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Levels of assurance: Choosing the right option for your business today

Three Closed Doors with Different Color in Front in the Room 3D Illustration, Choice Concept

The COVID-19 crisis is causing private companies to re-evaluate the type of financial statements they should generate for 2020. Some are considering downgrading to a lower level of assurance to reduce financial reporting costs — but a downgrade may compromise financial reporting quality and reliability. Others recognize the additional risks that work-from-home and COVID-19-related financial distress are causing, leading them to upgrade their assurance level to help prevent and detect potential fraud and financial misstatement schemes.

When deciding what’s appropriate for your company, it’s important to factor in the needs of creditors or investors, as well as the size, complexity and risk level of your organization. Some companies also worry that major changes to U.S. Generally Accepted Accounting Principles (GAAP) and federal tax laws in recent years may be overwhelming internal accounting personnel — and additional guidance from external accountants is a welcome resource for them to rely on while implementing the changes.

3 levels

In plain English, the term “assurance” refers to how confident (or assured) you are that your financial reports are reliable, timely and relevant. In order of increasing level of rigor, accountants generally offer three types of assurance services:

1. Compilations. These engagements provide no assurance that financial statements are free from material misstatement and conform with Generally Accepted Accounting Principles (GAAP). Instead, the CPA puts financial information that management generates in-house into a GAAP financial statement format. Footnote disclosures and cash flow information are optional and often omitted.

2. Reviews. Reviewed financial statements provide limited assurance that the statements are free from material misstatement and conform with GAAP. Here, the accountant applies analytical procedures to identify unusual items or trends in the financial statements. She or he inquires about these anomalies, as well as the company’s accounting policies and procedures.

Reviewed statements always include footnote disclosures and a statement of cash flows. But the accountant isn’t required to evaluate internal controls, verify information with third parties or physically inspect assets.

3. Audits. The most rigorous level of assurance is provided by an audit. It offers a reasonable level of assurance that your financial statements are free from material misstatement and conform with GAAP.

The Securities and Exchange Commission requires public companies to have an annual audit. Larger private companies also may opt for this service to satisfy outside lenders and investors. Audited financial statements are the only type of report to include an express opinion about whether the financial statements are fairly presented and conform with GAAP.

Beyond the analytical and inquiry steps taken in a review, auditors perform “search and verification” procedures. They also review internal control systems, tailor audit programs for potential risks of material misstatement and report on control weaknesses when they deliver the audit report.

Time for a change?

Not every business needs audited financial statements, and audits don’t guarantee against fraud or financial misstatement. But the higher the level of assurance you choose, the more confidence you’ll have that the financial statements fairly present your company’s performance.

© 2020

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CARES Act provides option to delay CECL reporting

Updated accounting rules

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, in response to the financial crisis of 2007–2008. The updated CECL standard relies on estimates of probable future losses. By contrast, existing guidance relies on an incurred-loss model to recognize losses.

In general, the updated standard will require entities to recognize losses on bad loans earlier than under current U.S. Generally Accepted Accounting Principles (GAAP). It’s scheduled to go into effect for most public companies in 2020. In October 2019, the deadline for smaller reporting companies was extended from 2021 to 2023, and, for private entities and nonprofits, it was extended from 2022 to 2023.

Option to delay

Under the CARES Act, large public insured depository institutions (including credit unions), bank holding companies, and their affiliates have the option of postponing implementation of the CECL standard until the earlier of:

  • The end of the national emergency declaration related to the COVID-19 crisis, or
  • December 31, 2020.

Many public banks have made significant investments in systems and processes to comply with the CECL standard, and they’ve communicated with investors about the changes. So, some may decide to stay the course. But many large banks are expected to take advantage of the option to delay implementation.

Congress decided to provide a temporary reprieve from implementing the changes for a variety of reasons. Notably, the COVID-19 pandemic has created a volatile, uncertain lending environment that may result in significant credit losses for some banks.

