Even before starting work on implementing new accounting standards, companies may have to consider giving their current revenue recognition practices more attention after regulators alerted auditors to buckle down on their revenue-related audit procedures.

The Public Company Accounting Oversight Board issued a fresh practice alert to the audit profession earlier this month indicating concerns. “PCAOB inspections staff continue to observe frequently significant audit deficiencies in which auditors did not perform sufficient auditing procedures with respect to revenue,” the alert says.

The alert addresses specific concerns that have surfaced in recent years’ inspection reports for all the major audit firms: the testing of revenue recognition from contractual arrangements; evaluating gross vs. net presentation of revenue; testing whether revenue is recognized in the correct period; evaluating revenue-related disclosures; responding to risks of material mis-statement due to fraud; testing and evaluating controls; applying audit sampling procedures; performing substantive analytical procedures; and testing revenue arising from multiple locations.

The PCAOB also acknowledges that the Financial Accounting Standards Board recently issued a new standard on revenue recognition that takes effect in 2017, but believes the issues are still relevant even looking into the future. “The board’s staff believes that the auditing matters discussed in this practice alert are likely to continue to have relevance to auditing revenue under the new accounting standard,” the alert says.

“Auditors will be going back more to source documents, maybe doing more substantive testing, more sampling, digging deeper. You’d be making a bad decision if you didn’t beef up your revenue testing.”
Justin Van Fleet, Principal, Friedman

Among the Big 4 firms whose reports have been published for 2013 (Deloitte, EY, and PwC), inspectors called out procedures around revenue in 40 percent of the audits that were criticized. In 2012, across all four Big 4 firms, 34 percent of audit failures somehow involved revenue. That’s troubling to the PCAOB, which notes in its practice alert that revenue is one of the largest accounts in financial statements, an important driver of a company’s results, and a frequent target for manipulation by fraudsters.

While the alert is directed at auditors, preparers would be wise to study it as well, says Chris Wright, managing director at consulting firm Protiviti. “Whatever affects the external auditors quickly affects their clients,” he says. “Companies should read through it and think about what they might need to do in response. It is a good refresher list of things to look at as companies prepare to get their own houses in order. There’s some useful and helpful information in there.”

Jason Hille, senior counsel with law firm Foley & Lardner, says it’s important for companies and their auditors to take note that the alert does not set new standards. “It’s more of a reminder type of document,” he says. “It lays out a reminder of procedures that are already required procedures. It is a wakeup call both to companies and the independent auditing community that they need to refocus attention on auditing revenue.”

Audit experts offered varying views on the extent to which audit practice will be affected by the alert. On the one hand, the PCAOB issued the alert to call for change. The alert tells auditors to take note of the issues raised in the alert in planning and performing their audit procedures over revenue, and it advises audit firms to “revisit their audit methodologies, and their implementation of those methodologies,” to assure standards are followed. It also advises firms to consider whether they need additional training internally, and that supervisors need to “take action” to assure auditors comply with standards.

Testing, Testing

“Auditors will be going back more to source documents, maybe doing more substantive testing, more sampling, digging deeper,” says Justin Van Fleet, a principal with audit firm Friedman. “You’d be making a bad decision if you didn’t beef up your revenue testing.”

Michael Scudder, a partner with law firm Skadden, Arps, Slate, Meagher & Flom, says auditors are likely to increase their audit documentation and audit evidence. “All of this is going to be measured after the fact,” he says, through inspections or enforcement actions, for example, that will occur well after the auditors have completed their work. “The audit alert makes it clear that the details are going to matter.” The alert includes an “extended discussion,” for example, on audit sampling, he says. “It would be well worth it to devote added doses of time and care to ensuring that the details around sampling are well documented in work papers.”

On the other hand, PCAOB concerns over the issues raised in the alert are not breaking news to the audit firms. The PCAOB interacts extensively with the audit firms as it delivers inspection results and calls for improvements. “At the large firm levels, they are certainly already well aware of these concerns,” says Dan Goelzer, a partner at Baker & McKenzie and a former board member at the PCAOB. “That’s not to diminish the importance of the alert, but I don’t think there would be anything surprising to them in here.” Smaller firms are more likely to make fresh changes to their audit practices as a result of the recent alert, he says.

AUDIT DEFICIENCIES

Because of the importance of revenue, it often is a significant focus area in PCAOB inspections of firms. Inspections staff continue to observe frequently significant audit deficiencies in which auditors did not perform sufficient auditing procedures with respect to revenue, including:
• The failure to perform sufficient procedures to test whether revenue was recognized in conformity with the applicable financial reporting framework, including whether revenue was recognized in the correct period;
• The failure to evaluate, or evaluate sufficiently, whether revenue was appropriately disclosed in the financial statements;
• The failure to address fraud risks regarding revenue;
• Unsupported reliance on controls over revenue because either controls were not tested sufficiently or identified control deficiencies were not evaluated sufficiently;
• Unsupported reliance on company-generated data and reports used to audit revenue because the data and reports were not tested or not tested sufficiently;
• Insufficient testing of revenue transactions, including failure to appropriately apply audit sampling;
• The failure to perform sufficient substantive analytical procedures; and
• The failure to sufficiently test revenue in companies with multiple locations or business units.
Source: PCAOB.

James Comito, a shareholder at audit firm Mayer Hoffman McCann, says the exact response from any given firm will depend to some extent on its own inspection experience. “The document cuts across many topics, so it will depend a little bit on what rings true to you,” he says. “Firms are going to latch on to things that are specific to them, maybe specific things the board identified in a specific inspection cycle.”

Michael Scanlon, a partner with law firm Gibson, Dunn & Crutcher, says company leadership should ask the audit firm about the alert as a new audit cycle approaches for calendar-year companies. “They should discuss the audit plan and the strategy for the audit, and to what extent a focus on revenue recognition and a review of material contracts and multiple-element arrangements will come up,” he says. Those are among the topics of concern raised by the PCAOB in its alert.

Depending on how a given firm reacts to the alert, companies might also ask about their audit costs, says Wright. “It’s reasonable to expect this might require more time of auditors if they’re being told to do more by the PCAOB,” he says.

Companies can possibly mitigate cost increases by doing more work on their own end to assure less work for auditors, he says. “We don’t know every circumstance, but if the auditor’s reaction is that more sampling needs to occur, that clearly will point to more work and higher fees. It depends on which bullet points in the alert apply to a firm and its particular clients. None if it points to less work.”