Accounting for revenue and the FASB/IASB convergence project: a case study exploring the new exposure draft.
James, Marianne L.
CASE DESCRIPTION
The primary subject matter of this case concerns significant
changes to revenue recognition that are proposed under the joint
exposure draft issued by the Financial Accounting Standards Board (FASB)
and the International Accounting Standards Board (IASB) as part of their
convergence efforts. The case focuses on fundamental changes to the
revenue recognition model and potential changes to the timing and
measurement of revenue and related transactions such as product or
service warranties, merchandise returns, uncollectible accounts, and
multiple deliverables.
Secondary, strategic business and ethical considerations that
companies and accounting professionals should consider are explored.
This case has a difficulty level of three to four and can be taught in
about 40 minutes. Approximately two hours of outside preparation are
needed for students to address every question. The case can be used in
an Intermediate Accounting course to help students understand the
expected changes to revenue recognition and the financial reporting
issues that may arise, but can also be utilized in a more advanced
course by focusing on the strategic business issues. The case has
technical, analytical, and research aspects. Utilizing this case may
enhance students' communications skills.
CASE SYNOPSIS
Accounting for revenue and sales/service related transactions will
change significantly. In June of 2010, the Financial Accounting
Standards Board (FASB) and the International Accounting Standards Board
(IASB) jointly issued an exposure draft that will change accounting for
revenue and related transactions under both U.S. Generally Accepted
Accounting Principles (GAAP) and International Financial Reporting
Standards (IFRS). The exposure draft, which introduces a five-step
performance obligation model, proposes significant changes to the
measurement, classification, and potentially, the timing of recognition
of revenue and related transactions, such as warranty costs, returns and
allowances, provisions for uncollectible accounts, and multiple
deliverables. This case focuses on these key issues that are common and
important to most business entities.
Because of the importance of revenue and the expected significant
changes to revenue recognition, accounting students must begin to learn
about these changes, understand the potential effect on financial
reporting, and become aware of the business and ethical issues that may
arise. Educators play an important role in helping students accomplish
these goals. This case focuses on the new revenue recognition model,
provides an overview of key changes to current requirements that are
proposed under the new exposure draft, and explores strategic business
as well as ethical considerations.
This case can be utilized in an Intermediate Accounting course
focusing primarily on the technical accounting, financial reporting and
ethical issues, or in an advanced course focusing primarily on the
strategic issues. The case includes questions that can be addressed
using the case specific information, but also includes questions that
require research. Using this case can enhance students' critical
thinking, research, analytical, and communications skills.
INSTRUCTORS' NOTES
Teaching Strategies
The pace of standard setting has increased significantly during the
last few years and particularly during the last twelve months.
Currently, the FASB and IASB are actively working on ten convergence
projects. Of these projects, nine are scheduled to be issued as final
standards by the end of 2011. Information on the status of these
projects is available on the FASB website (fasb.org) under their
projects link.
While the SEC is planning to make a final decision on the potential
mandatory adoption of IFRS for U.S. public companies by the end of 2011,
the accounting standards issued under the converge project will change
U.S. GAAP, as well as IFRS, regardless of the SEC's decision.
Revenue recognition is one of the FASB/IASB priority projects. The
Boards planned to release a final standard by June 30, 2011, but
recently decided to re-expose the proposed standard and to issue a final
standard during the second half of 2011 (FASB, 2011).
The more than 170-page exposure draft shows that revenue
recognition and the recognition (and measurement) of related
transactions and events likely will change dramatically. Educators can
start to help students become familiar with the proposed changes by
discussing the major requirements of the ED in class.
This case is designed to help educators introduce the proposed
changes to revenue recognition in their classes and can be used to
accomplish several objectives. It includes technical content that helps
students become familiar with the expected changes; it facilitates
comparison of the current revenue recognition requirements with the
proposed requirements; and it helps students consider related issues and
strategies, ethical considerations, as well as the economic consequences
of accounting rules.
