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Conducting an Effective Post – M&A Audit

So, you’re about to merge with another company. What’s next? The integration process typically starts with audited financial statements that reflect the results and financial position of the combined entity. This exercise requires a close partnership between the external audit team and in-house accounting personnel from both companies. Collaboration is key to a seamless transition.

Prepare the audit team

It’s important to notify your audit team about M&A plans long before a transaction takes place — even if there’s still a chance the deal might fall through. This gives the audit team time to pull specialists together who can help you generate timely, accurate postacquisition financial statements.

For example, you’ll need someone with experience applying the business combination rules under U.S. Generally Accepted Accounting Principles (GAAP) and tax experts who know the rules for reporting different types of deal structures under today’s federal and state tax rules. Likewise, if you’re acquiring a company that uses different accounting systems, you’ll need someone who’s familiar with the acquired company’s software, especially if it’s no longer supported by the vendor.

Anticipate auditor needs

Even if your team of specialists has been assembled in advance, once you’ve merged, expect audit fieldwork to take more time than usual. The auditors will review documents associated with the merger, such as due diligence workpapers and legal documents governing the purchase. They’ll also ask to review prior financial statements and audit reports for the acquired company.

The audit partner might even ask to review board minutes discussing the acquisition, as well as minutes from meetings conducted by the team responsible for the integration of the newly acquired entity.

Documents don’t tell the full story, however. The audit team will interview key members of your team, such as accounting personnel and members of the due diligence team. To streamline the process, designate an employee to serve as the audit liaison. He or she will be the primary point of contact to gather your auditor’s requests for information and access to company employees and executives.

Contact us

M&As provide opportunities to enhance your company’s value. But it’s hard to gauge the relative success of a transaction without reliable, timely financial statements. Our auditors can help you allocate the purchase price to acquired assets and liabilities and otherwise report combined financial results in accordance with U.S. GAAP.

© 2018

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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.

The basics

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.

© 2018

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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.

Cash method

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.

Accrual method

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.

TCJA considerations

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.

© 2018

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Choosing the Right Accounting Method for Tax Purposes

The Tax Cuts and Jobs Act (TCJA) liberalized the eligibility rules for using the cash method of accounting, making this method — which is simpler than the accrual method — available to more businesses. Now the IRS has provided procedures a small business taxpayer can use to obtain automatic consent to change its method of accounting under the TCJA. If you have the option to use either accounting method, it pays to consider whether switching methods would be beneficial.

Cash vs. accrual

Generally, cash-basis businesses recognize income when it’s received and deduct expenses when they’re paid. Accrual-basis businesses, on the other hand, recognize income when it’s earned and deduct expenses when they’re incurred, without regard to the timing of cash receipts or payments.

In most cases, a business is permitted to use the cash method of accounting for tax purposes unless it’s:

1. Expressly prohibited from using the cash method, or
2. Expressly required to use the accrual method.

Cash method advantages

The cash method offers several advantages, including:

Simplicity. It’s easier and cheaper to implement and maintain.

Tax-planning flexibility. It offers greater flexibility to control the timing of income and deductible expenses. For example, it allows you to defer income to next year by delaying invoices or to shift deductions into this year by accelerating the payment of expenses. An accrual-basis business doesn’t enjoy this flexibility. For example, to defer income, delaying invoices wouldn’t be enough; the business would have to put off shipping products or performing services.

Cash flow benefits. Because income is taxed in the year it’s received, the cash method does a better job of ensuring that a business has the funds it needs to pay its tax bill.

Accrual method advantages

In some cases, the accrual method may offer tax advantages. For example, accrual-basis businesses may be able to use certain tax-planning strategies that aren’t available to cash-basis businesses, such as deducting year-end bonuses that are paid within the first 2½ months of the following year and deferring income on certain advance payments.

The accrual method also does a better job of matching income and expenses, so it provides a more accurate picture of a business’s financial performance. That’s why it’s required under Generally Accepted Accounting Principles (GAAP).

