Posted on

Identifying and Reporting Critical Audit Matters

For over 40 years, the Securities and Exchange Commission (SEC) has required only a simple pass-fail statement in public companies’ audit reports. But the deadline for mandatory reporting of critical audit matters (CAMs) in audit reports is fast approaching. The revised model will provide insight to help investors and other stakeholders better understand a public company’s financial reporting practices — and help management reduce potential risks.

Deadlines

Under existing SEC standards, auditor communication of CAMs is permissible on a voluntary basis. However, disclosure of CAMs in audit reports will be required for audits of fiscal years ending on or after June 30, 2019, for large accelerated filers; and for fiscal years ending on or after December 15, 2020, for all other companies to which the requirement applies.

The new rule doesn’t apply to audits of emerging growth companies (EGCs), which are companies that have less than $1 billion in revenue and meet certain other requirements. This class of companies gets a host of regulatory breaks for five years after becoming public, under the Jumpstart Our Business Startups (JOBS) Act.

Criteria

In 2017, the Public Company Accounting Oversight Board (PCAOB) published Release No. 2017-001, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards. The main provision of the rule requires auditors to describe CAMs in their audit reports. These are issues that:

  • Have been communicated to the audit committee,
  • Are related to accounts or disclosures that are material to the financial statements, and
  • Involve especially challenging, subjective or complex judgments from the auditor.

By highlighting a CAM, an auditor is essentially saying that the matter requires closer attention. Examples might include complex valuations of indefinite-lived intangible assets, uncertain tax positions, goodwill impairment, and manual accounting processes that rely on spreadsheets, rather than automated accounting software.

New guidance

In July 2018, the Center for Audit Quality issued a 12-page guide on implementing the revised model of the auditor’s report. The guide instructs auditors to select CAMs based on:

  • The risks of material misstatement,
  • The degree of auditor judgment for areas such as management estimates,
  • Significant unusual transactions,
  • The degree of subjectivity for a certain matter, and
  • The evidence the auditor gathered during the review of the financial statements.

The guide doesn’t say how many CAMs are required in an audit report or provide a checklist of potential issues. Instead, CAMs will be determined on a case-by-case basis.

Coming soon

PCAOB Chairman James Doty has promised that CAMs will “breathe life into the audit report and give investors the information they’ve been asking for from auditors.” By identifying CAMs on the face of the audit report, auditors highlight challenging, subjective or complex matters that also may warrant closer attention from management. For more information about CAMs, contact us.

© 2018

Posted on

Hidden Liabilities: What’s Excluded From the Balance Sheet?

Financial statements help investors and lenders monitor a company’s performance. However, financial statements may not provide a full picture of financial health. What’s undisclosed could be just as significant as the disclosures. Here’s how a CPA can help stakeholders identify unrecorded items either through external auditing procedures or by conducting agreed upon procedures (AUPs) that target specific accounts.

Start with assets

Revealing undisclosed liabilities and risks begins with assets. For each asset, it’s important to evaluate what could cause the account to diminish. For example, accounts receivable may include bad debts, or inventory may include damaged goods. In addition, some fixed assets may be broken or in desperate need of repairs and maintenance. These items may signal financial distress and affect financial ratios just as much as unreported liabilities do.

Some of these problems may be uncovered by touring the company’s facilities or reviewing asset schedules for slow-moving items. Benchmarking can also help. For example, if receivables are growing much faster than sales, it could be a sign of aging, uncollectible accounts.

Evaluate liabilities

Next, external accountants can assess liabilities to determine whether the amount reported for each item seems accurate and complete. For example, a company may forget to accrue liabilities for salary or vacation time.

Alternatively, management might underreport payables by holding checks for weeks (or months) to make the company appear healthier than it really is. This ploy preserves the checking account while giving the impression that supplier invoices are being paid. It also mismatches revenues and expenses, understates liabilities and artificially enhances profits. Delayed payments can hurt the company’s reputation and cause suppliers to restrict their credit terms.

Identify unrecorded items

Finally, CPAs can investigate what isn’t showing on the balance sheet. Examples include warranties, pending lawsuits, IRS investigations and an underfunded pension. Such risks appear on the balance sheet only when they’re “reasonably estimable” and “more than likely” to be incurred.

These are subjective standards. In-house accounting personnel may claim that liabilities are too unpredictable or remote to warrant disclosure. Footnotes, when available, may shed additional light on the nature and extent of these contingent liabilities.

Need help?

An external audit is your best line of defense against hidden risks and potential liabilities. Or, if funds are limited, an AUP engagement can target specific high-risk accounts or transactions. Contact our experienced CPAs to gain a clearer picture of your company’s financial well-being.

© 2018

Posted on

Keep it SIMPLE: A Tax-Advantaged Retirement Plan Solution For Small Businesses

If your small business doesn’t offer its employees a retirement plan, you may want to consider a SIMPLE IRA. Offering a retirement plan can provide your business with valuable tax deductions and help you attract and retain employees. For a variety of reasons, a SIMPLE IRA can be a particularly appealing option for small businesses. The deadline for setting one up for this year is October 1, 2018.

The basics

SIMPLE stands for “savings incentive match plan for employees.” As the name implies, these plans are simple to set up and administer. Unlike 401(k) plans, SIMPLE IRAs don’t require annual filings or discrimination testing.

