The issue of income recognition in relation to long term contract accounting seem to be a controversial issue in the accounting practise and its evident following the efforts that have been put in addressing the issue by various researchers that form the accounting literature over the issue. Revenue recognition is importance because it has a great role in evaluating an organisation’s performance and also for external uses by investors and the entire public for varied reasons. The method that is adapted by an organisation in recognizing revenue affect the figure that is provided to imply the performance of the company at a particular period of time. The method that is chosen affect taxation in one given economic system on the assumption that taxation is based on the amount of revenue recorded, and on good faith that the figure that has been represented is a reflective of the company’s performance.
The recognition of revenue at the end of the contract implies that the costs incurred in generating the revenue are not matched with their respective revenues on calculating net incomes because the they are likely to be accounted for in the financial statements on varied times, hence resulting into inaccurate evaluation of the organisation’s performance at a particular moment of time.
The varied methods that are adapted by various organisation create variability in the way in which financial statements are presented and for this reason it becomes difficult to compare the performance of the various companies in one given sector or economy. This situation therefore call for the exploration of the various methods of recognising revenue that are practiced by various organization and the level comparability across the various methods. This problem is evident in the situation where the Security and Exchange Commission wrote letters to the Fortune 500 Cooperations requesting them to clarify on how the companies recognize revenues on the Commission examining their financial reports for accounting irregularities. The Security and Exchange Commission (SEC) sent letters to more than 350 companies, in February 2003, concerning the clarification on how they recognize revenue (Larson and Brown, 2004).
Objective of the study
The objective of the study is to describe the the current practices and disclosures on the longterm contacts in examining the level of comparability over the various methods that are adapted to recognize revenue. Both the SEC and the Financial Accounting Standard Board(FASB) have been examining on how companies handle revenue recognition with an aim of developing a method that can be universal for to all companies. The paper exposes the possibility for the efforts put at the current times yielding improved cooperate revenue recognition policies and disclosure that depend on the extent to which the the current longterm contracts revenue recognition practises and disclosures are understood as this is expected to provide a base over which various adjustments need to be done in ensuring improved policies for revenue recognition.
Significance of the study
The knowledge about the various methods of revenue recognition and how it affects comparability is best attained by first looking at the current practices within various industries and on how they implement different revenue recognition methods on varied situations. This is accompanied by the evaluation of various circumstances that influence the adaptation of specific methods of recognizing revenue. This relationship will be used by the SEC and the FASB on addressing the matters that are related to revenue recognition.
Limitation of the study.
The process of evaluating the current revenue recognition practices as a basis for improving the revenue recognition policies and practices is however limited to the possibility of the the companies might not be transparent on how they recognise revenue, their financial reporting and also disclosure which is certain to distort the whole process. The companies may fail to be transparent because of their respective interests and more especially with the aim of either luring the investors, avoiding taxes or not finding it convenient to share the information with their rival companies.
Stand of Positions
Most of the longterm contract accounting issues have been addressed by the American Institute of Certified Accounting (AICPA) and the Accounting research Bulletin who provide most of the authoritative guidance on accounting practises. The ARB permits the use of both the Percentage of Completing Method and the Completed Contract method in the longterm contract accounting, although it prefers the use of PCM. In the situations where CCM is applied the cost-to-cost method should be used. The GAAP allow the use of both PCM and CCM, but this should be disclosed on the method that was used. The SEC, through its Staff Accounting Bulletin, they also clarified some issues related to the revenue recognition in the financial statements, but their clarifications were limited to address the longterm contract accounting, however it supported for the adherence of the practices highlighted in the GAAP in the need to disclose the revenue recognition policies implemented in preparing financial statements.
On the application of the PMC, the measurement may take either input measures or output measures on evaluating the percentage of the contract that has been completed. Input measure involve the the evaluation of the effort and the resources that have be used to a contract and this include the cost-to-cost method and the efforts-expended method. The cost-to-cost method estimate the proportion of the contract that has been completed based on the costs which have been incurred to the current state of the contract over the expected total contract cost. The effort-expended method involves aspects like labour hours, machine hours or amount of materials used in place of cost as in the cost-to-cost method. On the side of output measure, it involves the measurement of the contact progress based on the number of units that have completed and it can be done on either using the unit-of-product method, the units-of-delivery method or the performance milestone method. The units-of-production method involves the measure of the contract progress based on the proportion of the output that has been completed in relation to the expected total output at the end of the contract. The units-of-delivery method is based on the same concept as with units-of-product method but use the number of units that have been delivered and accepted by the customer as the measure in place of the units produced as in the case for unit-of-production method. The performance milestone method uses the completion of distinct events as the measure for the progress of contract on recognising revenue.
