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Revenue recognition Essay

The study has been conducted to have a view on Revenue Recognition and how is important for entities in financial reporting and the link between revenue recognition and creative accounting.

The primary issue in accounting for revenue is to determining when to recognize revenue. Revenue is recognized when it is probable that future economic benefits will flow to the entity and these benefits can be measured reliably. There are identifiable criteria to be met and for revenue to be recognized. By definition, Revenue is the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.

The entities revenue may be arising from the transactions and events, such as the sale of goods; the rendering of services; and the use by others of entity assets yielding interest, royalties and dividends.

The recognition criteria usually applied separately to each transaction. However, in certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction transactions are dealt with shall be measured at the fair value of the consideration received or receivable.

Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.1 Creative on the other hand refers to the use of accounting knowledge to influence the reported figures while the jurisdiction of accounting rules and laws, so that instead of showing the actual performance or position of the company, they reflect what the management want to tell the shareholders. It is the transformation of financial accounting figures from what they actually are to what preparer desires by taking advantages of the existing rules and /or ignoring some of them2.

There are number of ways management can use to practice Creative accounting such the choice of accounting policy and also the use of artificial
transactions to Revenue Recognition. The focus of this study lies more on the Revenue recognition a tool of creative accounting. The Management objective is to maximize shareholders wealth. Sometimes Organizations performance do not always be good to meet this objective, Management may use creative accounting tactics to create a good image of company (find ways to improve results) to meet the objective of shareholders. Also Management use creative accounting to maximize for their own wealth maximization, among other thing is end bonus and salaries increments

Literature Review

Revenue recognition
Financial reporting statements are tools to communicate entity performance to internal and external users of its financial results information. Revenue recognition is important aspect of organizational.

The performance organization is measured based on the results from its operations activities and the bottom line (the profit) plays a significant role. Revenue is determinant of performance of Organization since the profit which is indicator of organizational performance is the results of the Organization’s total revenue less total costs.Internation Accounting Standard (IAS) 18 Revenue recognition, specify criteria to meet for revenue to be recognized in Financial Statements.

By definition, Revenue is the gross inflow of economic benefits (cash, receivables, other assets) arising from the ordinary operating activities of an entity (such as sales of goods, sales of services, interest, royalties, and dividends) Recognition of revenue, recognition, as defined in the International Accounting Standard Board (IASB) Framework, means incorporating an item that meets the definition of revenue (above) in the income statement when it meets the following criteria, that: Its probable that any future economic benefit associated with the item of revenue will flow to the entity, and the amount of revenue can be measured with reliability.

As mentioned, each activity has its recognition criteria on top of the one mention. These are as follows; Sale of goods Revenue arising from the sale of goods should be recognized when all of the following criteria have been satisfied: i. The seller has transferred to the buyer the significant risks and rewards of ownership ii. The seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold iii.

The amount of revenue can be measured reliably iv. It is probable that the economic benefits associated with the transaction will flow to the seller, and v. The costs incurred or to be incurred in respect of the transaction can be measured reliably

Rendering of services
For revenue arising from the rendering of services, provided that all of the following criteria are met, revenue should be recognized by reference to the stage of completion of the transaction at the balance sheet date (the percentage-of-completion method) i. The amount of revenue can be measured reliably;

ii. It is probable that the economic benefits will flow to the seller; iii. The stage of completion at the balance sheet date can be measured reliably; and iv. The costs incurred, or to be incurred, in respect of the transaction can be measured reliably.

When the above criteria are not met, revenue arising from the rendering of services should be recognized only to the extent of the expenses recognized that are recoverable (a “cost-recovery approach)

Interest, royalties, and dividends
For interest, royalties and dividends, provided that it is probable that the economic benefits will flow to the enterprise and the amount of revenue can be measured reliably, revenue should be recognized as follows: i. Interest: using the effective interest method

ii. Royalties: on an accruals basis in accordance with the substance of the relevant agreement iii. Dividends: when the shareholder’s right to receive payment is established

Creative Accounting
Creative accounting refers to the use of accounting knowledge to influence the reported figures, while remaining within the jurisdiction of accounting rules and laws, so that instead of showing the actual performance or position of the company, they reflect what the management wants to tell the stakeholders. Purposeful intervention in the external financial reporting process with the intent of obtaining some exclusive gain. There are some many ways management can use to practice creative accounting such as choices of accounting policies, use of artificial transactions and revenue recognition. In this study, our main focus will be on later, the revenue recognition.

