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Cutoffs: What counts in 2020 vs. 2021

As year end approaches, it’s a good idea for calendar-year entities to review the guidelines for recognizing revenue and expenses. There are specific rules regarding accounting cutoffs under U.S. Generally Accepted Accounting Principles (GAAP). Strict observance of these rules is generally the safest game plan.

The basics

Companies that follow GAAP must use the accrual method of accounting, not the cash method. That means revenues and expenses must be matched to the periods in which they were earned or incurred. The end of the period serves as a “cutoff” for recognizing revenue and expenses. For a calendar-year business, the cutoff is December 31.

However, some companies may be tempted to play timing games to lower taxes or boost financial results. The temptation might be especially high in 2020, as many companies struggle during the COVID-19 pandemic.

Now or later

Test your understanding of the cutoff rules with these two hypothetical situations:

  1. As of December 31, a calendar-year, accrual-basis auto dealership has verbally negotiated a deal on an SUV. But the customer hasn’t yet signed all the paperwork. Should the sale be reported in 2020 or 2021?
  2. On December 30, a calendar-year, accrual-basis retailer pays its rent bill for January. Rent is due on the first day of the month. Can the store deduct the extra month’s rent in 2020 to help lower its tax bill?

In both examples, the transactions should be reported in 2021, not 2020. In the first example, even if the customer takes the car home for the weekend, it doesn’t matter; there’s still the possibility the customer could back out of the deal. The dealership can’t report the transaction in 2020 revenue until the customer has signed the paperwork and paid for the vehicle with cash or financing.

Audit procedures

If your financial statements are audited, your CPA will enforce strict cutoff rules — and likely reverse any items that were reported inaccurately. Audit procedures may include reviewing customer contracts and returns reported near year end. Auditors also may compare expenses as a percentage of revenues from period to period to identify timing errors. And they may vouch expenses to invoices and contracts for accuracy.

It never reflects favorably — in the eyes of investor or lenders — when auditors adjust year-end financial statements for inaccurate observation of cutoffs. Don’t give cause for others to wonder about your operations.

Timing is critical

Contact us if you need help understanding the rules on when to record revenue or expenses. We can help you comply with the rules and minimize financial statement adjustments during your audit.

© 2020

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Put your company’s financial statements to work for you

1. Benchmarking

Historical financial statements can be used to evaluate the company’s current performance vs. past performance or industry norms. A comprehensive benchmarking study includes the following elements:

Size. This is usually in terms of annual revenue, total assets or market share.

Growth. This shows how much the company’s size has changed from previous periods.

Liquidity. Working capital ratios help assess how easily assets can be converted into cash and whether current assets are sufficient to cover current liabilities.

Profitability. This section evaluates whether the business is making money from operations — before considering changes in working capital accounts, investments in capital expenditures and financing activities.

Turnover. Such ratios as total asset turnover (revenue divided by total assets) or inventory turnover (cost of sales divided by inventory) show how effectively the company manages its assets.

Leverage. This refers to how the company finances its operations — through debt or equity. Each has pros and cons.

No universal benchmarks apply to all types of businesses. So, it’s important to seek data sorted by industry, size and geographic location, if possible. To understand what’s normal for businesses like yours, consider such sources as trade journals, conventions or local roundtable meetings. Your accountant can also provide access to benchmarking studies they use during audits, reviews and consulting engagements.

2. Forecasting

Historical financial statements also may serve as the starting point for forecasting, which is a critical part of strategic planning. Comprehensive business plans include forecasted balance sheets, income statements and statements of cash flows.

Many items in your forecasts will be derived from revenue. For example, variable expenses and working capital accounts are often assumed to grow in tandem with revenue. Other items, such as rent and management salaries, are fixed over the short run. These items may need to increase in steps over the long run. For example, if a company is currently at (or near) full capacity, it may eventually need to expand its factory or purchase equipment to grow.

By tracking sources and uses of cash on the forecasted statement of cash flows, management can identify when cash shortfalls might happen and plan how to make up the difference. For example, the company might need to draw on its line of credit, lay off workers, reduce inventory levels or improve its collections. In turn, these changes will flow through to the company’s forecasted balance sheet.