On choosing the use of either output measure or input measures, it will depend on the circumstances, and for ensuring effectiveness on the kind of measure chosen, a company needs to be consistent over the contracts that share similar characteristics.
Literature review and findings.
Following the initial researches that have been done, a large number of companies do not disclose how they applied the PMC (Freeman, 1976).The failure of the companies to full disclose poses a situation of inadequate information that seem to be misleading on using their respective accounting statements on either for taxation purposes or for decision making.
The other suggestion for evaluating the long-term contact accounting is the qualitative criteria that include aspects like relevance, reliability, comparability and also consistency an given by FSBA’s Statement of Financial Accounting (Trotman, 1982). According to Trotman, PCM is the best on ensuring representational faithfulness and also relevance, and the emphasis on consistency will enhance verifiability and reliability.
The companies that are working under the same industry are likely to adapt various methods for PMC, ranging from the methods contained in input measure to output measure. This follows from the freedom that is guaranteed by the GAAP Stand of Position that allows the use of any method in as far as the company discloses the method used and on how it was applied (Desmarias, 1983). This situation poses difficulties on comparing the performance of a company with other companies. If comparison id done then it is certain be inaccurate. The situation arises due to lack of disclosure standards which are meant to guide the companies on which information to consider and on how to use it in the preparation of their respective financial reports in enabling comparability. Comparability is necessary as it will enable external users like investors to make informed decisions that are likely to reduce the risks tha are inherent in various investment opportunities.
Despite the opposing forces on whether to use CCM or PCM, PCM seem to be dominating following the directive on the Revenue Reconciliation Act of 1980, that requires the companies to report their financial statements by using PCM for tax purposes (Seago and Davis, 1999). This act followed after the government of the US encountered problems on companies adapting methods of accounting that were meant to underestimate their income with the aim of reducing the tax burden.
According to the guidelines provided by the US GAAP, companies are expected to use PCM. The use of CCM should be supported by the reason why the company is using it. The choosing on CCM is however applied on the reasons that are based on the type of the contract, and the conditions and terms of the contract. The companies that are using PCM are also expected to disclose the method that was used as defined under the guideline provided by the GAAP and SEC. The most common method that is applied is the cost-to-cost method which is also used as a cost management tool in management accounting. It involves the comparison between the budgeted costs and the actual costs on making management decisions that are meant to control costs. The cost-to-cost method has an advantage over the other method because it allow estimations on using other methods that include the use the labour and machine hours.
Comparability of the companies’ financial statements is only possible if the similarities and the differences can be established, on the assumption that the financial statements were prepared based on similar accounting policies and practises. The comparability is undermined by the freedom that is awarded to the companies to choose the revenue recognising method on preparing their financial statements by GAAP and SEC. This poses a situation where companies in a similar industry are likely to adapt varied methods that make comparison difficult. However in some situations, the accounting method chosen can be justified depending on the factors that include the different sourcing of the contracts.
The firms that adapt PCM, and for this case output methods are likely to report most revenues, where the ones that use the input method will have a large asset base and a high level of income. The choice for using either PCM or CCM is also influenced the debt-to-equity ratio, where companies with a high debt-equity ration are expected to adapt PCM than CCM on the reason that they will be practising a conservative accounting methods( Trotman, 1980). Still within the PCM, the input method is likely to be chosen by companies practising conservative accounting compared to output methods.
Recommendations and conclusion
Companies have been left with freedom to choose the method of revenue recognition in as far as they disclose the method used and on how it was done. This situation lead to incomparability of the financial statements of various companies in one industry or in different industries. The incomparability that arises from such a cause pose difficulties for the external users of the financial statements as they may not be representational.
On the process of ensuring comparability, the GAAP and SEC should develop a standard method that should be adapted by the companies in them preparing their financial statements, where this should be designed depending on the requirements of respective industry. The method chosen should be in conformity with the taxation act, that is the PMC. PMC should be preferred to CMM on the reason that the costs are likely to be matched with the income that they generate overtime during the progress of the contract with an aim of achieving a representative net income on timely basis.
Desmarias A., 1983, Accounting for Longterm Contracts: A Longtime Problem, CA Magazine(March), pp 53.
Freeman R., 1976, Revenue Recognition and Disclosure on longterm Contracts, Management Accounting, pp 52.
Larson K. and Brown L., 2004, Where Are We With Longterm Contact Accounting, Accounting Horizons, pp2.
Seago W. and Davis R., 1999, Proposed Longterm contact regulations Avoid the Toughest Issues, Taxation Journal, pp 114.
Trotman K., 1980, Tradeoffs in the Choice between Logit and OLS for accounting choice studies, Prentice Hall, pp 142- 143.