SAS 145 – New Risk Assessment Standards

More Clarifications

In October 2021, the AICPA issued SAS 145, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement. SAS 145 is effective for audits of financial statements for periods ending on or after December 15, 2023. Early implementation is permitted. SAS 145, which supersedes SAS 122, section 315 of the same title, and amends various other sections in AICPA Professional Standards, enhances or clarifies specific areas of an auditor’s risk assessment while providing new performance requirements and new terminology in other areas.

Mine Field. For several years now, the subject of the auditor’s risk assessment has been a sore spot between the AICPA and many practitioners with a less complicated, non-public client base. Even though the original suite of risk assessment standards (SAS Nos. 104-111) was issued 15 years ago, peer reviewers continue to find deficiencies in risk assessments as a (perhaps the) leading reason for audit deficiencies

In my opinion, much of the push-back from practitioners of smaller, less complex companies is traced to a belief that the risk assessment standards are primarily applicable to CPAs who audit complex companies of enormous size. Furthermore, some CPAs believe, while a structured risk assessment approach may be necessary to identify risks and develop an audit approach for a company with billions of dollars in revenue, it’s a time-consuming overkill for many smaller, less complex, non-public companies. CPAs who follow this line of thought suggest that the risks for less complex companies are apparent, and the audit responses are obvious. Accordingly, there is little need for a formal structured risk assessment.

While the AICPA’s Auditing Standards Board (“ASB”) has not turned a deaf ear to the concerns noted above, it has not accepted the premise that a standard-based documented risk assessment is unnecessary for less complex companies. Instead, it views risk assessment as the foundational stone of every audit. Accordingly, SAS 145 applies to audits of all non-public companies, regardless of size or complexity. However, the ASB does address “scalability” in SAS 145. This concept of scalability, based on the complexity of the company, is described below.

Purpose of SAS 145. In short, the primary purpose of SAS 145 is to improve audit quality in a critical audit area where a disturbing number of audit deficiencies are found. As stated in the AICPA’s (SAS 145), At a glance:

“SAS No. 145 does not fundamentally change the key concepts underpinning audit risk. Rather, it clarifies and enhances certain aspects of the identification and assessment of the risks of material misstatement to drive better risk assessments and, therefore, enhance audit quality.”

What are the Key Changes? Ok. If it doesn’t “fundamentally change the key concepts underpinning audit risk,” then what does it change? Below are a few of the significant changes made to the prior risk assessment standards. We will describe other changes and nuances of SAS 145 in a later blog.

  1. Assessment of inherent risk and control risk. There is a new requirement to assess inherent risk and control risk separately. While this requirement was not explicitly stated in the prior standards, it’s something that many practitioners did anyway. This was driven, in part, by third-party vendors of auditing software tools who took the approach of a separate assessment of inherent and control risks. Nevertheless, the requirement to make separate assessments of inherent and control risk is now baked into the auditing standards via SAS 145.

  2. Assessing Control Risk at Maximum. If the auditor does not plan to test controls for operating effectiveness, SAS 145 requires that control risk (“CR”) be assessed at maximum risk. In that situation, the new standard requires that the assessment of the risk of material misstatement (“RMM”) be the same as the assessment of inherent risk (“IR”). In other words, if CR equals maximum risk because controls were not tested, then RMM must equal IR.

  3. Revised definition of significant risk. SAS 145 defines a significant risk as an identified risk of a material misstatement:
    • For which the assessment of inherent risk is close to the upper end of the spectrum of inherent risk based on the combination of the likelihood and the magnitude of a potential misstatement.
    • Is to be treated as a significant risk in other AU-C sections.

  4. IT Controls. A greater emphasis will be placed on the evaluation of the design and implementation of general IT controls. Auditors cannot continue to audit around IT controls.

  5. Stand-Back Requirement. SAS 145 incorporates a new so-called “stand-back” requirement. Auditors are now required to pause and evaluate the completeness of their identification of significant classes of transactions, account balances, and disclosures.

  6. Scalability. Under SAS 145, the concept of scalability recognizes “that some aspects of the entity’s system of internal control may be less formalized but still present and functioning, considering the nature and complexity of the entity.” Therefore, “…the auditor may still be able to perform risk assessment procedures through a combination of inquiries and other risk assessment procedures.” Those procedures may include observations or inspection of documents.

  7. Relevant Assertion. Under the new definition of relevant assertion, an assertion is relevant if it has an identified risk of a material misstatement. (Previously, the risk was described as a reasonable risk.) Risk of a material misstatement exists when there is a reasonable possibility that the risk will occur and be material.

  8. Significant Class of Transactions, Balance, or Disclosure. A significant class of transactions, account balance or disclosure is one for which there are one or more relevant assertions (see directly above.)

SAS 145 is effective beginning with audits of the calendar year 2023 financial statements. You can look forward to much discussion and CPE courses regarding this important SAS between now and then.

Changes To ERISA Audits And Reporting

The Times They Are-a-Changin, Part II

In July 2019, the AICPA issued SAS 136, Forming an Opinion and Reporting on Financial Statements of Employee Benefit Plans Subject to ERISA. SAS 136 is effective for periods ending on or after December 15, 2021. The purpose of SAS 136 is to “clarify” the auditor’s responsibility in forming an opinion on ERISA plan financial statements. It also addresses the form and expands the content of the auditor’s report.

The clarifications were driven, in part, in response to a study by the U.S. Department of Labor (“DOL”) that found major deficiencies in a significant number of ERISA audits it reviewed. According to the DOL, this study, published in 2015, found that 39% of the ERISA audits had major deficiencies, putting over 22 million plan participants and beneficiaries at risk.

What is SAS 136 All About? As presented in the standard, the objective of SAS 136 are:

  1. Perform an ERISA audit only if preconditions for the audit are agreed upon with management.
  2. When management elects an ERISA Section 103(a)(3)(C) audit (presently known as a limited scope audit), appropriately plan and perform procedures on the certified investment information required by SAS 136 and ERISA.
  3. Form an opinion on the financial statements based on the audit evidence obtained.
  4. Clearly express the opinion of the ERISA plan financial statements.
  5. Perform procedures and report on the presentation of supplemental information.
  6. Appropriately communicate to management and those charged with governance reportable findings.

So here we go. SAS 136 is relatively large. We have outlined some, but not all, of the significant provisions of SAS 136.

Engagement Letter. SAS 136 requires the auditor to obtain the following from management via the engagement letter:

  1. Management is to agree that it is their responsibility to:
    • Maintain current plan instruments, including all plan amendments.
    • Administer the plan and determine that transactions disclosed in the financial statements conform with the plan’s provisions. This includes maintaining sufficient records concerning each participant to determine benefits due.
    • When management elects to have a Section 103(a)(3)(C) audit, determine if:
      • such an audit is permissible,
      • the investment information is prepared and certified by a qualified institution as described in 29 CFR 2520.103-8,
      • the certification complies with 29 CFR 2520.103-5, and
      • the certified information is appropriately measured, presented, and disclosed.
  2. The auditor should inquire how management determined that the entity preparing and certifying the Section 103(a)(3)(C) investment information is a qualified institution.
  3. The auditor should also obtain agreement with management or those charged with governance to provide the auditor, before the dating of the auditor’s report, a draft Form 5500 that is substantially complete.

