Lexis nexus complexus: comparative contract law and international accounting collide in the IASB-FASB revenue recognition exposure draft.

• Author: Schulzke, Kurt S.
• Position: I. Introduction through II. Revenue Recognition Process, p. 515-549 - International and Financial Accounting Standards Boards

ABSTRACT

U.S. and international accounting-standard setters plan to launch a new, global revenue accounting standard, Revenue from Contracts with Customers, in 2013. Poised at the nexus of comparative contract law and international accounting, the proposal's contract-based revenue recognition model creates new legal risks and opportunities for accountants, lawyers, clients, and financial statement users. Despite its focus on legally enforceable contracts, the proposed standard was drafted without input from the legal community. This Article models the proposal's complex contract-analysis process, demonstrating that its revenue outcomes may vary materially because of seemingly minor interjurisdictional differences in law applicable to "open-price" contracts; offers practice pointers for attorneys, accountants, and auditors; recommends changes to the proposal, including the substitution of self-enforcing Nash equilibria for legally enforceable contracts; and encourages more collaboration between the legal and accounting professions in the joint deployment of legal and accounting expertise for better value creation, value allocation, and risk mitigation.

TABLE OF CONTENTS I. INTRODUCTION A. Revenue Primer B. Related Research and Commentary l. Comparative Contract Law 2. Accounting and Revenue Recognition II. REVENUE RECOGNITION PROCESS A. Overview B. Stage 1: Contract Analysis 1. Contract Analysis Overview 2. Contract Existence 3. Implied and Noncontract Obligations C. Stage 2: Recognition and Measurement III. ED APPLIED TO PRATT & WHITNEY--MALEV A. Fact Scenario: Jet Engine Transaction B. Contract Analysis: Legal Enforceability 1. European Union a. France b. Germany c. Italy 2. North America: United States 3. South America: Colombia 4. International Law: UN Convention on Contracts for the International Sale of Goods 5. Legal Analysis Summary C. Contract Analysis: ED Paragraphs 14 and 15 1. Paragraph 14(a): Commercial Substance 2. Paragraph 14(b): Parties' Commitment 3. Paragraph 14(c): Parties' Rights 4. Paragraph 14(d): Terms and Manner of Payment 5. Paragraph 15: Termination Compensation D. Recognition: ED paragraphs 23-80 IV. CONCLUSIONS AND RECOMMENDATIONS I. INTRODUCTION

The wheels of commerce would turn more smoothly if lawyers better understood accounting and accountants better understood the law. Exhibit A in support of this proposition is the international revenue accounting exposure draft (ED), Revenue from Contracts With Customers, (1) now under final review by the U.S. Financial Accounting Standards Board (2) (FASB) and the International Accounting Standards Board (3) (IASB) in preparation for global implementation.

Hovering at the nexus of comparative contract law and international accounting, the ED's contract-based revenue recognition model offers a prime context for accountants and lawyers to work together. Legal and management scholars in Europe and the United States have previously encouraged lawyers and other professionals to apply their expertise collaboratively to maximize business success. (4) So far, however, little, if any, collaboration has occurred in connection with the ED.

Despite its singular focus on legally enforceable contracts, the ED was drafted largely without input from the legal community, which plays a leading role in the negotiation, drafting, interpretation, and enforcement of contracts. Arguably, the ED's resulting redundancy, internal inconsistency, and superfluous legal complexity will increase both the costs of preparing and auditing financial statements and the risks of revenue-related misunderstanding, litigation, and regulatory-enforcement actions. This Article is, in part, a call for collaboration between accountants and lawyers in an effort to reduce or mitigate these costs and risks.

