Preparing for the vagaries of revenue recognition

Earlier this year, Corporate Secretary published a story on the expanded internal audit function that reported how several companies are asking for internal audit’s input earlier in their strategic planning process so they can better anticipate audit-related matters down the road. If there’s ever been a subject area that requires their early involvement it’s the new revenue recognition standards that FASB plans to implement from January 1, 2017.
 
Making this all the more critical is the elevated risk of fraud investigations by the SEC: the new standards are principles-based, creating more opportunity for misjudgment, errors and even earnings mismanagement, a December 12 article in CFO warned.
 
January 2017 may seem far enough away but, because companies have the option to decide whether they want to apply the new standards prospectively from when they take effect or retroactively (to cover 2015 and 2016), they need to start creating pathways soon for collecting the required data.
 
So says Chris Wright, managing director at Protiviti who leads the consulting firm’s financial remediation and compliance reporting practice. ‘The internal audit executive or those who interact with the [board’s] audit committee should consider whether the audit committee would like to be involved with some of the decisions concerning the revenue recognition standard,’ he says. That’s especially true if management opts to adopt the new standard retroactively, as audit committees have to sign off on all financial statements before they are released, he adds.
 
An essential principle of the new standards is that a company should recognize revenue to show the transfer of promised goods or services to customers according to the remuneration to which it expects to be entitled in exchange for such goods or services. FASB suggests a five-step process that initially relies heavily on identifying contracts with customers and their performance obligations.
 
‘Where it gets subjective is in determining how to allocate the price of a contract that covers three things to each of those three things,’ says Wright. ‘Lots of companies are struggling with the middle three of the five steps – identifying of performance obligations and how to allocate costs among multiple components [of a contract]. That’s why adoption of new standards by FASB may be delayed’ beyond 2017.
 
After meeting with companies to hear their concerns, FASB expects to announce a potential delay by mid-2015. That will potentially affect the timing of a new accounting standard for which there is no firm date but which was planned to take effect one year after the new revenue recognition standard.
 
Beyond seeking the audit committee’s and internal audit’s input on the decision about whether the new standard will be applied retroactively, Protiviti recommends that management pays attention to methodology, such as ensuring the proper controls are in place.
 
‘Are there business processes that are not financial processes that may need to change, like delivery processes or systems?’ Wright asks. ‘You have to look at the entirety of the data flow from the structure to the people. You’ve got the potential to change a number of steps along the way and a number of key controls you have to test or devise test plans for.’
 
Wright doesn’t know whether the new standards will directly lead to more fraud investigations. ‘First you have to sort out whether it’s bad behavior or bad accounting, or both,’ he says. But to the extent that greater subjectivity can increase susceptibility to manipulation, it’s true that fraud investigations may be more likely, he warns.