Internal Cntrl Requirements fr Adpting New Accunting Standards Backgrund In previus articles, BKD discussed the U.S. Securities and Exchange Cmmissin s (SEC) expectatins regarding the requirement t disclse the effect that recently issued accunting standards will have n a registrant s financial statements when adpted in a future perid, as required by SEC Staff Accunting Bulletin* (SAB) Tpic 11.M (SAB 74). As the effective dates f majr standards issued by the Financial Accunting Standards Bard (FASB) apprach, preadptin (transitinal) disclsures under SAB 74 shuld becme qualitatively and quantitatively mre elabrate and specific. Likewise, management s assessment and disclsure f changes in its internal cntrl ver financial reprting (ICFR)** is expected t change, as depicted in Appendix A. Changes in internal cntrls while transitining t new financial accunting standards are caused by risks inherent during this time, which can be summarized int three categries: Prcesses t capture data necessary t accumulate the new standard s effect n the entity s financial statements fail t ensure accurate, cmplete and easily understandable SAB 74 disclsures. SAB 74 disclsures shuld include the financial statement effect caused by the new recgnitin, measurement, presentatin and disclsure requirements Accunting and financial reprting prcess changes, including infrmatin technlgy (IT) system changes made t cmply with the new standards requirements, fail t ensure the new standard is effectively adpted resulting in financial statements, including disclsures, that are nt fairly presented, in all material respects, in accrdance with generally accepted accunting principles (GAAP) Significant changes t ICFR are nt captured and disclsed, r are nt disclsed in a timely, accurate, cmplete and understandable manner Management s annual ICFR assessment shuld be based n evidence abut hw the entity s ICFR is perating in relatin t its risk assessment. Cntrl design and implementatin changes (r expected changes) identified thrugh management s risk assessment prcess shuld be evaluated preadptin, upn adptin and pstadptin t determine whether they represent a substantial change t the filer s ICFR and require disclsure. This article highlights the imprtance f and discusses practice pints fr capturing and disclsing significant changes t ICFR ver the transitinal perid. Cntrls ver SAB 74 disclsures and the capturing and reprting f quarterly ICFR changes ften can be an afterthught as cmpanies fcus n prcesses fr adpting measurement and recgnitin requirements f newly effective standards. Likewise, prcesses fr cmplying with new ftnte disclsure requirements may be a secndary pririty. Hwever, the disclsure requirements mandated by FASB s new revenue standard, Accunting Standards Update (ASU) 2014-09, Revenue frm Cntracts with Custmers, fr example, are extensive. ICFR applies t disclsures as equally as it des t the main financial statements, and cmpanies are encuraged t heed the SEC s recent scrutiny f ICFR. Cmpanies nt required t be cmpliant with Sarbanes-Oxley Act f 2002 (SOX) are encuraged t maintain awareness that their auditrs are required t btain an understanding f the cmpany s internal cntrl system design and implementatin as part f their audit engagement, including specific attentin t fraud risk. * SEC Staff Accunting Bulletin 74, cdified as SAB Tpic 11.M, Disclsure f the Impact That Recently Issued Accunting Standards Will Have n the Financial Statements f the Registrant When Adpted in a Future Perid.
