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Test Your Accounting IQ

Posted on by dsp64

Regarding Some Fairly Heavy Topics

Introduction to the Quiz

Are you ready to put your accounting expertise to the test? This quick quiz dives into five significant areas shaping public accounting today — from leasing and credit loss estimates to risk assessments, quality management standards, and revenue recognition. Designed for CPAs with a couple of years under their belts, this quiz challenges your knowledge of recent standards and their real-world application. Answers and brief explanations follow — so you can check your score and sharpen your skills. This quiz covers five complex accounting, auditing, and firm quality management areas relevant to accountants in public practice. The topics include:

Benefits of AI in Audit and Accounting Research

  • ASC 842 – Leases, which has significantly impacted how companies account for leases;
  • ASC 326 – Current Expected Credit Losses (CECL), which introduces a forward-looking approach to estimating credit losses;
  • SAS 145 – Risk Assessment, which enhances audit quality by refining and clarifying the risk assessment processes;
  • Quality Management Standards (SQMS No. 1, SQMS No. 2, SAS No. 146, and SSARS No. 26), which aim to improve firm-wide quality management systems; and
  • ASC 606 – Revenue Recognition, which provides a unified framework for recognizing revenue across industries.

The best responses and explanations are provided following the quiz.

Quiz Questions

ASC 842 – Leases

  1. What is the purpose of the lease classification tests under ASC 842?
    • A) To determine whether leases should be capitalized
    • B) To decide if leases are finance or operating leases
    • C) To eliminate lease liabilities from the balance sheet
    • D) To reassess lease terms annually
  2. Under ASC 842, what happens if a lease meets one or more classification test criteria?
    • A) It is classified as an operating lease
    • B) It is classified as a finance lease
    • C) It is excluded from financial reporting
    • D) It is classified as a short-term lease
  3. Which test was added under ASC 842 to classify leases?
    • A) Bargain purchase option test
    • B) Present value test
    • C) Alternative use test
    • D) Lease term test
  4. How does ASC 842 impact transparency in financial reporting?
    • A) By eliminating lease liabilities from the balance sheet
    • B) By requiring all leases to be classified as operating leases
    • C) By reducing disclosure requirements for leases
    • D) By requiring recognition of Right-of-Use (ROU) assets and lease liabilities
  5. What is considered a key challenge for construction companies under ASC 842?
    • A) Eliminating ROU assets
    • B) Reducing lease liabilities on the balance sheet
    • C) Increasing lease term flexibility
    • D) Identifying embedded leases in service contracts

    ASC 326 – Current Expected Credit Losses (CECL)

  6. What distinguishes CECL from the legacy incurred loss model?
    • A) CECL estimates losses only when they are probable and estimable
    • B) CECL incorporates forward-looking information into credit loss estimates
    • C) CECL eliminates the need for credit loss reserves entirely
    • D) CECL applies only to large entities
  7. What methodology can construction companies use to estimate credit losses under CECL?
    • A) Historical write-offs only
    • B) Solely qualitative assessments without quantitative data
    • C) Pool-based assumptions incorporating reasonable forecasts of future conditions
    • D) Ignoring aging categories for receivables
  8. What defines a collateral-dependent loan under CECL?
    • A) Loans secured by collateral that must be sold immediately upon default
    • B) Loans secured by high-value collateral without borrower difficulty considerations
    • C) Loans where repayment depends substantially on the operation or sale of collateral due to borrower financial difficulty
    • D) Loans excluded from CECL requirements
  9. How are expected credit losses estimated for collateral-dependent loans under CECL?
    • A) Based on the fair value of collateral adjusted for costs to sell if foreclosure is probable
    • B) Using historical data only, without considering collateral value adjustments
    • C) Ignoring fair value considerations entirely in favor of qualitative assessments
    • D) Using arbitrary percentages assigned by management
  10. Why is CECL important for construction industry financial reporting?
    • A) It simplifies reporting by eliminating credit loss reserves entirely
    • B) It reduces reporting complexity by standardizing all methods across industries
    • C) It enhances transparency by incorporating forward-looking estimates of credit losses across financial assets like receivables and retainage balances
    • D) It applies only to government contracts

    SAS 145 – Risk Assessment

  11. How does SAS 145 refine risk assessment procedures?
    • A) By eliminating walkthroughs during audits
    • B) By removing material misstatement considerations
    • C) By combining inherent risk and control risk into a single assessment
    • D) By requiring auditors to assess inherent risk and control risk separately
  12. What must auditors evaluate regarding identified controls under SAS 145?
    • A) Whether controls are designed effectively and implemented properly
    • B) Whether controls can be ignored during substantive testing
    • C) Whether controls reduce inherent risk directly
    • D) Whether controls eliminate material misstatements entirely
  13. What happens if control risk is assessed at maximum under SAS 145?
    • A) Inherent risk is reduced automatically
    • B) Control risk is ignored during testing
    • C) The risk of material misstatement equals inherent risk
    • D) Audit procedures are terminated
  14. Why did SAS 145 revise the definition of relevant assertions?
    • A) To eliminate assertions altogether
    • B) To clarify that assertions are relevant only when there is both a reasonable possibility for the misstatement to occur and a reasonable possibility for it to be material
    • C) To expand the scope of relevant assertions to include all risks
    • D) To reduce auditor judgment during testing
  15. What impact does SAS 145 have on audit planning for areas with low inherent risks?
    • A) Reduced sample sizes, allowing focus on higher-risk areas
    • B) Increased sample sizes for testing
    • C) Elimination of testing in low-risk areas
    • D) Increased documentation requirements

    Quality Management Standards

  16. What is the primary objective of SQMS No. 1?
    • A) To design and implement a proactive, risk-based quality management system tailored to firm operations
    • B) To eliminate quality management systems altogether
    • C) To standardize quality management processes across all firms
    • D) To reduce audit costs by minimizing quality control measures
  17. How do SQMS No. 1 and SQMS No. 2 work together?
    • A) SQMS No. 1 replaces SQMS No. 2
    • B) Both standards eliminate the need for quality management
    • C) SQMS No. 1 is only for small firms, while SQMS No. 2 is for large firms
    • D) SQMS No. 1 focuses on quality management systems, while SQMS No. 2 addresses engagement quality reviews
  18. What is the role of the engagement partner under SAS No. 146?
    • A) To reduce professional skepticism
    • B) To ensure appropriate involvement and quality in audits
    • C) To eliminate audit documentation
    • D) To ignore firm policies
  19. How do the new Quality Management Standards enhance firm leadership?
    • A) By reducing accountability and governance
    • B) By increasing accountability and governance through a risk-based approach
    • C) By eliminating technology considerations
    • D) By ignoring external service providers
  20. What is the impact of SSARS No. 26 on quality management?
    • A) It reduces the importance of quality management
    • B) It eliminates the need for engagement quality reviews
    • C) It aligns with SQMS by enhancing quality management processes
    • D) It only applies to audits, not reviews

    ASC 606 – Revenue Recognition

  21. How does ASC 606 change revenue recognition for construction companies?
    • A) It eliminates the percentage of completion method
    • B) It reduces the need for contract modifications
    • C) It introduces a five-step model to determine revenue recognition timing
    • D) It only applies to point-in-time revenue recognition
  22. What is the first step in the ASC 606 revenue recognition model?
    • A) Recognize revenue at a point in time
    • B) Determine the transaction price
    • C) Identify the contract with the customer
    • D) Allocate the transaction price to performance obligations
  23. How do construction companies determine if revenue is recognized over time or at a point in time under ASC 606?
    • A) Based solely on contract duration
    • B) Based on whether the customer receives benefits as work is performed
    • C) Based on the type of construction project
    • D) Based on the contractor’s preference
  24. What is a key challenge in applying ASC 606 to construction contracts?
    • A) Determining the transaction price
    • B) Identifying performance obligations and their satisfaction timing
    • C) Ignoring contract modifications
    • D) Reducing costs to obtain and fulfill contracts
  25. Why is collaboration between accounting and project management teams important under ASC 606?
    • A) To reduce project costs
    • B) To increase audit risks
    • C) To eliminate the need for contract reviews
    • D) To ensure accurate revenue recognition and reflect the financial status of projects

Best Responses and Brief Explanations

  1. B) To decide if leases are finance or operating leases.

    ASC 842 uses classification tests to determine if a lease is a finance lease or operating lease.

  2. B) It is classified as a finance lease.

    If a lease meets one or more of the classification criteria, it is classified as a finance lease. Otherwise, it is classified as an operating lease.

  3. C) Alternative use test.

    Is the asset so specialized that it is only useful to the lessee is one of the criteria used to classify leases under ASC 842.

  4. D) By requiring recognition of Right-of-Use (ROU) assets and lease liabilities.

    ASC 842 enhances transparency by recognizing ROU assets and lease liabilities on the balance sheet.

  5. D) Identifying embedded leases in service contracts.

    Identifying embedded leases is a key challenge under ASC 842 because they are often disguised and not referred to as leases.

  6. B) CECL incorporates forward-looking information into credit loss estimates.

    CECL introduces a forward-looking approach to estimating credit losses, and credit losses are recognized even if the possibility is remote.

  7. C) Pool-based assumptions incorporating reasonable forecasts of future conditions.

    CECL allows for pool-based assumptions that incorporate future conditions.

