Throughout 2014, the Securities and Exchange Commission has signaled an increased focus on financial reporting fraud in general and revenue recognition in particular. In October, SEC Chair Mary Jo White said the SEC has seen a “significant jump” of more than 20% in enforcement actions in the area, and SEC Enforcement Director Andrew Ceresney called the area the “next frontier” for enforcement.
Recent changes in revenue recognition standards magnify the significance of the SEC’s increased focus on this subject. Indeed, at a conference in November, SEC Chief Accountant James Schnurr noted the monumental effort that will be necessary to prepare for the new standard.
Regardless of whether companies believe the new standard will significantly impact their financial statements, all companies will be required to make more judgments and estimates and spend a significant amount of time documenting such things. The lack of specific rules, coupled with increases in required estimates, will inevitably create an opportunity for misjudgment, error and even earnings management. Of course this also means increased focus from auditors and likely unwanted attention from the SEC.
Lessons Learned from Recent SEC Cases
Revenue recognition and financial reporting cases brought by the Enforcement Division in 2014 give a strong indication of the SEC’s areas of emphasis and concern that may carry over as companies implement the new standard.
One of the most common types of SEC financial reporting cases involves outright fabrication of data. For example, in August, the SEC alleged that an information technology company arranged for an equipment manufacturer to redirect through the company pre-existing orders the manufacturer already had received from one of its customers, giving the appearance that the company was involved in resale transactions when it in fact had no such involvement. While revenue is inherently an area of high fraud risk, the additional judgments required under the new standard may provide additional opportunities for fraud (and for the SEC to look for such fraud).
Similarly, the SEC often brings enforcement cases alleging a lack of proper controls in determining financial reporting data. In one such case in July, the SEC filed a complaint against officers of a Florida-based computer equipment company for misrepresenting to external auditors and the public the state of its financial reporting controls. Companies will need to review their revenue recognition internal controls in light of the new standard and, if necessary, upon discovering errors in current accounting, assess those errors for materiality.
Finally, the new standard may have its greatest impact on cases involving disagreements between companies and the SEC regarding application of GAAP. The SEC filed such a case in April, alleging improper reduction down to $0 of the value of certain personal property in an acquired entity, followed by a reversal of $49 million of depreciation taken since the acquisition. The undisclosed depreciation reversal increased third-quarter earnings and enabled the company to exceed analysts’ expectations. The SEC alleged that proper accounting would have treated the asset write-down as a current period expense, significantly reducing third-quarter earnings per share.
Unfortunately, with the new standard comes the potential for disputes over such issues as when a customer sales contract exists, what the performance obligations are under the contract, what the transaction price is, how the transaction price should be allocated to separate performance obligations and when each performance obligation has been satisfied. The SEC has shown that it is willing to go through years of investigation and litigation over such disputes.
How to Prepare for the New StandardTo ensure a successful implementation, companies should consider taking some precautionary steps, including the following.
- Don’t assume your company will not be affected. At the very least, obtain a good understanding of the standard’s requirements and perform a thorough assessment to determine the impact. Avoid being surprised by some of the technical details, including those still being debated. Regulators are still mulling over requirements to estimate variable consideration, assess even inconsequential and perfunctory performance obligations, and consider customary business practices and material rights.
- Begin early to ensure adequate time to review contracts and assess the impact of the standard on them. As companies work through their assessments and begin implementation, many are overwhelmed by the documentation required to support additional judgments, estimates and policy decisions. Automating the changes into systems will be time-consuming. Even for those contracts in which no change in accounting is expected, going through the process of proving that can be tedious and documentation-intensive.
- Don’t skimp on the documentation, and take the time to ensure your data is complete and accurate before getting started. In the early stages of a project, even locating the contracts and understanding their terms may prove challenging, particularly in foreign locations. Use the opportunity to improve internal transparency and control over your contract management process so you don’t run into the “garbage-in, garbage-out” issue.
- During the implementation process, don’t forget about required disclosures in filings regarding implementation of a new accounting standard, including the planned method of adoption. For public companies, the new Revenue Recognition guidance is effective for annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. For nonpublic companies and organizations (including not-for-profits), the new guidance will be required for annual reporting periods beginning after December 15, 2017, and interim and annual reporting periods after those reporting periods. As those effective dates near, the SEC will expect companies to provide more information about the anticipated effects. Remember that any significant changes in the control environment, such as those that may occur with system changes, are also required disclosures.
- Ensure current GAAP errors identified during implementation are accumulated and evaluated for materiality in a timely manner, along with the control implications.
- Finally, with increased judgment comes additional opportunity for fraud. Closely examine your controls, including controls over dual reporting or calculating the cumulative effect of adoption, to ensure appropriate preventative and detective measures.
With advanced planning and diligence, your project can run smoothly and your company can avoid the inconvenience of unwelcome scrutiny.
Nicolas Morgan is a partner and West coast chair of the securities enforcement practice at DLA Piper, a law firm, and Shauna Watson is global managing director of finance & accounting at RGP, a consultancy.