Revenue Recognition is the most manipulated item. Deloitte on its review on what fraud scheme are most common, revenue recognition represent 41% of all fraud schemes in United States between 2000-2006.For Many Companies the revenue figure is a single aggregated big number. Creative accountant has always known that, one of the ways to inflate profit is to inflate revenue. In achieving this goal first they manipulate fair value measurement criteria.

The criteria are subjective and depend upon the parties to the transactions integrity. The fair value determination is based on knowledge and willingness of the parties to the transactions. Secondly they recognize revenue before it is earned i.e. pre mature recognition of revenue. In complex transactions which involves the lengthy stages of sale especially with accrual system.

The recognition of revenue in terms of its timing can be very unclear, therefore the opportunity for manipulation occurs and this can facilitate premature recognition of revenue. Before looking how revenue recognition link with creative accounting, first we have to look the motive behind Creative accounting. Dr. Syed Zulfiqar Ali Shah and Dr. Safdar Butt in their article Creative Accounting: A Tool to Help Companies in a Crisis or a Practice to Land Them into Crises which also appeared on NBAA journal No.28 of April-June 2010states and explains the following as motives for creative accounting.

To meet internal targets
The managers want to cook the books for meeting internal targets set by higher management with respect to sales, profitability and share prices.

Meet external expectations.
Company has to face many expectations from its stakeholders. The Employees and customers want long term survival of the company for their interests. Suppliers want assurance about the payment and long term relationships with the company. Company also wants to meat analyst’s forecasts and dividend payout pattern.

Provide income smoothing.
Companies want to show steady income stream to impress the investors and to keep the share prices stable. Advocates of this approach favor it on account of measure against the ‘short-termism’ of evaluating an investment on the basis of the immediate yields. It also avoids raising expectations too high to be met by the management.

Taxation
The creative accounting may also be a result of desire for some tax benefit especially when taxable income is measured through accounting numbers.

Change in management
There is another important tendency of new managers to show losses due to poor management of old management by some provisions

Revenue Recognition as method for Creative accounting practices There are number of ways management use to conduct creative management, among them is revenue recognition. Firms virtually have a free hand in timing the booking of their revenues at any stage starting from the moment sales contracts are signed till the promised product or service has been fully delivered to and accepted by the clients.

For this we can refer to a classic example of Microsoft which was heavily fined by US SEC for its manipulative revenue recognition policy. Microsoft recognized only a small percentage (20-30%) as revenue at the time of the sale and remaining amount was kept as provision for future after sales services. Why Microsoft adopted that strategy.

The answer is to (1) hide substantial profits, (2) signaling effects, (3) avoiding complacency and last but not the least (4) to report smoothed earnings to its shareholders & stakeholders.3 Moreover, NBAA Account Journal vol.25 No 4 October –December 2010, outline ways in which Revenue Recognition can be used as a method of creative accounting. This include but not limited to Common revenue Manipulations and channel stuffing, Multiple element arrangements, side letters or agreement and non substantive round trip arrangement, Bill and hold arrangements, backdated contracts and Fictitious transactions

Common revenue Manipulations
Revenue recognition irregularities often involves both omission and commission acts which are inherently either or both inclusive and exclusive of creative accounting manipulation.In books and records include commissions such as false entries,misstated contracts,back dating,misapplication of accounting standards.Commissions result into overstated revenue,mis-timing of recognition,overstated receivables.

Channel Stuffing
Channel Stuffing is a practice of bringing revenue forward from future fiscal periods.This is done by inducing customers to submit purchase orders in advance.Channel Stuffing is an example of real earning management which involves manipulation of real or normal operations to influence reported performance. A good example of channel stuffing is Coca cola channel stuffing practice of 1997 to 1999 where coca cola offered downstream bottlers extended credit to induce them to purchase more than demanded.

Multiple element arrangements,
IAS 18 provides guidance on revenue gain from the normal sale of goods and provision of services. The complex issues that arise from the principle-agent relationship and multiple element arrangement .The revenue collected for third parties is not to be recognized by an entity.For example, in a telecommunication industry, operator firm form alliances and enter into Side letters or agreement

This involves act of seller to credit the buyer for unsold goods or to provide future stock rotation rights or to extend payment terms such that a
transaction becomes a consignment

Bill and hold arrangements,
This include the sale of product and performing the warehousing service for the product.It is a contract of supplying goods where the seller transfer the title but does not transfer physically deliver the goods until a later date.