The information provided in the case's "Margot's
Seminar" section can be used in class to teach students about the
significant new revenue recognition concepts and the proposed new model.
This discussion should follow coverage of current revenue recognition
related GAAP.
Each suggested case question can be assigned independently. Some of
questions can be answered from the case specific information and also
provide the opportunity for students to review their knowledge of
current revenue recognition related GAAP, while other questions require
research.
The primary purpose of the research questions is to help students
become familiar with the availability of authoritative sources,
including proposed changes to accounting standards, and the format in
which that information is available. This will help students enhance
their research skills and to develop the confidence to research current
and emerging issues in accounting.
In class discussion of the case will take about 40 minutes. If all
the questions are assigned to the students, approximately two hours of
outside preparation will be needed to address all the questions. A
preliminary version of this case was successfully tested in an
International Accounting course and subsequently utilized in two
sections of Intermediate Accounting I.
ASSIGNMENTS
Students should pretend that they are a member of the accountant
staff of Vielfalt Corporation and that they have participated in
"Margot's Seminar." Their daily responsibilities include
accounting for the revenue and receivable cycle. The following questions
can be assigned by the instructor. Suggested answers to each question
are shown in the "Answers to Suggested Questions" section.
1. Review the case background information and the section detailing
the company's revenue related business environment and strategies.
Compare and contrast accounting for (1) warranties, (2) equipment
returns, and (3) uncollectible accounts. Organize your answers by
preparing a five-column table indicating (a) the accounting issue, (b)
the current accounting treatment under U.S. GAAP, (c) the proposed
accounting treatment under the joint revenue recognition ED, (d) the
financial statement(s) that would be affected by the proposed changes,
and (e) what specific financial statement items would be affected and
what the expected effect (increase or decrease) would be.
The table shown below addresses all aspects of this question.
Accounting Issue Current Accounting Proposed
Treatment Accounting
Treatment
Warranties Accrue expense and Differentiate
contingent liability between latent and
during year of sale. subsequent defects.
Typically adjusted at Latent defects:
year end. defer revenue and
expense related to
defective products.
Subsequent
defects: allocate
contract price and
expense to this
(separate)
performance
obligation.
Equipment Sales revenue is Estimated returns
returns recognized at time of must be estimated
sale; an allowance for at time of sale;
estimated returns is revenue and related
made at end of cost not recognized
accounting period until return right
expires
Uncollectible Sales revenue is Estimated at time
accounts recognized; bad debt of sale using a
expense and an probability-based
allowance (contra measurement; the
accounts receivable) estimated amount
are recognized at end of uncollectible
of accounting period. accounts is
excluded from
revenue.
Accounting Issue Financial Potential
Statement(s) Financial
Affected Statement
Effect(s)
Warranties Income Initially lower
Statement revenue and
Balance Sheet lower expense.
Cost of goods
sold relating to
defective
products not
recognized.
Likely to affect
timing of
recognition of
revenue and
expense.
Equipment Balance sheet Cost related to
returns Income estimated returns
statement are treated as
return assets;
sales price
related to
estimated returns
is treated as a
return liability.
Initially lower
revenue and cost
of goods sold;
lower income.
Uncollectible Balance sheet At time of sale:
accounts Income lower revenue
statement and expense.
Lower income;
lower assets
2. What accounting issues will tend to arise as a result of the
requirements under the new ED with respect to product warranties,
returns, and uncollectible accounts?
3. Review the case information and the section detailing the
company's sales channels. Indicate how the proposed changes could
affect the amount of revenue recognized from contracts involving both
equipment and service. Also consider how revenue from (a) direct sales
to customers and (b) indirect sales through third parties could be
affected.
4. What positive consequences could arise from the requirements of
the ED with respect to financial reporting? What ethical considerations
and challenges could arise from the proposed changes? Review the
recently issued FASB/IASB Concept Statement No. 8, Chapter 3 and
summarize the guidelines that are available from the conceptual
framework. (May require some research).
