The Public Company Accounting Oversight Board has issued a practice alert to auditors to call special attention to their numerous duties under auditing standards to take a careful look at the work companies have done to adopt a new, five-step method for determining when and in what amounts to recognize revenue in financial statements. The guidance reminds auditors that revenue is one of the largest accounts in financial statements, and a classic target for fraud, especially in the midst of such a huge shift in requirements.
As companies work to implement the new revenue recognition requirements, they may need to change or develop new systems, processes, and controls to gather and assess contract data, arrive at required estimates and judgments, and provide the necessary disclosures, the PCAOB points out. “Inadequate or ineffective design or implementation of changes to systems, processes, and controls can pose heightened risks of material misstatements, including the risks of material misstatements due to fraud,” the PCAOB tells auditors.
Various indicators over the past several months suggest companies put off implementation efforts, perhaps due to limited resources or a belief that the standard would not pose much of a change or a burden to them. Now audit experts say they see companies kicking into high gear to complete their implementations in time for the Jan. 1, 2018, effective date for calendar-year public companies.
Some experts are even predicting that at least some companies won’t be ready on time—that capital markets can expect an uptick in disclosures of material weaknesses in internal control, late filings, and perhaps even restatements.
“There’s a time bomb in front of us,” says Phillip Austin, national managing partner of auditing at BDO USA. Many companies still have a lot of work to do in the waning months of 2017 to be prepared, says Austin. “The only thing that’s not changing is the Jan. 1 effective date. I expect a good portion of issuers will have to delay (filing) because they won’t be ready.”
Bryan Martin, a national assurance partner at BDO USA, says auditors are becoming concerned about the time pressure companies are likely to put on engagement teams to complete their audit work if companies are running behind schedule with their own work. Cutting corners either within the standard adoption or within the audit simply isn’t an option, says Martin.
“There’s a time bomb in front of us. Many companies still have a lot of work to do in the waning months of 2017 to be prepared. The only thing that’s not changing is the Jan. 1 effective date. I expect a good portion of issuers will have to delay (filing) because they won’t be ready.”
Phillip Austin, National Managing Partner of Auditing, BDO USA
“If their process is not sufficiently detailed or thorough, that doesn’t give us the detail we need to form our own opinion about their adoption adequacy,” says Martin. The PCAOB alert even warns auditors to be cautious about uses of spreadsheets or other manual controls in the absence of fully developed systems. “These short-term manual processes may present different or greater risks of material misstatement than automated processes subject to effective IT (general controls),” the PCAOB points out.
Martin says auditors will hone in on risks around manual methods. “When you’re using spreadsheets and manual processes, there’s a very significant danger of the analysis becoming flawed,” he says.
Companies should be prepared for auditors to be especially focused on fraud risk, says Trent Gazzaway, national managing partner at Grant Thornton, especially after the PCAOB has alerted auditors to pay close attention to it. “There’s always a presumptive fraud risk when dealing with revenue, and because we’re in this transition it’s important for all hands to be on deck,” he says. “We’re dealing with a very complex area of accounting that is very material to the financial statements.”
The PCAOB alert reminds auditors that the risk at year-end is not so much in the accounting itself, but in the transition effort—what companies have done to prepare for the new rules and how they’ve complied with disclosure requirements about that preparation. The adoption of the standard does not affect year-end 2017 reporting, which will still be presented under existing revenue recognition rules.
Chris Wright, managing director at consulting firm Protiviti, says in fact the “lion’s share” of audit activity around the new revenue standard won’t even begin until next year when companies start producing live numbers using the new accounting.
That’s an important reminder for both companies and auditors arising from the PCAOB alert, says Gazzaway. “We’re going to make sure we as auditors are focused on whether or not companies are transitioning effectively,” he says. That means scrutinizing whether companies have appropriate controls around both their adoption effort and the new accounting they intend to implement next year, as well as the transition disclosures.
“The focus is going to be on the process rather than the answer,” says Brad Hale, managing director at audit firm CBIZ MHM. That might actually come as a bit of a surprise to some companies, says Hale, some of which may be assuming auditors won’t kick into action until the new rules take effect next year. “The disclosures have to be audited this year, and this release from the PCAOB was clear about the auditor’s responsibility for those transition disclosures.”
The PCAOB is alerting auditors to be alert to the following audit requirements with respect to the adoption of the new revenue recognition standard:
auditing management’s transition disclosures in the notes to the financial statements,
auditing transition adjustments,
considering internal control over financial reporting,
identifying and assessing fraud risks,
evaluating whether revenue is recognized in conformity with the applicable financial reporting framework, and
evaluating whether the financial statements include the required disclosures regarding revenue.
Source: PCAOB Staff Audit Practice Alert #15
Eric Knachel, senior consultation partner at Deloitte & Touche, says he sees a few misconceptions about the new standard still lingering in some corporate environments. First, he said there’s still some confusion over the extent to which companies get to make choices under the new standard. The new rules are principles-based, so not highly prescriptive in terms of telling companies exactly how to recognize revenue. That means companies must exercises some judgments, but that’s not the same as having choices or options, he says.
“When we rely a lot on judgments as this standard does, you and I can have different judgments,” he says. “Sometimes that’s OK, and sometimes that’s not OK.” In other words, companies can’t simply elect or choose accounting that they like and call it a judgment as a way of defending it.
Somewhat related, Knachel says he see some cases where companies “may seek to achieve a desired outcome, so they start with the end in mind.” The Securities and Exchange Commission warned companies in the early days following the issuance of the new rules that they should guard against navigating the rules in a way that is meant to simply minimize disruption of current accounting.
It’s “reverse engineering,” says Knachel. “Some companies have decided what they want their end result to be, and now they’re trying to make the rules fit their facts.”
As the PCAOB alert advises, auditors will be looking at those areas of significant judgment and estimate, even at this year-end as part of the transition effort, as well as internal controls over the transition effort, to determine if the resulting conclusions make sense, says Knachel. That all points to the importance of good documentation over the process and the conclusions, he says. “If the approach is great but nothing is documented, from an audit standpoint that’s a problem.”
For companies that are still struggling to complete implementation by the end of the year, Wright is suggesting companies reconsider how they plan to staff both the completion of adoption efforts and the year-end close. The availability of expert staff to handle the implementation is getting constrained, he says, with even third-party providers filling up their appointment books. Maybe companies might be well served to reserve their internal experts for the implementation effort and look for third-party help with the routine financial statement close activity, he says.