Companies all over the world are required to periodically collect and release financial information about the current state of the business. This allows both existing and potential investors to understand the company’s current financial state, how it is spending money and whether the company is successful. It also allows an evaluation of multiple companies in the industry and comparison of their financial states and methods.
In order to make sure this sort of comparison is easy and documents are understandable, accounting standards called IFRS and GAAP have been made to guide firms in their records and revenue recognition.
The two main systems used in today’s economy for revenue recognition are GAAP, or generally accepted accounting principles, and IFRS, which stands for international financial reporting standards. GAAP is a set of accounting principles and rules used in the United States. IFRS is a global set of accepted standards and is used in over 120 countries across Europe, Africa and Asia.
Understanding both systems, how they differ and how each one applies good accounting practices is important for anyone working with financial information and accounting transactions like revenue recognition.
Revenue recognition by definition is whenever income earned is shown on a balance sheet or in your company’s books. The way this information is tracked varies depending on whether GAAP or IFRS standards are being followed.
Under GAAP, the revenue recognition principle requires that revenue be recognized when it is earned rather than when it is in hand. This means that you must note revenue when you have signed a contract for a service or an order has been placed by a customer. You should not wait for your customer’s payment to transfer to your account before noting the payment in your company’s books.
Under IFRS and according to the International Accounting Standards Board's Framework for the Preparation and Presentation of Financial Statements (the accounting standard-setting body for IFRS), revenue is recognized when “it is probable that any future economic benefit" will arise and can be recognized. In addition, the IASB framework indicates that revenue should be earned before it can be recognized.
When it comes to revenue recognition, GAAP is firm. This is a standard GAAP principle that identifies the specific conditions under which revenue can be recognized. In most instances, GAAP requires this to occur when certain “critical events” have transpired.
For instance, if a product is sold, the revenue recognition step occurs as soon as payment occurs. In a store, this would transpire when a customer swipes a credit card. If you offer a service, this would occur when the customer remits payment on the invoice you sent.
If, however, a good deal of time passes between when a product or service is ordered and you supply it to a customer, you may need to treat the recognition of this revenue differently. All treatment of revenue is outlined under GAAP standard ASC 606. Generally speaking, revenue can be recognized under GAAP when it is realized rather than actually in hand. For products sold in a store, this is immediate but may take longer depending on your business cycle.
GAAP also approves the treatment of revenue in certain situations using the percentage of completion method. This allows for your accounting department to bill clients as you progress through a job rather than all up front or at the completion of the entire project.
Take, for instance, a construction project. Rather than bill the client $10,000 at the start of the project, you might choose to bill 20% upon the signing of the contract, 30% when the work is started, another 30% at the halfway point and then 20% when the work is completed. Once again, under GAAP, this revenue should be recognized as soon as the income is realized (when the contract is signed).
Part 15 of the IFRS standards speak to revenue recognition. In essence, the recognition of revenue under these rules requires the following steps to be taken:
- Your company must identify the contract with the customer.
- You must then identify the performance obligations as outlined in the contract.
- Your business must determine the transaction price or the amount to which you expect to be entitled after the transfer of goods or services. If this amount might vary, IFRS requires that you use an estimated amount in your bookkeeping.
- Your company must then record the price of each distinct aspect of your contract separately within your books.
- You should document revenue whenever a “performance obligation is satisfied by transferring a promised good or service to a customer.” This is whenever the service has been performed or the good is in the hands of the customer.
GAAP is the standard used for financial reporting in the U.S. Adopted by the Securities and Exchange Commission, GAAP contains the standards and formats to be used when creating accounting reports. All public businesses in the U.S. are required to follow GAAP when doing any sort of financial reporting. This ensures that all companies are using the same set of rules, guidelines and principles when submitting their financial information to the public, which means reports are easily understandable, consistent across all industries and easily comparable.
GAAP consists of a set of core principles — they’re often discussed as smaller groups of principles, concepts and constraints — that provide the framework for tracking financial transactions, company value and other accounting information. These principles define and standardize the approach to be taken when producing these financial records and documents. One such principle is the revenue recognition principle, but it’s essential that it be employed properly alongside other GAAP rules.
In order to understand how to treat revenue recognition under GAAP, it’s essential to have a basic comprehension of the system’s principles. The first set of GAAP principles are assumptions made to better define the scope of the reporting with regard to the company’s ongoing activities.
- The Business as an Entity Assumption: Defines the business as its own entity, separate from any owner's personal finances or other business ventures. Business revenues and expenditures are defined as separate from personal transactions.
- The Specific Currency or Monetary Unit Assumption: This requires businesses to record their transactions in a monetary unit; the currency specified is the U.S. dollar. All transactions involving overseas currency must be converted to dollars using the proper exchange rate.
The Time Period Assumption: This specifies that financial records are to be captured over an artificial and somewhat arbitrary time period. Since company business is continuously ongoing, this allows accountants to set a specific time limit
a month, a quarter, a year — to capture the financial transactions during that time period.