Accounting standards are a form of regulatory law governing financial reporting. The ED, in particular, is a proposed regulation governing how, when, and in what amounts market players are entitled to claim credit, in the eyes of other market participants, for having persuaded others to buy goods or services. Under the ED, as currently written, revenue may be claimed or "recognized" only in the context of legally enforceable contracts with customers. (5) Yet, as discussed in greater detail below, some transactions or relationships that superficially appear to be enforceable contracts are revealed, on closer examination under applicable local law, not to be contracts or not to be enforceable. In contrast, some noncontractual relationships with customers are legally enforceable. Meanwhile, in most relationships, the parties perform their commitments because they must do so out of commercial necessity, not because of the threat of legal action in the event of a breach. Thus, it may be argued that the scope of the ED is narrower than the commercial and legal reality it seeks to portray.

Not surprisingly, in light of its contract focus, the ED relies on contract-law terms, such as contract, consideration, enforceable, legal title, modification, control, and transaction price. These terms appear in the ED 279, 150, 5, 7, 17, 55, and 81 times, respectively, and differ in definition and cultural authority across jurisdictions, (6) as do contract formation and validity, (7) which are essential prerequisites to legal enforceability. While the ED does not discuss contract formation or validity, this Article illuminates a subset thereof: the extent to which the price of goods or services must be specified in order to form a valid, enforceable contract.

More specifically, this Article (a) models the ED's contract-analysis and revenue recognition process, demonstrating in microcosm how outcomes may vary even because of seemingly minor interjurisdictional differences in contract law applicable to "open price" contracts; (b) offers practice pointers for attorneys, accountants, and auditors; (c) recommends changes to the ED; (8) and (d) encourages collaboration between legal and accounting professions in accounting-standard setting, especially in relation to the ED. (9)

The remainder of the Article is structured as follows. Part I.A defines and contextualizes revenue, highlighting its importance in the financial reporting and analysis environment. Part I.B summarizes related research and commentary in the fields of comparative law and accounting. Part II describes the ED's revenue recognition process and summarizes the ED's contract-relevant provisions. Part III applies the ED's contract-analysis and revenue recognition provisions to an historical transaction involving the proposed international sale of jet engines, comparing the likely results across six different contract-law regimes. Part IV concludes with summary observations and recommendations.

1. Revenue Primer

   Revenue may be viewed as fuel that powers a business enterprise and has been defined as the periodic "gross inflow of economic benefits" from the ordinary activities of the business. (10) Also called sales or turnover, (11) revenue is typically found on the first or top line of the income statements of U.S.- and European-listed firms. (12) Revenue's significance derives partly from its status as the central element of operating income, which is a component of net income or net earnings. (13) These relationships may be stated algebraically as follows:

   Operating income (14) = revenue--operating expenses,

   and

   Net income = operating income--nonoperating expenses.

   While net income is widely regarded as a key indicator of firm value, (15) recent research indicates that revenue itself also acts as a highly significant financial-performance indicator. (16) Furthermore, revenue has been found to be a predictor of firm value independent of net income, (17) and has increased in firm-value relevance over time, as the value relevance of net income has decreased. (18)

   The importance of revenue is further corroborated by the existence of Staff Accounting Bulletin No. 104, published by the Securities and Exchange Commission's (SEC's) chief accountant, which is focused solely on revenue recognition. (19) The frequent appearance of revenue recognition in financial reporting fraud provides additional evidence that revenue is independently material to preparers, readers, and regulators of financial statements. A 2010 study by the Committee of Sponsoring Organizations of the Treadway Commission (20) found that revenue recognition accounted for 61 percent of SEC fraud cases in the 1998-2007 interval, up from 50 percent in 1987-1997, and was the single most common source of financial reporting fraud in both periods. (21)

   Legal counsel and accountants must understand how the interplay between revenue and the law affects associated risks and returns, in order to effectively serve stakeholders, such as owners, creditors, officers, directors, and auditors. With respect to revenue recognition, mutual understanding between lawyers and accountants is essential to the achievement of three objectives at the intersection or nexus of law and accounting: value creation, value allocation, and risk mitigation.

   First, a cross-disciplinary, business-oriented approach to contract drafting, as advocated by the Nordic School, (22) can create firm value by favorably altering the fact, amount, and timing of revenue. These, in turn, affect financial position (through assets or liabilities reported in the balance sheet) and operating...