Introduction
The objective of financial reporting is to provide accounting information that is useful to current and potential investors, lenders, and creditors. Thus, financial reporting standards add value if they allow financial statement users to distinguish between better-performing firms and poorly performing firms in a timely manner. Revenue is almost always the single largest item reported in a company’s income statement. As with bottom-line income, top-line revenue is significant not only in monetary terms but also in its importance to investors’ decision-making process; trends and growth in a company’s revenue are barometers of the company’s past performance and future prospects. Consequently, revenue recognition has been one of the most important issues confronting standard setters and accountants.
One of the critical issues with respect to revenue recognition is the timing of the appropriate point in a sales cycle when revenue should be recognized. The U.S. GAAP broadly stipulates that revenue should be recognized when it is realized/ realizable and earned. This is based on the revenue recognition principle. However, in practice, the timing of revenue recognition is complicated because of the complexity and diversity in the underlying revenue-generating transactions.
Development of revenue recognition
Early investors, managers, and accountants developed a conservative culture around recognizing revenue in financial reporting. Conservatism is a doctrine in financial reporting dictating that possible errors in measurement are accounted in the direction of understatement rather than overstatement of net income and net assets. One of the principles guiding conservative financial reporting is called the matching principle, which states that expenses must be matched with the revenue that produced that expense. This means that companies offering products with multiple deliverables cannot recognize all of their revenue in one period. Instead, these companies are required to defer revenue on some of those products to a future period in the event future expenses arise.
Software revenue recognition and post-contract customer support
One of the key issues in software revenue recognition is the point at which software license revenue should be recognized. Some believe that revenue should be recognized at contract signing. They argue that delivery of software is incidental to the earnings process because most of the significant costs related to the transaction have been incurred and expensed prior to contract signing and because in the software industry, transfer of rights to software is achieved by license, rather than outright sale or delivery, in order to protect vendors from unauthorized duplication of their products.
In addition to licensing software, providing post-contract customer support (PCS) is another major source of revenue for many software firms. Those who favored immediate recognition of PCS revenue argued that such practice is easier to apply. SOP 91-1 took the second view and concluded that PCS revenue should be recognized ratably over the period of the PCS arrangement if collectability is probable. The SOP also stated that although PCS and software may be sold together, they are considered to be separate items that should be accounted for separately.
Over the last two decades, accounting standard setters have issued a number of standards aimed at preventing premature revenue recognition by requiring firms to meet strict criteria before revenue can be recognized. Critics argue that overly restrictive revenue recognition standards, especially those related to multiple deliverable arrangements, result in earnings that fail to reflect the underlying economics of sales transactions. While some research suggests that increased discretion allows managers to communicate their private information, other research suggests that managers use increased discretion opportunistically. Understanding the impact of increased discretion in revenue recognition is important because revenue is a key earnings component and is often used to manage earnings.
Besides, the FASB has modified and updated U.S. Generally Accepted Accounting Principles (GAAP) related to revenue recognition as a result of questions and uncertainties in the revenue recognition process, emerging forms of transactions, and alleged accounting abuses. While these have the potential to improve representational faithfulness, they can also reduce value-relevance if they prevent managers from making reporting decisions that accurately reflect underlying economic transactions or events. Besides, these modified and updated revenue recognition standards (which are sometimes industry-specific) may result in less comparability across entities, industries, and jurisdictions.
It is important to note that requirements about when and how to recognize revenue may limit managerial discretion and increase the complexity of the revenue recognition process. Early revenue recognition standards related to multiple deliverable arrangements such as SOP 91-1, SOP 97-2, and EITF 00- 21 used a rules-based approach in an attempt to prevent firms from opportunistically shifting revenues across periods. In October 2009, the FASB issued ASU 2009-13/14, which provides firms with greater discretion in accounting for multiple deliverable arrangements. One of the stated purposes of ASU 2009-13/14 was to report transactions with multiple deliverables in a way that more closely reflects the transfer of goods and services to customers.
Conclusion
In summary, early recognition yields more timely revenue information, as evidenced by a higher contemporaneous correlation with information impounded in stock returns. However, such early revenue recognition decreases the extent to which accounts receivable accruals map into cash flow realizations ex-post, suggesting greater uncertainty in reported revenue. Also, early revenue recognition also yields lower time-series predictability of reported revenue. Overall, the results suggest that early revenue recognition makes reported revenue more timely and hence more relevant, but at the cost of lower reliability and lower time-series predictability.
Bibliography
Myers, Linda, Roy Schmardebeck, Timothy Seidel & Michael Stuart, “Increased managerial discretion in revenue recognition and the value relevance of earnings.” Vanderbilt Owen Graduate School of Management Research Paper, (2016) 1-51.
Terry, Latasha, “Revenue Recognition rules for bundled sales in high technology undermine the purpose of section 10(b) of the securities and exchange act.” University of San Francisco law review, 48 (2014): 585-617.
Zhang, Yuan, “Revenue recognition timing and attributes of reported revenue: The case of software industry’s adoption of SOP 91-1.” Journal of Accounting and Economics 39: (2005):535–561.