  8. C) Loans where repayment depends substantially on the operation or sale of collateral due to borrower financial difficulty.

    This defines a collateral-dependent loan under CECL.

  9. A) Based on the fair value of collateral adjusted for costs to sell if foreclosure is probable.

    Expected credit losses for collateral-dependent loans are estimated based on collateral value.

  10. C) It enhances transparency by incorporating forward-looking estimates of credit losses.

    CECL improves financial reporting by incorporating future expectations.

  11. D) By requiring auditors to assess inherent risk and control risk separately.

    SAS 145 mandates separate assessments for inherent and control risk.

  12. A) Whether controls are designed effectively and implemented properly.

    Auditors must evaluate whether controls are effective and properly implemented.

  13. C) The risk of material misstatement equals inherent risk.

    If control risk is maximum, the risk of material misstatement equals inherent risk

  14. B) To clarify that assertions are relevant only when there is a reasonable possibility for the misstatement to occur and a reasonable possibility for it to be material.

    SAS 145 clarifies relevant assertions to enhance audit risk assessments.

  15. A) Reduced sample sizes, allowing focus on higher-risk areas.

    SAS 145 allows for reduced testing in low-risk areas, focusing on higher-risk ones.

  16. A) To design and implement a proactive, risk-based quality management system tailored to firm operations.

    SQMS No. 1 aims to create a customized quality management system.

  17. D) SQMS No. 1 focuses on quality management systems, while SQMS No. 2 addresses engagement quality reviews.

    Both standards work together to enhance quality management.

  18. B) To ensure appropriate involvement and quality in audits.

    The engagement partner ensures quality and involvement in audits under SAS No. 146.

  19. B) By increasing accountability and governance through a risk-based approach.

    The new Quality Management Standards enhance firm leadership by increasing accountability.

  20. C) It aligns with SQMS by enhancing quality management processes.

    SSARS No. 26 aligns with SQMS to enhance quality management.

  21. C) It introduces a five-step model to determine revenue recognition timing.

    ASC 606 introduces a five-step model for revenue recognition.

  22. C) Identify the contract with the customer.

    The first step in ASC 606 is identifying the contract with the customer.

  23. B) Based on whether the customer receives benefits as work is performed.

    Revenue is recognized over time if the customer receives benefits as work is performed.

  24. B) Identifying performance obligations and their satisfaction timing.

    Identifying performance obligations is a key challenge under ASC 606. However, a robust case can be made for A) Determining the transaction price.

  25. D) To ensure accurate revenue recognition and reflect the financial status of projects.

    Collaboration between accounting and project management teams helps ensure accurate revenue recognition under ASC 606.

How Did You Score?

Whether you aced it or picked up a few new insights, staying sharp on these evolving standards is key to staying ahead in public accounting. If you’d like to dive deeper into any of these areas, reach out to our team — we’re always here to help navigate the complexities.

Can Artificial Intelligence Be Used for Accounting Research?

Posted on by dsp64

Short Answer: Yes. But Be Very, Very, Carefully

Can AI be a helpful resource tool for audit and accounting research? Of course, it can. But the real question is this: can you rely on the response — can it be trusted to give you a correct, non-misleading answer? Will it be complete? Will it pick up on the nuances that often cling to such research? Would you take it to your supervisor or your client or to court?

This article will generally focus on generative AI tools that leverage large-language models, such as ChatGPT and Perplexity. This article is not intended to be a commentary on enterprise tools like Deloitte DARTbot and PwC ChatPwC.

The use of AI is changing how CPA firms conduct accounting and auditing. It should not be considered a complete overhaul, though. It’s another tool to be added to the research toolbox. AI tools like Perplexity can enhance the efficiency and accuracy of research tasks, but they also present challenges, particularly regarding data security and client confidentiality.

Benefits of AI in Audit and Accounting Research

  1. Efficiency: AI can analyze massive amounts of information, identify relevant information, and summarize complex accounting standards. This may reduce the time spent on research and minimize the risk of human error.
  2. Access to Comprehensive Resources: AI tools can access various financial databases and regulatory sources, ensuring researchers have the most current and comprehensive information.
  3. Personalized Insights: AI can provide tailored insights based on specific client needs, helping accountants offer more relevant advice and solutions. It’s an idea generator. Go with the good ones, and chuck the ideas your experience tells you are not so good.
  4. Accuracy: I use this word with a lot of caution. You never take the AI response at its word. In limited cases, it may confirm your understanding of the issue. But depending on the importance of the question at hand, you often need to dig even deeper using more conventional sources. AI can help put you on the right path, which you can confirm with traditional resources and by relying on your professional experience and judgment.

Using Perplexity As An Assist for Audit and Accounting Research

Perplexity is a powerful AI tool that can assist financial research by scouring the web and integrating with third-party data sources. Here’s how it can be used for GAAP, GAAS, and SSARS research:

  1. Searching Accounting Standards: Perplexity can quickly locate and summarize relevant GAAP standards related to specific accounting issues. For example, suppose you need to research the latest guidance on accounting for leases under ASC 842. In that case, Perplexity can find and summarize the most relevant information from the Financial Accounting Standards Board (FASB) website and other authoritative sources.

    Or, perhaps, you wish to get more specific. You can frame a lease question like “If both the lessor and lessee can cancel the lease at any time without substantial penalty, do you have a lease required to be accounted for under ASC 842?” You can ask a follow-up question, such as, “What if the lessee incurs prohibitive relocation costs if the lessee cancels the lease? Does that change the response?”

    And again, you do not accept the AI response as gold. However, it quickly gives you an excellent avenue for further research using more traditional sources.

  2. Analyzing Audit Standards: For GAAS research, Perplexity can help analyze auditing standards such as those related to risk assessment (AU-C 315) or audit evidence (AU-C 500). It can summarize recent updates and interpretations from the AICPA.

    You can ask questions like: “In IT general controls, are there new requirements under AU-C 315?” Or, “What other risk assessment requirements have recently changed or are new compared to the previous requirements?”

  3. Reviewing SSARS Updates: Perplexity can assist in reviewing updates to SSARS, such as SSARS No. 26, which enhances quality management objectives for accounting and review services. It can provide insights into how these updates impact accounting and review services for nonpublic entities.

    For example, you can frame the following question and get a quick response: “Summarize the new requirements under SSARS No. 26. Discuss the implications for a small CPA firm. Also, when is the effective date?”

It is also helpful to check the response with a follow-up inquiry where you ask the question again to see if you get a similar response. I often ask, “Are you sure?” or “Double-check yourself” in a follow-up question.

Viewing and Managing Sources with Perplexity

One of the key features of Perplexity is its ability to provide transparent sourcing for its answers. Here’s how you can view and manage sources:

  1. Viewing Sources: Perplexity provides a list of sources used to generate answers. You can view these sources by clicking on the citations within the answer or accessing the source list directly. This allows you to verify the accuracy of the information and explore topics further.
  2. Removing Sources: If you are uncomfortable with specific sources used in your research, you can remove them from the list. This is done by selecting the source and clicking the remove button. This feature helps ensure your research is based on credible and preferred sources.

AI Assist with Financial Statement Disclosure

AI can provide time-saving assistance by providing the first draft of financial statement disclosures, especially those that are not common in many financial statements. Here is an AI-generated example of disclosure for payments under a lease agreement that does not qualify as a lease under ASC 842:

Note X: Usage-Based Expenses

The Company has entered into specific arrangements for the use of construction equipment and vehicles that do not qualify as leases under Accounting Standards Codification ASC 842, Leases. These arrangements lack enforceable rights and obligations as required by the standard, as both the Company and the counterparty have the unilateral right to terminate the arrangement without permission from the other party and with no more than an insignificant penalty.

Although structured similarly to lease agreements, these arrangements are not recognized on the balance sheet and are not subject to the lease accounting and disclosure requirements of ASC 842. Instead, the Company accounts for the payments made under these arrangements as usage-based expenses.

For the year ended December 31, 202x, the Company incurred $xxx,xxx in usage-based expenses related to these arrangements for construction equipment and vehicles. These expenses are recognized in the period incurred based on the Company’s use of the underlying assets and are included as operating expenses in the income statement.

The Company continuously evaluates these arrangements for any changes in terms or circumstances that could alter their accounting treatment. If the arrangements become enforceable or meet the criteria for lease classification in the future, the Company will reassess its treatment under ASC 842.

AI Assistance with Excel

AI can significantly enhance the use of Excel by improving formula management and resolving issues. By “significantly enhance,” I mean it can save much research time when you face a complicated formula you have not used for several years. Just provide the AI tool a query explaining what you wish to do, and it will do its best to give you the formula. The more details you give in your inquiry, the more refined the response will be. I suggest that you give this a try.

Analyzing Complex Documents with AI

AI can be particularly useful in analyzing complex documents such as construction contracts and loan agreements. Here’s how:

  1. Construction Contract Analysis: AI tools can quickly review contracts to identify key terms, such as payment schedules, termination clauses, liquidated damages, and other liability provisions. Identification and understanding of these terms help accountants understand these agreements’ financial and risk implications for accounting and disclosure requirements.
  2. Loan Agreements: AI can assist in identifying essential dates, data points, and potential risks within loan documents, such as interest rates, maturity dates, financial loan covenants, security provisions, and due on-demand clauses that may impact financial reporting or compliance with accounting standards.

