dsp64, Author at Cooper, Travis & Company, PLC

5 Things You Should Tell Your CPA

Posted on August 16, 2021 by dsp64

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.

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.

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.

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.

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.

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

Posted on July 16, 2021 by dsp64

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)

Posted on June 17, 2021June 16, 2021 by dsp64

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:

Expected value approach
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:

Factors outside the contractor’s influence:

Market volatility
Weather conditions
Settled through adjudication or arbitration

This would generally increase the degree of uncertainty regarding the amount of consideration, causing a delay in revenue recognition until the uncertainty is resolved.

Length of time to resolve an uncertainty.
The contractor’s experience with similar contracts
The contractor’s history of offering a broad range of price concessions with similar contracts
The contract has a broad range of possible consideration outcomes
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.

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

Posted on May 18, 2021 by dsp64

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:

The lease transferred ownership of the property to the lessee by the end of the lease term.
The lease contained a bargain purchase option.
The lease term was equal to 75 percent or more of the estimated economic life of the leased property.
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.

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.

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.

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.

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.

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.

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

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.

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).

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.

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

Posted on April 16, 2021 by dsp64

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)

Posted on March 15, 2021March 15, 2021 by dsp64

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.

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.

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. 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. 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.

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:

Identify the contract with the customer
Identify the performance obligation in the contract
Determine the transaction price.
Allocate the transaction price to the performance obligations in the contract
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)

Posted on February 12, 2021 by dsp64

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.

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.

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.

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.

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.

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:

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.
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.
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.
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.
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.

Income Taxes Changes For 2020 Tax Returns

Posted on January 13, 2021January 13, 2021 by dsp64

And A Few Things to Cheer About

Below are some of the changes to expect in your 2020 tax returns. Except for the increases in the standard deduction, all were the result of Federal legislation drafted and passed in 2020 designed to keep the economy afloat during the COVID pandemic. And all were favorable to us as taxpayers. Even in such a year as challenging as 2020, that’s a little something to cheer about.

BUSINESS TAX

Deductibility of Expenses Related to PPP Loans. Congress stepped in the latter part of December 2020 and corrected an oversight they made in the CARES Act. The CARES Act, signed into law on March 27, 2020, established the Paycheck Protection Program (“PPP”) to provide limited relief to small businesses during the COVID pandemic. The PPP provided forgivable SBA loans to qualifying businesses to cover payroll costs, including benefits, mortgage interest, rent, and utilities. Assuming the company complies with the eligibility criteria for forgiveness, the loan principal and accrued interest will be forgiven by the SBA. Additionally, under the CARES Act, this forgiveness will not result in taxable debt cancellation income or the loss of tax attributes.

This sounded good. However, later during the year, the IRS opined that all was not well. In their view, the payroll cost and other qualifying expenses that gave rise to PPP loan forgiveness were not deductible. The IRS reminded Congress that other areas of the tax code and regulations prohibited deductions (and other favorable tax attributes) for expenses related to non-taxable income. The CARES Act was silent regarding the deductibility of the qualifying expenses. The IRS effectively turned the non-taxability of PPP loan forgiveness upside down.

Congress corrected their prior legislative oversight 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 original intent of Congress was satisfied. PPP loan forgiveness is not taxable income, and the qualifying expenses related to PPP are deductible. This is a much needed and sizable benefit to many closely held companies.

INDIVIDUAL TAX

Recovery Rebate Credit. Congress passed two rounds of economic impact payments (a.k.a stimulus payments) in 2020 directed to individual taxpayers to help alleviate the financial impact of the COVID pandemic. The CARES Act provided for payments up to $1,200 per person. The Consolidated Appropriations Act provided the second round of payments up to $600 per person.

