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Amy Nieman

Brainstorming for Controllers Considering Automation

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The topic of automating accounting processes is gaining momentum. When automation is properly planned and implemented, the benefits from cost reduction are clear, the biggest of which is lower audit fees through reliance on application controls and secure processes. Automation also allows management quicker access to accurate financial information to allow for faster decision making. Automation will also increase employee morale and attract more talent since tasks are more analytical and less data input and processing.

The concept of automation can seem very abstract, though. So, your CEO just told you have to automate your processes, but how? Thirty years ago, the answer was to put everything in excel, but now we have many other solutions. So, the first thing of which to be aware are the different types of automation. Most of these types of automation fall into the category of “robotics”, or configuring your system to do the work for you, while others simply leverage technology to reduce paperwork and risk of loss of audit evidence. Some common examples include:

  • Online storage
  • Electronic signatures (in the ERP directly or in reconciliation tools)
  • Automated journal postings
  • Automated reconciliations
  • Automated reporting
  • Integrations – importing and transmitting data among systems

These tools can be used to significantly truncate you data input, transaction processing and information output (or reporting) in countless ways. Some common examples to get you started are as follows:

Data input

Data input can be automated by setting up connections among all your data systems to feed into you ERP or from the ERP to another processing system. This is done by setting up integrations. The advantage of an integration is that it takes away the task of entering data manually. It also reduces the risk that there are inconsistencies in data from system to system when this is set up correctly. Some common examples of integrations are

  • ERP to bank integrations which allow
    • Cash bookings
    • Cash reconciliation transaction matching
    • Payment initiation
    • Payment approval
    • Cash receipt matching to open invoices
    • Closing open AP invoices upon payment

There are also intermediaries such as Kyriba available in case the integration directly with the bank is not initially possible

  • ERP to sales database matching to allow for automated revenue bookings and revenue reconciliations
  • ERP to payroll provider connections for
    • Reporting monthly salaries for processing by the payroll provider
    • Automated bookings of salary journal entries based on mappings provided to the payroll provider
    • Automated payroll tax reporting and booking
  • ERP to invoice readers such as Readsoft, which creates the ability for an invoice to be booked automatically when received from a vendor via email or scanning. These tools read the details of PDF invoices and book all the relevant data to avoid needing a person manually keying in the invoice.

Other data input solutions include excel or CSV uploads which allow you to upload many records at once rather than one by one and other mass processing functions which are available in most ERP’s. These solutions also save time and reduce risks of errors, but as they still are less sophisticated than integrations which do the data transfers automatically, they are not always the best long-term solution, but it can be a good interim step towards final automation.

Transaction processing and controls

Once the data is in the system, there are many tools available to process transactions for the team. Many ERP systems allow you to activate modules which will post predictable, recurring journals. Examples are:

  • Fixed asset modules which automatically post scheduled amortization and depreciation on assets paced in service. They also allow for easy initial posting of the asset and write offs for assets which are impaired or sold.
  • Prepaid expense modules which operate similarly to fixed asset modules by posting regularly scheduled amortizations of prepaid services.
  • Accounts payable and accounts receivable modules which keep track of invoice aging and post entries simultaneously with invoice processing
  • Revenue modules and add-ons such as Rev Pro or Zuora which book revenue schedules based on contract terms according to ASC 606 without manual intervention

There are also functions which can be enacted in the system such as system journal approvals which stores information on journal preparation and approval for control purposes.

Reconciliations can also be automated using systems like Blackline. With integrations between Blackline and the ERP, reconciliation data can be entered into the system and the system can automatically certify reconciliations based on criteria set by your company or can allow separate preparers and approvers to certify the reconciliations and then stores all the data for audit review, including names and times certified for preparation and review. These types of systems also often offer documentation and storage of close checklist to give management visibility of the status of close and to offer evidence to auditors of steps performed.

Information output (reporting and decision making)

The last step of the accounting process is reviewing and submitting the final financial information. One quick way to do this is proper report configuration to ensure the reports are complete and accurate and in a format that is easy to use for final reporting.

Other solutions include

  • Integrations such as an ERP to VAT authority connections for automated tax reporting
  • Control systems such as Blackline that display period over period financial statement analyses results and require comments. These systems then also store the explanations and sign offs on the analyses in case this needs to be used for control purposes
  • Cloud tools such as Workiva or Webfilings which allow you to more easily create SEC-ready documents including XBRL tags.
  • Online storage of reconciliations and supporting documents for audit evidence using tools like Blackline or Microsoft OneDrive

Other considerations

How flexible should the solution be? Before jumping into a laborious automation effort, consider the nature of your business and the required flexibility. Some automation solutions are quite ridged and shouldn’t be implemented if there is a need for change soon. For example, if your company is considering changing banking providers, an sophisticated banking integration is not a good idea until the final banking partner is selected. As another example, if your company is implemented ASC 606 soon, installing a 605-compliant revenue module will not be useful long-term.

