USA Does accepting payment before a signed contract in hand leave me open to liability?

[Jana]

Hi All,

This is obviously not common practice, and not something I condone, however my new place of employment has run amuck a bit over the last decade or so, and are subsequently very set in their ways. Trying to change process is slow. Departments have a habit of launching off an invoice before we have a signed contract in house. In some cases I have received payment before the contract as well. I'm wondering if this leaves me open to any liability, audit wise and legally? I know the rev recognition part is sticky, but I'm also wondering about the expectation set forth in accepting payment without a contract. Have we just agreed to basically anything the client wants by accepting payment?

Thanks!!

 

[ICAEW]

First, look up 'Bilateral contracts'.

Following on from there, the fact that your company has invoiced implies that the offer was accepted and therefore, the acceptance of consideration took place. Whatever terms and conditions were incorporated in the contract would ideally apply, unless someone disputes it.

A provision is an outflow of economic benefits (liability) of an uncertain timing or amount. So, if you've already incurred the costs, and have already received some payment, only recognise the revenue to match the costs incurred and leave the rest as a liability.

Onerous contracts. The provision should be provided for the lower of the exit costs (costs that will be incurred if the contract was breached) or the costs that will be incurred in performing the contract (once again, if stage of completion is being followed, it should be applied).

Auditing issue. The auditor is likely to ask for the actual contract in order to recalculate the revenue and costs recognised to date/in the year, after sampling the material items. And if the contract is still not signed by then, they might as you to either:

1) Get it signed by the third party; or
2) Make a provision.

Also note that he will be asking for a third party confirmation of gross receivable due/payable to the customer.


So, what I'd suggest is that you contact the client, and explain the issue to them. Make them understand it from an auditing perspective too. Try to get the contract signed so there are no legal issues either.

Otherwise, pass the journal entries to be on the safe side.

Best Regards,

Kian

 

[Jana]

Thank you! I was thinking about consideration, which is what prompted the question. It seems a bit of grey area if you loop in consideration without a signed contract (because the contract would technically still be in negotiation), and then accept payment, which would imply consideration, and a fully negotiated set of terms.

As for the auditing issue, we defer most of the revenue booked at time of invoicing, so I'm hoping that will come across as much less of an auditor issue. Just have to be sure the all contracts are signed and in-house before making adjusting entries to the P&L.

Would this be offset with a Letter of Intent? I know it's not common practice in these types of situation, but would a Letter of Intent suffice for payment coverage and serve as coverage for the engagement of the 2 entities, while the long form contract is still being red-lined, without opening up anyone to liability?

 

[ICAEW]

That would depend on how the said auditor approaches the issue.

Since you're deferring the revenue anyway, it shouldn't be that much of an issue, as it's not affecting the profit nor the equity. This is based on the assumption that it's not the year-end and no journal entries will be passed to transfer the revenue and the related costs.

Having a letter of intent would surely indicate that there's an intention to supply services, however, it's neither appropriate nor sufficient evidence to confirm that the contract will indeed go ahead (from an audit perspective). So please make sure that you do have a signed contract by the time your final audit starts.

In legal terms, an intention would be treated as an 'invitation to treat' but as the consideration has already been transferred without a formal contract, ideally, the common law should apply (that it's customary to exchange consideration without formalizing the contracts as both parties regularly trade--so kindly confirm that this is indeed the industry practice).

For now, it would be reasonable to recognise the amount received as a liability, as it would be offset by the same amount of cash, so the effect on the financial statements would be nil.

 

[Counterofbeans]

I'm wondering if this leaves me open to any liability, audit wise and legally? I know the rev recognition part is sticky, but I'm also wondering about the expectation set forth in accepting payment without a contract.

Yes, you have a liability from an accounting & a legal perspective. You eventually either need to provide the goods/services that you received the $$ for or return said $$.

And your instincts serve you well--do NOT recognize revenue until all applicable criteria have been met.

One other thing: Why is it that people constantly defer to the auditor? Auditors are NOT in charge of recording JEs in your financial statements. They are responsible for buying off on YOUR conclusions. Forget what the auditor thinks (at first), what do YOU think?

Note that this is not to mean that you shouldn't discuss certain transactions, especially technical transactions, with your auditors, but more to the point that the auditors are NOT in charge of your books--YOU ARE!

Have we just agreed to basically anything the client wants by accepting payment?

Thanks!!

Not in the slightest. I'm confused why you'd think that.

