Transparency is Key with Related Party Transactions

In recent years, external auditors have focused more attention on related party transactions. Although related party transactions aren’t necessarily bad, they do raise some concerns about the risk of misstatement or omission in financial reporting.

3 focal points

Issues with related parties played a prominent role in the scandals that surfaced nearly two decades ago at Enron, Tyco International and Refco. Public outrage about these scandals led Congress to pass the Sarbanes-Oxley Act of 2002 and establish the Public Company Accounting Oversight Board (PCAOB). Similar problems have arisen in more recent financial reporting fraud cases, prompting the PCAOB to enact tougher standards on related-party transactions and financial relationships.

PCAOB Auditing Standard No. 2410 (AS 2410), Related Parties, requires auditors of public companies to beef up their efforts in financial statement matters that pose increased risk of fraud. Specifically, auditors must focus on three critical areas:

1. Related-party transactions, such as those involving directors, executives and their family members,
2. Significant unusual transactions (SUTs) that are outside the company’s normal course of business or that otherwise appear to be unusual due to their timing, size or nature, and
3. Other financial relationships with the company’s executive officers and directors.

Subjecting these transactions and financial relationships to enhanced auditor scrutiny may help avert corporate failures. The PCAOB also hopes that enhanced auditor scrutiny will lead to improvements in accounting transparency and disclosures, which will help investors to more clearly gauge financial performance and fraud risks.

From start to finish

AS 2410 requires auditors to obtain a more in-depth understanding of every related-party financial relationship and transaction, including their nature, terms and business purpose (or lack thereof). Tougher related-party audit procedures must be performed in conjunction with the auditor’s risk assessment procedures, which occur in the planning phase of an audit.

In addition, auditors are expected to communicate with the audit committee throughout the audit process regarding the auditor’s evaluation of the company’s identification of, accounting for and disclosure of its related-party relationships and transactions. They can’t wait until the end of the engagement to communicate on these matters.

During fieldwork, expect auditors to be on the hunt for undisclosed related parties and unusual transactions. Examples of information that may be gathered during the audit that could reveal undisclosed related parties include information contained on the company’s website, tax filings, corporate life insurance policies, contracts and organizational charts.

Certain types of questionable transactions — such as contracts for below-market goods or services, bill-and-hold arrangements, uncollateralized loans and subsequent repurchase of goods sold — also might signal that a company is engaged in unusual or undisclosed related-party transactions.

To facilitate the audit process, management should be up-front with auditors about all related party transactions, even if they’re not required to be disclosed or consolidated on the company’s financial statements.

Let’s be honest

Private companies also engage in numerous related party transactions, and they may experience spillover effects of the tougher PCAOB auditing standard, which applies only to audits of public companies. Regardless of whether you’re publicly traded or privately held, it’s important to identify, evaluate and disclose all related parties. We can help you present related party relationships and transactions, openly and completely.

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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.

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Automating Your Accounting Department

Many businesses have adopted robotic process automation (RPA), or plan to do so in the future. While most RPA initiatives target “core” business operations, routine accounting functions also can be automated to help lower costs and allow personnel to focus on higher-level analyses and strategic projects. Here’s some insight into how to integrate RPA in your accounting department.

Paving the way

In general, RPA eliminates the need for manual (human) intervention. In the accounting department, automation software can assume control of such tasks as journal entries, bank reconciliations, and certain aspects of the budgeting and forecasting process. To begin automating your accounting department, follow these five preliminary steps:

1. Inventory manual processes. Prepare a list of manual processes and rank them by complexity and the number of hours to administer them. This provides a prioritized list of RPA candidates. Select the most straightforward process to convert first.

2. Standardize processes. RPA requires standardized tasks and processes. So, you’ll need to apply a standard approach to all transactions. Identify exceptions and scrutinize why they exist and how they can be eliminated.

3. Focus on the source data. Accounting data often exists in different formats and locations, which doesn’t facilitate RPA. So, you’ll need to centralize your accounting data using a consistent structure and format.

4. Document requirements. Many types of RPA software solutions exist. Identify the functionality and capabilities you’ll need and use this list to screen potential providers.

5. Conduct robust testing. Before relying on the output generated by RPA software, test the output to make sure it’s accurate and reliable. Such testing should use statistically valid sampling techniques. You’ll also need to consider judgmental sampling procedures, which allows team members to select transactions based on their training and experience.

Right for your accounting department?

Throughout your organization, RPA can minimize data entry errors, reduce processing time and lower costs. However, getting it to work in the accounting department takes some initial legwork and a fresh mindset. It also may affect the procedures a CPA performs when preparing your financial statements. Contact us for more information.

