Posted on

Adopting the new revenue recognition standard…are you ready?

As we move closer to 2018, more and more companies are facing challenges in adopting the new revenue recognition accounting standard, codified as ASC 606, Revenue from Contracts with Customers.  As a refresher, the adoption date of ASC 606 for publicly traded companies is for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period.  The effective date for all other entities is for annual reporting periods beginning after December 15, 2018, and interim periods within annual periods beginning after December 15, 2019.

As the deadline to adopt ASC 606 approaches, in accordance with SEC SAB Topic 11-M, Disclosure Of The Impact That Recently Issued Accounting Standards Will Have On The Financial Statements Of The Registrant When Adopted In A Future Period, the SEC expects to see disclosures regarding both qualitative and quantitative information.  Following are examples of disclosure items to consider:

  • What is the potential impact of adopting the new standard?
  • Is adoption of the new standard expected to result in a material change or not to the financial statements?
  • What are the expected changes to existing accounting policies?
  • Where is the registrant in the implementation process?
  • Are there any significant issues not yet addressed by the registrant?
  • If it can be reasonably estimated, disclose the potential quantitative impact on the registrant’s financial statements.

Many companies may not be able to intelligently answer these questions and, for this reason, they will need to accelerate their preparations for adopting the new standard.

As I explained in a previous post, internal coordination among the various departments is a must in order to effectively assess the impact that ASC 606 will have on a registrant’s financial reporting.

 

Posted on

A Look-back: 12 years of SOX Section 404

Many companies became subject to the provisions of Section 404 of the Sarbanes-Oxley Act of 2002 (SOX) beginning for fiscal years ending on or after November 15, 2004.  Specifically, Section 404(a) requires public companies’ annual reports to include the company’s own assessment of internal control over financial reporting (ICFR).  Section 404(b) requires an independent auditor’s report on the effectiveness of the company’s ICFR.

Since the implementation of SOX 12 years ago, we have seen some interesting trends in financial restatement statistics and SEC enforcement trends, which I have written about recently (here and here).  In fact, a recent Audit Analytics report has highlighted some key take-aways related to Section 404 disclosures.

Effectiveness of ICFR requiring auditor attestation

SOX Section 404(b) states that accelerated filers (including large accelerated filers) must provide an independent auditor’s report on the effectiveness of the filer’s ICFR.  The following chart shows adverse auditor reports as a percentage of total auditor reports on ICFR on an annual basis within the last 12 years.

% Adverse Auditor Attestations

For clarification, according to PCAOB Auditing Standard No. 5 (AS 5), An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements, an adverse opinion signifies that at least one material weakness exists within a company’s ICFR.

Naturally, one would expect the first year of implementation, 2004, to yield the least favorable results.  To also note is that because the SOX Section 404 requirements went into effect in late 2004, only a portion of companies whose fiscal years ended in 2004 were required to implement these requirements (i.e., those whose fiscal years ended on or after November 15, 2004).  This means that a smaller number of companies filed auditor attestations related to fiscal 2004 when compared to fiscal 2005.

What I find interesting about the above chart, and the Audit Analytics report discusses, is the historical “low” in the rate in 2010.  In 2010, the PCAOB inspection program began determining if audit firms had obtained adequate evidence to substantiate the auditor’s attestation of management’s assessment regarding the effectiveness of ICFR.  The impetus for this was the implementation of AS 5, which became effective in late 2007.

After initially reviewing audit firms’ implementation of AS 5 in 2008 and 2009, the PCAOB’s inspections began in 2010 to focus on inspecting for and reporting on whether firms obtained sufficient evidence to support their audit opinions on the effectiveness of ICFR.  Although somewhat unclear, we might gather from the above chart that the PCAOB’s scrutiny of audit firm compliance with AS 5 in 2010 may have re-focused the emphasis of audit firms on improving audit quality in 2011 (when compared to 2010).