What is the impact on the full process? If you are automating a step in the process, does it cause any downstream effects? Is there a way to automate the full process instead of just the step you are analyzing? For example, updating a reporting configuration to ease a reconciliation might cause problems with external reporting.

Control Considerations Some processes are cumbersome because of certain control requirements. It’s important that the new solutions also consider the control requirements and allow the company to properly track changes in the system. They should also consider proper segregation of duties. For example, reports which can be customized by any user sounds tempting, but if the user doesn’t have enough knowledge on the usage of the reports and there is no way to track the changes to the reports, it can very quickly result in incorrect external reporting.

Next Steps

Explore companies like Blackline, Readsoft, Zuora and Kyriba and speak with your ERP host to ask what solutions are available. There are also specialists available to evaluate your processes and provide recommendations for best practice or other improvements.

 

 

Why it’s Time to Rethink Goodwill Accounting

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Why it’s time to rethink Goodwill Accounting

In July 2019, the FASB issued an invitation to comment on the subsequent accounting for goodwill resulting from business combinations. The FASB performs such evaluations when they expect that “either:

  • the expected improvement in the quality of information provided to users—the benefit—justifies the cost of preparing, auditing, and providing that information or
  • reduced cost can be obtained in a manner that does not diminish the quality of information.” (excerpt from FASB invitation to comment dated July 9, 2019 File reference number 2019-720

In the case of accounting for goodwill, it is indeed time to reevaluate the current process of treating goodwill as an indefinite-lived asset because the current treatment results in a lag in the recognition of the reduction of the value of goodwill and is thus not as meaningful as potential other methods (i.e. there is an expected improvement in quality of information provided to users). There are also additional considerations resulting in the significant changes in the global business environment which have occurred over the last 20 years, specifically, tech companies are now a signification contribution to the economy which has resulted in start-up companies making up a larger proportion of businesses. As the composition of the economy contains more start-ups and tech companies, which include characteristics such as riskier and more frequent acquisition activity, along with new products and services which behave unlike any other in history, the application of current goodwill assumptions may not be relevant or accurate. This article briefly explains the transparency weaknesses inherent in the current model which is exacerbated by the new start-up environment and proposes an alternative method through the following questions:

  1. Is the current impairment test method sufficient to provide transparency to investors regarding the value of the asset?
  2. What is the best approach to recognizing reductions of goodwill in lieu of an impairment-only model?
  3. Should there be any other considerations given the significant shift in businesses from manufacturing to tech companies?

Question 1 – Is the current impairment test method sufficient to provide transparency to investors regarding the value of the asset?

First, a brief reminder of the current prescribed impairment evaluation process. Goodwill is tested annually for impairment using a “Step 0” analysis, which is meant to allow a company to perform a qualitative analysis to identify whether any impairment indicators exist prior to performing extensive quantitative analyses. If impairment indicators exist, the company is to perform a full impairment test, which essentially consists of assessing whether the fair value of the existing goodwill is below the carrying value and thus requires impairment.

Cashflows related to specific acquisitions are often not identifiable after the first year after the acquisition, as the target is often integrated into the legacy business. For this reason, the impairment tests are performed on a reporting unit level, i.e. in aggregation based on how the company views its operations.

There are three main reasons this process currently leads to results which are not meaningful:

