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Monthly Archives: December 2018

Unintended Consequences of Regulation

The Sarbanes-Oxley Act has created several unintended consequences including, in my opinion, eliminating many basic company controls it was intended to enhance in the first place.

Sarbanes-Oxley (SOX) became law in 2002 and was shortly followed by more regulation and the creation of the Public Accounting Oversight Board (PCAOB).  SOX has created many interesting dynamics and consequences, which I will elaborate on in this post.  Initially, public companies struggled with how to define a “control” to document that could be used to monitor compliance with Sarbanes-Oxley. I related it to one of my past roles where I was required to read two magazine articles a quarter to maintain my technical knowledge.  The way the control was written, it seemed I could read any magazine article to maintain compliance and I was uncertain how an article in People or Cosmopolitan was going to help fulfill this control. SOX regulators and my supervisor both needed to tighten up the definition of “control.”

Unintended Consequences of Regulation

Since 2002 there has been significant, well-documented analysis of the requirements related to SOX, leading to very specific rules and oversight.  The result in the public sector is that the audit team who is auditing for compliance now must to try to keep the regulators from sending them letters and questions about controls that may not be the most strategic as it relates to the health of the company. The auditors then, in turn, have their hands full during the audit process reviewing these types of controls, making it harder for them to add value and help with overall strategy. They have less time to step back and analyze the numbers in a way that results in a critical eye on the company’s financials, as they are auditing to the specific regulation to prevent the SEC from having a reason to come after them.

The increased regulation has flowed into the AICPA audit guidance, enhancing the rules of all audits; consequently, the cost of audits has increased for public and private sector companies. One of the most impactful changes has been the enhancement of the rules around auditor independence, including:

  • The auditor can no longer prepare the accounting records of the company they are auditing at all. Twenty years ago, if an auditor identified a small issue or difference, that auditor could determine what adjustment was required and make the entry to the financial statements. Now the auditor must communicate the finding to the client and request they analyze to determine what the entry should be and submit the entry to the auditor.  Especially in smaller companies, the staff may not have the specific expertise to carry this through.  These types of delays in the audit process drives the cost up.
  • The public company can not hire partners and managers on the audit team while they are working on the audit. Twenty years ago, public companies would frequently hire professionals from their audit firm who were already familiar with their company and the culture.  The SEC was concerned this impacted independence because if the auditor is expecting to be hired and receive a large salary, they may not work with complete independence.
  • The peer review regulation has been enhanced, requiring even the smallest audit firms participate in peer reviews. However, a small CPA firm has a difficult time allocating the time to either host a peer review of their work or go to another firm to perform a peer review on their work.

 

Those were some of the enhancements. Now for the unintended consequences of regulation:

  • Partners in big CPA firms are leaving the practice as they are tired of dealing with the PCAOB inquires while still having to complete their audit responsibilities.
  • The number of companies entering the public market with IPOs has declined over time as they are unwilling to incur the cost to comply with public reporting. This trend reversed in 2018; there has been an increase in IPOs as noted in the EY Global IPO trends Q4. Most of the increase is in the healthcare and technology sectors as you can see in this report from EY.
  • The typical entrepreneurial growth company does not have the disruptive technology and the ability to attract multi-billion-dollar valuations. Take Farfetch (FTCH), for example, who commanded the initial $6.2 billion valuation after the first day of trade in September 2018, with a $112 million loss in 2017. Farfetch’s valuation will make it worth the increased regulation of a public company. This example is the exception rather than the norm.
  • The cost of an audit for both public and private companies has increased significantly. As a result, many companies subject themselves to an audit when it is necessary. Recently, I learned of a company that was required to get an audit to comply with the buy-side due diligence of their potential acquirer. The cost of the audit was double the original estimate, significantly delaying the sale closing.
  • Private Equity firms struggle getting through buy-side due diligence without having audit reports or typical systems infrastructure and controls upon which they have historically relied. The standard of requesting an audit has been lowered and the Quality of Earnings (“QOE”) report is being used more often.
  • Public company accounting and finance executives are expending valuable energy managing to the specific concerns of the PCAOB, leaving inadequate time and mental space to think strategically and apply judgment to controls in their environment.
  • The companies electing not to have an audit due to the cost may not have proper data and information to run the business day-to-day, which an audit would reveal.
  • By choosing not to pay for an audit and the value a third party brings by reviewing their controls, the company may not have adequate controls, leaving companies more vulnerable for fraud and embezzlement.
  • High growth companies have grown without the benefit of audits and may be using a combination of QuickBooks and an Excel spreadsheet explosion to maintain their records. The accounting team may not be reconciling balance sheet accounts and applying proper month end closing process. When the company seeks outside investment or desires to implement an exit strategy, they may find themselves in a situation where they must get an audit completed.  The cost of an audit will likely be enormous at that point, as the books are probably not ready for an audit and chances are the existing staff may have never gone through a process of preparing a company for an audit.