What Are The Auditor’s Responsibilities?
SAS 136 also emphasizes the auditor’s responsibility to:

  1. Read the most current plan instrument and effective amendments in connection with assessing the audit risk.
  2. Consider whether management has performed the relevant Internal Revenue Code compliance tests
  3. Evaluate whether prohibited transactions have been appropriately reported
  4. Evaluate whether matters are reportable findings. Reportable findings include:
    • noncompliance or suspected noncompliance with laws or regulations,
    • any finding that should be significant and relevant to those charged with governance, and
    • an indication of deficiencies in internal control.
    • The auditor should not communicate in writing that no reportable findings were identified during the audit.

  5. Evaluate management’s assessment of whether the entity issuing the Section 103(a)(3)(C) certification is a qualified institution.
  6. Expand the management representation letter to include representation that:
    • management has provided the most current plan instrument for audit, including all plan amendments,
    • management is responsible for administering the plan and determining that transactions are presented and disclosed according to plan provisions, including sufficient records relating to benefits due participants.
    • When management elects to have a Section 103(a)(3)(C) audit, an acknowledgment that management’s election does not affect its responsibility for the financial statements and for determining whether:
      • Section 103(a)(3)(C) audit is permissible,
      • the investment information is prepared and certified by a qualified institution,
      • the certification meets the requirements in 29 CFR 2520.103-5, and
      • the certified investment information is appropriately measured, presented, and disclosed in accordance with the applicable financial reporting framework.

Different Auditor’s Report. The content and arrangement of the sections of the auditor’s report have changed. As a result, the auditor’s report (other than a Section 103(a)(3)(C) audit discussed below) is as follows.

  1. Title. As usual, the auditor’s report should have a title that clearly indicates that the report is that of an independent auditor
  2. Addressee. The report should be addressed as appropriate.
  3. Auditor’s Opinion. The first section is the auditor’s opinion. Accordingly, the opinion is now front and center instead of buried at the bottom of the report.
  4. Basis for Opinion. The next section is the “Basis of Opinion.”
  5. Going Concern. When applicable, the auditor should report per AU-C section 570, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern.
  6. Key Audit Matters. When engaged to do so, the auditor reports key audit matters under AU-C section 701. (See our blog posted September 15, 2021, for a discussion of key audit matters – it’s new.)
  7. Responsibilities of Management for the Financial Statements. This section describes management’s responsibility for:
    • the preparation and fair presentation of the financial statements,
    • when required by the applicable financial reporting framework, evaluating conditions and events that raise substantial doubt about the plan’s ability to continue as a going concern,
    • maintaining a current plan instrument, including all plan amendments,
    • administering the plan and determining that the plan’s transactions conform with the plan’s provisions, including keeping sufficient records regarding participant benefits
  8. Auditor’s Responsibilities for the Audit of the Financial Statements.
    • This section should state that the objectives of the auditor are to:
      • obtain reasonable assurance about whether the financial statements are free from material misstatement, whether due to fraud or error, and
      • issue an auditor’s report that includes the auditor’s opinion,
      • state that reasonable assurance is a high level of assurance, but not absolute,
      • state that the risk of not detecting a material misstatement resulting from fraud is higher than one resulting from error,
      • state that misstatements are material if, individually or in the aggregate, they could reasonably be expected to influence the economic decision of the users of the financial statements.
    • There are additional required wording related to:
      • exercise of professional judgment and maintenance of professional skepticism,
      • identification and assessment of risks of material misstatement, whether due to fraud or error and the design and performance of audit procedures in response to those risks,
      • obtaining an understanding of internal control to design audit procedures, but not to express an opinion on internal control,
      • evaluating the appropriateness of accounting policies and estimates, and evaluating the overall presentation of the financial statements,
      • concluding whether there is substantial doubt about going concern,
      • stating that the auditor is required to communicate with those charged with governance regarding certain matters.
  9. Modifications to the Opinion. The next section is to explain any modifications the auditor may have to the standard report.
    • Qualified opinion,
    • Inability to obtain sufficient appropriate audit evidence,
    • Adverse opinion.
  10. ERISA-Required Supplemental Schedules. This section of the report addresses whether the ERISA-required supplemental schedules are fairly stated
  11. Other Reporting Resposibilities. If the auditor addresses other reporting responsibilities in addition to GAAS, it is reported in a section titled “Report on Other Legal and Regulatory Requirements.”
  12. Conclusion. The report is concluded with the auditor’s signature, address, and date of the auditor’s report.

Not The Same Old Limited Scope Auditor’s Report. The auditor’s report for an ERISA section 103(a)(3)(C) audit arrangement is as follows.

  1. Scope and Nature of the ERISA Section 103(a)(3)(C) Audit
    • The first section should include a description of the scope and nature of the ERISA Section 103(a)(3)(C) audit and should have the heading “Scope and Nature of the ERISA Section 103(a)(3)(C) Audit.
    • This section includes several requirements describing the limitation of the auditor’s report under this section of ERISA.
  2. Auditor’s Opinion. If no material misstatements are identified, and no scope limitations exist, the auditor’s report should include a statement that:
    • the amounts and disclosures, other than those agreed to or derived from the certified investment information, are presented fairly, in all material respects, in accordance with the applicable framework,
    • the information related to assets held by and certified by a qualified institution agrees to, or is derived from, in all material respects, the information prepared and certified by an institution that management determined meets the necessary ERISA requirements,
    • identifies the applicable financial reporting framework
  3. Basis for Opinion. This section should:
    • state that the audit was conducted in accordance with US GAAS
    • refer to the section of the report that describes the auditor’s responsibilities for GAAS,
    • state that the auditor is required to be independent of the plan and meets other ethical requirements,
    • state whether the auditor believes that audit evidence is sufficient and appropriate to provide a basis for the ERISA Section 103(a)(3)(C) audit opinion.
  4. Going Concern. Next is the going concern section.
  5. Key Audit Matters. If so engaged to do so, the key audit matters section follows.
  6. Responsibilities of Management for the Financial Statements. This section describes management’s responsibility for the following:
    • the preparation and fair presentation of the financial statements following the applicable framework, and for the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether fraud or error,
    • the election of the ERISA section 103(a)(3)(C) audit and that the election does not affect management’s responsibility for the financial statements,
    • going concern discussion,
    • maintaining a current plan, including all amendments,
    • administering the plan.
  7. Auditor’s Responsibilities for the Audit of Financial Statements. The auditor should do the following:
    • state that except for investments under ERISA section 103(a)(3)(C), the auditor’s objectives are to
      • obtain reasonable assurance about whether the financial statements are free from material misstatements,
      • issue an auditor’s report that includes the auditor’s opinion
    • state that reasonable assurance is a high level of assurance, etc.,
    • state that the risk of not detecting a material misstatement from fraud is higher than that of an error,
    • describe what constitutes a material misstatement,
    • exercise professional judgment and skepticism,
    • identify and assess risks of material misstatement and design and perform procedures responsive to those risks
    • obtain an understanding of internal control to design appropriate audit procedures, but not for expressing an opinion on the plan’s internal control,
    • evaluate the appropriateness of accounting policies and estimates, and evaluate the overall presentation of the financial statements,
    • conclude if conditions or events in the aggregate raise substantial doubt about the plan’s ability to continue as a going concern,
    • state that the audit did not extend to the certified investment information, except for specific limited procedures performed
    • state that the objective of an ERISA section 103(a)(3)(C) is not to express an opinion about whether the financial statements as a whole are fairly presented,
    • and state that the auditor is required to communicate with those charged with governance certain matters.
  8. Modifications to the Opinion. The next section is to explain any modifications the auditor may have to the standard report.
    • Qualified opinion,
    • Inability to obtain sufficient appropriate audit evidence,
    • dverse opinion.
  9. ERISA-Required Supplemental Schedules
    • This section of the report addresses whether the ERISA-required supplemental schedules are fairly stated.
  10. Other Reporting Resposibilities
    • If the auditor addresses other reporting responsibilities in addition to GAAS, it is reported in a section titled “Report on Other Legal and Regulatory Requirements.”
  11. Conclusion. The report is concluded with the auditor’s signature, address, and date of the auditor’s report.

