The Untouchables: Getting a Handle on Intangibles

Businesswoman hands opened creating a space for product or text placement.

The average company’s balance sheet understates its value by 80%, according to Sarah Tomolonius, co-founder of the Sustainability Investment Leadership Council. Why? Intangible assets aren’t recorded on the balance sheet under U.S. Generally Accepted Accounting Principles (GAAP), unless they’re acquired from a third party.

Instead, GAAP generally calls for the costs associated with creating and maintaining these valuable assets to be expensed as they’re incurred — even though they provide future economic benefits.

Eye on intangibles

Many companies rely on intangible assets to generate revenue, and they often contribute significant value to the companies that own them. Examples of identifiable intangibles include:

  • Patents,
  • Brands and trademarks,
  • Customer lists,
  • Proprietary software, and
  • A trained and knowledgeable workforce.

In a business combination, acquired intangible assets are reported at fair value. When a company is purchased, any excess purchase price that isn’t allocated to identifiable tangible and intangible assets and liabilities is allocated to goodwill.

Acquired goodwill and other indefinite-lived intangibles are tested at least annually for impairment under GAAP. But private companies may elect to amortize them over a period not to exceed 10 years. Impairment testing also may be required when a triggering event happens, such as the loss of a major customer or introduction of new technology that makes the company’s offerings obsolete.

Inquiring minds want to know

Investors are interested in the fair value of acquired goodwill because it enables them to see how a business combination fared in the long run. But what about intangibles that are developed in-house?

At a sustainability conference earlier in May, Tomolonius said that businesses are more sustainable when they’re guided by a complete understanding of their assets, both tangible and intangible. Assigning values to internally generated intangibles can be useful in various decision-making scenarios, including obtaining financing, entering into licensing and joint venture arrangements, negotiating mergers and acquisitions, and settling shareholder disputes.

Calls for change

For more than a decade, there have been calls for accounting reforms related to intangible assets, with claims that internally generated intangibles are the new drivers of economic activity and should be reflected in balance sheets. Proponents of changing the rules argue that keeping these assets off the balance sheet forces investors to rely more on nonfinancial tools to assess a company’s value and sustainability.

It’s unlikely that the accounting rules for reporting internally generated intangibles will change anytime soon, however. In a quarterly report released in August, Financial Accounting Standards Board (FASB) member Gary Buesser pointed to challenges the issue would pose, including the difficulty of recognizing and measuring the assets, costs to companies, and limited usefulness of the resulting information to investors. Buesser explained that “the information would be highly subjective, require forward looking estimates, and would probably not be comparable across companies.”

Want to learn more about your “untouchable” intangible assets? We can help you identify them and estimate their value, using objective, market-based appraisal techniques. Contact us for more information.

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What to Expect During a Franchise Audit

It’s important for franchisors to periodically audit individual franchisees. These routine “check-ups” are especially valuable in a store’s early years of operations or if performance starts to deteriorate. They can be used to detect symptoms of unhealthy performance and treat problems before they spiral out of control.

Focus on royalty payments

Royalties are a franchisor’s primary source of income. Because royalties are typically based on a percentage of revenue, auditors pay close attention to the franchisee’s revenue reporting process.

To test whether revenue has been accurately reported, auditors trace transactions from the point-of-sale to:

  • The franchisee’s financial records,
  • Revenue reported to the franchisor, and
  • Tax returns submitted to the state and federal government.

If the revenue trail doesn’t hold up, further investigation may be required. In addition to vouching a representative sample of randomly selected sales transactions, auditors use analytical techniques to compare key metrics for an individual franchisee against benchmarks for franchises of a similar size and others in your franchise system. Any discrepancies from these benchmarks raise a red flag that the franchisee may have underreported revenue to minimize royalty payments.

Standard operating procedures

Beyond testing revenue, auditors spend extensive time examining whether the franchisee has complied with the franchise agreement. They consider such questions as:

  • Is the franchisee spending the required amount on advertising?
  • Does its signage comply with brand standards?
  • Is the franchisee purchasing materials and supplies from approved vendors?
  • Is the HR manager conducting appropriate employee background checks?