The payment amounts are intended to be based on adjusted gross income, filing status, and qualifying dependents as presented on your 2020 individual tax return. Of course, your 2020 Form 1040 will not be filed until sometime in 2021, as late as October 15. To get funds in the hands of the American people as quickly as possible, the IRS sent “advance payments” based on either your 2018 or 2019 tax returns. In other words, the IRS, for the sake of expediency, assumed your tax status (adjusted gross income, filing status, dependents, etc.) would be the same in 2020 as they were on either your 2018 or 2019 Form 1040.

However, your tax situation may have changed in 2020. For example, your income may have decreased, or the number of dependents may have increased. Therefore, you may need to true-up the amount you received. This true-up is reported on Line 30 of the 2020 Form 1040 and styled “Recovery rebate credit.” The IRS provides a worksheet in the Form 1040 instructions to calculate the additional amount of stimulus payment the IRS owes you.

The good news is that the true-up can only result in a larger stimulus payment in the form of a rebate credit. If the IRS’s original advance payments were, in fact, too much (because your situation improved in 2020), you are not required to pay it back.

Another bit of good news, the stimulus payment is not taxable.

Charitable Contributions. Last year, you could only deduct charitable contributions if you itemize deductions. However, the majority of Americans do not itemize but, instead, take the standard deduction. Therefore, most individual taxpayers received no tax benefit for their 2019 charitable contributions. However, the CARES Act and clarification by the recently passed Consolidated Appropriations Act, 2021 provides a small “above the line” benefit on your 2020 tax return for cash contributions to charities if you take the standard deduction. A deduction up to $300 ($600 for joint filers) is permitted on Line 10b of Form 1040.

Standard Deduction. As described above, most taxpayers take the standard deduction. The 2020 standard deduction for all filing statuses increased for 2020, as follows:

Single: $12,400 ($200 increase)
Married filing jointly and surviving spouse: $24,800 ($400 increase)
Married filing separately: $12,400 ($200 increase)
Head of household: $18,650 ($300 increase).

The 2020 additional standard deduction for those 65+ or blind remains unchanged:

Single: $1,650
Married filing jointly and surviving spouse: $1,300
Head of household: $1,650

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

Many More Changes. The above is a summary of just a few of the changes for the 2020 tax year. There are many more that impact both your 2020 and 2021 tax returns. Please contact us for the details.

Sensitive Areas Of A Construction Company Audit

Posted on December 15, 2020 by dsp64

Or — Things That Make You Go “Humph”

The majority of construction companies are private entities closely held by a small group of owners engaged in management. Many owners/managers began the company from scratch and remain active in the company’s day-to-day operations. While very competent in their chosen trade, many are not as comfortable or interested in the accounting related to their construction activities, except for tax savings and strategic planning.

Some construction companies choose to have an annual financial audit. However, most have an audit because it is required by the company’s surety, banker, or a governmental entity. Therefore, audits may be viewed as a necessary but inconvenient part of business ownership.

This article describes and attempts to explain the reason for certain aspects of a construction financial audit that may puzzle or even exasperate operational personnel.

CPA Independence and Professional Skepticism. “Why does the auditor check out the things I tell him? I’ve always been straight with him.” Auditors make a significant amount of inquiries. However, auditors are generally not permitted under generally accepted auditing standards (“GAAS”) to rely on inquiry alone, despite management’s trustworthiness.

The CPA who audits financial statements is required under the AICPA Code of Professional Conduct to be independent. What does independent mean? It means that the CPA is an advocate of his/her own opinion, not management’s opinion. At times, this opinion may be contrary to the views of the company’s management. The end-users of the financial statements expect this independence. Without independence, the assurance provided to the end-users regarding the fairness of the financial statements is useless.

At the heart of this assurance is what is known as professional skepticism. Professional skepticism is defined as “(A)n attitude that includes a questioning mind, being alert to conditions that may indicate possible misstatements due to fraud or error, and a critical assessment of audit evidence.” (AU-C § 200.14). Under the concept of professional skepticism, “(T)he auditor neither assumes that management is dishonest nor assumes unquestioned honesty.” (AU-C § 200.A26). Management could misunderstand professional skepticism as distrust or implication of misdeeds. However, it’s an audit state of mind that perhaps can be best summed up by an old Russian proverb often spoken by President Reagan, “Trust but verify.”

