FASB's new revenue recognition standard, FASB ASC Topic 606, Revenue From Contracts With Customers, is one of the most significant changes ever in U.S. GAAP. The new, principles-based standard requires consideration of a five-step framework that includes estimates on the revenue recognized for the accounting period (see the sidebar, "Independence Missteps Related to Revenue Recognition," below).
Auditors must understand the framework in order to perform audit procedures.
5-STEP PROCESS OVERVIEW
To properly assess the risk of material misstatements, an auditor must have robust knowledge of the new revenue recognition standard requirements and how they affect the client's financial statements. The following describes the five-step process for recognizing revenue and areas that require significant judgment:
1. Identify contracts with the customer
A contract exists when there is an agreement between two or more parties, creating enforceable rights and obligations. The client's procedures should verify that contracts meet the five criteria established by the standard. Clients may decide to apply the guidance from the standard to a portfolio of contracts with similar characteristics when they reasonably expect that the effects on the financial statements would not materially differ from applying the guidance to each individual contract.
Change orders or modifications to contracts is one area where clients make significant judgments. These occur when there is a change in the scope or price (and, in some cases, both) of a contract that is approved by both parties. During the evaluation of these modifications, clients judge whether the change or modification should be accounted for as part of the existing contract or as a new contract for the client. These judgments affect the amount of obligation and the revenue recognized for the period, depending on how the change is accounted for.
For instance, if the client determines the change should be accounted for as part of the existing contract, and if the remaining goods and services are distinct from those previously transferred, the client is required to account for the modification as a termination of the existing contract and the creation of a new one.
2. Identify separate performance obligations
Performance obligations are promises built into the contract that transfer a good or service to the customer. When a client promises to transfer more than one good or service to a customer in the contract, the client should identify each promise as a performance obligation if:
- A good or service (or a bundle of goods or services) is distinct, or
- A series of distinct goods or services are substantially the same and have the same pattern of transfer.
Within step two, increased judgment is involved when determining distinct performance obligations in complex contracts. Careful review of the contract terms will help clients identify separate performance obligations. Clients will need to judge whether there are factors that indicate a promise to transfer goods or services to a customer is separately identifiable. Factors from the standard that indicate that two or more promises to transfer goods or services to a customer are not separately identifiable include, but are not limited to, the following factors:
- The client provides a significant service of integrating the goods or services with other goods or services promised in the contract into a bundle of goods or services that represent the combined output for the customer.
- One or more of the goods or services significantly modify or customize, or are significantly modified or customized by, one or more of the goods or services promised in the contract.
- The goods or services are highly dependent on, or highly interrelated with, other goods or services promised in the contract.
Another challenge for companies involves customer options and determining whether the options represent a material right. Customer options allow a customer to acquire additional goods or services for free or at a discount. Judgment is needed to determine whether the options represent a material right for the customer, resulting in a separate performance obligation.
3. Determine the transaction price
The transaction price is the amount of consideration that a client expects to receive in exchange for promised goods or services. A client should consider the effects of several factors when estimating the transaction price:
- Variable considerations, such as discounts, rebates, refunds, returns, and performance bonuses.
- Constraining estimates of variable consideration.
- The existence of a significant financing component.
- Noncash considerations.
- Consideration payable to a customer.
Clients may need to exercise significant judgment when estimating the variable considerations that should be included in the transaction price and update those estimates each reporting period. Does the client normally provide implicit price concessions or incentives? Is there a financing component included in the contract that should be considered?
Clients should exercise judgment in determining whether an entity is acting as a principal or agent. This typically occurs when a third party is involved to provide goods or services to customers. The key to determining whether a client is acting as a principal or agent depends on who has control of the good or service before it is transferred to the customer. When a client has control of the good or service prior to customer transfer (principal), the client should recognize gross revenue. If the client does not have control (agent), it should recognize net revenue.
4. Allocate transaction price to the separate performance obligations
Using the information from step three, clients allocate the transaction price to each performance obligation identified in the contract on a relative stand-alone selling price basis. The stand-alone selling price is the price at which an entity would sell a promised good or service to a customer.