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Audits Home in on Cybersecurity

In 2018, U.S. organizations that suffered a data breach lost an average of $7.91 million as a result. That’s the highest average organizational cost of all the countries and regions covered in the 2018 Cost of a Data Breach Study by IBM and independent research firm Ponemon Institute. Malicious or criminal attacks were the source of more than half of those breaches, rather than system glitches and human errors.

With so much at stake, it’s no surprise that auditors consider these issues when conducting their audit risk assessments. This audit season, prepare to answer questions about cybersecurity and the effectiveness of your company’s internal controls against cyberthreats.

Inspections of public companies

In recent years, Public Company Accounting Oversight Board (PCAOB) inspectors have interviewed auditors of companies that have experienced a breach into their computer systems to find out how the auditors and their firms responded to the incidents. They report that auditors today are increasingly focused on matters related to cybersecurity.

Audit firms have provided varying levels of guidance, both when assessing risk at the start of an engagement and when uncovering a cybersecurity incident that occurred during audit fieldwork or the period under audit.

“Many of the firms are actually factoring cybersecurity issues into their risk assessment at this point in time, and there is a real focus on developing real understanding about cybersecurity incidents,” reported William Powers, deputy director for technology in the PCAOB’s Division of Registration and Inspections.

Audit inquiries

Possible questions that auditors might ask during fieldwork include:

  • How does management identify and prioritize cyberrisks?
  • What kind of internal controls has management established to safeguard digital assets and sensitive data (such as formal policies and procedures, employee training and the use of security analytics)?
  • How does management monitor internal controls to ensure effective operation?
  • Does management have a detailed breach response plan?
  • If a breach occurred during the accounting period, how did management respond and how much did it cost?
  • Has the company purchased cyber liability and breach response insurance?

The PCAOB hasn’t yet found any material misstatements on a public company’s financial statements as a result of a cybersecurity breach. But there’s a risk that future attacks may affect financial reporting. So, the PCAOB is planning to expand its inspection program to explore what auditors are doing to protect clients’ data and stakeholder data.

Universal risk factor

PCAOB inspectors target audits of public companies. But private companies can also be victims of cyberattacks — and the effects may be even more devastating for companies with fewer resources to absorb the losses and assign dedicated staff to respond to breaches.

The increasing frequency and severity of cyberattacks underscores the need for auditors of entities of all sizes to update their procedures. It’s our job to ask key questions about cyberrisks and the effectiveness of your internal controls. The answers, in turn, can help you formulate more effective governance strategies.

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How to Report Stock Compensation Paid to Non-employees

The accounting rules for reporting stock compensation have been expanded. They now include share-based payments to non-employees for providing goods and services, under recent guidance issued by the Financial Accounting Standards Board (FASB).

Old Rules

Under existing U.S. Generally Accepted Accounting Principles (GAAP), the FASB requires businesses that give stock awards to independent contractors or consultants to follow a separate standard from the one used for employee stock compensation.

Under Accounting Standards Codification (ASC) Subtopic 505-50, Equity — Equity-Based Payments to Non-Employees, the measurement date for nonemployees is determined at the earlier of the date at which:

  • The commitment for performance is complete, or
  • The counterparty’s performance is complete.

This requires judgment and tracking issues that have led to inconsistencies in financial reporting, especially if nonemployees are awarded stock options on a one-by-one basis, rather than a single large grant.

The FASB originally chose to apply different stock compensation guidance to nonemployees because independent contractors and consultants were perceived as having significant freedom to move from company to company. In theory, independent contractors could watch stock price movements to determine where to work.

However, the FASB now believes the assumptions behind the dual standards were overstated, because full-time employees also have the freedom to move from job to job.

New Rules

In June 2018, the FASB issued Accounting Standards Update (ASU) No. 2018-07, Compensation — Stock Compensation: Improvements to Non-employee Share-Based Payment Accounting. It eliminates the separate guidance for stock compensation paid to non-employees and aligns it with the guidance for stock compensation paid to employees.

Under the aligned guidance, all share-based compensation payments will be measured with an estimate of the fair value of the equity the business is obligated to issue at the grant date. The grant date is the date the business and the stock award recipient agree to the terms of the award. Essentially, compensation will be recognized in the same period and in the same manner as if the company had paid cash for goods or services instead of stock.

The guidance doesn’t cover stock compensation that’s used to provide financing to the company that issued the shares. It also doesn’t include stock awards tied to a sale of goods or services as part of a contract accounted for under the new-and-improved revenue recognition standard.

Effective Dates

The updated standard is effective for public companies for fiscal years that begin after December 15, 2018. Private companies have an extra year to implement the changes for annual reports.

Early adoption is generally permitted, but businesses aren’t allowed to follow the changes in ASU No. 2018-07 until they’ve implemented the new revenue recognition standard. Contact us for more information.

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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.