Security of Confidential Information

Of paramount concern when using AI to analyze a client’s complex documents is that of security and client information confidentiality. Accordingly, we are uncomfortable with assurances provided that data security will not be breached. Therefore, the use of AI to analyze client-sensitive documents is limited only to those that have been appropriately redacted.

Mitigating Risks

In regards to AI, there must be a balanced approach. Maintain a balance between AI-driven research and human expertise. AI should augment, not replace, human judgment in complex accounting and auditing decisions.

Conclusion

AI tools like Perplexity offer significant benefits for GAAP, GAAS, and SSARS research, enhancing efficiency, accuracy, and access to comprehensive resources. Additionally, AI can improve the use of standard office tools like Excel by automating tasks and resolving issues. By leveraging AI responsibly and maintaining a balanced approach between technology and human expertise, CPA firms can maximize the advantages of AI while ensuring compliance with professional standards and protecting client interests. As AI develops, its role in accounting research will only grow, making it crucial that CPAs remain informed about its applications and limitations.

The Role Of Materiality In Financial Reporting

Posted on by dsp64

It’s No Small Thing

Materiality is a cornerstone in accounting and financial reporting, particularly under Generally Accepted Accounting Principles (GAAP). It is the polar star for determining what information is significant enough to influence the decisions of financial statement users. While materiality may seem straightforward, its application is nuanced and requires professional judgment. This blog will explore what materiality means under GAAP, how it impacts financial reporting, and why it’s critical for businesses and stakeholders.

What Is Materiality?

Materiality refers to the impact of information on the decision-making process of financial statement users. According to GAAP, information is considered material if omitting or misstating it could influence the economic decisions of investors, creditors, or other stakeholders relying on the financial statements.

The Financial Accounting Standards Board (FASB) underscores that materiality is not a one-size-fits-all concept. It’s a nuanced aspect of accounting that hinges on professional judgment and consideration of several factors, such as the company’s operations, financial position, and the needs of its stakeholders.

Of particular importance, the FASB clarifies its provisions …” need not be applied to immaterial items.” (ASC 105-10-05-6.)

Why Is Materiality Important in GAAP?

Materiality is critical in ensuring that financial statements are relevant and reliable. Here are some reasons why materiality is essential:

  1. Focus on Relevant Information

    Materiality helps accountants prioritize what information should be included in financial statements. Companies can avoid overwhelming users with unnecessary details by focusing on material items while ensuring that critical information is disclosed.

  2. Cost-Benefit Balance

    Preparing financial statements involves time, effort, and resources. Materiality ensures that companies do not expend excessive resources on immaterial items that would not significantly impact decision-making.

  3. Enhances Decision-Making

    End users rely on financial statements to make informed decisions. Material disclosures provide them with the insights they need while filtering out noise.

  4. Compliance with GAAP Standards

    Materiality ensures that companies comply with GAAP requirements without overburdening themselves with immaterial disclosures or adjustments.

How Is Materiality Determined?

Determining materiality requires professional judgment and consideration of both quantitative and qualitative factors.

Quantitative Factors

Quantitative thresholds are often used as a starting point for assessing materiality. For example:

  • A common rule of thumb is that an item is material if it represents more than 5% of net income or total assets.
  • Smaller percentages may be used for companies with low-profit margins or highly sensitive stakeholders.

However, these thresholds are not absolute. Even small amounts can be material if they have significant qualitative implications.

Qualitative Factors

Qualitative factors often override purely numerical thresholds. For instance:

  • Nature of the Item: Certain transactions, such as fraud or regulatory violations, may be material regardless of their monetary value.
  • Impact on Trends: A misstatement that changes a company’s earnings trend from positive to negative (or vice versa) could be deemed material.
  • Stakeholder Sensitivity: Information relevant to investors or creditors—such as compliance with loan covenants—may be considered material even if it doesn’t meet quantitative thresholds.

Materiality in Practice: Real-World Examples

Example 1: Misstating Revenue

A company reports annual revenue of $20 million but fails to disclose an error that overstated revenue by $1 million (5%). While this meets the quantitative threshold for materiality, qualitative factors must also be considered:

  • Was this error intentional (e.g., fraudulent reporting)?
  • Did it affect key performance metrics like debt-to-equity ratios or loan covenants?

The error would likely be deemed material if it misleads investors or impacts their decisions.

Example 2: Legal Contingencies

A company faces a lawsuit with a potential liability of $100,000. While this amount may seem immaterial for a large corporation with billions in assets, qualitative factors like reputational damage or regulatory scrutiny could make it significant.

Challenges in Applying Materiality

While materiality is an essential concept, applying it can be challenging due to its inherent subjectivity. Here are some common challenges accountants face:

  1. Balancing Quantitative and Qualitative Factors

    Striking the right balance between numerical thresholds and qualitative considerations can be difficult, especially when stakeholders have differing priorities.

  2. Auditor Disagreements

    Auditors may have different views on what constitutes a material misstatement than management, leading to potential conflicts during audits.

Best Practices for Managing Materiality

To navigate the complexities of materiality effectively, companies should consider adopting these best practices:

  1. Develop Clear Policies

    Establish internal guidelines for assessing materiality based on both quantitative thresholds and qualitative factors.

  2. Document Judgments

    Maintain thorough documentation of how materiality judgments were made to provide transparency during audits or regulatory reviews.

  3. Engage Stakeholders

    Regularly communicate with investors, auditors, and regulators to understand their expectations regarding material disclosures.

  4. Stay Updated

    Monitor changes in accounting standards and stakeholder priorities to ensure your approach to materiality remains relevant.

Conclusion

Materiality is more than just an accounting concept—it’s a critical tool for ensuring that financial statements are meaningful and decision-useful for stakeholders. While its application requires significant professional judgment, understanding its principles under GAAP can help companies strike the right balance between relevance and reliability in their reporting.

Indirect Contract Costs

Posted on by dsp64

The Invisible Load Every Contractor Carries

In the construction industry, managing costs effectively is critical to profitability, compliance, and financial and tax reporting. Correctly identifying and allocating indirect contract costs is essential to this cost management. This blog will explore indirect contract costs, provide examples, explain their importance, discuss the benefits of proper allocation and risks of improper allocation, and outline some of the acceptable allocation methods under U.S. GAAP.

What Are Indirect Contract Costs?

Indirect contract costs are expenses that cannot be directly traced to a specific construction project but are necessary for overall project execution. Unlike direct costs—such as materials and labor directly tied to a particular job—indirect costs support multiple projects or the business as a whole.

Examples of Indirect Contract Costs

  • Indirect Contract Labor: Salaries for supervisors, project managers, and contract-related administrative staff who provide services across multiple contracts during an accounting period
  • Employee Benefits: Health insurance, retirement contributions, and other fringe benefits related to indirect contract labor (indirect labor burden)
  • Equipment Costs: Depreciation, maintenance, fuel, and repairs for machinery used across multiple projects
  • Utilities: Electricity, water, and gas for facilities supporting construction activities
  • Insurance: General liability and workers’ compensation insurance covering all projects
  • Office Overhead: Rent, supplies, and IT infrastructure directly supporting construction activities

These costs are often grouped into overhead pools and allocated to individual contracts based on an appropriate method, as described below.

Why Proper Allocation of Indirect Contract Costs Matters

Accurate allocation of indirect contract costs is vital for compliance with accounting standards under U.S. GAAP and, by extension, sound financial reporting. Additionally, it is necessary for meaningful project profitability analysis.

Key Benefits

The following are a few key benefits of a carefully designed system for allocating indirect contract costs.

  • Accurate Financial Reporting: Proper allocation ensures that financial statements reflect the actual cost of each contract, which is critical for stakeholders like investors and lenders.
  • Improved Decision-Making: By understanding the full cost of each contract (including indirect costs), contractors can make better pricing and bidding decisions.
  • Regulatory Compliance: Misallocation can violate tax laws or contractual agreements, especially in government-funded projects where cost breakdowns are scrutinized.
  • Enhanced Competitiveness: Allocating costs accurately allows contractors to identify inefficiencies and improve cost management strategies.

The Risks of Improper Allocation

Failing to allocate indirect job costs correctly can have significant consequences affecting profitability, decision-making, and overall business health. Below are some primary financial impacts:

  • Distorted Profitability: Under-allocated or over-allocated costs can misrepresent the profitability of individual contracts. For example, when performing a post-completion review of contracts, the under-allocation of indirect costs creates a false sense of profitability and can lead to overconfidence in bidding on future projects. Conversely, allocating too many indirect costs to a project can make it appear less profitable, potentially leading to unwarranted decisions such as discontinuing certain services or focusing on less profitable contracts.
  • Regulatory Issues: Non-compliance with U.S. GAAP or contractual requirements may result in penalties or disqualification from future bids.
  • Cash Flow Problems: Misallocation can lead to inaccurate billing or cost recovery issues, straining cash flow.
  • Fraud Risk: In the case of uncompleted contracts on the cost-to-cost percentage of completion method, improper allocation methods might be perceived as fraudulent if they result in an overstatement of contract profit.
  • Lost Opportunities for Operational Efficiency: Accurate allocation helps identify inefficiencies by revealing which projects consume disproportionate resources. Without this insight:

    • Contractors miss opportunities to streamline operations or renegotiate terms with subcontractors and suppliers.
    • Indirect cost drivers (e.g., equipment usage or labor hours) cannot be optimized effectively.

