August 12, 2021
To our peer review clients:
Annually we make an effort to highlight recent changes in professional standards for our peer review clients. We hope what follows is helpful to you in your accounting and auditing practice.
Revenue Standards
We are going to devote the majority of our update letter to the standards for revenue recognition. The new revenue recognition standards are effective for your calendar year 2020 engagements. You may have heard them called “ASC 606” or “ASU 2014-9,” which are references, respectively, to the FASB Codification and the initial and often postponed standard update on revenue recognition, first issued in 2014, and followed by several clarifying amendments. The effective date was delayed one last time due to the pandemic.
This one last extension, granted in ASU 2020-05, deferred the effective date to annual reporting periods beginning after December 15, 2019 (i.e., the 2020 calendar year and subsequent). This extension wasn’t approved by the FASB Board until June 3, 2020. Therefore, the extension applied only to entities that had not yet issued their financial statements as of June 3, 2020. In other words, if your accountant’s report on, for example, calendar year 2019 financial statements was dated June 2, 2020 or prior, the new revenue recognition standards apply to those 2019 financial statements.
The GAAP financial statements you are issuing right now for 2020 calendar year financial statements come under the new standards. As discussed in our peer review update letters in prior years, one strategy for dealing with ASC 606 is to encourage clients, when possible, to convert from GAAP to another reporting framework, such as tax basis.
We are finding in our peer reviews that most firms are aware of ASC 606, yet the depth of that knowledge, and the application of the new requirements, varies significantly among firms. There is an attitude on the part of many practitioners that ASC 606 merely codifies existing practice and, to an extent, we agree with this interpretation. However, we believe there should be at minimum a discussion with your clients about how revenue is currently recognized in their financial statements and whether there is a need to make changes.
In discussion with the client, go over the five steps outlined in ASC 606 for identifying contracts and the performance obligations therein, for determining and allocating the transaction price, and for establishing the timing of the revenue recognition. We highly recommend you write a memo documenting this discussion.
We have noted during our peer reviews that even when firms are aware of ASC 606, there is frequently limited documentation in the file analyzing the impact of the new standard. Further, we have noted that firms, even those who document their considerations about the new standard in their client files, have a lack of awareness about the new footnote disclosure requirements. Firms may believe that because they have determined the new standard has no material impact on net income, the existing footnote disclosure on revenue recognition is sufficient going forward. That is the wrong conclusion. ASC 606 requires new footnote disclosure in GAAP financial statements in virtually every case, because revenue is almost always a material number in the financial statements, and FASB, as always, determines the required footnote disclosure for material amounts in the financial statements.
Revenue Recognition in an Accounting Firm
Consider revenue recognition in your own firm. CPA firms tend to recognize revenue either based on actual time incurred by staff, multiplied by an hourly rate, or based on a fixed fee arrangement. Many firms use both approaches depending on the job.
Under ASC 606 revenue is recognized when the “customer gets control of a promised good or service.” In an accounting firm, when does the customer get control, or receive a benefit?
Revenues can be recognized over time or at a point in time. For example, a client comes into your office for an appointment to prepare a simple individual income tax return. You meet with the client, conduct an interview, and enter the client’s W-2 and 1099 forms on your tax preparation software. Later that day the client picks up a paper copy of the completed return and signs the e-file authorization. That evening you transmit the electronic version of the return to the IRS and state department of revenue. Clearly the customer got control, received the benefit of your service, that day. You would recognize the revenue that day, at a point in time, using either an hourly billing rate or a fixed fee. Another example of a service performed with revenue recognized at a point in time would be a tax planning conference.
What if the tax return is for a business account that involves summary time and may take several weeks to complete? Most CPA firms would recognize revenue on this account as work in progress (or WIP) based on standard hourly rates over a period of time. Is the use of WIP permitted under the new revenue recognition standard? Because ASC 606 does not allow you to recognize revenue until the “customer gets control of a promised good or service” are you compelled to postpone recognizing revenue in this circumstance until the point in time your deliver the tax return to the client?
Although the tax return is a deliverable at the end of the project, it is not likely deemed “a good” that you are providing the client. You are performing a service, the preparation of the tax return. Under ASC 606, you have to determine that your client is obtaining control over time; otherwise, the control transfers at a point in time, and the revenue cannot be recognized until that point is reached. The question is whether the client gets control of the benefits provided by your service over a period of time or at a point in time.