Failure to comply with such terms compromises future revenue and the reputation of your brand. So, areas of noncompliance should be identified during the audit — and corrected as soon as possible.

Site visits

Analyzing a franchisee’s books and records can only reveal so much. There’s no substitute for meeting face-to-face with the owner-operator.

Site visits give the auditor an opportunity to assess business operations from the customer’s perspective, evaluate the condition of equipment and the morale of workers, and interview the management team. These inquiries help the auditor understand how the business operates and investigate any anomalies unearthed during testing and analytical procedures.

Need help?

Hiring an outside auditor to enforce the audit provisions of your franchise agreement brings objectivity and financial expertise to the process. In addition to auditing a franchisee’s financial statements, our team can follow up on any compliance issues unearthed by the audit. Contact us for more information.

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Reporting Discontinued Operations

Old Way or New Way

Financial reporting generally focuses on the results of continuing operations. But sometimes businesses sell (or retire) a product line, asset group or another component. In certain situations, such a disposal should be reported as a discontinued operation under U.S. Generally Accepted Accounting Principles (GAAP). Starting in 2015, the rules changed, limiting the scope of transactions that must comply with the complex rules for discontinued operations.

Narrowed scope

A component comprises operations and cash flows that can be clearly distinguished, both operationally and for financial reporting purposes, from the rest of the company. It can be a reportable segment or an operating segment, a reporting unit, a subsidiary or an asset group. Under previous guidance, three requirements were needed for a transaction to be classified as discontinued operations:

  1. The component had been disposed of or was classified as “held for sale.”
  2. The operations and cash flows of the component had been (or would have been) eliminated from the ongoing operations of the entity as a result of the disposal transaction.
  3. The entity didn’t have any significant continuing involvement in the operations of the component after the disposal transaction.

Some stakeholders felt that too many disposals, including routine disposals of small groups of assets, qualified for discontinued operations presentation under the previous guidance. They also found the definition of discontinued operations to be unnecessarily complex and difficult to apply.

So, the Financial Accounting Standards Board updated the rules. Accounting Standards Update No. 2014-08 eliminated the second and third conditions. Instead, disposal of a component (including business activities) must be reported in discontinued operations only if the disposal represents a “strategic shift” that has or will have a major effect on the company’s operations and financial results. Examples of a qualifying strategic major shift include disposal of a major geographic area, a line of business or an equity method investment.

When such a strategic shift occurs, a company must present, for each comparative period, the assets and liabilities of a disposal group that includes a discontinued operation separately in the asset and liability sections of the balance sheet.

Expanded disclosures

Although fewer transactions qualify as discontinued operations than qualified under the previous rules, those that do qualify require expanded disclosures for the periods in which the operating results of the discontinued operation are presented in the income statement. For example, companies must disclose the major classes of line items constituting the pretax profit or loss of the discontinued operation. Examples of major line-item classes include revenue, cost of sales, depreciation and amortization, and interest expense.

In addition, companies must disclose either 1) the total operating and investing cash flows of the discontinued operation, or 2) the depreciation, amortization, capital expenditures, and significant operating and investing noncash items of the discontinued operation. And, if the discontinued operation includes a noncontrolling interest, the company must provide the pretax profit or loss attributable to the parent.

Management also must provide various disclosures and reconciliations of items held for sale for the period in which the discontinued operation is so classified and for all prior periods presented in the statement of financial position. Additional disclosures may be required if the company plans significant continuing involvement with a discontinued operation — or if a disposal doesn’t qualify for discontinued operations reporting.

Need help?

Most companies don’t report discontinued operations every year, so you might not have experience applying the current guidance for reporting these transactions. But we do. Our staff can help determine the appropriate treatment for your disposal and compose the requisite footnote disclosures. Contact us for more information.

© 2019

How Auditors Use Nonfinancial Information

Every financial transaction your company records generates nonfinancial data that doesn’t have a dollar value assigned to it. Though auditors may spend most of their time analyzing financial records, nonfinancial data can also help them analyze your business from multiple angles.

