Accounting: The Language of Business - Vol. 2 (Intermediate: Part 14)

I think about photographs as being full, or empty. You picture something in a frame and it's got lots of accounting going on in it-stones and buildings and trees and air - but that's not what fills up a frame. You fill up the frame with feelings, energy, discovery, and risk, and leave room enough for someone else to get in there.

Joel Meyerowitz

Financial Reporting Theory (Part H)

by

Charles Lamson

Recognition and Measurement: International Financial Reporting Standards (IFRS)

In this section, we discuss major differences in recognition and measurement between Generally Accepted Accounting Principles (GAAP or US GAAP) and IFRS.

General Recognition Principles. Recall from part 12 that, according to U.S. GAAP, Recognition is the process of reporting an economic event in the financial statements. Recognized events are included in a line item on the financial statements as opposed to in the notes to the statements [FASB, Statement of Financial Accounting Concept No. 5, "Recognition and Measurement in Financial Statements of Business Enterprises" (Stamford CT: FASB, 1984), Paragraph 6.]

Again, according to U.S. GAAP, companies should recognize items when (and only when) they have met the following four criteria.

1. The item meets the definition of one of the elements (the building blocks of the financial statement, see part 10) of the financial statements. For example, before a company records an asset, the item must meet the definition of an asset.

2.  The item is measurable. Events that are relevant to decision making are recognizable only if the firm can measure them. Consider an entity that has been sued. In the early stages of the lawsuit, it may not be possible to reliably estimate the amount of the potential obligation. Therefore, it does not report a liability on the balance sheet.

3.  The item must be reliable. This notion is similar to the faithful representation characteristic discussed earlier in that reliable financial information depicts the substance of an economic event in a manner that is complete, neutral, and free from error.

4.  The item is relevant. That is, it must allow financial statement users to make rational economic decisions.

IFRS also has four recognition criteria. Notice that the first three recognition criteria are similar to U.S. GAAP:

1. The item meets the definition of one of the elements.

2. The item is measurable.

3. The measurement of the item must be reliable.

4. It is probable that future economic benefits will flow to or from the company.

To illustrate the fourth criterion, assume management determines it is probable that the company will collect an estimated amount of receivables, resulting in an economic benefit to the company. Management should not include any receivables unlikely to be collected as assets by establishing an allowance for noncollectable accounts. The fourth criterion is used instead of relevance under U.S. GAAP.

The IFRS cost-benefit constraint and materiality constraint are similar to U.S. GAAP. We summarize the US GAAP and IFRS recognition criteria in Exhibit 2.11. 

Revenue and Expense Recognition. Under the current IFRS conceptual framework, firms recognize revenue when they meet both of the following criteria:

1. An increase in future economic benefits related to an increase in an asset or decrease of a liability has occurred.

2. The revenue can be measured reliably (IASB, Conceptual Framework for Financial Reporting, Paragraph 4.47.)

Similar to U.S. GAAP, the IASB recently adopted new revenue standards not completely aligned with the IFRS conceptual framework (The conceptual framework defines the objective of financial reporting as providing financial information that is useful in making decisions about resource allocation. It identifies characteristics associated with high-quality financial information. The conceptual framework also defines the elements of the financial reporting system, such as assets and liabilities, and specifies the recognition and measurement criteria to be used in practice. Therefore, when investors and creditors analyze financial statements of companies such as Facebook or Johnson & Johnson, they understand how the financial statements were prepared, what each financial statement contains, and what each line item on the statement represents.) The IASB adopted the same new revenue standard in the FASB, applying the notion of the transfer of control of the goods or services for revenue recognition. The IASB is expected to align the conceptual framework, with the new standard when it rewrites the framework.

Firms recognize expenses in the income statement when both of the following criteria are met:

1. A decrease in future economic benefits related to a decrease in an asset or an increase of a liability has occurred.

2. The expense can be measured reliably. (IASB, International Financial Reporting Standard 15, "Revenues from Contracts with Customers" (London, UK: International Accounting Standards Board, 2014).

