Accounting and Audit briefs
Assessing the effectiveness of internal controls
Strong internal controls can help prevent and detect fraud. That’s why Section 404(a) of the Sarbanes-Oxley Act (SOX) requires a public company’s management to annually assess the effectiveness of internal controls over financial reporting. And Sec. 404(b) requires the company’s independent auditors to provide an attestation report on management’s assessment of internal controls. Some smaller entities may be exempt from the latter requirement — but not the former one.
Burdensome for smaller entities
When the SEC published the regulations, smaller public companies told the SEC that the costs of complying with Sec. 404(b) would outweigh the benefits for investors. While the SEC explored ways to ease the compliance burden, the compliance deadline for Sec. 404(b) was repeatedly delayed for nonaccelerated filers — companies with a public float of less than $75 million on the last business day of their most recent second fiscal quarter.
In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act instructed the SEC to permanently exempt nonaccelerated filers from SOX Sec. 404(b). Absent this exemption, nonaccelerated filers would have been required to comply with Sec. 404(b) beginning with fiscal years ending on or after June 15, 2010.
New definition provides no new Sec. 404(b) relief
Earlier this year, the SEC expanded its definition of “smaller reporting companies” from companies with a public float of less than $75 million to those with a public float of less than $250 million. This change will allow nearly 1,000 more companies to qualify for a lighter set of disclosure rules available to smaller reporting companies. However, the SEC did not raise the public float thresholds for when a company qualifies as an accelerated filer. This means the $75 million threshold still applies in relation to the Sec. 404(b) exemption.
SEC Commissioners Michael Piwowar and Hester Peirce favored raising the accelerated filer threshold to $250 million to expand the number of companies that would be exempt from Sec. 404(b). But, based on feedback from auditors and investor advocate groups, SEC Chairman Jay Clayton decided to keep the current threshold at $75 million — at least for now.
It’s also important to note that not all companies with a public float of less than $75 million are considered nonaccelerated filers. If a company’s public float drops below $75 million, it continues to be an accelerated filer until it drops below $50 million, and thereby “exits” accelerated status.
Still on the hook
Even if your company is exempt from Sec.404(b), you’re still responsible for assessing the effectiveness of internal controls over financial reporting pursuant to Sec. 404(a). Contact us for any questions about complying with the SOX rules or for information regarding best practices in internal
Audit opinions: How your financial statements measure up
Audit opinions differ depending on the information available, financial viability, errors discovered during audit procedures and other limiting factors. The type of opinion your auditor issues tells stakeholders whether you’re in compliance with accounting rules and likely to continue operating as a going concern.
To find out what type of audit opinion you’ve received, scan the first page of your financial statements. Known as the “audit opinion letter,” this is where your auditor states whether the financial statements are fairly presented in all material respects, compliant with Generally Accepted Accounting Principles (GAAP) and free from material misstatement. But the opinion doesn’t constitute an endorsement or evaluation of the company’s financial results.
Most audit opinion letters consist of three paragraphs. The introductory paragraph identifies the company, accounting period and auditor’s responsibilities. The second discusses the scope of work performed. The third paragraph contains the audit opinion.
In general, there are four types of audit opinions, ranked from most to least desirable.
1. Unqualified. A clean “unqualified” opinion is the most common (and desirable). Here the auditor states that the company’s financial condition, position and operations are fairly presented in the financial statements.
2. Qualified. The auditor expresses a qualified opinion if the financial statements appear to contain a small deviation from GAAP, but are otherwise fairly presented. To illustrate: An auditor will “qualify” his or her opinion if a borrower incorrectly estimates warranty expense, but the exception doesn’t affect the rest of the financial statements.
Qualified opinions are also given if the company’s management limits the scope of audit procedures. For example, a qualified opinion may result if you deny the auditor access to a warehouse to observe year-end inventory counts.
3. Adverse. When an auditor issues an adverse opinion, there are material exceptions to GAAP that affect the financial statements as a whole. Here the auditor indicates that the financial statements aren’t presented fairly. Typically, an adverse opinion letter contains a fourth paragraph that outlines these exceptions.
