Now that both public and private companies have adopted the revenue recognition changes under ASC Topic 606, private companies will be gearing up for their next challenge: their audit. The first financial statement audit under the new standards may come with some additional questions and considerations, as public companies and their regulators demonstrated when public companies went through the adoption in 2018. The following are some provisions of the revenue recognition standard that may be problematic for private entities and their auditors.

Transition Adjustments

Your organization has two options for transitioning to the new standard: you can use the full retrospective method or the modified retrospective method. Under the full retrospective method, your organization will recast all prior periods presented in your financial statements as if the standard had been applied during those years, but you may elect several practical expedients to simply the transition.

Under the modified retrospective method, your organization can elect to apply the guidance only to contracts that are not complete at the date of initial application or to all contracts.

Auditors will be paying particular attention to whether the transition adjustments were applied appropriately, which practical expedients were applied and whether they were applied consistently, and that you appropriately applied the resulting change in accounting method.

Transition Disclosures

Disclosures in the notes to your 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.

A majority of companies elect to use the modified retrospective transition method. The retrospective transition method requires you to disclose the impact of changes to financial statement line items resulting from ASC Topic 606. If you chose the modified retrospective transition method, you will need to be thorough with your disclosures. Auditors will be paying close attention to the completeness and accuracy of these disclosures for any impacts that may occur due to the adoption of ASC Topic 606, as well as, costs to obtain contracts and costs to fulfill contracts discussed in ASC Subtopic 340-40.

Internal Controls over Financial Reporting

The new standard may change how your organization 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 you may also need to implement changes over financial statement disclosures.

Prior to the financial statement audit, you may want to walk-through the updates you made to internal controls with your auditor so your auditor 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 your management team manually performs. If your organization uses spreadsheets 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. Adoption brings new fraud risks related to your organization’s evaluation of the standard’s transition adjustment and your organization’s ongoing revenue recognition process.

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

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

Recognizing Revenue in Conformity with the Financial Reporting Framework

Public company regulators observed deficiencies with how auditors test the recognition of revenue. Auditors have been pressured 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 you are acting as a principal or an agent
  • How your 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 the period in which revenue should be recognized
  • How revenues are measured when revenue is recognized over time
  • What assets should be recognized from the costs to obtain or fulfill a contract with a customer

Your organization will want to make sure its reporting makes those questions as easy for your auditors to understand as possible.

Revenue Disclosures

Another common deficiency area public companies encountered relates to revenue disclosures. Public companies experienced a high number of regulator comments indicating their revenue disclosures in their financial statements were unclear or incomplete. Although private companies may elect out of a large number of the disclosures that were challenging for public companies, there are still many disclosures required that will be under a higher level of scrutiny by your auditors in the first few years of application.

For instance, under the new standard, your organization will want to make sure you have accurate disclosures about revenue recognized from contracts with customers. For private companies, this includes breaking down revenues correctly by performance obligations recognized over time and at a point in time.

Your organization will also want to pay close attention to the presentation of accounts receivable, contract assets, and contract liabilities. With the adoption of ASC Topic 606 entities will need to make sure all items classified as accounts receivable meet the new definition of an accounts receivable, and also properly net contract assets and liabilities on a contract by contract basis.

Another, topic of concern will be properly identifying, classifying and disclosing costs related to fulfilling or obtaining the contract.

How to Prepare for Revenue Recognition Audit Risks

Prior to undergoing the first financial statement audit under revenue recognition, CFOs 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. A complete guide to the ASC Topic 606 standard can be found here. For other comments, questions or concerns about the revenue recognition standard, please contact us.

Why Change Auditors

Published on January 28, 2020