Earlier this month, the Public Company Accounting Oversight Board (PCAOB) issued a new Practice Alert on the application of auditing standards relating to the implementation of the new revenue recognition accounting standard. The Practice Alert is the latest from the PCAOB on the new revenue recognition standard issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). Since the standard’s introduction in May 2014, Protiviti has detailed ongoing guidance emanating from the accounting profession, standard-setters and regulators in previous Flash Reports.
This latest PCAOB Practice Alert addresses areas to which organizations need to pay particular attention as they formally implement the new revenue recognition standard. While the PCAOB’s guidance is provided for the benefit of external auditors, because of the flow-down effect on companies through their external auditors, we believe it contains helpful information and insights for organizations as they prepare to comply with the new standard and become subject to audit. Indeed, public companies that report by calendar year should be well on their way to adopting the new standard, considering that they will be bound by it beginning in 2018 (the standard can take effect a year later for non-public organizations).
The Practice Alert discusses several areas of emphasis. We summarize these below and offer insights for organizations to consider as they prepare their financial statements and footnote disclosures and work with their external auditors in regard to the new revenue recognition standard.
Management’s Transition Disclosures in the Notes to the Financial Statements
The transition disclosures regarding this new standard will be the first thing companies report in any meaningful way to the public in quarterly reports, and again at year-end; consequently, they should be an area of focus for financial management and internal control functions. External auditors are tasked with determining whether annual and interim financial statements contain information that is essential to providing a fair presentation and that conforms to the applicable financial reporting frameworks. Therefore, companies will need to produce, and be clear in, their disclosures related to the transition to the revenue recognition standard, which their auditors will be reviewing. If these disclosures are inaccurate or incomplete, whether in interim or annual financial filings, then auditors likely will evaluate the sufficiency of the financial statements, inclusive of disclosures, and this may impact the auditor’s report on both the financial statements and the company’s internal control over financial reporting.
Examples of the auditor’s review procedures (and thus what management should prepare for) include:
- Inquiring about the company’s implementation progress and how the new standard will affect financial statements, as well as processes that may require information from personnel outside the accounting function.
- Obtaining evidence that transition disclosures about the new standard agree with supporting data in the company’s records, such as management’s reports to the audit committee about the standard’s anticipated impacts.
Additionally, according to comments from the Securities and Exchange Commission’s Chief Accountant, transition disclosures that find the impact of the new revenue recognition standard on the organization is immaterial should reflect consideration of the full scope of the standard, which covers recognition, measurement, presentation and disclosure for revenue transactions. Management should be assessing these areas carefully and take note of the disclosures made to date by early adopters of the new standard, which seem to indicate a predisposition to disclosing the specific impact of the new standard, regardless of what would appear to be relatively immaterial impacts in some instances.
Auditors will need to identify and assess risks of material misstatement connected to an organization’s transition to the new revenue recognition standard, and they will need to implement audit responses that address the risks. Among some of the newest guidance in this area, the PCAOB Practice Alert directs auditors to scrutinize data that may not have been audited previously, as well as prior-period misstatements found in the current period’s audit. Other areas of emphasis include internal control over financial reporting and opportunities for committing and concealing fraud.
While these general audit protocols are not new, these are specific focus areas that the PCAOB is beginning to discuss in their view on competent revenue recognition transition. These areas are indicative of a deeper dive by the PCAOB, likely borne from their own advancing readiness, in part from their reading of early adopter disclosures, and also perhaps in anticipation of questions on emerging risk areas. The specific mention of prior-period misstatement potential is an area with which financial reporting management should concern itself, as there is always potential that, upon reviewing the applicability of the new standard to current contracts, companies may discover errors in existing accounting policy or practical application of the current rules.
