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Audit & Accounting Alert Newsletter

Issue 4 | May 2012


Gerry Herter

In this issue, we continue through the joint FASB, IASB convergence process with a review of the revenue accounting project. Like the efforts described last month to standardize lease accounting throughout the world, the journey for revenue accounting has been long and difficult. In surprising contrast, the JOBS Act (Jumpstart Our Business Startups) became law in the United States relatively quickly, and with rare bipartisan support, even though heads of the accounting profession were in opposition. In our second article, we cover the accounting-related highlights that ease the way for the new law, while raising warning signals as well. Finally we enter the new frontier of Chinese accounting standards, and that country’s challenges to gaining acceptance from the international financial community.

Editor Gerald E. Herter, CPA

In This Issue 

Revenue Recognition Accounting

The path to convergence

On March 13, 2012, the comment period closed on the revised Exposure Draft, Revenue from Contracts with Customers, which was jointly issued by the FASB and IASB on November 14, 2011. The road to a new converged standard for revenue recognition has been even longer than the one for leases that we covered in our last issue. Discussions began over ten years ago in January 2002, initially focusing on a “fair value” model, and then shifted in 2005 to a “customer consideration” model that was finally developed into a Discussion Paper in November, 2008, Revenue Recognition in Contracts with Customers.

When leases are mentioned in the United States, FAS 13 (ASC 840) gets the most attention. But revenue recognition is touched on in over 100 pronouncements. While construction, software sales and real estate are prominent in the revenue measuring literature, a variety of industries have their own specialized approaches, leading to inconsistent and sometimes contradictory methods, when making the attempt to bring all entities under the same umbrella. In cases where there are no industry specific guidelines, the SEC follows four general revenue recognition concepts: 1) persuasive evidence of an arrangement, 2) delivery has occurred or services have been rendered, 3) price is fixed or determinable, and 4) collectability is reasonably assured.

For IFRS, the focus has been primarily on two standards, IAS 11 for construction and IAS 18 for sales of goods. Here the difficulties stem from inconsistencies between the two standards and how terms are defined, as well as from a lack of guidance in areas not covered. For example, IAS 18 stipulates that revenue should be recognized only when an entity transfers control and risks and rewards of ownership of the goods to the customer, while IAS 11 calls for recognition as the activities required to complete a contract take place, irrespective of the transfer of control and risks and rewards of ownership.

With these challenges, the goal became to propose a single revenue recognition model that would encompass all of the disparate approaches. A daunting task that was, indeed. The general consensus put forth in the Discussion Paper was that the overriding concept should be one where revenue is recognized when there is an increase in assets, a decrease in liabilities, or both.

The idea of a contract was used, whereby a company obtains rights to payment from the customer and assumes obligations to provide goods and services (the term “performance obligation” was introduced to describe this part) to the customer. When a performance obligation is fulfilled (when a good or service is transferred to the customer), revenue is recognized. When multiple goods or services are involved, the revenue is allocated based on what the stand alone price of each item would be. After the start of the contract, a performance obligation is remeasured and a loss recognized when it becomes “onerous,” that is when the cost exceeds the previously determined amount.

After considering comments on the Discussion Paper, the initial Exposure Draft was issued on June 24, 2010. The core principle of the proposed standard was that a company should recognize revenue when it transfers goods or services to a customer in the amount of consideration the company expects to receive from the customer. A five step process would be applied:
1. Identify the contract with the customer.
2. Identify the separate performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations.
5. Recognize revenue when a performance obligation is satisfied.

The proposal would be applied to all contracts to provide goods or services to customers, except for leases, insurance contracts, and financial instruments..

Almost 1000 comment letters were received, largely supportive of the core principal and the all-encompassing nature of the proposal. But most wanted more practical guidance for certain items, such as how to determine the transfer of control for service and construction contracts, and how to identify individual goods or services that constituted the measuring point for the completion of specific performance obligations. The construction industry was especially concerned that the percentage of completion method of recognizing revenue might be eliminated.

Consequently, the Exposure Draft was revised and reissued on November 14, 2011, to address the concerns. Criteria were added for determining the satisfaction of performance obligations over time. Criteria were simplified for identifying individual goods or services in relation to specific performance obligations. Collectability was to be treated separately and discounting was not required when dealing with a year or less. Estimation of variable consideration could be done using the concept of the “most likely amount.” Under the clarifications, current construction revenue accounting does not appear to be changed significantly.

As mentioned, the comment period has ended, and analysis and meetings are being held prior to the hoped for issuance of the final pronouncement, by the end of the year. This time the comment letters are only about a third of those received in the first go around. The new standard would not go into effect before 2015.