Changes To The Non-Public Auditor’s Report

The Times They Are-a-Changin

The AICPA has issued several Statements on Auditing Standards (“SASs”) that, on the effective date, will impact the auditor’s report. These changes are included in SAS 134 through 140 and are effective for periods ending on or after December 15, 2021, per SAS 141. Therefore, they will initially be effective for the calendar year 2021 audits. Early implementation is permitted.

Usually, busy private business owners don’t need to concern themselves with the SASs. Why should they? However, owners should be aware of these recently issued SASs because crucial decisions must be about engaging the auditor to report on what is styled as “Key Audit Matters.” Some of the more noteworthy changes related to the non-public auditor’s report are summarized below.

  1. SAS 134 changes both the contents and arrangement of the auditor’s report for non-public companies. These changes are designed to provide greater transparency and improve communication for the end-users of the financial statements.

    • Key Audit Matters. The Auditing Standards Board has added new AU-C Section 701, Communicating Key Audit Matters in the Independent Auditor’s Report. If the auditor is so engaged, the purpose of communicating key audit matters (“KAMs”) in the auditor’s report is to provide greater clarity regarding significant audit issues to the end-users of the financial statements. Many end-users thought the old standard boilerplate auditor’s report didn’t provide sufficient insight into the audit process. The KAM section of the SAS 134 auditor’s report is advanced in response to this concern.

      The new standard does not require that KAMs be communicated in the auditor’s report. However, end-users, such as banks, absentee owners, and potential buyers may request that KAM communications be included to facilitate their analysis and understanding of the audit. Accordingly, company management may find it prudent to comply with this request and engage the auditor to include a KAM section in the auditor’s report.

      KAMs include matters that, in the auditor’s professional judgment, are most significant in the audit. For example, the following are key matters areas that the auditor may communicate:

      • Areas in the audit that pose a higher risk of material misstatement
      • Significant estimates and related disclosures that are susceptible to material misstatement
      • Areas of high complexity
      • Transactions or events having a significant effect on the financial statements or the audit
      • Areas of the audit that were challenging to the auditor
      • Matters that required consultation by the auditor

      If reporting on KAMs, the audit report should describe the following for each KAM:

      • Why the KAM was considered to be significant
      • How the matter was addressed during the audit
      • Provide a reference to the financial statement areas or the related disclosures addressed by the KAM

    • SAS 134 also:

      • Expanded the descriptions of management’s responsibility about going concern evaluations
      • Expanded descriptions regarding the auditor’s professional judgment, professional skepticism, going concern, and communication with the governing board.

    • The arrangement of the auditor’s report has changed, as follows:

      • The opinion paragraph is now the first paragraph. The thought here is that most readers of the audit report immediately focused their attention on the opinion paragraph, which, in the current report, is positioned at the end. So it makes sense to move it to the first paragraph, thereby stating up-front the auditor’s opinion on the financial statements.
      • The basis for opinion follows the opinion paragraph
      • KAMs, if requested by company management, is the next paragraph, followed by a description of each KAM
      • The following paragraph describes the responsibilities of management, followed by
      • A paragraph on the auditor’s responsibilities

        NOTE: Both the management and auditor’s sections must now include each parties responsibilities for assessing the company’s going concern

      • The final three sections are the firm’s signature, city and state, and date.

    • SAS 134 also modified AU-C Section 706, Emphasis -of-Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report. It clarified the relationship between Emphasis of Matters and KAMs if both are included in the auditor’s report.

  2. SAS 136 made significant revisions to the ERISA auditor’s report. Next month we will discuss those revisions and their impact.

5 Things You Should Tell Your CPA

And The Sooner The Better

Construction is a risky business. Things can go wrong – even with the best-managed companies. Hoping the problem will work itself out is a natural knee-jerk reaction, but such delay may exacerbate it. Additionally, other situations and concerns may arise in the ordinary course of business. Some of these issues may necessitate outside assistance.

We’ve listed five occasions that warrant the immediate attention of your external CPA. But, of course, the best way to find out is to give a phone call to your trusted advisor and get their opinion.

  1. You are surprised by a significant fade on a huge contract. It happens. The prior year, your uncompleted job schedule presented a contract at 80 percent complete with a sizable gross profit. As it turns out, your project manager provided misinformation regarding the percentage of completion. As a result, the estimated cost to complete the contract was significantly understated, and the gross profit was overstated. The job is now showing a disturbingly significant gross loss and is still a long way from completion. The project manager has been fired, and you are scrambling to plug the profit leaks and complete the project.

    It doesn’t occur very often, but it could bring the company to its knees. So let your CPA know early on. They can assist in analyzing the fade and structuring the best way to present the situation to your banker and surety.

  2. You are the victim of financial or asset fraud. The trusted CFO is caught in an embezzlement scheme. Or, perhaps the long-time project manager has been cost-shifting for several years to overstate gross profit and his year-end bonus. Your CPA can assist in quantifying the losses and plugging the holes in your internal control system that facilitated the fraud.

    Fraud occurs all too often and causes untold grief. And I have seen it many times over the years. From CFOs making unauthorized “loans” to themselves with intentions of repayment, which, of course, never happened, to unsubstantiated expense reports, to payments made to fictitious vendors, to project managers shifting costs between contracts. The list, unfortunately, can go on and on.

    However, solid internal control procedures can help, though not entirely prevent, financial and asset fraud. Your CPA may be able to make recommendations on strengthening your company’s system of internal controls and place some restraints on potential fraud.

  3. You receive notice from the Department of Labor regarding non-compliance related to your Form 5500. These notices definitely should not be ignored. The notice may concern failure to timely file all or any part of Form 5500, including the financial statement that may be required with the filing. Failure to give timely attention to these notices can result in substantial daily penalties. Therefore, it is prudent to notify your CPA upon receipt of the DOL notice so that appropriate action can be taken.

    Of course, the same applies to tax notices received from the IRS and the state departments of revenue.

  4. You are considering a sale of your company in the near future. It’s a big decision. It takes planning long before, even years before making the placement for sale. You should let your CPA know if you are considering a future sale of the company. They can assist you in what can be done beforehand to enhance the company’s valuation and provide smoother due diligence when the time comes.

  5. You have had a great year, but the tax burden may be pretty heavy. It’s always an excellent strategy to do tax planning several months before your company’s tax year-end. This is a prudent thing to do every year. Cooper, Travis & Company recommends that the company and its members’ tax planning be done approximately two to three months before its tax year-end. There are several strategies available at that time that are unavailable after year-end.

Construction Company Alert – Warning Signs

Danger Will Robinson, Danger!

Construction is a risky business. Not only because of the occupational hazards associated with the industry, but it’s also risky from a business perspective. New companies, of course, are vulnerable, but even construction companies in business for thirty, forty, fifty years or more are not immune to business failures. I’ve witnessed strong companies, rock-solid for decades, lose half their equity in a year, and be on the rocks with their lenders and surety for years following. It can and does happen. But there are warning signs – some subtle and some in full view, but easy to overlook.

The scary thing about it is this. The financial statements of a construction company rely heavily on estimates. This includes estimates of the contract value, estimates of the amount of variable consideration for unapproved change orders, claims, and early completion bonuses, and estimates of the cost to complete a project. If those estimates are wildly wrong, for whatever reason, the company can be bankrupt long before it is apparent in the numbers.

