New standards highlight the importance of strong internal controls

Published January 29, 2018

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Companies need to pay close attention to how the adoption of some of the FASB’s new standards may affect their control systems in 2018 and beyond. In particular, major changes to the accounting requirements for reporting revenue, leases and credit losses will bring challenges when it comes to testing internal control over financial reporting (ICFR). Here’s how the impending changes will affect public and private companies — and their auditors.

Public companies

In the next few years, public companies must adopt three major accounting rule changes:

  • Accounting Standards Update (ASU) No. 2014-09, Revenue From Contracts With Customers (effective in 2018 for public companies)
  • ASU No. 2016-02, Leases (effective in 2019 for public companies), and
  • ASU No. 2016-13, Financial Instruments — Credit Losses: Measurement of Credit Losses on Financial Instruments (effective in 2020 for public companies).

Securities and Exchange Commission (SEC) officials see the implementation of these new standards as an opportunity to correct problems with ICFR. In recent years, the Public Company Accounting Oversight Board (PCAOB) has focused on ICFR during its inspection process, forcing auditors to apply more rigorous testing to their clients’ controls and companies to correct any weaknesses. ICFR will continue to be in the spotlight as companies implement the new accounting standards.

“Internal control that is effective within one set of conditions may not necessarily be effective when those conditions change significantly,” said Michael Dusza, a professional accounting fellow with the SEC, during a recent speech at the AICPA Conference on Current SEC and PCAOB Developments. “Adoption of the new accounting standards for revenue, leases and credit losses may be akin to a significant, complex or unusual transaction for many companies and, like those transactions, it will put the design of companies’ ICFR to the test.”

Principle No. 9

Principle No. 9 of the Internal Control — Integrated Framework from the Committee of Sponsoring Organizations of the Treadway Commission (COSO) is one source of guidance for ensuring that a company has controls that are working properly and is effectively prepared for the new accounting standards. The principle says an organization “identifies and assesses changes that could significantly impact the system of internal control.” It also directs companies to use the risk assessment to avoid making accounting errors in the future.

As companies implement the new accounting standards, management may need to rethink their existing ICFR. This could unearth underlying risks in internal controls or financial reporting systems that had been lurking in the background without detection.

“Such deficiencies need to be evaluated as to their severity and communicated to the company’s investors or audit committee,” Dusza said. “Identifying relevant risks of material misstatement that may arise under the new accounting standards and designing appropriately responsive controls may not be an easy task. However, we believe that, if done right, the foundation established will over time yield benefits of a more effective and efficient ICFR process.”

Companies are given significant leeway when designing and implementing their ICFR. But proactive companies generally make an effort to increase the likelihood that the controls are implemented properly by documenting the design and implementation stages. Proper planning and documentation can heighten the confidence a company’s management, auditors and audit committee have that the controls are solid.

Spillover to private companies

Private companies have a one-year reprieve on implementing each of the three new accounting standards, and these entities aren’t regulated by the SEC. But every company can benefit from stronger internal controls.

In addition to reducing financial reporting errors, sound controls can reduce the risk of fraud. This is especially beneficial to smaller companies, because fraud can be particularly devastating to a smaller entity with fewer resources to absorb any losses.

Beefed-up controls testing

Over the next few years, companies can expect auditors to beef up their controls testing. They may ask more questions about ICFR and perform new testing procedures to ensure that control systems are rock solid. Contact your CPA for advice on how to document your ICFR processes and correct any weaknesses in your systems before audit fieldwork starts.

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