Financial Statement Materiality and Audit Sampling. “The auditor is chasing a small amount that makes little difference – who cares?” At times, management may question why the auditor is raising questions about a small dollar amount. There are two possible explanations. One relates to materiality, and the other to audit sampling techniques.

Materiality is an essential concept in the financial audits of construction companies. Without the materiality concept, audits would never be completed or take much longer than they do. Everything cannot be audited, so auditors use materiality and risk assessment to sort through and determine what should be examined. But it’s not as simple as it may seem.

Materiality is used to determine which financial statement areas should be examined and to evaluate potential misstatements identified during an audit. “In general, misstatements, including omissions, are considered to be material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users that are taken based on the financial statements.” (AU-C § 200.07). However, materiality involves both a quantitative and qualitative analysis. Accordingly, materiality is determined by both the size and the nature of the misstatement. For example, a small amount may be considered material if the misstatement is related to fraud, such as cost-shifting from one project to another. Additionally, a slight variance may be significant if it results in a loan covenant violation or places project managers in a lower or higher bracket for bonus calculation.

The nature of audit sampling drives another reason an auditor may examine a small dollar item. Certain approaches to audit sampling will result in both large and small amounts selected for testing. Any misstatements that are identified in the sample are then extrapolated to the population as a whole. While this saves considerable time because an entire population is not tested, it may result in questions about smaller dollar items.

Fraud Inquiries. “Why was I selected for an interview? Does the auditor think I’m stealing?” GAAS requires auditors to inquire of those charged with governance, management, and others in the company whether they have any knowledge of fraud. (AU-C §240.18 &.21). The auditor performs these inquiries as part of the risk assessment related to fraud and compliance with laws and regulations. In a standard financial audit, and almost without exceptions, those chosen for interviews are not suspected of fraud. They are chosen primarily because of the type of job duties they perform (accounting, shipping and receiving, project management, CFO, etc.). The focus is to inquire of personnel who are in a position to observe a broad spectrum of situations and events, including some that give them concern. The fraud interview is a forum that allows them to voice those concerns in a non-threatening conversation.

Unpredictable Audit Procedures. “No auditor has ever done this before. Why is it necessary this time?” Doing an unexpected procedure, or performing a routine procedure at an unexpected time, for example, is a requirement of GAAS. (AU-C §240.29c). Performing an unpredictable audit procedure “…is important because individuals within the entity who are familiar with the audit procedures normally performed on engagements may be better able to conceal fraudulent financial reporting.” (AU-C §240.A42). The reason is no more complicated than that. Auditors are required to mix things up as a safeguard to thwart those who may be inclined to commit fraud.

Audit Scope Limitation. “I’m not sure we want to pay you to do that audit procedure.” If you’ve been in the audit business long enough, someone in management has probably non-maliciously suggested that an audit procedure is unnecessary. And truthfully, that is management’s prerogative. If management communicates to the auditor that he/she not do a particular audit step, the auditor must abide by their wishes. However, if the auditor cannot obtain sufficient audit evidence due to management’s prohibition, the auditor may have a scope limitation.

A scope limitation occurs when “the auditor is unable to obtain sufficient appropriate audit evidence to conclude that the financial statements as a whole are free from material misstatement.” (AU-C §705.07b).

A scope limitation is not a good thing. If the auditor cannot obtain sufficient appropriate audit evidence to base an opinion but concludes that the possible effects, if any, on the financial statements could be material but not pervasive, he may qualify his opinion on the financial statements.

Or, if the auditor concludes that the effects, if any, on the financial statements could be both material and pervasive, he may go so far as to disclaim an opinion on the financial statements as a whole.

Neither option is beneficial to the company. The best approach is to politely explain the consequences of a scope limitation to management and request that the audit procedure be permitted.