Generally, there are warning signs. This article will describe some of those warning signs that whisper all is not well.

Exodus of Key Employees. Those closest to the execution of the contracts, such as the project managers, will see a train wreck coming long before it happens. And if it’s bad enough, they often walk. Or perhaps they see something in upper management that keeps them awake at night. Or, on the other hand, it could be they just got a better offer or are disgruntled for some ancillary reason that has little to do with the company’s financial stability. Nevertheless, it should be a heads-up that there may be something rotten in the State of Denmark.

Large Underbillings. Underbillings are not normal, especially if the contract is 50% or more complete. It may indicate that the company has poor billing practices and cash flow issues, which may be why the company has drawn the line of credit to the limit. Or, worst-case scenario, underbillings are concealing significant losses.

Many times, large underbillings are traced to unfavorable contract terms. For example, some specialty trades incur substantial upfront costs. If favorable contract terms have not been negotiated to permit advance payments to cover upfront costs, significant underbillings may precipitate cash flow issues.

The most detrimental issue is that of concealed losses. For example, a project manager rewarded at year-end for contract profitability may intentionally overstate the contract amount for unapproved change orders, knowing that he cannot bill and collect the cost and profit for those change orders. As a result, this deception will increase underbillings or perhaps decrease overbillings as a possible red flag.

Overbillings Collected Are Not in the Bank. The rule of thumb is that the cash flows from a contract overbilled in the early stages should be available to fund the costs in excess of billings during the latter part of contract completion. Of course, many companies will “rob Peter to pay Paul” from time to time. However, in extreme cases, a company in a severe cash crisis may habitability channel overbillings from one contract to cover significant losses on other contracts while running their line of credit to the limit. In the end, they face a cash crunch when it’s time to pay the piper.

Taking on that Big Project Outside the Company’s Area of Expertise. Just because a contractor is a successful home builder does not mean their skills will translate to road building. I’ve seen it before, and it’s painful. Or, taking a contract in your niche in a different area of the country can be a disaster. Too much distance leads to a different labor market, travel costs, and unfamiliarity with local regulations.

If a company is awarded a large project outside their area of expertise, it’s a warning sign if they have not mitigated the danger by recruiting experienced personnel, performing a close review of the contract terms, and seeking advice where needed.

Insufficient Working Capital and Equity. Best of class construction companies maintain a minimum working capital ratio of 5% of contract revenue. Some trades should have more, perhaps up to 10% of revenue as a minimum. Tight working capital is a harbinger of problems to come.

Thin working capital coupled with lines of credit borrowed near or up to the maximum can cause all sorts of headaches. It can absorb all your time. And lead to lost vendor discounts, disruption of the supply chain, loss of credit, and even going concern issues.

Surety companies will also focus on equity. Generally, sureties expect that construction companies will need, as a minimum, equity of 10 to 15% of revenue. When the company’s equity position decreases below those levels, it raises questions. For example, is the company overleveraged, or are the stockholders or members taking too much in distributions? Has the company absorbed too many losses, or was it thinly capitalized at start-up?

Loss of Long-Time and Loyal Customers. It happens to every company, of course. But when many long-time customers leave the fold, that becomes a significant warning sign. It brings into question the company’s ability to honor its commitments, complete projects timely, perform quality work, and retain key employees.

Project Managers Have Unrestricted Rights to Reclassify Job Cost. Project managers should not have unrestricted rights to reclassify costs from one contract to another. But, if they do, they can conceal losses by rolling those losses forward to subsequent years. It’s called cost-shifting and is a form of financial statement fraud. This is possible because of the peculiarities of the cost-to-cost percentage of completion accounting method. (Note: Even though not referred to by name in the ASC 606 revenue standard, the percentage of completion method is alive and well.)

This is done by reclassifying costs from a loss (or soon-to-be-loss) contract to a profitable uncompleted contract. In good times, the loss can be rolled forward for several years. But eventually, when contract backlog drops, it will become apparent. But until then, the concealment can cause significant damage. (See our blog dated March 15, 2021, titled “How About Another Accounting Quiz?” for an example of how cost-shifting can disguise losses as gains.)

Low Profit Margins. A caution flag goes up when the company, to obtain work, is awarded a string of large contracts at below-market margins. That leaves little room for error in execution

But the contract that merits special attention is the large contract that has been reduced to a zero gross margin while in progress. This is because many, if not most contractors, are optimistic by nature. They are confident they can resurrect a diaster from the grave by picking up extra profit at the end of the job. But so many times, I have witnessed a zero gross profit contract not only end up in the red at completion but set records for losses. So, beware of zero-profit contracts.

Subcontractor Problems. It happens. Some contractors rely on vetting their subcontractors instead of bonding. And many do an excellent job and have great success with their subs. However, unbonded subcontractors can fail, walk off the job and leave the general or prime contractor in a lurch. Subcontract failure can even happen with subcontractors that have worked for the company for years. It’s very easy to develop a false sense of security because the sub has performed excellent work in the past.

Variable Consideration (It’s Probable)

ASC 606, Revenues from Contracts with Customers

For most privately-held construction companies, ASC 606, Revenues from Contracts with Customers, has been effective for over two years. For many construction companies, the transition to ASC 606 was not too bad, but it did make subtle changes in certain areas that continue to raise questions. One of those areas is estimating the contract price, i.e., total estimated consideration due under the long-term contract. ASC 606-10-32-2 states:

“An entity shall consider the terms of the contract and its customary business practices to determine the transaction price. The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties (for example, some sales taxes). The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both”.

What’s The Transaction Price?

ASC 606-10-32-4 defines the transaction price as:

“For the purpose of determining the transaction price, an entity shall assume that the goods or services will be transferred to the customer as promised in accordance with the existing contract and that the contract will not be canceled, renewed, or modified”.

In other words, contractual options to modify a contract are ignored when determining the transaction price.

The transaction price consist of 1) fixed consideration, 2) variable consideration, 3) financing components, 4) noncash consideration, and 5) consideration payable to the customer.

The area that seems to be the most contentious and has a significant impact on many contractors is variable consideration.

What is Variable Consideration?

ASC 606-10-32-5 states:

“If the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer.”.

So, the amount of consideration the company expects to receive should be estimated. Variable consideration is not fixed but is based on uncertain events. For a contractor, variable consideration may include unit-priced contracts (price per unit is fixed, but the quantities are uncertain), incentive bonuses, liquidated damages, shared savings, change orders, and claims.

ASC 606 is a principles-based standard that requires contractors to reasonably estimate profit for variable considerations, even at the early stages of a contract. The amount of variable consideration is determined at the beginning of the contract and is updated each reporting period. It may result in adjustments to the contract amount for incentive bonuses before the contract is complete, recognition of change orders before a formal change order is finalized, and adjustment to the contract price for claims before the claim resolution process is concluded.

Probability Analysis

Variable consideration is included in the contract amount based on a probability analysis that a significant revenue reversal will not occur in a subsequent period. This probability is based on certain revenue constraints.

Probability Analysis

Under ASC 606-10-32-8, variable consideration is determined under one of the following probability methods:

  1. Expected value approach
  2. Most likely amount approach

The expected value approach is based on the sum of probability-weighted amounts in a range of multiple expected consideration possibilities. The most likely amount approach is used, generally, when there are two possibilities. The possibility that is most likely is chosen as the variable consideration amount.

These two methods are not elections but are determined based on the facts and circumstances. Therefore, the expected value approach may be used on one contract, and the most likely amount approach used on another contract within the same year. However, the method chosen for a particular contract should be consistently applied throughout that contract.