Topic 606 indicates that the best evidence of stand-alone selling price is the observable price of a good or service the entity sells separately in similar circumstances to similar customers. When the stand-alone selling price does not exist, the estimate can be based on an adjusted market assessment, expected cost plus margin, or residual approaches. In cases where two or more goods or services have a higher variable or uncertain stand-alone selling prices, clients can use a combination of the various approaches.
Within step four, clients exercise judgment in various ways. For instance, if there are complex contracts, the client will need to consider how to allocate the transaction price to each performance obligation. Clients will also need to make judgments regarding how to allocate discounts and variable considerations.
5. Recognize revenue
Revenue is recognized when or as clients satisfy performance obligations by transferring a promised good or service to the customer. Performance obligations are satisfied when, or as, the customer obtains control of the asset. For each distinct performance obligation, the client is required to determine if it is satisfied over time or at a point in time. This assessment requires judgment and determines how and when revenue is recognized.
Transferring control may not always result in a customer's directly possessing the good. One example is bill-and-hold arrangements in which an entity bills a customer for a product but the entity retains physical possession of the product until it is transferred to the customer at a point in time in the future. Clients that have bill-and-hold arrangements will need to determine when they have satisfied their performance obligation to transfer a product by evaluating when a customer obtains control of that product. For a customer to have obtained control of a product in a bill-and-hold arrangement, all of the following four criteria must be met prior to recognizing revenue:
- The arrangement must be substantive.
- The product must be identified as separately belonging to the customer.
- The product must be ready for shipment.
- The entity cannot have the ability to use the product or direct it to another customer.
For example, assume a client's customer prepaid for products but didn't take delivery because of weather conditions. The client deals with bulk storage and cannot directly separate the product from the remaining inventory; however, they have processes to prevent selling the products to another customer. How should the client treat this scenario?
Based on the facts in the example and the criteria laid out, the client has a valid bill-and-hold arrangement that requires it to recognize revenue at the point at which the products are ready for shipment.
As private company auditors begin their engagements with clients having revenue subject to the new standard, consider common missteps identified from an analysis of PCAOB inspections reports and Peer Review Program data related to accounting estimates (Topic 606 was effective for most public companies a year or more prior to the effective date for private companies; for details of recent FASB actions delaying the effective date of Topic 606 for some private companies, see "FASB votes to delay revenue recognition effective date for private companies," May 20, 2020). Insights from the research demonstrate several areas where auditors were most challenged relative to the new standard, including procedures related to risk assessment, substantive procedures, and documentation.
Misstep No. 1: Risk assessment
A key to performing high-quality audit engagements is rooted in the auditor's risk assessment procedures. Peer Review data on issues related to AU-C Section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures, shows that auditors did not always consider the client's processes and controls related to the revenue transaction cycle. When performing risk assessment procedures, the auditor should obtain an understanding of the client's contract terms. Understanding the contract terms helps the auditor determine what the client expects to receive and provide. This also provides insight on how the requirements of Topic 606 should be applied.
To identify the risks of material misstatement, auditors will need to obtain an understanding of the procedures implemented by the client to meet the requirements of Topic 606. For instance, the auditor will want to assess the client's processes and controls implemented to determine whether all applicable contracts and contract modifications were identified. The auditor should also assess the procedures involved in identifying the different performance obligations. Did the client develop procedures and controls related to granting customer options? What is the process to determine whether options have material rights? The knowledge obtained from the risk assessment provides the basis for further audit procedures.
Misstep No. 2: Substantive testing
PCAOB inspections show that auditors performed insufficient test procedures relative to recognizing revenue where significant estimates are involved. AU-C Section 540, paragraph .12, requires auditors to determine whether:
- Management has appropriately applied the requirements of the applicable financial reporting framework relevant to the accounting estimate; and
- The methods for making the accounting estimates are appropriate and have been applied consistently and whether changes from the prior period are appropriate in the circumstances.
Auditors will need to understand the Topic 606 requirements as they design and perform procedures to test significant estimates affecting their client's financial statements. AU-C Section 540, paragraph .13, requires auditors to undertake one of more of the following in response to the assessed risks of material misstatements:
- Determine whether events occurring up to the date of the auditor's report provide audit evidence regarding the accounting estimate.
