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PCAOB Issues Practice Alert Related to Auditing Revenue - Protiviti Flash Report

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Last week, the PCAOB issued Staff Audit Practice Alert No. 12, which addresses significant audit deficiencies in which auditors, as noted by PCAOB Inspections staff, did not perform sufficient auditing procedures with respect to revenue. In its practice alert, the PCAOB highlights certain requirements of PCAOB standards relating to aspects of auditing revenue that address these significant auditing deficiencies.

We have issued a Flash Report summarizing the key areas addressed in the PCAOB’s practice alert. These issues apply not only to external audit firms, but also many client issuers who must respond and react to changing external auditor requests resulting from the PCAOB’s guidance.

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PCAOB Issues Practice Alert Related to Auditing Revenue - Protiviti Flash Report

  1. 1. PCAOB FLASH REPORT PCAOB Issues Practice Alert Related to Auditing Revenue September 16, 2014 Last week, the Public Company Accounting Oversight Board (PCAOB) issued Staff Audit Practice Alert No. 12 to address significant audit deficiencies noted by PCAOB Inspections staff in which auditors did not perform sufficient auditing procedures with respect to revenue. Due to these significant auditing practice issues, this practice alert highlights certain requirements of PCAOB standards relating to aspects of auditing revenue that address these significant auditing deficiencies. Although PCAOB requirements apply to external audit firms, it is frequently the case that such issues become relevant for client issuers who must respond and react to changing external auditor requests that arise therefrom. We are summarizing the particulars of this practice alert because it affects a pervasive area that is undergoing transition in the underlying accounting standards. The practice alert discusses the following topics, and related significant deficiencies, regarding auditing revenue: Testing Revenue Recognition, Presentation, and Disclosure • Testing the recognition of revenue from contractual arrangements • Evaluating the presentation of revenue – gross versus net revenue • Testing whether revenue was recognized in the correct period • Evaluating whether the financial statements include the required disclosures regarding revenue Other Aspects of Testing Revenue • Responding to risks of material misstatement due to fraud ("fraud risks") associated with revenue • Testing and evaluating controls over revenue • Applying audit sampling procedures to test revenue • Performing substantive analytical procedures to test revenue • Testing revenue in companies with multiple locations This development is of significance to audit clients because, as stated earlier, Staff Audit Practice Alerts highlight new, emerging, or otherwise noteworthy circumstances that may affect how auditors conduct audits under the existing requirements of the standards and rules of the PCAOB and relevant laws. While the statements contained in Staff Audit Practice Alerts do not establish rules of the Board and do not reflect any Board determination or judgment about the conduct of any particular firm, auditor, or any other person, they nonetheless can increase the emphasis auditors place on areas they address. Staff Audit Practice Alert No. 12 may be found at http://pcaobus.org/Standards/QandA/9-9- 14_SAPA_12.pdf.
  2. 2. Protiviti | 2 Testing Revenue Recognition for Contractual Arrangements With respect to various types of contractual arrangements, the PCAOB Inspections staff noted instances in which auditors failed to perform sufficient procedures to evaluate whether a company's revenue recognition conformed to the requirements of the applicable financial reporting framework. Following are illustrative examples of instances noted by PCAOB Inspections staff: • Auditors failed to perform sufficient procedures to evaluate whether the revenue under a company's contractual arrangements was recognized appropriately. Inspections staff noted instances where the auditors did not perform sufficient procedures to review the company's contracts and as a result did not sufficiently understand the contractual terms and conditions, such as transfer of title, risk of loss and delivery and acceptance terms. • Auditors identified sales contracts whose terms or conditions varied from the company's standard contract language, yet the auditors failed to evaluate the effect of such nonstandard contractual terms on the recognition of revenue. • With respect to construction-type or production-type contracts, auditors failed to perform audit procedures to: (1) test management's estimated costs to complete projects; (2) test the progress of the construction or production contracts; or (3) evaluate the reasonableness of the company's approach for applying the percentage-of-completion method of accounting. • With respect to multiple-element contractual arrangements, auditors failed to perform procedures to evaluate the company's recognition of revenue derived from transactions involving the delivery of multiple elements in accordance with the requirements of the applicable financial reporting framework. Examples of deficiencies observed by Inspections staff included the auditors' failures to (1) evaluate each of the deliverables to determine whether they represented separate units of accounting; and (2) test the value assigned to the undelivered elements (for example, allocation of relative