Constraints to Revenue Recognition

ASC 606-10-32-11 states:

“An entity shall include in the transaction price some or all of an amount of variable consideration estimated in accordance with paragraph 606-10-32-8 only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved”.

Under ASC 606-10-32-12, when assessing probabilities that a significant reversal in the amount of cumulative revenue will not occur, the contractor should consider both the likelihood and magnitude of the following constraints to revenue recognition:

  1. Factors outside the contractor’s influence:
    • Market volatility
    • Weather conditions
    • Settled through adjudication or arbitration
      1. This would generally increase the degree of uncertainty regarding the amount of consideration, causing a delay in revenue recognition until the uncertainty is resolved.
  2. Length of time to resolve an uncertainty.
  3. The contractor’s experience with similar contracts
  4. The contractor’s history of offering a broad range of price concessions with similar contracts
  5. The contract has a broad range of possible consideration outcomes
  6. Other restraints not listed but apply to the contractor’s situation

Probable

Probable is defined in the ASC 606-10-20 as “The future event or events are likely to occur.”

The probability of a significant revenue reversal not occurring in a subsequent period is a matter of judgment regarding the restraints, but generally, in our opinion, the confidence level should be 75% or better. Therefore, it is considered a high bar to reach.

  1. For example, you adjust the contract amount to include:
    • Incentive bonuses for early completion if you are 75%+ confident that the revenue recognized will not reverse later.
    • Pending/unsigned or unpriced change orders if you are 75%+ confident that significant revenue will not reverse.
    • Same with claims, liquidated damages, shared savings, etc.

Leases – 10 Takeaways

It’s Almost Time To Implement ASC 842

The implementation date for the new lease standard for private companies is just around the corner. As amended by ASU 2020-5, the extended effective date is fiscal years beginning after December 15, 2021 (i.e., January 1, 2022, for calendar year companies). It doesn’t apply to interim periods until 2023. That gives private companies a bit more breathing room, but not much. The new lease standards are codified in ASC 842.

I suspect that many are not quite up to speed yet on the tenants of ASC 842. That’s understandable, given the pandemic, PPP loans, stimulus payments, and the many other rapid-fire legislation that have monopolized our time. Everyone has had their hands full. This standard is enormous, both in terms of print and the impact of its changes. This piece will highlight a few of the many primary provisions.

Our focus in this article is on lessee accounting. This is because most of the significant changes under ASC 842 are directed at the lessee instead of the lessor.

Brief History. Over forty years ago, the Financial Standards Accounting Board (“FASB”) issued the original standard, FAS 13 – Accounting for Leases. It’s been amended several times through the years. FAS 13 was later codified as ASC 840. For lessee accounting, ASC 840 categorized leases as either capital leases or operating leases. Capital leases were capitalized as assets and liabilities on the balance sheet, and operating leases were not. Instead, operating leases were expensed in the period incurred. Footnote disclosure provided information about long-term commitments for operating leases.

The prior standards under ASC 840 provided four criteria for classifying a lease as a capital lease. If none of the following criteria were met, the lease would be classified and accounted for as an operating lease:

  1. The lease transferred ownership of the property to the lessee by the end of the lease term.
  2. The lease contained a bargain purchase option.
  3. The lease term was equal to 75 percent or more of the estimated economic life of the leased property.
  4. At the beginning of the lease term, the present value of the minimum lease payments equaled or exceeded 90 percent of the fair value of the leased property.

Under the bright-line tests in nos. 3 and 4 above, many, if not most, leases were classified as operating leases and therefore not presented on the balance sheet under (soon to be) legacy ASC 840. Furthermore, numerous leases were strategically structured to avoid classification as a capital lease and balance sheet presentation. This prompted many end users of the financial statements, such as bonding sureties, to make proforma adjustments to the balance sheet for the unrecorded operating leases.

Ten Key Takeaways. So ASC 842 steps in to address some of the gaps caused by the application of ASC 840. Here are ten essential takeaways from ASC 842.

  1. Identifying Leases. Agreements must be carefully reviewed to identify clauses that contain leases.
    • To be considered a lease under ASC 842, the lessee must have control of or direct how the asset is used
    • This identification can be tricky because some contracts, not described as lease agreements, may, nevertheless, contain lease clauses. For example, a service agreement for a copier may have an equipment lease embedded in the contract.
    • For larger companies, the process of locating agreements, identifying the lease clauses, and extracting the data points should begin as soon as possible. It could be a big undertaking.

  2. Capitalization of All Leases. All leases will now be included on the balance sheet.
    • That is, all leases, except those with a lease term of 12 months or less (if you choose to elect that practical expediency), will be capitalized on the balance sheet. In addition, such short-term leases must not include a purchase option reasonably certain to be exercised.
    • ASC 842 does not provide a low-dollar amount to exclude a lease from balance sheet capitalization. However, the general principle of materiality is still applicable.

  3. Right-of-Use Asset and Liability. The new standard requires recognition of a right-of-use asset and a lease liability at the inception of the lease.

  4. Lease Classifications. Under ASC 842, there are still only two types of leases for lessee accounting:
    • Finance lease – This is the new name for the legacy ASC 840 capital lease. And the accounting is pretty much the same for a finance lease as it was for a capital lease.
    • Operating lease – The name is the same. However, even though the FASB retained the name, accounting for operating leases under ASC 842 is profoundly different from ASC 840. This is because, under ASC 842, operating leases are also capitalized on the balance sheet.

  5. Finance Lease Criteria. Per ASC 842, the lessee will classify a lease as a finance lease when any of the following criteria are met at lease commencement. (The first four will sound familiar).
    • The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
    • The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
    • The lease term is for the major part of the remaining economic life of the underlying asset.
    • The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
    • The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.

    Notice that the first four criteria above for classification as a finance lease closely track the requirements for classification as a capital lease under legacy ASC 840. However, the bright-line 75% and 90% tests are removed from c and d above. Accordingly, ASC 842’s approach is more principle-based than the approach under ASC 840. Companies will need to develop policies on what constitutes a “major part of the remaining economic life” and “substantially all of the fair value of the underlying asset.”

    Also, notice that ASC 842 added one new criterion, i.e., the underlying asset has no alternative use to the lessor at the end of the lease term.

  6. Operating Lease Criteria. If the above criteria are not met, then the lease is classified as an operating lease.

  7. Purpose of Two Lease Classifications. If both finance and operating leases are capitalized on the balance sheet under ASC 842, what is the purpose of the two classifications? The reason is that the subsequent accounting and disclosure for each category differs.

  8. Discount Rate. Leases are capitalized using one of the following rates:
    • The rate implicit in the agreement (challenging to obtain)
    • Lessee’s incremental borrowing rate (the rate the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset)
    • Or use the risk-free interest rate as an accounting policy election for all leases (i. e., U.S. Treasury bond rate over the loan term).

  9. Embedded Leases. Leases included in broader agreements are important under ASC 842 because such embedded leases must be identified and capitalized on the balance sheet. These leases are often concealed in other contracts that are not explicitly considered lease agreements.

  10. Related Party Leases. ASC 842-10-55-12 states that “Leases between related parties should be classified in accordance with the lease classification criteria applicable to all other leases on the basis of the legally enforceable terms and conditions of the lease. In the separate financial statements of the related parties, the classification and accounting for the leases should be the same as for leases between unrelated parties.”
    • ASC 842-10-55-12 appears to represents a change in GAAP from that under ASC 840. Legacy GAAP required entities to account for the economic substance over the legal form of related party leases.

