How Do Profits and Cash Flow Differ?

Business owners sometimes mistakenly equate profits with cash flow. Here’s how this can lead to surprises when managing day-to-day operations — and why many profitable companies experience cash shortages.

Working capital

Profits are closely related to taxable income. Reported at the bottom of your company’s income statement, they’re essentially the result of revenue less the cost of goods sold and other operating expenses incurred in the accounting period.

Generally Accepted Accounting Principles (GAAP) require companies to “match” costs and expenses to the period in which revenue is recognized. Under accrual-basis accounting, it doesn’t necessarily matter when you receive payments from customers or when you pay expenses.

For example, inventory sitting in a warehouse or retail store can’t be deducted — even though it may have been long paid for (or financed). The expense hits your income statement only when an item is sold or used. Your inventory account contains many cash outflows that are waiting to be expensed.

Other working capital accounts — such as accounts receivable, accrued expenses and trade payables — also represent a difference between the timing of cash flows. As your business grows and prepares for increasing future sales, you invest more in working capital, which temporarily depletes cash.

The reverse also may be true. That is, a mature business may be a “cash cow” that generates ample cash, despite reporting lackluster profits.

Capital expenditures, loan payments and more

Working capital tells only part of the story. Your income statement also includes depreciation and amortization, which are noncash expenses. And it excludes changes in fixed assets, bank financing and owners’ capital accounts, which affect cash that’s on hand.

To illustrate: Suppose your company uses tax depreciation schedules for book purposes. In 2018, you purchased new equipment to take advantage of the expanded Section 179 and bonus depreciation allowances. The entire purchase price of these items was deducted from profits in 2018. However, these purchases were financed with debt. So, actual cash outflows from the investments in 2018 were minimal.

In 2019, your business will make loan payments that will reduce the amount of cash in the company’s checking account. But your profits will be hit with only the interest expense (not the amount of principal that’s being repaid). Plus, there will be no “basis” left in the 2018 purchases to depreciate in 2019. These circumstances will artificially boost profits in 2019, without a proportionate increase in cash.

Look beyond profits

It’s imperative for business owners and management to understand why profits and cash flow may not sync. If your profitable business has insufficient cash on hand to pay employees, suppliers, lenders or even the IRS, contact us to discuss ways to more effectively manage the cash flow cycle.

© 2019

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

Accounting for Overheads Costs

Accurate overhead allocations are essential to understanding financial performance and making informed pricing decisions. Here’s guidance on how to estimate overhead rates to allocate these indirect costs to your products and how to adjust for variances that may occur.

What’s included in overhead?

Overhead costs are a part of every business. These accounts frequently serve as catch-alls for any expense that can’t be directly allocated to production, including:

  • Equipment maintenance and depreciation,
  • Factory and warehouse rent,
  • Building maintenance,
  • Administrative and executive salaries,
  • Taxes,
  • Insurance, and
  • Utilities.

Generally, such indirect costs of production are fixed, meaning they won’t change appreciably whether production increases or diminishes.

How are overhead rates calculated?

The challenge comes in deciding how to allocate these costs to products using an overhead rate. The rate is typically determined by dividing estimated overhead expenses by estimated totals in the allocation base (for example, direct labor hours) for a future period of time. Then you multiply the rate by the actual number of direct labor hours for each product (or batch of products) to establish the amount of overhead that should be applied.

In some organizations, the rate is applied companywide, across all products. This is particularly appropriate for organizations that make single, standard products — such as bricks — over long periods of time. If your product mix is more complex and customized, you may use multiple overhead rates to allocate costs more accurately. If one department is machine-intensive and another is labor-intensive, for example, multiple rates may be appropriate.

How do you handle variances from actual costs?

There’s one problem with accounting for overhead costs: Variances are almost certain. There are likely to be more variances if you use a simple companywide overhead rate, but even the most carefully thought-out multiple rates won’t always be 100% accurate.

The result? Large accounts that many managers don’t understand and that require constant adjustment. This situation creates opportunities for errors — and for dishonest people to commit fraud. Fortunately, you can reduce the chance of overhead anomalies with strong internal control procedures, such as:

  • Conducting independent reviews of all adjustments to overhead and inventory accounts,
  • Studying significant overhead adjustments over different periods of time to spot anomalies,
  • Discussing complaints about high product costs with nonaccounting managers, and
  • Evaluating your existing overhead allocation and making adjustments as necessary.

Allocating costs more accurately won’t guarantee that you make a profit. To do that, you have to make prudent pricing decisions — based on the production costs and market conditions — and then sell what you produce.

Need help?

Cost accounting can be complex, and indirect overhead costs can be difficult to trace. We can help you understand how to minimize the guesswork in accounting for overhead and identify when it’s time to adjust your allocation rates. Our accounting pros can also suggest ways to monitor cost allocations to prevent errors and mismanagement.

