Fair-Value Risks; IFRS and Revenue; More

Auditors will be under close watch by their regulator this year to determine how they have assessed risk around fair-value accounting.

Mark Olson, Chairman of the Public Company Accounting Oversight Board told a conference of international bankers last week that auditors face three key challenges as companies make the transition to new rules involving the accounting and measuring of fair value.

Auditors may not have extensive training in valuation techniques, and financial statement preparers can be biased—even unintentionally—in their assessment of fair values, Olson said. Internal controls around fair-value measurements may be different from other controls over typical business transactions, further complicating the audit, he said.

“Fair value accounting, while presenting the promise of presenting financial statements with greater relevance, also can pose heightened audit risk, especially in illiquid markets,” he said. “The PCAOB will continue to monitor this area to understand how audit firms are addressing this potential risk.”

Olson

Olson told the audience of bankers that the board already has put auditors on alert with guidance to remind them of their duties to assess potential audit risks that are emerging as the credit market has deteriorated, first in mortgages and mortgage-backed securities and later involving more complex financial instruments. “Our dialogue has continued as the credit risks have deepened and spread to a number of other instruments,” he said.

Acknowledging the questions that have emerged over valuing securities in an illiquid market, Olson said the board has reminded auditors of their duties. “Throughout this dialogue, the PCAOB has communicated to auditors the need to stay the course and reminded the audit firms of the need to adhere to existing requirements,” he said. “To that end, we have discussed the approaches to determining fair value provided for in accounting standards and the relevant requirements for auditors.”

Reviewing the guidance auditors have already received from the PCAOB, Olson said auditors have been advised to study how a given fair-value measurement was reached. “These are not new requirements,” he said. “They are existing requirements that preparers and auditors must apply, even in the current market.”

GAAP, IFRS Rules Vary Greatly Among Tech Cos.

In comparing U.S. and international accounting rules, a Big 4 analysis says software companies in particular can’t assume compliance with revenue recognition rules under U.S. Generally Accepted Accounting Principles equals compliance with International Financial Reporting Standards.

Revenue recognition under U.S. GAAP is one of the most complex areas of accounting, especially for technology companies whose sales often are based on multidimensional arrangements with customers, says Dean Petracca, global and U.S. software leader for PricewaterhouseCoopers. While U.S. accounting literature has more than 90 pieces of literature governing revenue recognition alone, he says, international literature focuses only on a single standard based on principles, not prescriptive bright lines.

Companies that may be considering a switch to IFRS can’t necessarily assume that compliance with the rigid requirements of U.S. GAAP will guarantee compliance with IFRS, according to PwC’s analysis in its report, “A Shifting Software Revenue Recognition Landscape? Insights on Potential Impacts of IFRS and U.S. GAAP Convergence.”

Petracca

“With the evolution toward IFRS, there has been a mindset that if you followed the really detailed rule book of detailed GAAP, you’re likely in compliance with the broad-based requirements of IFRS,” Petracca says. “That’s the fundamental principle we wanted to address. We laid out five areas where we said no, if you follow U.S. GAAP, it might not be consistent with IFRS.”

Petracca says applying a GAAP approach to revenue recognition under IFRS could result in unrecognized revenue, either because IFRS allows recognition where GAAP prohibits it or because IFRS allows more flexibility than GAAP. The five ways GAAP and IFRS differ most significantly, Petracca says, is in provisions around written agreements, multiple-element arrangements, post-contract customer support, time-based licenses, and discounting under the residual method.

Tech CFOs Admit Benefits of Section 404

Although they went kicking and screaming into a Sarbanes-Oxley world, a majority of CFOs at leading U.S. tech companies say their businesses are now better off because of it, but they don’t anticipate any meaningful decline in compliance costs in the coming year.

According to a survey of technology companies by accounting firm BDO Seidman, 65 percent of CFOs say they believe the internal control reporting requirements of Sarbanes-Oxley Section 404 have led to improved processes, and 59 percent said the company’s appetite for taking risk has not been affected. Conversely, 35 percent of CFOs say they see 404 compliance curtailing innovation.

“Although technology companies were hesitant to adopt Section 404 of Sarbanes-Oxley, the majority have realized improved processes due to their compliance efforts and do not believe 404 has adversely impacted their level of risk taking,” says Hank Galligan, a partner in BDO Seidman’s technology practice.

Galligan adds that the number of CFOs who have seen improvement is probably higher. “My experience has probably been that more CFOs would say it has improved things, but they’re not always willing to publicly admit it,” he says. “I would expect it’s higher.”

Galligan

In terms of costs, 53 percent expect no change in the cost of Section 404 compliance this year, while 22 percent are bracing for an increase and 24 percent are expecting a decline. Galligan sees the spread as an overall sign of optimism that Section 404 costs are expected to stabilize in 2008, but he’s surprised companies aren’t more optimistic. “I would have expected a larger portion of CFOs to expect some decrease in cost,” he said.

Regulators last year adopted guidance for management and a new audit rule, Auditing Standard No. 5, that were intended to help companies become more efficient and cost-effective in their compliance efforts, Galligan notes. He’s surprised more CFOs aren’t expecting costs to decline as a result. “I would have thought AS5 would allow people when looking at costs to expect that to decline, to tell the truth,” he says.

BDO’s findings are summarized in a report titled the “2008 BDO Seidman Technology Outlook.”

The survey also revealed that CFOs are finding tax reporting requirements to be almost as onerous as SOX requirements. Of the CFOs in BDO’s survey, 49 percent say Section 404 remains the greatest reporting challenge but 36 percent cite new requirements around reporting uncertain tax positions pose the greatest challenge. They were referring to Financial Interpretation No. 48, Accounting for Uncertainty in Income Tax, which took effect with the beginning of the 2007 reporting cycle to require companies to show in greater detail where they have open or uncertain positions with tax authorities.

Galligan says FIN 48 compliance represented a big push for companies in 2007, much as Sarbanes-Oxley did when it first became effective, but he expects concern over FIN 48 to diminish as companies grow more experienced with the reporting process.