Do Firms Make Accounting Policy

Serdar Ozkan∗ and Cagnur Kaytmaz Balsariγ
Preliminary Version
Please do not quote.
Accounting policy disclosures are important parts of financial reports as addressed by
standard-setters and They provide value relevant information to decision makers on
choices taken by executives. The importance of reported revenue and its use in
earnings management makes revenue recognition policy disclosure especially critical for
user of financial statements. However, guidance provided by both IASB and FASB is
limited and confusing on revenue recognition policy disclosure. The motivation for this
study is to provide insight on revenue recognition policy disclosures in IFRS reporting
environment. Concurrently, study investigates the current state of revenue recognition
policy disclosures after IFRS adoption in Turkey. Additionally, we investigate the impact
of audit quality on revenue recognition policy disclosures. Analysis conducted in two
stages to show more general results in all sample firms and provide detailed analysis in
a small sample of big firms because of their economic transactions richness. Results
show that audit quality measured by big 4 and non-big 4 auditors, firm size, length of
disclosure and time is not related to accounting policy disclosure. Thus, it can be
concluded that the preparation of revenue recognition policy disclosure is related to
companies rather then auditors. This also shows the need for guidance and oversight for
accounting policy disclosures provided to firms and calls auditors to direct their attention
on audit of accounting policy disclosures.
Keywords: Accounting Policy, Revenue Recognition, Audit Quality, Turkey, Big 4
Importance of Accounting Policy Disclosure
According to IAS 8, accounting policies are defined as; “the specific principles, bases,
conventions, rules and practices applied by an entity in preparing and presenting
financial statements1.” Additionally, US GAAP defines accounting policies as “the
specific accounting principles and the methods of applying those principles that are
judged by the management of the entity to be the most appropriate in the
circumstances” and “have been adopted for preparing financial statements”. It notes that
accounting policies can affect the financial statements significantly, and that the
usefulness of statements “depends significantly on the user’s understanding of the
accounting policies followed by the entity”(AICPA, 1970). According to US GAAP,
annual reports are required to include a description of all significant accounting policies
of the reporting entity. Such disclosures are to encompass important judgments as to
the appropriateness of principles relating to recognition of revenue and allocation of
assets costs to current and future periods and those accounting principles and methods
that require a selection from existing alternatives, are peculiar to the industry in which
the reporting entity operates or represent unusual or innovative applications of GAAP.
Critical accounting policies are the three, four or five policies that are both very important
to the portrayal of the company’s financial condition and results, and that require
management’s most difficult, subjective or complex judgments often because they
require estimates about the effect of matters that are inherently uncertain (SEC 2002).
Disclosure quality reflects the overall informativeness of a firm’s disclosures and
depends on the amount, timeliness, and precision of the disclosed information. Healy,
Hutton and Palepu [1999] find that firms exhibit a great deal of discretion when
determining the amount of information to disclose, the level of detail to provide, and the
timeliness with which to convey information, for both mandatory reports and purely
voluntary disclosures.
Extracted from IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors. IASC
Examining the disclosures of critical accounting policies made by companies reporting
according to IFRS provides an opportunity to assess responses to a principles-based
standard as well. Research of accounting policy disclosures, which requires complex
and subjective judgments by management, provide evidence on how managers
interpreted the principles-based guidance and on the other factors that may have
affected managers’ disclosure of critical accounting policies.
According to contemporary corporate governance approach, management, auditors, and
audit committees are responsible for selection, monitoring and discussion of accounting
policies. Management is responsible for defending the quality and reasonableness of the
accounting policies. Auditors are responsible for satisfying themselves regarding the
selection, application, and disclosure of these policies. The audit committee is to be
apprised of the evaluative criteria used by management in their selection of these
Many scholars argue that the extent to which standards are enforced and violations
prosecuted is as important as the standards themselves (e.g., Sunder [1997, p. 167]). In
particular, the quality of financial information is a function of both the quality of
accounting standards and the regulatory enforcement or corporate application of the
standards (Kothari [2000, p. 92]). Absent adequate enforcement, even the best
accounting standards will be inconsequential. If nobody takes action when rules are
breached, the rules remain requirements only on paper. In some environments, for
example, firms behave toward "mandatory" requirements as if they were vol- untary
(Marston and Shrives [1996]). To illustrate, even though accounting policy disclosures
are required in most countries as well as by IAS 1 (e.g., Saudagaran and Diga [1997]),
Frost and Ramin [1997] document considerable variation in accounting policy
disclosures within and across countries.
Revenue Recognition Policy
Discussion paper (Financial Accounting Series, 2008) published by FASB on Revenue
recognition states that; Revenue is a crucial part of an entity’s financial statements.
