Summary of Revenue & Expenses

Nature of Revenue and various approaches taken to defining revenue, including behavioural
view of revenue
Revenue is a key accounting element and fundamental to reporting on a firm’s activities.
Revenue has to do with the gross increase in the value of assets and capital, and that the increase
eventually pertains to cash. For the main operations of business, the cash inflow is created
predominantly by the production and sale of the output of the entity. The flows connected with
the major operation of the business: physical flow (involves the event of producing and selling
the firm’s output or product) and monetary flows (involves the event of increasing the value of
the firm due to production or sales to customers of the firm’s output). Revenue is represented
finally by the flow of funds from customers’ thus capturing the monetary flow. Revenue is
directly related to the monetary event of value increasing in the firm which arises out of
production or sale of output.
Revenue is defined in IAS 18/AASB 118 Revenue, paragraph 7, as having a flow characteristic.
In the IASB, revenue forms part of income. This is made clear in paragraph 70(a) and 74 of the
framework. The definition of income encompasses both revenue and gains. Revenue arises in the
course of the ordinary activities of an entity and is referred to by a variety of different names
including sales, fees, interest, dividends, royalties and rent.
The IASB definition in consistent with the FASB’s definition of revenue and focuses on inflows
or other asset enhancements arising from an entity’s ongoing major or central operations. Since
income is defined to include both revenue and gains (framework, para.74), further clarification
about gains is provided. Gains are included as part of income since they represent future
economic benefits and are thus no different in nature from revenue. The definition of income
also includes unrealized gains which has implications for revenue recognition rules.
In contrast to the IASB approach, the FASB makes a distinction between revenues and gains,
although both are included in profit. Gains are increases in net assets from ‘peripheral or
incidental transactions’ and from other events that may be largely beyond the control of the firm.
Revenues pertain to the ongoing major or central operations.
Revenue represent increases in the total value of assets (or a decrease in the value of liabilities)
and capital other than additional investment by owners. Revenue generally comes about because
the entity does something to make it happen. Revenue is not simply a sum of money. Revenue
indicates the ‘accomplishment’ of the firm. It is a measure of the entity’s ‘gross performance’ as
a profit-making business. When expenses are seen as representing the ‘effort’ of the firm, then
the matching of revenues and expenses results in profit: the ‘net accomplishment’ of the firm.
This is a behavioural view of revenues, expenses and profit.
Profit arises only from those activities that are designated business operations. The general
business operations specified by Bedford are:
 Acquisition of money resources
 Acquisition of services
 Use of services
 Recombination of acquired services
 Disposition of services
 Distribution of money resources
Myers relates the concepts of revenue and profit to certain critical events and decisions made by
the managers of the firm. Despite inconsistencies in practice, Myers’s critical event theory
remains useful in helping the accountant determine the point at which revenue should be
recognized. All the activities undertaken by the firm to make profit, taken as a whole, are called
the ‘earning
process’.
Earning
process based
on Bedford
consists of the sequence illustrated as follows:

Purchase In contrast to Myers, Paton and Littleton argue that revenue and profit accrue
of service throughout the earning process that is there is a continual change in value of the
inputs total assets and capital as the firm undertakes the activities specified in the
process. The FASBS’s definition of revenue calls attention to ‘the inflows or
other enhancements of assets of an entity or settlements of its liabilities due to delivering or
producing goods, rendering services. Note that the definition does not specify that revenue is
only the amount of sales made to customers.