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Public Companies to Disclose Stock Hedging Policies and Practices

Does your company have policies in place regarding the use of hedging transactions by company insiders? Final Securities and Exchange Commission (SEC) guidance will soon require public companies to disclose whether their officers, employees and directors are allowed to offset a decrease in the market value of the company’s stock. Here’s what you should know to provide up-to-date disclosures.

Hedging concerns

Starting in the 1980s and 1990s, many companies adopted stock-compensation programs to help align the financial interests of executives and other company insiders with those of public shareholders. However, in the years leading up to the 2008 financial crisis, the growing prevalence of hedging instruments made many investors suspect those common interests had eroded.

Critics said a short-sale hedge could protect an executive, employee or director who receives stock incentives against a subsequent drop in the stock price. Similarly, selling a stock future increases the value of the insider’s position as the stock price drops.

Disclosure requirements

SEC Release No. 33-10593, Disclosure of Hedging by Employees, Officers, and Directors, was issued on December 20, 2018. Mandated by Section 955 of the Dodd-Frank Act, the rule amends Item 402 of Regulation S-K under the Securities Act of 1933.

The new rule doesn’t direct companies to establish policies regarding hedging. Rather, it requires a company to describe any policies it has adopted regarding the ability of its employees (including officers) or directors to purchase financial instruments that hedge or offset any decrease in the market value of equity securities granted as compensation, or held directly or indirectly by the employee or director. The new disclosure is required in a proxy statement or information statement relating to an election of directors.

The rule requires companies to disclose fully their hedging policies and practices for securities of:

  • The company,
  • Any parent company,
  • Any subsidiary of the company, or
  • Any subsidiary of the company parent.

Alternatively, companies can choose to provide a summary of hedging practices that includes a description of any categories of hedging transactions that are specifically permitted or disallowed. If a company doesn’t have any such policies, it needs to disclose that fact or state that hedging is generally permitted.

Effective date

The new disclosure rule goes into effect for fiscal years beginning on or after July 1, 2019. However, companies that qualify as smaller reporting companies (SRCs) or emerging growth companies (EGCs) will get an extra year to comply.

An SRC has a public float of less than $250 million. EGC is a class of company established in 2012 that’s eligible for lighter disclosure and reporting requirements for the first five years after going public. Listed closed-end funds and foreign private issuers (FPIs) won’t be subject to the new disclosure requirements.

Contact us to help your public company comply with the new SEC rule. We can draft comprehensive disclosures and, if necessary, help you implement effective hedging policies.

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Private Companies: Have You Implemented the New Revenue Recognition Standard?

Private companies that follow U.S. Generally Accepted Accounting Principles (GAAP) must comply with the landmark new revenue recognition standard in 2019. Many private company CFOs and controllers report that they still have significant work to do to meet the demands of the sweeping rules. If you haven’t started the implementation process, it’s time to get the ball rolling.

Lessons from public company peers

Affected private companies must start following Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Accounting Standards Codification Topic 606), the first time they issue financial statements in 2019. For private companies with a fiscal year end or issuing quarterly statements under U.S. GAAP, that could be within the next few months. Other private companies have until the end of the year or even early 2020. No matter what, it’s crunch time.

Public companies, which had to begin following the standard in 2018, reported that, even if the new accounting didn’t radically change the number they reported in the top line of their income statements, it changed the method by which they had to calculate it. They had to comb through contracts and offer paper trails to back up their estimates to auditors. Public companies largely reported that the standard was more work than they anticipated. Private companies can expect the same challenges.

An overview

The revenue recognition standard erases reams of industry-specific revenue guidance in U.S. GAAP and attempts to come up with the following five-step revenue recognition model for most businesses worldwide:

1. Identify the contracts with a customer.2. Identify the performance obligations in the contract.3. Determine the transaction price.4. Allocate the transaction price to the performance obligations.5. Recognize revenue as the entity satisfies a performance obligation.
In many cases, the revenue a company reports under the new guidance won’t differ much from what it reported under old rules. But the timing of when a company can record revenues may be affected, particularly for long-term, multi-part arrangements. Companies also must assess:

  • The extent by which payments could vary due to such terms as bonuses, discounts, rebates and refunds,
  • The extent that collected payments from customers is “probable” and won’t result in a significant reversal in the future, and
  • The time value of money to determine the transaction price.

The result is a process that offers fewer bright-line rules and more judgment calls compared to old U.S. GAAP.

We can help

Our accounting experts can help you avoid a “fire drill” right before your implementation deadline and employ best practices learned from public companies that made the switch in 2018. Contact us for help getting your revenue reporting systems, processes and policies up to speed.

