From the Existing GAAP to a New Accounting Approach

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Table of Contents

Introduction
The GAAP principles limitations
Potential benefits of the new practice
Conclusion
Work cited

Introduction

It is important to appreciate the role played by revenue recognition in the preparation of financial statements. Considering the wide use of financial statements in the decision-making process, it is important to have a universally recognized mechanism in order to ensure consistency. Efforts have therefore been directed towards replacing the existing generally accepted accounting principles (GAAP) with a new accounting approach. The move is aimed at creating consistency in the preparations of financial statements regardless of the industry the business operates in. In addition, the new approach will significantly seek to reduce the many standards involved in the GAAP. This paper seeks to analyze contract revenue recognitions.

The GAAP principles limitations

The current GAAP principle is accused of vagueness in the standards descriptions. As a result, there have been a lot of variations in the financial records preparations. The variations are mainly attributed to different interpretations from the various industries, which have limited the external users of the financial statements in making-up their decisions. The critics also claim that the current GAAP principles have many standards which burden the users. The various principles also seem to have some similarities which further complicate the financial interpretations. The new approach therefore seeks to reduce this number to a considerable level and also maintain their clarity in order to ensure consistency and ease comparability between firms (FASB S2&S3).

The board wishes to make some vital amendments to standards relating to non-financial contracts, insurance contracts and, lease contracts. This amendment will aim at ensuring similar revenue recognition models are used in every industry, thus improving their financial reporting. Similar firms will therefore use similar revenue recognition techniques in accounting for their contractual obligations. Such undertaking will also enhance comparability between different firms’ statements. It will also improve the decision usefulness of the information contained in the firms’ financial statements. In addition, the move will boost the decision usefulness of the financial information in the industry (FASB S11). The current GAAP principles are more complex, a quality that leads to interpretation variations. The board, therefore, seeks to simplify these principles which will, in turn, lead to quality financial reports. Therefore, people who depend on the financial statements in the decision-making will be at ease since the format, language and techniques used will be understandable (FASB 1.20).

The proposed version emphasizes revenue recognition on an increased basis of net wealth emanating from the contract. All the transactions that add up the total revenue from the contract should therefore be recognized in the books of account. The board has also interpreted the contract further to comprise not only written but also implied agreement between parties. This move seeks to delimit the legal contractual obligation between parties, and also between firms. Indeed, the rights and obligations of the parties to contract should be well outlined in order to ensure conformity (FASB 2.27&2.28).

Potential benefits of the new practice

The revenue recognition principles of many contracts will still remain as outlined in the GAAP. This is because the new practice does not aim at replacing the principles, but instead it targets improving them in order to ensure efficiency and effectiveness of the financial statements. However, the retail transactions together with the long-term contracts will not be affected by the new practice (FASB 6.2&6.3). According to the board, revenue should be recognized after the goods have been successfully delivered to the customer. This move aims at ensuring that all the performance obligations are accounted for in the books of accounts (FASB 6.7). In order to cater for the deficiency caused by the cash-based revenue recognition, the board intends to use the collectability of payment criteria in determining the amount which increases the contract net wealth. In case after the delivery of goods and services to the customer, there stands a high possibility of losing the amount, the amount should not be considered as revenue. This move will ensure that bad debt are not recognized as revenues in the financial statements (FASB 6.13).

The new approach requires the parties engaged in construction work that they should recognize revenue after the ownership rights of the inventories passed to the customer; otherwise, the inventory should still be accounted as inventories. This aims at ensuring no double counting occurs during the financial statements preparations (FASB 6.21). The board clearly defines the performance obligations to prevent different interpretations in the industry. The definitions will thus enhance similar accountability between firms which allows comparability in the industry.

All the post-depost-delivery should be accounted for as revenue if and only if the customer provides a warrant or a promise to the contracting party. This is according to the performance obligations new definitions. The board views that the financial statements will have a true reflection of the actual performance of the business. In addition the financial statement users will effectively decide well (FASB 6.28). The sales incentives together with other promotional promises will also be treated as performance obligations since it results to transfer of ownership (FASB 6.33).

The new approach seeks to ensure that estimates of the delivered goods are accounted for as revenue even without specific objective evidence on them. The main reason why the vendor should recognize the amount will solely depend on the reliability of the customer. Incase the vendors’ objective on the sold amount has reliable evidence the amount should be recognized as revenue. However, where the evidence seems unreliable, the vendor should not recognize the sales revenue using an estimated standalone selling price (FASB 6.38 & 6.39). The newly adopted residual method requires the vendor to use the total transaction price in accounting for the undelivered goods since it will assist in capturing the true entity performance in the contract. On the capitalization of cost, the board intends to recognize them as expenses in the financial statements. The costs must however be in accordance with the other accounting standards (FASB 6.44).

Conclusion

All the US firms, both the profit making and the non-profit making ones, have been following the GAAP principles in their financial statements preparations. The principles have nevertheless resulted to inconsistencies since firms have differently interpreted the standards. Partial changes of the principles are underway as the board seeks to ensure efficiency and consistency in the financial statements preparations. Consequently, the board also aims at simplifying the standards in order to increase their usability. The new approach intends to reduce the many standards that are currently used by the firms thus making them more user-friendly. It is also important to understand that some of the principles will continue been used as they are in the current GAAP. The new approach therefore aims at reinforcing the current principles and not replacing them.

Work cited

Financial Accounting Standards Board. Preliminary Views on Revenue Recognition in Contracts with Customers. 2008.

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From the Existing GAAP to a New Accounting Approach

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