Revenue Recognition Paper Task: The primary goal of this assignment is to examine and analyzethe selected case, ??Revenue Recognition: Understanding the Impact of IFRS 15 – Revenue

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Accounting and Business Research

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The real effects of a new accounting standard: the case of IFRS 15 Revenue from Contracts with Customers

Christopher J. Napier & Christian Stadler

To cite this article: Christopher J. Napier & Christian Stadler (2020) The real effects of a new accounting standard: the case of IFRS 15 Revenue�from�Contracts�with�Customers , Accounting and Business Research, 50:5, 474-503, DOI: 10.1080/00014788.2020.1770933

To link to this article: https://doi.org/10.1080/00014788.2020.1770933

© 2020 The Author(s). Published by Informa UK Limited, trading as Taylor & Francis Group

Published online: 26 Jun 2020.

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The real effects of a new accounting standard: the case of IFRS 15 Revenue from

Contracts with Customers

CHRISTOPHER J. NAPIER * and CHRISTIAN STADLER

School of Business and Management, Royal Holloway University of London, Egham, UK

International Financial Reporting Standard 15 (IFRS 15) Revenue from Contracts with Customers has significantly changed the philosophy of revenue recognition, not only to provide a fairer representation of corporate revenues, but also to inhibit the use of revenues for ‘earnings management’ purposes. We provide a framework to analyse the various effects of new and amended accounting standards. Changes in how companies recognise, measure, present and disclose their revenues (accounting effects) can affect how companies and their transactions are understood, both internally and externally (information effects), can change security prices (capital market effects) and can change how companies operate, and their costs and cash flows (real effects). We provide empirical evidence, based on a review of corporate annual reports, comment letters and interviews, on the effects of IFRS 15. We find evidence of accounting, information and, to a lesser extent, real effects, although, outside a few industries, IFRS 15 has had relatively little impact on the recognition and measurement of revenue.

Keywords: financial reporting; IFRS 15; revenue; accounting standards; real effects JEL Classification: M41

1. Introduction

The introduction or amendment of accounting regulations, including financial reporting stan- dards, may lead to changes in how entities carry on their activities. A new standard may revise the calculation of accounting numbers through amending the ways in which assets, liabilities, income and expenses are recognised and measured. As accounting numbers are used in contracts, and form the basis for determining tax liabilities, different numbers are likely to lead to different cash flows, unless contracts are written in such a way as to ignore subsequent accounting changes (this is sometimes referred to as ‘frozen GAAP’ – see, for example, Leftwich 1981; Christensen and Nikolaev 2017).

© 2020 The Author(s). Published by Informa UK Limited, trading as Taylor & Francis Group This is an Open Access article distributed under the terms of the Creative Commons Attribution-NonCommercial-NoDerivatives License (http://creativecommons.org/licenses/by-nc-nd/4.0/), which permits non-commercial re-use, distribution, and reproduction in any medium, provided the original work is properly cited, and is not altered, transformed, or built upon in any way.

*Corresponding author. Email: [email protected]

Accounting and Business Research, 2020 Vol. 50, No. 5, 474–503, https://doi.org/10.1080/00014788.2020.1770933

However, changes in accounting regulations may also lead entities to revise the ways in which they operate. Changing how certain transactions are accounted for may make these transactions appear more, or less, attractive to those outside the entity. This is particularly the case where the transactions were originally selected and structured so that they would be accounted for in ways that were, at the time, seen to be favourable to the entity involved. The impact of a revised stan- dard may also be experienced at a more ‘micro’ level, as entities change the detailed structure of their transactions and contracts both to comply more easily with the newly introduced provisions and to maintain an attractive appearance under the new rules. The information required by the new form of accounting may even change howmanagement regard the operations of the entity, leading them to realise that past economic decisions were sub-optimal. Where a change in an accounting rule or standard gives rise to changes in how an entity operates or affects its cash flows, we can say that the accounting change has ‘real effects’. Although we consider that real effects arise at the level of the individual entity, the combined impact of such real effects across all entities, which may affect the economy as a whole, could be described as the ‘economic consequences’ (Zeff 1978) of an accounting change.

