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Sensitive Areas Of A Construction Company Audit

Posted on by dsp64

Or — Things That Make You Go “Humph”

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Paycheck Protection Program

Posted on by dsp64

The Art of Accounting

Our FAQ section briefly describes possible approaches to account for loans received under the Paycheck Protection Program (“PPP”). This article will go into a bit more depth.

To address the economic issues caused by the COVID-19 pandemic, the CARES Act, signed into law on March 27, 2020, established the PPP to provide loans to qualifying businesses to pay up to 8 weeks of certain qualifying expenses. The PPP Flexibility Act, signed June 5, 2020, extended the pay period to 24 weeks. Qualifying expenses include payroll costs, including benefits, mortgage interest, rent, and utilities. The SBA administers the program. Under the program’s provisions, the loan and interest may be forgiven, provided the business meets the eligibility criteria for forgiveness.

The program intends to keep employees employed, and the doors open for business. And, by doing so, the loan and interest are subject to forgiveness by the SBA. So how does a for-profit business entity account for the loan? And when and how do you recognized the income if the loan is subsequently forgiven?

Most CPAs who have practiced accounting for some time realize that financial accounting is more art than science. Math is a science, but accounting is not math. Generally accepted accounting principles (“GAAP”), certainly for the last several years, are not a list of specific rules, per se. To a large degree, it is broad principles applied to the facts and circumstances fairly and consistently. When we say consistently applied, it means the same company consistently uses the accounting principle from period to period. It does not mean that GAAP is applied consistently across all companies. Therefore, it’s possible and acceptable for one company to account for a transaction one way, and another company to account for a similar transaction another way with different results. Because of numerous accounting elections available to account for a PPP loan, companies may present a similar transaction differently and still comply with GAAP.

The Financial Accounting Standards Board (“FASB”) is the organization responsible for establishing accounting and financial reporting standards in the United States. In other words, it determines GAAP. It has issued numerous authoritative pronouncements over the decades. Yet, none of the pronouncements seem to adequately address the accounting for a non-governmental business entity that receives an SBA forgivable loan if specific requirements are satisfied. That leaves us to look to other sources for guidance.

The AICPA, in its Q&A Section 3200.18, notes that while the legal form of a PPP loan is debt, in substance, it could be construed as a governmental grant. Q&A Section 3200.18 outlines the following nonauthoritative approaches to account for a PPP loan:

  1. Debt. The legal form of the funds is that of a debt. So, it is always permissible to account for the PPP loan under FASB ASC 470 – Debt. Our impression is that most companies will account for the PPP loan as a debt, even if it expects the debt and interest to be forgiven. If the stated interest rate is below market, interest will not be imputed because government-guaranteed obligations are excluded from this requirement. Under further guidance in FASB ASC 405-20-40-1, the loan remains recorded as a liability until it is paid off or forgiven, either in whole or in part. If forgiven, the debt liability is reduced by the amount forgiven, and gain on extinguishment of debt would be recorded.

    This approach’s appeal is twofold: a) The legal form of the funds received is debt; it is an SBA loan. b) It removes the requirement of estimating if it is probable the SBA requirements for the forgiveness of debt will be met. (See #2 below). Under the debt method, gain recognition and debt derecognition are postponed until the accounting period the loan is forgiven (i.e., legally released).

  2. Deferred Income Liability. If the company estimates that it is probable it will meet the PPP’s eligibility criteria for loan forgiveness, it may conclude that the loan is, in substance, a government grant. Therefore, it may account for the PPP loan as a grant by analogy to the provisions of International Accounting Standard 20, Accounting for Government Grants and Disclosure of Government Assistance (“IAS 20”). Bear in mind, though, that the likelihood of forgiveness must meet the probable threshold under GAAP, a high bar to reach. The standards define “probable” as a future event or events that are likely to occur. While no percentage threshold is given in authoritative accounting standards, in practice, many CPAs consider a 75% or greater likelihood of occurrence as necessary to meet the probable requirement.

    Under the IAS 20 model, the PPP loan funds are initially recorded as a deferred income liability. The liability is reduced as income is recognized “on a systematic basis over the periods in which the entity recognizes as expenses the related costs for which the grants are intended to compensate.” In other words, as qualifying expenses are incurred during the 8 or 24-week period, an equal amount of income is recognized.

    Under IAS 20, the PPP income is presented in the statement of income as either:

    1. A separate caption or under a general caption such as Other Income, or
    2. As a reduction to the related expenses.

      Many companies present income from operations on its statement of income. Under option #1 above, the company’s accounting policies determine if PPP income is included in operating income. However, if the company elects to net the income against the related expense, as described in option #2 above, then the PPP income would necessarily be included in operating income.

      We expect that most companies who choose the IAS 20 model would elect to present PPP income as either a separate caption or under a general caption such as Other Income, as described in #1.

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

  3. Refundable Advance. Suppose a business entity anticipates complying with the eligibility criteria and expects the loan to be forgiven. Another acceptable approach would be, by analogy, to follow the not-for-profit model (“NFP model”) described in FASB ASC 958-605-25-13. Under the NFP model, a conditional contribution is “…accounted for as a refundable advance until the conditions have been substantially met or explicitly waived by the donor.” Therefore, the SBA loan would be carried on the balance sheet as a refundable advance until the criteria for forgiveness are substantially met or explicitly waived. At that time, recognize the refundable advance as income.

    When are the criteria for forgiveness substantially met? Is it:

    • When the qualifying expenses are incurred?
    • When the company submits all required documentation to the lender for forgiveness?
    • When the lender submits approval of the application to the SBA?
    • Or, when the SBA remits payment to the lender?

    The point in which the criteria for forgiveness are substantially met is not entirely clear, and there will probably be diversity in practice. For this reason, we believe few business entities will follow the NFP model to account for PPP loans.

  4. Gain Contingency. Another method a business entity may elect, if it expects the loan to be forgiven, is by analogy to the gain contingency recognition model presented in FASB ASC 450-30. Under this model, the loan proceeds are recorded as a deferred income liability. Grant income will not be recognized until the period when the grant proceeds are realized or realizable. This will probably not be until the lender approves the company’s application for loan forgiveness.

    We think few businesses will use this model. If management is inclined to wait until forgiveness to recognize the grant income, they will use the debt model instead.

Regardless of the approach taken to account for the PPP loan, all companies must adequately disclose its accounting policy and its implications to the financial statements.

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