On June 24, 2010, The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) have published for public comment a draft standard (ED) to improve and align the financial reporting of revenue from contracts with customers and related costs.
The proposal would create a single revenue recognition standard for IFRSs and US GAAP. The proposed standard would replace IAS 18 Revenue, IAS 11 Construction Contracts and related interpretations. In US GAAP, it would supersede most of the guidance on revenue recognition.
Revenue
Revenue is a crucial number to the users of financial statements. Therefore, appropriate measurement of revenue and timing of its recognition, are of utmost importance in the preparation and presentation of financial statements. Application of the revenue recognition rule is quite simple in retail sales. But the application becomes complex and involve significant judgement when a transaction is complex. Definitive guidance is not available in extant IFRSs for recognising and measuring revenue in many complex situations. This gives an opportunity to managers to bend the rules in their favour. Moreover, lack of uniformity in accounting policy used by different entities impairs the comparability. The ED aims to reduce inconsistencies and weaknesses of extant accounting standard.
Convention
Till recently the convention was to recognise revenue on completion of the earning process. This rule was relaxed in case of multi-period contracts. In case of multi-period contracts (e.g. construction contracts and service contracts) revenue was recognised using the ‘stage of completion (also called percentage of completion) method, provided the outcome can be estimated reliably. The argument was that in case of a multi-period contract if an entity recognises revenue on completion of the contract, the profit and loss account would not provide information on economic consequences of activities undertaken during each period. Therefore, revenue should be recognised as work on a multi-period contract progresses.
IFRS
In case of real estate contracts, which are usually multi-period contracts, IFRS has deviated from the convention of recognising revenue from multi-period contracts using the stage of completion method. According to an interpretation issued by IASB (IFRIC 15) in July 2008, all agreements for construction contracts are not covered by IAS-11 (AS-7), Construction Contracts. An agreement for the construction of real estate meets the definition of a construction contract when the buyer is able to specify the major structural elements of the design of the real estate before construction begins and/or specify major structural changes once construction is in progress (whether or not it exercises that ability). Revenue from only those agreements, which meet the definition of construction contracts, should be recognised using the stage of completion method provided the outcome can be estimated reliably. Usually real estate developers who construct residential properties provide option to buyers to select flats/apartments/villas from a bouquet of pre-designed residential spaces.
Therefore, agreements with buyers of residential properties usually do not meet the definition of construction contract. Consequently, revenue from those agreements should not be recognised using the stage of completion method. Revenue should be recognised only on transfer of substantial risks and reward of ownership to the buyer. In most situations the transfer of risks and rewards takes place after completion of the construction of the residential space.
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Exposure draft
The model proposed in the ED is further shift from the convention. Under the model, an entity should recognise revenue from any contractual arrangement with a customer only when the customer obtains control over the goods and services transferred by the entity.
Customer obtains control when it is able to use, and receive benefits from, the good or service. This accounting principle will change the accounting for revenue for certain industries. For example, at present revenue in ship building industry is recognised using the stage of completion method.
If the proposed accounting principles in the ED are accepted, entities in the ship building industry will recognise revenue only on delivery of the sip because the customers obtain control only at that point. Similarly, in case of software projects, revenue will be recognised only when the software is accepted by the customer. At present the revenue is recognised using the stage of completion method.
Comments on the ED should be submitted by October 22, 2010. Indian industry and other should examine the ED carefully.
E Mail: asish.bhattacharyya@ gmail.com