To measure those losses, banks must forecast into the foreseeable future to predict losses over the life of a loan and immediately book those losses. But making estimates could prove challenging in today’s unprecedented market conditions. And, once a credit loss has been recognized, it generally can’t be recouped on the financial statements. Plus, there’s some concern that the CECL model would cause banks to needlessly hold more capital and curb lending when borrowers need it most.

Stay tuned

So far, the FASB hasn’t delayed the CECL standard. But the COVID-19 crisis has front-loaded concerns about the CECL standard, prompting critics in both the House and Senate to step up their efforts to block the standard. Contact us for the latest developments on this issue.

© 2020

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FAQs about prepaid expenses

The concept of “matching” is one of the basic principles of accrual-basis accounting. It requires companies to match expenses (efforts) with revenues (accomplishments) whenever it’s reasonable or practical to do so. This concept applies when companies make advance payments for expenses that will benefit more than one accounting period. Here are some questions small business owners and managers frequently ask about prepaying expenses.

When do prepaid expenses hit the income statement?

It’s common for companies to prepay such expenses as legal fees, advertising costs, insurance premiums, office supplies and rent. Rather than immediately report the full amount of an advance payment as an expense on the income statement, companies that use accrual-basis accounting methods must recognize a prepaid asset on the balance sheet.

A prepaid expense is a current asset that represents an expense the company won’t have to fund in the future. The remaining balance is gradually written off with the passage of time or as it’s consumed. The company then recognizes the reduction as an expense on the income statement.

Why can’t prepaid expenses be deducted immediately?

Immediate expensing of an item that has long-term benefits violates the matching principle under U.S. Generally Accepted Accounting Principles (GAAP).

Deducting prepaid assets in the period they’re paid makes your company look less profitable to lenders and investors, because you’re expensing the costs related to generating revenues that haven’t been earned yet. Immediate expensing of prepaid expenses also causes profits to fluctuate from period to period, making benchmarking performance over time or against competitors nearly impossible.

Does prepaying an expense make sense?

Some service providers — like your insurance carrier or an attorney in a major lawsuit — might require you to pay in advance. However, in many circumstances, prepaying expenses is optional.

There are pros and cons to prepaying. A major downside is that it takes cash away from other potential uses. Put another way, it gives vendors or suppliers interest-free use of your business’s funds. Plus, there’s a risk that the party you prepay won’t deliver what you’ve paid for.

For example, a landlord might terminate a lease — or they might file for bankruptcy, which could require a lengthy process to get your prepayment refunded, and you might not get a refund at all. Banks also might not count prepaids when computing working capital ratios. And since reporting prepaid expenses under GAAP differs slightly from reporting them for federal tax purposes, excessive prepaid activity may create complex differences to reconcile.

With that said, your company might receive a discount for prepaying. And companies without an established credit history, that have poor credit or that contract services with foreign providers, may need to prepay expenses to get favorable terms with their supply chain partners.

For more information

Start-ups and small businesses that are accustomed to using cash-basis accounting may not understand the requirement to capitalize business expenses on the balance sheet. But matching revenues and expenses is a critical part of accrual-basis accounting. Contact us with any questions you may have about reporting and managing prepaid assets.

© 2019

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The Art and Science of Goodwill Impairment Testing

Goodwill shows up on a company’s balance sheet when the company has been acquired in a business combination. It represents what’s left over after the purchase price in a merger or acquisition is allocated to the company’s tangible assets, identifiable intangible assets and liabilities. Periodically, companies must test goodwill for “impairment” — that is, whether the carrying value on the balance sheet has fallen below its fair value. This assessment can be complicated.

Reporting recap

Under current U.S. Generally Accepted Accounting Principles (GAAP), public companies that report goodwill on their balance sheet must test goodwill at least annually for impairment. In lieu of annual impairment testing, private companies may elect to amortize acquired goodwill over a useful life of up to 10 years.