Five Myths About Accounting

Posted on November 13, 2020November 13, 2020 by dsp64

The Bob Cratchit Stigma

Accounting is all about math. Is it? Little could be further from the truth. Do you recall the math courses you took in school; calculus, geometry, algebra, and trigonometry? They gave me nightmares. But accounting somehow made sense. When it comes to the number part of accounting, it’s more addition, subtraction, multiplication, and division. Those are not advanced mathematical topics. It’s more arithmetic than high-level math.

Accounting is about concepts and principles, analytics and organization, simplifying complex situations, clarity, and concise communication. True, it may borrow from statistics in certain areas, such as selecting sample sizes for audit testing. But in the end, accounting is about taking what appears to be an overwhelming amount of data and analyzing, organizing, summarizing, and simplifying that information whereby management can make sound financial decisions. It’s about using sound judgment to apply the appropriate accounting principle to a complicated situation. And all of that is done without relying too much on math.

An audit assures that the financial statements are 100% accurate. Does it? Not really. Auditors perform audits under the concepts of materiality and fair presentation. The auditor gives his/her opinion after obtaining a high level of assurance (called reasonable assurance) that the financial statements are not materially incorrect. Put another way; the auditor renders an unmodified opinion when the financial statements are presented fairly in all material respects. Misstatements or omissions in the financial statements are immaterial when, in the auditor’s professional judgment, those misstatements or omissions would not reasonably be expected to influence the end-users’ economic decisions. Therefore, it’s possible, even likely, that many audited financial statements have immaterial misstatements or omissions that would not affect the end-users’ conclusions. From a practical standpoint, to audit financial statements to the point that the auditor concludes they are 100% accurate would be unnecessary and cost prohibited.

Also, under professional standards, the auditor uses sampling and is not required to test every transaction. Therefore, the financial statements may have undetected material misstatements. The auditor must only obtain reasonable assurance, but not the absolute certainty that the financial statements are fairly presented.

Accounting is an exact science that leads to one correct answer. Not exactly true. Accounting is an art, not a science. While clients and company management expect accuracy in the end product, ideas and creativity are what’s truly appreciated. The Financial Accounting Standards Board has, for the last several years, moved the profession toward a principle-based approach instead of a rules-based approach. A principle-based framework creates guidelines rather than the rigorous rules found in a rules-based approach. Accordingly, under the principle-based approach, reasonable accountants may arrive at different conclusions when faced with similar facts and circumstances.

Additionally, many accounting transactions inherently have more than one appropriate treatment. Significant judgment is required for accounting estimates surrounding revenue recognition, depreciation, accounts receivable valuation, self-insurance liabilities, and warranty liabilities. The path to a fair presentation is often more art than science.

Financial statement materiality can be expressed as one number. Maybe yes and maybe no; it ain’t necessarily so. The bottom line is that materiality at the financial statement level is a matter of the accountant’s professional judgment. It involves both a quantitative and qualitative analysis. Many auditors use a quantitative approach to determine materiality for purposes of planning the audit. Planning materiality is used to determine sample size and to evaluate variances found during test work. However, they will use a combination of quantitative and qualitative analysis to assess materiality at the financial statement level. For example, a potential adjustment that would decrease pre-tax income by a relatively small immaterial amount (quantitative analysis) may be very material if the adjustment results in a loan covenant violation (qualitative analysis).

Accounting is boring. Not really. Well, it’s not performing a spacewalk, but it’s not Bob Cratchit either. Sure, there are number-crunching episodes, tight deadlines, and some long hours. However, the nature of the work will also bring you face-to-face with mission-critical issues for the business. As a trusted advisor for the company, the accountant will find himself/herself a significant player in management/stockholder meetings. Communication is vital in any organization, and the accountant is often central in channeling information throughout the company. The accountant is in a pivotal position to interact and understand the company and its industry from top-to-bottom. It’s a balance of people-to-people interaction, number crunching, and research. And at times, it will be anything but boring.