© 2018

4 Steps to Auditing AP

At most companies, the accounts payable (AP) department handles an enormous volume of transactions. So, the AP ledger may be prone to errors or used to bury fraudulent journal entries. How do auditors get a handle on AP? They use four key procedures to evaluate whether this account is free from “material misstatement” and compliant with U.S. Generally Accepted Accounting Principles (GAAP).

1. Examination of SOPs

Standard operating procedures (SOPs) are critical to a properly functioning AP department. However, some companies haven’t written formal SOPs — and others don’t always follow the SOPs they’ve created.

If SOPs exist, the audit team reviews them in detail. They also test a sample of transactions to determine whether payables personnel follow them.

If the AP department hasn’t created SOPs — or if existing SOPs don’t reflect what’s happening in the department — the audit team will temporarily stop fieldwork. Auditors will resume testing once the AP department has issued formal SOPs or updated them as needed.

2. Analysis of paper trails

Auditors use the term “vouching” to refer to the process of tracking a transaction from inception to completion. Analyzing this paper trail requires auditors to review original source documents, such as:

  • Purchase orders,
  • Vendor invoices,
  • Journal entries for AP and inventory, and
  • Bank records.

The audit team may select transactions randomly, as well as based on a transaction’s magnitude or frequency. They’ll also ascertain whether the company has complied with invoice terms and received the appropriate discounts.

3. Confirmations

Auditors may send forms to the company’s vendors asking them to “confirm” the balance owed. Confirmations can either:

  • Include the amount due based on the company’s accounting records, or
  • Leave the balance blank and ask the vendor to complete it.

If the amount confirmed by the vendor doesn’t match the amount recorded in the AP ledger, the audit team will note the exception and inquire about the reason. Unresolved discrepancies may require additional testing procedures and could even be cause for a qualified or adverse audit opinion, depending on the size and nature of the discrepancy.

4. Verification of financial statements

Auditors compare the amounts recorded in the company financial statements to the records maintained by the AP department. This includes reviewing the month-end close process to ensure that items are posted in the correct accounting period (the period in which expenses are incurred).

Auditors also review the process for identifying and recording related-party transactions. And they search for vendor invoices paid with cash and unrecorded liabilities involving goods or services received but yet not processed for payment.

Get it right

These four procedures may be conducted as part of a routine financial statement audit — or you may decide to hire an auditor to specifically target the AP department. Either way, your payables personnel can help streamline fieldwork by having the formal SOPs in place and source documents ready when the audit team arrives. Contact us for more information about what to expect during the coming audit season.

© 2018

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

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

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

A Fresh Look at Percentage of Completion Accounting

How do you report revenue and expenses from long-term contracts? Some companies that were required to use the percentage of completion method (PCM) under prior tax law may qualify for an exception that was expanded by the Tax Cuts and Jobs Act (TCJA). This could, in turn, have spillover effects on some companies’ financial statements.

Applying the PCM

Certain businesses — such as homebuilders, real estate developers, engineering firms and creative agencies — routinely enter into contracts that last for more than one calendar year. In general, under accrual-basis accounting, long-term contracts can be reported using either 1) the completed contract method, which records revenues and expenses upon completion of the contract terms, or 2) the PCM, which ties revenue recognition to the incurrence of job costs.

The latter method is generally prescribed by U.S. Generally Accepted Accounting Principles (GAAP), as long as you can make estimates that are “sufficiently dependable.” Under the PCM, the actual costs incurred are compared to expected total costs to estimate percentage complete. Alternatively, the percentage complete may be estimated using an annual completion factor. The application of the PCM is further complicated by job cost allocation policies, change orders and changes in estimates.

In addition to reporting income earlier under the PCM than under the completed contract method, the PCM can affect your balance sheet. If you underbill customers based on the percentage of costs incurred, you’ll report an asset for costs in excess of billings. Conversely, if you overbill based on the costs incurred, you’ll report a liability for billings in excess of costs.

Syncing financial statements and tax records

Starting in 2018, the TCJA modifies Section 451 of the Internal Revenue Code so that a business recognizes revenue for tax purposes no later than when it’s recognized for financial reporting purposes. Under Sec. 451(b), taxpayers that use the accrual method of accounting will meet the “all events test” no later than the taxable year in which the item is taken into account as revenue in a taxpayer’s “applicable financial statement.”

So, if your business uses the PCM for financial reporting purposes, you’ll generally need to follow suit for tax purposes (and vice versa).

In general, for federal income tax purposes, taxable income from long-term contracts is determined under the PCM. However, there’s an exception for smaller companies that enter into contracts to construct or improve real property.

Under the TCJA, for tax years beginning in 2017 and beyond, construction firms with average annual gross receipts of $25 million or less won’t be required to use the PCM for contracts expected to be completed within two years. Before the TCJA, the gross receipts test limit for the small construction contract exception was $10 million.

Got contracts?