Management needs to be aware that internal controls over transition adjustments will be relevant to the audit, especially for integrated audits. This includes controls the auditor selects to test an audit of financial statements or an audit of internal control over financial reporting. In cases where management states that transition adjustments are immaterial, the PCAOB notes it will be important for management to first determine impact and then determine materiality (rather than to assume materiality based on analytics), as it is very likely that auditors will need to perform procedures to test the accuracy of the assertion.
Internal Control Over Financial Reporting
Management’s evaluation of competence across the organization and among outsourced services – and its actions to address shortcomings – is a key area on which the PCAOB is particularly focused. Preparers and issuers should be aware that their auditors are expected to consider the following when assessing internal controls and prepare now for the following:
Information System and Manual Controls
- The auditor will be expected to obtain an understanding of the IT environment supporting financial reporting, including, generally, (a) the supported business processes; (b) the related accounting infrastructure and the information used to initiate, authorize, process and record transactions; and (c) how the IT environment captures events and conditions, other than transactions, that are significant to the financial statements. In the context of the new revenue recognition standard, examples of such “events and conditions” would likely include amortization of contract balances and conditions affecting the recoverability of capitalized assets.
- The use of short-term manual processes, such as spreadsheets, during the transition process may present different or greater risks of material misstatement than automated processes with effective information technology general controls.
Management Review Controls
- Auditors will be focused on evaluating management review control precision, along with factors that can affect that precision, including the level of aggregation and criteria for investigation.
- Controls over the accuracy and completeness of information used to perform the management review control can affect the control’s operating effectiveness.
Reviews of Interim Financial Information
- Auditors will seek to identify the types of potential material misstatements in the interim report and consider the likelihood of their occurrence.
- Auditors need to select the appropriate inquiries and analysis that will provide a basis for stating whether they are aware of any material modifications that should be made to the interim report to comply with generally accepted accounting principles.
Identifying and Assessing Fraud Risks
Issuers need to be mindful that their auditors will be envisioning elements that would create the conditions for management and others to commit fraud, such as incentives, pressures or opportunities, or a culture that rationalizes cutting corners. Management should be proactive in assessing and mitigating potential fraud risks. In particular, the PCAOB’s Practice Alert notes that potential incentives for fraud emerge when new accounting rules affect a company’s financial reports, especially when combined with internal or external pressures to meet certain targets, with revenue being a metric known to affect company valuations, commissions and bonuses in ways that provide motive for fraud beyond broad financial reporting.
Do the Financial Statements Include the Required Disclosures Regarding Revenue?
While PCAOB standards compel auditors to identify and assess risks of material misstatement related to omitted, incomplete or inaccurate disclosures, the PCAOB has identified some key areas of disclosure, including:
- Revenue recognized from customer contracts and disaggregated into appropriate categories.
- Contract balances, including the opening and closing balances of receivables and of contract assets and liabilities.
- Performance obligations, including when a company satisfies its requirements and the assets from contract acquisition costs, which, although not a revenue item, are addressed in the new standard, will also require management preparation and auditor review.
- Significant judgments, and changes to the judgments, made in applying the requirements to the contracts.
While crafted and issued for auditors, the latest PCAOB Practice Alert on the looming introduction of the new revenue recognition standard contains fresh insights that transitioning companies should find helpful. The basics of the PCAOB report are generally what was expected. It reiterates long-established audit standards but specific areas are being highlighted, which is indicative of the PCAOB’s view of significant emerging financial reporting risks over the new standard. It is important to note that this view is likely from scrutiny of the early adopters and other diligence and inquiry.
With the new revenue standard taking effect very soon for public companies, our analysis of the latest PCAOB guidance and the PCAOB review of transition guidance and information released by the accounting profession, standard-setters and regulators should be considered a valuable resource for any affected organization. You can find those materials and more at www.protiviti.com.
Protiviti previously issued the following Flash Reports on the new revenue recognition standard. All are available at www.protiviti.com.
“Effective Date of Revenue Recognition Standard to be Deferred,” April 2, 2015
“Last Call, the Rev Rec Train Is Leaving the Station,” June 12, 2017