  1. The evaluation process is a decidedly judgmental and is subject to a high amount of management bias and valuation assumptions. The result, therefore, is typically that if there is a goodwill impairment, it’s material. It rarely occurs that a goodwill impairment is recognized and not considered noteworthy in the financials. According to the Duff and Phelps 2018 US Goodwill Impairment Study, a small number of companies make up the largest portion of goodwill impairments. This is consistent with findings since 2012. This indicates that goodwill impairments are not a common transaction, but when they occur, they are material. Additional cost from the complexity of the calculations and the increased audit risk is also an issue as noted by the FASB.
  2. The evaluation occurs on an aggregated basis due to an inability of determinable cash flows resulting from a single business combination after integration. Further skewing the ability to analyze the results of a goodwill evaluation, if several acquired entities in one reporting unit or the acquiring company itself are over performing compared to original expectations, this can mask an impairment of goodwill of an individual business combination. The aggregated cashflows also include cashflows from assets and unrecorded goodwill created subsequent to the acquisition. There is no guidance which prescribes evaluation of goodwill from an individual business combination, even attempting to estimate the cashflows for each acquisition excluding acquirer cashflows and cashflows from assets created subsequent to the acquisition is not allowed, and would also likely be inaccurate as it would likely be estimated. Conversely, if an impairment is recognized, it may be the result of the acquiring company’s decline in performance, rather than the underperformance of target entities. Overperformance of other entities in a portfolio, inclusion of benefits resulting from assets created subsequent to acquisition, and underperformance of the acquiring entity are two of many examples of situations which lead to an inaccurate review of goodwill from an business combination.
  3. Recognition of the usage of goodwill should match the cashflows resulting from that goodwill rather than recognized at a single point in time as an impairment would imply. Theoretically, goodwill represents the additional value of synergies the new management will realize due to additional resources on-hand. There are arguments that synergies exist into perpetuity, thus goodwill is an asset which can conceivably be indefinite-lived. The basis for this is that if management is effective, the acquired entity will increase in value throughout time. This is inconsistent with US GAAP and IFRS frameworks. Goodwill should relate to the value acquired, not hypothetical future value. Goodwill does not represent anything which might be created in the future using future investment. The acquired attributes of the synergies make up the value of the goodwill. Said differently, a company cannot capitalize future assets. What they can capitalize is the current value of future cash flows. Examples of aspects of synergies which erode over time are:
  • Management acquired: Management turnover can be quite high after a company is acquired which can lead to knowledge and leadership loss
  • Product obsolescence or ennui in the market: Eventually, the cash flows from the product rights acquired diminish as a normal part of the product life cycle
  • Sunsetting of acquired processes and workforce due to evolution of the company

A company is always developing, so to make the argument that the company acquired will never change or be developed using the legacy company’s resources is inconsistent with normal economic incentives. It is thus not sufficient to conclude that goodwill is indefinite-lived and a useful life should be determined upon acquisition.

Conclusion 1 – Overall, the result is that goodwill impairments are recognized later than when the decline in value likely occurred as there needs to be a significant decline in the performance of an entire reporting unit before the impairment is detectible. The current impairment process, while more efficient than previous methods, does not result in meaningful results, and may lead to impairments which are recognized long after the indicators of impairment were present. There should be a modification to the current regulation for subsequent accounting of goodwill which more accurately reflects decreases in acquisition values in a way which is also timely and efficient.

Therefore, goodwill needs to be amortized or otherwise expensed prior to impairment in order to reflect the decrease in value in a manner which matches the cashflows resulting from the goodwill.

Question 2 – What is the best approach to recognizing reductions of goodwill in lieu of a impairment-only model?

The classic accounting proposal we should first consider is amortization over a pre-determined useful life, while also testing periodically for impairment in accordance with the rules for other assets.

The FASB Invitation to Comment File Reference No. 2019-720 provides the following suggestions for comment as useful life determination periods in lieu of an indefinite-lived asset conclusion:

  1. A default period
  2. A cap (or maximum) on the amortization period
  3. A floor (or minimum) on the amortization period
  4. Justification of an alternative amortization period other than a default period
  5. Amortization based on the useful life of the primary identifiable asset acquired
  6. Amortization based on the weighted-average useful lives of identifiable asset(s) acquired
  7. Management’s reasonable estimate (based on expected synergies or cash flows as a result of the business combination, the useful life of acquired processes, or other management judgments).

When considering the options above, the only logical selection which increases transparency and maintains efficiency for the company is option g. management’s best estimate supported by cash flows and other relevant facts. Due to high audit standards and PCAOB reviews, a high level of preparation and audit work will be required to justify any conclusion, so the most efficient method is to prepare the justification as a part of the initial business combination rather than as an afterthought subject to misstatement conclusions. All the other options will require the same analysis to justify use or rejection of a default of a default option. Using management’s best estimate also increases transparency as every transaction should be assumed to be unique, thus a default period would not likely truly reflect the future benefit of the goodwill recognized.

Conclusion 2 – Valuation work should to be done upon completion of the business combination to determine the useful life. Doing all the valuation work upon acquisition would allow for cost savings from only preparing this evaluation once and only auditing it once (except in cases where impairment indicators are identified). As it is unlikely that any asset is truly indefinite-lived, the burden of proving the indefinite life with more specific cash flows and more critical evaluations of triggers would serve as a deterrent to concluding the asset is indefinite-lived. For example, selecting 20 years as a useful should be more acceptable and defendable under the new guidance than concluding goodwill is indefinite-lived. Although the usage of goodwill may not truly be decline systematically over time, amortizing goodwill straight-line over the best estimate of the useful life is more representative than a one-time impairment (if any).

Question 3 – Should there be any other considerations?

