Joint Venture Proportional Consolidation

The Report of Its Death is Out of Proportion

Construction Joint Ventures

What is a construction joint venture (JV) anyway? And why do construction companies enter into such JVs? And, does US GAAP still permit the investing company the choice to use proportional consolidation, instead of the equity method, to present a construction JVs in its financial statements? This article will attempt to shed some light on these questions.

What is a Construction Joint Venture?

A construction JV is generally a legal entity of limited duration, usually between two construction companies, to join forces to bid, obtain, perform, and complete a single construction project.

Why Does a Construction Company Enter Into Such Arrangements?

These projects are often much larger than those that either construction company customarily performs. Thus, they may mutually agree to join together for the following reasons:

  • The potential contract owner considers the project too significant a risk for just one contractor
  • Each contractor’s aggregate bonding program is too small for the size of the project
  • For each contractor, the size and demands of the project exceed their individual liquidity, working capital, and equity necessary to perform and complete the project timely and successfully
  • One contractor may find a gap in their expertise in a particular project phase and therefore wishes to enlist the second contractor’s resources to supplement his capabilities
  • It permits a contractor who has not performed a project in a particular geographical territory to join forces with a local contractor, and
  • It improves backlog (and hopefully, profitable backlog.)

The JV partners will need the up-front expertise of a lawyer who specializes in construction law. A lawyer who has experience with construction JVs. Here are some of the areas the partners should seek advice:

  • JV Structure. Consideration should be given as to how the JV is structured. There are several ways to structure a construction JV. For example, will it be a line-item JV where each JV partner performs identified line-items of the project, or will it be a more traditional JV where resources (employees, working capital, financing, and equipment) are made available or contributed to the JV to perform the project?
  • Legal Form. What legal form should the JV take? This decision may impact the JV partner’s method of reporting JV assets, liabilities, and activity in their financial statements. (The methods of financial reporting are discussed in the next section.)
  • Governance. What will be the form of the JV governance?
  • Ownership Considerations. What will be the percentage ownership of the JV? If a line-item JV, how will ownership be structured?
  • Profit Allocation. How will the contract profit be split? Will one JV partner have a greater than 50% allocation?
  • Variable Consideration. How will early completion bonuses and shared savings be split? What about project delays and liquidated damages? Who will bear the brunt of this?
  • Subcontractors. Will the JV pay the subcontractors directly, or will it be the JV partners’ responsibility?
  • And the list and the clauses go on and on. Other matters to be discussed and decided include the disposition and handling of contingency funds, bonding, employee non-encroachment agreements, dispute resolutions, and non-compete agreements.

Is Proportional Consolidation Permitted?

In general, US GAAP provides the following methods of accounting for an investment in joint ventures:

  • Cost method. The cost method must be used if the investor cannot exercise significant influence over the financial or operating decisions of the investee unless such ability can be demonstrated. An investment of less than 20% of the voting stock creates the presumption that the investor does not have significant influence.
  • Equity method. The equity method should be used if the investor has significant influence. FASB ASC 323-10-15-8 clarifies that “(a)n investment (direct or indirect) of 20 percent or more of the voting stock of an investee shall lead to a presumption that in the absence of predominant evidence to the contrary an investor can exercise significant influence over an investee.” An investor with 20% to 50% of the voting stock of the investee is considered to have significant influence.
  • Full Consolidation. If it exercises control over the JV, an investor will add 100% of the joint venture’s assets, liabilities, revenue, and expenses to each applicable line of its financial statements. Any non-controlling interest will be backed-out of consolidated equity and net income. This control can take the form of financial investment in the JV greater than 50% or a variable interest structure in which the investor is the primary beneficiary.
  • Proportional Consolidation. If certain conditions under US GAAP are present, proportional consolidation may be used instead of the equity method. However, proportion consolidation cannot be used in place of the cost method or full consolidation. So what is proportional consolidation? Proportional consolidation is where the investor’s proportional share of the JV’s assets and liabilities are added to each applicable line of its own balance sheet. And the investor’s proportional share of the JV’s operations is included in each appropriate line in its income statement. There is a variation of this which we will describe in the last section.

