Recommend: Suzie’s sweater – Revenue recognition alternatives and the implication for faithful representation

Accountants trained under IFRS are likely unaware that during the joint IFRS and US GAAP convergence project, two vastly different approaches to revenue recognition were considered. IFRS 15 Revenue from Contracts With Customers ended up following a similar approach to the superseded IAS 18 Revenue, in that revenue is only recognised on transferring goods or services to the customer. This article briefly presents the two alternatives and considers the implication for the assumption that IFRS (or US GAAP for that matter) always achieve a ‘faithful representation’ of the economics of a business.

Of the two alternate accounting options, one perspective is more prudent while the other embraces the fair value accounting logic. To illustrate these alternatives, the renowned case of Suzie’s Sweater1 is presented. Imagine going to your local clothing store to find the perfect sweater for the holidays. As Murphy’s Law would have it, they have every size but yours. To secure a sweater, you pay R100 now2 for the sweater and are assured it will be delivered to you next week. The delivery will occur after the retailer’s year-end later that day. The obligation to obtain the right sweater size and have it delivered to the customer will cost the retailer R80. The question then arises, how should the company account for the transaction in their books?

Option 1, and the US’s and Enron’s infamous Jeffrey Skilling’s view, is that signing a contract (or the creative act that will lead to profits3) is what matters most. That is where a difference in the net assets of the company arises. This is because the cash increased by R100, while the obligation to secure and deliver the right sized sweater to the customer is only R80. In other words, the retailer could pay another company R80 to take over its obligation and make a tidy profit of R20. This R20 is the revenue Option 1 would have the retailer recognize on the date of sale. Accountants that support the fair value logic4 are likely to support this view.5

Those prudent stewardship accountants are likely asking: what if the right size sweater cannot be sourced and delivered? In that scenario, did the company still make a R20 profit just for securing the contract? This introduces Option 2, supported by the IASB. This perspective is more prudent in that it believes revenue is only earned once the obligation has been satisfied. You should recognize this language from the IASB’s IFRS 15.

According to Option 2 (and IFRS 15), revenue is not earned when rights and obligations are created but rather when obligations to perform work are satisfied. Unlike Option 1, until the performance obligation is satisfied, no revenue may be recognized. This is because the performance obligation is measured at the transaction price of the revenue contract (R100) and not with reference to the fair value of the performance obligation nor the entity-specific cost to fulfil the performance obligation (R80). This is because if the company cannot fulfil their obligation to deliver the right size sweater, it must return the full R100 to the customer.

From a purely theoretical perspective, one alternative is not obviously superior to the other. At the end of the day, a decision needed to be made. But importantly, this example demonstrates how vastly different accounting can be based purely on how a group of (albeit highly knowledgeable and competent) individuals decide to go. Again, this raises the question of whether financial statements do, obviously and automatically, present a faithful representation of the economics of a business. At the very least, it implies that there is more than one way to faithfully represent those economic phenomena.

To further complicate the matter, consider the statement by the previous chairman of the IASB, Hans Hoogervorst, in a 2012 speech:
[P]eople always tell us we should not set our standards from an anti-abuse perspective. I think that is nonsense. If we see ample scope for abuse in a standard, we had better do something about it. There are sufficient temptations and incentives for creative accounting as it is.6

This quote raises questions about the extent to which anti-abuse influences our accounting standards. If standards include anti-abuse provisions, do they still faithfully represent the economic phenomena of a company? What should users of IFRS financial statements bear in mind when relying on financial statements? Are any adjustments required? Should additional questions be put to executive management during results presentations because of anti-abuse provisions? Should company management teams use voluntary non-GAAP7 disclosures to supplement financials? How credible are these non-GAAP disclosures? Can integrated reports play a role here?

The key ‘so what’ of this article is to awaken accountants to the possibility that IFRS accounts are not as black and white as your lecturers may have led you to believe. Many factors affect accounting’s evolution and expanding one’s mind to these possibilities may help you differentiate yourself from other accountants and unlock value for your own business or your clients’ businesses. Be open and innovative, but from an educated perspective. This will help ensure that your ideas are taken seriously and are credible. We already know accountants don’t like change − but that doesn’t mean we shouldn’t change.

NOTES
1 A M King, 2005, Suzie’s sweater: the new paradigm in accounting, Strategic Finance, 87, 44−45.
2 Even if a non-cancellable contract was signed, the cash would be substituted for a right to receive R100 in future.
3 S Haswell and E Evans, 2018, Enron, fair value accounting, and financial crises: a concise history, Accounting, Auditing and Accountability Journal, 31, 25−50.
4 See ‘Stewardship versus neoliberalism’ in Accountancy SA’s August 2021 issue, pages 36–37.
5 Or recognise the liability at fair value, which will likely be approximately R80 with the difference as profit.
6 H Hoogervorst, 2012, The imprecise world of accounting, in a speech at the IAAER Conference in Amsterdam, 2012.
7 Generally Accepted Accounting Practice.

Authors
Carli Jonker CA(SA), Senior Lecturer and Head of Financial Accounting at the University of the Witwatersrand, and Professor Wayne van Zijl CA(SA), lecturer on the University of the Witwatersrand’s Chartered Accountant and Master of Commerce programmes