Revenues and Fair Values - Assignment Example

Revenues and Fair Values Question Part I: Outline the key requirements of IAS 18 Revenues IAS 18 prescribes the accounting treatment for revenuearising from certain types of transactions and events. It defines revenue as the gross inflow of economic benefits, such as cash, receivables, and other assets, arising from the ordinary operating activities of an enterprise, such as sales of goods or services, interest, royalties, and dividends (IAS 18 §7). Revenues are different from gains, a type of income which also represent increases in economic benefits but may not arise in the course of the ordinary activities of an enterprise. The key requirements of IAS 18 are reliability, recognition, and measurement of revenue. Revenue should be measured at the fair value of the consideration receivable (IAS 18 §9). An exchange for goods or services of a similar nature and value is not regarded as a transaction that generates revenue, which only applies to exchanges of dissimilar items (IAS 18 §12). IAS 18 has the following basic principles to guide accountants on the timing of revenue recognition: Significant risks and/or rewards of ownership are transferred to the buyer; No continuing involvement nor control associated with ownership; Amount of revenue can be measured reliably; Probable that economic benefits from the transaction will flow to the entity (both the buyer and seller); and, Costs incurred or stage of completion can be measured reliably. Question I, Part II: Based on the extract (Appendix A), what major changes to earlier practice are implied by such an approach? The approach focuses on the balance sheet elements to address the issues arising from complex revenue recognition situations. The current standard is based on the assumed primacy of the income statement whereas the proposal is based on a balance sheet approach. The latter relates revenues (gains) to an increase in net assets (increase in ownership interest not resulting from new contributions from owners) rather than recognising revenue first, with the movement in net assets the residual. The change in focus would have to be linked, or even subsumed, in a new standard covering “substance over form” to enable gains on such items as sale and repurchase agreements to be covered, in addition to the more obvious revenue generating activities, in a single statement. The other major change is in the area of measurement, defined as the process of assigning monetary amounts at which elements of the financial statements are to be recognised and reported (IASB, 2001, § 99-100). There are several measurement bases currently used to different degrees and in varying combinations in financial statements, such as historical cost, current cost, net realisable (settlement value), and discounted present value. Historical cost is the measurement basis most commonly used, but it is usually combined with other measurement bases. The IASB at present does not include concepts or principles for selecting which measurement basis should be used for particular elements of financial statements or in particular circumstances. It merely provides some guidance through recommendations on qualitative characteristics (IASB, 2001, § 101). By suggesting that fair value measurement in revenue recognition be adopted as an international standard, the new approach hopes to provide a basic framework that consistently addresses issues arising from complex cross-border transactions. The main problem is that not everyone agrees that financial statements should concern itself with calculating the value of a company, which is subjective, but rather with presenting the public with an objective, reliable measure of costs. Question 2: Explain, analyse, and discuss: “Fair values are more relevant than alternative valuation bases, but less reliable”. Several standards, such as IAS 39, require companies to record a range of financial instruments at fair value on the balance sheet. Any changes in the value of those instruments must be reflected in the income statement, or shown in shareholders’ equity depending on the instrument. The impact of this change in accounting procedures is tremendous since many financial assets and liabilities have been held at historical cost rather than fair value, or else not recorded on the balance sheet at all. IAS 39 requires that these instruments be brought out of the reporting closet and displayed in the income statement or balance sheet. Supporters of ‘fair values’ claim that it is more realistic, comprehensive, relevant, up-to-date, and makes earnings management or window dressing more difficult. Critics attack its lack of reliability, arguing that using fair value is more subjective and result in less stable earnings, a higher beta stock, a higher company’s cost of equity, and lower share prices. This may not be true because analysts base their share price valuations on free cash flows and not accounting profits and losses, and IAS 39 only changes the company’s accounting but not the cash flows. Critics also gripe about the paperwork, as changes in valuation (and fair value may lead to dramatic changes year-on-year depending on the behaviour of the macro-economy) need assumptions and explanations to be better understood. Investors would then need to be more discerning and knowledgeable of what goes into financial reports, the explanatory notes, and other assumptions. However, its supporters claim that fair value accounting was designed to give a more complete picture of a company’s financial position. Any volatility in earnings would therefore merely reflect the inherent business risk and help potential investors make better decisions. Fair value comes closest to reflecting real earnings, and hence real value, and would be a more relevant measurement criterion for financial decision-making. Besides, fair value is nothing new; it has been around for years, as companies wrote down bad debts and impaired inventory, but critics still find fair value accounting dangerous. The subjectivity of valuation may be easy if markets are liquid, but if not, the room for error and abuse goes up when companies assess fair value using discounted cash flow models. Historical cost accounting may be flawed, but at least it is objective. Companies know what they get. Fair value, on the other hand, relies on too many assumptions and forward-looking statements. But then again, accountants have been using estimates – such as guessing the useful life of an asset – and models like straight-line depreciation in the past. The real issue, as with other accounting standards, is the trade-off between relevance and reliability. As accounting should reflect true economic substance, fair value as a more relevant measurement attribute for an asset or liability would be useful only if it is reliable. More powerful information technology systems would help improve data and reporting reliability. Another danger is that accounting could start driving economic decision-making, as management is pressured to modify its risk profile based on perceived volatility. As short-termism in management is driven by pressure from financial analysts, new standards such as IAS 39 might begin to influence the quality of strategic decisions. The arguments boil down to how reports are presented, how investors are educated, and how investors understand these reports. If information is clear, wild swings in value can be understood and factored into the valuation process. Thicker reports require deeper study, but good accounting, corporate governance, and disciplinary mechanisms would cope with this, even if opportunistic reporting risks remain. Fair value reporting makes even more transparent the managers’ assumptions of the company’s future, helping markets judge the available information and improving the public’s perception of management thinking. Appendix The following extract is taken from a recent IASB newsletter: “Revenue recognition – The Board is conducting a project jointly with the US Financial Accounting Standards Board to develop a conceptual model for revenue recognition and a general standard derived from that model. The Model the Boards are considering is one in which the entity recognizes revenue on the basis of changes in assets and liabilities resulting from contracts with customers. The entity recognizes revenue when it discharges its contractual obligations to supply goods, services or other rights to a customer. The first steps in applying this model are to identify the entity’s contractual rights and obligations and to measure the resulting assets and liabilities. The Board tentatively decided that, at a conceptual level, non-financial liabilities should be measured at fair value, i.e. the amount the entity would have to pay another business to take over the liability. However, it acknowledges that it can be difficult to measure reliably fair values for many performance obligations. Therefore, the Board decided to explore an alternative approach that would measure the liabilities based on the amount received or receivable from the customer for fulfilling them.” What major changes to earlier practice are implied by such an approach? Reference List IASB (1993). IAS 18 Revenue recognition. London: IASB. IASB (2001). Conceptual framework. London: IASB. Read More