For more information

Let’s take your financial statements to the next level! We can help you benchmark your company’s performance and create forecasts from your year-end financial statements.

© 2020

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Preparing for the possibility of a remote audit

The coming audit season might be much different than seasons of yore. As many companies continue to operate remotely during the COVID-19 pandemic, audit procedures are being adjusted accordingly. Here’s what might change as auditors work on your company’s 2020 year-end financial statements.

Eye on technology

Fortunately, when the pandemic hit, many accounting firms already had invested in staff training and technology to work remotely. For example, they were using cloud computing, remote access, videoconferencing software and drones with cameras. These technologies were intended to reduce business disruptions and costs during normal operating conditions. But they’ve also helped firms adapt while businesses are limiting face-to-face contact to prevent the spread of COVID-19.

When social distancing measures went into effect in the United States around mid-March, many calendar-year audits for 2019 were already done. As we head into the next audit season, be prepared for the possibility that most procedures — from year-end inventory observations to management inquiries and audit testing — to be performed remotely. Before the start of next year’s audit, discuss which technologies your audit team will be using to conduct inquiries, access and verify data, and perform testing procedures.

Emphasis on high-risk areas

During a remote audit, expect your accountant to target three critical areas to help minimize the risk of material misstatement:

1. Internal controls. Historically, auditors have relied on the effectiveness of a client’s controls and testing of controls. Now, they must evaluate how transactions are being processed by employees who work remotely, rather than on-site as in prior periods. Specifically, your auditor will need to consider whether modified controls have been adequately designed and put into place and whether they’re operating effectively.

2. Fraud and financial misstatement. During fieldwork, auditors interview key managers and those charged with governance about fraud risks. These inquiries are most effective when done in person, because auditors can read body language and, if more than one person is present during an interview, judge the dynamics in a room. Auditors may request video conferences to help overcome the shortcomings of inquiries done over the phone or via email.

3. Physical inventory counts. Normally, auditors go where inventory is located and observe the counting process. They also perform independent test counts and check them against the inventory records. Depending on the COVID-19 situation at the time of an audit, auditors may be unable to travel to the company’s facilities, and employees might not be there physically to perform the counts. Drones, videoconferencing and live video feeds from a warehouse’s security cameras may be suitable alternatives to on-site observations.

Modified reports

In some cases, audit firms may be unable to perform certain procedures remotely, due to technology limitations or insufficient access to data needed to comply with all the requirements of the auditing standards. In those situations, your auditor might decide to issue a modified audit report with scope restrictions and limitations. Contact your CPA for more information about remote auditing and possible modifications to your company’s audit report.

© 2020

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Avoiding conflicts of interest with auditors

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A conflict of interest could impair your auditor’s objectivity and integrity and potentially compromise you company’s financial statements. That’s why it’s important to identify and manage potential conflicts of interest.

What is a conflict of interest?

According to the America Institute of Certified Public Accountants (AICPA), “A conflict of interest may occur if a member performs a professional service for a client and the member or his or her firm has a relationship with another person, entity, product or service that could, in the member’s professional judgment, be viewed by the client or other appropriate parties as impairing the member’s objectivity.” Companies should be on the lookout for potential conflicts when:

  • Hiring an external auditor,
  • Upgrading the level of assurance from a compilation or review to an audit, and
  • Using the auditor for a non-audit purposes, such as investment advisory services and human resource consulting.

Determining whether a conflict of interest exists requires an analysis of facts. Some conflicts may be obvious, while others may require in-depth scrutiny.

For example, if an auditor recommends an accounting software to an audit client and receives a commission from the software provider, a conflict of interest likely exists. Why? While the software may suit the company’s needs, the payment of a commission calls into question the auditor’s motivation in making the recommendation. That’s why the AICPA prohibits an audit firm from accepting commissions from a third party when it involves a company the firm audits.

Now consider a situation in which a company approaches an audit firm to provide assistance in a legal dispute with another company that’s an existing audit client. Here, given the inside knowledge the audit firm possesses of the company it audits, a conflict of interest likely exists. The audit firm can’t serve both parties to the lawsuit and comply with the AICPA’s ethical and professional standards.

How can auditors prevent potential conflicts?