So, if you've already incurred the costs, and have already received some payment, only recognise the revenue to match the costs incurred and leave the rest as a liability.

No, especially if this person/company reports pursuant to US GAAP.

FYI: The matching principle no longer applies under US GAAP. We set up assets and liabilities on our financial statements when the corresponding definitions have been met, which may or may not correspond to how the related revenue is recorded.

So, what I'd suggest is that you contact the client, and explain the issue to them. Make them understand it from an auditing perspective too.

What major issue is there? It seems fairly simple to account for

 

[ICAEW]

It's not the accounting that's the issue, but the inconsistency in the evidence available at the time the audit is performed. If journals are going to be passed and the contract is still unavailable, it is bound to become an audit issue if the amounts recognised are material (which in turn would depend on how the auditor chooses to set the performance materiality threshold). The completeness and accuracy will definitely be tested, along with the existence, rights and obligations and valuation of the balances appearing on the statement of financial position. Like I mentioned earlier, for the auditor, it's all a matter of obtaining 'sufficient and appropriate' evidence for the figures appearing in the financial statements.

@Jana. Kindly note that the advice provided earlier was in accordance with the IASs and IFRSs and not the US GAAP. However, the common law/precedent law would still apply in the US.

 

[Counterofbeans]

It's not the accounting that's the issue, but the inconsistency in the evidence available at the time the audit is performed. If journals are going to be passed and the contract is still unavailable, it is bound to become an audit issue if the amounts recognised are material (which in turn would depend on how the auditor chooses to set the performance materiality threshold). The completeness and accuracy will definitely be tested, along with the existence, rights and obligations and valuation of the balances appearing on the statement of financial position. Like I mentioned earlier, for the auditor, it's all a matter of obtaining 'sufficient and appropriate' evidence for the figures appearing in the financial statements.

@Jana. Kindly note that the advice provided earlier was in accordance with the IASs and IFRSs and not the US GAAP. However, the common law/precedent law would still apply in the US.

Once again, I don't understand the need to even worry about the auditor as the primary concern. If you book what's appropriate, who cares what the auditor thinks. The appropriate hurdle should be the company's own internal policies.

I don't understand what inconsistency exists. Just because they have invoiced and received $$ prior to a signed contract doesn't mean there's some glaring inconsistency. You just record a liability for the cash received and call it a day.

And I'm far from an expert in IFRS, but I refuse to believe that IFRS allows revenue recognition prior to goods delivered/services rendered. In other words, just because they received $$$ and incurred costs, that doesn't automatically mean you should record revenue. If it actually does, I'll laugh my ass off at IFRS.

 

[kirby]

Hi Counterofbeans
I'm with you on not being an iFRS expert. I wish I knew the reason why the US leadership caved and decided to adopt IFRS. Just saying it kinda looks bad for US accountants, like we've been doing the wrong thing all along. I hope its just a dim fad that will go away. Like when the US told everyone we were going metric.

 

[ICAEW]

Once again, I don't understand the need to even worry about the auditor as the primary concern. If you book what's appropriate, who cares what the auditor thinks. The appropriate hurdle should be the company's own internal policies.

I don't understand what inconsistency exists. Just because they have invoiced and received $$ prior to a signed contract doesn't mean there's some glaring inconsistency. You just record a liability for the cash received and call it a day.

And I'm far from an expert in IFRS, but I refuse to believe that IFRS allows revenue recognition prior to goods delivered/services rendered. In other words, just because they received $$$ and incurred costs, that doesn't automatically mean you should record revenue. If it actually does, I'll laugh my ass off at IFRS.

You're right in saying that her primary concern should be the internal policies of the company, which should "ideally" be documented and consistent throughout the whole organisation. And when it comes down to who cares about the auditor and his opinion, I think you need to recall the fact that it's the shareholders who appoint the external auditors in order to comply with the regulatory requirements. So, basically, it's the people who provide the funds for the organisation in order for it to run are the ones who really care. Who else cares about the auditors and their opinion? The general public does have an interest in the financial information available to them (especially if they're paying the company registrar to obtain the financial statements) so I'm sure they're more confident in relying on the financial statements that have been verified by independent accountants.