Capital providers use an entity’s revenue when analyzing the entity’s financial position
and financial performance as a basis for making economic decisions”. For this reason,
corporate executives are under significant pressure to aggressively recognize revenue.
Financial engineering with respect to revenue is also used to meet market expectations,
obtain better contracting costs, meet financial covenants, and capture higher market
capitalization (Altamuro, Beatty, and Weber, 2002). For some industries, gross margins
and sales are the key metrics used to assess a company's prospects and performance
(Chlala and Landry, 2003). The pressure on executives to increase revenue emphasizes
the importance of revenue, and the pressure brought on professional judgment in this
Over a five-year period (July 1997 to July 2002), the SEC launched 227 investigations of
suspected financial misreporting, 126 of them relating to revenue recognition (Gillies,
2003). Improper timing of sales was the biggest offence — "borrowing" from the next
quarter in an effort to meet market expectations for the current quarter. The SEC also
found 80 cases of utterly fictitious revenues and 21 cases of improperly valued revenue.
Then SEC chair Lynn Tumer (2001) stated that revenue recognition was the largest
single issue involved in restatement of financial statements.
In 2002, as part of its process of reviewing financial and non-financial disclosures made
by public companies in the US, SEC reviewed all annual reports on Form 10-K filed by
Fortune 500 companies and noted a substantial number of companies did not provide
any critical accounting policy disclosure. Among others revenue recognition policy
related problems, especially in some industries like computer software, computer
semiconductor, and electronic instruments and controls, energy and retail, were
significantly affecting the understandability of the financial statements.
On the other hand, since the use of IFRS by countries increasing by years, a
considerable attention has also been given to the quality of IFRS reports. For example in
2007, The Institute of Chartered Accountants in England and Wales (ICAEW) has
prepared the EU Implementation of IFRS and the Fair Value Directive Report to
demonstrate the recent situation in the EU (ICAEW, 2007). One of the main findings of
the report is that for the substantial majority of companies’ financial reports, the
accounting policies are either the repetition of the exact wording in the appropriate IFRS
or are standard summaries of that wording. According the report, one of the frequently
occurring examples of the problems is revenue recognition accounting policies that
summarize IAS 18 Revenue rather than explaining how and when the company
recognizes revenue on its particular transactions. The report also provides summaries of
some country observations on accounting policy disclosure as follows:
The Finnish regulator FIN-FSA comments in its review of the IFRS consolidated
financial statements of Finnish publicly traded companies:
‘Accounting policy description should be disclosed on issues that are relevant to
the company’s business. In many financial statements, it remained unclear whether
and how the disclosed accounting policy was relevant to the company’s business.
Some companies for example presented in the section of accounting policies a
definition of investment property although they did not have any assets classified
as investment property in their balance sheet.’
In its report on the 2005 IFRS consolidated financial statements of publicly traded
companies in the UK, the FRRP observed:
“There was also a tendency for companies to include boilerplate descriptions of
accounting policies. In some cases, it appeared that the wording of accounting
policies had been copied from the relevant standards with no indication of
company specific application.
Standardized disclosures have a limited use especially when the policy is
prescribed by IFRS. Descriptions of accounting policies are more useful when they
identify issues relevant to a company’s individual circumstances. For example,
revenue recognition policies may need to describe the methods applied to
determine the stage of completion of transactions involving the rendering of
services. As the methods used will vary according to the nature of the
circumstances it is helpful that the policy includes specific relevant details”
The AMF, the French securities regulator, urged French publicly traded companies
to improve:
‘It should be stressed, however, that disclosure presented under the heading
significant accounting policy must not simply reproduce the main provisions of the
accounting standards in question. This would have little informative benefit and
would probably drastically inflate the volume of the notes. Information tailored to
the specific characteristics of the entity is of more interest to the user.’
The AMF paper gives revenue recognition as an example of the problem. It
suggests: ‘A mere mention that revenue is recognized when acquired is too brief to
enable the user to understand the major element of the entity’s activities.’
In 2006 the US SEC staff reviewed the annual reports of around 30 foreign private
issuers containing financial statements prepared for the first time on the basis of
International Financial Reporting Standards. During the review staff asked a number of
companies to provide additional information or disclosure about revenue recognition,
especially where a company provided generic policy disclosure and did not provide
disclosure specific to its circumstances. When a company did not address all material
revenue-generating activities, they asked it to do so. In some instances, they asked
questions about the scope and timing of revenue recognition (SEC 2006a).
Both US GAAP and IFRS have problems related to revenue. In U.S. GAAP, revenue
recognition guidance comprises too many standards which can produce conflicting
results for economically similar transactions. In IFRS, the principles underlying the two
main revenue recognition standards (IAS 18, Revenue, and IAS 11, Construction
Contracts) are inconsistent and vague, and provide limited guidance2.