Proportional Consolidation Criteria

Under what situations or criteria is proportional consolidated permitted in place of the one-line equity method?

Generally, proportional consolidation may be used under US GAAP in two situations:

  1. Undivided interest. FASB ASC 810-10-45-14 states, “If the investor-venturer owns an undivided interest in each asset and is proportionately liable for its share of each liability, the provisions of paragraph 323-10-45-1 may not apply in some industries.” (ASC 323-10-45-1 describes the applicability of the equity method.) Therefore, the equity method may not apply when the construction JV is an undivided interest and not a legal entity. In such cases, the venturer may use the proportional consolidation method.
  2. Construction and extractive industries subject to the equity method. FASB ASC 810-10-45-14 further states, “Specifically, a proportionate gross financial statement presentation is not appropriate for an investment in an unincorporated legal entity accounted for by the equity method of accounting unless the investee is in either the construction industry…or an extractive industry.” (Emphasis added.)Therefore, if an investor has a non-controlling interest in a construction unincorporated legal entity that may be accounted for under the equity method, it may elect to use proportional consolidation instead.

It should be noted that a limited liability company (“LLC”) is a separate legal entity. However, it is not incorporated. Therefore, it is subject to proportional consolidation in lieu of the equity method of presentation.

Therefore, an investor in a construction JV may use proportional consolidation if the JV is formed as:

  • An undivided interest
  • General partnership
  • An LLC or limited liability partnership, provided it has governance and economic characteristics more like a partnership than a corporation.

However, if the construction JV is incorporated or an unincorporated entity, such as an LLC, with the governance and economic characteristics like a corporation, then the equity method must be used instead of proportional consolidation. Additionally, all majority-owned subsidiaries in which the parent has a controlling interest must be fully consolidated. Therefore, it is not subject to proportional consolidation.

As can be seen, proportional consolidation is very restrictive under US GAAP. However, its use is established in the construction industry and therefore permitted to continue subject to the restrictions outlined above. (FASB ASC 810-10-45-14.)

Financial Reporting Under Proportional Consolidation

There are two basic approaches to proportional consolidation in practice. Each is acceptable.

  1. The investor company combines its proportional amount of the construction JV’s assets, liabilities, and operations on its balance sheet and income statement on a line-by-line basis. The JV’s construction contract is presented on the contract schedule at 100% on one line, with a reduction on the line below for the amounts that represent the other JV partner’s percentage ownership. The third line will be the net amount representing the reporting JV partner’s percentage ownership.
  2. A hybrid method is also used in practice. The investor company reports its proportional amount of the construction JV’s assets and liabilities using the one-line equity method on the balance sheet and its gross proportional amount of operations on the income statement on a line-by-line basis. Public construction company investors often use this hybrid method.

    The contract schedule presentation will be the same as number 1 above, except the over and underbillings will need adjustment since they are netted into the one-line presentation on the balance sheet.

Income Tax Changes Affecting Individuals in 2021

A Few Changes to What Is Certain

Below are some of the changes that may affect your 2021 tax returns. A few of the changes noted below are routine, such as the increases in the standard deduction. However, many changes directly result from recent legislation intended to soften the financial impact of the pandemic.

As the great statesman said, “nothing is certain but death and taxes.”And while taxes are certain to impact us all, it is just as certain that they will continually change.

Standard Deduction. Most U.S. taxpayers take the standard deduction. The 2021 standard deduction for all filing statuses increased as follows:

  • Single: $12,550 ($150 increase)
  • Married filing jointly and surviving spouse: $25,100 ($300 increase)
  • Married filing separately: $12,550 ($150 increase)
  • Head of household: $18,800 ($150 increase)
  • Dependent Standard Deduction (minimum) $1,100 (no change).

The 2021 additional standard deduction for those 65+ or blind is:

  • Single: $1,700 ($50 increase)
  • Married filing jointly, married filing separately, and surviving spouse: $1,350 ($50 increase)
  • Head of household: $1,700 ($50 increase).