If your business prepares GAAP-compliant financial statements, you can still use the cash method for tax purposes. But weigh the cost of maintaining two sets of books against the potential tax benefits.

Making a change

Keep in mind that cash and accrual are the two primary tax accounting methods, but they’re not the only ones. Some businesses may qualify for a different method, such as a hybrid of the cash and accrual methods.

If your business is eligible for more than one method, we can help you determine whether switching methods would make sense and can execute the change for you if appropriate.

© 2018

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Transitioning to Remote Audits


Are you comfortable communicating electronically with your auditors? If so, a logical next step might be to transition from on-site audit procedures to a more “remote” approach. Remote audits can help reduce the time and cost of preparing audited financial statements.

21st century audits

Traditionally, audit fieldwork has involved a team of auditors camping out for weeks (or even months) in one of the conference rooms at the headquarters of the company being audited. Now, thanks to technological advances — including cloud storage, smart devices and secure data-sharing platforms — many audit firms are testing the feasibility of remote auditing as a replacement for sending auditors on-site.

In addition to saving time and audit fees, allowing auditors to work remotely improves the work-life balance for auditors and in-house accounting personnel. Your employees won’t need to stay glued to their desks for the duration of the audit, because they can respond to the auditor’s inquiries and document requests remotely.

Best practices

Changing the format of an audit requires flexibility, including a willingness to embrace the technology needed to facilitate the exchange, review and analysis of relevant documents. You can facilitate the transition process by:

Being responsive to electronic requests. Auditors who are out of sight shouldn’t be out of mind. Answer all remote requests from your auditors in a timely manner. If a key employee will be on vacation or out of the office for an extended period, give the audit team the contact information for the key person’s backup.

Giving employees access to the requisite software. Sharing documents with remote auditors may require you to install specific software on employees’ computers. But your company’s policies may prohibit employees from downloading software without approval from the IT department.

Before remote auditors start “fieldwork,” ask for a list of software and platforms that will be used to interact with in-house personnel. Give the appropriate employees access and authorization to share audit-related data from your company’s systems. Work with IT specialists to address any security concerns they may have with sharing data with the remote auditors.

Tracking audit progress. With less face-to-face time with your auditors, you have fewer opportunities to receive updates on the team’s progress. Ask the engagement partner to explain how they’ll track the performance of their remote auditors, and how they plan to communicate the team’s progress to in-house accounting personnel.

Wave of the future

Like remote working arrangements with employees and contractors, remote audits are a growing trend that could potentially reduce the costs of preparing financial statements. But not every audit firm or business is ready to embrace remote auditing. Contact us to discuss ways to make next year’s audit more efficient and cost-effective.

© 2018

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Using Analytical Procedures in An Audit Provides Many Benefits

Analytical procedures can make audits more efficient and effective. First, they can help during the planning and review stages of the audit. But analytics can have an even bigger impact when used to supplement substantive testing during fieldwork.

Defining audit analytics

AICPA auditing standards define analytical procedures as “evaluations of financial information through analysis of plausible relationships among both financial and nonfinancial data.” Analytical procedures also investigate “identified fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount.” Examples of analytical tests include trend, ratio and regression analysis.

Using analytical procedures

During fieldwork, auditors can use analytical procedures to obtain evidence, sometimes in combination with other substantive testing procedures, that identifies misstatements in account balances. Analytical procedures are often more efficient than traditional, manual audit testing procedures that typically require the business being audited to produce significant paperwork. Traditional procedures also usually require substantial time to verify account balances and transactions.

Analytical procedures generally follow these five steps:

1. Form an independent expectation about an account balance or financial relationship.
2. Identify differences between expected and reported amounts.
3. Investigate the most probable cause(s) of any discrepancies.
4. Evaluate the likelihood of material misstatement.
5. Determine the nature and extent of any additional auditing procedures needed.

When using analytical procedures, the auditor must establish a threshold that can be accepted without further investigation. This threshold is a matter of professional judgment, but it’s influenced primarily by the concept of materiality and the desired level of assurance.