In May 2014, the International Accounting Standards Board (IASB) published International Financial Reporting Standard 15 Revenue from Contracts with Customers (IFRS 15 – IASB 2014). At the same time, the Financial Accounting Standards Board (FASB) published Accounting Standards Classification Topic 606 (ASC 606 – FASB 2014), with the same title. These standards were the result of a development process extending over twelve years, intended to replace, in the IASB’s case, a brief and outdated revenue recognition standard, and in the FASB’s case, over 100 separate guidelines for recognising revenue. The revenue number in the income statement rep- resents the ‘top line’ in the same way that profit after tax (earnings) is the ‘bottom line’. The revenue number is an overall indication of what an entity has achieved in a period, in terms of selling goods and providing services. Because recognition of revenue is usually associated with recognition of expenses, such as cost of sales, revenue and earnings are intimately linked. If an entity seeks to report higher earnings, one way of achieving this is to increase reported revenue. As we discuss in section 3.1 below, the call for a new revenue standard was stimulated not only by a sense that existing standards provided inadequate guidance for entities entering the twenty-first century, but also by fears, evidenced in some cases by financial scandals, that entities were able to engage in ‘earnings management’ through recognising revenues earlier (or in exceptional cases later) than more conventional accounting practice would accept. A new revenue accounting standard, there- fore, would at the same time give clearer guidance on revenue recognition for all entities with con- tracts with customers and reduce the potential for earnings management.

Entities have been required to apply IFRS 15 for accounting periods beginning on or after 1 January 2018 (although earlier adoption was possible). The standard replaced International Accounting Standard 18 Revenue (IAS 18 – IASC 1993b), which had first been issued in 1981, as well as International Accounting Standard 11 Construction Contracts (IAS11 – IASC 1993a), which had first been issued in 1979. Both these standards were last substantially revised in 1993. While IAS 18 required revenues to be recognised when the risks and rewards of ownership of goods had been substantially transferred from seller to buyer, IFRS 15 has adopted a ‘performance obligation’ approach, where revenue is recognised as and when an entity performs obligations included in a contract with a customer. Entities should therefore review their contracts to identify the performance obligations that the contracts impose on the entity. Such a review provides entities with the opportunity of changing how they structure con- tracts, and in extreme cases to make substantial modifications to their business models. In other words, the new revenue accounting standard may lead to real effects.

The aim of this paper is to provide a framework for understanding the effects of a change in accounting regulations, which would generally take the form of new or amended legislation, or

Accounting and Business Research 475

new or amended standards, and to apply this framework to analyse a specific example of a new accounting standard. The framework includes accounting, information, capital market and real effects, but in the present paper we do not address whether the adoption of IFRS 15 has had any effects on capital markets, for example changes to security prices, concentrating instead on accounting, information and real effects. We chose IFRS 15 because it affects all active entities that sell goods or provide services, and so the implementation of IFRS 15 is likely to reveal a wide range of effects. Our contribution is twofold. First, our framework could be used in other studies of the effects of accounting change, ensuring that future researchers consider the wide range of potential effects. Second, through our example study of IFRS 15, we show how entities have addressed the impact of a new financial reporting standard. We conclude that IFRS 15 has led to much effort in implementing the standard, but that, in terms of the impact on reported revenue in the income statement, the new standard has not generated significant changes in the accounting numbers for the majority of companies.

We begin by briefly discussing the existing literature on real effects of accounting, and we provide a framework setting out the different types of effect that a new accounting requirement may induce. We show how direct accounting effects of applying a new standard can induce additional effects, which we classify as information effects, capital market effects and real effects, and that these additional effects can themselves induce indirect accounting effects. We then consider the history of the concept of ‘revenue’ in financial reporting, with a focus on the UK, the USA and the international standard-setting context. This is followed by a discussion of our empirical findings, based on an examination of annual reports prepared by the largest Euro- pean companies, comment letters submitted to the IASB during the development process leading to IFRS 15, and a small number of interviews. The final section sets out some conclusions.