Acceptable Allocation Methods Under U.S. GAAP

U.S. GAAP provides flexibility in allocating indirect contract costs but requires systematic, rational, and consistently applied methods. Below are examples of commonly accepted methods:

  • Direct Labor Hours: The allocation of indirect costs is based on the number of hours worked on each project. For example, if a supervisor spends 75% of their time on Project A and 25% on Project B, their salary and burden would be allocated accordingly.
  • Direct Labor Costs: Allocate based on the proportion of direct labor expenses incurred by each project. For example, if Project A incurs 10% of total direct labor costs, it would absorb 10% of indirect labor costs.
  • Machine Hours: Allocate equipment-related indirect costs based on the number of machine hours used per project. For example, if a specific piece of heavy equipment is used for 75 hours on Project A and 25 hours on Project B, Project A would bear 75% of the equipment-related indirect costs.
  • Internal Rental Rate: A related acceptable and commonly used method to allocate equipment cost to jobs is that of an “internal rental rate.” The hourly internal rate is developed by estimating the annual equipment cost divided by the estimated yearly machine hours.
  • Square Footage: For projects involving physical spaces used both for manufacturing related to the contract and for administrative purposes, costs such as depreciation, rent, utilities, etc., can be allocated based on a ratio of square footage.

Conclusion

Indirect job costs play a crucial role in determining the true profitability of construction projects. Proper allocation ensures compliance with U.S. GAAP and provides valuable insights into operational efficiency and financial performance. CPA firms specializing in construction accounting can add significant value by guiding clients through this complex but essential process.

2025 Tax Issues To Consider

Posted on by dsp64

In Lite of the Election Results

President-Elect Trump has increasingly touted new tax cuts for individual constituencies. Trump first proposed exempting tips from income tax, then discussed exempting Social Security payments from income. The focus on individual relief over corporate and business interests may reflect changes in voter sentiment.

The consensus seems to be that Trump, and the Republicans will extend the TCJA as currently written, which the Congressional Budget Office estimates will add $4.6 trillion in debt over the 10-year budget window. That figure doesn’t include the cost of expensive new Trump tax proposals, such as lowering the corporate rate to 15% and exempting tip income and Social Security payments for tax.

The traditional Republican view, popular among many Senate Republicans, is that tax cuts grow the economy and don’t need to be offset, particularly when lawmakers are only extending current policy. But growing deficits and the immense cost of the TCJA extensions is straining this view, particularly among many House Republicans. It’s one of the reasons some congressional Republicans have openly discussed corporate tax rate increases.

“Without a doubt one of the biggest challenges that will be discussed, debated, and decided in 2025 is, should (tax cuts) be paid for or should they not be paid for,” said Ways and Means Chair Jason Smith, R-Mo., recently.

With Republicans winning control of the White House and both chambers of Congress, reconciliation will be a key factor. Reconciliation is a special budget process that allows lawmakers to bypass 60-vote procedural hurdles in the Senate. It was used to pass both the IRA and the TCJA.

Republicans have already signaled they would use reconciliation aggressively and expansively to address not only tax policy but potentially other areas. Reconciliation, however, comes with key limitations. Reconciliation bills generally cannot lose revenue outside of the 10-year budget window. This restriction is the main reason why so much of the TCJA is expected to expire after 2025, and it could again prevent Republicans from making permanent tax policy even though they swept back the power.

The following considerations may be important for key aspects of the Republican platform:

  • Corporate rate: It is hard to see Republicans raising corporate rates now that Trump has won the presidency and they control both chambers of Congress. At the same time, deficits and the cost of other priorities would make it very difficult for Republicans to cut the corporate rate any further despite Trump proposing a 15% rate for some domestic activities. Top Republican tax writers have said openly that the corporate rate may be on the table.
  • TCJA extensions: Congressional Republicans have made it clear that they want to re-examine the TCJA rather than blindly extend it, but Trump and many Republicans would be expected to support extensions of much of the policy. Section 199A could emerge as top priority to help small and private businesses. Cost could become an issue, especially as some Republicans will be reluctant to extend aspects of the TCJA that actually would raise revenue, such as the cap on state and local tax (SALT) deductions.
  • Energy incentives: Trump has been very critical of the IRA’s energy incentives, particularly the electric vehicle credit. Repealing these incentives could be a source of revenue for other priorities, but repeal could be difficult. Republicans typically have been reluctant to rescind tax cuts, and there is a group of House Republicans who openly support many of the energy measures for the investment it has brought to their districts.
  • New tax cuts: Trump’s proposal to exempt tips from income quicky picked up traction, even among some Democrats. Its popularity could translate into serious consideration in 2025, though there may be concerns over cost and administrability. The proposal to exempt Social Security payments from income seems less likely based on the reaction so far. It would be very costly and could accelerate the insolvency of Social Security and Medicare.

Lawmakers will be under tremendous pressure to enact legislation in 2025 before the TCJA provisions expire, but there is no guarantee they will act in a timely manner. Congress has become increasingly tardy addressing expiring tax provisions in recent years, often acting retroactively to reinstate provisions even after taxpayers have filed returns. Many businesses are still hoping Congress will retroactively address Section 174 and other changes that took effect in 2022.

The major TCJA changes will not take effect until 2026, meaning it will be early 2027 before they impact most tax returns. Political stalemate could delay action until then, particularly if one party thinks they could gain leverage in the 2026 midterm elections. Pressure could also force action much sooner. Unlike many of the other tax provisions Congress has reinstated retroactively, the TCJA changes will affect individual withholding and could reduce paychecks immediately in 2026. This may be enough to prompt action. When the 2001 and 2003 tax cuts were scheduled to expire at the end of 2010 and 2012, Congress addressed them both times before they could affect withholding.

Be sure to check out the Resources tab on our website to find FAQ’s and tax planning tips.

Continuing Profession Education

Posted on by dsp64

It’s a Long Road That Never Turns

Continuing Professional Education (CPE) for Certified Public Accountants (CPAs) is crucial to maintaining professional competence and staying current and compliant in the rapidly evolving accounting field.

CPE is not just a requirement but a vital tool for professional growth and development. It can give you a deeper understanding. It can give you a broader perspective. It can also give you a much-needed break from actual (but paying) number crunching. However, the system can also be somewhat complex due to the various rules and requirements of the many reporting jurisdictions. And because of this array of rules and reporting jurisdictions, it can be found to be a non-compliance trap.

After we briefly examine CPE’s importance, shortcomings, and criticisms, we will explore the rules and boobytraps the CPA faces every reporting period.

Importance of CPE

CPE is critical in ensuring that CPAs provide high-quality services, comply with ethical standards, and adapt to the ever-changing financial landscape. It helps CPAs:

  1. Obtain, maintain, and improve professional competence
  2. Stay informed about industry changes
  3. Obtain ethical training and reminders
  4. Become comfortable with specialization
  5. Become more flexible in learning methods
  6. Become more open to new technologies
  7. With career advancement.
  8. Fulfill regulatory requirements

Shortcomings and Criticisms

Despite its importance, the current CPE program faces several criticisms:

  1. Relevance: Some CPAs argue that many CPE courses are not directly applicable to their specific practice areas.
  2. Quality: The quality of CPE programs can vary significantly, with some offering little practical value.
  3. Flexibility: Many CPAs find balancing work commitments with CPE requirements challenging.
  4. Cost: High-quality CPE programs, particularly for independent practitioners or small firms, can be expensive.

How did this happen?

What is the genesis of the accounting profession having such a heavy CPE load compared to other professions? For example, in Tennessee, CPAs must obtain 80 hours of CPE each two-year reporting cycle, with those 80 hours being stratified into many compliance categories. On the other hand, the Tennessee Supreme Court requires its lawyers to obtain 15 CLE hours per year, with only two compliance categories (general and ethics.) What’s up with that?

Many of the accounting profession’s CPE woes can probably be traced to the Savings & Loan (S&L)crises during the 1980s and early 1990s. The S&L crisis was a massive financial disaster that caused the failure of 1,000-plus savings and loan associations in the United States. This widespread collapse highlighted the need for improved financial oversight and accounting practices in the minds of some in the U.S. Congress. To prevent congressional action, I believe, in part, the profession’s response was the promise of increased self-regulation manifested by stringent CPE requirements.

Additionally, pressure came to bear on the profession due to financial scandals in the early 2000s following major accounting disasters such as Enron and WorldCom. These events precipitated a general loss of confidence in the accounting profession and financial reporting.

Other events and matters came to bear, pushing the profession toward a robust education structure. These events and matters, and the complexity that followed were:

  1. Sarbanes-Oxley Act of 2002
  2. Technological advancements
  3. Globalization of business
  4. Increased complexity of accounting standards, partially because of the items listed above.

That is a lot to learn. However, in my opinion, the primary current behind the emphasis on heavy CPE requirements for the accounting profession was the desire to thwart U.S. legislative control of accounting principles and auditing standards. This effort was, at best, only partially successful.