Compared to the completed contract method, the PCM is significantly more complicated. But it can provide more current insight into financial performance on long-term contracts, if your estimates are reliable. We can help determine the appropriate method for reporting revenue and expenses, based on the nature of your operations and your company’s size.

© 2018

Use Pay-Ratio Disclosures with Caution

Starting in 2018, certain public companies must disclose the ratio of their CEO’s annual compensation to that of its “median employee.” The rule allows for significant flexibility in calculating these ratios, leading to widely divergent ratios within the same industry. Therefore, public companies and their investors should tread carefully before they rely on these metrics.

Complying with the rule

The pay-ratio disclosure rule applies to all U.S. public companies required to provide Summary Compensation Table disclosures. With limited exceptions, covered companies must disclose pay ratios in annual reports, on Form 10-K, in proxy and information statements, and in registration statements — if these filings require executive compensation disclosures.

The rule doesn’t apply to the following companies:

Smaller reporting companies (SRCs). The Securities and Exchange Commission (SEC) voted unanimously in June 2018 to increase the public float threshold for SRCs to $250 million.

Emerging growth companies (EGCs). This term generally refers to new public companies with gross revenues under $1 billion in the most recent fiscal year. (The SEC allows a transition period for newly public companies.)

The rule also exempts registered investment companies, foreign private issuers and Canadian companies filing in the United States pursuant to the Multijurisdictional Disclosure System.

Calculating pay ratios

The SEC allows significant leeway in calculating pay ratios to ease the burden of complying with the rule. Companies may choose a process that fits their structure and compensation programs. But they must disclose the methodology used to determine the median employee pay and the estimates used in calculating the pay ratio.

For example, a company could use a statistically representative sample of its workforce rather than the entire population. Or they could compare only base salary or W-2 wages, excluding from their computations bonuses, overtime, stock options and other forms of compensation.

Companies also aren’t required to calculate the exact compensation when identifying the median. Rather, the SEC lets them use “reasonable estimates.” In addition, the rule allows companies to exclude up to 5% of their non-U.S. workers and to adjust foreign pay to account for differences in the cost of living between regions.

As a result, the initial round of pay-ratio disclosures published in early 2018 vary widely. For example, a recent study found that ratios disclosed by companies in the financial services industry ranged from 1:1 to 1:429.

Comparing apples to oranges

Before relying on pay-ratio disclosures to evaluate compensation practices or cost efficiency, it’s important to compare a company’s process for calculating pay ratios to others used in the same industry. Contact us for more information about pay-ratio disclosures and how a company’s compensation practices measure up.

© 2018

Auditing the Use of Estimates and Specialists

Complex accounting estimates — such as allowances for doubtful accounts, impairments of long-lived assets, and valuations of financial and nonfinancial assets — have been blamed for many high-profile accounting scams and financial restatements. Estimates generally involve some level of measurement uncertainty, and some may even require the use of outside specialists, such as appraisers or engineers.

As a result, examining estimates is a critical part of an audit. Companies that understand the audit process are better equipped to facilitate audit fieldwork and can communicate more effectively with their auditors. Here’s what you need to know about auditing the use of estimates as we head into next audit season.

Audit techniques

Some estimates may be easily determinable, but many are inherently complex. Auditing standards generally provide the following three approaches for substantively testing accounting estimates and fair value measurements:

1. Testing management’s process. Auditors evaluate the reasonableness and consistency of management’s assumptions, as well as test whether the underlying data is complete, accurate and relevant.
2. Developing an independent estimate. Using management’s assumptions (or alternate assumptions), auditors come up with an estimate to compare to what’s reported on the internally prepared financial statements.
3. Reviewing subsequent events or transactions. The reasonableness of estimates can be gauged by looking at events or transactions that happen after the balance sheet date but before the date of the auditor’s report.

When performing an audit, all three approaches might not necessarily be appropriate for every estimate. For each estimate, the auditor typically selects one or a combination of these approaches.

Regulatory oversight

Accounting estimates have been on the agenda of the Public Company Accounting Oversight Board (PCAOB) since it was established by Congress under the Sarbanes-Oxley Act of 2002. Although the leadership of PCAOB changed hands in early 2018, proposals to enhance the auditing standards for the use of accounting estimates and the work of specialists remain top priorities.

Earlier this summer, Chairman William Duhnke told the PCAOB’s Standard Advisory Group (SAG) that he hopes to complete these projects in the coming months. The updated auditing standards would help reduce diversity in practice, provide more-specific direction and be better aligned with the risk assessment standards.

Prepare for next audit season

Improvements on the audit standards for the use of estimates and the work of specialists could be coming soon. As companies plan for next year’s audit, they should contact their audit partners for the latest developments on the standards for auditing the use of estimates and specialists to determine what (if anything) has changed.

We can help you understand how estimates and specialists are used in the preparation of your company’s financial statements and minimize the risk of financial misstatement.

© 2018