For differences that are due to misstatement (rather than a plausible explanation), the auditor must decide whether the misstatement is material (individually or in the aggregate). Material misstatements typically require adjustments to the amount reported and may also necessitate additional audit procedures to determine the scope of the misstatement.

Your role in audit analytics

Done right, analytical procedures can help make your audit less time-consuming, less expensive and more effective at detecting errors and omissions. But it’s important to notify your auditor about any major changes to your operations, accounting methods or market conditions that occurred during the current accounting period.

This insight can help auditors develop more reliable expectations for analytical testing and identify plausible explanations for significant changes from the balance reported in prior periods. Moreover, now that you understand the role analytical procedures play in an audit, you can anticipate audit inquiries, prepare explanations and compile supporting documents before fieldwork starts.

© 2018

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Auditing Related-Party Transactions

Business owners generally prefer to work with entities they know and trust. But related-party transactions can provide opportunities for individuals to act in a manner that’s inconsistent with the interests of shareholders. That’s why auditors take pains to identify and properly address related-party transactions.

What is a related party?

Accounting Standards Codification (ASC) Topic 850 defines a related-party transaction as one that takes place between:

  • A parent entity and its subsidiaries,
  • Subsidiaries of a common parent,
  • An entity and trusts for the benefit of its employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of the entity’s management,
  • An entity and its principal owners and managers (or members of their immediate families), and
  • Affiliated entities.

What’s the risk?

Related-party transactions sometimes involve contracts for goods or services that are priced at less (or more) favorable terms than those in similar arm’s length transactions between unrelated third parties. For example, a spinoff business might lease office space from its parent company at below-market rates. Or a closely held manufacturer might pay the owner’s son an above-market salary and various perks that aren’t available to unrelated employees.

How do auditors address these transactions?

Given the potential for double dealing with related parties, auditors spend significant time hunting for undisclosed related-party transactions. Examples of documents and data sources that can help uncover these transactions are:

  • A list of the company’s current related parties and associated transactions,
  • Minutes from board of directors’ meetings, particularly when the board discusses significant business transactions,
  • Disclosures from board members and senior executives regarding their ownership of other entities, participation on additional boards and previous employment history,
  • Bank statements, especially transactions involving intercompany wires, automated clearing house (ACH) transfers, and check payments, and
  • Press releases announcing significant business transactions with related parties.

Audit procedures that target related-party transactions include 1) testing how related-party transactions are identified and coded in the company’s enterprise resource planning (ERP) system, 2) interviewing accounting personnel responsible for reporting related-party transactions in the company’s financial statements, and 3) analyzing presentation of related-party transactions in financial statements.

Accurate, complete reporting of these transactions requires robust internal controls. A company’s vendor approval process should provide guidelines to help accounting personnel determine whether a supplier qualifies as a related party and mark it accordingly in the ERP system. Without the right mechanisms in place, a company may inadvertently omit a disclosure about a related-party transaction.

Get it right

Undisclosed related-party transactions can raise a red flag to lenders and investors — and may even require a business to restate its financial results. Our auditors are committed to finding, disclosing and reporting these transactions in a transparent manner that complies with U.S. Generally Accepted Accounting Principles (GAAP). Contact us for help.

© 2018

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Why Revenue Matters In An Audit

For many companies, revenue is one of the largest financial statement accounts. It’s also highly susceptible to financial misstatement.

When it comes to revenue, auditors customarily watch for fictitious transactions and premature recognition ploys. Here’s a look at some examples of critical issues that auditors may target to prevent and detect improper revenue recognition tactics.

Contractual arrangements

Auditors aim to understand the company, its environment and its internal controls. This includes becoming familiar with key products and services and the contractual terms of the company’s sales transactions. With this knowledge, the auditor can identify key terms of standardized contracts and evaluate the effects of nonstandard terms. Such information helps the auditor determine the procedures necessary to test whether revenue was properly reported.