Now, with that being said, below are the CPE requirements mandated by the following:

  1. Tennessee State Board of Accountancy
  2. AICPA – General Membership Requirements
  3. AICPA – Accreditation in Business Valuations credentials
  4. AICPA – Certified in Financial Forensics credentials

Tennessee State Board of Accountancy Requirements

General requirements:

  1. 80 credit hours of CPE every two years, based on a fixed two-year period (not a rolling two-year period.)
  2. Minimum of 20 hours each year
  3. Reporting period based on calendar year (January 1 to December 31)
  4. Even-numbered licenses report during even-numbered years, odd-numbered licenses during odd-numbered years.

Subject requirements:

  1. At least 40 hours must be in technical fields, which include accounting (including governmental accounting), auditing (including governmental auditing), business law, economics, finance, information technology, management services, regulatory ethics, specialized knowledge, statistics, and taxes.
  2. 20 hours of the 40 technical hours must be in accounting and auditing if performing attestation services (including compilations)
  3. If the CPA provides expert witness testimony, then at least 20 hours must be in the general area in which the court deems the accountant an expert, such as tax, auditing, etc.
  4. Ethics. The CPA must obtain two hours of Board-approved ethics for every two-year licensing period.

Carryover hours:

  1. Hours in excess of the requirement of 80 hours in a regular two-year fixed reporting period may be applied, up to 24 hours, to the subsequent reporting period. Such carryover hours come over as non-technical hours and do not help meet the requirements for yearly minimums, technical CPE, or other benchmarks.

See the Tennessee State Board of Accountancy website for further information.

AICPA Requirements

General Membership: CPAs who are members of the AICPA must comply with the following general membership CPE requirements:

  1. Earn 120 CPE credits every three years (A fixed three-year period, not a rolling three-year period) with no ethics requirement.
  2. The three-year reporting period begins on January 1 of the year following admission to the AICPA.
  3. A grace period is available for the two months immediately following the reporting period. Hours credited toward a prior year deficiency may not be counted toward the reporting period that the courses are taken. (No double-dipping.)

Accredited in Business Valuation (ABV) Credential: CPAs who have the ABV credential must comply with the following:

  1. Sixty hours of CPE within the credential body of knowledge every three years, with at least ten hours earned annually.

    • NOTE. The AICPA’s ABV Credential Handbook is silent as to whether the three-year period is a fixed or a rolling three-year period. However, my conversations with the AICPA’s ABV division confirmed that the ABV three-year period is a fixed three-year period, consistent with the general membership fixed three-year requirement.

  2. Four hours of professional ethics education every three years (in addition to the 60-hour requirement.)

    • HEADS-UP – Tennessee CPAs with the AICPA’s ABV credentials must be careful of the ethics trap. Tennessee only requires two ethics hours every two years. The ABV credentials require four ethics hours every three years. The strategy to always obtain the Tennessee ethics the first year (or second year) of each two-year cycle will leave you short, at some point, as to the AICPA requirement of four hours of ethics over a three-year cycle.

Certified in Financial Forensics (CFF) Credential: CPAs who have the CFF credential must comply with the following:

  1. Complete 20 hours of CPE within the credential body of knowledge annually.
  2. There is no ethics requirement.

Enforcement and Ramifications

Tennessee State Board of Accountancy

The Tennessee State Board of Accountancy conducts annual CPE audits:

  1. Ten percent of renewing licenses are randomly selected each year
  2. The Board typically sends audit notifications in early May
  3. Selected CPAs must submit documentation of CPE credits earned in the previous two-year reporting period
  4. All audit responses must be submitted through the core.tn.gov website
  5. Board members are audited each renewal cycle
  6. Failure to comply may result in license suspension or revocation
  7. Monetary penalties may be imposed
  8. Damage to professional reputation.

AICPA

The AICPA also conducts periodic audits of its members’ CPE compliance:

  1. Non-compliance may lead to membership suspension or termination
  2. Credential revocation for specialized certifications
  3. Reinstatement requirements must be met to regain membership or credentials.

Conclusion

In conclusion, while CPE may be a long road that never turns, it remains essential to maintaining professional competence for CPAs. Yes, there is room for improvement in the current system. Addressing the challenges of relevance, quality, flexibility, and cost could enhance the effectiveness of CPE programs and better serve the needs of accounting professionals. As the field evolves, CPAs must stay informed about their specific CPE requirements and ensure compliance to maintain their licenses, memberships, and credentials.

Statement of Cash Flows

Posted on by dsp64

Common Pitfalls of this Middle Child

Ahh — the Statement of Cash Flows, the bane of every staff accountant. This article will describe some of the pitfalls of preparing the Statement of Cash Flows. But first, a bit of history.

When I first entered public accounting as a staff accountant during the Accounting Principles Board (APB) era, the Statement of Cash Flows was not a required financial statement. Instead, a Statement of Changes in Financial Position was required under GAAP. This legacy statement focused primarily on changes in working capital rather than cash flows. To the best of my memory, it was a reasonably easy financial statement to prepare. However, during the 1970s and early 1980s, there was growing dissatisfaction with this statement due to the diversity of practice and lack of focus on cash flows.

Accordingly, in 1987, the Financial Accounting Standards Board (successor to the APB) issued Statement of Financial Accounting Standard (SFAS) No. 95 (codified in ASC 230), which replaced the relatively easy-to-prepare (but less useful) Statement of Changes in Financial Position with the more difficult-to-prepare but more useful, Statement of Cash Flows. The Statement of Cash Flows focuses more directly on a company’s cash flows and provides more consistent and pertinent information to the end users.

Navigating the Treacherous Waters of ASC 230

As any seasoned CPA or construction industry CFO knows, preparing a Statement of Cash Flows can feel like trying to build a skyscraper on quicksand. When you think you’ve figured it out, a tricky transaction throws your carefully constructed statement into disarray. Let’s dive into the murky depths of ASC 230 and explore some of the most common pitfalls and challenging aspects of this deceptively complex financial statement.

The Classification Puzzle

The most frequent error in preparing the Statement of Cash Flows is misclassifying cash flows among the three categories of cash flow activities: operating, investing, and financing. Here are some clues for solving this puzzle:

  • Operating activities: Think income statement and changes in current assets and current liabilities
  • Investing activities: Always related to assets, and it is usually associated with long-term assets
  • Financing activities: Always related to liabilities and equity and typically involves changes in long-term liabilities

However, these are only guidelines and do have exceptions. For example, changes in a current bank line of credit are categorized as financing activities.

One of the trickier areas is insurance claims. Cash receipts from insurance claims are generally classified based on the nature of the loss. For example, for an inventory loss, the cash proceeds received on the claim are classified as an operating cash flow. For a loss related to PPE, the insurance proceeds are classified as an investing activity.

Another area to watch is customer notes receivable. They are classified as an operating cash flow instead of an investing activity.

The Non-Cash Transaction Pitfall

Another stumbling block is the treatment of non-cash transactions. It’s easy to fall into the trap of including these in the cash flow statement as if cash changed hands. For example, when you finance the acquisition of a new excavator through a note payable, it’s too easy to present the total purchase price in investing activities and the new note balance in financing activities. However, no cash flowed, except for the possibility of the payment of a deposit on the equipment and other upfront capitalized costs. Otherwise, this transaction shouldn’t appear in the main body of the cash flow statement.

Instead, non-cash transactions should be disclosed separately, either in a narrative at the bottom of the statement or in a separate footnote. It’s essential information but doesn’t belong in the body of the cash flows statement because no cash changed hands.

Getting Snagged in the Improper Netting of Cash Flows

CPAs often mistakenly report the net amount of certain cash receipts and payments. FASB ASC 230-10-45-7 to 230-10-45-9 provides guidance on when it is appropriate to report cash flows on a net basis instead of a gross basis in the statement of cash flows. Generally, reporting on a gross basis is more relevant because it provides greater detail on cash receipts and payments. However, there are circumstances where net reporting is acceptable and sufficient.

  • Quick Turnover: Items with fast turnover rates, large amounts, and short maturities can be netted (e.g., certain investments, loans receivable, and debt)
  • Short-term Maturities: Assets or liabilities with original maturities of three months or less can be reported net. This includes specific items like investments (excluding cash equivalents), loans receivable, and debt.

For purposes of the quick turnover criteria described above, netting may be appropriate regardless of the balance sheet classification as current or long-term.

Here are some examples where the netting of cash receipts and payments is appropriate:

  • Investments: Purchasing and selling a short-term treasury bill with less than three months maturity from the date of acquisition can be netted.
  • Loans Receivable: Issuing and collecting short-term loans due within three months can be netted.
  • Debt: Issuing and repaying short-term debt, such as a loan to a related party, with original maturities of three months or less can be netted. Remember that amounts due on demand are considered (by definition) to have maturities of three months or less. Those with original maturities over three months will present borrowings and payments at the gross amounts in the financing section.

    However, revolving lines of credit may be somewhat more dubious. In practice, some companies that borrow and quickly repay large amounts on their bank line of credit with original maturities greater than three months present the cash flow activity at the net amount in the financing section of the statement. This approach’s rationale is that short-term borrowings with quick turnover are akin to cash management activities rather than long-term financing arrangements. Therefore, reporting them on a net basis clarifies the company’s cash flow dynamics. While this practice is not strictly in line with GAAP, it has become accepted for certain revolving credit facilities. However, companies should carefully consider the materiality and usefulness of information when deciding between gross and net presentation for revolvers.