4. Disclaimer. Even more alarming to lenders and investors is a disclaimer opinion. Disclaimers occur when an auditor gives up midaudit. Reasons for disclaimers may include significant scope limitations, material doubt about the company’s going-concern status and uncertainties within the subject company itself. A disclaimer opinion letter briefly outlines the auditor’s reasons for throwing in the towel.
Ready, set, audit
Before fieldwork starts for the audit of your 2018 financial statements, let’s discuss any foreseeable scope limitations and possible deviations from GAAP. Depending on the situation, we may be able to recommend corrective actions and help you proactively communicate with stakeholders about the reasons for a less-than-perfect audit opinion.
Should cloud computing setup costs be expensed or capitalized?
Companies will be able to capitalize, or spread out the costs of, setting up pricey business systems that operate on cloud technology under an update to U.S. Generally Accepted Accounting Principles (GAAP). Here are the details.
FASB responds to business complaints
Over the last three years, businesses have complained to the Financial Accounting Standards Board (FASB) about the different accounting treatment for cloud-based services vs. those operated on physical servers onsite. Businesses told the FASB that the economics of these arrangements are virtually the same.
As more businesses moved to cloud-based business applications, those complaints grew louder. So, in August, the FASB published Accounting Standards Update (ASU) No. 2018-15, Intangibles — Goodwill and Other — Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract.
Existing GAAP “resulted in unnecessary complexity and needed to be updated to reflect emerging transactions in cloud computing arrangements that are service contracts,” FASB Chairman Russell Golden said in a statement. “To address this diversity in practice, this standard aligns the accounting for implementation costs of hosting arrangements — regardless of whether they convey a license to the hosted software.”
Old rules, new rules
Under existing GAAP, the accounting for services managed in the cloud differs depending on the type of contract a business has with a software provider. When a cloud computing (or hosting) arrangement doesn’t include a software license, the arrangement must be accounted for as a service contract. This means businesses must expense the costs as incurred.
Under the updated guidance, businesses will be able to treat the expenses of reconfiguring their systems and setting up cloud-managed business services as long-term assets and amortize them over the life of the arrangement.
The update also will align the accounting for implementation costs for cloud-managed systems with the accounting for costs associated with developing or obtaining internal-use software. Businesses will have to record the expense related to the capitalized implementation costs in the same line item in the income statement as the expense for the fees for the hosting arrangement.
The update is effective for public businesses for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. (This means 2020 for calendar-year companies.) For all other entities, the update is effective for annual reporting periods beginning after December 15, 2020, and interim periods within annual periods beginning after December 15, 2021. Early adoption is also permitted.
Auditing royalty agreements
Companies often grant licenses to others allowing them to use intellectual property — such as a patent or proprietary computer code — in exchange for royalties. Licensors can hire an external audit firm to ensure the licensee pays the correct royalty rate and amount. Here’s how the audit process works.
The parties’ attorneys usually create a royalty agreement that governs the use of the intellectual property. This legal contract between the licensor and licensee details the terms of the arrangement. It spells out how the licensee may use the asset, the duration of the license and how much the licensee agrees to pay the licensor in royalties for the right to use the asset.
Unfortunately, royalty payments sometimes fall short of the agreed-upon amount. This may be due to a clerical error, confusion regarding the agreement’s terms — or even fraud. To detect and deter shortfalls, most contracts include a “right-to-audit” clause, meaning that the licensor retains the legal right to hire an outside firm to audit the licensee’s payments to confirm compliance with the terms detailed in the agreement.
The auditor’s role
When auditing royalty agreements, CPAs typically perform the following six steps:
- Review the agreement to understand its scope, including the asset under license, the duration of the contract, prohibited uses and the royalty rate.
- Analyze sales data used to derive royalty payments to date. Depending on the type of asset under license, the audit team may request production and inventory records.
- Perform a detailed walk-through of the process the licensee follows to identify, track and report sales subject to a royalty payment.
- Conduct random sampling of sales data to ensure the licensee applies the correct rate to generate the royalty payment.
- Review sales and royalty payment trends to confirm that the licensee’s sales align with the royalty payments.
