ASC 606 (revenue recognition) transition: The role of internal control over financial reporting (ICFR) and auditor expectations

Changes to accounting under ASC 606 will require scrutiny from companies and their auditors as the new standard is implemented.

Auditors will be placing increased emphasis on the internal control over financial reporting (ICFR) issues in connection with annual audits covering the initial year of ASC 606 implementation. Auditors of public companies may begin their assessment of management’s plans during the 2017 audit cycle. The level of attention will be on a spectrum, with accelerated filers receiving the most attention in connection with integrated audits.

Since ASC 606 is a principles-based standard, there are many more management estimates and judgments required compared to previous accounting standards. The time and effort necessary to implement the new standard due to these judgments will be substantial. Many organizations are unprepared for the changes to their systems and processes that will be required. Current revenue recognition controls must be adjusted to enable adequate documentation and control to support the judgments.

Entities are expected to follow an established framework when designing ICFR, and in the U.S. the accepted framework is COSO.1 The five COSO components and the 17 principles thereunder can be a good framework for adjusting ICFR to the demands of ASC 606. Below we provide specific considerations related to ASC 606 for each COSO element.

Control environment considerations

Does management, including the board, understand the new standard and the impacts it may have on the organization? This is a key piece in the control environment and sets the tone for the organization.

• Management and the board have obtained an understanding of the new standard
• Internal audit has been informed of the upcoming changes and is involved with the change process
• Adequate personnel resources have been allocated to the process:
  
• Change management processes are in place
• Personnel have received training and understand the entity’s revenue streams
• Cross functional teams have been organized

Risk assessment considerations

The organization will need to fully understand and weigh the risks adoption of the new accounting standard will pose.

• The entity has undertaken an assessment of the risks associated with the adoption
• Understands how an entity’s unique revenue streams may be impacted by the standard
• Considered the transition method and the risks related to that choice
• Understands the risks associated with dual accounting records for a period of time
• Adequately considered the controls to deploy for transition accounting
• Considered the need for new or revised controls to address the five steps of revenue recognition
• Considered the need for new or revised controls to adequately address the enhanced disclosure requirements

Organizations will need to design and implement new controls to address the new processes and judgments they adopt to implement ASC 606.

Control activities considerations

New control activities will be required addressing the five elements (steps) and the related estimates and judgments. These will also likely include more documentation supporting the estimates and may include more entity level controls than previously deemed necessary.

Specific control activities related to the ASC 606 five elements

1) Identifying the contract

• Supporting contract recognition for oral agreements
  
• Determining collectibility
  
• Evaluating whether contracts should be combined
• Assessing specific accounting for contract changes
• For contracts not recognized; reassessment processes
• Considering legal issues
• Standard credit verification processes
• Expanded processes when implicit price considerations are in play

2) Identifying performance obligations

• Determining  the promises in a contract
• Explicit as well as implicit promises
• Determining whether a performance obligation is distinct in the context of the contract
• Assessing warranties, implied, explicit, extended

3) Determining the transaction price

• Support for estimating variable consideration
• Applying the probability weighted approach or the most likely outcome approach
• How was the probability of constraint on variable consideration determined
• Assessing the fair value of non-cash consideration
• Issues related to finance component for long term contracts
• Periodic reassessment of variable consideration
• Assessment of amounts due to customers (refund liabilities)
• Handling catch up revenue adjustments
• Handling variable consideration when ERP cannot

4) Allocating the transaction price

• Supporting standalone selling prices
  
• Applying discounts
  
• Applying changes to allocation when estimated variable consideration changes
• Estimating when not sold separately
• Proportionately
• To selected performance obligations

5) Recognizing revenue

• Determining whether to recognize at a point in time or over time
• For over time recognition, supporting the criteria for passage of control
  
• Recognition pattern
  
• Determining whether the consideration subject to an enforceable right matches cost plus margin
• Input measures-subject to constraints
• Output measures-reflective of progress toward contract completion

Many organizations are unprepared for the amount of time disclosures will now take: each judgment will need adequate disclosure in the financial statement.

Disclosure considerations

Under ASC 606, disclosures are extremely robust. This is an area for which organizations should allow additional time and effort during implementation and in the early years of adoption.

• Controls over disclosure information not in accounting records:
  
• Qualitative disclosures
  
• Uncompleted contracts
• Changes in contracts: cumulative catch up adjustments
• Significant estimates and judgments: variable consideration; financing element; applying the constraint and releasing the constraint; how discounts were applied; how refund obligations were determined, etc.

Transition considerations

Organizations will need to determine how they will transition to the new accounting standard. Beyond the determination of which transition method, organizations will need to take a close look at how they will accomplish the documentation during the transition period of actual accounting and management’s determinations and judgments.

• Process for dual accounting records during the transition period(s):
  
• Support for applying any practical expedients
• SEC issuers have current period disclosures required under SAB 74 (SAB Topic 11.M); non-SEC issuers should also consider engaging stakeholders to communicate transition plans and potential effects on the financial statements
• Maintaining integrity and reliability of off line record keeping processes
• Entity level reviews for estimates and related judgments

Information and communication considerations

The information needs of ASC 606 and the transition are extensive. Companies will need to gather information that previously did not need to be documented as part of the accounting process and may not exist in easy to access or consistent locations.

• Will likely need to be gathered from across the organization: contracts, implied promises, side deals, etc.
• Assessing completeness and accuracy of such data will be critical

Monitoring activity considerations

Monitoring activity is likely to be increased, both on an ongoing basis and as it relates to the transition process. The internal audit function, management and board are likely to have roles in the monitoring function. Organizations should prepare to incorporate this activity across these functions.

Additional considerations

• The early effective date (1/1/2018) applies to public companies and not-for-profit organizations that are conduit debt obligors
• External auditors and regulators are highly likely to pay more critical attention to ICFR over the implementation of ASC 606
• Public companies subject to Sarbanes-Oxley reporting requirements will need to have robust controls in place to avoid disclosing material weaknesses in Section 404 reports
• Not-for-profit organizations subject to Yellow Book requirements will also need to have robust controls to avoid deficiencies in internal control reporting and potential additional attention from oversight agencies.

Conclusion

The adoption of ASC 606 will present significant challenges to existing ICFR systems; many companies are likely to find that their enterprise resource planning (ERP) systems were not designed to capture or report the information required for ASC 606 accounting and disclosures. ICFR and ERP system changes should be addressed as soon as possible in order to achieve a smooth and compliant transition to ASC 606. Organizations should begin to evaluate the time and effort the implementation will require of their internal staff and external vendors.

For more information on revenue recognition, or to learn how Baker Tilly’s specialists can help, contact our team.

(1) Currently Internal Control​​​​​​ — Integrated F​​​ramework, which was issued in May 2013 and effective on Dec. 15, 2014, published by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The 2013 COSO framework superseded the 1992 framework.