Misreporting Interest and Taxes Paid

The amount of interest and income taxes paid is often overlooked or improperly reported when using the indirect method. Remember, we’re talking about cash paid, so accrual balances must be adjusted to the cash basis for proper reporting.

Improper Handling of Restricted Cash

ASU 2016-18 requires that total cash and cash equivalents include restricted cash. Failing to do so is a common mistake that can distort a company’s cash position.

Conslusion

Preparing an accurate Statement of Cash Flows under ASC 230 requires attention to detail and a thorough understanding of the guidance. By being aware of these common pitfalls described above, CPAs can improve the quality and reliability of this important financial statement.

Accounting For Investments In Equity Securities

Posted on by dsp64

Heads Up -Choose Very Carefully

Under U.S. GAAP, there are three methods of accounting for a company’s investment in equity securities:

  • Fair value method
  • Equity method
  • Consolidation

The method of accounting depends on the level of control or influence the acquiring company has over the investee’s operating and financial policies AND whether the securities acquired have readily determinable fair values. However, remember that the method used is not elective or optional but is a matter of GAAP.

We will discuss consolidations, but this article will focus on the fair value and equity methods.

When the Method is Appropriate

Fair Value Method. The fair value method (FVM) is utilized when the acquiring company does not control or have significant influence over the acquired company AND the acquired company’s securities have readily determinable fair values. For example, you generally will use the FVM when the company invests in the equity of a publicly traded company.

  • If the securities do not have readily determinable fair values but would otherwise be accounted for under the FVM, the alternative method to fair value is appropriate (described below.)

Equity Method. The equity method is utilized when the acquiring company exercises significant influence over the investee but does not control the entity.

Consolidation. Consolidation is utilized when the parent company controls the subsidiary. Consolidated financial statements must be prepared.

Fair Value Method

FVM is appropriate when the investor does not control or cannot exercise significant influence over the investee company, and the securities have a readily determinable fair value.

An investor with an ownership of 20% or less is presumed unable to exert significant influence. But 20% is not a bright line. Based on facts and circumstances, an investor with ownership of 20% or less may be able to exert significant influence. In that case, the FVM is not appropriate.

The FVM applies to investments in equity securities (ASC Topic 321) and investments in joint ventures (ASC Topic 323.)

Under the FVM:

  • The original investment is recorded at the acquisition cost plus the cost of any direct transaction fees.
  • Receipt of investment income, such as dividends, is recorded as income and, therefore, does not impact the investment’s carrying amount.
  • The investee’s income and expenses do not affect the carrying amount of the investing company’s investment in the investee.
  • However, the investment should be marked to market at the end of each reporting period with the offset to the income statement’s unrealized gain or unrealized loss accounts.

Alternative to Fair Value Method

When the investing company does not have control or significant influence over the investee, AND the securities don’t have a readily determinable fair value, an “alternative to the fair value method” may be used.

The investing company may elect to record those securities at cost, less impairment.

The election to measure securities using this alternative method is made for each investment separately. Therefore, it is not a “summary of significant accounting policy” disclosure.

HEADS UP: The traditional cost method was replaced under ASU 2016-01 with the FVM. However, the “alternative to the fair value method” can be elected if the investment does not have a readily determinable fair value. It is similar to the traditional cost method. In practice, the “alternative to the fair value method” is often called the cost method.

Equity Method

It is appropriate to use the equity method when the investor exercises significant influence over the operating and financial policies of the investee.

  • Significant influence is presumed when the investor owns 20% to 50% of the investee’s common stock or other securities that grant voting rights.
  • However, 20% to 50% is not a bright-line rule. The presumption of significant influence can be overcome by contrary evidence, such as:
    • The investing company cannot obtain the necessary financial information from the investee company to apply the equity method.
    • The investing company and the investee have an agreement in which the investing company surrenders essential rights as a stockholder.
    • A small group of stockholders collectively own and operate the investee without regard to the investor’s views.
    • The investor cannot obtain representation on the investee’s board.
  • As described above, if the investor cannot obtain sufficient information from the investee to apply the equity method, then the investor does not have sufficient influence. Therefore, the equity method cannot be used. The FVM must be applied instead (or the alternative to the FVM discussed above.)
  • On the flip side, an investor with less than 20% ownership may be able to exert significant influence. That investor should use the equity method instead of the fair value method to account for that particular investment.

Under the Equity Method:

  • The original investment is recorded at the acquisition cost. Any direct transaction fees are added to the investment cost.
    • The total acquisition cost may or may not equal the fair value of the underlying assets and liabilities acquired.
    • HEADS UP: If the acquisition cost is greater than the carrying amounts of the net assets acquired, then the acquisition cost should be allocated to the assets and liabilities of the investee based on their fair values.
    • HEADS UP: The excess of the acquisition cost over the total fair value of the net assets acquired is called equity method goodwill. This equity method goodwill is not reported separately as goodwill on the acquiring company’s balance sheet.
      • Equity method goodwill is not reviewed for impairment.
      • However, the investment accounted for under the equity method is reviewed for impairment.
      • HEADS UP: If a private company has elected the accounting alternative for goodwill, its equity method goodwill must be amortized.
  • The acquiring company will adjust the investment account for its share of the investee’s net income or net loss and present it on the statement of income as a single line item.
  • Any dividends paid by the investee reduce the investment account.
  • Net losses of the acquired company may reduce the investment account to zero. Equity method accounting should be discontinued at that point.
  • HEADS UP: The purchase price allocated to depreciable assets is depreciated in accordance with the investee’s depreciation policies. Note that this is the investee’s depreciation policy, not the depreciation policies of the investing company. The entry will reduce the investment account.
  • HEADS UP: If the investee disposes of an asset to which specific excess amounts have been allocated, the unamortized excess is removed from the investment account and adjusted to income via the equity in the net income of the investee account.
  • HEADS UP: Under the equity method, unrealized intercompany profits are eliminated, much like done with consolidated financial statements, except, under the equity method:
    • When the investee initiates the transaction, only the actual ownership percentage of the intercompany gains and losses are eliminated.
    • However, when the investor initiates the transaction, the entire intercompany gain or loss is eliminated through equity.
  • HEADS UP: If the investor cannot obtain information from the investee company to determine such things as the investee’s depreciation method, etc., then this is an indication that the investor company does not have sufficient influence that is required to use the equity method. As discussed above, the FVM or the alternative to the FVM must be used instead.
  • HEADS UP: A variation of the equity method is available for investment in a construction joint venture in which the investor construction company can exercise significant influence but does not own more than 50%. The method is called proportional consolidation. Its use is limited to specific types of construction joint ventures. See our April 18, 2022, blog for a discussion.

Consolidation

It is a presumption that consolidated financial statements are more meaningful than separate financial statements. However, remember that the equity method is not a substitute for consolidated financial statements, and there are notable differences between the two methods.

For example, unlike the equity method, consolidated financial statements record the original investment at the acquisition cost but do not include direct transaction fees, such as finder’s and accounting fees. They are expensed as incurred.

  • If there is a noncontrolling interest, regardless of ownership interest percentage, the total amounts of the subsidiary’s assets and liabilities are presented on the parent’s financial statements.
  • The noncontrolling interest is reported as one line on the consolidated financial statements (one line on the balance sheet as a component of consolidated stockholders’ equity and one line on the statement of income, generally presented as a deduction in arriving at net income attributed to the controlling interest.)

Contingencies

Posted on by dsp64

Maybe Yes, Maybe No, It Ain’t Necessarily So

If you wish to dive into an accounting topic akin to scrambled eggs, then accounting contingencies is a fine choice. It’s scattered, can be a bit messy, and cumbersome to bring it all together.

Underlying Uncertainty

In the Master Glossary of the FASB Codification, contingency is defined as “An existing condition, situation, or set of circumstances involving uncertainty as to possible gain (gain contingency) or loss (loss contingency) to an entity that will ultimately be resolved when one or more future events occur or fail to occur.”

As can be seen, to be accounted for as a contingency under FAS Topic 450, there must be an underlying uncertainty that existed at or before the balance sheet date, which will ultimately be resolved in the future, either by occurring or not occurring.

However, not all uncertainties give rise to a contingency, as defined in FAS Topic 450. It expressly excludes the following uncertainties from consideration under FAS Topic 450:

  • Depreciation. Estimates used to allocate the cost of a depreciable asset over the life of the asset are not a FAS Topic 450 type contingency.
  • Estimates used in accruals. Amounts owed for services received, even if the amounts must be estimated, are not a FAS Topic 450 type contingency.
  • Changes in tax law. Uncertainties related to the possibility of a future change in tax law are not a FAS Topic 450 type contingency.
  • Other similar uncertainties. FAS 450-10-55 clarifies that other variations similar to the above are also excluded from FAS Topic 450 consideration.

Loss Contingencies

The guidance on contingencies is situated in the Liability section of the Codification, thus providing a clue that the FASB places greater emphasis on loss contingencies over its fraternal twin of gain contingencies. And, obviously, perhaps, the accounting treatment for a loss contingency is different than that of a gain, with the conservative principle coming front and center.

Definition of Loss Contingency

The Master Glossary defines a loss contingency as “An existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an entity that will ultimately be resolved when one or more future events occur or fail to occur. The term loss is used for convenience to include many charges against income that are commonly referred to as expenses and others that are commonly referred to as losses.”

