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Financial Reporting and the Law

The PCAOB recently issued Staff Audit Practice Alert No. 12, which outlines significant audit deficiencies relating to revenue that PCAOB inspections have identified. Although the alert, issued on September 9, focuses on steps that auditors should consider when auditing revenue, it also states the following with respect to audit committees: “Due to the significance of revenue to many companies’ financial and operating results, auditing revenue also raises matters of potential interest to audit committees. Audit committees might wish to discuss with their auditors their approach to auditing revenue, including the matters addressed in this alert.”

The alert notes that its guidance will also be applicable to the FASB’s new revenue recognition standard, which will be effective for fiscal years beginning after December 16, 2015. According to the alert, not only is “revenue . . . one of the largest accounts in the financial statements,” but revenue recognition is also one of the most frequent problems with financial statements. The alert states that 61% of the 347 companies involved in SEC accounting and auditing enforcement cases over a 10-year period recognized revenue inappropriately, primarily through fictitious revenue transactions or premature revenue recognition.

The audit steps intended to address the audit deficiencies involve (1) testing revenue recognition, presentation, and disclosure and (2) other aspects of testing revenue. We suggest that audit committees consider discussing with auditors the following topics, which are among the areas covered by the audit steps:

  • A company’s business, the different types of sales contracts, the primary terms and conditions of sales contracts, the existence of nonstandard contracts, and the number of locations in which the company operates. Understanding these items is crucial to understanding how the company accounts for revenue in accordance with GAAP.
  • A company’s role with its customer, that is, whether the company is a seller with the primary obligation to the customer or whether the company is acting as an agent, such as if the company earns a commission or a fee as an agent. GAAP requires a company to present revenue on a gross basis if it is a principal because of its primary obligation to the customer and on a net basis if it acts as an agent.
  • A company’s controls over the recognition of revenue, including the company's development of accounting estimates for revenue and controls designed to ensure that revenue is accounted for in the appropriate periods, and any risks that such controls may not be effective. Effective controls are crucial to the appropriate recognition of revenue. Auditors must have cutoff procedures designed to determine whether revenue transactions are recorded in the appropriate period and must test the controls to determine the extent to which they can rely on the controls.
  • A company’s disclosures about revenue recognition. Auditors must conduct steps to evaluate whether the financial statements include the required disclosures regarding revenue.
  • Any risks the auditors have identified that revenue could be intentionally misstated. Auditors must respond to risks of material misstatement because of fraud associated with revenue, including management override of controls, by performing substantive procedures to address such risk.
  • The analytical procedures that auditors use to test revenue because of the relevance of those procedures to the audit committee’s understanding of the company’s financial results.