All companies — regardless of whether they’re publicly traded or privately held — must test goodwill for impairment when a triggering event happens. Examples of triggering events that could lower the fair value of goodwill include:

  • The loss of a key customer or key person,
  • Adverse regulatory actions,
  • Unanticipated competition, and
  • Negative cash flows from operations.

Impairment may also occur if, after an acquisition has been completed, there’s an economic downturn that causes the parent company or the acquired business to lose value. Impairment write-downs reduce the carrying value of goodwill on the balance sheet. They also lower profits reported on the income statement, which may raise a red flag to lenders and investors.

Quantifying impairment

Calculating goodwill impairment was originally a two-step process: First, businesses must figure out whether an impairment exists, and then they must put a dollar figure on it. The second step includes determining the implied fair value of goodwill and comparing it with the carrying amount of goodwill on the balance sheet.

The rules for testing goodwill impairment were simplified in Accounting Standards Update (ASU) No. 2017-04, Intangibles — Goodwill and Other, Simplifying the Test for Goodwill Impairment. The changes go live for fiscal periods starting after:

  • December 15, 2019, for public companies that file with the Securities and Exchange Commission,
  • December 15, 2020, for other public companies,
  • December 15, 2021, for privately held businesses.

Early adoption is permitted for testing dates after January 1, 2017. The updated guidance nixes the second step of the impairment test. Instead, a business will perform the impairment test by comparing the fair value of a reporting unit that includes goodwill with its carrying amount.

Who can help?

Few companies employ internal accounting staff with the requisite training and time to handle impairment testing. And most auditors won’t perform valuation services for their audit clients for fear of violating their independence standards. Instead, valuation specialists are often called in to handle these complex assignments. Contact us for more information.

© 2019

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Close-Up on Pushdown Accounting for M&As

Change-in-control events — like merger and acquisition (M&A) transactions — don’t happen every day. If you’re currently in the market to merge with or buy a business, you might not be aware of updated financial reporting guidance that took effect in November 2014. The changes provide greater flexibility to post-M&A accounting.

Pushdown accounting is optional

Accounting Standards Update (ASU) No. 2014-17, Business Combinations (Topic 805): Pushdown Accounting (a consensus of the FASB Emerging Issues Task Force), made pushdown accounting optional when there’s a change-in-control event. The update applies to all companies, both public and private.

Pushdown accounting refers to the practice of adjusting an acquired company’s standalone financial statements to reflect the acquirer’s accounting basis rather than the target’s historical costs. Typically, this means stepping up the target’s net assets to fair value and, to the extent the purchase price exceeds fair value, recognizing the excess as goodwill. Previously, U.S. Generally Accepted Accounting Principles (GAAP) provided little guidance on when pushdown accounting might be appropriate.

For public companies, Securities and Exchange Commission (SEC) guidance generally prohibited pushdown accounting unless the acquirer obtained at least an 80% interest in the target and required it when the acquirer’s interest reached 95%. The SEC has rescinded portions of its pushdown accounting guidance, bringing it in line with the FASB’s updated standard.

To push down or not?

Under the updated guidance, all acquired companies may decide if they should apply pushdown accounting. Whether it’s appropriate depends on a company’s circumstances. For some companies, there may be advantages to reporting assets and liabilities at fair value and adopting consistent accounting policies for both parent and subsidiary. Other companies may prefer not to apply pushdown accounting to avoid the negative impact on earnings, often associated with a step-up to fair value.

After pushdown accounting is applied to a change-in-control event, the election is irrevocable. Acquired companies that apply pushdown accounting in their standalone financial statements should include disclosures in the current reporting period to help users evaluate its effects.

We can help

If you’re contemplating an M&A deal, we can help you decide whether pushdown accounting is a smart choice for reporting your transaction. Whichever option you choose, our accounting pros also can help you comply with financial reporting requirements under GAAP.