Key areas of adverse auditor reports

Among those auditor reports with an adverse audit opinion on ICFR, the Audit Analytics report identifies the following internal controls issues with the highest frequency in 2015:

Ineffective ICFR issues

Total number of attestations

As % of total attestations citing ineffective ICFR
Material and/or numerous auditor and/or management adjustments

118

58%
Inadequate accounting personnel resources, competency, and/or training

105

52%
IT, software, security, and access controls

60

30%
Segregation of duties and/or design of controls

50

25%
Controls related to non-routine transactions

39

19%

As illustrated in the table above, the top reason for ineffective ICFR in 2015 was due to accounting issues which were known to materially misstate the financial statements.  Said differently, without recording the necessary adjustments, the financial statements taken as a whole would have been materially misstated.  The remaining top five reasons for ineffective ICFR in 2015 were due to internal controls issues (which either did or “could have” contributed to material errors in the financial statements).

Moreover, the Audit Analytics report lists the following accounting-related ICFR issues as most commonly cited in adverse audit reports in 2015:

Ineffective ICFR issues related to accounting

 Total number of attestations

As % of total attestations citing ineffective ICFR
Revenue recognition 47

23%
Income taxes

36

18%
A/R, notes receivable, investments, and cash

34

17%
Fixed assets and/or intangible assets

29

14%
Related parties and/or affiliates/subsidiaries

27

13%

Effectiveness of ICFR not requiring auditor attestation

In contrast to the requirements in Section 404(b) for accelerated filers, non-accelerated filers and smaller reporting companies need not comply with this provision, thanks to the Dodd-Frank Act of 2010, but they must comply with Section 404(a).  Furthermore, non-accelerated filers were not required to implement Section 404 until late 2007.

For clarification, a non-accelerated filer, as defined by SEC Rule 12b-2, is public company whose public float (as opposed to market capitalization) does not exceed $75 million as of the last business day of the company’s most recently completed fiscal Q2.  Furthermore, smaller reporting companies are those companies that meet the definition of a non-accelerated filer and had annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available.

Having said that, the following chart shows the percentage of adverse management-only assessments relative to total management-only assessments on an annual basis in the last 12 years.

% Mgmt-Only Reports

Interestingly, this chart shows a negative trend over the years, with a drop in 2015.

Key areas of adverse management-only assessments

The Audit Analytics report identifies the following internal controls issues with the highest frequency in 2015 in management-only assessments:

Ineffective ICFR issues

 Total number of assessments

As % of total assessments citing ineffective ICFR
Inadequate accounting personnel resources, competency, and/or training

985

79%
Segregation of duties and/or design of controls

893

72%
Ineffective, non-existent, or understaffed audit committee

388

31%
Inadequate accounting disclosure controls

246

20%
Material and/or numerous auditor and/or management adjustments

204

16%

To note is that two of the five top ICFR issues in the table above are also among the top five ICFR issues in adverse auditor attestations.  A key reason for the provision in the 2010 Dodd-Frank Act eliminating the requirement for non-accelerated filers and smaller reporting companies to comply with SOX Section 404(b) was due to cost of compliance.  Since we can see from the table above that overwhelmingly the two most common ICFR issues were inadequate accounting resources and segregation of duties/design of controls, it certainly seems reasonable to conclude that the cost of accounting resources is a relatively big factor for smaller public companies.  While understanding that these statistics describe ICFR issues for public companies, to my surprise is that the third most common issue deals with inadequacies of the audit committee.

With respect to accounting-related ICFR issues noted in management-only assessments, the Audit Analytics report lists the following most commonly cited in 2015:

Ineffective ICFR issues related to accounting

 Total number of assessments

As % of total assessments citing ineffective ICFR
A/R, notes receivable, investments, and cash

95

8%
Debt, quasi-debt, warrants and equity-related (beneficial conversion features)

53

4%
Income taxes

48

4%
Revenue recognition

38

3%
Related parties and/or affiliates/subsidiaries

24

2%

The above table demonstrates that the most frequently cited accounting-related issues in ICFR was similar between accelerated and non-accelerated filers and smaller reporting companies.  Furthermore, the Audit Analytics report indicates the top five accounting-related issues represented approximately two-thirds of the total accounting-related issues in 2015, both for adverse auditor reports and management-only assessments.

Summary

To put these findings into context for 2015, of those accelerated filers whose auditors issued an adverse SOX report, there was a pull toward ICFR failures due to accounting-related issues.  On the other hand, companies that issued management-only assessments citing ICFR failures experienced significantly higher rates of ICFR failures due to internal controls issues as opposed to accounting-related issues.

