ESSAY ON THE ISSUES IN FINANCIAL REPORTING
Revenue recognition
The revenue recognition principle states that one should only
record revenue when it has been earned, not when the related cash is collected.
Revenue recognition is the main issue in the literature of financial reporting.
According to SEC revenue recognition is the largest issue contributing to the
restatement of the financial statement. The main thing in the profit and loss
account is revenue recognition. There are three major issues in financial
reporting. One is recognition issue, second is classification issue and third is
valuation issue. The main issue in revenue recognition is that how, when and
what amount revenue should be recognized. It includes many examples like those
industries in which after sales service are more important. For example software
companies in which when the software sales out ,then for almost 1 year all the
bugs occur in it is the responsibility of the producer to correct that software and
implement it. So the main issue is that whether the whole contract amount is
reported under revenue or some estimated expense will take from after sales and
minus from it and the remaining amount is reported under revenue.
Fraud usually started with small things. In psychology fraud is considered as
slippery slope, which means that when you sit on slippery slope then it is not
possible for you to stop anywhere. Sometimes company recognizes the revenue
in the period in which company was suffering the loss and they wanted to float
the shares in the market, it is also considered as fraud. Fraud is determined by
manipulating, falsifying or changing the documents from which financial
statements are prepared. More dangerous is that when you falsifying or alter the
documents or misrepresenting the financial statements but still play within
standards IFRS and GAAP. Fraud usually occurs due to lack of knowledge of users.
Users like investors, shareholders must have enough knowledge to understand
the fraud occurs in the financial reporting and they must understand that what
type of issues occur in the financial statements.
Why revenue recognition so important?
Sometimes companies move towards financial statement restatement in which
the company reports the improper revenue and the result of this there are large
drops in the market capitalization than any other type of restatement. And mostly
the companies face the market losses due to improper revenue recognition.
There are some examples in which revenue is reported overstated. First thing
consist of those sales contingencies which were not disclosed to management for
example in retail stores many companies put their stock in the stores and they
said that if the stock would sale out then you take money from us otherwise we
take our stock back. And if the company reports these sales in their profit and loss
account then it is considered as fraud because there is no guarantee that their
whole stock would be sales out in future. And the other issue in revenue
recognition was that sales were booked before delivery was completed. False
sales agreements and documentation were created for example in banks; they
make the false sales documents for the markups, in actual there is no sales and
purchase. It is also a sort of fraud.
Income smoothing
To overcome the operating profit fluctuation company adopted the concept of
cookie jar reserves in which the year the more profit is shown the company make
the provisions in which the expense is added whether in the form of deferred tax
added in this year so the profit is going down in this year and in the year more
loss occur then the company reverse that provision and loss is shown less in that
year, this is also called as income smoothing in this way the companies
manipulate the standards and mislead the investors. It is also considered as fraud
as it misleading the investors. Main reason of the income smoothing is to manage
the risk perception and through managing the risk perception they are basically
controlling the cost of equity.
When the revenue is recognized through contracts with customers, the company
is considered to be the point of delivery of the goods to the customer but I do not
understand that how they recognized all these revenues. I think revenue
recognition is also a big issue in the profit or loss account as the only one heading
of revenue is shown in profit or loss account, it is not separately recognized that
from where they come and on which basis.
Revenue recognition according to IFRS 15 (Revenue from Contracts with
Customers)
IFRS 15 has made significant adjustments to the recognition principles and has
specified that:
1) Extracts must be recognized for control of the asset at the time of transfer and
Recognized at the amount of the sum that is expected to receive in exchange for
the transfer of goods and services;
2) The principles set out in IFRS 15, Revenue from Contracts with Customers’’ and
their application in practice provide for disclosure in the financial;
3) The Standard clarifies that recognition of a gain in respect of a obligation over
time is permissible where a reasonable assessment of the degree of fulfillment of
the obligation is possible. However, if the enterprise fails to do so, the enterprise
must be recognized by the cost and maintain this approach until it is provide a
reasonable estimate of the quality of the obligations to be performed.
4) Although, the introduction of IFRS 15 is a complex and time-consuming
process, as the financial experts say, this standard will make significant changes in
all areas. It is also worth noting, that this is the most effective way of
standardizing the financial process that ensures transparent, comparable,
consistent and efficient processes in the enterprise.
Conclusion
In the bachelors we have not learn that revenue recognition is the main issue in
the financial reporting but now in MS we have learnt that it is the main issue and
how we deal with this issue. I think that these issues must be told to students at
bachelor’s level as well so they understand the financial statements very well.
And the second thing is that users like investors, shareholders must have enough
knowledge to understand the issues occur in the financial statements so they do
not misunderstand or misinterpret through these statements. And as a finance
manager in the construction industry I do not report the whole contract amount
in the revenue but the some estimated expense will take from after sales and
minus from it and the remaining amount is reported under revenue.