5 Things You Should Expect From Your CPA

And There Are More

What should you expect from your CPA? What in-grained traits do you want them to have? You expect them to be honest, of course. That’s critically important. But what else? Do you want your accountant to be an air traffic controller watching and safeguarding your business assets and transactions? Many company controllers take that role. In this article, we drill down to the core to see what makes a good accountant tick. And from that, we identified the following five traits your CPA should possess.

Organization and Concise Clarity. Organization is the defining attribute of an accountant. It’s the cornerstone. Without organization, there is chaos. You should expect your accountant to be able to take an overwhelming amount of disjointed and seeming unrelated information and sift it down to concise clarity. He or she should be able to explain to you what it means. That’s what a business needs. Too much information is, well, just that – too much information. Management cannot reach meaningful decisions without concise clarity. And clarity cannot be achieved without organization. What does this pile of numbers mean? That’s the question your CPA should be able to answer.

I recall an anecdotal story about President Reagan. A member of his staff presented him with a behemoth report. In his non-threatening manner, the President requested the aide to summarize it to about one or two pages. One or two pages, sir, the aide asked? To which Reagan replied… you’re right, make it one page.

Even the most complicated areas of physics, when properly understood, can be expressed in a very concise way. Albert Einstein synthesized his special theory of relativity’s complexities to the now-famous equation of E = mc 2. And James Maxwell described the non-intuitive interrelation of electric and magnetic fields with only four equations. It’s called organization and concise clarity.

Communication. Communication doesn’t have to dazzle. But to be authentic, communication must be understood.

CPAs, as a group, are not exactly known for their communication skills. Think Louis Tully (played by Rick Moranis) in Ghostbusters. Or the accountant joke, What do you call an accountant that speaks to one person a day? Popular.”

I recall a time several decades ago when, as a young CPA, I attended a local country club’s annual membership meeting. Of course, a fine meal was included. My firm performed the yearly audit. That evening, my job was to hand-deliver the audit report to the club’s treasurer (a partner for a then Big-Eight accounting firm) and brief him in private before he made the presentation to the membership group. As it turned out, when the treasurer stood before the large group to deliver the report, he mentioned that I was there and turned the presentation over to me. That fine steak I was enjoying suddenly turned sour in my stomach. The presentation did not go well. However, I think the membership group had a very good time. One thing for sure, though, it did impress upon me the importance of communication.

Communication is an essential skill for a CPA. And your CPA should have the ability to communicate with clarity. When there is a need to renegotiate the company’s bank line of credit, the CPA will be involved. If it’s discussions with the company’s surety regarding a problematic project, the accountant will be front and center. Conversations with project managers regarding project evaluations will need input from the company’s CPA. And, discussions of quarterly financial results with the ownership group or the company’s board of directors require a combination of the communicative and diplomatic skills of the CPA. It’s called communication.

Analytical. Being analytical for an accountant is somewhat akin to critical thinking. It’s objectively reasoning through a complicated situation to come to a (hopefully correct) judgment.

My observation is that many, if not most, students attracted to the accounting profession are drawn to it because they are analytical by nature. They enjoy and are successful at working through puzzles. They find that this attribute is helpful in many of the accounting courses they take in college.

Solutions to accounting issues are not always apparent. Accordingly, your company’s CPA should be well-versed in the use of research tools. Research is critical in tax planning. Research is essential to financial reporting. The answer to most difficult questions is “maybe yes and maybe no, it ain’t necessarily so.” Analytically reasoned judgment is required.

Most of accounting is not black and white. For example, the area of accounting estimates is problematic. They can make a significant difference in the company’s financial statements and taxable income. Areas affected by accounting estimates include the determination of contract gross profit, depreciation, and warranty reserves. An analytical approach is beneficial in arriving at an appropriate range of values for estimates.

Your accountant should be analytical. An analytical mind can unravel a thorny problem and come to reasonable conclusions. But beware. It can also drive you up a wall. What may seem clear to you may not strike your CPA the same way. They want to explore a few more avenues. Turn over more stones. Be professionally skeptical. But, on the whole, you should expect your CPA to possess this characteristic. It’s called analytical.

Accurate. Your CPA should be accurate. Precise information is necessary when drafting your company’s ongoing business strategy, determining bonuses, and developing tax projections. Much of that information comes from your accountant. To be a trusted business advisor, your accountant should provide reliable data.

But just how precise should you expect your CPA to be? After all, accountants deal in numbers, and since numbers are pretty exact, there is only one correct answer, right? Well, not really. As described above, accounting estimates are just that — estimates. There may be a range of acceptable values. Any value within that range will be considered accurate, even if later, it’s found not to be very close.

Furthermore, for financial statement reporting, the concept of accuracy is intertwined with the concept of materiality. Misstatements are considered material if there is a substantial likelihood they would influence the judgment made by a reasonable user based on the financial statements.

If the financial statements are somewhat inaccurate, but those inaccuracies do not mislead a “reasonable user,” then the financial statements are not materially misstated. In other words, even though the financial statements are not precisely accurate, they are accurate enough if the end-user would otherwise come to the same conclusion.

So, yes. You should expect your accountant to be accurate. But you don’t want him or her chasing every penny. The particular accounting area and the task drive the degree of accuracy expected. For example, you should expect a much higher degree of accuracy in the area of cash than you do in the area of prepaid insurance. It’s a matter of professional judgment. It’s called accurate.

Business Savvy. You want an accountant that has an interest in your industry. A CPA that likes what you do. Someone fascinated with your work will naturally learn more and understand more about your business sector because they have that interest.

I know CPAs who practice in the construction industry. They are very good at what they do. They frequent heavy equipment auctions during their off-hours because they enjoy it. They like the smell of asphalt and are fascinated by the engineering that goes into highway construction. They know the names of your subcontractors. They understand the types of contracts you enter into. They follow the bid tabs. They are good at what they do because they know the business itself. They understand where profit leaks can develop. They know the soft areas susceptible to fraud. They have an antenna up for the business risks and are familiar with ways to minimize those risks.

You should expect this in your CPA. It’s called business savvy.

How About Another Accounting Quiz? (Along with a Few More Answers)

Part II

Last month we presented some questions (along with suggested answers) related to the Paycheck Protection Program. Part II of this Q&A blog will focus on construction accounting. Specifically, the spotlight will be on accounting for long-term construction contracts.

Construction accounting can be somewhat counter-intuitive. For example, billings and revenue generally are not the same thing. Also, an asset nicknamed underbillings may cause considerable concern to end-users of the financial statements, such as the company’s surety. At the same time, a liability referred to as overbillings may be construed in a favorable light. So, without further ado, here we go.

  1. Did the relatively new revenue recognition standard (ASC Topic 606) eliminate the percentage of completion accounting for long-term construction contracts?
    • a. No. Percentage-of-completion revenue recognition method was incorporated into ASC 606 without any variances from the prior approach under ASC 605.
    • b. No. ASC 606 did not eliminate percentage-of-completion accounting for construction contracts in premise. While ASC 606 does not refer to “percentage-of-completion” by name, the over-time input method in ASC 606 can be very similar, though not precisely the same as the former percentage-of-completion under ASC 605.
    • c. Yes. ASC 606 specifically eliminated the percentage-of-completion approach to revenue recognition for long-term contracts.
    • d. Yes. All construction contracts are accounted for on either the cash or accrual method, whichever best approximates the transfer of goods and services to the customer.