In addition, the ICFR failure rates reported by companies with management-only assessments were significantly higher than the ICFR failure rates reported by accelerated filers.  By applying a simple average over the last 12 years for accelerated filers and nine years for non-accelerated filers, the ICFR failure rates were 6.9% and 35.4%, respectively.

Finally, for additional context, I noted per review of the Audit Analytics report that in 2015 there were approximately 3,800 auditor attestations on SOX effectiveness filed with the SEC.  With regard to management-only assessments, there were approximately 3,500 management reports filed in 2015 with the SEC.  Therefore, the quantity of filings with the SEC between these two groups was comparable.

Source for charts:  Audit Analytics August 2016 report, SOX 404 Disclosures, a Twelve Year Review.

Photo credit

Posted on

Potentially costly accounting standards on the horizon

For a number of years we experienced a “lull” in significant accounting standards issued by the FASB.  However, just within the last two years, the FASB has issued two significant, complicated accounting standards that will have far-reaching implications for companies.

These two accounting standards affect how companies recognize revenues and recognize leases.  Based on my experience, I expect that just about every company whose financial reporting framework is U.S. GAAP will be affected by at least one, if not both, of these standards.  As such, today’s post will focus on what these two standards are and how they will affect companies.

Revenue recognition

In May 2014, the FASB issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606).  This standard is designed to achieve a number of goals.  First, the standard removes inconsistencies and weaknesses in revenue requirements and provides a more robust framework for addressing revenue issues.  Second, the standard improves comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets (particularly companies that have adopted IFRS).  Third, it provides more useful information to users of financial statements through improved disclosure requirements.  Finally, the standard simplifies the preparation of financial statements by reducing the number of requirements to which an entity must refer.

The core principle of the guidance in Topic 606 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  With a move away from industry and more prescriptive guidance on recognizing revenue, this standard uses the following five-step model:

  1. Identify the contract(s) with a customer
  2. Identify the performance obligations in the contract
  3. Determine the transaction price
  4. Allocate the transaction price to the performance obligations in the contract
  5. Recognize revenue when (or as) the entity satisfies a performance obligation

The desired goals of this standard seem nice on paper and I believe they are a significant step toward improved financial reporting.  However, what this means for companies is that they will need to apply a significant amount of resources and thought to achieving the objectives set forth in the standard.

ASU No. 2014-09 has been subsequently amended as follows:

Accounting for leases

Earlier this year the FASB issued ASU No. 2016-02, Leases (Topic 842).  The key change from the existing leasing accounting standard (Topic 840) is that, under the new standard, lessees will need to recognize lease assets and lease liabilities for leases classified as operating leases.  For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities.  If a lessee makes this election, it should recognize lease expense for such leases generally on a straight-line basis over the lease term.

This standard is effective for fiscal years beginning after December 15, 2018 for publicly traded companies.  Although 2019 seems like a long way into the future, many companies will need to make significant endeavors to effectively implement this accounting standard.

Internal coordination a must

It goes without saying that departmental decisions within a company tend to have an effect on accounting and financial reporting.  With this in mind, in implementing these new accounting standards companies will need to coordinate internally to ensure that all of the relevant facts and circumstances are gathered for accounting and financial reporting consideration.

In the spirit of coordinating between the accounting function and other departments to ensure that business operations are not adversely affected by adoption of these new accounting standards, following are things to consider:

  • Legal – In implementing the new lease standard, leases with terms greater than 12 months will be included in the balance sheet.  Companies will need to revisit their contractual terms, particularly with lenders, to ensure that the accounting changes on the balance sheet do not adversely affect compliance with debt covenants.  Further, companies will need to consider implications of adopting these two standards on securing financing.  Finally, companies may wish to revisit the terms and conditions, including pricing structure, in customer contracts and consider how adoption of the new revenue recognition standard may affect the timing of revenue recognition.
  • Financial planning and analysis – Companies will need to consider the timing of revenue recognition for internal budgeting and forecasts.
  • Information technology – Companies will need to revisit their accounting and operational systems and processes.  Specifically, systems and processes will likely need to be reconfigured and/or reports may need to be modified or created to obtain relevant data for appropriate accounting and more extensive accounting disclosures.
  • Human resources – Often times variable compensation is based on key financial metrics, such as revenues, earnings, and EBITDA.  With the adoption of the new accounting standards, because the timing of revenue recognition may change, companies will need to revisit their variable compensation arrangements with employees to ensure that targets are reasonable and achievable.  Moreover, companies will need to ensure there is adequate staffing with the right level of experience and technical skills to implement these standards.
  • Tax – With expected changes in the recognition of revenue, for example, companies will need to consider the impact on income taxes.
  • Investor relations – Companies will need to consider changes to guidance provided to the street on revenues, EPS, and non-GAAP measures (such as EBITDA) as these metrics will be affected by adoption of these new accounting standards.  Furthermore, companies will need to consider the nature and extent of communications with users of their financial statements regarding expected changes to business practices from adopting these standards.