For those both 65+ and blind, the above amounts are doubled.

Charitable Contributions. In 2019, you could only deduct charitable contributions if you itemize deductions. However, most Americans did not itemize but, instead, took the standard deduction. Therefore, most individual taxpayers received no tax benefit for their 2019 charitable contributions.

For 2020 tax returns, a small “above the line” benefit was provided for cash contributions to charities if you took the standard deduction. However, under the IRS’s interpretation of the law, this deduction was limited to $300 per return.

But, for 2021, couples who file jointly may now deduct up to $600 on line 12b of form 1040 if you do not itemize your deductions.

Recovery Rebate Credit. Taxpayers received a third round of stimulus money in 2021. The amount received was up to $1,400, plus an additional $1,400 for each eligible dependent. However, some taxpayers did not receive the total amount or, perhaps, anything at all because of adjusted gross income phase-outs.

The amounts paid were considered advance payments based on prior tax information available to the IRS. Unfortunately, many taxpayers received less than they were entitled to, based on their tax situation in previous years. This shortfall can be trued-up on Line 30 of Form 1040.

The good news is that if the IRS overpaid you, you will not have to repay the overpayment, and it will not be taxable. On the other hand, if the IRS underpaid you, you can claim the shortfall credit on Line 30. It’s one of those rare tax situations where you can have your cake and eat it too.

Child Tax Credit. Thanks to the American Rescue Plan Act of 2021, there was a sizeable one-year increase in the child tax credit for 2021. The maximum child tax credit for 2021 is:

  • $3,600 for each qualifying child under age six,
  • $3,000 for each qualifying child under age 18, but at least age six,
  • $500 for any other dependant.

Additionally, the credit is refundable. A refundable credit means you receive a refund even if the credit exceeds your tax liability. However, on the downside, the credit begins to decrease as your income rises. The phase-out starts at adjusted gross incomes of $75,000 for single filers or married filing separately filers, $112,500 for head-of-household filers, and $150,000 for married filing jointly filers.

Half the credit was available to be received in advance monthly in 2021. Taxpayers must reconcile the credit due on Schedule 8812 and Line 28 of Form 1040.

Child and Dependent Care Credit. The American Rescue Plan Act of 2021 also sweetened the pie for the child and dependant care credit. For 2021, the credit is a percentage of qualifying expenses and tops out at $4,000 for one child or disabled person and $8,000 if you have more than one child or disabled person. Phase-out of the credit is based on income level using a somewhat convoluted formula.

Additionally, the credit is refundable, without limits.

Student Loans. For tax years 2018 through 2020, student loan forgiveness could be excluded from gross income only if the forgiveness was due to the student’s death or disability.

However, there is good news for tax years 2021 through 2025. The forgiveness of student loans for any reason will not be a taxable event.

Payroll Taxes. The social security annual wage base increased by $5,100 to $142,800. (The annual wage base rises to $147,000 in 2022.) Medicare tax has no ceiling. The combined tax rate remains at 7.65% on both the employee and the employer.

The medicare surtax remains at 0.9% on 2021 wages and self-employment income. The tax is on employees only (not the employer) on amounts greater than $200,000 for single filers and $250,000 for those filing jointly (or $125,000 for married filing separately.)

Standard Mileage Rates. The standard mileage rate for business use of auto is 56 cents per mile for 2021. It was 57.5 cents in 2020. Deemed depreciation for 2021 is 26 cents per mile.

Many More Changes. The above summarizes just a few of the changes for the 2021 tax year. However, many more impact both your 2021 and 2022 tax returns. Don’t hesitate to contact your tax professional for the details.

Employee Retention Tax Credit

Financial Statement Presentation of Government Grants

Our last blog, dated December 21, 2021, made mention of the employee retention tax credit (“ERTC”). This tax credit originated from no less than three separate acts of Congress over a twenty-one-month period in 2020 and 2021. The legislative purpose was to provide economic assistance to entities suffering from the COVID-19 pandemic. While this series of laws tended to make the ERTC more generous, it also added much confusion and complexity. Not a big surprise when it comes to such a widespread government program.

