Changes in Accounting for Revenue Recognition, Part 1

Revenue Recognition and SEC Enforcement: A History
Under the leadership of Chair Mary Jo White and Director Andrew Ceresney, the U.S. Securities and Exchange Commission's Division of Enforcement has reinvigorated its efforts to root out financial reporting fraud, and revenue recognition is an ever-present issue. The division's renewed focus followed a period of relative relaxed activity relating to financial reporting and accounting. Historically, 25 percent or more of the Enforcement Division's case load was devoted to public company accounting and disclosure; that number has been closer to 10 percent in recent years. In July 2013, the SEC announced the formation of a Financial Reporting and Audit Task Force, a multidisciplinary group with members located across the SEC's regions charged with employing new and old investigation techniques to better identify indicia of potential accounting irregularities and other signifiers of fraud.

Revenue recognition is a significant focus in these enforcement efforts, and perhaps even a harkening back to the Levitt-era focus on revenue recognition fraud. In 1998, SEC Chairman Arthur Levitt expressed concern in a speech to the NYU Center for Law and Business that the "motivation to meet Wall Street earnings expectations may be overriding common sense business practices." He warned of an "erosion of the quality of earnings, and therefore the quality of financial reporting." One of the key identified "accounting gimmicks" he recognized as often used to manipulate earnings was the premature recognition of revenue. In the year following Chairman Levitt's speech, the SEC issued Staff Accounting Bulletin No. 101 to summarize the Commission's views on applying accounting principles to revenue recognition. This guidance was provided, in part, due to the large number of revenue recognition issues encountered by SEC registrants.

Following a period of numerous restatements by prominent corporations, resulting in the loss of billions of dollars by investors, Congress passed the Sarbanes-Oxley Act of 2002 (SOX), which, among other things, provided greater enforcement tools for the SEC and increased penalties for securities fraud. As part of SOX, the SEC was directed in Section 704 to study enforcement actions to identify areas of issuer financial reporting most susceptible to fraud, inappropriate manipulation or inappropriate earnings management. The results of that study found that the SEC brought the greatest number of actions in the area of improper revenue recognition. Of the 227 enforcement actions studied during the period (1997–2002), 126, or more than 55 percent, involved revenue recognition issues, including the reporting of fictitious sales, improper timing of recognition and improper valuation of revenue. The commission's enforcement actions during that period clearly reflected the prevalence of revenue recognition as a tool for financial reporting fraud.

In May 2010, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) released a report it sponsored of ten years of public company fraudulent financial reporting investigated by the SEC between 1998–2007. The COSO-sponsored report found that the most common fraud technique was improper revenue recognition, which accounted for over 60 percent of the cases. With this total up 50 percent from the prior ten years, it was clear that revenue recognition continued to be a prevalent tool for financial reporting fraud.

With the upcoming implementation of a new revenue recognition standard, it will be especially important to consider the effects of the new guidance given recent SEC enforcement activity and what history shows is an area of financial reporting that is particularly prone to manipulation.

The New Standard
The New Standard is codified in Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. Concurrently, the International Accounting Standards Board (IASB) issued a new, mostly identical, revenue recognition standard, IFRS 15—Revenue from Contracts with Customers. The new standard is an attempt to simplify and streamline existing revenue recognition guidance as well as bring U.S. accounting practices in line with international accounting standards.

The new revenue recognition standard will supersede all existing revenue recognition guidance, including all industry specific guidance. With this standard, the FASB and IASB have essentially reached global convergence for revenue recognition. For the numerous companies with both U.S. and international operations, the ability to account for revenue under one coherent set of guidance will be greatly beneficial for efficiency and consistency.

As originally proposed, publicly traded U.S. companies will be required to adopt the new standard for annual and interim reporting periods beginning after December 15, 2016. For nonpublic companies, adoption is required for annual reporting periods beginning on or after December 15, 2017 and interim periods beginning after December 15, 2018. Early adoption is permitted with certain requirements. Under IFRS, the new standard is effective for annual periods beginning on or after January 1, 2017. Early implementation is permitted, meaning that public companies reporting under GAAP and IFRS will not have to report using two different standards when adoption is required in December 2016. On April 1, 2015, FASB voted to propose a one-year deferred effective date until (reporting periods beginning after) December 15, 2017. A final decision is expected after a 30-day exposure period. The proposed delay was prompted by feedback from financial statement preparers citing additional time needed to develop and implement IT solutions for the new standard, logistical issues in reviewing customer contracts and time needed for the redesign and implementation of related internal controls, among others. A 2014 survey of U.S. public company board members reported that 28 percent found updating systems and policies as their top implementation challenge, followed by 25 percent citing updating existing revenue contracts with customers as the top challenge.