2. Accounting changes and real effects

2.1. The real effects concept

It has long been recognised that entities pay regard to accounting requirements when structuring their transactions, and even when deciding which transactions to undertake. Accounting numbers may be used for regulatory and contractual purposes, and changes in how accounting numbers are determined will have an impact on cash flows that depend on particular laws and other regulations using specific accounting numbers, as well as cash flows that are set by contracts. As early as 1972, Ball (1972, p. 1) noted that:

The distinction between real and accounting effects on income is far from being clear, since changes in accounting techniques can be responses to real variables (such as changes in expected future inventory prices, or the firm moving into a new industry), and they can also induce real effects (such as changes in taxable income).

Ball uses the term ‘real effects’ in a restricted sense, the implication of the phrase ‘changes in taxable income’ being that an accounting change can alter the amount of profit subject to tax and therefore can lead to the entity paying a different amount of tax from its liability under the old accounting rules. However, the notion of ‘real effects’ has gradually expanded to embrace changes that an entity makes to how it carries out its activities.

Zeff (1978, p. 56) was among the first to point out that the standard-setting process in the USA in the 1960s and 1970s was increasingly being influenced by ‘individuals and groups that had rarely shown any interest in the setting of accounting standards’, who ‘began to invoke arguments other than those which have traditionally been employed in accounting discussions’. These argu- ments were not related to the technical characteristics of a proposed accounting standard, but

476 C.J. Napier and C. Stadler

rather the possibility that the standard would have a detrimental impact on both individual businesses and the wider economy and society. Zeff (1978, p. 59) observed that such external pressure arose in particular in the context of accounting for marketable equity securities, leases, and oil and gas exploration and drilling costs.

More recently, Kanodia and Sapra (2016, p. 624, emphasis in original) have set out what they describe as the ‘real effects hypothesis’. This states that:

[T]he measurement and disclosure rules that govern the functioning of accounting systems – which economic transactions are measured and which are not measured, how they are measured and aggre- gated, what is disclosed to capital markets and how frequently such disclosures are made – have sig- nificant effects on the real decisions that firms make.

These authors argue that the notion of providing decision-useful information to investors and the principle of ‘representational faithfulness’ may be ‘insufficient guides to standard setting’ (Kanodia and Sapra 2016, p. 624), because they do not necessarily reflect the extent to which accounting requirements may lead entities to change what they do. To more critical accounting scholars, the recognition that accounting changes can have real effects is hardly a novelty: classic discussions such as that of Ruth Hines (1988) already pointed out how financial reporting is not a simple mirror of an externally given ‘reality’, but helps to construct the very ‘reality’ that it claims to represent.

The notion of studying real effects of financial reporting provisions has been increasingly advocated, particularly over the past 10–15 years. For example, Leuz and Wysocki (2016, p. 530, emphasis in original) call for ‘researchers to examine non-traditional disclosure and reporting settings, especially to learn about the real effects of disclosure mandates’. They define real effects as ‘situations in which the disclosing person or reporting entity changes its be- havior in the real economy (e.g. investment, use of resources, consumption) as a result of the dis- closure mandate’. An indicator of how little attention was given to real effects in past accounting research is the review of empirical research on accounting choice undertaken by Fields et al. (2001). This paper does not mention the expression ‘real effects’, and, in her comment on the paper, Jennifer Francis (2001, p. 311) observes that ‘the motivation for a real decision [one with cash flow implications] may be unrelated to the accounting outcome’, suggesting that explor- ing for real effects may be unproductive. This negativity did not stop scholars such as Chandra Kanodia from discussing, over many decades, how disclosure of accounting information may affect not just security prices but also corporate production-investment decisions (Kanodia 1980; see also Kanodia and Mukherji 1996; Kanodia 2006), but perhaps the difficulty of observ- ing corporate decisions and actions, as compared to variables such as security prices, acted as a deterrent to extensive work on real effects.