© 2019

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Reasons Why Cash is King

Dollar Pipeline – lots of 20 Dollar Bills building a tube.

In financial reporting, investors and business owners tend to focus on four key metrics: 1) revenue, 2) net income, 3) total assets and 4) net worth. But, when it comes to gauging short-term financial performance and creditworthiness, the trump card is cash flow.

If a business doesn’t have enough cash on hand to pay payroll, rent and other bills, it can spell disaster — no matter how profitable the company is or how fast it’s growing. That’s why you can’t afford to cast aside the statement of cash flows and the important insight it can provide.

Monitoring cash

The statement of cash flows reveals clues about a company’s ability to manage cash. It shows changes in balance sheet items from one accounting period to the next. Special attention should be given to significant balance changes.

For example, if accounts receivable were $1 million in 2018 and $2 million in 2019, the change would be reported as a cash outflow of $1 million. That’s because more money was tied up in receivables in 2019 than in 2018. An increase in receivables is common for growing businesses, because receivables generally grow in proportion to revenue. But a mounting receivables balance also might signal cash management inefficiencies. Additional financial information — such as an aging schedule — might reveal significant write-offs.

Continually reporting negative cash flows from operations can also signal danger. There’s a limit to how much money a company can get from selling off its assets, issuing new stock or taking on more debt. A red flag should go up when operating cash outflows consistently outpace operating inflows. It can signal weaknesses, such as out-of-control growth, poor inventory management, mounting costs and weak customer demand.

Categorizing cash flows

The statement of cash flows typically consists of three sections:

1. Cash flows from operations. This section converts accrual net income to cash provided or used by operations. All income-related items flow through this part of the cash flow statement, such as net income; gains (or losses) on asset sales; depreciation and amortization; and net changes in accounts receivable, inventory, prepaid assets, accrued expenses and payables.

2. Cash flows from investing activities. If a company buys or sells property, equipment or marketable securities, the transaction shows up here. This section could reveal whether a company is divesting assets for emergency funds or whether it’s reinvesting in future operations.

3. Cash flows from financing activities. This shows transactions with investors and lenders. Examples include Treasury stock purchases, additional capital contributions, debt issuances and payoffs, and dividend payments.

Below these three categories is the schedule of noncash investing and financing transactions. This portion of the cash flow statement summarizes significant transactions in which cash did not directly change hands: for example, like-kind exchanges or assets purchased directly with loan proceeds.

Keep a watchful eye

Effective cash management can be the difference between staying afloat and filing for bankruptcy — especially in an unpredictable economy. Contact us to help identify potential problems and find solutions to shore up inefficiencies and shortfalls.

© 2019

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Internal Audit 2.0: Paperless and continuous Auditing Trends

Technology is altering the traditional approach to internal audits. Instead of reviewing reams of paperwork, today’s auditor is learning to use electronic records. In turn, going paperless facilitates a concept known as “continuous auditing,” where internal auditors continually gather data to support their procedures. Here’s how your business can modernize this process.

Targeting specific areas

Not every functional area of your company lends itself to paperless and continuous auditing. To determine whether sufficient, timely and accurate electronic data exists, you’ll need to review the systems that store and generate your company’s data.

For example, if a portion of your inventory accounting processes still relies on paper, it may not present an ideal candidate for paperless and continuous auditing. Alternatively, if your accounts payable (AP) process functions entirely on electronic records, it’s logical to include AP in the continuous audit program.

Planning the program

Before you can adopt a continuous audit program, you must determine:

  • Your primary and secondary business goals, and
  • The key risks you hope to mitigate.

Then you can design your program accordingly. For example, if you plan to continuously audit the AP process and you’re concerned about occupational fraud, you may decide to put a rule in place that looks for the creation of vendors whose address matches that of an employee.

From a practical perspective, it’s important to document how often you plan to sample the data that the continuous audit program makes available. Keep in mind that a daily review of the output often generates the greatest benefit.