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Evaluating Your Audit Committee

Under the Sarbanes-Oxley Act, the audit committee — not management or the full board of directors — is directly responsible for appointing, compensating and overseeing external auditors. Periodically, it’s a good idea to assess the effectiveness of your audit committee by performing a self-evaluation. Here are reasons to conduct a self-evaluation, along with some common techniques.

Why?

If your company is listed on the New York Stock Exchange, an annual self-evaluation is required. However, the American Institute of Certified Public Accountants (AICPA) recommends that all other companies, including not-for-profit entities and private firms, complete voluntary self-evaluations. The benefits include:

• Improving audit committee performance,
• Promoting candid discussions, and
• Identifying practices and procedures to conduct more effective meetings.

In general, a self-evaluation strives to make your audit committee more effective at assessing fraud risks and evaluating internal and independent auditors.

How?

There’s no universal right way to conduct a self-evaluation. Some companies do it strictly in-house, while others use outside evaluators. Some rely on written questionnaires, while others use personal interviews. According to the AICPA’s Audit Committee Effectiveness Center, common approaches to self-evaluation include:

Introspection. The committee members — and, possibly, the board chair — evaluate the committee’s performance by answering specific questions about the committee’s impact on the financial reporting process and its relationships with management and internal and independent auditors.

Performance improvement. The chief audit executive, CFO, CEO and independent auditor are asked to comment on the committee’s performance.

360-degree. Each committee member (including the chair) evaluates all the other members. To minimize the risk of alienating committee members, consider beginning the process by assessing the committee’s overall performance and then move on to individual performance reviews.

Competence. The committee, others within the company or an outside evaluator assesses the financial literacy of committee members. They look at, among other things, recent training on enterprise risk management, accounting, auditing, financial reporting developments, and current business and industry practices.

Leadership. The committee members discuss the committee chair’s performance, communicating any concerns to the board chair or the chair of the corporate governance committee.

Whichever approach or combination of approaches your company uses, it’s important to phrase questions in terms designed to elicit ideas for improvement rather than to highlight weaknesses.

Need help?

Whether your company is required to perform audit committee self-evaluations or you conduct them voluntarily, careful planning is critical to maximize the benefits. Contact us to help design an effective self-evaluation process based on your company’s specific needs.

© 2019

M&A Due Diligence: Don’t Accept Financial Statements at Face Value

The M&A market was hot last year, and that momentum is expected to continue in 2019. Before acquiring another business, however, it’s important to do your homework. Conducting comprehensive due diligence can be a daunting task, especially if you’ve never negotiated a deal before. So, consider seeking input from an experienced accounting professional.

Reviewing historical performance

For starters, the target company’s historical financial statements must be reviewed. This will help you understand the nature of the company’s operations and the types of assets it owns — and the liabilities it owes.

When reviewing historical results, it’s important to evaluate a full business cycle, including any cyclical peaks and troughs. If a seller provides statements during only peak years, there’s a risk that you could overpay.

Historical financial statements also may be used to determine how much to offer the seller. An offer should be based on how much return the business interest is expected to generate. An accounting expert can project expected returns, as well as provide pricing multiples based on real-world comparable transactions.

Evaluating the target’s historical balance sheet also may help you decide whether to structure the deal as a stock purchase (where all assets and liabilities transfer from the seller to the buyer) or as an asset purchase (where the buyer cherry-picks specific assets and liabilities).

Looking to the Future

Prospective financial statements are typically based on management’s expectations for the future. When reviewing these reports, the underlying assumptions must be critically evaluated, especially for start-ups and other businesses where prospective financials serve as the primary basis for your offer price.

It’s also important to consider who prepared the prospective financials. If forecasts or projections are prepared by an outside accountant, do the reports follow the AICPA standards? You may have more confidence when reports provided by the seller conform to these standards. However, it’s a good idea to hire your own expert to perform an independent analysis, because management may have an incentive to paint a rosy picture of financial performance.

Digging deeper

A target company’s historical balance sheet tells you about the company’s tangible assets, acquired intangibles and debts. But some liabilities may not appear on the financial statements. An accounting expert can help you identify unrecorded liabilities, such as:

•Pending lawsuits and regulatory audits, •Warranty and insurance claims, •Uncollectible accounts receivable, and •Underfunded pensions.
You also need to be skeptical of representations the seller makes to seal a deal. Misrepresentations that are found after closing can lead to expensive legal battles. An earnout provision or escrow account can be used to reduce the risk that the deal won’t pan out as the seller claimed it would.

Avoiding M&A mishaps

Do-it-yourself acquisitions can lead to costly mistakes. In addition to evaluating historical and prospective financial statements, we can help identify potential hidden liabilities and misrepresentations, as well as prepare independent forecasts and projections. We also can help you determine the optimal offer price and deal terms based on an objective review of the target’s historical, prospective and unreported financial information.

© 2019