Nonetheless, a growing literature is addressing the impact not just of disclosures but also of changes in accounting regulations and practices on corporate decisions. For example, Barth et al. (2017) have looked at how the quality of integrated reporting in South African companies may enhance the companies’ stock market value not only through providing better information for capital markets but also by improving investment efficiency – which they see as a ‘real effects channel’ for enhancing corporate value. Ernstberger et al. (2017) suggest that the introduction of a European Union requirement for listed companies to provide quarterly ‘interim management statements’ has led to an increase in what they call (following Roychowdhury 2006) ‘real activi- ties manipulations’, such as changing production levels and varying expenditure on research and development or on selling, general and administrative expenses. These commercial effects have been identified as methods by which companies can engage in ‘real earnings management’ (see, for example, Healy and Wahlen 1999), and Bereskin et al. (2018) have suggested that real

Accounting and Business Research 477

earnings management can have measurable real effects on the level of innovation: companies that managed reported earnings by spending less on research and development ultimately filed fewer patents. Although in one sense the result was unsurprising, the research demonstrated that redu- cing research and development spending was more likely to be driven by the earnings manage- ment motive than by other economic and commercial considerations. Additionally, there is evidence of real effects that benefit employees: Christensen et al. (2017) find that mine-related injuries decreased after the introduction of mandatory disclosure about mine safety records in financial reports.

Studies of real effects rarely address specific changes in accounting regulations and standards. An exception to the general lack of work in this field is the study by Dou et al. (2018), who inves- tigate the real effects of a change in US accounting standards effective in 2010 relating to account- ing by banks for securitisations and the consolidation of variable interest entities. They found that the requirement to recognise substantial securitised assets (about US$800 billion) on balance sheets affected banks’ mortgage approval rates: banks recognising greater amounts of ‘new’ securitised assets tended to show larger decreases in mortgage approvals. Arguably, the account- ing change in question was a requirement for additional disclosure, rather than one that affected the measurement of assets, liabilities, income and expense, and much ongoing work in the area of real effects still focuses on disclosure rather than measurement: for example, Dou and Zou (2019) examine whether US banks’ disclosure of the geographical distribution of small business lending has an impact on lending policies (as measured by the proportion of non-performing loans to small businesses). This means that there is a need for studies that examine how accounting regu- lation changes that require different measurement methods to be adopted, rather than simply man- dating additional disclosures, can have real effects. The existence and nature of such effects could be examined at a ‘macro’ level, by identifying variables that could be used as evidence for real effects (this is the approach of Barth et al. 2017), but also at the ‘micro’ level, by attempting to identify real effects in specific entities. In this paper, we adopt a mainly ‘micro’ approach, using a range of evidence to probe for real effects. However, before turning to the subject matter of this paper, the new revenue accounting standard, we set out a framework for understand- ing the various effects of a change in an accounting regulation.

2.2. Effects of a new or amended accounting standard

Although we refer to accounting standards in this section, our analysis would apply to any change in accounting regulation, for example, changes in legislation relating to corporate reporting. A new or amended accounting standard (hereafter ‘new standard’ for simplicity) can have various effects. Figure 1 shows how such effects may be classified and how the different cat- egories are related to each other. We will use the classification throughout this paper in order to structure our discussion of the various effects of a specific new accounting standard.

