Posted on

Time to Celebrate! FASB Expands VIE Exception for Private Companies

The Financial Accounting Standards Board (FASB) recently gave private companies long-awaited relief from one of the most complicated aspects of financial reporting — consolidation of variable interest entities (VIEs). Here are the details.

Old rules

Accounting Standards Codification (ASC) Topic 810, Consolidation, was designed to prevent companies from hiding liabilities in off-balance sheet vehicles. It requires businesses to report on their balance sheets holdings they have in other entities when they have a controlling financial interest in those entities.

For years, the decision to consolidate was based largely on whether a business had majority voting rights in a related legal entity. In 2003, in the wake of the Enron scandal, the FASB amended the standard to beef up the guidelines on when to consolidate.

New rules

The updated standard introduced the concept of VIEs. Under the VIE guidance, a business has a controlling financial interest when it has:

  • The power to direct the activities that most significantly affect an entity’s economic performance,
  • The right to receive significant benefits from the entity, and
  • The obligation to absorb losses from the entity.

Private companies contend that some of their most common business relationships could be considered VIEs under ASC 810. These relationships are set up for tax or estate planning purposes — not to trick investors or pump up stock prices.

Private company alternative

Private companies told the FASB that the VIE model forced them to consolidate multiple affiliated and subsidiary businesses onto a parent’s balance sheet. This frustrated lenders and creditors, who wanted cleaner balance sheets. In addition, in companies where ownership is shared among close relatives, determining who holds the power may not always be clear.

In 2014, the FASB issued an updated standard that let private companies ignore the VIE guidance for certain leasing transactions. Private companies applauded this update, but problems persisted with the consolidation guidance for transactions that didn’t involve leases.

So this past October, the FASB issued Accounting Standards Update (ASU) No. 2018-17, Consolidation (Topic 810): Targeted Improvements to Related Party Guidance for Variable Interest Entities, which expands the exception to include all private company VIEs. However, a private company that makes use of the latest amendments to Topic 810 must disclose in its financial statements its involvement with, and exposure to, the legal entity under common control.

Right for you?

The amendments in ASU No. 2018-17 are effective for private companies for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. Early adoption is permitted. Contact us to determine whether this election makes sense for your business — and, if so, when you should adopt the simplified alternative.

© 2018

Posted on

Using Analytical Procedures in An Audit Provides Many Benefits

Analytical procedures can make audits more efficient and effective. First, they can help during the planning and review stages of the audit. But analytics can have an even bigger impact when used to supplement substantive testing during fieldwork.

Defining audit analytics

AICPA auditing standards define analytical procedures as “evaluations of financial information through analysis of plausible relationships among both financial and nonfinancial data.” Analytical procedures also investigate “identified fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount.” Examples of analytical tests include trend, ratio and regression analysis.

Using analytical procedures

During fieldwork, auditors can use analytical procedures to obtain evidence, sometimes in combination with other substantive testing procedures, that identifies misstatements in account balances. Analytical procedures are often more efficient than traditional, manual audit testing procedures that typically require the business being audited to produce significant paperwork. Traditional procedures also usually require substantial time to verify account balances and transactions.

Analytical procedures generally follow these five steps:

1. Form an independent expectation about an account balance or financial relationship.
2. Identify differences between expected and reported amounts.
3. Investigate the most probable cause(s) of any discrepancies.
4. Evaluate the likelihood of material misstatement.
5. Determine the nature and extent of any additional auditing procedures needed.

When using analytical procedures, the auditor must establish a threshold that can be accepted without further investigation. This threshold is a matter of professional judgment, but it’s influenced primarily by the concept of materiality and the desired level of assurance.

For differences that are due to misstatement (rather than a plausible explanation), the auditor must decide whether the misstatement is material (individually or in the aggregate). Material misstatements typically require adjustments to the amount reported and may also necessitate additional audit procedures to determine the scope of the misstatement.

Your role in audit analytics

Done right, analytical procedures can help make your audit less time-consuming, less expensive and more effective at detecting errors and omissions. But it’s important to notify your auditor about any major changes to your operations, accounting methods or market conditions that occurred during the current accounting period.

This insight can help auditors develop more reliable expectations for analytical testing and identify plausible explanations for significant changes from the balance reported in prior periods. Moreover, now that you understand the role analytical procedures play in an audit, you can anticipate audit inquiries, prepare explanations and compile supporting documents before fieldwork starts.

© 2018

Posted on

Should Cloud Computing Setup Costs Be Expensed or Capitalized?

