Accounting and Audit briefs
How auditors use nonfinancial information
Every financial transaction your company records generates nonfinancial data that doesn’t have a dollar value assigned to it. Though auditors may spend most of their time analyzing financial records, nonfinancial data can also help them analyze your business from multiple angles.
Gathering audit evidence
The purpose of an audit is to determine whether your financial statements are “fairly presented in all material respects, compliant with Generally Accepted Accounting Principles (GAAP) and free from material misstatement.” To thoroughly assess these issues, auditors need to expand their procedures beyond the line items recorded in your company’s financial statements.
Nonfinancial information helps auditors understand your business and how it operates. During planning, inquiry, analytics and testing procedures, auditors will be on the lookout for inconsistencies between financial and nonfinancial measures. This information also helps auditors test the accuracy and reasonableness of the amounts recorded on your financial statements.
Looking beyond the numbers
A good starting point is a tour of your facilities to observe how and where the company spends its money. The number of machines operating, the amount of inventory in the warehouse, the number of employees and even the overall morale of your staff can help bring to life the amounts shown in your company’s financial statements.
Auditors also may ask questions during fieldwork to help determine the reasonableness of financial measures. For instance, they may ask you for detailed information about a key vendor when analyzing accounts payable. This might include the vendor’s ownership structure, its location, copies of email communications between company personnel and vendor reps, and the name of the person who selected the vendor. Such information can give the auditor insight into the size of the relationship and whether the timing and magnitude of vendor payments appear accurate and appropriate.
Your auditor may even look outside your company for nonfinancial data. Many websites allow customers and employees to submit reviews of the company. These reviews can provide valuable insight regarding the company’s inner workings. If the reviews uncover consistent themes — such as an unwillingness to honor product guarantees or allegations of illegal business practices — it may signal deep-seated problems that require further analysis.
Facilitating the audit process
Auditors typically ask lots of questions and request specific documentation to test the accuracy and integrity of a company’s financial records. While these procedures may seem probing or superfluous, analyzing nonfinancial data is critical to issuing a nonqualified audit opinion. Let’s work together to get it right!
AUP engagements: A middle ground between audits and consulting services
Your CPA offers a wide menu of services. An audit is a familiar type of attestation service that provides a formal opinion about whether the company’s financial statements conform to U.S. Generally Accepted Accounting Principles (GAAP).
Consulting services, in contrast, provide advice or technical assistance that’s only for internal purposes. That is, lenders and other third parties can’t rely on the findings, conclusions and recommendations presented during a consulting project.
If you need a report that falls somewhere between these alternatives, consider an agreed upon procedures (AUP) engagement.
An AUP engagement uses procedures similar to an audit, but on a limited scale. It can be used to identify specific problems that require immediate action. When performing an AUP engagement, your CPA makes no formal opinion; he or she simply acts as a fact finder. The report lists:
- The procedures performed, and
- The CPA’s findings.
It’s the user’s responsibility to draw conclusions based on those findings. AUP engagements may target specific financial data (such as accounts payable, accounts receivable or related party transactions), nonfinancial information (such as a review of internal controls or compliance with royalty agreements), a specific financial statement (such as the income statement or balance sheet) or even a complete set of financial statements.
AUP engagements boast several advantages. They can be performed at any time during the year, and they can be relied on by third parties. Plus, you have the flexibility to choose only those procedures you feel are necessary, so AUP engagements can be cost-effective.
Specifically, AUP engagements can be useful:
- In M&A due diligence,
- When a business owner suspects an employee of misrepresenting financial results, and
- To determine compliance with specific regulatory requirements, such as the Health Insurance Portability and Accountability Act (HIPAA) or the Federal Information Security Management Act (FISMA).
In addition, lenders or franchisors may request an AUP engagement if they have doubts or questions about a company’s financials or the effectiveness of its internal controls — or if they want to check on the progress of a distressed company’s turnaround plan.
AUP engagements can be performed to supplement audits and consulting engagements — or as a standalone service. We can help you customize an AUP engagement that fits the needs of your business and its stakeholders.
Measuring “fair value” for financial reporting purposes
The standard for valuing certain assets and liabilities under U.S. Generally Accepted Accounting Principles (GAAP) is “fair value.” This differs from other valuation standards that may apply when valuing a security or business interest in a litigation or mergers and acquisitions (M&A) setting.
The Financial Accounting Standards Board (FASB) issued Accounting Standards Codification (ASC) Topic 820, Fair Value Measurements and Disclosures, in 2006. It defines fair value as “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.”
The statement unified approximately 60 existing accounting pronouncements that used this term. Among the items currently reported at fair value (rather than historic cost) are asset retirement obligations, derivatives and intangible assets acquired in a business combination.
The statement also establishes a “fair value hierarchy” that emphasizes market-based valuation methods. In order of decreasing relevance, the following factors should be considered when measuring fair value:
- Quoted prices in active markets for identical assets or liabilities,
- Quoted prices in active markets for similar assets or liabilities, or other “observable” inputs, and
- Unobservable inputs, such as the reporting entity’s own data.
When the recession hit in 2008, the FASB advised companies to use internal assumptions, such as expected cash flows and appropriately risk-adjusted discount rates, to value securities when relevant market data is unavailable. FASB guidance said that, in times of “market dislocation,” market prices may not always be determinative of fair value. Rather, valuations “may require the use of significant judgment about whether individual transactions are forced liquidations or distressed sales.”
Different purposes, different standards
Though it may be tempting to “recycle” valuations prepared for litigation or M&A purposes for use in financial reporting (or vice versa), the values may not be equivalent. That’s because different standards sometimes apply, depending on the purpose of the valuation.
For example, “fair value” in an oppressed shareholder or divorce case may be statutorily defined and based on relevant case law. Likewise, “strategic value,” which is commonly used in M&As, may include buyer-specific synergies and, therefore, warrant a premium above the price others in the marketplace would pay.
In addition, the FASB specifically avoided using the term “fair market value” in ASC 820. This term applies to valuations prepared for federal tax purposes. The rationale was that the FASB wanted to separate its guidance from the extensive body of IRS guidance and Tax Court precedent. The term “fair value” has less baggage tied to it and allowed the FASB to start with a clean slate.
Use valuation experts
Estimating fair value, like any valuation assignment, generally requires the use of specialists who are independent of your audit team. Contact us for more information about fair value measurements.