As a service provider, you are not creating a tangible asset you can transfer to the client. In this situation ASC 606 allows recognition of revenue over time if either of the following apply:
The customer simultaneously receives and consumes the benefits of the service contract. If it is not clear that the customer is receiving benefit as the contract progresses, you should consider what would happen if you stopped providing the service partway through the contract term. For example, a freight company has a contract with a customer to ship goods from Portland to Seattle. Its truck breaks down in Centralia. The customer hires a Centralia based trucking company to complete the delivery to Seattle. Because the Centralia based trucker does not have to travel the miles from Portland to Centralia that have already been completed, the Portland based trucker can recognize the revenue over time. Are services provided by a CPA firm comparable to the service provided by the trucking company? In some cases, such as with a monthly bookkeeping client, the service is comparable, and the client is simultaneously receiving and the consuming the benefits of the service contract. Is the complex business income tax return preparation project different though? If the client relationship were severed halfway through the preparation of the business return, it is possible that you would not provide the former client with anything the next CPA firm could utilize in preparing the tax return. On the other hand, perhaps the client could receive benefit from your services, such as a completed summary of cash receipts and disbursements or completed bank reconciliations. If another CPA would need to substantially re-perform the work you had already accomplished, using this provision, you should not recognize the revenue until the contract is complete. However, the standard says you are allowed to disregard contractual restrictions or “practical limitations” that otherwise would prevent you from transferring the remaining performance obligation to another CPA firm.
The service provided is tailored for the unique needs of a single customer, with no alternative possible use, and the service provider has an enforceable right to be paid for partial performance. This fact pattern appears to apply neatly to a tax preparation project. However, there has to be an enforceable right to payment (including a reasonable profit margin) for performance completed to date. The right does not have to be explicit in the contract with the customer if legal precedent confers a right to payment for performance to date. On the other hand, you also have to consider your customary practice of pursuing, or not pursuing, payment in these circumstances. If you do not customarily pursue collection in these circumstances, that may render the legal right unenforceable.
In summary, there is a basis for retaining the use of a WIP account in an accounting practice.
If you are using a WIP account, how do you measure progress on a project? There are both output methods and input methods available. An example of an output method, returning to the freight company in the example above, is if revenue were recognized based on number of miles the truck travelled divided by total miles for the trip. On the other hand, an input method for the freight company might be labor hours incurred or diesel consumed to date divided by anticipated totals.
For a CPA firm, an output method that can be used is to recognize revenue based on billable hours. If your agreement with the client is to charge based on time multiplied by standard hourly rates, you may recognize revenue in the amount to which you have the right to invoice. However, this output method would not likely work well on certain fixed fee arrangements in CPA firms, such as contracts to conduct municipal audits. Since fee recovery for this off-season work is lower than in tax season, using standard billing rates on a municipal audit contract would overstate revenues early on in the contract period. In our firm’s approach to billing, for example, we increase WIP at standard hourly rates until the fee fixed in the contract is reached, then we stop adding to WIP, which inappropriately accelerates revenue recognition. Our approach represents a GAAP departure and, if material, would be reported as an adjustment to beginning retained earnings in the year ASC 606 is implemented. We should adopt an input method for recognizing revenue on municipal contracts, such as dividing staff hours incurred to date by total anticipated hours necessary to complete the work multiplied by the contract amount.
Revenue Recognition Footnote for an Accounting Firm
As noted in our update letter last year, peer reviewers may not be able to determine whether you have properly implemented ASC 606 insofar as the impact on the financial statements, but at a minimum they will be looking for new footnote disclosure required by the standard. Because revenue is almost always a material amount in the financial statements, you will need these disclosures:
Revenue recognized from contracts with customers separated from other sources of revenue;
Revenue disaggregated in accordance with the timing of transfer of goods or services;
The opening and closing balances of receivables, contract assets and contract liabilities (note that in the following example, the financial statements are for a single period, the year ended December 31, 2020; if the financial statements were comparative, the December 31, 2018 balances would have to be disclosed);
Information about the nature of the performance obligations, such as when the company satisfies its performance obligations;
Significant payment terms, obligations for returns and refunds, and warranties;
Significant judgments in the application of the standard and information about the methods used; and
In the year of implementation, include disclosure regarding adopting a new accounting principle.
Here is how a footnote for an accounting firm might look:
Revenue Recognition: The firm provides audit, accounting and tax preparation services to the public. Transaction prices for services provided are based on management’s judgment of market conditions. Clients receive no material rights to purchase additional services at discounted rates. The firm considers its performance obligations fulfilled, and recognizes revenue, both at a point in time and over time depending on the service. For simple tax returns, revenue is computed based on a fee schedule or on a markup of the prior year fee and recognized and billed at the point in time when the tax return is finished and made available to the client. On more complex projects, the firm recognizes revenue at standard hourly rates as the services are performed and for which the firm has the right to consideration from the client in an amount that corresponds directly with the value to the client of the firm’s performance completed to date. Clients are typically invoiced monthly on such projects. In addition, the firm recognizes revenues from fixed-price contracts using the percentage-of-completion method, measured by the percentage of hours incurred to date compared to management’s estimated total hours for each contract. This method is used because management considers hours incurred to be the best available measure of progress on fixed-price contracts. Because of the inherent uncertainties in estimating costs, it is at least reasonably possible that the estimates used will change within the near term. The firm believes these methods of revenue recognition most accurately reflect the economics of the transactions with its clients. Variable consideration—such as an incentive, penalty clause, rebate, or discount— included within a contract must be considered when the transaction price is initially calculated. Once the contract commences, subsequent contract modifications may require adjustment of the cumulative revenue recognized previously. Variable consideration factors did not have a material impact on the results of operation for the year ended December 31, 2020.