So far, this article has covered why an impairment-only model does not accurately represent the usage of goodwill and has proposed a method for amortizing instead. What the FASB does not request is an evaluation of whether goodwill should be considered an asset in the first place. In today’s new start-up environment, there is very high company over-valuation due to extra cash on-hand from venture capitalists (VC). One only has to consider the fate of WeWork to see how quickly a star can rise and fall. This is not a unique story. There is a myriad of start-ups that get VC funding and then are subsequently acquired by the Googles of the world for millions. The valuations are based on cash flows developed by VC’s in order to sponsor private funding. The nature of these companies is likely 15-20 employees with a good idea and a bit of developed technology, but maybe no product, yet. Consider the FASB guidance defining businesses within the scope of business combination accounting:

“An integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return…” ASC 805-10-20

The guidance further explains in ASC 805-10-55-4 through 55-5 that, specifically, a business must consist of inputs, established processes, and outputs, but most importantly inputs and processes which “are or will be used to create outputs”. The significance is that the business acquired does not need to have a product or service, only the potential of a product or service.

Under the current guidance, an entity consisting of only cost and some kind of on-going process but no product, only a plan for a product, is viewed as a business, and thus can result in goodwill if acquired.

The question is, “Is this goodwill really an asset?”. Are the cashflows really achievable? What additional resources does the new management have which would ensure these new cash flows? What would happen if the start-up founders left the company? If the founders leave, does the developed technology still live up to the potential that was envisioned in the original cash flow projections?

In this light, one can easily imagine a situation where a start-up company with brilliant engineers and a promising new product are acquired. Most of the purchase price is goodwill, as there are very few assets in this small new company. The consideration is contingent consideration to the founders based on an agreement that they stay and ensure the success of the development and launch of the technology. It often happens that founders may leave due to preferring the start up environment to the new corporate environment. Then the development stops. The product is never realized. The contingent consideration is recognized as income due to the release of the liability because the founders left, thus the amounts are no longer payable. The goodwill remains on the ledger without impairment, but the whole business acquisition is a loss. The result is a company which acquired a business that did not provide benefit now as an asset on the books and income on the P&L.

Conclusion 3 – The solution is to create a more rigid definition of a business and incorporate a test to confirm that goodwill qualifies as an asset upon acquisition, i.e. confirm there is stand-alone value which can be measured in case of immediate impairment or if the arrangement is instead compensation. This can be through thorough cash flow analyses which confirm the cash flows are dependent on the success of the acquiring company rather than the target or a more strict definition of a business.

Overall – The intent of the FASB is to provide meaningful information to users of the financials while avoiding over-burdening companies reporting in US GAAP. The most direct way to do this is

  1. Create a test to confirm that the business acquisition results in goodwill rather than immediate expense or future compensation arrangements to founders
  2. Define goodwill as finite-lived intangibles as all assets inherently have an end value due to developing economies
  3. Amortize goodwill over management’s best estimate of the useful life in order to fairly represent the usage of goodwill

Goodwill can be treated like other intangible assets which require confirmation that the amounts represent future benefit and an assessment of the useful life. By treating goodwill like other assets, complexity and inefficiencies are reduced and more meaningful information is available to the users of financials.

Source links:

https://www.duffandphelps.com/-/media/assets/pdfs/publications/valuation/gwi/2018-us-goodwill-impairment-study.ashx

https://www.fasb.org/cs/ContentServer?c=Document_C&cid=1176172950529&d=&pagename=FASB%2FDocument_C%2FDocumentPage

Starting Your Company’s Accounting Policy Library

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Background

An accounting policy library is essential for ensuring consistent processes and is a critical requirement for financial statement audits. A robust accounting policy library also serves as a crucial part of the COSO framework implementation for internal controls as this represents the communication of your US GAAP accounting compliance guidelines. As this is such a critical part of the control environment, it can be daunting starting the task of documenting all the key accounting policies. In order to help, this article provides:

  • A list of accounting policies which will normally always be required regardless of materiality of the recorded amounts the policy guides
  • A method for evaluating additional policies required
  • An easy-to-implement framework for writing policies

Although accounting policies are required for many audit purposes, you will likely find that having strong accounting policies will also create process efficiencies as it increases consistency in accounting practice across teams and reduces ambiguity in order to empower teams to make decisions locally regarding accounting treatment of transactions.

Accounting Policies to Always Include

Revenue Recognition

Even if revenue is small, for example for early start-up companies with a small customer base, a revenue recognition policy will always be required for two main reasons:

  1. Revenue is complex under US GAAP. Even simple revenue transactions have the same 5-step process to follow for concluding on revenue recognition, so this needs to be thoroughly documented
  2. Revenue is an important metric to investors, which makes it a material measure, even when amounts are small.

As revenue is complex and always considered material, this should be one of your first policies and will end up likely being the most thorough.

