Revenue is very crucial element for users of the financial statements in assessing a company´s current performance and future prospects.
For most businesses, income is recognized as revenue when the company delivers the required product or performs its service and receives payment for it. However, there are numerous circumstances in which exceptions may apply. For example, if a company's business has a very extraordinary rate of product returns, revenue should only be recognized after the expiration of return period.
Companies can sometimes mislead users of financial statements with revenue recognition to make their financial statements look better. For example, if ABC Corp. wants to hide the fact that their sales are low in the current year, it may choose to recognize income that has not yet been collected as revenue in order to boost its sales revenue and ultimately profits for the year.
Revenue recognition principle says that revenue is to be recognized only when the rewards and benefits associated with the items sold or service provided is transferred, where the amount can be estimated reliably and when the amount is recoverable.
The accrual basis of accounting is used in recognizing revenue which tells that revenue is to be recognized ignoring when the cash inflows occur.
In case where payment is received before the event triggering recognition of revenue happens, the debit goes to cash and credit to unearned revenue. In case the event triggering revenue recognition occurs before payment is received, the debit goes to accounts receivable and credit to revenue.
Revenue is the item which is the easiest to misstate, hence more stringent rules and guidance is required in this area. IAS 18 Revenue deals with recognition of revenue.
Revenue: the gross inflow of economic benefits (cash, receivables, other assets) arising from the ordinary operating activities of an entity (such as sales of goods, sales of services, interest, royalties, and dividends). [IAS 18.7]
Recognition, as defined in the IASB Framework, means incorporating an item that meets the definition of revenue (above) in the income statement when it meets the following criteria:
For revenue arising from the rendering of services, provided that all of the following criteria are met, revenue should be recognized by reference to the stage of completion of the transaction on the balance sheet date (the percentage-of-completion method): [IAS 18.20]
When the above criteria are not met, the revenue arising from the rendering of services should be recognized only to the extent of the expenses recognized that are recoverable (a "cost-recovery approach". [IAS 18.26]
Revenue recognition is a complex issue in the telecom industry. Part of the complexity arises because of the different types of telecom services. For example, fixed line (principally voice and data) services have recognition issues that may differ from wireless (principally mobile voice and data) services. Moreover, the industry is continuing to develop rapidly and it is likely that new business models will continue to be adopted by operators − in particular the convergence of fixed line voice services and broadband with wireless services − that will give rise to new revenue recognition challenges.
Many telecommunications carriers often sell international prepaid calling cards such as the MCI prepaid calling card and ATT prepaid calling card. Under US GAAP, revenue is deferred and revenue recognition occurs only once the minutes are used.
Revenue related to prepaid phone cards and recharges is recognized as airtime minutes are consumed in accordance with IAS 18, paragraph 20. Unconsumed airtime minutes are recorded as deferred income or unearned income under "Trade and other payables" on the liability side of the balance sheet. Revenue is deferred until the prepaid calling cards are used. Revenue from the sale of prepaid credit is deferred until such time as the customer uses the airtime, or the credit expires.
Callmate Telips Telecom Limited (Callmate) was in the telecommunications industry in which the regulatory controls were gradually being undone by the government of Pakistan as part of an economic deregulation program. Callmate was the pioneer in the field of pay phones and prepaid calling card in Pakistan and had significant opportunity to develop into a major business entity. The events in the case demonstrate that the company strategy, as well as aggressive share price management, could be dangerous if there were no checks on the directors.
All the directors of Callmate were close family members and the audit committee consisted of three of the directors. The external audit firm that audited Callmate was A.F. Ferguson & Co. (Ferguson) and they were an affiliate of Price Waterhouse Coopers (PWC) International. Ferguson was regarded among the top professional accounting firms in Pakistan. As Callmate was listed on the Karachi Stock Exchange, it was required to publish its financial quarterly after the review of Ferguson. The company had received permission during early 1995 to enter into the long distance international market, which was earlier the monopoly of the state firm Pakistan Telecommunication Corporation Limited (PTCL).
A disagreement arose between the auditors and the company on the accounting policy related to revenue recognition used in the Financials of the half year ended December 2005. The company was trying to increase its share by increasing profits and that became public knowledge as the company tried to malign the auditors. The case examines corporate governance by examining the role of the external auditor, the conduct of the board of directors and the regulator of public listed companies. There were a series of events that caused a profitable company to rapidly become a pariah on the stock exchange and be suspended from the Karachi stock exchange.
The auditors have objected to the policy of recording revenues of card sales on dispatch basis rather than usage. The aggressive practice of recording revenue on dispatch has resulted in an overstatement of bottom line by PRs280.27mn (PRs4.72/ share) in Dec 2005 accounts. The huge variation in the bottom line as calculated by the auditors (PRs3.56/share) and the company (PRs8.28/share) is due to export of cards on December 30th 2005, which had obviously not been utilized by Dec 31st . This has led to a time lag issue, the magnitude of which would decrease over the remainder of the fiscal year.
Callmate was recording its sales on the sale of prepaid calling cards rather than on the usage. According to IAS 18, companies should recognize revenue until the usage of card or at the expiry of the card rather than on the sale.
The argument between the company and its statutory auditors in respect of correct accounting policy to recognize revenue when the cards were actually utilized by customers (usage-based policy recommended by the auditors) or at the time of sale to dealers (dispatch base policy followed by the company), led to a qualification in the audit report and fury and rage.
The company board changed auditors, but the decision was overturned by the Securities and Exchange Commission of Pakistan. The SECP also suspended trading in the company`s stocks for 60 days and ruled as illegal a bonus issue declared by it. But all that came was too little and too late. The stocks had already started to head towards the pit.