Contracts Receivable: Trade accounts receivable are stated at the amount management expects to collect from balances outstanding at year end. Based on management’s assessment of the credit history with customers having outstanding balances and current relationships with them, it has concluded that realization losses on balances outstanding at year end will be immaterial. Contracts receivable are ordinarily due 30 days after the issuance of the invoice. Accounts that are unpaid after the due date bear interest at 1.5% per month. Accounts past due more than 60 days are considered delinquent. Interest continues to accrue on delinquent accounts.
Contract Assets and Liabilities: Contract assets include unbilled receivables due for projects that have not been invoiced as of the reporting date. Unbilled receivables are typically invoiced every month. In addition, contract assets include unbilled amounts resulting from sales under fixed-price contracts when the percentage-of-completion method of revenue recognition is utilized and revenue recognized exceeds the amount billed to the customer. Contract liabilities include billings in excess of revenue recognized.
Disaggregated Revenue
Contract Assets and Liabilities
Contracts receivable, contract assets and contract liabilities were as follows for the years ended December 31:
Recently Adopted Accounting Pronouncements: ASU 2014-09 (ASC Topic 606), Revenue from Contracts with Customers, outlines a comprehensive model for accounting for revenue from contracts with customers and is effective for the year ended December 31, 2020. ASC Topic 606 also requires enhanced disclosures to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue arising from contracts with customers. The Company adopted ASC 606 and all related amendments using the modified retrospective transition method. As part of the adoption of the ASU, the Company elected the following transition practical expedients: (i) to reflect the aggregate of all contract modifications that occurred prior to the date of initial application when identifying satisfied and unsatisfied performance obligations, determining the transaction price, and allocating the transaction price; and (ii) to apply the standard only to contracts that are not completed at the initial date of application. Because contract modifications are minimal, there is not a significant impact as a result of electing these practical expedients. Management has analyzed the provisions of ASC Topic 606 and has concluded that no changes to the financial statement presentation are necessary to conform with the new standard, nor is an adjustment to beginning retained earnings required.
Changes in Standards Effective for 2021 Calendar Year Engagements
Audits: SAS No. 134 – 141 require a complete overhaul of the language used in the audit report on the financial statements, as well as for internal control and compliance reports, such as those used in Single Audits, and other audit communications. You may already be preparing engagement letters for audits to be performed under SAS No. 134 - 141 and, if so, you want to make sure the language in those engagement letters comply. In addition, audit programs will change, with increased procedures on related party and unusual transactions, and your approach to documenting materiality may change.
Included in the Suite of SAS No. 134 – 141, SAS No. 138 ties the definition of materiality to a US Supreme Court decision and says that misstatements, including omissions, are material if there is a “substantial likelihood” the misstatements would “influence judgments” made by “reasonable” financial statement users. This replaced “reasonably be expected to influence the economic decisions of users of the financial statements.” In addition, the new standard clarifies that “judgments about materiality involve both qualitative and quantitative considerations.” In other words, dollar amounts are not the only factor in determining materiality.
Reviews: Speaking of materiality, SSARS No. 25 requires you to calculate and document materiality considerations on review engagements. In addition, you will need to add a paragraph about independence to all of your review reports. Further, report language changes for financial statements prepared in accordance with a contractual basis of accounting. Other changes to the review report language apply when there are adjustments to correct material misstatements in previously issued financial statements; where there is a GAAP departure; and when there is a going concern. When there are material misstatements in the financial statements, including those due to a GAAP departure, language for a qualified or adverse conclusion is now available.
Agreed-upon procedures: SSAE No. 19 is effective for agreed-upon procedures (AUP) reports dated on or after July 15, 2021. This is an improvement on the existing standard, particularly for AUP engagements in which the procedures are specified in regulation. As with the new SSARS No. 25 review report, the AUP report language now includes a paragraph on the topic of independence. By the way, SSAE No. 20 is effective now and addresses materiality considerations, consistent with changes made for other levels of service.
Other Changes
The new leasing standard is effective for periods beginning after December 15, 2021. Please read our previous update letters for more guidance on this major new standard.
The Quality Control standards are undergoing revision, currently scheduled to be effective in December 2023. The name of the standards will change from “Quality Control” to “Quality Management.” Statement on Quality Control Management Standards (SQMS) #1 and #2 are in exposure draft stage right now. Be prepared to overhaul your firm’s Quality Control Document. Under the new standards sole proprietors and smaller firms may have to hire an outside CPA to conduct the firm’s annual internal inspections.
The Peer Review standards are undergoing a “clarity” revision.
Please do not hesitate to contact us if you have any questions. We appreciate your business.
Very truly yours,
The RBH Group, LLC