Expense policy

This does not refer to employee expense and travel guidelines, but rather when are total company expenses recognized. Total company expense is normally also considered material, even if the amounts are small. As such, the Company should document its basis for recognizing expenses. This can normally be as simple as wording such as “The Company recognizes expenses in the period in which the expense is occurred and matching the revenue generated by that expense where appropriate according to the matching principle in US GAAP.”

Capitalization policy

As a compliment to the expense policy, the company should list when amounts are capitalized rather than expensed. This normally also includes discussion on when amounts are expensed instead of capitalized in order to recognize efficiencies from not tracking or counting certain small items. This kind of conclusion should leverage a materiality policy.

Financial Statement Presentation Method

Amounts disclosed in financial statement captions are going to be the main information which investors can analyze. Accordingly, there should always be a policy which explains what is disclosed in each caption and the basis for deciding on the captions included.

Determination of Materiality

The basis for a lot of internal decision making is going to be materiality, so this should be clearly outlined for the company and re-evaluated each year. Materiality definitions should include the point at which the Company would require

  • Restatement of prior period financials
  • Disclosure to auditors of adjustments to the financials which were identified but not made

This is, in other words, a SAB 108 analysis for US GAAP. In addition, the policy can contain threshold for the following:

  • Amounts that can be left unaddressed in account reconciliations
  • Amounts that can be left unaddressed in financial fluctuation analyses
  • Accounts that can be reconciled monthly rather than quarterly

Segment Definition Memo

The segments you define are the areas of business which need to be disclosed separately. This can be product segments, regional segments, or anything else which your company views as important for determining results. A common mistake among companies is that if there is only one segment, this policy is not required, but as the analysis is more complex and the determination of segment information can be material to investors, it is important to document the conclusion on why there is only one segment if this is the conclusion.

How to Determine When to Write Additional Policies

As demonstrated in the section above, the determination of when to write a policy is based on

  1. Materiality
  2. Complexity

This is another way of saying that the decision on when to implement a policy is based on risk. If a transaction cycle is material or complex, it should have an accounting policy.

For example, as each caption of the financials is likely material as it is disclosed separately, there should likely be a policy for the accounting of each caption and the relevant guidance. Additionally, any policy disclosed in the notes of the financials should also have its own internal document as this was determined to be either material or complex (e.g. required disclosure per US GAAP) for the Company.

Some additional examples are

  • Goodwill
  • Fixed Asset, Intangible or Investment Impairment
  • Accounts Receivable and accounting for doubtful accounts
  • Stock-based Compensation (normally required even if amounts are small due to complexity)
  • Foreign Currency Accounting
  • Business Combinations
  • Financing Arrangements (debt)
  • Hedging
  • Leases

For more ideas, check the policy disclosure in your company’s competitors’ 10-K filing. This is also normally a good indicator of what is expected of your company.

Recommendation for Policy Structure

Most policies can be organized in the following way:

  • Background or Purpose
  • Guidance
  • Policy
  • Controls

Background or Purpose

Start off by describing the types of transactions that are occurring which cause the requirement for analysis. In other words, this is the “why” section of the policy. This can include the transaction amount per year, the number of transactions, an explanation of the complexity of the transactions. For example, if the company is documenting a policy on investments, the background might state something like:

The Company recognized 10 million USD in investments in cost-method investments in the current year financials. Entities in which the company is invested are ABC, Inc. for 19%, XYZ, LLP. for 5%, and Investment Entity, Inc. for 6%. The purpose of this policy is to support the Company’s conclusion that the risk associate with the investments allows the company to recognize the entities as cost-method investments.

This represents a more detailed policy. It is also an acceptable method to document a high-level policy such as:

The Company periodically invests in other entities as a way to create synergies with strategic partners or in order to use what would otherwise be idle cash. The purpose of this memo is to document when such investments are classified as cost-method investments. Please see the separate annual memo regarding whether any impairment exists on these investments as well as an assessment of the individual risk characteristics which allow the company to conclude on cost-method classification of investments.

Both methods are perfectly acceptable.

Guidance

This section should contain the guidance on which your company is relying to determine the accounting policy. This can be copy-paste from the FASB guidance on which you are relying. For a really strong policy, you can also reference guidance which you are not using and why the guidance is not in use. This helps avoid questions on why some guidance was used and other parts of the guidance which could seem relevant are not used. An example might be discussion of refunds in a revenue recognition policy. If the company has a history of refusing refunds, then there is no need to discuss refund guidance in depth; however, it’s helpful to state that refund guidance is not included because it is irrelevant due to the company’s operating policy.

Policy

Use this section to describe exactly what the company does and the conclusion on accounting policy. This should be where you explain most of your process and company-specific facts.