Gathering audit evidence

The purpose of an audit is to determine whether your financial statements are “fairly presented in all material respects, compliant with Generally Accepted Accounting Principles (GAAP) and free from material misstatement.” To thoroughly assess these issues, auditors need to expand their procedures beyond the line items recorded in your company’s financial statements.

Nonfinancial information helps auditors understand your business and how it operates. During planning, inquiry, analytics and testing procedures, auditors will be on the lookout for inconsistencies between financial and nonfinancial measures. This information also helps auditors test the accuracy and reasonableness of the amounts recorded on your financial statements.

Looking beyond the numbers

A good starting point is a tour of your facilities to observe how and where the company spends its money. The number of machines operating, the amount of inventory in the warehouse, the number of employees and even the overall morale of your staff can help bring to life the amounts shown in your company’s financial statements.

Auditors also may ask questions during fieldwork to help determine the reasonableness of financial measures. For instance, they may ask you for detailed information about a key vendor when analyzing accounts payable. This might include the vendor’s ownership structure, its location, copies of email communications between company personnel and vendor reps, and the name of the person who selected the vendor. Such information can give the auditor insight into the size of the relationship and whether the timing and magnitude of vendor payments appear accurate and appropriate.

Your auditor may even look outside your company for nonfinancial data. Many websites allow customers and employees to submit reviews of the company. These reviews can provide valuable insight regarding the company’s inner workings. If the reviews uncover consistent themes — such as an unwillingness to honor product guarantees or allegations of illegal business practices — it may signal deep-seated problems that require further analysis.

Facilitating the audit process

Auditors typically ask lots of questions and request specific documentation to test the accuracy and integrity of a company’s financial records. While these procedures may seem probing or superfluous, analyzing nonfinancial data is critical to issuing a nonqualified audit opinion. Let’s work together to get it right!

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Close-Up on Financial Statements

There are three types of financial statements under U.S. Generally Accepted Accounting Principles (GAAP). Each one reveals different, but equally important, information about your company’s financial performance. And, together, they can be analyzed to help owners, management, lenders and investors make informed business decisions.

Profit or loss

The income statement shows revenue and expenses over the accounting period. A commonly used term when discussing income statements is “net income,“ which is the income remaining after all expenses (including taxes) have been paid.

It’s also important to check out the company’s “gross profit.“ This is the income earned after subtracting the cost of goods sold from revenue. Cost of goods sold includes the cost of direct labor and materials, as well as any manufacturing overhead costs required to make a product.

The income statement also lists sales, general and administrative (SG&A) expenses. They reflect functions, such as marketing and payroll, that support a company’s production of products or services. Often, SG&A costs are relatively fixed, no matter how well your business is doing. Compute the ratio of SG&A costs to revenue. If the percentage increases over time, business may be slowing down.

Financial position

The balance sheet tallies your company’s assets, liabilities and net worth to create a snapshot of its financial health on the financial statement date. Assets are customarily listed in order of liquidity. Current assets (such as accounts receivable) are expected to be converted into cash within a year, while long-term assets (such as plant and equipment) will be used to generate revenue beyond the next 12 months.

Similarly, liabilities are listed in order of maturity. Current liabilities (such as accounts payable) come due within a year, while long-term liabilities are payment obligations that extend beyond the current year.

Because the balance sheet must balance, assets must equal liabilities plus net worth. So, net worth is the extent to which assets exceed liabilities. It may signal financial distress if your net worth is negative. Other red flags include:

  • Current assets that grow faster than sales, and
  • A deteriorating ratio of current assets to current liabilities.

These trends could indicate that management is managing working capital less efficiently than in prior periods.

Cash inflows and outflows

The statement of cash flows shows all the cash flowing in and out of your company during the accounting period. For example, your company may have cash inflows from selling products, borrowing, and selling stock. Outflows may result from paying expenses, investing in capital equipment and repaying debt.

The statement of cash flows is organized into three sections: cash flows from operating, financing and investing activities. Ideally, a company will generate enough cash from operations to cover its expenses. If not, it may need to borrow money or sell stock to survive.

Ratios and trends

The most successful businesses continually monitor ratios and trends revealed in their financial statements. Contact us if you need help interpreting your financial results.