Companies will be able to capitalize, or spread out the costs of, setting up pricey business systems that operate on cloud technology under an update to U.S. Generally Accepted Accounting Principles (GAAP). Here are the details.

FASB responds to business complaints

Over the last three years, businesses have complained to the Financial Accounting Standards Board (FASB) about the different accounting treatment for cloud-based services vs. those operated on physical servers onsite. Businesses told the FASB that the economics of these arrangements are virtually the same.

As more businesses moved to cloud-based business applications, those complaints grew louder. So, in August, the FASB published Accounting Standards Update (ASU) No. 2018-15, Intangibles — Goodwill and Other — Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract.

Existing GAAP “resulted in unnecessary complexity and needed to be updated to reflect emerging transactions in cloud computing arrangements that are service contracts,” FASB Chairman Russell Golden said in a statement. “To address this diversity in practice, this standard aligns the accounting for implementation costs of hosting arrangements — regardless of whether they convey a license to the hosted software.”

Old rules, new rules

Under existing GAAP, the accounting for services managed in the cloud differs depending on the type of contract a business has with a software provider. When a cloud computing (or hosting) arrangement doesn’t include a software license, the arrangement must be accounted for as a service contract. This means businesses must expense the costs as incurred.

Under the updated guidance, businesses will be able to treat the expenses of reconfiguring their systems and setting up cloud-managed business services as long-term assets and amortize them over the life of the arrangement.

The update also will align the accounting for implementation costs for cloud-managed systems with the accounting for costs associated with developing or obtaining internal-use software. Businesses will have to record the expense related to the capitalized implementation costs in the same line item in the income statement as the expense for the fees for the hosting arrangement.

Coming soon

The update is effective for public businesses for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. (This means 2020 for calendar-year companies.) For all other entities, the update is effective for annual reporting periods beginning after December 15, 2020, and interim periods within annual periods beginning after December 15, 2021. Early adoption is also permitted.

© 2018

Posted on

Identifying and Reporting Critical Audit Matters

For over 40 years, the Securities and Exchange Commission (SEC) has required only a simple pass-fail statement in public companies’ audit reports. But the deadline for mandatory reporting of critical audit matters (CAMs) in audit reports is fast approaching. The revised model will provide insight to help investors and other stakeholders better understand a public company’s financial reporting practices — and help management reduce potential risks.

Deadlines

Under existing SEC standards, auditor communication of CAMs is permissible on a voluntary basis. However, disclosure of CAMs in audit reports will be required for audits of fiscal years ending on or after June 30, 2019, for large accelerated filers; and for fiscal years ending on or after December 15, 2020, for all other companies to which the requirement applies.

The new rule doesn’t apply to audits of emerging growth companies (EGCs), which are companies that have less than $1 billion in revenue and meet certain other requirements. This class of companies gets a host of regulatory breaks for five years after becoming public, under the Jumpstart Our Business Startups (JOBS) Act.

Criteria

In 2017, the Public Company Accounting Oversight Board (PCAOB) published Release No. 2017-001, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards. The main provision of the rule requires auditors to describe CAMs in their audit reports. These are issues that:

  • Have been communicated to the audit committee,
  • Are related to accounts or disclosures that are material to the financial statements, and
  • Involve especially challenging, subjective or complex judgments from the auditor.

By highlighting a CAM, an auditor is essentially saying that the matter requires closer attention. Examples might include complex valuations of indefinite-lived intangible assets, uncertain tax positions, goodwill impairment, and manual accounting processes that rely on spreadsheets, rather than automated accounting software.

New guidance

In July 2018, the Center for Audit Quality issued a 12-page guide on implementing the revised model of the auditor’s report. The guide instructs auditors to select CAMs based on:

  • The risks of material misstatement,
  • The degree of auditor judgment for areas such as management estimates,
  • Significant unusual transactions,
  • The degree of subjectivity for a certain matter, and
  • The evidence the auditor gathered during the review of the financial statements.

The guide doesn’t say how many CAMs are required in an audit report or provide a checklist of potential issues. Instead, CAMs will be determined on a case-by-case basis.

Coming soon

PCAOB Chairman James Doty has promised that CAMs will “breathe life into the audit report and give investors the information they’ve been asking for from auditors.” By identifying CAMs on the face of the audit report, auditors highlight challenging, subjective or complex matters that also may warrant closer attention from management. For more information about CAMs, contact us.

© 2018

Posted on

Hidden Liabilities: What’s Excluded From the Balance Sheet?