Controls

Although this is not necessary, a strong policy document will also include discussion of the controls in place to ensure the policy is followed, as controls are required at all US publicly traded companies. The controls discussed should match the company’s risk control matrix, so if controls discussion is included in the policy, it will need to be reviewed annually with internal audit.

Final Thoughts

Although it can feel like a huge task to put together accounting policies, some of the policies can be quite quick document. The main requirement of policies is that they address questions that a team member or auditor might have, not that the policy is long. As you might have observed from the discussion above, there are many different methods of compiling policies, so you should balance detail included in each policy with efficiency of maintaining each policy. Make this judgment based on internal resources available and overall complexity of your financials.

Valuing a Contract under ASC 606 – a Controller’s Guide

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Executive Summary

This article provides a framework for performing revenue valuation and allocation according to US Generally Accepted Accounting Principles (US GAAP) as these are the most complex steps in the new process. Specifically, this process is covered in steps two and three of the revenue process prescribed by ASC 606. This framework allows controllers to efficiently and accurately implement or improve their ASC 606 accounting to reduce effort and risk inherent in the revenue accounting process. Service providers (including auditors) tend to over complicate the topic and provide very technical solutions for very simple challenges. What the essay below emphasizes is the accounting version of Occam’s Razor, the simplest way is likely the correct way. Overcomplicating a topic leads to additional scrutiny of processes and assumptions and increased risk of misstatement.

The article also provides guidance on operational considerations in order to ensure the analysis is complete and repeatable.

Background: The main points of ASC 606

The fundamentals of revenue recognition do not substantially change under ASC 606 (IFRS 15) as compared to ASC 605; a Company should measure revenue based on consideration received (or to be received) and recognize revenue when it’s earned. The objective of the standard is to provide a more robust framework for revenue recognition. The new pronouncement, therefore, provides more specific guidance on how to value revenue and at what point the revenue is earned. This, of course, adds complexity to the revenue recognition process. Let’s consider first the overall framework of the guidance. The five steps prescribed in revenue recognition are:

  1. Identify the contract
  2. Identify the performance obligation(s)
  3. Determine transaction price
  4. Allocate transaction price
  5. Recognize revenue as performance obligations are satisfied

In practice, steps two and three are essentially analyzed together at the same moment during the sales process. As soon as the transaction consideration and performance obligations can be measured, the prices can be allocated to the performance obligations in the contract. This article, therefore, considers the two steps together in order to propose a stream-lined approach to accounting for revenue.

Practical Expedient

The FASB allows entities to use the portfolio method as a practical expedient. This means that an entity may group similar transactions tougher for evaluation and recognition rather than providing a separate analysis for each contract.

If there is compelling evidence requiring the Company to have several groups of revenue streams (several portfolios), it is best to aggregate revenue streams at the highest level at which products can be grouped in order to reduce the number of analyses required to perform. The key here is to identify the key characteristics which drive revenue recognition and the characteristics which are inconsequential. Grouping at the highest supportable level helps ensure simplicity and replicability.

As you read through the approach below, consider how your company can group revenue streams to reduce the number of analyses required while also maintaining accuracy of the final accounting.

The Process

Determining Transaction Price

The initial contract price includes all current and future consideration. In some cases, for the lucky controllers, measuring revenue can be as simple as using a single amount on an invoice or within a single contract document. For most, there are other elements to consider such as multiple element arrangements, warranties, discounts, refunds, accompanying services and many other considerations which might be bundled into one contract.

The simplest wat to conceptualize this is, what is the final cash/benefit which will be received by the Company at the end of the full sales cycle. A simplified formula for this approach is:

Initial contract value = Sales price – reserves + contingencies – direct costs

Each of these elements can be calculated separately by portfolio in order to create a clear, repeatable process. That is to say, sales price for all similar contracts can be calculated and recorded together (in many cases it’s as simple as recording the invoice when its issued which is normally automatic when creating the invoice), then reserves can be calculated and recorded in aggregate (for example calculating a refund reserve), and so on.

Sales price – Sales price is the gross amount expected to be realized as consideration for the contract. The first, most persuasive support is the invoice price, or the price listed in the contract with the customer. Ideally, this is base this on sales catalog supported by historical invoicing. In real world cases, there can be a large amount of negotiation. This will impact the SSP allocation which is discussed later if there are multiple products sold in one contract. Any discounts offered would be included within the sales price

Minus

Reserves (warranties, rebates, chargebacks, refunds, gift cards give away or other price reductions and other liabilities not subject to ASC 450) Estimating and accounting for reserves is not new to US GAAP. The difference is that now there is an obligation for the Company to prove that the reserves can be calculated based on each customer contract. In most cases, this can be calculated assuming the standard portfolio method. This means that in general, there is no need to adapt the ASC 605 methods of calculating reserves, but rather only a documentation burden for a company to prove there is no change in the accounting for reserves.