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Lean Manufacturers: Reap the Benefits of Lean Accounting

Standard cost accounting doesn’t necessarily work for lean operations. Instead, lean accounting offers a simplified reporting alternative that generates more timely, relevant financial data. But it’s not right for every situation.

What’s lean manufacturing?

Lean manufacturers strive for continuous improvement and elimination of non-value-added activities. Rather than scheduling workflow from one functional department to another, these manufacturers organize their facilities into cross-functional work groups or cells.

Lean manufacturing is a “pull-demand” system, where customer orders jumpstart the production process. Lean companies view inventory not as an asset but as a waste of cash flow and storage space.

Why won’t traditional accounting methods work?

From a benchmarking standpoint, liquidity and profitability ratios tend to decline when traditional cost accounting methods are applied to newly improved operations. For example, to minimize inventory, companies transitioning from mass production to lean production must initially deplete in-stock inventories before producing more units. They also must write off obsolete items. As they implement lean principles, many companies learn that their inventories were overvalued due to obsolete items and inaccurate overhead allocation rates (traditionally based on direct labor hours).

During the transition phase, several costs — such as deferred compensation and overhead expense — transition from the balance sheet to the income statement. Accordingly, lean manufacturers may initially report higher costs and, therefore, reduced profits on their income statements. In addition, their balance sheets initially show lower inventory.

Alone, these financial statement trends will likely raise a red flag among investors and lenders — and possibly lead to erroneous business decisions.

How does lean accounting work?

Standard cost accounting is time consuming and transaction-driven. To estimate cost of goods sold, standard cost accounting uses complex variance accounts, such as purchase price variances, labor efficiency variances and overhead spending variances.

In contrast, lean accounting is relatively simple and flexible. Rather than lumping costs into overhead, lean accounting methods trace costs directly to the manufacturer’s cost of goods sold, typically dividing them into four value stream categories:

  1. Materials costs,
  2. Procurement costs,
  3. Conversion costs, such as factory wages and benefits, equipment depreciation and repairs, supplies, and scrap, and
  4. Occupancy costs.

These are easier to understand and evaluate than the variances used in standard cost accounting. In addition, box score reports are often used in lean accounting to supplement profit and loss statements. These reports list performance measures that traditional financial statements neglect, such as scrap rates, inventory turns, on-time delivery rates, customer satisfaction scores and sales per employee.

Should your company abandon standard cost accounting?

Most companies are required to use standard cost accounting methods for formal reporting purposes to comply with U.S. Generally Accepted Accounting Principles (GAAP). But lean manufacturers may benefit from comparing traditional and lean financial statements. Such comparisons may even highlight areas to target with future lean improvement initiatives. Contact us for more information.

© 2019

Put a QOE Report to Work for You

An independent quality of earnings (QOE) report can be a valuable tool in mergers and acquisitions. It’s important for both buyers and sellers to look beyond the quantitative information provided by the selling company’s financial statements.

Quality matters

There’s a lack of guidance from the American Institute of Certified Public Accountants (AICPA) regarding scope and format of a QOE report. As a result, these engagements may be customized to meet the needs of the party requesting the report.

Typically, QOE reports analyze the individual components of earnings (that is, revenue and expenses) on a month-to-month basis. The goals are twofold: 1) to determine whether earnings are sustainable, and 2) to identify potential risks and opportunities, both internal and external, that could affect the company’s ability to operate as a going concern.

Examples of issues that a QOE report might uncover include:

  • Deficient accounting policies and procedures,
  • Excessive concentration of revenue with one customer,
  • Transactions with undisclosed related parties,
  • Inaccurate period-end adjustments,
  • Unusual revenue or expense items,
  • Insufficient loss reserves, and
  • Overly optimistic prospective financial statements.

QOE analyses can be performed on financial statements that have been prepared in-house, as well as those that have been compiled, reviewed or audited by a CPA firm. Rather than focus on historical results and compliance with Generally Accepted Accounting Principles (GAAP), QOE reports focus on how much cash flow the company is likely to generate for investors in the future.