Once again, I'll repeat myself, it's not an accounting issue at all. But it would definitely be an audit issue. How am I so certain? Maybe because I am an auditor myself and which is why my advice to her was to ensure that the relevant source documents are available at the time the audit is being conducted. If the finalised contract is unavailable, it would create a Limitation of Scope for the auditor when gathering the evidence and if the accountant were to argue over the revenue recognised despite the lack of supporting documents, it would further lead to a 'Disagreement' which in turn would lead him to either change the way he performs the tests and if the issue is material, the opinion is likely to get affected.

And yes, I'd laugh with you if IFRS did allow revenue recognition before the services were rendered or the products were delivered. But did I ever mention that it does? No. Kindly go through my initial reply to her where I specifically mentioned that if the costs have been incurred (in that the services have indeed been provided) in relation to the contract, then the revenue to be recognised should ideally be limited to the costs incurred.

 

[Counterofbeans]

And when it comes down to who cares about the auditor and his opinion, I think you need to recall the fact that it's the shareholders who appoint the external auditors in order to comply with the regulatory requirements.

No, not really. In reality, the external auditor is primarily chosen by the company management and, if public, the audit committee. These may or may not be significant shareholders (especially if the company is privately held!).

Besides, you're missing the entire point: Before it can ever become, "an audit issue," it's a company/accounting issue (for SOX opinion, it can be company wide. If it's a financial statement opinion, it overwhelmingly rests within the accounting department).

You state, "That would depend on how the said auditor approaches the issue."

Phrases like this need to go the way of the Dodo bird...

If the company is following the appropriate accounting rules, it simply doesn't matter what the auditor thinks. Overwhelmingly, the auditor's job is to confirm management's representations. The auditors should not be creating policy, like ever.

If the company can justify a certain accounting treatment pursuant to the applicable rules, the auditor should be saying, "Yes, that appears reasonable."

It really is that simple.

Now, once again, the above is not to suggest that you shouldn't work to get the auditors involved early and often in key transactions. If there's one thing I've learned about accounting it's that there is often a different point of view out there that might justify "X" accounting treatment over "Y" accounting treatment, especially in "crazy" transactions.

But it's still a company issue first & foremost each and every time before it's an audit issue. As a matter of fact, all an, "audit issue" really means is that the company dropped the ball somewhere, like, in this situation, not having appropriate support for recording certain transactions. Companies should constantly push themselves to be better.

But, at no point, should we ever be touting the external auditor as the maker of company accounting policy. EVER...

Want to know the (primary) extent of the auditors thoughts?

"Do you agree with management's representations?"

Yeah, that's about it.

So, basically, it's the people who provide the funds for the organisation in order for it to run are the ones who really care.

Huh?

I got news for you. Investors don't necessarily put $$ into the company they are investing in. Many/most (especially in large, publicly traded companies) look to play the stock market and many companies don't need investor cash, "in order for it to run."

Who else cares about the auditors and their opinion? The general public does have an interest in the financial information available to them (especially if they're paying the company registrar to obtain the financial statements) so I'm sure they're more confident in relying on the financial statements that have been verified by independent accountants.

There's a reason that audits are often referred to as, "necessary evils" & that reason is because they seldom add significant value. Why? Because, overwhelmingly, their sole job is to confirm what management is already disclosing/representing.

As stated above, external auditors should not be making company policy

Once again, I'll repeat myself, it's not an accounting issue at all. But it would definitely be an audit issue. How am I so certain? Maybe because I am an auditor myself

You absolutely cannot have an audit issue without it also being a company/accounting issue. If it's not an accounting issue, what is the auditor doing?

How am I so certain? Maybe because I have been both an auditor for (cough) many years, as well as a practitioner for an even longer period of time.

 

[ICAEW]

Yes, once again you're correct in saying that the management "chooses" the auditors but be clear on this--the management can only recommend, the shareholders still need the justifications for approval. And yes, the audit committee chooses for plcs, but for private companies, it's usually the shareholders themselves.

And how exactly am I "missing the entire point?" That's not to say what you're saying is wrong. It's simple logic. It's a company issue that the auditor would've picked up. And as for the auditor's approach, yes, it certainly would depend on how he would look at it especially if it involves potential legal issues (the firm's own legal department may need to be involved for an opinion).
Do not get confused with what I've been saying, it is indeed a company issue (lack of controls and inconsistency in policies) but has the potential to become an audit issue (Deviation in controls and/or control failure if the situation remains unresolved). And yes, the auditors shall never be involved in making decisions which the company's management would ideally make (specific Management threat, as per APB Ethical Standards and ISAs).

And indeed, there could be differing opinions over a certain transaction or policy but in the end, it all boils down to the substance, not just the legality.