  2. In job cost accounting for a construction company, unsubstantiated reclassification of cost from one contract to another (aka cost-shifting) may be done to:
    • a. Fraudulently increase construction revenue and gross profit for financial statement presentation.
    • b. Conceal a loss contract.
    • c. Increase project manager bonuses based on contact performance.
    • d. All of the above.

  3. 3. Under ASC Topic 606 for a construction contractor, wasted cost, such as the purchase and installation cost of materials that do not meet specifications, and therefore must be replaced:
    • a. Are charged to job cost but excluded from the percentage-of-completion calculation since they do not contribute to contract progress.
    • b. Are charged to job cost and included in the percentage-of-completion calculation with both the percentage-of-completion numerator and denominator adjusted accordingly.
    • c. Are captured as inventoriable job cost and subject to write-off at the end of the job, based on contract evaluation.
    • d. Are charged to indirect job cost not subject to allocation to work-in-progress contracts. It is presented as a mezzanine classification on the statement of income between gross profit from operations and general and administrative expenses.

  4. 4. A general contractor negotiates a new revolving-line-of-credit secured by accounts receivable and the personal guarantees of the company’s members. The bank promissory note specifies a maturity date of three years. How should the LOC be classified on the balance sheet at the end of the first year?
    • a. As a current liability, since the company assets securing the obligation are presented as current assets.
    • b. As a current liability, if the company expects to repay the outstanding balance during the next subsequent year.
    • c. As a long-term liability, but only if the company is contractually permitted and intends to delay repayments until maturity.
    • d. As a long-term liability, since the term of the promissory note has a long-term maturity date.
    • e. It depends.

  5. Our construction company obtained a contract in a specialty that is new to us. Therefore, we experienced a reasonably steep learning curve during the first half of the contract. How should we account for the learning curve cost?
    • a. The learning curve cost should be capitalized and amortized straight-line over the entire term of the contract. Otherwise, you bunch up the revenue during the first half of the job and may end up showing a loss in the second half.
    • b. Since learning curve costs generally contribute to the contract’s performance and lead to greater efficiencies and cost savings in the latter part of the contract, they should be included in the percentage-of-completion calculation as incurred.
    • c. Learning curve costs should be presented as general and administrative expenses. If charged to job cost, the contract would earn more revenue during the inefficient learning curve stage.
    • d. Since learning curve costs do not contribute to the contract’s performance, those costs should be excluded from the percentage-of-completion calculation.

Here are the answers:

1b. No. ASC 606 did not eliminate percentage-of-completion accounting for construction contracts in premise. While ASC 606 does not refer to “percentage-of-completion” by name, the over-time input method in ASC 606 can be very similar, though not precisely the same as the former percentage-of-completion under ASC 605.

The percentage-of-completion method survived under ASC 606 as a type of input method, but it’s not front and center. What are front and center is the new five-step method of determining revenue recognition from customers. The basic premise of ASC 606 is that “…an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” This premise is embodied in the five-step method of recognizing revenue from customers:

  1. Identify the contract with the customer
  2. Identify the performance obligation in the contract
  3. Determine the transaction price.
  4. Allocate the transaction price to the performance obligations in the contract
  5. Recognize revenue as performance obligations are satisfied.

2d. All of the above.

Cost shifting is deceptively dangerous. On the face of it, it looks like reclassifying costs from one contract to another will not affect the overall gross profit. Not exactly correct. It can have a considerable effect if, for example, $1 million of cost is improperly reclassified (shifted) from a completed contract showing a loss to a very profitable uncompleted contract at 50% complete. Consider the following example where a company performs two contracts for the year:

  • Completed contract with the following at year-end:
    • Revenue of $5 million
    • Cost of $6 million
    • Gross loss of $1 million
  • Uncompleted contract 50% complete with the following at year-end:
    • Projected revenue of $10 million
    • Projected cost of $8 million
    • Revenue-to-date of $5 million (50% of $10 million projected revenue)
    • Cost-to-date of $4 million
    • Gross profit to date of $1 million

The project manager is responsible for both contracts and has system rights to reclassify costs between jobs. The PM is very unhappy with his combined gross profit of zero because his annual bonus is paid on contract profitability. Therefore, he quietly moves $1 million from the completed loss job to the profitable uncompleted job. Here is the effect:

  • Completed contract with the following at year-end:
    • Revenue of $5 million
    • Cost of $5 million
    • The job breaks even with a gross profit of $0.
  • Uncompleted contract (now 62.5% complete with the following at year-end):
    • Projected revenue of $10 million
    • Projected cost of $8 million
    • Revenue-to-date of $6.25 million (62.5% of $10 million projected revenue)
    • Cost-to-date of $5 million
    • Gross profit to date of $1.25 million

So, at year-end, the PM picked up $1.25 million with a sleight of hand. However, this will come back to haunt him the following year. His uncompleted contract will finish with only $1 million job-to-date gross profit instead of the original projected $2 million. Additionally, the current year’s gross profit will be a loss of $250,000.

3a. Are charged to job cost but excluded from the percentage-of-completion calculation since they do not contribute to contract progress.

For some contractors, this is a change from legacy ASC 605. Before the effective date of ASC 606, many contractors who measured revenue using cost-to-cost percentage-of-completion would include wasted cost in both the numerator and denomination. However, under ASC 606, wasted cost is not included in the cost-to-cost revenue measurement if it does not contribute to satisfying the performance obligation. Instead, such wasted cost is included in job cost but excluded from the percentage-of-completion revenue measurement. Accordingly, this generally will have the effect of accelerating the reduction of the contract’s gross profit at the end of the accounting period compared to gross profit recognition under legacy ASC 605.

4e. It depends.

Not enough information is provided in the question.

Answer “a” is incorrect. The balance sheet classification of the assets securing the debt has no bearing on the debt classification. However, suppose the debt is an asset-based financing arrangement. In that case, the asset securing the debt could have a bearing if the estimated amount of the borrowing base (accounts receivable) at any point during the next year is less than the debt amount at the balance sheet date. In that case, the gap between the debt balance at year-end and the estimated low point of the borrowing base the next year should be classified as current debt. However, this distinction relates to the estimated future amount of the security, not the security’s classification as current.

As for answers b, c, and d, it depends on whether you give greater weight to the company’s intent or the debt’s contractual provisions. If the company anticipates repaying part or the total amount of the line-of-credit the following year, many practitioners suggest that amount should be presented as current. Other practitioners look more to the date the debt is contractually due to be settled because of the uncertainty of future repayment and that contractual stipulations should carry greater weight than mere intent. Those practitioners would classify the debt as long-term in our example.

The Financial Accounting Standards Board has issued Proposed Accounting Standards Update No. 2019-780 (revised September 12, 2019). If the exposure draft is issued in its present form, it will simplify some of the complexities highlighted in question #4. Proposed ASU No. 2019-780 would establish a principle for classifying debt as noncurrent if it meets either of the following criteria as of the balance sheet date:

  • The liability is contractually due to be settled more than one year after the balance sheet date.
  • The entity has a contractual right to defer settlement of the liability for a period greater than one year after the balance sheet date.

5b. Since learning curve costs generally contribute to the contract’s performance and lead to greater efficiencies and cost savings in the latter part of the contract, they should be included in the percentage-of-completion calculation as incurred.

The cost associated with a learning curve is generally anticipated between the contractor and the customer during contract negotiations. Therefore, they are not considered wasted costs which are excluded from the cost-to-cost percentage of completion calculations. Nor are they capitalized. Instead, they should be charged directly to job cost as incurred and drive revenue recognition. In theory, they will lead to greater efficiencies and cost savings in the latter part of the contract.