5. Access the FASB or IASB website, and research the objective of
the Boards' revenue recognition project. Provide a brief synopsis
of the Boards' objectives for revising the revenue recognition
requirements. (Research question).
6. Research the perceptions of financial statement preparers in (a)
the telecommunication industry and (b) in an unrelated industry
regarding the revenue recognition project. Choose two sources and
summarize which provisions of the proposal they agree with and which
they do not agree with. (Research question).
7. Research the perceptions of accounting professionals regarding
the revenue recognition project. Choose two sources and summarize which
provisions of the proposal they agree with and which they do not agree
with. (Research question).
8. Access the FASB or IASB website, review the FASB/IASB revenue
recognition exposure draft and find a general definition for
"control." (Research question).
9. Access the FASB or IASB website and review the FASB/IASB revenue
recognition exposure draft and especially the section regarding transfer
of control. List factors that according to the ED may be indicators of
the transfer of control. (Research question).
10. Access the FASB or IASB website and review the FASB/IASB
revenue recognition exposure draft. Research the conditions for
recognizing revenue on long-term construction projects. What revenue
related issues should Vielfalt consider regarding its overall
profitability if the company were to acquire the construction company
referred to in the "Diversification Strategies" section of the
case.
SUGGESTED ANSWERS TO QUESTIONS
1. Review the case background information and the section detailing
the company's revenue related business environment and strategies.
Compare and contrast accounting for (1) warranties, (2) equipment
returns, and (3) uncollectible accounts. Organize your answers by
preparing a five-column table indicating (a) the accounting issue, (b)
the current accounting treatment under U.S. GAAP, (c) the proposed
accounting treatment under the joint revenue recognition ED, (d) the
financial statement(s) that would be affected by the proposed changes,
and (e) what specific financial statement items would be affected and
what the expected effect (increase or decrease) would be.
2. What accounting issues will tend to arise as a result of the
requirements under the new ED with respect to product warranties,
returns, and uncollectible accounts?
The requirements of the proposed revenue recognition standard would
necessitate many additional estimates at the time of sale or service.
For example, while most companies will estimate uncollectible accounts
(bad debt expense) at the end of the accounting period, under the
proposal this would have to be estimated at time of sale or service and
would immediately lead to lower revenue at that point of time. Thus, the
timing of recognition tends to be affected by the requirements in this
ED. In addition, additional analysis, estimation, and projections would
be necessary; this includes analyzing contracts to identify separate
performance obligation within the same contract and assigning revenue
and cost to each performance obligation; estimating defects covered by
warranty from existing and subsequent causes; and deriving probability
weighted estimates of returns (and uncollectible accounts receivables)
at time of sale or service.
3. Review the case information and the section detailing the
company's sales channels. Indicate how the proposed changes could
affect the amount of revenue recognized from contracts involving both
equipment and service. Also consider how revenue from (a) direct sales
to customers and (b) indirect sales through third parties could be
affected.
Vielfalt Corporation sells telecommunication equipment directly to
customers and to third parties (for indirect sales) at different prices.
Under the ED, revenue would be allocated based on the respective
stand-alone prices of the equipment and service. Since the equipment is
typically discounted for customers who sign or renew service contracts,
some of the revenue could be reallocated to the equipment. In addition,
the amount of revenue allocated to equipment and service may differ
depending on whether the sale/contract was direct between the company
and the customer, or indirect through third party sales channels. Thus,
initial sales revenue as well as service revenue during subsequent
months and years may differ depending on whether the contract was
initiated directly with Vielfalt or through an indirect channel.
4. What positive consequences could arise from the requirements of
the ED with respect to financial reporting? What ethical considerations
and challenges could arise from the proposed changes? Review the
recently issued FASB/IASB Concept Statement No. 8, Chapter 3 and
summarize the guidelines that are available from the conceptual
framework. (May require some research).