Assuming that the correct accounting treatment is applied (because that's fairly simple and already sorted out, as you've also pointed out as well), questions of whether audit (evidence wise: when performing Test of Operating Effectiveness and Test of Details: specific vouching (T.O.Es & T.O.Ds)) and legal issues could arise due to this specific transaction would remain. I do realise that these are issues for the auditor and not the accountant, but it definitely would bother the accountant when the auditor comes asking questions and whatnot.

Also, why exactly are you referring to "the investors" when speaking of shareholders? Or is that your definition of shareholders? It doesn't matter who it is (whether private/institutional investors, management, employees, etc.). When a company initially starts, the funds are required and these are indeed provided by the public or these shareholders. It's not the management who invest their own money to run the organisation usually, unless they're both shareholders and directors.

And, corporate finance is a whole other area of practice and expertise, and frankly, irrelevant here.

When I said "it's not an accounting issue at all. But it would definitely be an audit issue," it was based on the assumption that the accountant has passed accurate/correct journal entries (therefore, no accounting issue) but the issue of not having a finalised contract would still be there and would need to be resolved, so an audit issue in that sense would arise (in accordance with ISA 500: Audit evidence).

So, if it's not an accounting issue, what is the auditor doing?

And here I thought you're the one who's been in practice and has been an auditor for many years.

 

[Counterofbeans]

Yes, once again you're correct in saying that the management "chooses" the auditors but be clear on this--the management can only recommend, the shareholders still need the justifications for approval. And yes, the audit committee chooses for plcs, but for private companies, it's usually the shareholders themselves.

Please tell me how many situations you've ever seen where a private company's shareholders does not "equal" management...

And barring some unusual situations, the audit committee will overwhelmingly go with who management recommends. This is why I used the word, "primarily."

And how exactly am I "missing the entire point?" That's not to say what you're saying is wrong. It's simple logic. It's a company issue that the auditor would've picked up.

You're missing the point because as soon as the auditor identifies it as an issue, the Company has already likely dropped the ball. It's that simple.

As soon as you say, "that the auditor would've picked up," you've missed the point.

Do not get confused with what I've been saying, it is indeed a company issue (lack of controls and inconsistency in policies) but has the potential to become an audit issue (Deviation in controls and/or control failure if the situation remains unresolved).

Now you're saying it has the potential to become an audit issue, which is pretty much precisely my point. The Company has to have dropped the ball first (i.e. it's a Company issue first and foremost).

And indeed, there could be differing opinions over a certain transaction or policy but in the end, it all boils down to the substance, not just the legality.

Oh, believe me, this is NOT always the case. Laughably, I have personal experience where a few firms (Big 4 firms, notably Ernst & Young, as well as Deloitte & Touche) relied on the legal position and flat out ignored the substance of the transaction. I literally laughed at them; they had no response, but they insisted the, "legal" interpretation generated the correct accounting, despite the "substance" of the transaction.

Oh yes, they are often biased with their own accounting treatment and sometimes patently incorrect. With one of the interpretations, I was 1" away from flat out contacting the SEC directly and get their view on it, but, ultimately, I rationalized that it really didn't make too much difference, so I let it go, but they were flat out wrong... It was, and remains, pretty funny actually.

When a company initially starts, the funds are required and these are indeed provided by the public or these shareholders. It's not the management who invest their own money to run the organisation usually, unless they're both shareholders and directors.

Once again, you are myopically focused on when the Company initially starts operations, but, as is often the case, people invest in a company that doesn't need $$ in the slightest.

For example, Apple, one of the few companies who could pretty much blow off the "Liquidity" and "Capital Resources" sections of Item 303 in Reg S-K, don't need investor $$ right now to run the business. When you, "invest" in them by purchasing their stock, you are investing in the stock market only; you aren't providing funds to them to run their operations.

Not all investments are related to S-1 (or related) Registration Statements

When I said "it's not an accounting issue at all. But it would definitely be an audit issue," it was based on the assumption that the accountant has passed accurate/correct journal entries (therefore, no accounting issue) but the issue of not having a finalised contract would still be there and would need to be resolved, so an audit issue in that sense would arise (in accordance with ISA 500: Audit evidence).

See comment above.

And here I thought you're the one who's been in practice and has been an auditor for many years.

This is a bizarre comment, especially since you fed me your resume first. I hope you now realize that such is a completely irrelevant comment.