AICPA standards require audit firms to be vigilant about avoiding potential conflicts. If a potential conflict is unearthed, audit firms have the following options:

  • Seek guidance from legal counsel or a professional body on the best path forward,
  • Disclose the conflict and secure consent from all parties to proceed,
  • Segregate responsibilities within the firm to avoid the potential for conflict, and/or
  • Decline or withdraw from the engagement that’s the source of the conflict.

Ask your auditors about the mechanisms the firm has put in place to identify and manage potential conflicts of interest before and during an engagement. For example, partners and staff members are usually required to complete annual compliance-related questionnaires and participate in education programs that cover conflicts of interest. Firms should monitor conflicts regularly, because circumstances may change over time, for example, due to employee turnover or M&A activity.

For more information

Conflicts of interest are one of the gray areas in auditing. But it’s an issue our firm takes seriously and proactively safeguards against. If you suspect that a conflict exists, contact us to discuss the matter and determine the most appropriate way to handle it.

© 2020

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Why face-to-face meetings with your auditor are important

Woman having video chat on laptop at at office

Remote audit procedures can help streamline the audit process and protect the parties from health risks during the COVID-19 crisis. However, seeing people can be essential when it comes to identifying and assessing fraud risks during a financial statement audit. Virtual face-to-face meetings can be the solution.

Asking questions

Auditing standards require auditors to identify and assess the risks of material misstatement due to fraud and to determine overall and specific responses to those risks. Specific areas of inquiry under Clarified Statement on Auditing Standards (AU-C) Section 240, Consideration of Fraud in a Financial Statement Audit include:

  • Whether management has knowledge of any actual, suspected or alleged fraud,
  • Management’s process for identifying, responding to and monitoring the fraud risks in the entity,
  • The nature, extent and frequency of management’s assessment of fraud risks and the results of those assessments,
  • Any specific fraud risks that management has identified or that have been brought to its attention, and
  • The classes of transactions, account balances or disclosures for which a fraud risk is likely to exist.

In addition, auditors will inquire about management’s communications, if any, to those charged with governance about the management team’s process for identifying and responding to fraud risks, and to employees on its views on appropriate business practices and ethical behavior.

Seeing is believing

Traditionally, auditors require in-person meetings with managers and others to discuss fraud risks. That’s because a large part of uncovering fraud involves picking up on nonverbal cues of dishonesty. In a face-to-face interview, the auditor can, for example, observe signs of stress on the part of the interviewee in responding to the question.

However, during the COVID-19 pandemic, in-person meetings may give rise to safety concerns, especially if either party is an older adult or has underlying medical conditions that increase the risk for severe illness from COVID-19 (or lives with a person who’s at high risk). In-person meetings with face masks also aren’t ideal from an audit perspective, because they can muffle speech and limit the interviewer’s ability to observe facial expressions.

A videoconference can help address both of these issues. Though some people may prefer the simplicity of telephone or audioconferences, the use of up-to-date videoconferencing technology can help retain the visual benefits of in-person interviews. For example, high-definition videoconferencing equipment can allow auditors to detect slight physical changes, such as smirks, eyerolls, wrinkled brows and even beads of sweat. These nonverbal cues may be critical to assessing an interviewee’s honesty and reliability.

Risky business

Evaluating fraud risks is a critical part of your auditor’s responsibilities. You can facilitate this process by anticipating the types of questions your auditor will ask and ensuring your managers and accounting personnel are all familiar with how videoconferencing technology works. Contact us for more information.

© 2020

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

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

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

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

3 levels

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

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

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

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

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

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

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

Time for a change?

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

© 2020

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Promoting and reporting diversity

Increasing diversity is a key initiative at many companies in 2020. This movement goes beyond social responsibility — it can lead to better-informed decision-making, improved productivity and enhanced value. Congress has also jumped on the diversity-and-inclusion bandwagon: Legislation is in the works that would require public companies to expand their disclosures about diversity.

Good for business

Even though it’s not reported on the balance sheet, an assembled workforce is one of your most valuable business assets. From the boardroom to the production line, people are essential to converting hard assets into revenue. However, the tone of any organization starts at the top, where key decisions are made.