Firms recognize expenses simultaneously with an increase in liabilities or a decrease in assets. For example, salaries payable is increased when a company recognizes salary expense. Unlike U.S. GAAP, IFRS does not use the matching approach [The matching principle (or approach) requires that a business records expenses alongside revenues earned. Ideally, they both fall within the same period of time for the clearest tracking. This principle recognizes that businesses must incur expenses to earn revenues (freshbooks.com).} for expense recognition.

Bases of Measurement. IFRS includes four of the five measurement bases used under U.S. GAAP. The four IFRS measurement bases are:

1. Historical cost

2. Current cost

3. Net realizable value

4. Present value of future cash flows 

IFRS does not include current market value as a separate measurement basis. Rather, The view under IFRS is that current cost, net reliable value, and the present value of future cash flows are all current market value measures.

Cash versus Accrual Accounting

U.S. GAAP is based on accrual accounting. It follows U.S. GAAP does not allow a cash basis system. [In U.S. GAAP the mandate for accrual accounting is in the FASB's Statement of Financial Accounting Concepts No. 6, "Elements of Financial Statements" (Norwalk, CT: FASB, 1985), Paragraph 134. IFRS discusses accrual accounting in IASB. Conceptual Framework for Financial Reporting, Paragraphs OB17-19.)]. To highlight the advantages of accrual accounting, we will begin by reviewing the cash-basis system.

Cash-Basis Accounting. Under the cash basis, firms recognize revenues only when they receive cash and recognize expenses only when they pay cash. Consequently, the cash basis measures cash receipts and disbursements but does not measure economic activity. Further, the cash basis enables firms to manipulate net income with the timing of cash flows. For example, a company using the cash basis could report higher net income by delaying payment of expenses until the next accounting period. Alternatively, to reduce reported earnings, a company could delay billing its customers until the next account. To ensure that it would not receive cash revenues in the current period. 

Accrual Accounting. Under the accrual basis, firms recognize revenues and expenses according to the principles we discussed in part 12. Accrual accounting is a financial accounting method that allows a company to record revenue before receiving payment for goods or services sold and record expenses as they are incurred (investopedia.com).

In other words, the revenue earned and expenses incurred are entered into the company's journals regardless of when money changes hands. When the firm receives or pays cash does not matter.

In summary, the accrual basis of accounting recognizes revenues when control of a good or service passes to the customer and expenses when incurred. As a result the major difference between cash and accrual accounting is the timing of revenue and expense recognition.

Example: The Cash versus the Accrual Basis of Accounting

PROBLEM: Yards, Inc. mows lawns at a fee of $100 per month. In the current year, 200 customers prepaid for the four months in the summer, beginning on May 1. Yards received $80,000 of cash receipts ($100 per month * 200 customers * 4 months) in May. Yards, Inc. provided the required service for 4 months by mowing lawns throughout May, June, July, and August. During those months the company incurred expenses of $10,000, $13,000, $12,000, and $10,000, respectively, and paid these expenses during the same month it consumed the economic benefit. Determine Yards Inc.'s net income for each month from May through August under both the cash and the accrual basis of accounting.

SOLUTION: Because Yards Inc. paid for the expenses in the same months it consumed the benefits, there is no difference in expense recognition between the cash basis and the accrual basis. However, there is a difference in revenue recognition.

Under cash-basis accounting, Yards would recognize revenue of $80,000 in May because that is when it received cash. However, under the accrual basis, it would recognize revenue of $20,000 ($100 per yard x 200 yards) in each of the four months.

Thus, under both systems Yards will ultimately recognize $80,000 revenue, $45,000 in expenses and $35,000 in net income. However, the timing of the revenue recognition differs, as illustrated in the following table. 

            

Note that the cash basis reports only cash receipts and disbursements but does not properly measure economic activity. Yards' cash-basis net income is overstated in May and understated in June, July, and August. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 40-42*

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