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6 Audit Risks to Watch for with the New Revenue Recognition Standard

Oct. 31, 2017

Adopting the new revenue recognition standard introduced under ASC Topic 606 will be one challenge; being audited with the new standard will be another. The Public Company Accounting Oversight Board (PCAOB) has already identified some provisions of the revenue recognition standard that may be problematic for entities and their auditors.

Public business entities will be among the first adopters of the revenue recognition standard and must implement the changes at the beginning of the 2018 calendar year. In anticipation of the first financial statement audits that include the new revenue recognition standard, the PCAOB released Staff Audit Practice Alert No. 15: Matters Related to Auditing Revenue from Contracts with Customers. It highlights six provisions of the new revenue recognition standard that pose the greatest risk for audit deficiencies. Although the PCAOB directs the staff alert at auditors of the public sector, the audit risks will be similar for private business entities as well.

Transition Disclosures

Disclosures in the notes to their financial statements are required about the transition to the new standard. Some of the disclosures may be significant and therefore subject to more extensive substantive procedure testing. Auditors will also be looking for omitted, incomplete or inaccurate disclosures.

Companies should be particularly mindful of how they describe the implementation process and the anticipated effects of the new standard on the company's financial statement. The PCAOB alert also encourages auditors to carefully review any interim financial statement disclosures, including whether the interim disclosures agree with management report to the audit committee about the anticipated effects of the new revenue recognition standard.

Transition Adjustments

Entities have two options for transitioning to the new standard: they can use the full retrospective method or the modified retrospective method. Under the full retrospective method, entities will recast all prior periods presented in the financial statements as if the standard had been applied during those years. Under the modified retrospective method, entities will disclose how adopting the standard affected each line item along with explanations of significant changes between reported results and what would have been reported under previous accounting guidance.

Auditors will be paying particular attention to whether the transition and resulting change in accounting method was appropriately applied, including whether practical expedients were used correctly.

Internal Controls over Financial Reporting

The new standard may change how an entity has traditionally recognized revenue, which may require updates to processes and systems gathering contract data. Additionally, the new standard may require the use of estimates where estimates were not previously used, and the entity may also need to implement changes over financial statement disclosures.

Prior to the financial statement audit, entities may want to walk-through the updates they made to internal controls with their auditor so the author understands the flow of transactions and the relevant controls in place.

Auditors will be paying particular attention to controls over revenue, especially if your organization has any controls over revenue that are manually performed by your management team. If spreadsheets are used for any part of the process, for example, that might be a focal point for auditors because manual controls, by their nature, leave more potential for error.

Identifying and Assessing Fraud Risk

The potential for fraud may increase under the new revenue recognition standard with new fraud risks existing related to the evaluation of the transition adjustment to the new standard and increased fraud risks over ongoing revenue recognition process.

For instance, estimates and significant judgments come into play with the standard, particular for contracts with variable consideration or when management is determining the standalone selling price of a separate performance obligation. Auditors will be taking a close look how estimates and judgments were reached, so extensive documentation of the process and data used to create estimates is highly recommended. Fraud could occur if the standalone selling price or variable consideration is purposefully set at too high of an amount.

The new standard also carries a risk of fraud if performance obligations are improperly identified so that revenue is accelerated or deferred. Auditors will be paying particular attention to performance obligations and how the organizations determined which ones would be recognized at a point in time versus over time.

Recognizing Revenue in Conformity with the Financial Reporting Framework

PCAOB staff has frequently observed deficiencies with how auditors test the recognition of revenue. In its alert, it encourages auditors to understand contractual arrangements before applying auditing estimates or substantive analytical procedures. Specifically, auditors will be looking to know:

  • How performance obligations are identified, including whether the company is acting as a principal or an agent
  • How the company determines the transaction price and estimates variable consideration
  • How the transaction price is allocated in determining the standalone selling price
  • When a performance obligation is satisfied and thus, the period in which revenue should be recognized
  • What assets should be recognized from the costs to obtain or fulfill a contract with a customer

Entities will want to make sure their reporting makes those questions as easy for their auditors to understand as possible.

Revenue Disclosures

Another common deficiency area relates to revenue disclosures. The PCAOB has found audit deficiencies where revenue was inappropriately disclosed in financial statements. Under the new standard, entities will want to make sure they have accurate disclosures about revenue recognized from contracts with customers, broken into categories by type of contract. They'll also want to clearly state contract balances, including opening and closing balances of receivables, contract assets and contract liabilities. Performance obligations will also be closely examined as well significant judgments made in applying requirements to the contract. Costs related to fulfilling or obtaining the contract will need thorough explanation as well.

How to Prepare for Revenue Recognition Audit Risks

Prior to adopting the standard, entities may want to meet with their audit team or with another knowledgeable resource that can walk through how the standard may affect current processes and practices for contracts. Understanding the changes needed under the new standard is one of the best defenses against financial reporting deficiencies. For comments, questions or concerns about the revenue recognition standard, please contact Mark Winiarski of MHM's Professional Standards Group.

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