As companies have begun preparing for the transition to the new standard, many are finding difficulties in its interpretation and implementation. Sixty-four percent of U.S. companies are uncertain about the path that they will take to adopt the new standard. The Journal of Accountancy reports that nearly one-third of corporate finance executives rate revenue recognition as their top concern for year-end reporting.

The New Standard Calls for Greatly Increased Use of Professional Judgment
One of the hallmarks of the new revenue recognition standard is a shift from a "rules-based" approach to a "principles-based" approach. The FASB's adoption of a principles-based approach is arguably the cornerstone of convergence with international standards. The IASB has long used this approach, which emphasizes the broad application of a set of conceptual principles and the necessity of good professional judgment to determine how to apply those principles.

A principles-based system provides companies with a conceptual framework to follow, rather than a listing of detailed rules. Under the current rules-based approach, guidance includes many specific details and rules in order to address common situations and expected contingencies. A principles-based standard lays out key objectives (principles) and requires those accounting for transactions to determine how those transactions should be accounted for consistent with the aim of the principles.

As part of a transition from a rules-based to a principles-based standard, all existing industry guidance (rules) for revenue recognition will be eliminated. Those industries, including software, real estate and construction, which have long relied on these detailed rules will have an especially difficult time with the transition to non-rules, principle applications.

The absence of detailed rules will call for increased use of professional judgment on the part of company management in determining how to properly recognize revenue, including estimating the amount and timing of revenue recognition; this may result in varied interpretations of the standard as well as an increased potential for manipulation.

The Potential Impact on Financial Reporting and SEC Enforcement
The elimination of more well-defined rules may create greater opportunities to take advantage of gray areas and engage in fraudulent accounting practices. There is also a great deal of room for confusion and interpretation as companies work through the transition from "bright-line" accounting rules to broader concept-based guidelines. From a risk perspective, the increased use of management judgment and applying principles in revenue recognition instead of rules-based decisions may lead to increased scrutiny and challenge by (1) the SEC, as to financial reporting and internal controls; (2) lenders, as to covenants and financial reporting; (3) purchasers in acquisitions, as to accounting reps and warranties; and (4) regulators, as to compliance and controls. How will management's judgments be evaluated and challenged by third parties?

Accounting rules that require a significant degree of judgment, not surprisingly, present unique challenges from an enforcement and litigation perspective. In a 2003 study prepared by the SEC staff, titled "Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System," the staff reported that principles-based standards present enforcement difficulties because of a dearth of guidance or structure for exercising professional judgment for companies and auditors. As there will be no clear "rule-book" to follow, the risk of subjective judgment, or even reasonable differences of opinion, introduce a level of unpredictability in enforcement investigations. While there will undoubtedly continue to be those clear-cut cases of revenue fraud, cases in the margin may result in protracted investigations as the enforcement division and issuer debate the reasonableness of management's judgments made in real time.

Important Registrant Considerations and Actions
A registrant's preparation for implementation of the new standard cannot be a last minute or unplanned effort. There are significant implications to a registrant's business, operations, systems, controls and accounting. Also, in order to prepare for potential inquiry and scrutiny from the SEC and others, companies must fully think through all of the direct and indirect implications to ensure that they are appropriately and fully capturing all of the information that could be requested by others about management's interpretation and application of the new revenue recognition principles. The maintenance of detailed records related to revenue recognition policies, assumptions, controls, and judgments will be a company's most valuable asset when answering questions raised by interested challengers. Management's undocumented assertions after the fact about how and why decisions were made may prove to be insufficient. Timely, detailed documentation will be useful to demonstrate appropriate judgment and due professional care in the application of the new standard.

SEC staff has also indicated a renewed focus on internal controls over financial reporting. Enforcement charges brought by the SEC for internal control violations appear to be on the rise. In the process of transitioning to the new standard, it will be important for companies to review accounting processes and internal controls relating to revenue recognition and determine the need for modifying and updating deficiencies.

Revenue recognition has proven to be an area of financial reporting subject to a high level of fraud risk and SEC enforcement focus. Companies must be prepared to make and defend required future judgments. Part 2 of this article will focus on those risks and what companies can do to be prepared.