- Gather individual invoices from key customers to locate and confirm that sales transactions subject to royalties actually generated a royalty payment.
Usually, the licensor assumes the cost of the royalty audit. However, some agreements include a clause that requires the licensee to assume responsibility for the cost of the audit if the audit uncovers underpayment of royalties by a certain margin.
Keep licensees on their toes
Most licensing arrangements function without a hitch. But a minor error or oversight could result in a significant shortfall in royalty payments. Periodic royalty audits can prevent small, but honest, mistakes from spiraling out of control — and help reduce the temptation for dishonest licensees to commit fraud. Contact us to discuss the benefits of auditing your royalty agreements.
Cash vs. accrual reporting: Which is right for your business?
Small businesses often use the cash-basis method of accounting. As businesses grow, they usually convert to accrual-basis reporting for federal tax purposes and to conform with U.S. Generally Accepted Accounting Principles (GAAP).
Starting this tax year, the Tax Cuts and Jobs Act (TCJA) has increased the threshold for businesses that qualify for the simpler cash method for federal tax purposes. Here’s how these accounting methods compare and how the TCJA could affect your financial and tax reporting decisions.
Companies that use the cash-basis method of accounting recognize revenue as customers pay invoices and expenses as they pay bills. So, cash-basis entities often report large fluctuations in profits from period to period, especially if they’re engaged in long-term projects. This can make it hard to benchmark a company’s performance from year to year — or against other entities that use the accrual method.
Cash-basis entities also tend to postpone revenue recognition and accelerate expense payments at year end. This strategy can temporarily defer the company’s tax liability. But the flipside is that it can make a company appear less profitable to lenders and investors.
The more complex accrual-basis accounting method conforms to the matching principle under GAAP. That is, revenue (and expenses) are “matched” to the periods in which they’re earned (or incurred).
Accrual-basis entities report several asset and liability accounts that are generally absent on a cash-basis balance sheet. Examples include prepaid expenses, accounts receivable, accounts payable, work in progress, accrued expenses and deferred taxes.
Under the TCJA, for tax years beginning after 2017, businesses with average annual gross receipts of $25 million or less for the previous three tax years are eligible for the cash method of accounting for federal income tax purposes. Under prior law, the gross-receipts threshold for the cash method was only $5 million.
In addition, for tax years beginning after 2017, 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. So, if you use the accrual method for financial reporting purposes, you must also use it for federal income tax purposes.
These changes could prompt more companies to opt for the simpler, tax-deferred cash method for both financial reporting and tax purposes. But it’s not right for everyone.
Look before you leap
As your small business grows, you might be tempted to switch to the accrual method of accounting to reduce variability in financial reporting from year to year — and to attract more sophisticated lenders and investors who prefer GAAP financials. But doing so could accelerate your tax obligations. On the other hand, if you’re newly eligible for the cash method for tax purposes, you may want to switch to that method for the simplicity and tax deferral it offers.
If you’re in either situation, contact us to discuss the pros and cons of these two options to ensure you’re using the optimal method based on your circumstances.
Sustainability reports look beyond the numbers
In recent years, environmental, social and governance (ESG) issues have become a hot topic. Many companies voluntarily include so-called “sustainability disclosures” about these issues in their financial statements. But should the Securities and Exchange Commission (SEC) make these disclosures mandatory and more consistent?
Identifying ESG issues
The term “sustainability” refers to anything that helps your company sustain itself — its people, its profits — into the future. A variety of nonfinancial issues fall under the ESG umbrella, including:
- Pollution and carbon emissions,
- Union relations,
- Political spending,
- Tax strategies,
- Employee training and education programs,
- Diversity practices,
- Health and safety matters, and
- Human rights policies.
There’s often a link between ESG issues and financial performance. For example, regulatory violations can lead to fines, remedial costs and reputational damage. And the sale of toxic or unsafe products can result in product liability lawsuits, recalls and boycotts.
On the flipside, identifying and successfully navigating ESG issues can add value by building trust with stakeholders, providing improved access to capital and lower borrowing costs, and enhancing loyalty with customers and employees. Tracking sustainability also helps companies identify ways to reduce their energy consumption, streamline their supply chains, eliminate waste and operate more efficiently.
