In September 2014, the Public Company Accounting Oversight Board (PCAOB) issued Staff Audit Practice Alert No. 12, Matters Related to Auditing Revenue in an Audit of Financial Statements. It released the alert because of concern about the frequency with which its inspectors were observing significant audit deficiencies in which auditors didn’t perform sufficient auditing procedures related to revenue.
Why Revenue Matters
For many companies, revenue is one of the largest financial statement accounts. It has a big effect on operating results and presents a significant fraud risk. Last year the Financial Accounting Standards Board issued new accounting standards for revenue recognition, which apply to annual reporting periods beginning after Dec. 15, 2016. The PCAOB staff believes this alert will continue to have relevance under the new guidance.
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. In a 2010 study of U.S. Securities and Exchange Commission enforcement actions from 1998 to 2007, COSO found that 61% of the companies involved recorded revenue inappropriately, either by creating fictitious transactions or by recording revenue prematurely.
Despite the prevalence of revenue reporting issues among public companies, PCAOB inspections reveal that, among those engagements inspected, auditors often didn’t perform sufficient auditing procedures with respect to revenue. (See the sidebar “Common audit deficiencies.”)
The alert discusses several critical auditing issues, including testing revenue recognition, presentation and disclosure. Aspects of these include:
Testing revenue from contractual arrangements. PCAOB inspection staff observed that, in construction-type or production-type contracts, some auditors didn’t perform audit procedures to 1) test management’s estimated costs to complete projects, 2) test the progress of contracts, or 3) evaluate the reasonableness of the company’s application of the percentage-of-completion method of accounting.
For multiple-element arrangements, some auditors didn’t 1) evaluate each of the deliverables to determine whether they represented separate units of accounting, or 2) test the value assigned to undelivered elements.
It’s critical, the PCAOB explains, for auditors to gain an understanding of the company, its environment and its internal controls. This includes becoming familiar with the company’s 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. This information helps the auditor determine the audit procedures necessary to test whether revenue was properly reported.
The PCAOB also notes that revenue recognition often involves accounting estimates, such as those of future obligations under a contract’s sale terms. The alert reviews the appropriate auditing standards, depending on whether an estimate involves a fair value measurement or another type of measurement.
Gross vs. net revenue. The alert emphasizes the importance of determining whether the company is the principal or the agent in a transaction. The auditor requires this information to evaluate whether the company’s presentation of revenue on a gross basis (as a principal) vs. a net basis (as an agent) complies with applicable standards.
Recognizing revenue in the correct period. PCAOB inspection staff observed instances of auditors who didn’t perform sufficient cutoff procedures — that is, testing whether revenue was recognized in the correct period. When designing and performing such procedures, the alert says, auditors should perform audit procedures that address the risk of material misstatement. These procedures should be designed to detect the types of potential misstatements related to that risk and to obtain sufficient relevant and reliable evidence regarding whether revenue is recorded in the appropriate period.
The alert also explains that, if the risk of improper cutoff is related to overstatement or understatement of revenue, the cutoff procedures should encompass testing of revenue recorded in the period covered by the financial statements as well as in the subsequent 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 to evaluate whether revenue recognition criteria were met and sales were recorded in the proper period.
Talk to your Auditors
In light of the risks associated with revenue reporting and upcoming changes to accounting standards for revenue recognition, a company’s audit committee should discuss revenue auditing approaches with their auditors, including the matters addressed in the PCAOB’s alert.