FASB’s new revenue recognition standards are now effective, but how well will the new standard prevent fraud and abuse?
FASB had many goals in issuing the new Accounting Standards Codification Section 606, “Revenue Recognition from Contracts with Customers.” Concern about fraud was one of the original goals, but FASB also sought to remove inconsistencies in other guidance while providing a more comprehensive framework for addressing when and how revenue is recognized, and improving the usefulness and comparability of financial information. The new ASC 606 standard will change the way your company records revenue and structures deals and contracts. You will have to adopt the new rules to be in compliance with GAAP, so as not to jeopardize relationships with your bank, investors, and the stakeholders who rely on your financial statements.
ASC 606 was effective for annual reporting periods beginning after December 15, 2018, for non-public companies.
So what’s new? Increased disclosures and a core principle that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Companies will have to provide financial statement users with more information about the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The new standard will require both quantitative and qualitative information about assets recognized from the costs to obtain or fulfill a contract with a customer.
To improve the way companies account for revenue and deferred revenue, FASB established five criteria to filter out contracts that may not be valid or do not represent genuine transactions, and other variables of impact. Here is an outline:
1. Identify the contract: Does the contract establish enforceable rights and obligations with the customer? All parties must have approved the agreement and be committed to their obligations. Each party’s rights and payment terms must be identifiable, the agreement must have commercial substance, and collection must be probable. An entity should apply these requirements to each contract:
- Approval and commitment of the parties,
- Identification of the rights of the parties,
- Identification of the payment terms,
- The contract has commercial substance,
- It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.
Auditors will be looking to obtain persuasive evidence of whether there is a valid contract with a customer. Management will need to ensure that the controls over the contracting process provide assurance that contracts meet the above criteria and auditors will be testing those controls. Because contract terms may be implied by customary practices, auditors will need to understand an entity’s customary practices as well as both explicit and implicit contract terms. Auditors may also need to confirm with an entity’s customers the contract terms, approvals, acceptance, and written or oral side agreements.
Accounting guidance by itself cannot eliminate the risk of fake contracts, back-dated contracts, or undisclosed side agreements, but FASB’s specific requirements for evidence of contract existence should result in renewed attention to controls and procedures to provide reasonable assurance that revenue is recognized only on contracts that actually exist.
FASB states that accounting for a contract should depend on an entity’s rights and obligations rather than how the entity structures the contract. To address this FASB requires that contracts entered into at or near the same time must be combined when one or more of three criteria are met: negotiation as a package with a single commercial objective; price interdependence; and interdependence of promised goods or services. The new guidance should help identify contracts that must be combined, and identify contracts that are linked in substance but structured as separate legal contracts.
FASB has made clear that an entity should not recognize revenue for activities that it needs to perform which do not themselves explicitly transfer control of goods or services to the customer. Activities such as account setup or mobilization of resources may be necessary upfront, but they do not directly transfer goods or services to the customer.
The change is that assessing whether an entity has satisfied an identified performance obligation by transferring control of a promised good or service to the customer replaced the concept of assessing whether an entity has transferred an appropriate level of the risks and rewards of ownership of a good or service. FASB provided different types of criteria for performance obligations satisfied over time versus at a point in time. Frauds and abuses in which revenue was recognized prior to delivery of goods or services are a common means of prematurely or falsely recognizing revenue. Bill-and-hold schemes are common. Cutoff schemes recognize revenue for goods or services in the current period when they are delivered in the next reporting period. Similar fraud uncovered involved shipping goods to entities other than customers where they were parked until eventual sale or return.
Variables might include the effects of the time value of money if the timing of the payments agreed upon by the parties to the contract provides the customer or the entity with a significant benefit of financing for the transfer of goods or services to the customer. Another variable might be when a customer promises consideration in a form other than cash, an entity should measure the noncash consideration at fair market value. Lastly, if an entity pays, or expects to pay, consideration to a customer in the form of cash or items, such as a credit, a coupon, or a voucher that the customer can apply against amounts owed to the entity, the entity should account for the payment as a reduction of the transaction price or as a payment for a distinct good or service, or both.
For entities using contract accounting and recognizing revenue over time, a common fraud scheme has been to manipulate the measure of progress toward completion. Some entities have been known to overstate progress, inflate costs incurred, or understate costs.
Auditors will need to be thorough in identifying whether customary business practices result in uncertainties that will cause revenue to vary. Transactions will also have to be viewed from the customer’s perspective. Greater attention will be paid to uncertainties that may reduce revenue from the stated transaction price. Auditors will examine historical, current, and forecasted information available in order to estimate expected consideration.
Auditors will focus on validating contract terms, including those created by oral side agreements or implied by customary business practices. Validating the transfer of control will focus on the substance of making a transfer of control rather than the appearance of physical delivery. Auditors must assess rights to payment, legal title, physical possession, risks and rewards of ownership, and customer acceptance, rather than just the shipment of goods.
Improvements in guidance alone will never eliminate revenue frauds and recognition abuses, but careful attention to the new accounting guidance can make several types of fraud and abuse less likely. Management will need to implement and diligently monitor new policies, practices, and procedures to faithfully comply with the new guidance, while auditors will need to make modifications to risk assessments, audit planning, and audit approaches and procedures.
Tax Implications of Revenue Recognition Changes
The new revenue recognition standard will impact taxes in addition to financial reporting. Further IRS guidance is expected around questions related to the taxation of changes in estimates within the financial reporting framework; the treatment of advanced payments; and the taxation of amounts recognized in retained earnings.
It has been observed that when certain corporations adopted the revenue recognition standard it increased revenues when liabilities that would have been deferred revenue on the balance sheet were recognized all at once. Companies that see an acceleration of income tax due as a result of revenue recognition changes may require additional planning for income tax strategies, the timing of payments from customers, and more.
Some firms will have to change how they account for sales commissions, which qualify as a cost of obtaining contracts. Under ASC 606 sales commissions can be capitalized over the term of a contract, rather than expensed immediately. Deferred commissions will increase as an asset on the balance sheet, and the amortization costs will be expensed over the term of the contract.
Considerations for Management
The steps above are complex and will be a time-consuming endeavor for many companies that will require time and effort from both internal and external resources. Some questions for management to consider include:
- Are there existing personnel with the requisite skills to identify potential fraud risks?
- Will the company be able to identify potential control exceptions?
- If exceptions exist, is there a protocol in place for these to be addressed?
- What types of reporting requirements will result and how will any issues be remedied?