Academic research has found that boards with diverse members have better financial reporting quality and are more likely to hold management accountable for poor financial performance. This concept also extends to private companies: Management teams with people from diverse backgrounds and functional areas expand the business’s abilities to respond to growth opportunities and potential threats.

Bills to expand disclosures

The Securities and Exchange Commission (SEC) currently requires limited disclosures on boardroom diversity. Under current SEC rules, a public company must disclose whether and how it considers diversity in identifying board of director nominees. However, the rules don’t provide a definition of diversity.

In recent years, the SEC rules have been criticized for failing to provide useful information to investors. Critics want broader rules that provide more information about corporate board diversity.

In response, Congress is currently considering legislation to expand the SEC disclosure requirements. In November 2019, the House passed the Improving Corporate Governance Through Diversity Act. It would require public companies’ proxy materials to disclose additional diversity information on directors and board nominees.

The Senate introduced a similar bill in March 2020. In addition to expanding proxy statement disclosures, the Senate’s Diversity in Corporate Leadership Act would set up a diversity advisory group within the SEC to recommend ways to increase “gender, racial and ethnic diversity” on public company boards. The group would be tasked with studying strategies to improve diversity on boards of directors and would be required within nine months of its creation to report its findings and recommendations to the SEC, the Senate Banking Committee and the House Financial Services Committee.

In late July, a coalition of industry groups that included the American Bankers Association and U.S. Chamber of Commerce urged the Senate Banking Committee to pass the bill. “Our associations and members support efforts to increase gender, racial, and ethnic diversity on corporate boards of directors, as diversity has become increasingly important to institutional investors, pension funds, and other stakeholders,” the groups said.

Be a leader, not a follower

For now, Congressional legislation on diversity matters appears to have taken a backseat to more pressing matters related to the COVID-19 pandemic. In the meantime, many companies are planning to voluntarily expand their disclosures for 2020. We can help assess your level of boardroom or management team diversity — and provide cutting-edge disclosures that showcase your commitment to race, gender and ethnic diversity in the workplace.

© 2020

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Forecasting Financial Results For A Start-Up Business

There’s a bright side to today’s unprecedented market conditions: Agile people may discover opportunities to start new business ventures. Start-ups need a comprehensive business plan, including detailed financial forecasts, to drum up capital from investors and lenders. Entrepreneurs may also use forecasts as yardsticks for evaluating and improving performance over time.

However, forecasting can be challenging for a business with no track record, especially during today’s unprecedented conditions. Here’s an objective approach to developing forecasts based on realistic, market-based assumptions.

Starting point

Revenue is a critical line item in the forecast, because it drives many other accounts, such as direct costs, accounts receivable and inventory. To create a credible estimate of your start-up’s revenue-generating potential, consider the following questions:

  • What’s the size of the potential market?
  • How many competitors are vying for market share? What positioning strategies will the start-up use to compete?
  • How will the start-up price its products and services? Will its prices fall below, match or surpass those of competitors?
  • How will the start-up distribute products or services?
  • How many customers can the start-up support with its existing infrastructure? How will the start-up scale its operations to meet forecasted increases in demand?

It’s generally a good idea to develop multiple revenue scenarios — best, worst and most likely case. Then weight each scenario based on how likely it is to happen.

Costs and investments

Next, the costs directly attributable to producing revenue, such as materials, utilities and labor, need to be identified and quantified. These variable costs are typically stated as a percentage of forecasted revenue.

Some expenses — such as rent, insurance and administrative salaries — are fixed. That is, they remain constant over the short run, though they often have limited capacity. For example, you might need to add office space and headcount once a start-up grows beyond a certain level.

Besides expenses that are recorded on the income statement, start-ups may need working capital to ramp up operations. They may also need to invest in fixed assets, such as equipment, furniture and software. These expenditures are typically capitalized (reported) on the balance sheet and gradually depreciated their useful lives.

Finally, it’s time to focus on the missing puzzle piece: financing. You may need an initial round of capital to acquire (or produce) inventory, purchase essential assets and generate buzz about your new offering. Plus, start-ups often need ongoing access to capital — such as a revolving line of credit — to help fund the cash conversion cycle as the business grows.