Beyond EBITDA

Earnings before interest, taxes, depreciation and amortization (EBITDA) for the trailing 12 months is often the starting point for assessing earnings quality. To reflect a more accurate picture of a company’s operations, EBITDA may need to be adjusted for such items as:

  • Nonrecurring items, such as a loss from a natural disaster or a gain from an asset sale,
  • Above- or below-market owners’ compensation,
  • Discretionary expenses, and
  • Differences in accounting methods used by the company compared to industry peers.

In addition, QOE reports usually entail detailed ratio and trend analysis to identify unusual activity. Additional procedures can help determine whether changes are positive or negative.

For example, an increase in accounts receivable could result from revenue growth (a positive indicator) or a buildup of uncollectible accounts (a negative indicator). If it’s the former, the gross margin on incremental revenue should be analyzed to determine if the new business is profitable — or if the revenue growth results from aggressive price cuts.   

We can help

Using an objective accounting professional to provide a QOE report can help the parties stay focused on financial matters during M&A discussions and add credibility to management’s historical and prospective financial statements. Contact us if you’re in the market to buy or sell a business.

© 2019

Auditing Accounting Estimates and the Use of Specialists

The Public Company Accounting Oversight Board (PCAOB) recently voted to finalize two related standards aimed at improving audits of accounting estimates and the work of specialists. Though the new, more consistent guidance would apply specifically to public companies, the effects would likely filter down to audits of private entities that use accounting estimates or rely on the work of specialists.

Estimates

Financial statements often report assets at fair value or use other types of accounting estimates, such as allowances for doubtful accounts, credit losses and impairments of long-lived assets. These estimates may involve some level of measurement uncertainty. So, they may be susceptible to misstatement and require more auditor focus.

PCAOB Release No. 2018-005, Auditing Accounting Estimates, Including Fair Value Measurements , aims to improve audits of estimates. The new risk-based standard would promote greater consistency in application. It would emphasize the importance of professional skepticism when auditors evaluate management’s estimates and the need to devote greater attention to potential management bias. Under the updated standard, auditors would consider both corroborating and contradictory evidence that’s obtained during the audit.

Use of specialists

Some accounting estimates may be easily determinable. But many are inherently subjective or complex, requiring the use of specialists. Examples include:

  • Actuaries to determine employee benefit obligations,
  • Engineers to determine obligations regarding environmental remediation, and
  • Appraisers to determine the value of intangible assets or real estate.

The audit guidance on using the work of specialists hasn’t changed much since it was originally published in the 1970s. It deals with auditors’ oversight of third-party specialists, as well as the auditor’s use of the work of a professional hired by management. Existing guidance requires auditors to evaluate the relationship of a specialist to the client, including situations that might impair the specialist’s objectivity. But it doesn’t provide specific requirements.

PCAOB Release No. 2018-006, Amendments to Auditing Standards for Auditor’s Use of the Work of Specialists , would provide more direction for carrying out that evaluation. The updated standard would extend the auditor’s responsibility for evaluating specialists beyond simply obtaining an understanding of their work. It would require auditors to perform additional procedures to evaluate the appropriateness of the company’s data, as well as significant assumptions and methods used. However, auditors wouldn’t be required to reperform the work of the company’s specialist.

Stay tuned

The PCAOB issued these related standards simultaneously at the end of 2018, and wants both to become effective for audits of financial statements for fiscal years ending on or after December 15, 2020. However, the updated guidance is pending approval by the Securities and Exchange Commission. Contact us to discuss how these updated standards are likely to affect your company’s audit procedures in the coming years.

© 2019

ESG Issues: To Report or Not to Report?

Securities and Exchange Commission (SEC) Chairman Jay Clayton recently said that public companies shouldn’t be required to disclose information concerning environmental, social and governance (ESG) matters in their financial statements using a standardized format. Right now, these disclosures are voluntary and unstandardized.

ESG issues

The SEC is a long-standing member of the International Organization of Securities Commissions (IOSCO). But, in January, the SEC refused to sign a statement issued by IOSCO that urged companies to disclose nonfinancial ESG matters that may affect a company’s financial condition and performance. Examples include:

• The size of the company’s carbon footprint,
• Efforts to replace fossil fuels with renewable energy sources,
• Workplace, health and safety issues, and
• Consumer product safety risks.