The loss could result in the impairment of an asset or the incurrence of a liability.

Examples

  • Litigation exposure
  • Guarantees of indebtedness of others
  • Obligations related to product warranties and product defects
  • Sales and use tax audits
  • Fire losses
  • Environmental Remediation

What is Excluded from Contingency Losses under ASC Topic 450?

In general, areas discussed by other sections of the Codification are excluded from contingency loss considerations under ASC Topic 450, such as:

  • Measurement of credit losses for instruments within its scope, such as accounts receivable (Topic 326) (Credit losses are discussed at the end of this article.)
  • Stock issued to employees (ASC Topic 718)
  • Employment-related costs, including deferred compensation contracts (ASC Topics 710, 712, 715)
  • Uncertainty in income taxes (ASC Section 740-10-25)
  • Accounting and reporting by insurance entities (ASC Topic 944)

How is the Likelihood of Loss Measured

ASC 450-20-25-1 states that “(w)hen a loss contingency exists, the likelihood that the future event or events will confirm the loss or impairment of an asset or the incurrence of a liability can range from probable to remote.”…

“The Contingencies Topic uses the terms probable, reasonably possible, and remote to identify three areas within that range.”

  • Probable is defined as the future event or events are likely to occur. (Think in terms of 75% or greater chance of happening.)
  • Remote is defined as the chance of the future event or events occurring is slight (think in terms of 10% or less chance of occurring.)
  • Reasonably possible is defined as the chance of the future event or events occurring is more than remote but less than likely. In other words, it ranges in that broad area between probable and remote.

What are the Two Considerations for Contingency Loss Recognition

If the underlying loss event happened on or prior to the balance sheet date, ASC 450-20-25 requires two criteria for recognition of a loss contingency:

  1. It must be probable that the loss will occur.
  2. The amount of the loss must be reasonably estimable using a fair-value objective, which would be the most probable amount at which the contingent liability would be settled.
    • Notice that this fair value objective measurement differs from the one in ASC Topic 820, defined as the exit price in a hypothetical orderly transaction between market participants.
    • The amount of the loss should be estimated and evaluated independent of any claim for recovery.
    • The contingent liability is generally not discounted. But there are exceptions. See ASC 835-30-15-2.

If both of the above criteria are met, and the reasonably estimable loss is a range, the standard requires accrual of the amount that appears to be the better estimate within the range, or accrual of the minimum amount in the range if no amount within the range is a better estimate than any other amount.

In rare cases where the probable loss cannot be reasonably estimated, no loss accrual is made. Of course, disclosure is required describing the contingency and the fact that the company could not reasonably estimate the loss amount.

When is There No Accrual of Loss, but Disclosure Is Required

As described above, if an underlying loss event happened on or prior to the balance sheet date, a loss contingency is recognized in the balance sheet when two criteria are met: 1) It is probable that a loss will occur, and 2) the amount of the loss is reasonably estimable.

But when is disclosure only required?

If an underlying loss event happened on or before the balance sheet date, but it is only reasonably possible that the loss will occur (i.e., it does not rise to the probable threshold but is more than remote), then the loss is not accrued, but disclosure is required.

The company should disclose the nature of the contingency and provide an estimate of the possible loss or the range of loss or disclose that such an estimate cannot be made.

When is No Recognition of Loss and No Disclosure Required

As described in ASC 450-20, loss recognition and disclosure are not required when a loss is remote, defined as a slight chance of occurrence. A slight chance of a loss occurrence is generally considered to be 10% or less.

Disclosure is still permissible and may sometimes be necessary, depending on the situation. Whether to disclose a potential loss whose occurrence is considered remote is based on the fairness principle; i.e., is it information that a reasonable user of the financial statements would find meaningful?

What About Unasserted Claims

An unasserted claim is one not asserted by the potential claimant. Perhaps the potential claimant is unaware of the matter. Or, maybe the potential claimant is aware of the matter but has not pursued it.

That raises the question of whether a claim or lawsuit will be filed. If it is determined that it is probable a claim or suit will be filed, then the unasserted claim contingency is evaluated the same way as any other contingency under ASC Topic 450.

On the other hand, if it is determined that the likelihood of a suit or claim being asserted is only reasonably possible or remote, then the evaluation under ASC Topic 450 is not necessary for those unasserted claims.

Gain Contingencies

The Master Glossary defines a gain contingency as “(a)n existing condition, situation, or set of circumstances involving uncertainty as to possible gain to an entity that will ultimately be resolved when one or more future events occur or fail to occur.“

Examples of gain contingencies include:

  • Legal settlements where the company is the plaintiff and expects to win the case, resulting in a monetary award
  • Insurance claims if the company has suffered a loss and expects to receive insurance proceeds exceeding the carrying amount of the damaged assets.

The polar star principle for gain contingencies is found at ASC 450-30-25-1. “A contingency that might result in a gain usually should not be reflected in the financial statements because to do so might be to recognize revenue before its realization.”

ASC 450-30-50-1 further provides that “(a)dequate disclosure shall be made of a contingency that might result in a gain, but care shall be exercised to avoid misleading implications as to the likelihood of realization.“

The accounting principle of conservatism is heard loud and clear when it comes to recognizing a gain related to the resolution of future events. Gain contingencies should not be recognized on the balance sheet before their realization. This realization principle also encompasses a recovery related to a loss contingency, such as an insurance recovery, which is considered a contingency gain.

So, when is realization? It’s when the company has resolved all uncertainties and contingencies related to the receipt of cash. In short, gain contingencies are not recognized on the balance sheet until all contingencies are resolved. It’s rare to see a gain contingency on a company’s balance sheet.

The possible exception to the realization principle stated in the paragraph immediately above relates to the recovery of a contingent loss recognized on the balance sheet. Recovery (such as insurance proceeds) of a contingent loss may be recognized, but only to the extent of the contingent loss, if the recovery’s realization is considered probable and the amount of recovery can be reasonably estimated. However, amounts recovered in excess of the related recognized contingency loss can only be recognized as a gain contingency when all contingencies related to the contingency are resolved. (In other words, the excess gain contingency is usually unrecognized.)

Accounts Receivables and Current Expected Credit Losses

Before ASU No. 2016-13 – Financial Instruments – Credit Losses (codified in ASC Topic 326), the collectability of accounts receivables was evaluated under the ASC 450 contingency model. Accordingly, an allowance for doubtful accounts was not recognized unless it was probable that a loss would be incurred (i.e., a 75% or better chance the receivable would not be collected.)

However, that approach changed on the effective date of ASU No. 2016-13 (beginning with 2023, calendar year-ends.) The Incurred Loss model, which used the probable loss recognition method, was replaced with the CECL (current expected credit loss) model, which uses the expected loss recognition method.

Under the CECL model, losses expected to be incurred will result in loss recognition, even if the loss is remote (remember that remote is as low as 10% or less.) So, the standard has dropped from a probable loss threshold for loss recognition to a remote loss threshold for recognition of the loss. Therefore, a loss must be recognized even if the risk for loss is as low as 10%.

Here is an illustration. Suppose there is a 95% chance that accounts receivable of $1,000,000 will be entirely collected and a 5% chance that none will be collected. A CECL allowance for credit losses of $50,000 should be recognized.

Under the old and now retired incurred loss model previously used to determine the bad debt loss, no loss would have been recognized because it was not probable that a loss would be incurred (75% or greater chance of loss.)

Just a heads-up here. Under the CECL expected loss approach, credit losses will be recognized sooner, and a zero allowance for credit losses is questionable.

SAS 145 Audit Risk Assessment

Posted on by dsp64

All Together Now

Now that our firm has been through a few months of audit risk assessment under SAS 145, we felt it beneficial to identify key takeaways to keep in mind as we go forward. To give a frame of reference for our outline below, our clientele is concentrated in the construction industry, and we use Checkpoint Engage for our risk analysis. Hopefully, this outline will help bring the various pieces of the risk assessment process together.

  1. Risk of material misstatements (RMM). Remember that we, as auditors, are searching for areas of the financial statements that may be materially misstated.
    • We tailor the audit program to address the identified risks, especially those we identified as significant risks.
      • Checkpoint Engage is the tool we use to tailor the audit program.
    • Not all risks are created equal. To be a RMM, there must be:
      • A reasonable possibility of a misstatement occurring and
      • If a misstatement were to occur, there must be a reasonable possibility it would be material.
      • Reasonable possibility means there is more than a remote chance (a very low threshold.)
      • Remember the formula: RMM = Occurrence + Magnitude

    The two types of risk are:

    • At the financial statement level,
    • At the assertion level

  2. Risks at the financial statement level. Risks of a material misstatement at the financial statement level are pervasive to the financial statements as a whole.
    • All audit engagements have the overall financial statement risk of management overriding controls. This risk and the audit response are automatically populated in Part I of the Risk Assessment Summary Form.
    • Some companies may have additional overall risks at the financial statement level, such as:
      • Going concern issues
      • Pressure to meet or exceed debt covenants and
      • Lack of qualified accounting personnel.
    • These risks and the audit responses should also be included in Part I of the Risk Assessment Summary Form.

