Revenue recognition continues to be under the microscope
as regulators step up their scrutiny of financial statements.
At the same time, businesses, accounting firms and consulting advisors
are working to understand the full impact
of the coming converged standards.
Wise companies will walk parallel paths –
one to ensure compliance and their good reputation today
in the face of escalating oversight
and another to ensure the same when the new standards take effect.
Recent statements from the Securities and Exchange Commission (SEC) and Public Company Accounting Oversight Board (PCAOB) continue to emphasize the importance not only of proper accounting treatment of revenue recognition, but also the documentation, analysis and disclosures that underpin good reporting.
At the same time, all of us – businesses, audit firms and consulting advisors – are evaluating what it will take to implement the new converged standards for revenue recognition as they apply to all contracts with customers – what changes to practices, processes, systems and internal controls might be needed to capture new data and address changes in financial reporting.
In this newsletter, I’ll review some of the recent pronouncements from the SEC and the PCAOB and offer my perspective on how companies can ensure their reports withstand increasingly intense regulatory reviews. I’ll also discuss where finance and accounting professionals are beginning to think the new converged standards will have their biggest impact and suggest steps companies should be taking now to minimize costs and maintain investor confidence and compliance.
Spoiler alert: It’s my conclusion that companies can’t assume their practices and processes – even if they’ve been deemed best of breed in the past – will continue to produce satisfactory reports in the near-term – let alone further out. In addition to continually reassessing present procedures to meet sharper scrutiny, companies should also be looking at revenue recognition practices ahead of the looming changes that go into effect in the next few years. To succeed today and be ready for tomorrow, companies need to follow parallel paths.
The Current State: Staying Compliant in the Face of Increased Regulatory Oversight
Over the past months, SEC observers report that while the agency is considering ways to make disclosures more effective, it has decided for the present to leave it to companies to improve the content of their reports. That said, the SEC is also taking a proactive approach toward implementing the new standards and is considering making changes to its own rules that go beyond Financial Accounting Standards Board (FASB) directives.
Over at the PCAOB, that agency issued a practice alert in September 2014 on the audit of revenue in financial statements. The document emphasized that (1) revenue reporting will remain a significant focus area in PCAOB inspections; (2) PCAOB inspections staff continue to observe frequently significant audit deficiencies; and (3) the PCAOB continues to look to audit firms to ensure that PCAOB standards are followed. The alert detailed the following standards for an acceptable audit – standards the PCAOB believes will continue to have relevance under the new converged rules: testing the revenue recognition from contractual arrangements, evaluating the presentation of revenue, ensuring the inclusion of required disclosures, testing and evaluating controls, responding to fraud risks, applying audit sampling procedures to test revenue, performing substantive analytical procedures, and testing revenue in multiple locations.
Bottom line: Expect both agencies’ increased oversight to continue under current rules and when the new standards take effect.
What can companies do to ensure they pass such stringent reviews?
The most important action in my view is to ensure revenue recognition practices are adequate to current business models and revenue streams. Recently, Blythe Global Advisors has been helping companies who are finding that practices and processes that produced satisfactory reports for years are suddenly coming up short in PCAOB reviews because small, slow changes over time have resulted in a fundamentally different company requiring significantly different accounting treatment. The cost to companies caught in this situation is steep, including post-signoff auditor remediation, late filings, increased regulatory scrutiny on subsequent reviews, diminished image among stakeholders, etc. To remain compliant, companies need to be diligent that all aspects of revenue recognition practices remain appropriate to evolving oversight and rules on the outside and evolving business realities on the inside.
The Future State: Steps to Take Now to Remain Compliant Under the New Standards
Right after the FASB and IASB issued their converged standards on May 28, 2014, there was a flurry of articles – most of which summarized the FASB/IASB content but didn’t offer much insight into what companies needed to do to get ready.
A review that I conducted of 10Q reports for the quarter ended April 30, 2014 as submitted by several larger companies – traditionally the bellwethers for corporate policy – found that disclosures for that first reporting period after the FASB/IASB announcement were mostly generic with little insight into the potential effect of the new standards on strategic goals or future contracts and revenue.
The truth is that as of this moment none of us – neither corporate finance executives nor auditors nor non-audit consultants – are more of an expert than another. As the current regulatory state wends its way into the future state, the most important question we should be asking is, “What should companies be doing now – as opposed to two years from now – to be ready for full implementation?”