Issues Related to the recognition of revenue and the criteria used in the revenue recognition
process
Historical Perspective
During 19th century, income (profit) for a business was determined on the basis of an increase in
net worth. The now familiar recognition or realization principle was not always a part of standard
accounting practices. The increase in net worth view of income was gradually supplanted by the
notion that income had to be ‘realized’. This change arose because the use of specialized non-
current assets by firms became significant in the period between World War I and the 1930s.
Determining the value of these specialized assets was difficult, making calculation of changes in
asset value of these specialized more difficult to ascertain. Chatfield points out that the first
authoritative use of the word ‘realisation’ occurred in 1932 in correspondence between a special
committee of the American Institute and the New York Stock Exchange. However, they were
commonly observed in the UK and Australia prior to the adoption of IASB standards in 2005.
Criteria for Revenue Recognition
Revenue recognition may take place at a number of stages in a firm’s operating (or earnings)
cycle outlined by Coombes and Martin as follows:
Over the years, based on the need for objective evidence, 3 criteria have evolved to ascertain
whether revenue or gain should be recognized. Recognition criteria are based on the desire for
both relevant and reliable accounting information but traditionally emphasis is placed on the
latter. The three criteria are:
 Measurability of asset value
Revenue can be viewed as an inflow that increases the value of the total assets of the firm,
with a concurrent increase in equity. Measurability of asset value is a reasonable criteria for
recognizing revenue. If there is no inflow of asset value that can be objectively determined,
revenue cannot be calculated objectively. The use of fair value measurement in standards also
focuses on the enhancement of assets, without any actual or physical inflow of assets. Under
fair value accounting, changes in the value of assets are reported as expenses or revenues
arising from holding the assets. This entirely consistent with the accrual accounting approach
but inconsistent with historical cost conservatism and the realization concept.
Recognition requires an inflow of assets or a measurable (quantifiable) change in the value of
an asset whereas realization requires an inflow of liquid assets.
An aspect of the criterion of measurability is whether collectability of the cash is reasonably
assured. Measurability of asset values relates to their collectability. Collectability is a matter
of judgment, usually based on the previous experience of the firm. The longer the collection
period, the more uncertain it is that all the cash will be collected. Determining collectability is
matter of resolving the uncertainty associated with the realization of revenue. Measurability
relates to the objective ability to assign value to the sale. The term ‘objective’ can be broadly
interpreted as unbiased and subject to verification by another competent investigator. The
second factor of ‘permanence’ implies that, once recognized, there should be no reason for
subsequently ‘reversing’ the revenue out of the accounts.
 Existence of transaction
When an external party in an arm’s length transaction expresses willingness to pay a given
price for the firm’s product, the transaction constitutes objective evidence of an increase in
value in the firm. The outside party provides corroboration of the value of the output.
Presently, except in specified cases, the firm must be a direct participant in the transaction.
Note that if we insist on the firm being a party to the transaction before revenue can be
recognized, then historical cost becomes the most feasible basis for asset valuation. We should
 not lose sight of the fact that the desire for a transaction is due to the need for objective
evidence. Too many instances of the use of market prices as the basis of valuation currently
exist for anyone to say that market prices do not constitute sufficient objective evidence. The
transaction test will be appropriate in the majority of cases to validate the recognition of
revenue.
 Substantial completion of the earning process.
The criterion, not explicitly stated in the framework, focuses on the notion that revenue is not
generated (earned) until the firm has performed most of the activities for which the firm earns
revenue. For this criterion to be applicable, revenue is not regarded as having been earned
until the firm has done something. When most of the operations that constitute the earning
process have been undertaken by the enterprise, then the cost associated with those operations
can also be determined.

Guidance provided by standard setters in relation to revenue recognition and measurement

Two criteria for revenue recognition provided in the framework paragraph 83:
 It is probable that any future economic benefit associated with the item will flow to or
from the entity, and
 The item has a cost or value that can be measured with reliability.
IAS 18/AASB 118 Revenue is more specific. It states that revenue to be measured at the fair
value of the consideration received or receivable (para.9). Further, it provides specific rules for
recognition and measurement of different types of revenue, namely (a) sale of goods, (b)
rendering of services, (c) interest, royalties and dividends.

Standard setters’ current activities in relation to revenue recognition and measurement

The IASB and FASB have undertaken a joint project in relation to revenue recognition and
measurement because revenue transactions are not well served by existing guidance literature.
The standard setters have noted that inconsistencies exist between the IASB Framework and
some standards. Further, the standard does not deal well with transactions involving components
(multi-element revenue arrangements). The FASB has indicated there is a void in revenue
recognition guidance and a lack of a conceptual basis for resolving the relevant issues.
The FASB/IASB project aims to develop a comprehensive set of principles for revenue
recognition that will eliminate the inconsistencies in the existing authoritative literature and
accepted practices. The FASB and IASB have proposed the following fundamental principles for
revenue and measurement. The principles are an extension of previous guidance. However, they
encompass a change in emphasis in some areas, which may lead to changes in accounting
practice. Further, the IASB has tentatively agreed that two criteria must be met to recognize
revenue.
The measurement criterion does not contain a probability criterion, such as that in the IASB and
AASB frameworks. The decision not to use a probability criterion reflects the IASB’s view that
probability should be part of the measurement of elements of financial statements and should not
be a criterion for recognition. Measurability is still an important element of the new criteria but
there is less emphasis on substantial completion of the earning process. The approach taken in
the project is to focus on the change in value of assets and liabilities rather than the completion
of an earnings process.
The emergence of assets with different characteristics (such as financial instruments) and greater
use of fair value measurement in specific standards such as IAS 39/AASB 139, IAS 40/AASB
140 and IAS 41/AASB 141. In addition, IASB has a joint project with the FASB in relation to
financial statements presentation (a continuation of their work on reporting financial
performance).

