The depth and breadth of FASB's enormously consequential revenue recognition standard presented challenges to auditors as well as those who prepare financial statements.
Feedback from peer reviewers demonstrates the areas related to revenue recognition that have caused the most difficulty for practitioners.
Many preparers and auditors received a bit of a reprieve when FASB granted a one-year effective date delay for certain companies and organizations applying FASB Accounting Standards Codification (ASC) Topic 606, Revenue From Contracts With Customers. Through this action, private companies and not-for-profit organizations that had not yet issued their financial statements (or made financial statements available for issuance) reflecting the adoption of Topic 606 were permitted to apply the standard for annual reporting periods beginning after Dec. 15, 2019, and for interim reporting periods within annual reporting periods beginning after Dec. 15, 2020.
But while some entities opted to defer implementation of Topic 606, many others continued their efforts with implementing the requirements of the standard. To learn where challenges exist for entities and their auditors, the AICPA conducted a survey of peer reviewers, asking them to identify the areas where their firm or their peer review clients have experienced challenges in auditing revenue recognition. Over 230 peer reviewers responded to the survey to share what they've seen or experienced relative to the new accounting standard. The biggest Topic 606-related challenges were identified as the following:
Assessing associated risks
Historical data from domestic and international practice monitoring programs indicates that assessing risk associated with revenue recognition is a common challenge for auditors. The recent peer reviewer survey supports this in that 21% of the respondents identified the assessment of a client's risks of material misstatement associated with recognizing revenue under Topic 606 as one of the top audit challenges. Further, peer review matters for further consideration (MFC) data also indicates that auditors are challenged with assessing client risks associated with Topic 606.
Auditors are required under AU-C Section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement, to identify and assess the risks of material misstatement in their client's financial statements by obtaining an understanding of the entity and its environment, including its internal control. In many cases, the client's environment and internal control were affected by the global coronavirus pandemic. There may be instances where controls changed early in 2020 to accommodate remote operations and virtual conditions.
A thorough understanding of the facts and considerations for the client's process aids the auditor in assessing the specific risks for that client and developing further audit procedures. For instance, with respect to revenue recognized under Topic 606, it will be important for auditors to obtain an understanding of the controls and procedures management uses to identify the contracts that meet the required criteria defined in each of the five steps described in the standard. When assessing risks, auditors can consider the areas where entities appear most challenged by the new accounting standard, such as identifying the performance obligations built into the contracts and period of recognition.
Certain risks rise to the level of a significant risk that warrants special audit consideration, including but not limited to risks of fraud and recent accounting developments. Recognizing revenue is a presumed fraud risk under AU-C Section 240, Consideration of Fraud in a Financial Statement Audit. Additionally, based on AU-C Section 315, Paragraph .29, auditors should carefully consider whether revenue recognition should be classified as a significant risk.
When designing audit procedures, auditors should be responsive to their client's specific risks, including those identified as significant risks. Paragraph .22 of AU-C Section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained, requires auditors to perform substantive procedures that are specifically responsive to the identified risks. If, in the auditor's professional judgment, revenue recognition is not considered a significant risk, the auditor should include the reasons for that assessment in their audit documentation. MFC data suggests that some auditors are not always complying with that documentation requirement, contained in AU-C Section 240, Paragraph .46.
Understanding of contracts
The first step of Topic 606 is to identify contracts with customers. To understand which contracts are subject to the new standard, auditors can ask management and staff how the company enters into contracts and agreements and how they determine which contracts are subject to Topic 606.
They can then consider the contracts in place and evaluate the key terms of those contracts to determine whether management appropriately applied Topic 606. Some key contractual terms auditors might focus on include, but are not limited to, contract duration, contract amount, and any modifications.
Auditors can also evaluate the terms of the contracts to determine if management properly identified the performance obligations built into each contract based on those key terms. Understanding these terms allows the auditor to assess the reasonableness of the revenue recognized by the client.
One important aspect of this process is to understand what is considered normal or customary for the client's industry, as this can also affect key contractual terms. Contracts can be written, oral, or implied by an entity's customary business practices, and the processes for establishing contracts with customers can vary. It is important to consider those practices and processes in determining whether and when an agreement with a customer creates enforceable rights and obligations. In performing substantive audit procedures around this, the use of confirmations may be helpful, as this allows the customer an opportunity to describe its understanding of the agreement with the audit client.