Here are the top areas that I believe companies should focus on today to ensure not just compliance but stakeholder confidence under both current and forthcoming rules.
- Get comfortable with expanded judgment decisions: Current U.S. GAAP rules provide proscribed guidance. The new rules are more theoretical, requiring more judgment decisions in coming up with estimates that, in turn, must be supported by more accounting documentation and analysis and more detailed disclosure statements. All of this puts more pressure on your senior management team. Start a discussion now with your CEO, other C-level executives and your finance and accounting staff regarding what new or additional information is needed to make more knowledgeable, actionable decisions. These measures will also help compliance under current rules because, as noted above, documentation and MD&A are prime review areas for regulators.
- Conduct a company-wide contract review: The entire focus of the converged rules is on the application of contracts. The language in all contracts needs to be evaluated and decisions made as to whether the company will continue doing business as in the past or make fundamental changes. This review needs to be a cross-functional effort involving finance, accounting, legal, human resources, sales and marketing – including counterparts around the globe for companies with multiple, worldwide locations and contracts in multiple languages.
In some cases, adoption of the new rules may necessitate changes to contract language. And there are more questions: Regardless of contract stipulations, how do companies with multiple, worldwide locations ensure absolute consistency? How does the company communicate all this to stakeholders? How does it avoid stock fluctuations?
Conducting a comprehensive contract review now will prepare companies to answer these questions while also ensuring that reporting under current rules continues to accurately reflect the company’s present revenue streams.
- Review all mission-critical IT systems: Are current IT systems sufficiently robust to accommodate the new rules? Are they flexible enough to calculate revenue under current rules and also perform a multi-year retrospective under the new rules? Are two systems needed? Is ERP adaptable or will Excel become the default process?
When the new rules go into effect, companies will need to know and may have to present up to five years of restated historical results. Because revenue growth is an increasingly important key performance indicator, it’s my opinion that most companies will choose to restate five years – instead of the SEC’s optional three years – putting more stress on systems.
- Re-evaluate internal controls for proper revenue recognition: Just as the bar for complying with today’s rules is constantly rising, companies should be ready for cascading changes once the new rules are implemented. When it comes to internal control processes and practices, best of breed with regular stress tests is mandatory.
As for the people who are responsible for maintaining effective internal controls, both public and private companies need to employ highly skilled professionals. Let’s take contracts as an example. Companies need to ensure contracts receive the right level of review. That means people with sufficient knowledge of accounting rules to recognize when new activities affect revenue recognition or to discern the tipping point when the business model has shifted significantly enough to warrant changes to accounting treatment.
Much of what I’ve outlined above involves new and different questions that require different processes and perhaps even different personnel to generate the appropriate qualitative and quantitative information necessary for compliance. However, I strongly believe that the pain in getting ready for these new standards will be lessened if companies start now. Here’s why:
First, even though the FASB may ultimately delay the implementation date, companies need to begin discussing the new standards in upcoming quarterly disclosure statements regarding any significant impact the new standards will impose on the company and what the company will do to address the impact. Taking the steps outlined above will enable executives to make more informed statements prior to full implementation and to prepare stakeholders for how future revenue will flow. Companies will be able to avoid surprises – and the publicity and volatility that surprises can generate — when they issue their first, full report under the new standards.
Second, with oversight of public companies on the increase, auditors are on heightened alert. Because the new converged rules apply to all companies – public and private alike – all companies can expect a domino effect in the form of intensified scrutiny from their auditors. To produce the level of documentation auditors are now asking for, many companies will find they need to augment their technical expertise and/or internal controls.
Deep, fundamental change is always difficult. Deep, fundamental change is coming to revenue reporting. The companies that will fare best are the companies that are the best prepared – the ones with a couple of dry runs under their belts.
In closing, let me recommend some people outside the finance and accounting functions that you can ask to join you on your parallel-path odyssey. First is your corporate communications function. As your organization’s professional storytellers, they can provide invaluable help in crafting extended disclosure statements. Second are your trusted partners – your audit firm, non-audit advisors (such as us at Blythe Global Advisors) and investor relations agency – whose job is to be ahead of the curve on these issues.
If you would like to discuss anything in this or any of my newsletters, please contact me. I’d be delighted to talk with you.
* As a reminder, implementation for public companies is currently set for fiscal years starting after December 15, 2016. For private companies, it’s for fiscal years starting after December 15, 2017. Companies using International Financial Reporting Standards (IFRS) must apply the new standards starting after January 1, 2017.
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