Ensuring accountability

To help ensure accountability, a process must exist to review and evaluate the audit output. For example, if the review of employee payroll data uncovers unusual payroll disbursements, a process must exist to investigate those discrepancies.

The individual who should be responsible for reviewing the data will depend on the size and structure of your company. It could fall to the internal audit department, someone within the fraud team or a department manager.

Time for change?

Robust internal audits help management correct operational issues quickly, which prevents money from being wasted and risks from spiraling out of control. If implemented correctly, paperless and continuous auditing can improve your company’s internal audit and oversight abilities while also reducing its costs. Contact us for help converting paper records to an electronic format, as well as planning and implementing a continuous internal audit program that targets the optimal areas of your business operations.

© 2019

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Measuring Fair Value for Financial Reporting

Two hands holding a caliper, measuring the word “Improvement”.

Business assets are generally reported at the lower of cost or market value. Under this accounting principle, certain assets are reported at fair value, such as asset retirement obligations and derivatives.

Fair value also comes into play in M&A transactions. That is, if one company acquires another, the buyer must allocate the purchase price of the target company to its assets and liabilities. This allocation requires the valuation of identifiable intangible assets that weren’t on the target company’s balance sheet, such as brands, patents, customer lists and goodwill.

What is fair value?

Under U.S. Generally Accepted Accounting Principles (GAAP), fair value is “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Though this term is similar to “fair market value,” which is defined in IRS Revenue Ruling 59-60, the terms aren’t synonymous.

The FASB chose the term “fair value” to prevent companies from applying IRS regulations or guidance and U.S. Tax Court precedent when valuing assets and liabilities for financial reporting purposes.

The FASB’s use of the term “market participants” refers to buyers and sellers in the item’s principal market. This market is entity specific and may vary among companies.

What goes into a fair value estimate?

When valuing an asset, there are three general valuation approaches: cost, income and market. For financial reporting purposes, fair value should first be based on quoted prices in active markets for identical assets and liabilities. When that information isn’t available, fair value should be based on observable market data, such as quoted prices for similar items in active markets.

In the absence of observable market data, fair value should be based on unobservable inputs. Examples include cash-flow projections prepared by management or other internal financial data.

While a CFO or controller can enlist the help of outside valuation specialists to estimate fair value, a company’s management is ultimately responsible for fair value estimates. So, it’s important to understand the assumptions, methods and models underlying a fair value estimate. Management also must implement adequate internal controls over fair value measurements, impairment charges and disclosures.

Valuation pros needed

Asset valuations are typically outside the comfort zone of in-house accounting personnel, so it pays to hire an outside specialist who will get it right. We can help you evaluate subjective inputs and methods, as well as recommend additional controls over the process to ensure that you’re meeting your financial reporting responsibilities.

© 2019

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Budgeting is Key to a Successful Start-Up

More than half of recent college graduates plan to start a business someday, according to the results of a survey published in August by the American Institute of Certified Public Accountants (AICPA). Unfortunately, the AICPA estimates that only half of new businesses survive the five-year mark, and only about one in three reach the 10-year mark.

What can you do to improve your start-up’s odds of success? Comprehensive, realistic budgets can help entrepreneurs navigate the challenges that lie ahead.

3 financial statements

Many businesses base their budgets on the prior year’s financial results. But start-ups lack historical financial statements, which can make budgeting difficult.

In your first year of operation, it’s helpful to create an annual budget that forecasts all three financial statements on a monthly basis:

1. The income statement. Start your annual budget by estimating how much you expect to sell each month. Then estimate direct costs (such as materials, labor, sales tax and shipping) based on that sales volume. Many operating costs, such as rent, salaries and insurance, will be fixed over the short run.

Once you spread overhead costs over your sales, it’s unlikely that you’ll report a net profit in your first year of operation. Profitability takes time and hard work! Once you turn a profit, however, remember to save room in your budget for income taxes.

