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Sarbanes Oxley : Technology : Business Process Management
The Impact of Sarbanes-Oxley on Revenue Recognition Practices Part 1
Part One: Key Processes for Revenue Compliance
By
Robert O'Connor
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Robert O'Connor
CEO
Softrax
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Revenue accounting has become a ?hot spot? for auditors and investors. It is simultaneously coming under greater scrutiny and becoming more complex. Guidelines and regulations are under constant review, and many industries are adopting new business models involving wide ranging customer relationships with long-term financial implications.
The introduction by the Securities and Exchange Commission of Staff Accounting Bulletins (SAB) 101 and 104, as well as FASB?s Emerging Issues Task Force (EITF) 00-21 and the Sarbanes-Oxley Act underscore the fact that reliable revenue reporting is a demand all companies must meet, and that it is non-negotiable. Accurate, timely, and comprehensive revenue reporting is a requirement for enterprise infrastructures and an essential component for regulatory compliance.
One of the primary objectives of Sarbanes-Oxley is to ensure that companies are reporting accurate revenue numbers. Therefore, one might expect to see sweeping changes in this area. A survey conducted by RevenueRecognition.com and IDC in August 2005 found that more than half (55%) of all public companies have changed revenue recognition practices as a result of Sarbox, see Figure 1. More than a quarter (26%) of companies that did so reported the changes were ?moderate? or ?significant.?
Figure 1: Have you modified your revenue recognition practices as a result of Sarbanes-Oxley? (Public companies only, n=162)
Compliance Processes Efficiency and Risk
The business process implications of Sarbox, especially section 404, are enormous. With respect to revenue alone, the entire order entry to journal entry process must be reviewed, remediated, and documented across all offerings, divisions, and regions. As a result, many companies have taken a long term approach to compliance in which continuous improvement is a central practice. Only 14% of public companies believe their compliance processes are ?highly efficient? requiring no further investment. A majority of companies (82%) said their compliance processes may or will require incremental improvement, while 4% said these processes were largely temporary fixes that are being or will be replaced.
Managing the Revenue Cycle
The foundation on which all revenue related activities depend is the order to revenue process. The order to revenue process is similar to the order to cash process. In fact, the two processes are inextricably linked, with cash and revenue proceeding through the cycle under different criteria, at different rates and amounts. Therefore, automation should be applied to these parallel processes in a separate but coordinated way.
Figure 3: The Revenue Parallel - When business models become more sophisticated, revenue and cash accounting must be managed separately. Billing and collections drive cash and receivables on the balance sheet, while revenue drives the income statement.
It is surprising, however, that while most financial and enterprise systems have developed rigorous mechanisms to manage the order to cash process, the same systems have typically failed to treat the order to revenue process as anything more than an afterthought. While the cash position of a company and the balance sheet are critical indicators of corporate health, it is often the information behind the revenue numbers that provide the granularity needed to understand true corporate performance. The essential question is which offerings, accounts, regions, and contracts are driving revenue growth, and which are creating bottlenecks.
The situation is exacerbated by the sales pipeline. The pipeline to cash process is the subject of continuous planning as assumptions are made about when contracts under negotiation may lead to cash. The same level of analysis is required for revenue but is often missing from systems developed around simple financial models in which there is little or no separation between cash and revenue. With the advent of more sophisticated long-term financial relationships with customers, more and more companies are looking for a solution to provide the revenue counterpart to the cash analysis.
The Order to Revenue Process
To support a rigorous approach to revenue, there are five core business processes that should be addressed by the implementation of a revenue compliance system:
Revenue Allocation
The critical first step is properly allocating revenue across a complex set of products and services with different pricing schemes. Both GAAP (e.g. based on EITF 00-21) and non-GAAP (e.g. driven by internal reporting needs) allocation rules should be able to be applied to the appropriate revenue streams. This process must be automated as much as possible and robust transaction tracking must be built in to limit audit exposure. Inaccurate allocation and has been the cause of many financial restatements.
Revenue Scheduling
Best business practices call for revenue scheduling to be applied at the transaction level. This simplifies managing the changes that inevitably occur after the original contract has been initiated and represents a point of detailed audit control. The major challenge faced by most companies is the sheer volume of data that needs to be created and managed. This typically exceeds the capability of general financial applications.
Revenue Recognition
Revenue recognition covers a wide range of processing. It can be triggered from a recognition date or can require intense manual scrutiny by the financial staff to ensure the four pillars of recognition have been satisfied. Ultimately, most corporations are forced to establish controls for recognition so that each transaction is appropriately treated. The major problem is providing visibility into the critical events that impact revenue recognition.
Revenue Accounting
Revenue accounting is the bridge between the subsidiary ledger and the general ledger. There are effectively two major hurdles that must be addressed. The first is the ability to record accurate billing/receivables against the revenue schedules so that the correct amount can be booked into unbilled and billed revenue. This is known as the six-account problem where revenue moves from being unbilled and unearned to billed and earned over the transaction lifetime. Unfortunately, most companies fail to control the unbilled revenue even though it typically represents a significant amount of future revenue booking.
Figure 4: The Six Account Problem - Money can flow from Unbilled/Deferred to either Billed/Deferred or Recognized/Unbilled depending on contract terms for delivery and payment. Then the billing and recognition processes must be reconciled before it becomes Billed and Recognized. This flow must be coordinated with Accounts Receivable entries.
The second problem relates to multi-currency transactions as defined by FASB 52. A revenue schedule may need to be revalued to provide accurate revenue bookings due to fluctuations in the exchange rate over length of the recognition period.
Revenue Compliance
The last key component is to control the compliance of the revenue recognition process and ensure the appropriate steps and re-mediation is applied. Compliance is a holistic effort that must be consistently rigorous throughout the revenue cycle. Revenue transactions must be supported with a robust audit trail in order to provide the records necessary to fully document internal controls. User identities, access privileges, and authorization rights must be centrally controlled.
Most companies reach a point where 80% to 90% of the transactions can be booked through a standard business process. However, there are always exceptions that fall outside the normal business practice that need to be addressed uniquely. These transactions are often materially significant since they stem from a new business or entry in a new market. These risks put the revenue from such ventures under increased scrutiny. It is critical therefore, that the underlying infrastructure be flexible enough to quickly and easily systematize new revenue streams and apply corporate compliance standards.
Closing Thoughts
Revenue compliance must become a core competency of every finance department to ensure proper reporting, to produce optimal performance, and to mitigate risk. Accurate revenue reporting provides a clearer picture of the overall health and well being of the corporation, while inaccurate revenue reporting substantially increases the risk of financial restatements.
The benefits of improved revenue accounting processes are wide ranging. The availability, reliability, and usability of key business performance information improve tremendously. Compliance processes are easier to manage. Tedious mandatory tasks such as closing the books and supporting audit processes become far more efficient allowing more time for proactive analysis. Executives are better informed about key revenue drivers, enabling issues to be identified and acted upon with greater immediacy. With an optimistic approach to compliance, the initiative can and will turn into a competitive advantage for your organization.
Robert O'Connor
CEO
Softrax
Robert O?Connor is President and CEO of Softrax Corporation, a leading provider of enterprise billing and revenue management solutions.
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