Auditors and government agencies have given a wide latitude when it comes to enforcement of ASC 606 and IFRS 15 accounting guidelines. But signs point to that grace coming to an end. Tom Zauli of Softrax says companies would be wise to plan for stricter oversight in the near-term.
Since the ASC 606 and IFRS 15 guidelines were announced by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) in May 2014, there has been a soft touch by auditors and others in enforcing some of the more complex parts of the guidance.
Judging by the recent rise in SEC activity, this reticence by auditors and government agencies may be ending. Moreover, the percentage of major deficiencies found by the Public Company Accounting Oversight Board (PCAOB) in inspection audits reached a whopping 40% in 2022, up from 34% in 2021 and 29% in 2020, with 43% related to revenue and related accounts. A review of these actions in 2022 against reporting and other accounting irregularities should be an alert to all companies that they should evaluate and affirm compliance with the ASC 606 and IFRS 15 guidelines.
What is ASC 606 and IFRS 15?
FASB and IASB developed the guidelines as a five-step model for revenue recognition that could be used across all industries. The core of ASC 606 and IFRS 15 lies in its five steps that tie revenue recognition to various parts of the customer contract:
Identify the contract
This step includes evaluating whether the contract creates enforceable rights and obligations and whether it has commercial substance. Where contract identification can get tricky under ASC 606 is when upgrades or the chance to buy additional products or services are included for long-standing company or client relationships.
Identify the performance obligations
Performance obligations mean the promises of a good or service provided to a customer. With complicated contracts, companies need to define performance obligations carefully, making sure that each good or service can stand in its own performance obligation, so that revenue can be recognized properly.
Determine the transaction price
This involves estimating the net revenue expected for each contract term, and it seems straightforward. Where this step gets difficult is when rebates or discounts are introduced.
Allocate the transaction price
The objective is for an entity to allocate the transaction price to each performance obligation (or distinct good or service) in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer.
Recognize revenue when or as the entity satisfies a performance obligation
This step determines that a good or service is transferred when the customer obtains control.
ASC 606 is straightforward, but it can vary from past accounting practices, and companies implementing these compliance standards may find disparities with their previous practices that can affect the bottom line. Alternatively, they may find that ASC 606 compliance becomes more complex when tied with service offerings.
SEC activity regarding accounting and auditing
Although SEC actions involving accounting and auditing enforcement initiated by the SEC in Fisal Year (FY) 2022 increased by 55% from FY 2021, the numbers are still below pre-pandemic levels. It is generally believed that the SEC and auditors took a softer approach to ASC 606 and IFRS 15 auditing during the Covid-19 pandemic, especially for private companies, given the unique nature of the pandemic and the associated economic fallout. Companies, both public and private, should be prepared to have revenue recognition adhere to ASC 606, which is a generally accepted accounting principle.
Using the Cornerstone Research report “SEC Accounting and Auditing Enforcement Activity Year in Review: FY 2022” as a guide, we see that of the 68 actions undertaken by the SEC in 2022, 36 referred to announced restatements of financial statements. Of note, 69% of those 36 restatements alleged improper revenue recognition, which is a sharp increase over the prior fiscal year when only 40% referred to a restatement also alleged improper revenue recognition.
What makes 2022 different from other years is a difference in some actions by the SEC. The Harvard Law School Forum on Corporate Governance noted, “some shifts in the SEC’s enforcement priorities and strategy,” including increased penalties, a drive for faster investigations and a focus on cooperation credit and individual accountability. Some of the SEC proposed orders involved working with compliance professionals, including:
- A mining company was ordered to retain a compliance consultant to review its disclosure controls.
- After settling charges that it failed to abide by professional standards in the audits of two companies later accused of accounting fraud, an audit firm agreed to retain a compliance consultant to review its audit and quality control standards.
What can companies do?
The obvious solution is to mirror your revenue recognition practices to the ASC 606 and IFRS 15 accounting guidance, potentially with the help of outside compliance or accounting teams if there are areas that are unfamiliar. Companies that must follow the allocation process outlined in Step 4 may get particularly bogged down in adhering to the full guidance, given the complexity of this step and the potential need to follow the associated contract combination and modification portion of the guidance. Any company selling multiple line items with a significant discount is likely to fall under this guidance. Companies that sell based on consumption, like many of the SaaS companies out there, may also need to follow the variable consideration portion of the guidance, which also can get quite complex.
Contract renewals can provide up to 90% of a company’s revenue, so insight into recurring revenue, identifying possible new revenue streams and surfacing areas in which customer churn is occurring are essential. Contract renewals also have a number of tie-ins to the ASC 606 standards. To comply with ASC 606 for contract renewals, a company should do all it can to ensure its access to financial data in an automated fashion so that it sees necessary actions to take and places to record revenue. There are a number of scenarios that can be tricky with ASC 606, such as discounted rates for early renewals or if the renewal covers a number of products and services.
Subscription and usage-based billing are areas that have enriched many companies but also touch the most complex areas of ASC 606 and IFRS 15. The complexities include receipt of consumption metrics and fulfillment metrics. Ideally, companies will set up the recording of these metrics within their overall revenue management system and not have a secondary reporting mechanism, such as an Excel spreadsheet to record the billing metrics. The reason for this is any secondary system adds time to getting the correct data and potentially introduces human error. In fact, PwC estimates that business partners still spend about 30% of their time collecting data and reconciling it between systems.
In conclusion, given both the SEC’s recent moves and the desire of most companies to have the most detailed revenue recognition snapshot possible, the time is now to either start using the five steps in ASC 606 or to review how effective a company’s current compliance efforts are. Companies should also look to have data in one system so that reporting can be streamlined and reduce human error. A review of revenue recognition and accounting practices considering ASC 606 or IFRS 15 compliance can provide a company with a valuable health check of its finances. Finally, getting the processing done in one system will save time and resources in the long run.