The proposed requirements would necessitate additional estimates
and judgment. This may have positive, but also potentially negative
implications.
Positive implications: Because companies must identify separate
performance obligations; allocate the contract price to each performance
obligation; estimate returns, covered defects, and uncollectible
accounts (some using probabilities and time value of money concepts);
the measurement and recognition of related financial statement amounts
may better reflect the underlying economic events.
Ethical considerations and challenges: Enhanced need for judgment
and estimation could provide opportunities to manage earnings. From the
perspective of financial statement users, earnings management is always
an undesirable event.
Concept Statement No. 8 was issued jointly by the FASB and IASB
(2010). Chapter 3 addresses the qualitative characteristics of useful
financial information. The boards identify relevance and faithful
representation as fundamental qualitative characteristics. Faithful
representation replaces reliability set forth in concept statement No.
2. According to FASB and the IASB, "... financial information not
only must represent relevant phenomena, but it also must faithfully
represent the phenomena that it purports to represent." (Concept
Statement No. 8, 3, QC12). Information must represent an economic
events' substance, instead of the form of the contract (FASB &
IASB, 2010). This is commonly referred to as "substance over
form" and could lead to interesting class discussions. Students can
be asked to discuss how separation of contracts into performance
obligations (such as product sales, service, and related warranty
obligations) and allocating respective revenue and cost to each
performance obligation could enhance the relevance and faithful
representation of the information provided in the financial statements.
5. Access the FASB or IASB website, and research the objective of
the Boards' revenue recognition project. Provide a brief synopsis
of the Boards' objectives for revising the revenue recognition
requirements. (Research question).
The FASB website provides an official answer to this question.
Instructors can direct the students to the FASB website, "Current
Technical Plan and Project Updates" link. According to the FASB and
IASB, "The objective of the FASB and IASB's project is to
clarify the principles for recognizing revenue and to develop a common
revenue standard for U.S. GAAP and IFRSs that would: (a) remove
inconsistencies and weaknesses in existing revenue recognition standards
and practices; (b) provide a more robust framework for addressing
revenue recognition issues; (c) improve comparability of revenue
recognition practices across entities, industries, jurisdictions, and
capital markets; and (d) simplify the preparation of financial
statements by reducing the number of requirements to which entities must
refer." (FASB, 2011).
Students should paraphrase these objectives and properly cite the
source.
6. Research the perceptions of financial statement preparers in (a)
the telecommunication industry and (b) in an unrelated industry
regarding the revenue recognition project. Choose two sources and
summarize which provisions of the proposal they agree with and which
they do not agree with. (Research question).
The FASB and IASB received 972 comments on their revenue
recognition exposure draft. The comment letters are available on-line at
http://www.fasb. org/jsp/FASB/CommentLetter_C/CommentLetterPage&cid=121822013 7090&project_id=1820-100. Many of those who submitted
comments agree with the objective of the project and applaud the
boards' efforts to jointly develop a single revenue recognition
standard. However, concerns are also expressed regarding the initial and
continuing cost and difficulties of implementing the new requirements;
the need to separate contracts into performance obligations; the
retroactive provision for contract modifications; and other provisions.
All student answers that are well written and properly cited should be
accepted.
7. Research the perceptions of accounting professionals regarding
the revenue recognition project. Choose two sources and summarize which
provisions of the proposal they agree with and which they do not agree
with. (Research question).
The FASB and IASB received 972 comments on their revenue
recognition exposure draft. The comment letters are available on-line at
http://www.fasb.org/jsp/FASB/CommentLetter_C/
CommentLetterPage&cid=121822013 7090&project_id=1820-100. Many
of those who submitted comments agree with the objective of the project
and applaud the boards' efforts to jointly develop a single revenue
recognition standard. However, concerns are also expressed regarding the
initial and continuing cost and difficulties of implementing the new
requirements, as well as some of the specific issues/requirements. All
student answers that are well written and properly cited should be
accepted.
