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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.

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.