Financial statements help investors and lenders monitor a company’s performance. However, financial statements may not provide a full picture of financial health. What’s undisclosed could be just as significant as the disclosures. Here’s how a CPA can help stakeholders identify unrecorded items either through external auditing procedures or by conducting agreed upon procedures (AUPs) that target specific accounts.

Start with assets

Revealing undisclosed liabilities and risks begins with assets. For each asset, it’s important to evaluate what could cause the account to diminish. For example, accounts receivable may include bad debts, or inventory may include damaged goods. In addition, some fixed assets may be broken or in desperate need of repairs and maintenance. These items may signal financial distress and affect financial ratios just as much as unreported liabilities do.

Some of these problems may be uncovered by touring the company’s facilities or reviewing asset schedules for slow-moving items. Benchmarking can also help. For example, if receivables are growing much faster than sales, it could be a sign of aging, uncollectible accounts.

Evaluate liabilities

Next, external accountants can assess liabilities to determine whether the amount reported for each item seems accurate and complete. For example, a company may forget to accrue liabilities for salary or vacation time.

Alternatively, management might underreport payables by holding checks for weeks (or months) to make the company appear healthier than it really is. This ploy preserves the checking account while giving the impression that supplier invoices are being paid. It also mismatches revenues and expenses, understates liabilities and artificially enhances profits. Delayed payments can hurt the company’s reputation and cause suppliers to restrict their credit terms.

Identify unrecorded items

Finally, CPAs can investigate what isn’t showing on the balance sheet. Examples include warranties, pending lawsuits, IRS investigations and an underfunded pension. Such risks appear on the balance sheet only when they’re “reasonably estimable” and “more than likely” to be incurred.

These are subjective standards. In-house accounting personnel may claim that liabilities are too unpredictable or remote to warrant disclosure. Footnotes, when available, may shed additional light on the nature and extent of these contingent liabilities.

Need help?

An external audit is your best line of defense against hidden risks and potential liabilities. Or, if funds are limited, an AUP engagement can target specific high-risk accounts or transactions. Contact our experienced CPAs to gain a clearer picture of your company’s financial well-being.

© 2018

Posted on

Is It Time to Adopt the New Hedge Accounting Principles?

Implementing changes in accounting rules can be a real drag. But the new hedge accounting standard may be an exception to this generality. Many companies welcome this update and may even want to adopt it early, because the new rules are more flexible and attempt to make hedging strategies easier to report on financial statements.

Hedging strategies today

Hedging strategies protect earnings from unexpected price jumps in raw materials, changes in interest rates or fluctuations in foreign currencies. How? A business purchases futures, options or swaps and then designates these derivative instruments to a hedged item. Gains and losses from both items are then recognized in the same period, which, in turn, stabilizes earnings.

The existing rules require hedging transactions to be documented at inception and to be “highly effective.” After purchasing hedging instruments, businesses must periodically assess the transactions for their effectiveness.

The existing guidance on hedging is one of the most complex areas of U.S. Generally Accepted Accounting Principles (GAAP). So, companies have historically shied away from applying these rules to avoid errors and restatements.

In turn, investors complain that, when a business opts not to use the hedge accounting rules, it prevents stakeholders from truly understanding how the business operates. The new standard tries to address these potential shortcomings.

Future of hedge accounting

Accounting Standards Update (ASU) No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, expands the strategies that are eligible for hedge accounting to include 1) hedges of the benchmark rate component of the contractual coupon cash flows of fixed-rate assets or liabilities, 2) hedges of the portion of a closed portfolio of prepayable assets not expected to prepay, and 3) partial-term hedges of fixed-rate assets or liabilities.

In addition, the updated standard:

  • Allows for hedging of nonfinancial components, such as corrugated material in a cardboard box or rubber in a tire,
  • Eliminates an onerous penalty in the “shortcut” method of hedge accounting for interest rate swaps that meet specific criteria,
  • Eliminates the concept of recording hedge “ineffectiveness,”
  • Adds the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate to a list of acceptable benchmark interest rates for hedges of fixed-interest-rate items, and
  • Revises the presentation and disclosure requirements for hedging to be more user-friendly.

ASU 2017-12 also provides practical expedients to make it easier for private businesses to apply the hedge accounting guidance.

Early adoption

The update will be effective for public companies for reporting periods starting after December 15, 2018. Private companies and other organizations will have an extra year to comply with the changes. But many companies are expected to adopt the amended standard for hedge accounting ahead of the effective date.

If you use hedging strategies, contact us to discuss how to report these complex transactions — and whether it makes sense to adopt the updated rules sooner rather than later. While many companies expect to adopt the amendments early, the transition process calls for more work than just picking up a calculator and applying the new guidance.