The structure of the ERTC was to provide refundable payroll tax credits to entities as an incentive to retain employees during the pandemic. The entity obtained the credit by incurring qualifying payroll expenses and certain health insurance costs. The credit could be taken as an advance on IRS Form 7200 or credit on either a timely filed IRS Form 941 or amended IRS Form 941-X. Like most legislation, the aim was noble, but the practical application became complex.

This blog, however, will not discuss how to navigate the complexity of obtaining the ERTC. That is pretty much history now, since the program ended September 30, 2021, for most business entities. (Certain “Recovery Startup Businesses” remained eligible for the credit through December 31, 2021). So instead, we will briefly describe the possible approaches for the accounting and financial statement presentation of the ERTC available to a for-profit business entity.

A Little Related History First. The choices available for financial accounting and presentation of the ERTC may be limited to the company’s financial statement election made under the Paycheck Protection Program (“PPP”). There were four methods available to account for the government funding received under the PPP. Those methods were as follows:

  1. As debt under FASB ASC 470-Debt,
  2. By analogy to International Accounting Standard 20, Accounting for Government Grants and Disclosure of Government Assistance (“IAS 20”),
  3. By analogy to the not-for-profit model (“NFP model”) described in FASB ASC 958-605-25-13,
  4. By analogy to the gain contingency recognition model presented in FASB ASC 450-30.

Two Scenarios.

Suppose the business entity previously applied for a PPP loan and elected to account for the loan as a grant under IAS 20. How should the entity subsequently account for the ERTC?

  • Since the entity had selected, as an accounting principle, to account for government grants by analogy under IAS 20, then all subsequent governmental grants (i.e., the ERTC) must consistently be accounted for the same way.
  • The same would be true if the entity had previously chosen to account for the PPP loan under the NFP model or by analogy to the gain contingency model. Those would be accounting elections that the entity should consistently follow for similar governmental grants from period to period.

But, on the other hand, suppose the business entity previously applied for a PPP loan and elected to account for the loan as debt under FASB ASC 470. Or, what if the business entity did not make an application and therefore did not receive government assistance under the PPP. In those two cases, how should the entity account for the ERTC?

  • Since the ERTC is a refundable tax credit and not a loan, the treatment as debt is not available.
  • The ERTC cannot be accounted for under FASB ASC 740, Income Taxes, because the credit applies to payroll taxes, not income taxes.
  • Therefore, the entity would be free to elect any of the remaining three options as described 2,3, or 4 above.

The Three Methods to Account for ERTC.

  1. IAS 20 Model. If the company estimates that it is probable it will meet the conditions contained in the grant, and the ERTC will be received, it may account for the ERTC under the IAS 20 model. Bear in mind, though, that the likelihood that the conditions of the law will be met must meet the probable threshold under GAAP, a high bar to reach. The standards define “probable” as a future event or events that are likely to occur. While no percentage threshold is given in authoritative accounting standards, in practice, many CPAs consider a 75% or greater likelihood of occurrence as necessary to meet the probable requirement.

    If the probable threshold is met, the entity would recognize the tax credits as income” on a systematic basis over the periods in which the entity recognizes as expenses the related costs for which the grants are intended to compensate.”

    Under IAS 20, the ERTC is presented in the statement of income as either: 1) A separate caption or under a general caption such as Other Income, or 2) as a reduction to the related expenses.

    Generally, U.S. GAAP does not permit the netting of income against the related expense. Accordingly, we expect that most companies who choose the IAS 20 model would elect to present ERTC income as either a separate caption or under a general caption such as Other Income, as described above.

    If all or a portion of the previously recognized income is deemed repayable in a subsequent accounting period, it will be accounted for prospectively as a change in estimate.