How About An Accounting Quiz? (Along with a Few Answers)

Part 1

I recall from my college days when Dr. Baker, the dean of the business administration department, casually mentioned that we would have a quiz the very next class. So I prepared for a quiz, which was barely any preparation at all. As it turned out, the “quiz “was a 200-question mammoth examination, weighted to be half our course grade. Holy drop-the-course, Batman.

Well, here’s an accounting quiz for you. But it’s not 200 questions, you do not have to prepare for it, and you will not be graded. You will find what I consider to be the best answers at the end. Here we go.

  1. If the SBA forgives my company’s PPP loan, will I pay federal income tax on the forgiven amount?
    • a. Yes. Because the related expenses are not deductible. This effectively makes it taxable.
    • b. No. The loan forgiveness income is not taxable, and the related expenses are deductible.
    • c. It depends. If your company’s taxable income exceeds $2 million, exclusive of the PPP loan forgiveness amount, then yes, it is taxable.
    • d. Maybe. If the company fails to make the first loan payment on the date stipulated in the lender’s promissory note, the entire amount that the SBA would potentially forgive is deemed taxable income by the IRS.
  2. If my company accounts for our PPP loan as an in-substance government grant under IAS 20, can the grant income be presented as operating income in our GAAP basis income statement?
    • a. No. Receipt of the grant income is ancillary to the company’s primary operations.
    • b. No. GAAP prohibits its presentation as income from operations because it is both unusual and infrequent.
    • c. Yes. IAS 20 requires its presentation as income from operations.
    • d. Maybe. It’s permissible to classify PPP grant income as either operating or nonoperating income, depending on the company’s policy election.
  3. Our company’s PPP promissory note stipulates that our first loan payment is due on the seventh month after the note’s date. However, we expect the SBA will forgive the entire debt, so we have made no payments, even though we are three months past the due date. Are we in default, and, if so, how should this default be disclosed in our financial statements?
    • a. Yes. The bank elected not to revise the promissory note and did not extend the loan deferral date. Disclose the default, and if you account for the PPP loan as debt, it all becomes current.
    • b. Yes. The Paycheck Protection Flexibility Act of 2020 extended the payment date, but this extension did not apply to loans made before the Flexibility Act. Disclose the default, and if you account for the PPP loan as debt, it all becomes current.
    • c. No. The Paycheck Protection Flexibility Act of 2020 retroactively extended the deferral period for loan principal and interest payments.
    • d. Maybe. Under the Paycheck Protection Flexibility Act of 2020, companies must formally apply and received an extension from the bank.
  4. If my company treats our PPP loan as debt for financial statement presentation, how do we determine the classification between current and long-term debt if we are confident the SBA will forgive the loan after application for forgiveness?
    • a. Since the expectation is that the debt will be forgiven and not paid, the entire debt should be classified as long-term because it will not be paid within one year.
    • b. Since the expectation is that the debt will be forgiven and not paid, the entire debt should be classified as current because it will be settled within the next year.
    • c. The debt should be classified as current or noncurrent under ASC-470-10-45, without regard to the expectation that the debt will be forgiven.
    • d. The company should make it simple and present an unclassified balance sheet.
  5. If my company decides to account for the PPP loan by analogy to IAS 20, the company must conclude that it is reasonably assured (i.e., ”probable”) it will comply with the forgiveness term of the CARES Act and SBA rules. Under GAAP, probable means:
    • a. A 75% or greater likelihood.
    • b. More likely than not.
    • c. A very high threshold.
    • d. Likely to occur.

Here are the answers:

  1. 1b. No. The loan forgiveness income is not taxable, and the related expenses are deductible.

    Under the CARES Act, the congressional intent was that the PPP debt forgiveness income be non-taxable, and the expenses that the PPP income defrayed be deductible. Unfortunately, Congress was silent about the deductibility of the expenses to be defrayed by the PPP loan. But the IRS was not quiet. The IRS opined that other areas of the tax code and regulations prohibited the deductibility of those expenses. Congress later corrected this in the Consolidated Appropriations Act, 2021 (“the Act”), signed into law on December 27, 2020. Under provisions of the Act, qualifying expenses related to PPP debt forgiveness are retroactively deductible. Therefore, the PPP debt forgiveness income is not taxable, and the costs defrayed are deductible.

  2. 2d. Maybe. It’s permissible to classify PPP grant income as either operating or non-operating income, depending on the company’s policy election.

    GAAP is somewhat opaque as to the classification of items in the statement of income. Therefore, it becomes a matter of the company’s policy. Suppose the company presents income from operations as a subtotal in the statement of income. In that case, we believe it is acceptable to include the grant income in that subtotal. Since the grant income is intended to defray certain operating expenses (payroll, rent, utilities, etc.), we believe it is acceptable to present the grant income as a separate line item to operating income. For example, you can show PPP grant income below general and administrative expenses in a section captioned Other Operating Income.

    However, the company’s accounting policy may call for the grant income to be presented as non-operating income. In that case, the grant income can be presented as a separate line item below income from operations in the Other Income section.

  3. 3c. No. The Paycheck Protection Flexibility Act of 2020 retroactively extended the deferral period for loan principal and interest payments.

    Under the CARES Act, the principal and interest deferral period ends six months from the date of the note. Accordingly, many early PPP promissory notes stipulated that payments were to begin on the seventh month. However, the Paycheck Protection Program Flexibility Act of 2020, enacted in June 2020, (Flexibility Act) retroactively extended the deferral period for payment of principal and interest on all PPP loans to either:

    1. The date that the SBA remits the borrower’s loan forgiveness amount to the lender,
    2. Or, if the borrower does not apply for loan forgiveness, ten months after the end of the covered period. (Note: The “covered period” is either the 8-week or 24-week period after the loan is made, during which the borrower must incur the qualified expenses).

    The SBA required lenders to give immediate effect to the deferral period’s statutory extension under the Flexibility Act and to notify the borrowers of the change. However, the SBA did not require a formal modification to the promissory note. Therefore, many PPP promissory notes may have incorrect dates for when payments commence.

  4. 4c. The debt should be classified as current or noncurrent under ASC-470-10-45, without regard to the expectation that the debt will be forgiven.

    Even if the SBA forgives the entire PPP loan after year-end and before the financial statements are issued, the debt should be classified as current and long-term based on the promissory note’s terms, as modified by the Flexibility Act. The Flexibility Act makes the initial payment date uncertain. As described above, the Flexibility Act specifies that the deferral period for payment of the PPP loan ends on either:

    1. The date that the SBA remits the borrower’s loan forgiveness amount to the lender,
    2. Or, if the borrower does not apply for loan forgiveness, ten months after the end of the covered period. (Note: The “covered period” is either the 8-week or 24-week period after the loan is made, during which the borrower must incur the qualified expenses).

    Determining the initial payment date requires significant judgment and is based on facts and circumstances specific to the company. Of course, this determination will impact how much of the debt, if any, will be classified as current.

  5. 5d. Likely to occur.

    Under GAAP, probable means likely to occur. Probable is understood (though not defined this way in GAAP) as a very high threshold to clear. Many CPAs consider probable to be a 75% or greater likelihood of occurring, but this percent is not mentioned in GAAP. Therefore, if the probability of loan forgiveness does not rise to this high threshold, then the PPP loan should probably be accounted for as debt.

    Given the current environment of perceived loan application misstatements of the good-faith certification, the SBA may put loans of $2 million or larger under greater scrutiny for compliance after the submission of the forgiveness application. Therefore, larger loans may find it more difficult to reach the high hurdle of forgiveness probably.

Next month, we’ll have Part 2 of this accounting quiz. It will focus on construction accounting.