Depending on the system used, a discount might appear in the system on one item in the contract, equally applied to all items on the contract or might be a separate line in the system. This can lead to challenges in determining the proper price allocation as well whether the discount applies to one item in the contract or to the entire contract. Data to consider maintaining is

  • Contract number to which a discount applies
  • Discount reason (adding reason codes or tags in the system is a good option for this)

Plus

Contingencies (not covered by FAS 5) and other consideration (for example breakage) This might be the biggest change in initial contract pricing for many companies. Under ASC 605, it was considered conservative to wait until a gain occurred to account for it. Under ASC 606, there is often an obligation to estimate the gains from customer contracts as this is measurable consideration. Once again, the recommendation is to use the portfolio approach and bundle similar contracts in order to estimate the impact on consideration.

Minus

Direct Costs (e.g. sales commissions, implementation costs, development costs) This category is often the most complicated to link to revenues because it often comes from a different transaction population. These costs are often tracked in different systems using different identifying information. The first recommendation on these costs is to really scrutinize whether the costs are truly linked to the revenue or if they can be expensed as incurred. Once the company determines it is required under US GAAP to match these costs with revenue, the Company should start tracking the costs at the contract level. This will often require a significant amount of input from other operational departments such as sales, project management, developers, engineering, etc.

Determination of Stand-Alone Selling Price (SSP) and Price Allocation

When a contract contains more than one performance obligation, then the controller must consider the allocation of consideration among the obligations within the contract. The first consideration with SSP is whether it impacts reporting. If all products are recognized at the same point in time and presented externally in one line item within the financials, then there is absolutely no need to re-allocate the fair value of consideration. This is purely an academic exercise.

In cases where the controller has determined that the company needs to perform a price allocation (i.e. revenue is presented separately or at different points in time), there are four common methods that the FASB recommends for determining SSP and allocating consideration:

  • Directly observable prices
  • Adjusted market assessment
  • Expected cost plus margin
  • The residual approach

Directly observable prices

Using directly observable prices to determine stand-alone selling price often has the most available data and requires fewer assumptions, thus it is generally the easiest to support in an audit. Often the data set is contract prices, historically invoiced amounts, cash collected, etc. Price lists are also good source, but the price lists need to be supported by historical data in order to prove they are accurate, so often the price lists end up providing additional support for SSP assumptions, but they are not necessary.

Adjusted market assessment

An entity could evaluate the market in which it sells goods or services and estimate the price that a customer in that market would be willing to pay for those goods or services.  That approach also might include referring to prices from the entity’s competitors for similar goods or services and adjusting those prices as necessary to reflect the entity’s costs and margins.

When using the adjusted market assessment, the two biggest considerations are

  1. How can the entity get enough data to do a comprehensive analysis – This might involve paying for access to a market database or manually collecting and documenting competitor prices in the market.
  2. How can the company document that the market data used is appropriate for the assessment – When using competitor metrics, it’s important to document why the company considers these companies competitors. If there are major differences in the competitors or the market they serve, this should be considered in the assumptions. For example, sales data for products sold in China is not likely to be a reliable data set to assess the market value of the same product in Europe, or a luxury goods provider will not be comparable to a discount goods provider.

Involving the sales team in this exercise is very useful as they should have this data readily available and will be able to help assess that the data is reasonable. They can also normally provide very good narratives for the market assumption documentation.

Expected cost plus margin

Expected cost plus margin is a good method because it can be highly simplified. Projected costs and the margin to apply can both be calculated using historical data. The challenge with this method is that costs and margin need to be tracked very closely and each contract needs to be reconciled when the contract is closed to ensure revenue estimated throughout the project agrees to final consideration received.

When using this method cost by contract needs to be tracked closely. In addition, support for the assumed margin should be documented and periodically reevaluated to ensure it is still reasonable.

The residual approach

In order to use the residual approach, the controller should gather as much data as possible to support the stand-alone selling price of the performance obligations for which there are observable selling prices. In this method, the controller should emphasize the reasons for performing the residual approach in the documentation. It is also beneficial to maintain a data set which shows contracts on which the residual method is applied which allows the controller to perform price allocations in aggregate rather than one contract at a time.

The Big Picture and Application

Remember to keep it simple. Address the big, most material points. Use data which is reliable and can be locked. Automate processes and draw the auditor’s attention to the reliability of inputs, assumption and most importantly, process.  For any other potential questions on revenue, find a data set and analysis which proves the amount is immaterial, and recalculate the potential amounts quarterly to confirm no further consideration is required.