Don’t let a competitor beat you to the punch!

Time is of the essence if you want to capitalize on emerging opportunities. So that you can focus on starting the business, we can help create an objective, defensible financial forecast for your start-up and benchmark your forecasted results against other successful businesses. This diligence will help impress prospective investors and lenders — and build value over the long run.

© 2020

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Steps to a Successful Company Audit

While few companies will experience tax audits, all public and some closely held companies should undergo periodic company audits to stay on top of their businesses. This is an exercise that can fray nerves without preparation. But there are steps you can take to ensure audit success.

GROUNDWORK

Start by selecting your auditor. If your tax professional doesn’t offer this service, ask for a referral experienced with your business type and size. Next, pick your company liaison. This person could be an owner of a small, closely held business or a controller in a larger company.

Talk to your auditor to learn which documents, papers and files you’ll need for the review, and then compare any previous audit’s findings with actions taken. Learn where efficiencies increased and where they didn’t. Remember, an audit is only as good as the actions you undertake to correct identifiable deficiencies.

COMMUNICATION

An audit needs accurate information, so take your emotions out of the auditor relationship and be open and honest about your business. Communicate with your auditor each week to ensure deadlines are met, and expect a written report when the audit is completed.

You have a right to disagree with the audit in writing if you run a public company, and the freedom to take it or leave it if you own a privately held business. Ultimately, a properly conducted audit should help you limit risk, create efficiencies and even increase profits.

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Adjusting your financial statements for COVID-19 tax relief measures

The Coronavirus Aid, Relief, and Economic Security (CARES) Act, signed into law on March 27, 2020, contains several tax-related provisions for businesses hit by the novel coronavirus (COVID-19) crisis. Those provisions will also have an impact on financial reporting.

Companies that issue financial statements under U.S. Generally Accepted Accounting Principles (GAAP) are required to follow Accounting Standards Codification (ASC) Topic 740, Income Taxes. This complicated guidance requires companies to report the effects of new tax laws in the period they’re enacted. As a result, companies — especially those that issue quarterly financial statements or that have fiscal year ends in the coming months — are scrambling to interpret the business tax relief measures under the new law.

Overview of business tax law changes

The CARES Act suspends several revenue-generating provisions of the Tax Cuts and Jobs Act (TCJA). These changes aim to help improve operating cash flow for businesses during the COVID-19 crisis. Specifically, the new law temporarily scales back TCJA deduction limitations on:

  • Net operating losses (NOL),
  • Business tax losses sustained by individuals,
  • Business interest expense, and
  • Charitable contributions for corporations.

The CARES Act also accelerates the recovery of credits for prior-year corporate alternative minimum tax (AMT) liability. And it fixes a TCJA drafting error for real estate qualified improvement property (QIP). The fix retroactively allows a 15-year depreciation period for QIP, making it eligible for first-year bonus depreciation in tax years after the TCJA took effect. The correction allows businesses to choose between first-year bonus depreciation for QIP expenditures and 15-year depreciation.

These changes are subject to numerous rules and restrictions. So, it’s not always clear whether a business will benefit from a particular change. In some cases, businesses may need to file amended federal income tax returns to take advantage of retroactive changes in the law. In addition, a company’s tax obligations may be impacted by relief measures provided in the states and countries where it operates.

Impact on financial reporting

Under ASC 740, companies must adjust deferred tax assets and liabilities for the effect of a change in tax laws or tax rates. On the income statement side, the adjustment is included in income from continuing operations.

If your business follows U.S. GAAP, you’ll need to account for the effect of the CARES Act on deferred tax assets and liabilities for interim and annual reporting periods that include March 27, 2020 (the date the law was signed by President Trump). Also, certain provisions, such as the modified NOL and business interest deduction rules, may impact a company’s current taxes payable. Unfortunately, some companies may have difficulty accurately forecasting income or loss in the current period due to the economic disruptions caused by COVID-19.

Stay tuned

In the coming months, the Financial Accounting Standards Board (FASB) plans to focus on supporting businesses as they navigate the impact of the COVID-19 crisis and providing guidance to clarify financial reporting issues as they arise. We are atop the latest developments and can help guide you through your tax and financial reporting challenges.

© 2020