For example, in construction-type or production-type contracts, audit procedures may be designed to 1) test management’s estimated costs to complete projects, 2) test the progress of contracts, and 3) evaluate the reasonableness of the company’s application of the percentage-of-completion method of accounting.

Gross vs. net revenue

Auditors evaluate whether the company is the principal or agent in a given transaction. This information is needed to evaluate whether the company’s presentation of revenue on a gross basis (as a principal) vs. a net basis (as an agent) complies with applicable standards.

Revenue cutoffs

Revenue must be reported in the correct accounting period (generally the period in which it’s earned). Cutoff testing procedures should be designed to detect potential misstatements related to timing issues, as well as to obtain sufficient relevant and reliable evidence regarding whether revenue is recorded in the appropriate period.

If the risk of improper accounting cutoffs is related to overstatement or understatement of revenue, the procedures should encompass testing of revenue recorded in the period covered by the financial statements — and in the subsequent period.

A typical cutoff procedure might involve testing sales transactions by comparing sales data for a sufficient period before and after year end to sales invoices, shipping documentation or other evidence. Such comparisons help determine whether revenue recognition criteria were met and sales were recorded in the proper period.

Renewed attention

Starting in 2018 for public companies and 2019 for other entities, revenue must be reported using the new principles-based guidance found in Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. The updated guidance doesn’t affect the amount of revenue companies report over the life of a contract. Rather, it affects the timing of revenue recognition.

In light of the new revenue recognition standard, companies should expect revenue to receive renewed attention in the coming audit season. Contact us to help implement the new revenue recognition rules or to discuss how the changes will affect audit fieldwork.

© 2018

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How Auditors Assess Risk When Preparing Financial Statements

Every year, your audit firm will conduct a fresh risk assessment before the start of fieldwork. Why? Because your auditor wants to mitigate the risk of expressing an incorrect opinion regarding the accuracy and integrity of the company’s financial statements. Inadvertently signing off on financial statements that contain material misstatements can open a Pandora’s box of risks — from shareholder lawsuits to increased regulatory oversight.

3-prong assessment

Audit risk is a combination of three components:

1. Control risk. Sometimes a company’s internal controls are inadequate to prevent or detect material misstatements. Control risk increases when the company fails to deploy and enforce effective internal controls, or when employees or third parties override them without the company discovering their actions.

2. Inherent risk. This term refers to susceptibility to a material misstatement, regardless of whether the company has strong internal controls. Certain transactions and industries present greater inherent risk than others.

For example, companies operating in developing countries face a greater threat of bribery and corruption by government officials, regardless of the internal controls they put in place. Inherent risk is also greater when accounting transactions are complex or involve a high degree of judgment.

3. Detection risk. Audit procedures are designed to uncover material misstatements. Detection risk is high when there’s a high probability that substantive audit procedures will fail to detect a material misstatement. When detection risk is elevated, the auditor might, for example, test a larger sample of transactions to mitigate audit risk.

Control risk and inherent risk stem from a company’s industry and actions. Conversely, detection risk is typically managed by the audit team.

Customized audit procedures

The auditor’s role is to attest to your company’s financial statements. Specifically, your audit firm assures that your financial statements are “fairly presented in all material respects, compliant with Generally Accepted Accounting Principles (GAAP) and free from material misstatement.”

Unqualified (or clean) audit opinions require detailed substantive procedures, such as confirming accounts receivable balances with customers and conducting test counts of inventory in the company’s warehouse. Generally, the more rigorous the auditor’s substantive procedures, the lower the likelihood of the audit team failing to detect a material misstatement.

Collaborative effort

Audit season is coming soon for calendar year-end entities. Before the start of fieldwork, let’s discuss changes in your business operations, accounting methods and industry conditions, along with other factors, that could create audit risk. We’ll adjust our audit programs accordingly to ensure that your financial statements are prepared with the highest level of quality and efficiency.

© 2018

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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.

Coming soon

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.

© 2018