Under these circumstances it is especially important for financial statement users to gain
insight to revenue recognition policies of companies from revenue recognition policy
disclosures. Unfortunately, concern remains whether financial statement notes generate
sufficient clarity for the readers or provide camouflage for actual revenue recognition
policy changes (Conrod and Cumby, 2006).
This study is conducted to investigate the current state of revenue recognition policy
disclosures after IFRS adoption in Turkey. Additionally, we investigate the impact of
audit quality on revenue recognition policy disclosures.
Information for Observers on IASB meeting on April, 2008 states revenue recognition as one of the
fundamental deficiencies in IFRS that require completion as a high priority follows; “…revenue is
fundamental to financial statement analysis, and the existing guidance in IAS 18 is incomplete, insufficient,
and internally inconsistent. We need to recognize that IAS 18 often is applied with US GAAP as a
Data analysis is conducted in two stages. In the first stage, an overall investigation of
revenue recognition policy of ISE listed non-financial companies reporting in accordance
with IFRS is conducted where data was available between the years 2003-2007. At this
stage, whether, companies report revenue recognition policy, the quality of revenue
recognition policy, and auditor quality of these companies are investigated.
In the
second stage, deeper analysis regarding the quality of revenue recognition policy is
conducted on non-financial firms at ISE-100 index. This sample is chosen because;
bigger firms are expected to have more complicated revenue related transactions, so
their revenue recognition policy is expected to be richer.
In our analysis, we assessed the sample firms’ revenue recognition policies by using
SEC’s approach on what should be exist in an ideal revenue recognition policy
disclosure. According to “Current Accounting and Disclosure Issues in the Division of
Corporation Finance” report dated November 30, 2006, the Division of Corporation
Finance US SEC, revenue recognition disclosure should be viewed as follows (SEC
Since revenue recognition is often a critical accounting policy, registrants should
review the completeness and accuracy of disclosures concerning their sources of
revenues, method of accounting for revenues, and material considerations in
evaluating the quality and uncertainties surrounding their revenue generating
activity. The disclosure should be concise and to the point; more disclosure is not
necessarily better. Basic descriptive information about revenue generating
activities, customary contract terms and practices, and specific uncertainties
inherent in the registrant’s business activities may be most appropriate in
Description of Business. Descriptive information about the effects of variations in
revenue generating activities and practices, or changes in the magnitude of
specific uncertainties, is most appropriate in MD&A. Accounting policies, material
assumptions and estimates, and significant quantitative information about
revenues should be included in notes to the financial statements or in MD&A, as
appropriate. Some disclosure examples follow:
Disaggregate product and service information
• Report product and service revenues (and costs of revenues) separately on the
face of the income statement.
• Furnish separate revenues of each major product or service within segment data
• Describe the major revenue-generating products, services, or arrangements
• For major contracts or groups of similar contracts, disclose essential terms,
including payment terms and unusual provisions or conditions
Disclose when revenue is recognized (examples)
• Upon delivery (indicate whether terms are customarily FOB shipping point or FOB
• Upon completion of service
• After commencement of service, ratably over service period
• Upon satisfaction of a significant condition of sale – (identify the condition)
o Only after customer acceptance?
o Only after testing?
• Upon completion of all terms of contract
• Over performance period based on progress toward completion
• Upon delivery of separate elements in multi-element arrangement
If revenue is recognized over the service period, based on progress toward
completion, proportional performance, or based on separate contract elements or
milestones, disclose how the period’s revenue is measured
• Disclose how progress is measured (cost to cost, time and materials, units of
delivery, units of work performed)
• Identify types of contract payment milestones, and explain how they relate to
substantive performance and revenue recognition events
• Disclose whether contracts with a single counterparty are combined or bifurcated
• Identify contract elements permitting separate revenue recognition, and describe
how they are distinguished
• Explain how contract revenue is allocated among elements
o Relative fair value or residual method?
o Fair value based on vendor specific evidence or by other means?
Disclose material assumptions, estimates and uncertainties
• Disclose contingencies such as rights of return, conditions of acceptance,
warranties, price protection, etc.
• Describe the accounting treatments for the contingencies
• Describe significant assumptions, material changes, and reasonably likely
• Special disclosures and conditions are specified by SAB Topic 13 for companies
that recognize refundable revenues by analogy to FASB Statement No. 48, Sales
With the Right of Return. "
Findings of first stage analysis are provided at Table 1. Results show that, percentage of
companies that state revenue recognition policy increases through years. This can be
attributed to the experience gained in IFRS application. However, an increasing
percentage of companies through years found to be reporting exact wording of IAS as
revenue recognition policy in their reports. This result implies that, even though there is
an increase in policy reporting firms, most of these firms does not report revenue
recognition policy in its intended spirit.