© 2018

Posted on

Which Intangibles Should Private Firms Report Following a Merger?

2018 is expected to be a hot year for mergers and acquisitions. But accounting for these transactions under U.S. Generally Accepted Accounting Principles (GAAP) can be complicated, especially if the deal involves intangible assets. Fortunately, the Financial Accounting Standards Board (FASB) offers a reporting alternative for private companies that simplifies accounting for new business combinations, avoiding a lot of red tape.

Private performance metrics

Companies that merge with or acquire another business must identify and recognize — separately from goodwill — the fair value of intangible assets that are separable or arise from contractual or other legal rights. Valuing intangibles can be costly, subjective and complex, often requiring the use of third-party appraisers and increasing audit costs.

When it comes to private business combinations, however, investors, lenders and other stakeholders question whether the benefits of reporting the values of all of these intangibles outweigh the costs. Private company stakeholders are primarily interested in tangible assets, cash flows, and earnings before interest, taxes, depreciation and amortization (EBITDA). Such metrics are unrelated to how companies report intangible assets in M&As.

Moreover, buyers in private business combinations generally evaluate a for-sale business based on its expected earnings and cash flows. They don’t customarily assign specific values to all of the seller’s intangible assets, especially not those that can’t be sold or licensed independently.

Exception to the rules

Since 2015, the FASB has allowed private companies to elect an accounting alternative that exempts noncompetes and certain customer-related intangibles from being identified and reported separately on the balance sheet after a business combination. This guidance requires no new disclosures for companies that elect this alternative accounting treatment.

Private companies that elect this alternative report fewer intangible assets in business combinations, thereby simplifying accounting for intangibles on the acquisition date and amortization in future periods. But the alternative doesn’t eliminate the requirement under GAAP to recognize and separately value other intangible assets acquired in business combinations, such as trade names and patents.

In addition, private companies with noncompetes and other customer-related intangibles that were acquired before the adoption of the alternative must continue to amortize those intangibles over the expected life that was set when the business combination occurred.
Although the reporting alternative simplifies matters, private companies will in most cases continue to need third-party appraisals for other separable and contract-based intangibles. Outside appraisals can be costly, but auditors typically won’t rely on fair value estimates made by management for these items.

Get it right

Accounting for business combinations can be complicated. And mistakes can lead to restatements and write-offs in future periods that may alarm stakeholders. We can help take the guesswork out of postacquisition accounting, including deciding whether to elect private company reporting alternatives and allocating the purchase price among acquired assets and liabilities. Contact us for more information.

© 2018

Posted on

Assessing the Effectiveness of Internal Controls

Strong internal controls can help prevent and detect fraud. That’s why Section 404(a) of the Sarbanes-Oxley Act (SOX) requires a public company’s management to annually assess the effectiveness of internal controls over financial reporting. And Sec. 404(b) requires the company’s independent auditors to provide an attestation report on management’s assessment of internal controls. Some smaller entities may be exempt from the latter requirement — but not the former one.

Burdensome for smaller entities

When the SEC published the regulations, smaller public companies told the SEC that the costs of complying with Sec. 404(b) would outweigh the benefits for investors. While the SEC explored ways to ease the compliance burden, the compliance deadline for Sec. 404(b) was repeatedly delayed for nonaccelerated filers — companies with a public float of less than $75 million on the last business day of their most recent second fiscal quarter.

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act instructed the SEC to permanently exempt nonaccelerated filers from SOX Sec. 404(b). Absent this exemption, nonaccelerated filers would have been required to comply with Sec. 404(b) beginning with fiscal years ending on or after June 15, 2010.

New definition provides no new Sec. 404(b) relief

Earlier this year, the SEC expanded its definition of “smaller reporting companies” from companies with a public float of less than $75 million to those with a public float of less than $250 million. This change will allow nearly 1,000 more companies to qualify for a lighter set of disclosure rules available to smaller reporting companies. However, the SEC did not raise the public float thresholds for when a company qualifies as an accelerated filer. This means the $75 million threshold still applies in relation to the Sec. 404(b) exemption.

SEC Commissioners Michael Piwowar and Hester Peirce favored raising the accelerated filer threshold to $250 million to expand the number of companies that would be exempt from Sec. 404(b). But, based on feedback from auditors and investor advocate groups, SEC Chairman Jay Clayton decided to keep the current threshold at $75 million — at least for now.

It’s also important to note that not all companies with a public float of less than $75 million are considered nonaccelerated filers. If a company’s public float drops below $75 million, it continues to be an accelerated filer until it drops below $50 million, and thereby “exits” accelerated status.

