of fictitious revenue.
There are two uncertainties regarding revenue. The first uncertainty is regarding the point in time when the delivery has occurred or services have been rendered, particularly when the contract is a multi-period contract. The second uncertainty is regarding the probability that the customer may not pay the amount due from him.
Usually it is the management which has the best information regarding these uncertainties and that provides significant scope for earnings management.
Application of accounting rules for recognition of revenue from sale of goods is quite straight forward. Revenue is recognised when, as per the contract, the risk and reward of ownership is passed on to the customer. The difficult part is the estimation of the probability that the amount might not be collected or the goods will be returned. It is the task of the management to put in place a process to manage the risks of return of goods and non-collectibility of amounts receivables from the customers.
For example, an effective system of quality assurance ensures that only those products that meet the quality criteria of customers are despatched. Other control systems ensure that goods are produced and despatched exactly in accordance with the terms and conditions of the contracts with customers.
In situations where there are no standard contracts, managers evaluate each contract to ensure that the terms of the contract are not detrimental to the interests of the enterprise and that the enterprise has the capability to honour commitments arising from contract terms. Collectibility risk is managed through effective credit analysis or by transferring receivables to a third party.
Management, in order to manage earnings, sometimes knowingly violates the principle of collectibility. For example, it may sell goods to marginal customers with high credit risk. Similarly, in order to boost sales, near the end of the reporting period, an enterprise may allow buyers (eg. dealers) rights of return and other privileges that violate the realisation principle. These result in recognition of fictitious revenue.
In the USA, most restatement of profits arises due to premature recognition of revenue or recognition of fictitious revenue. An outside analyst can seldom assess whether the revenue recognised meets the realisability criteria.
Application of the accounting rules for recognition of revenue from multi-period contracts involves judgement in determining how much revenue should be recognised from incomplete contracts. Let us take the example of service contracts.
In a service transaction, the seller performs an act or acts for a mutually agreed price. Therefore, recognition of revenue from service transactions should be based on performance. Often service contracts require an enterprise to provide services over many periods. Therefore enterprises use percentage completion methods to recognise service revenue.
For example, a company providing mobile telephony services should recognise the registration charges over the average retention period of customers. As a general accounting principle, when services are provided through an indeterminate number of acts over a specified period of time, the seller recognises revenue on a straight line basis over the specified period. When a specified act is much more significant than other acts, the recognition is postponed until the significant act is executed.
Usually, companies set milestones for the entire contract and recognise proportionate revenue when a particular milestone is achieved. Assessment of the proportion of service completed and identification of the critical activity involves judgment and bias might creep in the estimation.
Long-term contracts like service contracts and construction contracts give rise to two types of risks: risk that the buyer will be dissatisfied with the quality of service and demand additional work or reimbursement; and risk that the cost of providing the future service will be greater than anticipated.
Accounting rules take care of those risks by requiring an enterprise to provide for estimated loss, if any, that might arise on completion of the contract. They also require that if the outcome of the transaction cannot be estimated reliably, the seller should recognise the revenue only to the extent of recoverable expenses recognised.
Analysts do not usually have the opportunity to assess the effectiveness of the risk management processes directly. They rely on the certification by the CEO, CFO and the auditors on the effectiveness of the internal control system.
Again analysts have no opportunity to independently assess that judgements involved in recognising revenue from multi period contracts is free from bias. They have no option but to rely on the certification of CEO, CFO and the auditor. This cast a very important responsibility on auditors.
However, when large number of companies in advanced economies like the USA restate their income for previous years due to inappropriate recognition of revenue, analysts doubt on the effectiveness of audit tools and auditors skills to detect inappropriate application of accounting rules. This also raises a question on auditors independence. This is an important challenge before the auditing profession.
In India, we do not hear about restatement of income by companies. It may be wrong to assume that everything is hunky-dory here. The real reason is the weakness of the oversight mechanism. There is a peer review mechanism in place. But that is not adequate. Regulators should put in place an effective oversight mechanism and make public the report of findings by the authority responsible to oversee the quality of audit.
In USA, in accordance with the Sarbanes Oxley Act 2002, Public Companies Accounting Oversight Board (PCAOB) has been established. It is a private sector non-profit corporation, which has the responsibility to oversee the auditors of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit report.
It is high time that we consider establishment of such an institution to oversee auditors. It is not necessary that such institution should be in the private sector. But it is important to ensure that such an institution should be independent of the Institute of Chartered Accountants of India and is free from bureaucratic set-up of government departments.
Asish K Bhattacharyya The writer is prof, finance and control, IIM-C