  2. NFP Model. Suppose a business entity anticipates complying with the eligibility criteria and expects to receive the ERTC. Another acceptable approach would be, by analogy, to follow the not-for-profit model. Under the NFP model, a conditional contribution is “…accounted for as a refundable advance until the conditions have been substantially met or explicitly waived by the donor.” Therefore, the ERTC amount would be carried on the balance sheet as a refundable advance until the criteria for forgiveness are substantially met or explicitly waived. At that point, the refundable advance would be recognized as income.

  3. Gain Contingency Model. Another method a business entity may elect if it expects to comply with the requirements of the law is by analogy to the gain contingency recognition model presented in FASB ASC 450-30. Under this model, the ERTC is recorded as a deferred income liability. As a result, grant income will not be recognized until the period when the grant proceeds are realized or realizable.

A Few Predictions for 2022

Hold on to Your Hat

As we approach the end of 2021, we find ourselves two years into a “once-in-a-century” pandemic. Unfortunately, at the time of this blog, there is no apparent clear path to an end. Instead, the virus seems to have a life of its own, as evidenced by its various mutations. The pandemic, and our response to it, has precipitated business closures, supply chain disruptions, travel issues, employee shortages, work stoppage, interruptions in the education of our children, anger, and, most tragically, the loss of life and health. On the macro level, collectively, this has led to inflationary pressure that is likely to continue deep into 2022. In response, the Federal Reserve has indicated the likelihood of interest rate increases for the coming year.

World of Accounting. The accounting profession has not been immune to the impact of the pandemic. The profession had its hands full addressing responses to federal programs designed to ease the burden of the pandemic. Such programs included the Paycheck Protection Program, recovery rebate credits, expansion of the child tax credit, and the employee retention credit.

The new lease standard has been in discussion for several years. Despite that, we predict that many companies will be surprised by its impact. It will be impactful in two areas:

  • The amount of time it will take to capture all necessary information to properly account for leases under the new standard, and
  • The change in the balance sheet. Essentially all leases will now be capitalized on the balance sheet, both operating and finance leases.

Companies should not underestimate how labor-intensive it will be to identify all leases the company may have. That’s because leases may be scattered in several departments. Additionally, certain leases may be “embedded” in other contracts and will have to be dug out. So the advice is to not delay implementation any longer. There will also be added complexity in determining the lease term subject to capitalization and other data points necessary for capitalization and extended disclosure.

Under the legacy lease standard, operating leases were not presented on the balance sheet. Instead, the future obligations were disclosed in footnote presentation. Under the new standard, the asset and the debt will be classified on the balance sheet. This may be shocking to company management when looking at the hard numbers for the first time.

Be sure and look at our blog posted May 18, 2021, on leases. Also, consider discussing lease accounting and presentation with your accounting professional.

Federal Income Taxes. It may come as no surprise, but we predict that corporate and individual income taxes will become more complicated, not less complicated, in 2022. There is a tendency among politicians to attempt to correct economic and social ill through tax legislation along with well-meaning attempts to incorporate fairness into the code. As righteous as this may be, it often has unintended consequences. Those consequences are corrected by further legislation, which results in incomprehensible and complicated tax law.

Working Remotely From Home. The pandemic accelerated the trend of working remotely from home. For many people, working from home was not an option. However, those who could work from home, instead of the office, found both pros and cons to the arrangement. The pros included:

  • No commute. No fighting traffic to and from work.
  • Eliminating the commute frees up more time for work without extending the workday. For the period I worked remotely in 2020 and part of 2021, I found that eliminating my commute made available an additional eight productive hours per week.
  • Working remotely provided greater flexibility to handle personal matters that required attention during the workday.

The disadvantages of working remotely from home included:

  • Working remotely results in a disconnect with those working in the office. It’s the old “out-of-sight, out-of-mind” thing.
  • Remote internet meetings are great for many situations. However, there are numerous occasions when it’s a poor substitute for face-to-face interaction. For example, I have found no viable replacement for a live, person-to-person interface for training.

I predict that 2022 will move toward a balance regarding working remotely from home. The concept is not all good – nor is it all bad. Faster home internet connections and cloud computing have enhanced the possibilities of working from home. However, good old-fashion face-to-face interaction will never go out of style.

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.

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