Internal Cntrl Requirements fr Adpting New Accunting Standards ** Management is required t evaluate and assess ICFR under Sectin 13(a) r 15(d) f the Securities Exchange Act f 1934, an implementatin f Sectin 404 f SOX. The rules the SEC adpted in June 2003 t implement Sectin 404 require management t annually evaluate the effectiveness f its ICFR and t disclse its assessment t investrs. SEC Final Rule N. 33-8238, Management s Reprt n Internal Cntrl Over Financial Reprting and Certificatin f Disclsure in Exchange Act Peridic Reprts, requires disclsure f significant changes t an entity s ICFR. Item 308(c) f Regulatin S-K requires filers t disclse material changes t ICFR. SAB 74 & ICFR Disclsure Cntrls Overview f SAB 74 Disclsures In additin t disclsing the expected financial statement effect f recently issued standards (when the standard will be adpted in a future perid), SEC filers are required t disclse in the ntes t the financial statements: The status f the implementatin prcess, including the nature f significant implementatin matters that have nt been addressed The transitin methd elected (full r mdified retrspective), including practical expedients A cmparisn f the cmpany s current accunting plicies with the accunting plicy under the new standard If a cmpany des nt knw the expected effect, r cannt reasnably estimate, this fact shuld be disclsed. In thse cases, the quantitative disclsure f the new standard s effect shuld be replaced with a qualitative descriptin f the new accunting plicies effect and a cmparisn f the new accunting requirements t the cmpany s current accunting. ICFR Includes SAB 74 Disclsures Management s ICFR assessment includes cntrls designed t help ensure that financial statements, including the ftntes, are prepared in accrdance with GAAP. Because transitinal disclsures required under SAB 74 are part f the ntes t the financial statements, cntrls arund them are included in the ICFR annual assessment in years prir t adpting a newly issued standard. Management is required t disclse in the entity s quarterly Exchange Act reprts changes in internal cntrls that have r will materially affect the issuer s ICFR. In ding s, it shuld cnsider shrt-term circumstances and risks uniquely present during the adptin perid. Significant new cntrls may include cntrls t ensure accurate, cmplete and understandable SAB 74 disclsures and cntrls t address risks assciated with prcess changes t develp and supprt significant judgments and estimates, fr example, which will be necessary t recgnize revenue and prvide the required ASU 2014-09 disclsures. Management wuld evaluate the risk that prcess changes will result in inaccurate and unreliable financial reprting in the current reprting perid (and future reprting perids). Hencefrth, capturing significant changes t ICFR (and ensuring apprpriate disclsure f these changes) requires prcesses and cntrls f its wn generally including versight by knwledgeable persnnel with apprpriate authrity, e.g., senir management, internal audit and disclsure cmmittee. Judgments required t identify newly required prcesses and cntrls ften will require a careful evaluatin f the detailed infrmatin regarding the nature, design and ecnmic substance f cntracts and changes theret. Applying the new cncepts, particularly fr cmpanies with cmplex cntracts r reprting revenue frm mre than ne revenue stream, may require mre resurces and cllabrative effrt acrss the cmpany than riginally planned. 2
Internal Cntrl Requirements fr Adpting New Accunting Standards Practice Pints: Revenue recgnitin is ne f the mst cmmn issues triggering an ICFR material weakness, primarily due t accunting and financial reprting cmplexity and subjectivity and the elevated risk f financial statement fraud and management verride. Fr issuer entities subject t an assessment and reprting n ICFR, dcumentatin f the design, implementatin and perating effectiveness f ICFR cntrls shuld be cnsidered as imprtant as accurately understanding the standard s new measurement, recgnitin, presentatin and disclsure requirements. With subjective-based standards such as the new revenue recgnitin standard, the risk f material misstatements inherently increases with the increased use f significant judgments, critical accunting estimates and assumptins. Subjective accunting and financial reprting characteristics generally result in a systemic effect n the entity s entire internal cntrl system. An entity using the Cmmittee f Spnsring Organizatin s (COSO) 2013 Internal Cntrl Integrated Framewrk, fr example, will evaluate changes required t all five COSO cmpnents cntrl envirnment, e.g., tne at the tp, mnitring, risk assessment and infrmatin and cmmunicatin in additin t cntrl activities. Filers frequently avid prcess changes in the last quarter f the reprting perid. Onging