In preparation for the year-end close, companies should anticipate plenty of questions from auditors about the riskiest areas of financial reporting, especially around new accounting rules on the horizon.
To minimize the risk of auditors finding problems after the close, companies typically need to put some extra elbow grease into the application of new accounting standards that took effect in the current year. At the end of 2017, however, auditors will focus much more intently on rules that have not yet taken effect, like new standards on revenue recognition, leasing, and financial instruments.
“There really were no big-ticket accounting standards taking effect in 2017,” says Barry Kohn, a partner at Deloitte. “There were a few minor things that took effect this year that for the vast majority of companies are not going to have a significant impact.”
In fact, where the Financial Accounting Standards Board issued new standards taking effect for this year end, in many cases they were simplifications meant to make the accounting easier, says Kohn. Those include for example, a new standard on hedge accounting, a change to the measurement of inventory, and a simplification in transitioning to equity method accounting. Also new in 2017, companies have some new rules on stock compensation to apply, a change to the balance sheet classification of deferred tax assets and an adjustment to consolidation rules.
The bigger focus, auditors say, is on what companies accomplished in 2017 to be ready for massive accounting changes that take place in 2018 and beyond. The first and most significant, of course, is around revenue recognition, with a huge new standard taking effect Jan. 1.
The Securities and Exchange Commission has signaled repeatedly that it expects companies to put some significant effort into preparing for implementation of the new revenue recognition standard, which introduces a new, five-step method all companies must follow to determine the timing and amounts of revenue to recognize in financial statements. Companies are required to give investors some early warning about what effect they expect the new accounting to have on their financial statements, and the specificity of those disclosures is expected to increase as the adoption date draws closer.
“Auditors will be reading those disclosures,” says Jeffrey Jones, a partner at KPMG. “The SEC is emphasizing disclosures should be robust and that they should evolve over time. The auditor’s role for year-end reporting will be getting clients to understand that, to embrace the spirit of those expectations.”
“The belief is you should be at a point where you should be able to estimate it. If you aren’t, that raises a question around the process to implement the new standard. Are those controls in place? There’s going to be a tremendous amount of focus on those disclosures.”
Jeff Burgess, Partner, Grant Thornton
Jeff Burgess, national managing partner of audit services at Grant Thornton, says auditors will be looking at those disclosures in search of numerical detail about how companies will be affected. “The belief is you should be at a point where you should be able to estimate it,” he says. “If you aren’t, that raises a question around the process to implement the new standard. Are those controls in place? There’s going to be a tremendous amount of focus on those disclosures.”
Although the similarly significant accounting change around leasing doesn’t take effect until 2019, auditors may be examining how companies have prepared for that as well, says Burgess. “Depending on whether a company deals with a lot of leases, that’s an area we’ll focus on,” he says. Even further on the horizon, financial institutions that must implement new rules on credit impairment in 2020 may also face questions, given the enormity of the change and the significance it has on financial statements.
In addition to new accounting standards, auditors will also be focusing on how companies are reflecting the effects of major natural disasters at year’s end. Hurricanes Harvey, Irma, and Maria, as well as the recent earthquake in Mexico, could have a number of rippling effects for companies that have operations in those regions or that do business with customers affected in those areas.
“There are a number of potential accounting implications from these awful events,” says Kohn. “For companies that were affected, or if their markets that were affected, there are impacts that need to be considered.”
From an accounting standpoint, natural disasters can affect asset impairments, the collectbility of accounts receivable, hedge accounting strategies, and much more. Companies need to properly account for any insurance claims and be mindful of any non-GAAP measures they plan to report. They also need to consider the effect on bank covenant or loan agreements, lease obligations, tax liabilities, and the need for loss contingency disclosures.
FASB’s recently released standards are grouped below by effective date - those that are effective in 2017 for calendar year-end public.
*early adoption permitted
**Recent amendments require separate effective dates for public business entities (PBEs) and all other entities. The effective dates show in this table are applicable to PBEs. Certain recent amendments further specify separate effective dates for PBEs that are U.S. Securities and Exchange Commission (SEC) filers and PBEs that are not SEC filers. The separate effective dates for PBEs that are SEC filers and PBEs that are not SEC filers are noted in the tables.
In addition to natural disasters, companies need to be alert to various business or political environmental factors that can affect financial statements, as auditors have made their risk lists in that area as well. That includes things like the British plan to exit the European Union, the prospect of U.S. tax reform, volatility in oil and gas prices, and rising risks associated with technology or cyber-security, says Len Combs, a partner and audit leader at PwC. “Anytime change is introduced, it’s making sure management has thought through the implications from a financial reporting standpoint,” he says.
The Public Company Accounting Oversight Board recently issued an inspection brief describing where they're looking for significant risks during 2017 inspections of 2016 financial statement audits with observations on common problem spots. That's the most timely indicator so far of what inspectors might look for when they conduct next year’s inspections of 2017 year-end audits. The themes from that report are not terribly different from what the PCAOB has targeted the past few years, says Charles Soranno, managing director at consulting firm Protiviti.
“They have the usual suspects on the list,” Soranno says. “Valuations, impairments, goodwill, intangibles, long-lived assets, illiquid securities. Nothing ever comes off the list.”
Indeed, they are the usual suspects because they are steeped in judgments and estimates, which has been a recurring theme with the PCAOB the past few years. The board is leaning on auditors to get more skeptical and look for more audit evidence anywhere management is relying on such subjective measures for the numbers that appear in the company’s financial statements.
Of course, no year-end audit plan would be complete without plenty of attention to internal control over financial reporting. Audit regulators are showing no signs of relaxing their focus during inspections on how auditors have scrutinized controls, so companies can expect auditors to be all over controls at this year end as well.
Auditors are paying special attention to risk assessments, says Combs, assuring they’ve properly identified the controls associated with key risks, especially with respect to management review controls. That’s been a hot button with the PCAOB the past few years. “Auditors will be making sure they’ve appropriately considered the controls management may have with a review element,” he says. “That includes any controls where data or reports are used by management or the auditors.”
Auditors will be particularly focused on the precision of controls, says Glenn Richards, a partner at audit firm Crowe Horwath. The PCAOB has called on auditors through inspections to scrutinize whether controls operate at a level of precision necessary to catch material misstatements. “That’s a trend that’s only going to continue this year,” says Richards.
That means management can expect plenty of questions around controls over revenue recognition, journal entries, inventory, complex contracts, and plenty of other areas where control precision is important to financial statement assertions. “There’s been over time an increased focus on the level at which management can document and provide evidence that can prove the operation of controls,” says Richards. “Auditors are expecting management teams to get better and better at documentation.”