If principles-based standards, with their room for judgment and interpretation, can be a cause for heightened fraud risk, the new standard on revenue recognition must look positively terrifying to compliance officers.
“One might title this standard ‘Pick a Number, Any Number,’” wrote Lynn Turner, former chief accountant at the Securities and Exchange Commission, about the newly issued standard.
In 700 pages of guidance—not only the rules themselves but also the conforming amendments, background, and basis for conclusions—the term “judgment” or some variation of it appears nearly 50 times. Its close cousin, the term “estimate” or some variation of it, appears more than 500 times.
The list of required or permitted judgments and estimates along with the disclosures necessary to explain them is daunting. In a complex business environment, where a contract with a customer includes multiple separate performance obligations, delivered at different intervals over time, under variable or various different pricing arrangements, the list of judgments and estimates to determine the proper timing and amounts of revenue recognition is extensive.
While revenue recognition is a common target for would-be fraudsters, and while Turner is known for his candor, not all accounting experts are prepared to say the new standard carries increased fraud risk. “There’s always a risk of fraud,” says Doug Reynolds, a partner with Grant Thornton. “I can’t say if there’s more or less risk with this standard.”
Bryan Anderson, a partner with Deloitte & Touche, says companies can begin with their current fraud risk analysis and ad more scrutiny on where there will be new or increased judgments on revenue. “The rules and bright lines from U.S. GAAP have been removed, but I don’t think that should in and of itself create massive amounts of new fraud risk.”
Tracy McBride, vice president at Financial Executives International, says companies will need to turn to their internal controls. “Senior executives will have to be really diligent in setting policies on how those judgments will be made,” she says. “So long as you set policies that everyone will be held accountable to and you have documentation as with any standard, that will definitely negate any additional risk.”
“The rules and bright lines from U.S. GAAP have been removed, but I don’t think that should in and of itself create massive amounts of new fraud risk.”
Bryan Anderson, Partner, Deloitte & Touche
With the standard taking effect in 2017, Reynolds says companies have a long runway to adopt strong controls. “I would suggest companies avail themselves of the time and bake in appropriate safeguards,” he says. “They’ve got time to go back and look at every little thing.”
Alex Wodka, a partner with Crowe Horwath, says companies should be equally or even more concerned about the variability of interpretation that is inherent with areas where judgment is involved. “That will create challenges both in interpreting and, for auditors, in ascertaining whether the accounting is consistent with the standard,” he says.
Experts say companies will be wise to involve their auditors early in the process to assure they buy into the judgment framework and controls put in place to mitigate risks of fraud or any other cause for mis-statement. Lorraine Malonza, a director with Financial Executives International, says companies can certainly anticipate thorough audits in their first year of adopting the new standard. “There’s always extra rigor in that first year,” she says.
Cross-Functional Team Needed
Apart from just involving external auditors, companies will need to form a cross-functional team to fully assess the changes and prepare for the adoption. The new revenue recognition standard is much bigger than a discrete accounting exercise. It touches into virtually all areas of the business.
“Revenue is a number in the financial statements that a lot of people care about, and not just accountants,” says Chris Smith, a partner with PwC. Many aspects of the way businesses operate today have been driven by present revenue recognition rules, he says. “It affects business practices and the way people go to market; contracts with customers, the structure of compensation plans; the design of business processes; and the structure of systems.” Because those rules are changing, companies might choose to do things in any number of such areas differently than they have in the past, he says.
Companies need to approach the adoption of the standard as a major new process, says Chad Kokenge, a partner at PwC, assuring plenty of education and planning at all levels. “It’s an accounting change, so it starts with someone in finance, but there’s lots of process change going on as well,” he says. “You need a cross-functional team to really make this go.”
Business unit leaders who understand the various revenue streams need to be at the table. Any changes may affect how they will operate or how they will report information.
Sales and Marketing
Those who best understand arrangements with customers will be critical to the conversation, especially where contracts might include multiple deliverables, variable consideration terms, discounts, special provisions, etc. Changes in the accounting could open discussions about whether there are alternative or more cost-effective selling or marketing approaches to consider.
Compensation, commissions, and bonuses often are based on revenue. If the timing or amounts of revenue could change, that could have implications for how such compensation plans are structured.
REVENUE RECOGNITION STATUS
Below is an update from McGladrey on the new standard’s effective date and transition information.
The ASU is effective in annual reporting periods beginning after December 15, 2016 and the interim periods within that year for the following entities: (a) public business entities, (b) not-for-profit entities that have issued, or are conduit bond obligors for, securities that are traded, listed or quoted on an exchange or an over-the-counter market and (c) employee benefit plans that file or furnish financial statements to the SEC. As such, for a public business entity with a calendar year end, the ASU is effective on January 1, 2017 for both its interim and annual reporting periods. A public business entity cannot apply the ASU early. For all other entities (e.g., private companies), the ASU is effective in annual reporting periods beginning after December 15, 2017 and interim periods within annual periods beginning after December 15, 2018. As such, for a private company with a calendar year end, the ASU is effective for the year ending December 31, 2018 and for interim periods in the year ending December 31, 2019. A few early adoption alternatives are provided for these entities. However, in no circumstances can one of these entities apply the ASU earlier than the effective date for a public business entity.
The ASU provides transition alternatives that an entity must choose between. One of the alternatives is retrospective application to all periods presented with the option to elect one or more practical expedients. Another of the alternatives only requires application of the guidance in the ASU to contracts for which revenue recognition is not complete as of the date of initial application (e.g., for a calendar year-end public business entity, January 1, 2017). If an entity elects this method, it must record a cumulative effect adjustment as of the date of initial application for the effects of applying the ASU to incomplete contracts at that date and also disclose a variety of information, including the effects of applying the ASU in the period of adoption. To comply with this disclosure requirement, an entity needs to determine the amount of revenue and related costs it would have recognized if it had continued to apply legacy GAAP in the period of adoption.
Financial Planning and Analysis
Forecasts are based on revenue, and the revenue numbers might be heavily or only minimally affected by the new standard. FP&A will be an important resource to assess the financial impact of adopting the standards.
Because the standard is based on assessing contracts with customers, the legal team will need to help interpret contract obligations and the determination of when those obligations are met under the standard. That will drive the judgments around when and in what amounts to recognize revenue. The more complex and varied the contracts that a company has with its customers, the more legal analysis that will be necessary.
Virtually every company will have to consider some magnitude of change to information systems, whether only minimal tweaks to capture and report new information or substantial overhaul to adopt an entirely new method of capturing, calculating, and reporting data. The complexity of change might be further exacerbated by any existing or pending system changes that are already in process or in planning.
Loan covenants may be based on reported revenue figures, which may change. Contracts will need to be assessed so the magnitude of effect can be considered and scoped into the adoption plan.
Investors and Investor Relations
Investors may have strong opinions about whether they can accept a cumulative presentation or will need a full retrospective presentation, the determination of which is key to the adoption plan.
Any major process change should be brought to the attention of auditors so they can share any concerns along the way. It is far better to get the auditor’s buy-in throughout than to put into place a system that auditors can’t audit or give a favorable opinion on in the first reporting cycle.
All of this new accounting will necessitate new controls. The internal audit department can be a great resource in helping design an appropriate control framework for making the critical judgments that will be key to the new accounting.
New revenue rules will surely have tax implications, raising new concerns around any number of strategies, including transfer pricing for global corporations. The timing difference between book and tax recognition of tax liabilities and tax assets could change considerably.