Media attention on these external threats has increased public awareness and prompted concerns about how ESG issues could impact value or increase a company’s risk of litigation. Some investor groups and regulators are calling for formal rules that would mandate the use of a standardized framework.

SEC position

SEC Commissioner Hester Peirce and Chairman Clayton recognize that voluntary ESG disclosures provide insight into company operations when used in conjunction with traditional financial metrics. But they oppose a one-size-fits-all reporting format. They contend that some ESG information isn’t relevant to a reasonable investor and thus takes time away from focusing on more pressing matters.

They also point out that companies that follow U.S. Generally Accepted Accounting Principles (GAAP) already must disclose material ESG matters in the following sections of their financial statements:

Description of business. This disclosure describes the business and that of its subsidiaries, including information about its form of organization, principal products and services, major customers, competitive conditions and costs of complying with environmental laws.

Legal proceedings. This disclosure briefly explains any material pending legal proceedings in which the company, any of its subsidiaries and any of its property are involved.

Risk factors. These disclosures highlight the most significant factors that make an investment in the company speculative or risky.

Management’s discussion and analysis (MD&A). Public companies must identify known trends, events, demands, commitments and uncertainties that are reasonably likely to have a material effect on financial condition or operating performance.

In addition, some companies voluntarily issue separate standalone “sustainability” reports that cover a broad range of nonfinancial issues. However, these nonfinancial figures aren’t audited, and, unfortunately, some companies use ESG data to present a stronger financial picture than the ones that appear in their audited financial statements.

A custom approach

Voluntary ESG reporting can provide valuable insight to investors and lenders. We can help your company create customized financial statement disclosures and standalone sustainability reports that reflect its most pressing ESG concerns. Contact us for more information.

© 2019

Auditing Cashless Transactions

Like most businesses, you’ve probably experienced a significant increase in the number of customers who prefer to make cashless payments. And you may be wondering: How does the acceptance of these types of transactions affect the auditing of your financial statements?

Cashless transactions require the exchange of digital information to facilitate payments. Instead of focusing on the collection and recording of physical cash, your auditors will spend significant time analyzing your company’s electronic sales records. This requires four specific procedures.

1. Identifying accepted payment methods

Auditors will ask for a list of the types of payments your company accepts and the process maps for each payment vehicle. Examples of cashless payment methods include:

  • Credit and debit cards,
  • Mobile wallets (such as Venmo),
  • Digital currencies (such as Bitcoin),
  • Automated Clearing House (ACH) payments,
  • Wire transfers, and
  • Payments via intermediaries (such as PayPal).

Be prepared to provide documents detailing how the receipt of cashless payments works and how the funds end up in your company’s bank account.

2. Evaluating roles and responsibilities

Your auditors will request a list of employees involved in the receipt, recording, reporting and analysis of cashless transactions. They will also want to see how your company manages and monitors employee access to every technology platform connected to cashless payments.

Evaluating who handles each aspect of the cashless payment cycle helps auditors confirm whether you have the appropriate level of security and segregation of duties to prevent fraud and misstatement.

3. Testing the reconciliation process

Auditors will review prior sales reconciliations to test their accuracy and ensure appropriate recognition of revenue. This may be especially challenging as companies implement the new accounting rules on revenue recognition for long-term contracts. Auditors also will test accounting entries related to such accounts as inventory, deferred revenue and accounts receivable.

4. Analyzing trends

Cashless transactions create an electronic audit trail. So, there’s ample data for auditors to analyze. To uncover anomalies, auditors may, for example, analyze sales by payment vehicle, over different time periods and according to each employee’s sales activity.

If your company has experienced payment fraud, it’s important to share that information with your audit team. Also tell them about steps you took to remediate the problem and recover losses.

Preparing for a cashless future

Before we arrive to conduct fieldwork, let’s discuss the types of cashless payments you now accept — or plan to accept in the future. Depending on the number of cashless methods, we’ll amend our audit program to review them in detail.

© 2019