Studying the costs of mandatory disclosures
Currently, most sustainability disclosures are made voluntarily. The Securities and Exchange Commission (SEC) does require companies to describe the effects of climate change under Release No. 33-9106, Commission Guidance Regarding Disclosure Related to Climate Change. Unfortunately, these disclosures have been criticized by investors for being too general and not useful.
Recently, Sen. Mark Warner (D-VA) asked the Government Accountability Office (GAO) — an independent, nonpartisan U.S. government watchdog agency — to study the costs of requiring public companies to make ESG disclosures. His letter to the GAO references a 2015 survey, which found that 73% of institutional investors take ESG issues into consideration when they’re evaluating investment or voting decisions and managing investment risks.
Specifically, Warner asked the GAO to:
- Analyze the effect of revising U.S. Generally Accepted Accounting Principles (GAAP) to account for ESG issues,
- Evaluate the extent to which 1) companies address ESG issues in their disclosures, and 2) investors seek ESG disclosures and why,
- Identify possible regulatory and nonregulatory actions that could improve and standardize ESG disclosures, and
- Compare U.S. and foreign ESG disclosure regimes.
A major downside to today’s disclosures is inconsistency. Warner would like the GAO to explore ways to help investors “understand the likelihood of ESG risks and cut through boilerplate disclosure.”
Not everyone wants the GAO to proceed with the study, however. Some business groups, including the U.S. Chamber of Commerce and Business Roundtable, believe the SEC should focus on providing material information to investors and not cater to what they call “special interest groups.”
It’s uncertain whether ESG disclosures will become mandatory, but many companies already share information about green business practices, diversity programs, fraud prevention policies and other ESG issues. These disclosures can help add long-term value and improve relationships with stakeholders. Contact us for help preparing or auditing an independent, integrated sustainability report for 2018.
How to trim the fat from your inventory
Inventory is expensive. So, it needs to be as lean as possible. Here are some smart ways to cut back inventory without compromising revenue and customer service.
Objective inventory counts
Effective inventory management starts with a physical inventory count. Accuracy is essential to knowing your cost of goods sold — and to identifying and remedying discrepancies between your physical count and perpetual inventory records. A CPA can introduce an element of objectivity to the counting process and help minimize errors.
The next step is to compare your inventory costs to those of other companies in your industry. Trade associations often publish benchmarks for:
- Gross margin [(revenue – cost of sales) / revenue],
- Net profit margin (net income / revenue), and
- Days in inventory (annual revenue / average inventory × 365 days).
Your company should strive to meet — or beat — industry standards. For a retailer or wholesaler, inventory is simply purchased from the manufacturer. But the inventory account is more complicated for manufacturers and construction firms; it’s a function of raw materials, labor and overhead costs.
The composition of your company’s cost of goods will guide you on where to cut. In a tight labor market, it’s hard to reduce labor costs. But it may be possible to renegotiate prices with suppliers.
And don’t forget the carrying costs of inventory, such as storage, insurance, obsolescence and pilferage. You can also improve margins by negotiating a net lease for your warehouse, installing antitheft devices or opting for less expensive insurance coverage.
To cut your days-in-inventory ratio, compute product-by-product margins. Stock more products with high margins and high demand — and less of everything else. Whenever possible, return excessive supplies of slow moving materials or products to your suppliers.
Product mix can be a delicate balance, however. It should be sufficiently broad and in tune with consumer needs. Before cutting back on inventory, you might need to negotiate speedier delivery from suppliers or give suppliers access to your perpetual inventory system. These precautionary measures can help prevent lost sales due to lean inventory.
Another important metric that’s not available from benchmarking studies is reorder point. That’s the quantity level that triggers a new order. Reorder point is a function of your volume and the purchase order lead time. If your suppliers have access to your inventory system, they can automatically ship additional stock once inventory levels reach the reorder point.
Take inventory of your inventory
Often management is so focused on sales, HR issues and product innovation that they lose control over inventory. Contact us for a reality check. We can provide industry benchmarks and calculate ratios to help minimize the guesswork in managing your inventory.