The last column of Table 1 show percentage of companies that use exact wording of IAS
that are audited by big four auditors. Even though the results show improvement by
time, it is striking that there is no implication of high audit quality on revenue recognition
policy disclosures. This led us to believe that the preparation of revenue recognition
policy disclosure is related to companies rather then auditors.
In the second stage, deeper analysis regarding the quality of revenue recognition policy
is conducted on non-financial firms at ISE-100 index between 2003-2008. The sample
consists of 297 firm year observations as shown in Table 2. These firms are those
prepared their financial reports according to IFRS. The firms in 2003 and 2004 were
early and others were mandatory IFRS adapters. Financial firms were excluded from the
sample because they have different characteristics and are subject to different
We first investigated the nature of revenue recognition policies in terms of whether firms
clearly identified goods and/or service revenue recognition policies in their disclosures.
We classified policies into four types as
Not specified: firms provided revenue recognition policy but there’s no specific
criteria such as delivery, acceptance of goods or services given.
Partial disclosure: firms provided revenue recognition policy but not for all
products and services, or there is conflicting criteria.
Full disclosure: firms provided revenue recognition policy and there are specific
criteria such as delivery, acceptance of goods or services given.
No clear disclosure: firms provided revenue recognition policy and the criteria
given does not clearly address the policy and having two conflicting criteria such
as delivery or acceptance for the same group of goods and services.
As shown in Table 3, 156 of 297 observations (52 %) provided full and clear
disclosure whereas 108 of 297 (36 %) observations do not provide any disclosure.
Since auditor plays a very important role in the disclosure of accounting policies further
analysis has been conducted on the impact of audit quality on accounting policy
disclosure. Audit quality is measured as big-4 and non-big-4 audit companies consistent
with previous literature. Results are provided at Tables 4 and 5 which classifies findings
reported at Table 3 by big 4 or non-big 4 auditors.
When results presented at tables 4 and 5 are compared, it can be said that audit quality
does not affect policy disclosure much. Table 4 shows that, 49 of 93 non big-4 audited
companies had full disclosure on revenue recognition policy. This is 53% of the total.
Table 5 shows that, 107 of 204 big-4 audited companies had full disclosure on revenue
recognition policy. This is also 53% of the total.
An important line of policy disclosure research focuses on the length of the policy
disclosures in terms of the number of the words used. Table 6 shows the average
number of words used to disclose revenue recognition policies. As seen in Table 6
average number of words draws an increasing trend through years. An interesting
observation is that the difference between full disclosure firms and not specified firms is
very small. This result points to the fact that the length of disclosure does not relate to
disclosure quality.
Another important question to ask is to see if firms change revenue recognition policy
through years and if auditor change is connected to revenue recognition policy change.
The results show that in 2004-2007 periods, number of no-policy change firms exceeds
policy change firms. However in 2008 number of policy change firms exceeds the
number of no-policy change firms.
Moreover, Table 8 shows that auditor change does not seem to affect policy change.
Results interpreted together shows that both in full sample and big firms sample number
of companies that do not provide proper disclosure increases through years. For big
companies, number of firms that provide full disclosure increase after year 2005,
mandatory adoption year, but stays the same afterwards. Interestingly, percentage of full
disclosure firms is equal for big-4 and non-big 4 audit companies. This shows that
quality of policy disclosures is not related to audit quality. Additionally, length of
disclosure is not related to disclosure quality even though the length of policies
increases through years. When policy changes are investigated, it is seen that number
of policy changes increase through years but its relation to auditor change can not be
interpreted properly due to data limitations.
The results of the study shows the need for guidance and oversight for accounting policy
disclosures provided to firms and calls auditors to direct their attention on audit of
accounting policy disclosures.
Number (%) of
companies which
state a revenue
recognition policy
Number (%) companies
which Took Their
Revenue Recognition
Policy from IAS 18
Number (%) companies
which Took Their Revenue
Recognition Policy from IAS
18 and are audited by One
of the Big 4 Companies
Table 1: Results of preliminary analysis
Table 2: Non-financial ISE 100 firms those have IFRS reports
Table 3: Firms revenue recognition policy disclosure (goods and services)
Table 4: Revenue recognition policy disclosures of firms those were audited by non-big 4 firms
Table 5: Revenue recognition policy disclosures of firms those were audited by big 4 firms
Table 6: Average number of words used to disclose revenue recognition policy
Table 7: Accounting policy changes by years
Table 8: Relationship between auditor changes and the revenue recognition policy changes