So there I was, attending a conference of our friends in the corporate audit and finance functions. I attended a session on the new accounting standard for operating leases, which goes into effect in December.
The room, one of the largest in the facility, was packed to the gills. Finance and audit professionals were taking detailed notes on a major new accounting standard now less than three months away.
Oh dear, I thought. Compliance officers better brace for impact.
Worse, the new leasing standard is one of three major changes to corporate financial reporting gusting through the corporate finance and audit functions right now. A new standard for revenue recognition went into effect in December 2017, and a new format for the external auditor’s report goes into effect in June 2019.
Those three changes in external reporting could bring profound changes to a company’s internal processes, especially for contract management. Compliance officers need to understand what those changes might be, so the changes don’t ignore or sweep aside the anti-corruption compliance procedures you’ve been cultivating for years.
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Start With the Standards
1. Revenue Recognition
Begin with the new standard for revenue recognition, which went into effect for fiscal years ending on or after Dec. 15, 2017.
That new standard defines revenue as a series of performance obligations spelled out in a contract. A company can recognize revenue only as it fulfills each obligation in a contract: customize a widget for the customer; deliver the widget; perform follow-up widget maintenance annually for a set period of years, and so forth.
For most companies, the new standard doesn’t change the numbers reported to Wall Street. Some companies do see a material change in the timing of when they recognize revenue, but a $1,000 sale is still worth $1,000 even if you now recognize portions of the $1,000 at different times.
2. Operating Leases
Meanwhile, the new standard for operating leases goes into effect for fiscal years ending on or after Dec. 15, 2018. This standard requires companies to move the future costs of their operating leases out of the footnotes (where they’re listed now) and onto the balance sheet, as liabilities.
For both standards, however, the crucial matter is that the company needs to know all the contracts it has.
Again, the numbers themselves won’t change. Whatever leasing costs you report in the footnotes today (for office space, equipment, vehicles, data storage, and so forth) will still exist tomorrow. They’ll simply appear in a more prominent location.
For both standards, however, the crucial matter is that the company needs to know all the contracts it has — contracts with customers and vendors alike. Only then can the company identify cost and revenue numbers, total them up, and present them to investors in financial statements.
3. The Audit Report
Auditor reports for fiscal years ending on or after June 30, 2019, will introduce a significant new item: Critical Audit Matters, affectionately called CAMs. These are financial reporting concerns serious enough that the external auditor discusses them with the company’s audit committee.
What is a CAM? The standard adopted by the Public Company Accounting Oversight Board has two criteria:
- Relates to accounts or disclosures that are material to the financial statements; and,
- Involve especially challenging, subjective, or complex auditor judgment.
Well, revenue will always be material to financial statements, and leasing costs can be material for most companies. And sweeping new accounting standards tend to produce lots of — how shall we put it? — improvisational procedures in the first few years a company tries to implement them. Which gives rise to especially challenging, subjective, or complex auditor judgment as your audit firm tries to understand what the heck you’re doing.
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So two major new accounting standards are likely to upend how your finance and audit teams manage major parts of financial reporting, just as a new audit report format will compel auditors to disclose more clearly where they see uncertainty and risk in a client’s financial processes. That’s what is afoot here.
Understand How Your Company Will Respond
Your audit committee, CFO, and finance function want as few CAMs as possible. So wherever a company might be able to improve its internal controls and processes for revenue recognition and operating leases, it probably will. As one speaker at my conference told the audience, “This is a great opportunity to ask for some funding, and take care of those things you know you want to take care of.”
That is what you, the compliance officer, want to look for. What things? Take care of them how, exactly?
For example, your company could create a centralized real estate function to control leases. It might impose standardized contracts with customers so a new document management system can extract pricing and performance obligations data automatically. It could adopt new policies about the types of contracts it will sign, or who can sign them; which requires new policy management and training.
Ultimately these changes will likely be good things: they impose order on process, and compliance officers like that. You might even be able to sneak the compliance improvements you want into whatever broader changes the finance and audit teams undertake.
First, however, you need to understand what’s happening in the finance function. Right now, it’s quite a lot.