selling price based on vendor-specific objective evidence, third-party evidence or best estimate of selling price). Revenue recognition often involves accounting estimates, such as estimates of future obligations under the terms of sale in the contract. The practice alert states that, if the accounting estimate is a fair value measurement, the auditor should apply the requirements of AU Section 328, Auditing Fair Value Measurements and Disclosures. For other estimates, the auditor should apply the requirements of AU Section 342, Auditing Accounting Estimates, e.g., when auditing accounting estimates used to record revenue in transactions involving seller performance obligations. In evaluating the reasonableness of an estimate, the auditor is required to obtain an understanding of how management developed the estimate. Based on that understanding, the auditor should use one or a combination of the following approaches: • Review and test the process used by management to develop the estimate; • Develop an independent expectation of the estimate to corroborate the reasonableness of management's estimate; or • Review subsequent events or transactions occurring prior to the date of the auditor's report.
  3. 3. Protiviti | 3 Evaluating Presentation of Revenue Inspections staff observed instances in which auditors failed to perform sufficient procedures to evaluate whether a company's presentation of revenue on a gross basis (as a principal) versus a net basis (as an agent) was in conformity with the applicable financial reporting framework. More specifically, deficiencies were observed in which auditors failed to evaluate whether the company is a seller that has the primary obligation to the customer or the company is a seller that is acting in the capacity of an agent, and to evaluate the effect that determination would have on the presentation of revenue. The auditor's evaluation of audit results is required to include an evaluation of, among other things, the presentation of the financial statements. This includes the auditor's evaluation of whether revenue is presented in conformity with the applicable financial reporting framework. When understanding the contractual terms of sales, the practice alert states that it is important for the auditor to evaluate whether the company is the principal or the agent in the transaction in order to evaluate the presentation of revenue relative to whether gross or net revenue is appropriate. Testing Revenue Recognition Cut-Off Inspections staff observed instances in which auditors failed to perform, or sufficiently perform, procedures to test whether revenue was recognized in the correct period (so-called "cutoff procedures"). For example: • Cutoff procedures were not performed to address the risk of material misstatement; • Evidence was not obtained about whether the necessary delivery of goods had occurred or service had been rendered to enable the company to record revenue appropriately in the current period; and • Inappropriate reliance on untested company-generated information, such as sales invoices or inventory records, to determine whether revenue was recorded in the appropriate period. When designing and performing cutoff procedures, the practice alert asserts that auditors should plan and perform audit procedures that address the risk of an improper cutoff. It is important for cutoff procedures to encompass testing of revenue recorded in the period covered by the financial statements and revenue recorded in the subsequent period. To illustrate, a typical cutoff procedure is to test sales transactions by comparing sales data for a sufficient period before and after year-end to sales invoices, shipping documentation, or other appropriate evidential matter, to determine that the revenue recognition criteria were met and the sales transactions were recorded in the proper period. Evaluating Revenue-Related Disclosures Inspections staff observed instances in which auditors did not evaluate whether the disclosures of revenue in the financial statements were in conformity with the applicable financial reporting framework. The staff observed instances in which firms did not evaluate whether the company's disclosures regarding its revenue recognition policy regarding multiple-element arrangements and warranty policies were in conformity with U.S. Generally Accepted Accounting Principles (GAAP). In one instance, the auditor failed to identify the company's omitted disclosures regarding the revenue recognition policies for the company's new line of business. As part of obtaining an understanding of the company's selection and application of accounting principles, including related disclosures, PCAOB standards require the auditor to evaluate whether the company's selection and application of accounting principles are appropriate for its business and consistent with the applicable financial reporting framework and accounting principles used in the relevant industry. To
