Traditionally, audit procedures for private companies tend to focus on the balance sheet. That is, auditors evaluate whether the book values of the company’s assets are overstated and its liabilities are understated. However, the income statement needs attention, too, especially in light of the updated guidance on recognizing revenue from contracts and the potential for misstatement.
New guidance in effect
In 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. The revenue recognition standard erases reams of industry-specific accounting guidance and provides a five-step model for recognizing revenue for most businesses worldwide. The updated guidance went into effect in fiscal year 2018 for public companies and in fiscal year 2019 for private ones.
In many cases, the revenue a company reports under the new guidance won’t differ much from what is reported under the old rules. But the timing of when a company can record revenues may be affected, particularly for long-term, multi-part arrangements. The result is a recognition process that offers fewer bright-line rules and more judgment calls compared to the old rules.
Potential for misstatement
For many companies, revenue is one of the largest financial statement accounts. It has a major effect on operating results and presents a significant fraud risk.
According to the Committee of Sponsoring Organizations (COSO) of the Treadway Commission, improper revenue recognition is the most common method used to falsify financial statement information. Common methods of improperly boosting revenue include creating fictitious transactions or recording revenue prematurely. The risk of material misstatement — either due to fraud or unintentional error — is particularly high as companies implement ASU 2014-09.
Audit procedures that are relevant for testing revenue vary from company to company. Expect your auditors to ask questions about your company, its environment, and its internal controls. This includes becoming familiar with its key products and services and the contractual terms of its sales transactions. With this knowledge, the auditor can identify key terms of standardized contracts and evaluate the effects of nonstandard terms.
For instance, with construction-type or production-type contracts, auditors might test:
- Management’s estimated costs to complete projects,
- The progress of contracts,
- The reasonableness of the company’s application of the percentage-of-completion method of accounting,
- Whether each deliverable represented separate units of accounting, and
- The value assigned to undelivered elements.
Auditors also must evaluate accounting cutoffs to decide whether the company recognized revenue in the correct period. A typical cutoff procedure might involve testing sales transactions by comparing sales data for a sufficient period before and after year end to sales invoices, shipping documentation, or other evidence. This helps auditors determine whether revenue recognition criteria were met and sales were recorded in the proper period.
A custom approach
Contact us to discuss revenue testing approaches given the risks associated with revenue reporting and the recent changes to accounting standards for revenue recognition. We can help you get it right.