According to survey responses, 30% of peer reviewers found auditors were challenged with documenting their understanding of key contract terms where necessary. AU-C Section 230, Audit Documentation, requires auditors to prepare audit documentation that provides a sufficient and appropriate record of the basis for the audit opinion. Auditors are required 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. For audit procedures related to the inspection of significant contracts or agreements, auditors should include abstracts or copies of those contracts or agreements in their audit documentation.
Did management appropriately apply Topic 606?
Survey responses indicate that 48% of peer reviewers cited determining whether management appropriately applied Topic 606 as a current challenge. We also found that the Audit and Accounting Technical Hotline staff continue to receive calls regarding Topic 606 and how auditors should determine whether management appropriately applied the standard.
As auditors perform procedures to make this determination, it's important for them to understand that their clients may struggle in the following areas, based on insight from the peer reviewer survey:
- Identifying performance obligations: Entities may have introduced new obligations during the pandemic to alleviate some financial burden on their customers. For example, clients may have begun offering free shipping or delivery during the pandemic, and consideration may need to be assigned to those obligations.
- Variable consideration: Since the start of the pandemic, some clients may have experienced challenges in making accounting estimates, which affect the revenue that should be recognized for the period. Auditors can analyze relevant estimates, like those relative to the achievement of sales-volume-based bonuses, to determine whether they were realistic given the facts and circumstances.
- Period of revenue recognition: With the pandemic resulting in stay-at-home orders and office closures, some businesses may have seen a shift in the timeline for execution in their large-scale projects. When determining the appropriateness of a client's application of Topic 606, auditors can consider whether these projects were delayed and the impact, if any, on the period of revenue recognition.
By considering these factors, auditors are better positioned to determine if management properly recognized revenue based on the relevant facts and circumstances.
Evaluating management's process for developing estimate(s)
More than one in four (28%) of the surveyed peer reviewers found auditors were challenged when evaluating management's process for developing estimates. According to Paragraph .13 of AU-C Section 540, Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures, in responding to the assessed risks of material misstatement, auditors should undertake one or more of the following, taking into account the nature of the accounting estimate:
- 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.
- 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.
According to the survey responses, 23% of peer reviewers found that determining whether assumptions used by management were reasonable was also a challenge. AU-C Section 540, Paragraph .18, indicates that auditors should evaluate, based on the audit evidence, whether the accounting estimates in the financial statements are reasonable in the context of the applicable financial reporting framework or misstated.
The auditor's evaluation of management's assumptions is based only on the information that is available at the time of the audit engagement. For example, when evaluating the assumptions used by management, auditors will want to consider the pandemic's impact on the collectibility of a client's accounts receivable. With disruption of business operations affecting a number of entities and raising questions about their ability to continue as a going concern, some may be unable to pay for contracted services.
There could also be issues where an auditor's client is unable to complete its performance obligations, further affecting the amount of revenue recognized. For instance, an IT client may be responsible for completing maintenance on equipment every month, but office closures may have prohibited scheduled maintenance for some amount of time. It will be important for auditors to understand how management factored these issues into its estimates, as it directly impacts the amount of revenue recognized for the period.
A key point to remember is that the procedures used to evaluate management's assumptions are performed in the context of the audit and not for the purpose of providing an opinion on those assumptions. When evaluating the assumptions, auditors may consider whether the assumptions appear reasonable individually and if they are interdependent and internally consistent.
Keeping an eye on audit quality
As auditors work through their engagements, keeping these challenges in mind when performing engagements with revenue subject to Topic 606 requirements will help avoid audit quality issues and assure that they've complied with auditing standards applicable when considering revenue recognition. For additional guidance or resources, visit the AICPA's revenue recognition toolkit.
When designing audit procedures, auditors should be responsive to that client's specific risks, including those identified as significant risks.
About the author
Deana N. Thorps, CPA, is a manager 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.
"Revenue, Lease Accounting Still Challenge Private Companies," JofA, Aug. 19, 2021
"Not-for-Profit Auditors Face New Challenges Amid Pandemic," JofA, Jan. 27, 2021
"9 Tips for Successful Auditing of Revenue Recognition," JofA, Nov. 3, 2020
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This guide is essential for preparers and auditors involved with revenue recognition from contracts with customers, especially those working in any of 16 industry-specific areas that this guide addresses.
Created for the experienced in-charge/senior auditor, this module is aimed at helping you plan and perform test work in audits that meet current and upcoming accounting guidance regarding auditing revenues.
Learn how FASB's revenue recognition standard, as well as the grants and contracts standard, will affect NFP accounting for revenues.
Learn the five-step process for recognizing revenue under FASB ASC Topic 606. Supported with practical examples and disclosure illustrations, this webcast addresses core principles that all CPAs need to know.
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