For further information, see Revenue Accounting - Joint Project of the FASB and the IASB

JOBS Act Becomes Law

SOX rules weakened to ease startups’ access to investors

The Jump Start Our Business Startups Act was signed into law on April 5, over the strong objections of the heads of the AICPA, SEC and Financial Accounting Foundation. While the hoped for result from the bipartisan action is a stimulation of new business activity through less burdensome regulatory measures, the concern relates to the reduction of investor protections put in place after the collapse of Enron and others from massive accounting fraud in 2001.

Finding a proper balance between regulation and a free market has been an ongoing challenge. A mere six years after the Sarbanes Oxley Act of 2002 was put in place to address the Enron situation, Lehman Brothers fell, from even more sophisticated maneuvers that financial reporting precautions were unable to forestall. Though the Dodd-Frank Act of 2009 took steps to deal with this latest financial meltdown, the JOBS Act has moved the accounting safeguards back in the other direction, for better or worse. Only time will tell.

It may seem natural for accountants to have mixed feelings about the new law. On the one hand, SOX requirements produced much growth and new employment for the profession during the first decade of the 21st century. On the other hand, the costliness and complexity of regulations were roadblocks to potential companies that would have needed accountants to staff and audit their financial functions.

The JOBS Act defines an “Emerging Growth Company” (EGC) as a new public company that has less than $1 billion in revenue during its most recent year, and less than $700 million in stock. It can retain this status for up to its first five years unless it exceeds either of those benchmarks during that period. The primary financial reporting benefits for an EGC are:
1. Exemption from the SOX 404(b) requirement to have internal controls audited.
2. Only two years of audited financial statements are required in the IPO rather than three years, and selected financial data from years prior to the two audited years are not required.
3. Exemption from new PCAOB rules.
4. Compliance with new financial standards is deferred until the date required for private companies.
5. Opportunity to have the SEC review a draft of the IPO privately before public disclosure.
6. Various easings of investor community communications and disclosures.

Other provisions of the Act under certain circumstances allow exemption from registration for offerings under $50 million, or for companies with fewer than 1,000 shareholders. Also, a “crowdfunding” provision enables up to $1 million to be raised from individual investors in small amounts.

While the JOBS Act loosens up the rules, examples of potential pitfalls are in the news as well. Groupon, the “overnight” internet discount coupon sensation that recently joined the public ranks, is now the center of attention with questionable accounting and internal controls. Also, MF Global, a major securities dealer is reeling in bankruptcy from Enron-like off-balance sheet transactions. Of course, these are not the small companies the JOBS Act appears designed to help. But considering that the Act can be used by companies with up to $1 billion in sales, the perils of a Groupon with $1.6 billion in sales are not that far from where some companies under the Act may find themselves.

Groupon apparently has not determined an effective way to estimate an allowance for customer refund claims. Material weaknesses were also noted in their financial closing process requiring manual adjustments, and a lack of detail support and reconciliations to assure complete and accurate account balances. With these kinds of shortcomings cropping up in a company going through the normal IPO process, there is no telling what to expect from smaller companies that fall under the JOBS Act exemptions.

As auditors, we know how difficult it can be to estimate a bad debt allowance for a new company without a track record. Typically, the company’s experience over a number of years provides helpful input in what is basically an informed judgment call. However, prospective investors cannot be expected to have the background of an auditor. The challenge in determining an allowance for customer refunds is akin to that for bad debts. This area would seem to call for especially prominent disclosures, so that investors can better weigh the risks of investment.

A couple other points about SOX 404(b) should be mentioned. An April, 2011 SEC study required by the Dodd-Frank Act analyzed the cost and effectiveness of SOX 404(b) since its enactment in 2002. Academic research cited in the study found that companies required to comply with SOX 404(b) reported 45% less restatements of their financial statements for material misstatement. And over a six year period, 65% of the 6,000-plus restatements were from companies not required to have SOX 404(b) audits. So financial reporting has significantly improved as a result of SOX 404(b).

When SOX 404(b) occurs should be addressed as well. Even prior to the JOBS Act, companies were not required to provide an audit of their internal controls until the first or second annual report after they went public. So regardless of whether SOX 404(b) is considered beneficial or not, the timing is of no help to prospective investors.