  4. 4. Protiviti | 4 identify and assess risks of material misstatement related to omitted, incomplete, or inaccurate disclosures, the auditor should develop expectations about the disclosures that are necessary for the company's financial statements to be presented fairly in conformity with the applicable financial reporting framework. Other Matters Relating to Testing Revenue PCAOB standards require the auditor to design and perform audit procedures in a manner that addresses the assessed risks of material misstatement for each relevant assertion of each significant account and disclosure, including revenue. In designing the audit procedures to be performed, the auditor is required to: (1) obtain more persuasive audit evidence, the higher the auditor's assessment of risk; (2) take into account the types of potential misstatements that could result from the identified risks and the likelihood and magnitude of potential misstatement; and (3) in a financial statement audit, design the tests of controls over revenue to obtain sufficient evidence to support the auditor's control risk assessments when the auditor relies on controls. As the assessed risk of material misstatement increases, the evidence from substantive procedures that the auditor should obtain to test revenue also increases. The evidence provided by the auditor's substantive procedures depends upon the mix of the nature, timing, and extent of those procedures. There were other areas where the PCAOB’s Inspections staff frequently observed significant deficiencies in the auditing procedures applied to revenue. These areas include responding to risks of material misstatement due to fraud associated with revenue, testing and evaluating controls over revenue, applying audit sampling procedures to test revenue, performing substantive analytical procedures to test revenue and testing revenue in companies with multiple locations. The message is the same in each area – the auditor did not perform sufficient work in the instances cited by the inspections process. Implications to Audit Clients New Accounting Rules Looming The Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers 1 , earlier this year. The new standard is expected to be effective for public entities for fiscal years, including interim periods within those years, beginning after December 15, 2016. 2 It affects any entity that enters into contracts with customers unless those contracts are in the scope of other FASB standards. 3 As the U.S. GAAP and IFRS convergence raises numerous questions for companies as they transition to the new rules, management of public companies are advised to invest time now to assess the impact of these changes on the organization to identify and prioritize accounting, reporting and other infrastructure issues that require attention. Protiviti has issued a Flash Report on these new revenue recognition standards. 4 1 The new standard is Topic 606 in FASB’s Accounting Standards Codification. 2 For nonpublic entities, the standard is expected to be effective for fiscal years beginning after December 15, 2017, and interim periods thereafter (although nonpublic entities may adopt at the same time as public entities). 3 For example, insurance contracts or lease contracts – and lease accounting is the subject of the next expected converged standard. 4 See Protiviti Flash Report, “It’s Here, Are You Ready? – Transitioning to the New Revenue Recognition Standard,” www.protiviti.com/en-US/Documents/Regulatory-Reports/General-Business/Protiviti-Flash-Report-New-Revenue- Recognition-Standard-060214.pdf.
  5. 5. © 2014 Protiviti Inc. An Equal Opportunity Employer M/F/D/V. Protiviti is not licensed or registered as a public accounting firm and does not issue opinions on financial statements or offer attestation services. PCAOB Inspection Results Relate to Current Rules The PCAOB staff’s practice alert “doubles down” on revenue recognition, alerting auditors of deficiencies noted in PCAOB inspections in the revenue area even under current accounting rules. For audit clients, this development may mean increased auditor attention. Thus, in dealing with the new revenue accounting standard, appropriate organizational personnel need to get educated as to its impact on top- line reporting and disclosure and determine the required (1) development and/or modification of policies and procedures, (2) redesign of accounting and reporting processes, IT and ERP system controls updates or improvements, and (3) program, project and change management issues, among other areas. For public companies, getting started with planning and implementing the transition is important because of the likely increased auditor scrutiny of the revenue recognition transition process. Summary Revenue is one of the largest accounts in the financial statements and is an important driver of a company's operating results. Because of the importance of auditing revenue and the new accounting standard, we can expect it will be an area of increased focus in PCAOB inspections of registered firms. Companies will want to get ahead of the curve in transitioning to the new revenue accounting standard as they can anticipate the possibility of being subject to more stringent auditing from the accounting firms in this area. About Protiviti Protiviti (www.protiviti.com) is a global consulting firm that helps companies solve problems in finance, technology, operations, governance, risk and internal audit, and has served more than 40 percent of FORTUNE 1000 ® and FORTUNE Global 500 ® companies. Protiviti and its independently owned Member Firms serve clients through a network of more than 75 locations in 25 countries. The firm also works with smaller, growing companies, including those looking to go public, as well as with government agencies. Protiviti is a wholly owned subsidiary of Robert Half (NYSE: RHI). Founded in 1948, Robert Half is a member of the S&P 500 index. Contacts Christopher Wright +1.212.603.5434 christopher.wright@protiviti.com Steve Hobbs +1.415.402.6913 steve.hobbs@protiviti.com Robert Gould +1.212.708.6354 robert.gould@protiviti.com Charles Soranno +1.732.326.4518 charles.soranno@protiviti.com

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