Chapter 5: Revenue
Trouble at Tesco
On November 9, 2014, it was reported that several legal firms were considering launching a class action suit against British grocery giant Tesco PLC. The claims were related to revelations made by the company in September that its profits for the first half of the year were overstated by £ 263 million. In October, the United Kingdom's Serious Fraud Office announced that it was launching its own investigation into the accounting practices at Tesco. This followed the company's suspension of eight senior executives along with the resignation of the CEO.
The issue at Tesco stemmed primarily from a misstatement of a revenue category described as "commercial income." Although the company's primary business is selling groceries to consumers, it also earns a significant amount from suppliers. Manufacturers and suppliers understand that in a grocery store, the location of the product on the shelves can have a significant effect on the level of sales generated. Many of these suppliers will offer rebates or other payments to Tesco in exchange for preferential placement of their products on the shelves. These rebates will often be calculated on a sliding scale, increasing as the level of sales increases.
In Tesco's interim financial statements, many of these rebates would need to be estimated, as the sales level for the entire year would not yet be known. Tesco's auditor, PwC, indicated in its 2014 audit report that the determination of commercial income was an area of audit risk due to the judgment required and possibility of manipulation. Tesco had been experiencing decreasing market share in 2014, and this may have provided an incentive for some degree of earnings management. Some analysts suggested that Tesco might have booked promotional rebates based on historic results rather than current activity.
Problems with revenue recognition have been a source of many accounting errors and frauds over the years. Given the complex nature of some types of business transactions and contracts, the criteria for recognition of revenue may not always be clear. When significant levels of judgment are required to determine the point at which revenue should be recognized, the opportunity for misstatement grows. Given that many of the complex issues surrounding revenue recognition are not always well understood by financial-statement readers, managers may sometimes give in to the temptation to "work" the numbers a little bit.
This chapter will explore some of the issues and judgments required with respect to revenue recognition and some of the problems that companies like Tesco may face.
(Source: Marriage, 2014)
After completing this chapter, you should be able to:
- Describe the criteria for recognizing revenue and determine if a company has earned revenue in a business transaction.
- Discuss the problem of measurement uncertainty and alternative accounting treatments for these situations.
- Prepare journal entries for a number of different types of sales transactions.
- Apply revenue recognition concepts to the determination of profit from long-term construction contracts.
- Prepare journal entries for long-term construction contracts.
- Apply revenue recognition concepts to unprofitable long-term construction contracts.
- Describe presentation and disclosure requirements for revenue-related accounts.
- Discuss the earnings approach to revenue recognition and compare it to current IFRS requirements.
Introduction
Revenue is the essence of any business. Without revenue, a business cannot exist. The basic concept of revenue is well understood by business people, but complex and important accounting issues complicate the recognition and reporting of revenue. Sometimes, the complexity of these issues can lead to erroneous or inappropriate recognition of revenue. In 2007, Nortel Networks Corporation paid a $35 million settlement in response to a Securities and Exchange Commission (SEC) investigation into its reporting practices. Although several problems were identified, one of the specific issues that the SEC investigated was Nortel's earlier accounting for bill-and-hold transactions. In a separate matter, Nortel was also required to restate its financial statements due to errors in the timing of revenue recognition for bundled sales contracts. In this chapter, we will examine these issues and determine the appropriate accounting treatment for revenues.