2. The balance sheet. To start generating revenue, you’ll also need equipment and marketing materials (including a website). Other operating assets (like accounts receivable and inventory) typically move in tandem with revenue. How will you finance these assets? Entrepreneurs may invest personal funds, receive money from other investors or take out loans. These items fall under liabilities and equity on the balance sheet.

3. The statement of cash flows. This report tracks sources and uses of cash from operating, investing and financing activities. Essentially, it shows how your business will make ends meet each month. In addition to acquiring assets, start-ups need cash to cover fixed expenses each month.

By forecasting these statements on a monthly basis, you can identify when cash shortfalls, as well as seasonal peaks and troughs, are likely to occur.

Reality check

Budgeting isn’t a static process. Each month, entrepreneurs must compare actual results to the budget — and then adjust the budget based on what they’ve learned. For instance, you may have underbudgeted or overbudgeted on some items and, thus, spent more or less than you anticipated.

Some variances may be the result of macroeconomic forces. For example, increased government regulation, new competition or an economic downturn can adversely affect your budget. Although these items may be outside of an entrepreneur’s control, it’s important to identify them early and develop a contingency plan before variances spiral out of control.

Outside input

An accounting professional can help your start-up put together a realistic budget based on industry benchmarks and demand for your products and services in the marketplace. A CPA-prepared budget can serve as more than just a management tool — it also can be presented to lenders and investors who want to know more about your start-up’s operations.

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Auditing Grant Compliance

A business situation.

Has your organization received any public or private grants to fund its growth? Grants sometimes require an independent audit by a qualified accounting firm. Here’s what grant recipients should know to help facilitate matters and ensure compliance at all levels.

Federal compliance

Federal awards require compliance with the Uniform Administrative Requirements, Cost Principles, and Audit Requirements for Federal Awards (also known as 2 CFR Part 200). This guidance requires any entity that expends $750,000 or more of federal assistance received for its operations to undergo a “single audit,” which is a rigorous, organizationwide examination.

To provide grant recipients with the latest guidance on compliance, the Office of Management and Budget (OMB) releases an annual compliance supplement. It covers compliance requirements for a dozen areas when performing a single audit:

  1. Activities allowed or unallowed,
  2. Allowable costs/cost principles,
  3. Cash management,
  4. Eligibility,
  5. Equipment and real property management,
  6. Matching, level of effort and earmarking,
  7. Period of performance,
  8. Procurement, suspension and debarment,
  9. Program income,
  10. Reporting,
  11. Subrecipient monitoring, and
  12. Special tests and provisions.

The supplement also includes sections dedicated to agency program requirements, including clusters of programs that share common compliance requirements.

Your auditor will assess whether your organization has sufficient internal controls in each of the 12 areas. To help ensure compliance, your organization should clearly document decisions and processes, as well as provide a clear audit trail of activity.

Other levels of compliance

The requirements for state, local and private sector grants vary significantly. But compliance generally hinges on the following, regardless of the source providing the funding:

  • A detailed understanding of the grant’s compliance and reporting requirements,
  • A mapping of requirements to individual controls and processes,
  • A documented set of grant management policies and procedures that your organization publicizes and follows,
  • A robust set of internal controls and mechanisms to prevent fraud, waste, and abuse,
  • Training programs designed to promote grant compliance,
  • Frequent risk assessments to map your organization’s policies and procedures against evolving requirements for each grant, and
  • Periodic auditing in compliance with relevant guidance and statutes.

In addition, your auditor will evaluate whether your organization is willing to adapt to regulatory changes. For example, has it adopted new grant controls to accommodate best practices or legislative changes?

We can help

If juggling multiple levels of grant compliance seems overwhelming, contact us to learn how to streamline your approach. We can help your organization improve its ability to satisfy grant requirements at multiple levels.

© 2019