 

SOX and PCAOB are certainly necessary in the United States regulatory environment.  Public reporting and transparency are necessary for investors to be properly informed.  The regulation should be reviewed and “right-sized” for the current environment.  It is a shame that a few companies with less-than-stellar ethics, like Enron, led to a set of rules that has grown into such a powerful force.  The PCAOB is not strategically focused on keeping businesses in business, and C-level executives should be pushing back for regulations that help businesses and against those controls that waste time.

 

Private companies that feel they are unable to afford an audit should keep their books and records so they are auditable.  Basics such as monthly bank and balance sheet reconciliations and proper month end cut off should be a normal business practice.

 

Other articles of interest:

Instant – Not Always Good

The New Sales Tax Laws- What You NEED to know!

ASC 606 Revenue Recognition

One of the changes affecting private businesses in 2019 is ASC 606, Revenue Recognition.

Danielle Moga provided the insights below about what ASC really means to you.  She is an associate of Barker Associates with a wide variety of accounting and finance experience with non-profit and public companies.

ASC 606 Revenue Recognition

ASC 606 What it Means to Private Business
Contributed by Danielle Moga

Public companies had to adopt the standard in 2018 and what we’ve learned is that the process to implement was not a straightforward exercise. Many companies underestimated the complexity of the change and did not have the appropriate time, resources or processes in place to implement seamlessly.

The new standard changes the way companies need to record and recognize revenue from their contracts.  The goal of the new standard is to enable users to understand better and consistently analyze revenues across industries, transactions, and geographies but the disclosure requirements are comprehensive, and the changes to the nature and timing of revenue recognition can be significant.

The good news is that you don’t have to be an industry-specific guru to implement the changes, as FASB opted for a more principles-based approach.  The challenge is, those preparing financial statements and disclosures will require more judgement.

ASC 606 breaks down the analysis of contracts into a 5-step process that is intended to help preparers wrangle the chaos of details but the task to determine revenue recognition can be daunting depending on the volume and types of contracts that exist.

  1. Identify the contract(s) with a customer

The contract must be fully executed, clearly identify the good/services to be transferred and specifically outline the payment terms.

  1. Determine the performance obligations in the contract

All distinct transfers of goods or services must be identified.  A good or service is distinct if 1) the customer can benefit from it on their own, or with resources they already have, and 2) can be transferred independent of other performance obligations.

  1. Determine the transaction price

The amount of consideration the company expects to be entitled to in exchange for transferring the promised good or service.

  1. Allocate the transaction price to the performance obligations in the contract

Performance obligations in the contract need to be separately identified priced or estimated.

  1. Recognize revenue when (or as) the entity satisfies a performance obligation

The timing of recognition of revenue is dependent upon the time frame in which satisfaction of the obligation occurs.  Point in time vs. variable over time.

The five steps are handy but don’t realistically help to manage the complexity of the project or the time it will take to meet the looming deadline.

We recommend a 3-phase approach:

  1. Analyze contracts and systems
  • Ensure you have the right resources on hand with the skills and time necessary to lead and organize the project; or hire those resources externally for support.
  • Outline all components of the contract(s), as denoted in the 5-step process.
  • Decide if the retrospective or cumulative method will be utilized.
  • Document the existing methods and systems used to report revenue streams.
  • Determine the necessary changes to process and systems to implement and control the new recognition methods.
  • Document judgements made where clarity is needed.
  1. Implement
  • Outline historical journal entries and the new ones necessary for compliance.
  • Determine differences and the impact on revenue, KPI’s and other material items.
  • Begin the conversion process and maintain parallel systems to ensure accuracy.
  1. Maintain
  • Schedule internal assessments of reporting and systems to ensure ongoing compliance.
  • Assess the skills and time of the internal team designated to safeguard this process to establish if additional support is needed.

 

Even with steps and a process, companies must set aside the time necessary to transition.  Companies with minimal impact may only need a few months to go through the process of outlining and documenting.  Companies with complex revenue streams and required system changes could take six months or more to transition and implement.

Don’t get caught in the 11th hour, start now!  If your internal team is seasoned enough to handle this change then there are many resources available to educate and plan.  Alternatively, leverage outside talent to minimize the chaos and challenges that come with significant change.