8. Access the FASB or IASB website, review the FASB/IASB revenue
recognition exposure draft and find a general definition for
"control." (Research question).
According to the ED, control includes the "ability to prevent
other entities from directing the use of, and receiving the benefits
from, a good or service" (FASB & IASB, 2010, IG44-73, 26).
9. Access the FASB or IASB website and review the FASB/IASB revenue
recognition exposure draft and especially the section regarding transfer
of control. List factors that according to the ED may be indicators of
the transfer of control. (Research question).
In their exposure draft (FASB & IASB, 2010), the FASB/IASB list
the following indicators that may indicate a transfer of control:
* Legal title passes to the customer
* Customer takes physical possession
* Customer has the obligation to pay contract price and the
obligation is unconditional
* Product or service is based on customer-specified design
10. Access the FASB or IASB website and review the FASB/IASB
revenue recognition exposure draft. Research the conditions for
recognizing revenue on long-term construction projects. What revenue
related issues should Vielfalt consider regarding its overall
profitability if the company were to acquire the construction company
referred to in the "Diversification Strategies" section of the
case.
Vielfalt is considering acquiring a construction company that
utilizes the percentage of completion method, which currently is a
choice under U.S. GAAP and required under IFRS. The ED (FASB & IASB,
2010) stipulates that revenue cannot be recognized until a transfer of
control occurs. Typically, a transfer of control does not occur until a
construction project is completed. The ED indicates that a continuous
transfer of control would allow partial recognition before the project
is fully completed but only if certain criteria are met. An important
criterion is that the costumer can take control of the project before it
is complete and can choose to have someone else complete it without
re-performance of already finished aspects of the project. This
requirement will tend to make it difficult to recognize any revenue and
related expense until construction projects are finished.
This can significantly affect the timing of recognition of revenue
(i.e., delaying the recognition, which will affect Vielfalt's
overall profitability in a given year). Also progress payments that are
common in the construction industry will have be recognized as unearned
revenue (a liability). The company's financial statements may be
affected quite significantly by this requirement.
REFERENCES
Financial Accounting Standards Board & International Accounting
Standards Board (2002). Memorandum of Understanding. The Norwalk
Agreement. September 18. Retrieved on June 18, 2008, from
fasb.org/newsmemoradum.pdf.
Financial Accounting Standards Board & International Accounting
Standards Board (2010). Joint statement by the IASB and the FASB on
their convergence work. Retrieved on March 30, 2010, from
http://www.fasb.org/cs/ContentServer?
c=Document_C&pagename=FASB%2FDocument_C%2FDocument
Page&cid=1176156919319
Financial Accounting Standards Board & International Accounting
Standards Board (2010). Proposed Accounting Standards Update--Revenue
Recognition (Topic 605): Revenue from Contracts with Customers.
Retrieved on July 1, 2010, from http://www.
fasb.org/cs/BlobServer?blobcol=urldata&blobtable
=MungoBlobs&blobkey=id&blobwhere=1175820852272&
blobheader=application%2Fpdf
Financial Accounting Standards Board & International Accounting
Standards Board (2010). Statement of Financial Accounting Concepts No.
8. Chapter 3, Qualitative Characteristics of Useful Financial
Information. http://www.fasb.org/cs/BlobServer?
blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=11
75821997186&blobheader=application%2Fpdf, Retrieved on January 2,
2011.
Financial Accounting Standards Board (2011). Revenue Recognition
Project Objective and Summary of Proposed Model.
www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASBContent_C%2F ProjectUpdatePage&cid=900000011146, Retrieved on February
7, 2011.
Financial Accounting Standards Board (2011). Current Technical Plan
and Project Updates. Retrieved on April 21, 2011,
http://www.fasb.org/cs/ContentServer? c=Page&pagename
=FASB%2FPage%2FSectionPage&c
Marianne L. James, California State University, Los Angeles
