FASB’s new revenue recognition standard and the coronavirus pandemic are presenting dual challenges for auditors of private company financial statements.
The standard itself requires numerous new judgments, estimates, and disclosures that require close auditor attention to some of the most important metrics that their clients report.
The pandemic makes auditing revenue recognition even more difficult because companies’ operations, processes, and controls have changed in many cases.
These tips can help practitioners succeed amid all this difficulty.
Be sure your client really did the work. Some clients won’t want to go through the complicated, five-step revenue recognition process, particularly if they believe there won’t be an impact on their financial statements.
But if they want their financial statements to conform with GAAP, they need to faithfully go through this exercise.
“I would try to tell my clients, ‘You’ve got to show your work. How do you know there’s not an impact if you don’t actually take a contract and walk through the five steps of the standard?’” said Stephanie Markert, CPA, a principal in the National Assurance Technical Group at CLA in Minneapolis.
Julie Killian, CPA, a shareholder who leads the Advisory & Assurance practice at Clayton & McKervey in Southfield, Mich., said some of her clients who went through the process ended up appreciating the insight they gained into their processes and controls over contracts.
But when clients dug in their heels and refused to go through the process, she encouraged them to meet with their stakeholders, consider their long-term goals for their company, and decide if they might be better off switching to a non-GAAP accounting framework such as the AICPA’s Financial Reporting Framework for SMEs.
Maintain professional skepticism while having empathy. This is a difficult task that requires delicate people skills.
The challenges created by the new standard and the pandemic demand vigilance and scrutiny from auditors. At the same time, auditors need to understand that their clients may be struggling.
“Increasing our professional skepticism during this time [is important],” Markert said. “At the same time, we do have empathy. We do understand that it’s difficult for everyone in this time. I think it’s going to be a balance, trying not to lose that professional skepticism in the midst of a pandemic as we have to ask these questions.”
Start early on reading and understanding contracts. The first two steps in the five-step revenue recognition process require identifying the contract with a customer and identifying the performance engagements in the contract.
Familiarity with the contracts gives auditors a head start on all the work that is to follow. Killian, for instance, had some clients show her purchase orders that they thought were contracts, when actually the purchase orders were governed by a master supply agreement that needed to be provided.
“I can’t emphasize that enough, because there’s so much in those contracts that drive management’s decisions about rev rec,” Killian said. “You really have to understand all parts of the contract, whether the contract is written or unwritten.”
Understand the company, its processes, and controls over revenue recognition. In any audit, it’s important to understand the client, its business model, and the industry it operates in.
It won’t be enough to spend time with the client’s finance department. Auditors should visit with people in other departments who negotiate contracts and fulfill orders to understand important processes.
“You can get insight into business practices that may be totally different from what someone in the accounting department thinks they are,” Killian said.
Carefully analyze when control transfers. Markert has short-term manufacturing clients that typically recognized revenue when they shipped a product to the customer.
She encouraged them to think carefully about when control transfers if the product is manufactured and sitting in the client’s warehouse, but the customer wasn’t ready to take delivery yet.
Auditors also need to make sure that clients that recognize revenue on a percentage-of-completion basis gathered information and documentation on the status of their projects.
“Accounting systems aren’t normally set up to do that, so [the client] may have to get special reports on all outstanding projects and work in process at the end of the period, for example,” she said.
Determine separate or distinct from a customer’s perspective. A contract that might seem to contain separate performance obligations might have just one if the client agreed to deliver just one project, good, or service.
“Things would not be distinct if it all had to go together to make up the promised good or service,” Killian said. “That’s something that’s really important to get your arms around, is understanding really what the promised good or service was. What did the customer agree to buy?”
Variable prices demand extra attention. Clients that use variable pricing based on quantity of items purchased or discounting may have difficulty determining and allocating the transaction price.
Sales returns and allowances also may need to be considered in determining the transaction price. Auditors need to consider how the transaction price was developed, Killian said.
“The most complex thing for the auditors is looking at management’s estimates and, if you have to, doing a lookback to see if their assumptions that went into these estimates seem to be biased at all,” Killian said.
Prepare for pandemic-related judgment questions. The revenue recognition standard is principles-based, so it relies a lot on new judgments and estimates to begin with.
These judgments and estimates will be more difficult to evaluate as a result of the pandemic. Rights and options that might have seemed enforceable under normal conditions might be less so when businesses and customers are economically damaged by the pandemic.
Companies are dealing with various concessions, decreases (and sometimes increases) in goods or services to be delivered, changes in minimum purchase commitments, and new questions about whether collection is probable. Significant financing components also may become more common.
The rules for accounting for these issues have not changed, but auditors will need to be more vigilant in watching out for them and verifying that the accounting is performed correctly.
“There are a lot of things that are going to come up because of COVID-19 that are going to be added on to your normal auditing of revenue recognition,” Killian said.
Make sure disclosures are client-specific. One key feature of the revenue recognition standard was the requirement for disclosures that provide users of financial statements with comprehensive information on the critically important process of revenue recognition.
As a result, disclosures may vary significantly between industries, and private companies may find that their disclosures need to be different from those of the public companies whose financial reports they study as they prepare their own financials. Auditors need to make sure they understand which disclosures are appropriate.
“I think there’s an enormous amount of education that has to go on within your own staff on this standard,” Killian said.
For more information and resources on revenue recognition, visit aicpa.org/revenuerecognition.
— Ken Tysiac (Kenneth.Tysiac@aicpa-cima.com) is the JofA’s editorial director.