Still on the hook

Even if your company is exempt from Sec.404(b), you’re still responsible for assessing the effectiveness of internal controls over financial reporting pursuant to Sec. 404(a). Contact us for any questions about complying with the SOX rules or for information regarding best practices in internal controls.

© 2018

Posted on

Auditing Royalty Agreements

Companies often grant licenses to others allowing them to use intellectual property — such as a patent or proprietary computer code — in exchange for royalties. Licensors can hire an external audit firm to ensure the licensee pays the correct royalty rate and amount. Here’s how the audit process works.

The agreement

The parties’ attorneys usually create a royalty agreement that governs the use of the intellectual property. This legal contract between the licensor and licensee details the terms of the arrangement. It spells out how the licensee may use the asset, the duration of the license and how much the licensee agrees to pay the licensor in royalties for the right to use the asset.

Unfortunately, royalty payments sometimes fall short of the agreed-upon amount. This may be due to a clerical error, confusion regarding the agreement’s terms — or even fraud. To detect and deter shortfalls, most contracts include a “right-to-audit” clause, meaning that the licensor retains the legal right to hire an outside firm to audit the licensee’s payments to confirm compliance with the terms detailed in the agreement.

The auditor’s role

When auditing royalty agreements, CPAs typically perform the following six steps:

1. Review the agreement to understand its scope, including the asset under license, the duration of the contract, prohibited uses and the royalty rate.

2. Analyze sales data used to derive royalty payments to date. Depending on the type of asset under license, the audit team may request production and inventory records.

3. Perform a detailed walk-through of the process the licensee follows to identify, track and report sales subject to a royalty payment.

4. Conduct random sampling of sales data to ensure the licensee applies the correct rate to generate the royalty payment.

5. Review sales and royalty payment trends to confirm that the licensee’s sales align with the royalty payments.

6. Gather individual invoices from key customers to locate and confirm that sales transactions subject to royalties actually generated a royalty payment.

Usually, the licensor assumes the cost of the royalty audit. However, some agreements include a clause that requires the licensee to assume responsibility for the cost of the audit if the audit uncovers underpayment of royalties by a certain margin.

Keep licensees on their toes

Most licensing arrangements function without a hitch. But a minor error or oversight could result in a significant shortfall in royalty payments. Periodic royalty audits can prevent small, but honest, mistakes from spiraling out of control — and help reduce the temptation for dishonest licensees to commit fraud. Contact us to discuss the benefits of auditing your royalty agreements.

© 2018

Posted on

Consider These Financial Reporting Issues Before Going Private

Issuing stock on the public markets isn’t right for every business. Some public companies decide to delist — or “go private” — often due to the high costs of complying with the requirements of the Securities and Exchange Commission (SEC). But going private can be nearly as complex as going public, so it’s important to dot your i’s and cross your t’s.

SEC requirements

The SEC scrutinizes going-private transactions to ensure that unaffiliated shareholders are treated fairly. A company that’s going private — together with its controlling shareholders and other affiliates — must, among other requirements, file detailed disclosures pursuant to SEC Rule 13e-3.

The SEC allows a public company to deregister its equity securities when they’re held by fewer than 300 shareholders of record, or fewer than 500 shareholders of record if the company doesn’t have significant assets. Depending on the facts and circumstances, a company may no longer be required to file periodic reports with the SEC once the number of shareholders of record drops below the above thresholds.

Detailed disclosures

To comply with SEC Rule 13e-3 and Schedule 13E-3, companies executing a going-private transaction must disclose:

  • The purposes of the transaction, including any alternatives considered and the reasons they were rejected,
  • The fairness of the transaction, both substantive (price) and procedural, and
  • Any reports, opinions and appraisals “materially related” to the transaction.

The SEC’s rules are intended to protect shareholders, and some states even have takeover statutes to provide shareholders with dissenters’ rights. Such a transition results in a limited trading market to be able to sell the stock.

Failure to act with the utmost fairness and transparency can bring harsh consequences. SEC scrutiny can lead to costly damages awards and penalties if your company is guilty of treating minority shareholders unfairly or making misleading disclosures.

Handle with care

Companies that pursue going-private transactions should exercise extreme caution. To withstand SEC scrutiny and avoid lawsuits, it’s critical to structure these transactions in a manner that ensures transparency, procedural fairness and a fair price.

In addition to helping you comply with the SEC rules, we can evaluate whether going private can help your company reduce its compliance costs or allow it to focus on long-term goals rather than satisfying Wall Street’s demand for short-term profits.

© 2018