  3. Risks at the assertion level. A risk of material misstatement at the assertion level is a risk that is not pervasive at the financial statement level. It’s a risk at the assertion level for a particular class of transactions (such as revenue), account balance (such as accounts payable), or disclosure (such as those provided for financial loan covenants.)
    • Every engagement is presumed to identify improper revenue recognition as a fraud and significant risk at the assertion level in Part II of the Risk Assessment Summary Form.
    • The peer review expectation is that almost all engagements will have at least one or more additional risks (in addition to improper revenue recognition) that are identified as significant risks (those on the upper end of the spectrum in inherent risk), which should be added to Part II of the Risk Assessment Summary Form.

  4. Inherent risk (IR). Inherent risk is assessed as LOW, MODERATE, HIGH, or NOT RELEVANT.
    • IR is the susceptibility of an assertion to a material misstatement, ignoring any controls the company has in place.
    • An assertion is NOT RELEVANT if the risk of a material misstatement is remote or there is no risk because, due to the nature of the assertion, it does not apply to the class of transactions, account balance, or disclosure. For example, due to the nature of cash, the valuation assertion is NOT RELEVANT.
    • Inherent risk factors include: Size, volume, and composition of items; Susceptibility to theft or fraud, management bias, and obsolescence; Complexity; Subjectivity; Uncertainty; Changes in business environment, operations, and personnel.
    • CON-CX-7.2 Inherent Risk Assessment Form is an excellent way to document your reasoning for IR assessment.

  5. Relevant assertion. A relevant assertion (for IR) has one or more identified risks of material misstatement (an identified RMM.)
    • Rarely are all assertions relevant to an account balance, class of transactions, or disclosures. Usually, one or more assertions are relevant (i.e., have an identified RMM), but not all.
      • The IR for assertions that do not have an identified RMM are assessed as NOT RELEVANT when:
        • The risk of misstatement is remote, or
        • The assertion is not applicable due to the nature of the audit area.

          NOTE: See # 12 below for a further description of LOW inherent risk as it relates to the spectrum of IR.

      • The assertions used by PPC are:
        • Existence or occurrence
        • Completeness
        • Rights or obligations
        • Accuracy, classification, or presentation
        • Valuation or allocation
        • Cutoff

  6. Identified risk (a.k.a. Identified RMM). If the inherent risk for an assertion is assessed as either MODERATE or HIGH, you must specifically identify the risk (“identified risk”) on Part II of the Risk Assessment Summary Form (or elsewhere in the risk assessment workpapers.) If done elsewhere in the workpapers, you must link it to the Risk Assessment Summary Form. This specific identification of the risk is required under the new standard.
    • Scalability. SAS 145 requires auditors to document the identified risk for all relevant assertions. Under PPC methodology, an identified risk can be LOW, MODERATE, or HIGH RMMs. However, relying on the standard’s concept of scalability, we only need to clearly document the identified risks for MODERATE AND HIGH risks of material misstatements.

  7. Significant risk. A significant risk is an identified risk of material misstatement at the higher end of the spectrum of inherent risk. It’s a RMM on steroids.
    • What you are looking to dig out are the significant risks.
    • Significant risks are high-end risks (the upper end of the spectrum of inherent risk) whose related controls must be tested for design and implementation.

  8. Control risk. Remember that we assess all control risks at the assertion level as HIGH unless the IR assertion is NOT RELEVANT. In that case, the CR will also automatically be assessed as NOT RELEVANT.

  9. Combined risk. Since we assess all control risks as HIGH, then, per SAS 145, the combined risk MUST be assessed the same as the inherent risk. For example, if IR is LOW and CR is HIGH, the assessment for the combined risk must be LOW. In that case, by definition, it cannot be MODERATE.

  10. Significant audit area. A significant audit area has nothing to do with materiality, as it did under the prior standard. Under SAS 145, a significant audit area has one or more assertions with an identified risk of a material misstatement (a.k.a “relevant assertion” – see #5 above.)
    • Most audit areas will be marked as significant audit areas since the risk threshold is so low under the new standard. All it takes is one assertion with a low risk that is reasonably possible of materially misstating the financial statements. (See #11 directly below.)
    • You must apply substantive procedures for each relevant assertion of significant audit areas.
    • If the audit area is a significant audit area, you cannot only apply limited procedures. (Limited procedures are preliminary and final analytical, as well as other risk assessment procedures).
    • Stand back requirements. Auditors are required, at some point during the audit, to “stand back” and consider if their original assessment of what is regarded as a significant audit area is still appropriate – or should additional areas also be deemed significant. You indicate that you did this by signing off on the appropriate step (generally step 13b) of Checkpoint Engage program AP-10:General Planning Procedures.

  11. Risk of material misstatement. A risk of a material misstatement is a risk that has more than a remote chance (i.e., “reasonably possible” chance) of occurring and, if it does happen, has more than a remote chance of being material.

  12. Low inherent risk vs. Not relevant. An assertion with a LOW inherent RMM is deemed a relevant assertion because, under PPC’s methodology, LOW-risk designation is one in which the risk of a material misstatement of the financial statements is reasonably possible (more than remote) but does not rise to the level of MODERATE or HIGH on the spectrum of inherent risk.

    On the other hand, under PPC’s methodology, if the risk is remote or less, then inherent risk should be marked as NOT RELEVANT instead of LOW.

    • Marking an assertion with a remote risk as NOT RELEVANT is important because PPC will only permit you to perform limited procedures when all assertions are marked as NOT RELEVANT. You cannot perform limited procedures if one or more assertions are marked as LOW, MODERATE, or HIGH inherent risk of material misstatement.

  13. High inherent risk. An assertion assessed as a HIGH inherent risk of material misstatement may or may not be a significant risk of material misstatement.
    • If the risk is on the upper end of the spectrum of inherent risk, it is considered a significant risk of material misstatement, subject to design and implementation testing.
    • PPC only provides three risk categories: LOW, MODERATE, and HIGH. So, an inherent risk can be assessed as a HIGH risk but not be on the upper end of the spectrum of IR and, therefore, not be considered a significant risk under the standard.
    • If you have inherent risks assessed as HIGH but not identified as significant risks, it would be prudent to note in the comment section of the Risk Assessment Summary Form that IR is on the lower end of the high section of the spectrum of IR and, therefore, the risk is HIGH, but is not considered high enough on the spectrum of IR to be a significant risk.

  14. IMPORTANT! Identified controls (previously key controls). Identified controls must be tested for design and implementation. Identified controls are controls that address the following three high-end risk categories:
    • Significant risks. As stated in 3b, 7b, & 13a above, significant risks are inherent risks on the upper end of the spectrum of inherent risks. Therefore, controls over significant risks are identified controls subject to design and implementation testing.
    • Journal entries and adjustments. Controls over journal entries are identified controls and must be tested for design and implementation.
    • Risks from the use of IT. General IT controls that address a significant risk of material misstatement arising from the use of IT are also a type of identified controls subject to design and implementation testing.
      • For all identified controls, AU-C 315.28–.29 requires the auditor to identify related IT applications and other aspects of the IT environment subject to risks related to the use of IT, as well as general IT controls that address such risks.
      • This identification may affect the testing of the design and implementation of the required identified control(s). It may have broader implications on the audit strategy, including the design of further audit procedures. For instance, if information-processing controls depend on general IT controls, and the auditor determines that general IT controls are expected to be ineffective, the related risks arising from the use of IT may need to be addressed through the design of substantive procedures.
      • For example, the company’s use of Excel to calculate POC revenue presents a risk from the use of IT. General IT controls, such as the following, may be subject to design and implementation:
        • Access control – Limit who can change formulas, cell protection, etc.
        • Passwords
        • Data backup and recovery
        • Physical security
        • Segregation of duties
        • IT Governance
        • Vulnerability management
        • Security awareness training
      • Another example may relate to the significant risk of cost shifting by a project manager. In this example, the risk from the use of IT relates to the job cost module and who uses and has IT rights to the module. The possible general IT controls subject to design and implementation testing are:
        • Access control
        • Passwords
        • User authentication
        • Segregation of duties
        • Security awareness training
      • Complete Checkpoint Engage form CON-CX-4.2.2: Internal Control Documentation—IT Environment and General IT Controls.
      • e. Consider using Part 1 of Checkpoint Engage form CX-4.2.3:Internal Control Documentation –Evaluation of the Design and Implementation of Identified Controls to document the identified controls subject to design and implementation testing.
        • Parts II & III can also be used to describe the design and implementation, but narratives and walkthroughs are probably the better and more efficient way to do each of those procedures.

  15. COSO internal control components. SAS 145 requires us to gain an understanding of the five components of the company’s system of internal controls
    • “Gain an understanding” means becoming knowledgeably aware of the company’s policies and procedures for each of the five internal control components.
    • The five COSO internal control components are:
      • Control environment (tone at the top)
      • Risk assessment (i.e., the assessment performed by the company.)
      • Monitoring
      • Information and communication
      • Activity level controls and information processing
    • However, as described above in #14, certain activity level controls and information processing require more than a mere understanding.
      • For identified controls, the auditor is required to:
        • Evaluate the design of the control,
        • And to determine whether the control has been implemented.
      • IMPORTANT. If identified controls are not properly designed, or controls have not been implemented, or both, then the auditor MUST consider the need to expand substantive testing for the assertions affected.