* The Going Concern Assumption: Considers the business as an entity that will continue to exist and function in the future. The assumption that the company will remain in business indefinitely allows the sorting of short-term and long-term assets and transactions.
The next set of principles are accounting principles that dictate how information is to be used, valued and recorded.
- The Historical Cost Principle: Specifies that assets are recorded as their cost at the time of the transaction. While assets can gain or lose value over time and inflation can affect the value of cash as well, this principle simplifies the issue by keeping each transaction value as it was when the transaction occurred.
- The Revenue Recognition Principle: This principle declares revenue to be recognized in financial statements at the end of delivery or transaction no matter when the cash is actually received. Revenue is to be recorded when the service is complete. This is the key to accrual-based accounting practices. It links revenue to the delivery of the product rather than considering lags or prepayments.
- The Matching Principle: States that revenues must be matched with the cost of doing business whenever possible. This is the same concept as the matching of debits and credits for every transaction used in double-entry bookkeeping. This is usually captured by adjusting values of assets and inventory as goods and services are sold for revenue.
- The Full-Disclosure Principle: The company is required to report all factors that may affect financial performance within the accounting report. While the report captures a picture of the company’s performance over a previous period of time, any ongoing issues that may affect the business’s financial status should be disclosed, often as footnotes to assumptions.
The final set of GAAP principles that must be understood to properly account for revenues sets forth constraints that direct the way the accountant makes decisions.
- The Objectivity or Sincerity Principle: Expects accountants to produce reports without bias, based on factual numbers rather than assumptions.
- The Materiality Principle: Determines the level of detail to which accounting transactions must be tracked. This principle captures the space in which the accountant may use good judgment to make decisions on transactional information. While accountants must strive for full disclosure, this captures the way accountants determine whether transactions are significant or not.
- The Consistency Principle: The company is expected to use the same set of methods and assumptions in each report from period to period.
The Conservatism Principle: In cases where judgment is required to choose between two solutions, it’s expected that the accountant choose the more conservative one
the solution with the less-favorable outcome for the business.
* The Good Faith Principle: This final principle assumes the accountant and the company are acting in good faith and recording accurate information to the best of their ability.
IFRS is the set of standards used for financial reporting for most major countries (over 120) outside of the U.S. These standards were developed by an international board and are meant to ensure consistency and accuracy of financial reporting for ease of understanding and comparison across international borders.
The IFRS system is in many ways principle-based; the framework describes a set of concepts and principles and a set of required documents that make up a company’s financial report. It defines a set of terms to use as a framework, which includes assets, liabilities, equity, income and expenses. There are also specific sets of IFRS guidelines for the following types of documents that must be understood in order to properly account for revenues under IFRS:
- Statement of Financial Position: This is a company’s balance sheet, which is a conceptual snapshot of the company’s financial position at the time of record. There are sets of guidelines on how to report the components of the balance sheet to stay in compliance.
- Statement of Comprehensive Income: This document captures the increase in value of the company. This can be a profit and loss statement, but rules also require increases in assets like equipment or property to be considered as increases in income.
- Statement of Changes in Equity: This captures the company’s actual change in earnings, profit or revenue over the declared time period. Retained earnings are often represented as equity for the company.
- Statement of Cash Flow: This looks at the business’s actual transactions over the period of time. IFRS provides rules on how to document individual transactions and how to record them over time.
The biggest difference conceptually between GAAP and IFRS when it comes to revenues is often summed up to say that GAAP is a rules-based system, whereas IFRS is a principle-based system.
What exactly does this mean? GAAP has many more specific requirements, rules and details than IFRS. The IFRS system is based on concepts, which may leave more room for interpretation but is likely to better represent the economics and accounting of a company’s financial transactions. In either case, both systems are fairly clear when it comes to documentation of revenues, so consistency within each system is key.
GAAP and IFRS differ specifically in the ways they approach certain types of transactions as well:
- Inventory Transactions: GAAP allows inventory tracking under both the first-in, first-out method and the last-in, first-out methods, while IFRS bands the LIFO method. The argument is that LIFO calculations often underestimate inventory value and do not result in an accurate picture of the financial situation. In addition, IFRS allows modifications to inventory assets based on market changes; if the value of the asset changes, certain write-downs can be reversed. GAAP does not capture this market change in its calculations.
Intangible Assets: Intangible assets are things like research and development, advertising, community relationships and so on
things that are difficult to value. IFRS principles look at the future value of these assets and consider whether the asset will have an economic benefit in the future. With GAAP, these assets are only considered at their fair market value, which may not entirely capture the value they represent.
Fixed Assets: GAAP looks at an asset’s cost without considering any change in market value or depreciation. IFRS allows assets to be revalued over time, so the value of a fixed asset could potentially increase or decrease depending on how much potential value it holds at that time.
Development Costs: Under GAAP, expenses are recorded at the time they occur and must be expensed in full. IFRS allows capitalization of certain development costs as long as certain criteria are met, which allows adjustment for depreciation.