implementatin team meetings with members f accunting, financial reprting and ICFR versight can be an effective way t share the new standard s effect n each department and ensure timely disclsure f material changes t ICFR. Cntrls ver an entity s disclsures extend t infrmatin cntained in management s discussin and analysis (MD&A), e.g., cntrls t address the risk that MD&A infrmatin is misleading r cnfusing. Fr the new revenue recgnitin standard, fr example, an entity will assess the standard s effect n nn- GAAP disclsures, key perating metrics, perfrmance indicatrs and frecasts many f which are affected by GAAP-based revenue and update its disclsure cntrls accrdingly. Althugh nt part f the ICFR assessment, an entity may benefit frm perfrming the SEC disclsure cntrl assessment made cncurrently with it. Refer t BKD s article, Nn-GAAP Financial Measures, fr nn-gaap financial reprting insights. Next Steps BKD will cntinue t stay abreast f implementatin best practices regarding the new revenue recgnitin standard and prvide practical insights. Fr further infrmatin, cntact yur BKD advisr. Cntributr Cnnie L. Spinelli, CPA Additinal Resurces: SEC Staff Expectatin n Disclsing the Impact f Upcming Accunting Standards Revenue Recgnitin: SAB 74 Disclsures 3
Internal Cntrl Requirements fr Adpting New Accunting Standards Appendix A Internal cntrl systems are expected t change as the entity s revenue recgnitin transactins are rewrked t capture the required infrmatin, particularly fr cmpanies with diverse cntracts and multiple revenue streams. Preadptin Clser t Adptin Year f Adptin Disclsure f the new standard's effect n future financial statements (SAB 74) Disclsure f significant ICFR mdificatins assciated with implementatin activities Mre quanitative disclsures, when pssible, f the new standard's effect n future financial statements (SAB 74) Disclsure f significant ICFR mdificatins assciated with prcess and IT system changes related t accunting and financial reprting under the new standard Adptin disclsures and disclsures required by the new standard (ASU 2014-09) Disclsure f significant ICFR mdificatins assciated with accunting plicy and prcedure changes and IT system changes related t accunting and financial reprting under the new standard ICFR Cntrls The fllwing is a nninclusive listing f risks a cmpany may cnsider at each phase as it develps and implements transitinal and nging disclsure cntrls: Risks t accurate and cmplete applicatin and implementatin f the five-step mdel fr recgnizing revenue. Cntrls addressing implementatin risk generally will include mnitring f the adptin prcess, versight ver implementing a new IT system t recrd revenue, cntrls ver transitin jurnal entries and cntrls ver adjustments t financial statements fr prir years presented, e.g., the risk that: All material revenue streams and cntract types are nt identified, e.g., whether the entity is a principal r an agent, licensing revenue Accunting cnclusins are nt accurate cntract csts, presentatin f cntract assets and liabilities, presentatin f revenue grss f net (principal versus agent) Initial recrding at adptin is nt accurate IT systems are nt capturing the right infrmatin, r IT-generated reprts used fr jurnal entries and accunting estimates, assumptins, etc., are invalid and nt mnitred fr data quality Changes t custmer cntracts are nt captured 4
Internal Cntrl Requirements fr Adpting New Accunting Standards Risks t accurate, cmplete and understandable disclsures required by ASU 2014-09 and disclsure f the accunting changes at adptin, e.g., the disclsure cntrls address the risk that: The financial reprting functin des nt have in place a sustainable prcess fr the IT system t capture the right infrmatin IT-generated reprts used as surce dcuments t prepare disclsures are nt adequately tested t ensure validity Disclsures d nt include significant judgments the cmpany made when applying the guidance Disclsure d nt allw an investr t understand the revenue arrangement and the entity s rle in it. This is particularly pertinent in revenue versus agent assessments because a cmpany is expected t disclse the pertinent facts related t these judgments BKD s previus article, Revenue Recgnitin: New Disclsures, prvides insight int the extensive new disclsure requirements f ASU 2014-09. Mst ntable are the qualitative and quantitative disclsures arund revenue disaggregatin; cntract assets, cntract liabilities and receivables; and fr public business entities, remaining perfrmance bligatins. These disclsures are in additin t a descriptin f significant judgments made particularly arund satisfactin f perfrmance bligatins and a descriptin f the methds, inputs and assumptins used fr determining transactin price, including variable cnsideratin and measuring returns and similar bligatins. 5