Issues for auditors arising from revenue recognition and measurement

The primary issue for auditors surrounding revenue is the risk that recorded revenue is overstated
by managers. Evidence of the importance of the issue of revenue overstatement can be found in
the PCAOB report of its inspections of auditors for the period 2004-2006. Overestimating
revenue can occur within accounting standards by making estimates that later prove to be too
optimistic. Other cases of revenue overstatement can be attributed simply to fraud. The PCAOB
has found frequent deficiencies in audit firms’ performance of audit procedures related to
revenue accounts. In particular, auditors were not sufficiently investigating significant
unexpected results of their testing. Too often, when auditors sought explanations from managers
about any issues arising from their work, the auditors were not obtaining corroboration of
managers’ explanations.

The nature of expenses and the way they are defined in the accounting literature
Expense has to do with a decrease in value of the firm. Expenses arising in the course of the
ordinary activities include. They usually the form of an outflow or depletion of assets such as
cash and equivalents, inventory and property, plant and equipment (framework, para 78).
Expenses encompass losses as well as expenses which arise in the course of ordinary activities of
the entity. Losses may or may not arise in the course of ordinary activities of the entity. However,
the framework states that losses represent decreases in economic benefits and are therefore not
different in nature from other expenses. Therefore, they are not regarded as a separate element
(para 79), Firms have sought to distinguish between expenses and losses occurring within and
outside ordinary activities by categorizing items as abnormal or extraordinary in the income
statement. This practice is not permitted under IAS 1/AASB 101.
The view represented in the IASB/AASB Framework differs from that promulgated by the
FASB, the US standard setter. Concepts Statement No.6 (paragraphs 68-9) distinguishes between
expenses and losses. The latter are decreases in net assets from ‘peripheral or incidental
transactions’ and from other events that may be largely beyond the control of the firm. Expenses
pertain to the ongoing major central operations. It is interesting to note the point made by
Henderson, Peirson and Brown concerning this dichotomy.
Changes in the assets and liabilities
What makes a definition of expenses operational is the concept of physical flows involving the
entity, thus the framework definition refers to outflows or depletions of assets or incurrences of
liabilities. The framework’s definition makes no reference to the relationship of expenses to
revenue, although both are defined in terms of future economic benefits. Although revenues
expenses occur as the firm undertakes the activities that will generate profit, it is preferable to
correlate revenues with the actual events of production and sale and to correlate expenses with
the using up to goods or services in support of those events, rather than with those events
themselves. The definitions in the framework all revolve around future economic benefits, thus
ensuring their consistency, using the definition of assets as the point of reference.
Expenses and ‘Costs’
The framework implies that the using up of assets entails a cost to the entity. This is in accord
with the previous argument that expenses represent a value change. The value change refers to
the sacrifice which the firm must make in acquiring the services. If there is no cost to the firm,
then there is no expense.

Recognition criteria and the matching concept as they are applied to expenses in the accrual
accounting system
Once we have determined if an outflow is an expense to the firm, the next step is to decide when
it should be recognized. The framework specifies 2 criteria for the recognition of expenses in
paragraph 83:
a) It is probable that any future economic benefit associated with the item will flow to or
from the entity, and
b) The item has a cost of value that can be measured with reliability.
The framework indicates that an expense is to be recognized in the income statement when a
decrease in future economic benefits related to a decrease in an asset or an increase of a liability
has arisen and can be measured reliably (para 94). This means, in effect, that recognition of
expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in
assets.