For further information, see JOBS Act becomes law

China Moves Toward IFRS

Major accomplishments and daunting challenges along the way to international acceptance

When my firm performed an audit in China just over ten years ago, I felt that our foray into Chinese accounting standards was akin to roaming America’s “wild west” of the nineteenth century. Granted, the country had come a long way since early 1971, the time of my military service in the Far East, when I gazed over a fence to the Chinese frontier beyond, forbidden to cross that border from Hong Kong’s New Territories. Nevertheless, the hesitance to rely on Chinese accounting processes and controls underscored the perceived risk of misstatement, intended or otherwise.

By the start of the twenty-first century, the Chinese Securities Regulatory Commission (CSRC) had been established, preceded a couple decades earlier by the Chinese Institute of Public Accountants (CICPA). But in a state controlled society, real market reforms don’t happen overnight, and decades can be required to overcome the deeply ingrained cultural mores.

However, since that time, China has made great strides on many fronts to enter the modern world. The country has recognized, at least in theory, that credible accounting standards are crucial to gaining acceptance into the major financial marketplaces.

In 2006, Chinese Accounting Standards (CAS) were put into effect for public companies, replacing the old Peoples Republic of China GAAP, and aligning closely though not completely with IFRS. Some of the differences include adherence to the historical cost method for valuations, pooling of interests method for business combinations, and defined contribution pension accounting since defined benefit plans are rare. Also, disclosure requirements can differ, as well as a prohibition on early adoption of IFRS amendments while the government agency considers the impact on the country.

Because of the different influences of regions, industries and regulatory agencies, the pace and level of adoption of CAS has been somewhat erratic. In some cases, private companies will be required to come on board also. Then in 2008, the Basic Standard for Enterprise Internal Control was issued to promulgate a SOX 404(b)-like approach to audited internal control assessments.

The enormity of the shift required was pointed out by IASB Chairman Hans Hoogervorst in a July 2011 speech in Beijing. “Since it began its programme of economic reform, China has sought to transition its accounting system from one based on the needs of a planned economy towards international accounting standards based on market economic principles.”

Part of the challenge is a shortage of qualified accountants. The numbers have been growing rapidly, exemplified by a member of my own CPA staff choosing to return to her native Shanghai to be part of the dramatic developments. Audits have been dominated by the Big Four firms, working on 20-25 year licenses. As these licenses expire shortly, renewals will call for firms to form partnerships and have signors of audits carry CICPA membership. Operating in partnership form will instill individual liability exposure to the CPAs, an improvement over the past where only the entity with limited assets could be held responsible.

Hoogervorst feels that China is well on the way to having a trustworthy system of accounting standards. But to overcome the well earned suspicions of the rest of the world for such a long time, he urges the Chinese to eliminate all remaining differences from IFRS, devise ways to promote the understanding of the strong joint commitment to IFRS between China and the IASB, and to encourage more involvement by the Chinese in the standard setting process.

Optimism is understandable from a top-down approach that looks at the establishment of standards and professional institutions. However, when considering the effort required to retrain accountants and restructure systems at the entity level, experience suggests that there is still a long way to go. Also, while the accounting standards put in place in 2006 may have been closer to IFRS at the time than prior standards, IFRS has moved on since then, leaving the country further behind in their goal of full adoption.

Thanks to the foresight of Integra’s Global Board and Board member Steve Austin’s multiple fact finding trips during the past decade, Integra International is well placed in China with three accomplished member firms and over 300 CPAs well suited to serve the needs of our member’s clients: .K. Cheung (CPA) Co., Limited in Hong Kong, Shanghai Perfect CPA Partnership in Shanghai, and Dezan Shira & Associates, a multi-national firm with offices in those cities, as well as Beijing and cities across China and Asia.

For further information see China Accounting Standards

Additional A&A News

The following links provide a selection of current articles devoted to highlighting other A&A topics currently making news.

  1. FASB, IASB tentatively agree on two financial instrument items
  2. IFAC Urges G-20 to Stop Inconsistent, Unreliable Public Sector Financial Reporting
  3. CPAs as Market Leaders for Reporting on Service Organization Controls 
  4. Microsoft's Laux: Multiple Challenges Face Accounting Profession
  5. Auditors “Monkeying Around with Documents,” Top PCAOB Cop Says
  6. FASB makes decision on qualitative going-concern disclosures

Audit & Accounting Alert is a publication of Integra International intended to highlight emerging issues in the profession. The goal is to give Integra members an awareness of developments impacting the practice of Audit & Accounting, enabling them to stay on the forefront of industry trends.

Editor Gerald E. Herter  •  HMWC CPAs & Business Advisors, 17501 E. 17th Street, Suite 100, Tustin, CA 92780-7924
 •  Tel: 1 714 505-9000  •  Fax: 1 714 505-9200  •  Email: [email protected]