As I indicated in a previous post, just like individuals, companies can procrastinate decision-making until it becomes costly.  Of particular concern in light of these two significant accounting standards is that companies may lack sufficient resources to effectively adopt them, either in terms of quantity or quality of headcount.

Likewise, companies may not provide adequate budgeting for additional resources needed to effectively adopt these standards.  Many companies, whether by choice or out of necessity, may find themselves hiring consultants carrying price tags higher than internal resources to accomplish the following two objectives.  First, they will need to meet the adoption requirements in the accounting standards.  Second, they will need to satisfy their external auditor of compliance with these accounting standards.

Potentially costly audits

In my line of business, hiring outside assistance to pass financial statement audits can become costly in a relatively short period of time.  With this in mind, in connection with an audit of financial statements, public companies should be mindful of the implications that the adoption of these standards will have on internal controls over financial reporting.

In essence, there are multiple “types” of internal controls:  IT general, application, automated, manual, and IT-dependent manual controls.  As is typical of significant changes in accounting and disclosure, the adoption of these new standards will likely require more manual-type controls to verify that financial reporting is reliable.

In light of this, companies will need to consider the increased risk of material misstatement that manual controls introduce to an audit.

Next steps

For these reasons companies should begin now planning for these scenarios.  In reality, these new accounting standards are a significant undertaking and companies should approach implementation of these standards with a high degree of determination.

Photo credit

Posted on

Proving out cash and revenues

For many small business owners, ensuring that revenue and cash make sense when compared to each other is a critical exercise since cash is the most liquid account in the financial statements (which means it can be highly susceptible to theft) and revenue is often times the largest and/or one of the most important accounts to measure business performance.  How does one know if all cash receipts have been properly entered into the accounting system?  How does one verify that all revenues have been reported in the ledger for the period?

One such exercise can greatly help businesses to answer these questions, called a “proof of cash and revenue.”  By proving out cash and revenue, businesses can get comfortable that either (1) the accounting accurately reflects all business transactions or (2) there are transactions not appropriately accounted for, triggering additional investigation.

A proof of cash and revenue exercise is rather simple, although differing degrees of complexity in a business could complicate the exercise.  In essence a proof of cash and revenue exercise takes all cash receipts from an entity’s bank account statement and removes any non-revenue deposits (such as cash transfers from one bank account to another, proceeds from sale of equipment, bank account interest received, insurance reimbursements, and so forth) to arrive at what I will call “revenue deposits.”

Next, beginning-of-the-period accounts receivable, gross (make it a positive number) is netted against end-of-the-period accounts receivable, gross (make it a negative number).  The result is added to revenues from the general ledger (“G/L”).  The theory in adding beginning accounts receivable and subtracting ending accounts receivable is that the beginning accounts receivable is “assumed” to have been collected within the period, meanwhile the ending accounts receivable has not yet been collected, and, therefore, it will not show up in the bank account statement for the period.  I will refer to this calculation as “adjusted revenue per G/L”.

The final step is to compare “revenue deposits” to “adjusted revenue per G/L” and investigate any variance that exceeds what is considered to be an acceptable variance.

When done right, this exercise can uncover errors in accounting, missing deposits, or even fraud.  Although this exercise is fruitful for businesses that have standard revenue recognition practices, one can see that when customer sales exist with multiple elements, whereby “delivering” a service or a product to a customer doesn’t necessarily result in revenues (but rather some or all deferred revenue), a proof of cash and revenue is not likely to yield meaningful results.

Having said this, I’ve assisted a number of clients in performing this proof of cash and revenue analysis and clients gain valuable insight into their business practices and controls that they otherwise may not be aware of.

Photo credit