The bill and hold arrangement are popular in the oil and gas industry as well as international sales.They are only acceptable when it is probably that the delivery will be made,the items on hand is identified and ready for delivery to the buyer at the time when sale is recognized, the buyer specifically recognizes the differed delivered instructions and the usual payment terms apply. The sale on bill and hold arrangement must satisfy conditions that the seller only retains the goods for safe keeping and shipping and the goods must not used by the seller to fulfill other orders.

When these condition are met then sales can be recognized on a bill and hold arrangements. In practice these rules can be violated by seller and this go to be an act of creative accounting. The specific case in point would be on timing of the recognition between years as the transfer of risks and rewards can be distinguish and difficult to uncover. Therefore due to this the Revenue recognition can be shifted forward or backward to suit the needs of the creative accounting.

Backdated Contracts
Backdating of revenues contracts facilitates early recognition of revenue than normally expected recognition date. Company must comply with any laws, rules and regulations relating to dating documents used in business. Any departure from this may attract litigation because such backdating may amount to fraud, forgery and criminal offenses.

Recognition of revenue earlier than its expected date act as a method of creative accounting because the financial statements for early recognition period will not present a true and fair value of the company’s performance, rather performance results from manipulated figure through creative accounting.

Genuine Transaction
Genuine transactions can also be timed so as to give the desired impression in the accounts. As an example, suppose a business has an investment at historic cost which can easily be sold for a higher sales price, being the current value. The managers of the business are free to choose in which year they sell the investment and so increase the profit in the accounts Fictitious Transactions

Financial Statements are inflated by recording sales of goods or services that never occurred or by inflating actual sales. This is one of the leading malicious manipulations than the other type of earning management because it engrosses documents falsification, forgeryand manipulation. On the other hand fictitious revenue can be accomplished with side agreements, contra agreements (sales that offset a purchase transaction) and conditional sales.

Practical Example

Xerox Corporation
Source: The Wall Street Journal, February 6, 2001
Xerox Corporation had the habit of recognizing leasing payments as sales. In April 2002, after an investigation by the SEC, the American company was forced to reclassify its financial statements for the years 1997 to 2000 and reduce recognized revenues by US$3,000 million and profits by US$1,500 million, with equity being reduced in the same amount. As a result, the SEC fined Xerox US$10 million. By that time, the price of the company’s shares had plummeted from US$62 to US$4.5.

How did this company manipulate its revenue figures?

Xerox sold customers photocopiers under long-term agreements, in which the customers paid a sum of money to Xerox, part of which was to purchase the machine and the other part to cover repairs and maintenance on a long-term basis. This was not problematic in itself from a bookkeeping perspective, provided that the amount corresponding to the sale price of the machine was recognized as revenue in the first year, plus revenues corresponding to maintenance services in the current year, transferring the rest of the received amount to deferred Revenues, which, in turn, were recorded as sales
in the year in which the repair services were rendered. So, if a photocopier, for example, is valued at US$100, and five-year maintenance costs US$50, the customer would pay Xerox US$150 when purchasing the machine.

The correct accounting method for recording this operation, if the transaction were performed on 1 January, would be to recognize US$110 of sales in year 1 and US$10 of sales in each of the following four years. Accounting malpractice on the part of Xerox consisted in recognizing US$125 of revenues from the sale of the machine, thus undervaluing the amount of future repair services, recording US$130 as revenues in year 1 and deferring only US$20 over the remaining four years of the contract. In this way, it increased year 1profits substantially and reduced future profits. The total amount of the transaction in sales remained the same (US$150); the problem is simply the timing of the recognition of these sales

ENRON

Enron and other energy merchants earned profits by providing services such as wholesale trading and risk management in addition to developing electric power plants, natural gas pipelines, storage, and processing facilities. When taking on the risk of buying and selling products, merchants are allowed to report the selling price as revenues and the products costs as cost of goods sold. In contrast an “agent” provides a service to the customer, but does not take on the same risks as merchants for buying and selling.

Service providers, when classified as agents, are able to report trading and brokerage fees as revenue. Enron’s method of reporting inflated trading revenue was later adopted by other companies in the energy trading industry in attempt to stay competitive with the company’s large increase in revenue. Enron’s use of distorted, “hyper-inflated” revenues was more important to it in creating the impression of innovation, high growth, and spectacular business performance than the masking of debt. Between 1996 to 2000, Enron’s revenues increased by more than 750%, rising from $13.3 billion in 1996 to $100.8 billion in 2000.