- Test how management made the accounting estimate and the data on which it is based, including significant assumptions used by management.
- Test the operating effectiveness of the controls over how management made the accounting estimate, together with appropriate substantive procedures.
- Develop a point estimate or range to evaluate management's point estimate.
Misstep No. 3: Documentation
Insights from Peer Review data relative to AU-C Section 540 indicate there are misconceptions around the documentation required for material accounting estimates. Auditors will need to recall AU-C Section 230, Audit Documentation, which requires auditors to prepare audit documentation that allows an experienced auditor having no previous connection to the audit to understand the procedures performed, the results of those procedures, and the conclusions reached. Auditors should consider the impact of the client's estimated revenue from contracts and determine if it is material to the financial statements. When contracts are material, AU-C Section 230, paragraph .10, states that auditors should include abstracts or copies of contracts or agreements in their audit documentation when audit procedures relate to the inspection of significant contracts or agreements.
These misconceptions all are important for practitioners to keep in mind as they start auditing clients under Topic 606.
Independence missteps related to revenue recognition
Independence issues may arise if auditors assist clients with implementing FASB ASC Topic 606, Revenue From Contracts With Customers. While some assistance activities are considered routine, you will need to be cautious about crossing a line that may lead to providing prohibited nonattest services.
Some auditors may believe they can develop a Topic 606 implementation plan and present the plan to their client's board of directors, which falls under the scope of management responsibility. Auditors should ensure that adequate safeguards of the "General Requirements for Performing Nonattest Services" interpretation (ET §1.295.040) are implemented when assisting clients. Clients should:
- Designate an individual who possesses suitable skills, knowledge, and expertise to understand the services performed in order to sufficiently oversee the activities.
- Assume all management responsibilities.
- Evaluate the adequacy and results of services performed.
- Accept responsibility for the results of the services.
Peer Review Program data shows instances where auditors did not evaluate the effect of multiple nonattest services provided to attest clients. The AICPA Code of Professional Conduct's "Cumulative Effect on Independence When Providing Multiple Nonattest Services" interpretation (ET §1.295.020) indicates that performing multiple nonattest services can increase the significance of threats to independence, which a member should evaluate using the "Conceptual Framework for Independence" interpretation (ET §1.210.010).
Before agreeing to perform multiple nonattest services for an attest client, the member should evaluate whether performing those services, in the aggregate, poses significant threats to independence (i.e., threats are not at an acceptable level). If threats are not at an acceptable level, the member should apply safeguards to eliminate the threats or reduce them to an acceptable level. Otherwise, independence would be impaired.
If the firm provides advisory services for Topic 606 beyond what is routine, it should consider how that service, in addition to other services such as tax or bookkeeping, affects independence.
About the authors
Deana Thorps, CPA, is a manager; Bob Dohrer, CPA, CGMA, is chief auditor; Kim Kushmerick, CPA, CGMA, is an associate director; and Toni Lee-Andrews, CPA/PFS, CGMA, is a director, all with the Association of International Certified Professional Accountants.
To comment on this article or to suggest an idea for another article, contact Ken Tysiac, the JofA's editorial director, at Kenneth.Tysiac@aicpa-cima.com.
- "Going Concern Tips for Auditors During the Pandemic," April 3, 2020
- "How Auditors Can Test Inventory Without a Site Visit," March 26, 2020
- "Remote Auditing Comes to Forefront During Pandemic," JofA, March 24, 2020
- Revenue Recognition: Audit and Accounting Guide (#AAGREV19P, paperback; #AAGREV19E, ebook; #WAR-XX, online access)
- Audit Staff Essentials: Experienced In-Charge/Senior — Auditing Revenue Recognition (#161351, online access)
- Interpreting the New Revenue Recognition Standard: What All CPAs Need to Know (#158064, online access)
- Revenue Recognition: Mastering the New FASB Requirements (#746324, text; #164244, online access)
- National Advanced Accounting and Auditing Technical Symposium (July 20—22) at ENGAGE Digital (July 20—24), aicpaengage.com
For more information or to make a purchase or register, go to aicpastore.com or call the Institute at 888-777-7077.