A new accounting standard necessarily leads to accounting effects [A]. These include changes in recognition [A.1], measurement [A.2], presentation [A.3] and disclosures [A.4]. A new stan- dard may require items previously not included in the financial statements to be recognised [A.1], for example a leasing standard may require certain leases previously kept off-balance sheet to be accounted for as assets and liabilities. In some situations, a new standard may deter- mine that certain items, such as deferred costs, are no longer to be recognised. In itself, recog- nition of a new item will require that item to be measured, but a new standard may change the basis on which particular items already included in the financial statements are measured [A.2]. For example, a standard might require entities to measure a specific asset at fair value, where previously the required measurement basis was historical cost. A new standard may change the way in which certain items are presented [A.3], for example, items previously included

478 C.J. Napier and C. Stadler

in other comprehensive income may be moved into profit or loss. Many changes in recognition and measurement are associated with additional or changed disclosure requirements, and new dis- closures are often the result of legislation rather than accounting standards [A.4]. Disclosure could relate to new statements (for example, a cash flow statement) or to specific items. A new standard may not lead to all of these changes. For example, an increase in disclosures need not be associ- ated with recognition, measurement or presentation changes. These accounting effects are regarded as direct effects of the standard. In Figure 1, we represent the direct accounting effects of a new standard using a double arrow.

The direct accounting effects of a new standard can induce various additional effects, which we refer to as primary additional effects. We classify these as information effects [I], capital market effects [C] and real effects [R]. The induction of these various effects is represented as solid single arrows in Figure 1. Regarding information effects [I], first, the new standard might lead internal users of accounting information to a better understanding of transactions [I.1]. This can happen because the commercial implications of a transaction are more appropriately reflected in the accounting numbers. For example, managers may come to realise that the rights and obligations arising from a particular transaction are more extensive and complex than they had previously thought. Changes in financial reporting as a consequence of adopting a new standard may also enhance (but could impair) how external users understand transactions [I.2]. If the accounting effects [A] are significant, management might communicate the effects to stakeholders [I.3], poss- ibly before the publication of financial information under the new standard.

Regarding capital market effects [C], first, the accounting effects [A] may impact both equity markets [C.1] and debt markets [C.2]. In equity markets, share prices may change because the disclosure of additional information leads investors to revise their expectations of the amounts, timing and uncertainty of future cash flows, or because new numbers suggest that previous esti- mates of corporate value are no longer tenable. New accounting information following adoption

Figure 1. Effects of a new or amended accounting standard. Note: This figure shows the effects of a new or amended accounting standard. The double arrow represents direct accounting effects. The solid single arrows represent primary additional effects. The dashed single arrows represent secondary additional effects. The dashed single arrows going into [A] represent indirect accounting effects.

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of a new standard may also affect bid-ask spreads and trading volume. In debt markets, new accounting information may change perceptions of risk, and therefore borrowing costs and the pricing of credit default swaps may change. Managers face pressures to maintain or improve cor- porate performance and financial position [C.3], and changes in accounting numbers that are used by investors and lenders to assess managerial performance may induce further effects (see ‘sec- ondary additional effects’ below).

Real effects [R] are those effects that change how an entity undertakes its operations or that affect its cash flows. First, a new standard is likely to result in both implementation and ongoing application costs [R.1], and for some new standards these costs may be substantial for specific entities. On the other hand, a new standard could reduce costs through simplifying recognition and measurement or reducing disclosure. We consider that the need to use resources for implementation is a real effect because it involves the allocation of resources to a use that many managers and stakeholders would consider to be unproductive. This is consistent with the definition of real effects provided by Leuz and Wysocki (2016) quoted above. Second, if the new standard results in accounting effects that managers consider to be undesirable because of how accounting numbers are used in contracts, the entity may amend its contracts [R.2]. For example, a new standard might affect accounting-related debt covenants and any result- ing problem can be solved by amending the debt contract. Third, if a new standard results in unde- sirable accounting outcomes because of certain business practices, which cannot be solved by changing contracts, a company may change its behaviour [R.3]. This may mean withdrawing from certain activities or, less dramatically, modifying how the business operates.

Changes in accounting numbers and disclosures could have regulatory effects [R.4], for exa

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