This extensive expansion of 65% per year was unprecedented in any industry, including the energy industry which typically considered growth of 2-3% per year to be respectable for just the first nine months of 2001; Enron reported $138.7 billion in
revenues, which placed the company at the sixth position on the Fortune global 500.

Group Discussion Regarding Revenue Recognition
The Management objective is to maximize shareholders wealth and this is achieved when the companies they are managing are performing well, recording high revenue figure and a good bottom line figure, the profit.

Though this study we have learn that, Revenue recognition and Creative accounting is a tool which is much like a weapon. If used correctly it can be of great benefit to the user but if it is mishandled it can cause much harm. Many people are taking creative accounting as negative act; the image to their mind is that creative accounting is dishonest act and manipulation of figures. Though the study we have learned out that Creative accounting has both advantages and disadvantages. It can help the company to get out of a crisis than land them to a crisis. Therefore our discussion will focus much the advantages of creative accounting as the results of Revenue Recognition to the Organization.

Not all aspects of revenue are covered under IAS 18 (Revenue Recognition), which give the room to management to use their judgments which will ends up with results favors position. For example IAS 18 provides guidelines on revenue gain from the normal sale of goods and provision of services. The revenue that arises from the principle-agent relationship and multiple element arrangement is not falls on the two. Deciding whether one operator is acting as an agent in delivering of services is subjective and unclear. Thus the decision will be based on matter of judgment and circumstances of situation. When Management use their judgment to recognize revenue for situation like this we can not say they have manipulated the figure, therefore creative accounting become advantageous to them.

Creative accounting also can be used in genuine transactions. For example, the disposal of Investment, the authorization of sale lies on owners but the decision on when to sale is on hands of Management. For example, if the Company have investment of TZS 2m at historical cost which can be easily sold for TZS 3m in current Value, when authorized to sale, the Management of Company are free to choose in which year to sell the investment and to increase profit in the company results.

Due to the tendency of Investors preference on smooth income to up and down income, Management would like to dispose this Investment in the period when they see the entity’s performance is poor. The revenue from sale will help to boost their performance and end up reporting smooth income and help to meet expectations. This is creative accounting, but applied on genuine transaction and according to the requirement of the transaction. Revenue recognition acts as a method of creative accounting but on genuine transaction.

The two examples we have discussed explain in brief how weapon, creative accounting could be beneficial to Company. When using creative accounting on in good manner, if the Company is in crisis, can help the company to acquire loans from Bank, to attract Investors and also to motivate employees because not only lenders and Invertors interested with Company Performance, Employees also interested to assure their job security and this is important because will enable the Company to retain their key personnel and also attract more qualified workers

Conclusion

Creative Accounting is both desirable and undesirable. It depends on the point of one’s argument. The practice of creative management has some advantages and disadvantages. Creative accounting is a tool which helps a company to get out of crisis than to land in it. It is much like a weapon. If used correctly it can be a great benefit to the user. Some advantages of creative accounting as a result of revenue recognition has helped to stabilize share prices, helps/helped companies to straighten their borrowing limits and rescue companies from hostiles takeover.

On other hand it has brought more harm to companies especially through untimely corporate failures that have brought immense losses to various stakeholders. Also the improper use of such creative accounting practices had fooled both auditors and regulators in the past and it continues to do the same.

The complex and diverse nature of the business transactions and the latitude available in the accounting standards and policies make it difficult to handle the issue of creative accounting. It is not that creative accounting solutions are always wrong. It is the intent and the magnitude of the disclosure which determines its true nature and justification. Revenue recognition can as a tool can enhance both advantage and disadvantages of creative accounting.

When Revenue recognition applied on genuine transaction and company end up with good results it enhance the advantages of using creative accounting practices but the worse of it is when it is used to recognize revenue on artificial transactions and fictitious transactions, this end up landing the company into crisis like ENRON, this is disadvantages of practicing creative accounting.

REFERENCE
1. The Accountant. The Journal of the National Board of Accountants and Auditors Tanzania.No.4 October-December,2010 2. The Journal of the National Board of Accountants and Auditors Tanzania.Vol.25 No.28 April-June 2012 3. The Wall Street Journal, February 6, 2001

4. Oriol,Amat:Journal of Economic Literature classification: M41.Creative Accounting: Nature, Incidence and Ethical Issues


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