Criticisms of the matching process and accountants’ use of allocations

The measurement of addition to liabilities and depletion of assets in the current period may seem
a simple task. However, liabilities may increase because of the acquisition in the current period
of the key operating equipment with an estimated operating life of many years. In measuring
expenses in the current period a number decisions need to be made as to how expenses should be
allocated across future periods of resultant revenue. There are a number of accounting standards
that provide guidance on such matters, but offer a choice in the method of expense and revenue
apportionment. The decision criteria are meant to be supported by the accrual accounting concept
of matching expenses against revenues in the period to which they relate. The complexity of thus
process and the underlying discretion in adoption of allocation and measurement techniques are
key issues for students of accounting and are the focus of this section.
Allocation of expenses
One approach to measuring expenses is to allocate them to periods to which they relate. The
matching concept forms the basis of accrual accounting. The matching process involves the
simultaneous or combined recognition of revenues and expenses that result directly and jointly
from the same transactions or other events.
For many accountants, relating effort (expenses) and accomplishment (revenue) for a given
period is the main function of accounting. However, in practice, proper matching is a difficult
task, and involves a great deal of judgement on the part of the accountant. The accountant must
identify which assets have been used up (expired) and the amount that should be written off
against revenue for the period.
The matching concept is of critical importance in historical cost accounting. It guides the
accountant in deciding which costs should be expensed and matched against revenue for the
period, and which costs remain unexpired, to be recorded as assets in the balance sheet. To
overcome problems associated with determining and measuring costs to be expensed and to be
carried forward, three basic methods of matching are commonly relied on. These are:
 Associating cause and effect
 Systematic and rational allocation
 Immediate recognition
Immediate Recognition
This last principle for recognizing and measuring expenses can be viewed as one that accounts
for all other possibilities not covered by the first two principles. Impairment expenses are another
item given immediate recognition. Although both tangible and intangible assets may be subject
to depreciation or amortization requirements, the allocation process may involve errors in
judgment or asset value may be affected by other unexpected events. The impairment expenses
arise because of a decline in the value of assets, consistent with the framework’s definition of
expenses.
Criticisms of allocations
The matching concept is one of the key features in this framework. Determining the amount of
costs that have expired is one of the main tasks of the accountant. However, as indicated by
Sprouse, the matching process has made the balance sheet secondary to the income statement; it
serves simply as a repository of unexpired costs as they await their time to expire on a future
income statement. This approach reduces the usefulness of the balance sheet for users’ decision
making.
Current practice is also criticized by Thomas, who contends that much of what accountant report
is ‘rubbish’, because accounting information is based mostly on allocations.
Defence of allocations
Eckel supports Thomas in saying that allocations are arbitrary, but only because the objectives of
allocations is not defensible. The objective of allocations in conventional accounting is to
determine profit by a process of matching, in particular by cause and effect. Zimmerman has
demonstrated that allocations of costs for internal purposes are useful as devices for controlling
and motivating managers, and therefore are justified.

Challenges for standard setters and issues for auditors relating to expense recognition
recognition and measurement
IASB standards have been written and revised over a period of more than 30 years. The
framework aims to provide common definitions and recognition criteria to improve consistency
between standards.
Conservatism
The matching concept requires a great deal of judgement in determining whether a given amount
of cost is applicable to the future or to the current period. It is not worthy that accountants
demand objective evidence in relation to recognizing expenses. Instead the plea is for the
recognition of revenue, but there has been limited discussion of objective evidence in relation to
recognizing expenses.
One reason for the lesser requirement for objective evidence in recognizing expenses as
compared with revenues is the convention of conservatism. This convention calls for the
recording of expenses, losses and liabilities as soon as possible, even though the evidence may
be weak, however it requires that revenues, gains and assets be supported by more substantial
evidence before they are recorded.
Some argue that conservatism underlies the probability and reliability criteria espoused in the
framework. The term ‘probable’ means that a future event is likely to occur to confirm the loss or
expenses.
Issues for auditors
Auditors face issues surrounding the distinction between expenses and assets, the period in
which expenses are recognized, and appropriate measurement of expenses. Treating expenses as
assets is a relatively uncomplicated way to overstate profit for the period, and auditors usually
require strong evidence to support capitalization of expenditure. Another difficult area for
auditors related to expenses is accounting estimates, such as provisions for inventory
obsolescene, warranties, losses on lawsuits, and construction contracts in progress.