Preparing for Financial Statement Audits

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Audits are a necessary part of the accounting process, and, while there are clear benefits resulting from audits, the process also places resources constraints on controlling processes. This analysis focuses on how to manage an audit to require fewer resources while maintaining effectiveness of the audit. This article is meant to provide a framework for financial statement audit preparation in order to allow controllers to efficiently prepare for the arrival of internal and external audit. The controller should build the process for ensuring accurate financial reporting (normally in the order listed):

The controller will find that every audit question fits into one of the above categories. By addressing each point above when preparing GL balances through internal documentation and procedures, the controller prepares to efficiently manage a financial statement audit. Throughout the article, “documentation” means narratives in either word documents or excel. The standard of documentation should be such that a new user can use the documentation to prepare the procedures in a way which is materially correct (COSO 2013).

Policy

The policy development is always the first step. A good policy is very technical and includes discussion of any situation which might occur. One good tool is to discuss why certain complex situations are either not likely or not material and include data which demonstrates this. This will allow the controller to avoid implementing complex processes for immaterial transactions. A good policy also prescribes how the company will execute ASC 606 accounting and ensure financials are materially correct.

Inputs

Inputs are metrics or data which often result from actions from non-accounting departments, for example shipping information entered by the logistics team. Accordingly, it is important to have internal controls on the process of developing inputs or a process for confirming that there is little to no risk that input data will be incorrect or inaccurate. Operational controls should be in place to ensure that the data entered by non-accountants is sufficient and accurate enough for accounting reporting. Testing sample data is a good approach for allowing a controller to ensure the data is accurate.

It is also best to use a data set which will not often fluctuate. This will have implications on future conclusions and assumptions used in accounting as well as call into question past accounting and reporting decisions and ensure data can be locked for past periods to maintain the integrity of the data. Locking data is also necessary for audit purposes as a typical audit procedure is to re-pull the data to confirm the same results.

Assumptions

Assumptions are applied to inputs prior to performing final calculations of GL balances. The fewer assumptions, the better. To paraphrase Occam’s Razor, the fewer the assumptions, the more likely it is that you have the correct result. Each time an assumption is added to the process, there needs to be robust documentation supporting the assumption and an analysis of the sensitivity of the calculation to the assumption. Support for the assumption should use historical data which has been tested internally whenever possible and documented. If the assumption has a significant impact on the calculation, then there needs to be a narrative supporting the basis of the assumption. If the assumption can change within a wide range and not impact the calculation much, normally it is sufficient to document that the calculation is not sensitive to the assumption and leave the documentation simple.

Calculations

Calculations often are applied to inputs and assumptions in order to develop the final GL balance or entry for booking. In some cases, the calculation is as simple as a sum of records, but could also be quite complex, for example, a regression analysis. If the data being used are kept in Excel, then the best approach is to lock calculation cells or pages so that they cannot be edited. The best solution, though, as discussed later, is to configure an ERP or interface to perform the calculations. This allows the audit process to focus on testing the configuration of the system (application controls) which is much more efficient. Clear documentation of the support for the calculation method should be maintained and easily accessible in order to facilitate audit procedures.

Reconciliation

Of course, it goes without saying that in the end of the process, there needs to be a reconciliation from the GL calculations to the general ledger. For excel calculations, the most efficient is to have this in a tab within the calculation. When an ERP or other automated tool performs the calculation, then the controller should build a process to check the subledger data from the ERP to the general ledger. Document within the reconciliation clear, quantitative thresholds for further investigation and amounts which are immaterial and thus do not require additional investigation or consideration. Example of adequate language is “The difference is neither qualitative nor quantitively significant is the causes are not pervasive and the amount is immaterial to the financials per the company’s policy on reconciliation difference.”

Automation

Automation can take many forms. The simplest form of automation is excel models. Building detailed, robust reporting is another form of automation in order to facilitate excel models or GL entry generation. More complex forms include building ERP functions or build-on applications that do automated calculations and GL entries without user intervention. Automating processes and calculations goes a long way to decreasing risk and reducing processing time, thus decreasing cost. It can also significantly decrease audit work performed as audit can then focus on only the few failure risks and rely on the rest of the process. The more manual/error-prone a process is, the more the auditors will question the process and results.

Reconciliations and review procedures can also be automated using tools like Blackline which automatically population GL balances to ensure the proper balance is being reconcilied and also keeps electronic signatures and time stamps of preparation and review for reliable audit evidence that controls are performed.

The Big Picture

Remember to keep it simple. Document the big, most material points. Use data which is reliable and can be locked. Automate processes and draw the auditor’s attention to the reliability of inputs, assumption and most importantly, process.  For any other potential questions on revenue, find a data set and analysis which proves the amount is immaterial, and recalculate the potential amounts quarterly to confirm no further consideration is required.