SIMPLE IRAs are available to businesses with 100 or fewer employees. Employers must contribute and employees have the option to contribute. The contributions are pretax, and accounts can grow tax-deferred like a traditional IRA or 401(k) plan, with distributions taxed when taken in retirement.

As the employer, you can choose from two contribution options:

1. Make a “nonelective” contribution equal to 2% of compensation for all eligible employees. You must make the contribution regardless of whether the employee contributes. This applies to compensation up to the annual limit of $275,000 for 2018 (annually adjusted for inflation).

2. Match employee contributions up to 3% of compensation. Here, you contribute only if the employee contributes. This isn’t subject to the annual compensation limit.

Employees are immediately 100% vested in all SIMPLE IRA contributions.

Employee contribution limits

Any employee who has compensation of at least $5,000 in any prior two years, and is reasonably expected to earn $5,000 in the current year, can elect to have a percentage of compensation put into a SIMPLE IRA.

SIMPLE IRAs offer greater income deferral opportunities than ordinary IRAs, but lower limits than 401(k)s. An employee may contribute up to $12,500 to a SIMPLE IRA in 2018. Employees age 50 or older can also make a catch-up contribution of up to $3,000. This compares to $5,500 and $1,000, respectively, for ordinary IRAs, and to $18,500 and $6,000 for 401(k)s. (Some or all of these limits may increase for 2019 under annual cost-of-living adjustments.)

You’ve got options

A SIMPLE IRA might be a good choice for your small business, but it isn’t the only option. The more-complex 401(k) plan we’ve already mentioned is one alternative. Some others are a Simplified Employee Pension (SEP) and a defined-benefit pension plan. These two plans don’t allow employee contributions and have other pluses and minuses. Contact us to learn more about a SIMPLE IRA or to hear about other retirement plan alternatives for your business.

© 2018

Posted on

Which Intangibles Should Private Firms Report Following a Merger?

2018 is expected to be a hot year for mergers and acquisitions. But accounting for these transactions under U.S. Generally Accepted Accounting Principles (GAAP) can be complicated, especially if the deal involves intangible assets. Fortunately, the Financial Accounting Standards Board (FASB) offers a reporting alternative for private companies that simplifies accounting for new business combinations, avoiding a lot of red tape.

Private performance metrics

Companies that merge with or acquire another business must identify and recognize — separately from goodwill — the fair value of intangible assets that are separable or arise from contractual or other legal rights. Valuing intangibles can be costly, subjective and complex, often requiring the use of third-party appraisers and increasing audit costs.

When it comes to private business combinations, however, investors, lenders and other stakeholders question whether the benefits of reporting the values of all of these intangibles outweigh the costs. Private company stakeholders are primarily interested in tangible assets, cash flows, and earnings before interest, taxes, depreciation and amortization (EBITDA). Such metrics are unrelated to how companies report intangible assets in M&As.

Moreover, buyers in private business combinations generally evaluate a for-sale business based on its expected earnings and cash flows. They don’t customarily assign specific values to all of the seller’s intangible assets, especially not those that can’t be sold or licensed independently.

Exception to the rules

Since 2015, the FASB has allowed private companies to elect an accounting alternative that exempts noncompetes and certain customer-related intangibles from being identified and reported separately on the balance sheet after a business combination. This guidance requires no new disclosures for companies that elect this alternative accounting treatment.

Private companies that elect this alternative report fewer intangible assets in business combinations, thereby simplifying accounting for intangibles on the acquisition date and amortization in future periods. But the alternative doesn’t eliminate the requirement under GAAP to recognize and separately value other intangible assets acquired in business combinations, such as trade names and patents.

In addition, private companies with noncompetes and other customer-related intangibles that were acquired before the adoption of the alternative must continue to amortize those intangibles over the expected life that was set when the business combination occurred.
Although the reporting alternative simplifies matters, private companies will in most cases continue to need third-party appraisals for other separable and contract-based intangibles. Outside appraisals can be costly, but auditors typically won’t rely on fair value estimates made by management for these items.

Get it right

Accounting for business combinations can be complicated. And mistakes can lead to restatements and write-offs in future periods that may alarm stakeholders. We can help take the guesswork out of postacquisition accounting, including deciding whether to elect private company reporting alternatives and allocating the purchase price among acquired assets and liabilities. Contact us for more information.

© 2018

Posted on

A Fresh Look at Percentage of Completion Accounting

How do you report revenue and expenses from long-term contracts? Some companies that were required to use the percentage of completion method (PCM) under prior tax law may qualify for an exception that was expanded by the Tax Cuts and Jobs Act (TCJA). This could, in turn, have spillover effects on some companies’ financial statements.

Applying the PCM

Certain businesses — such as homebuilders, real estate developers, engineering firms and creative agencies — routinely enter into contracts that last for more than one calendar year. In general, under accrual-basis accounting, long-term contracts can be reported using either 1) the completed contract method, which records revenues and expenses upon completion of the contract terms, or 2) the PCM, which ties revenue recognition to the incurrence of job costs.

The latter method is generally prescribed by U.S. Generally Accepted Accounting Principles (GAAP), as long as you can make estimates that are “sufficiently dependable.” Under the PCM, the actual costs incurred are compared to expected total costs to estimate percentage complete. Alternatively, the percentage complete may be estimated using an annual completion factor. The application of the PCM is further complicated by job cost allocation policies, change orders and changes in estimates.

In addition to reporting income earlier under the PCM than under the completed contract method, the PCM can affect your balance sheet. If you underbill customers based on the percentage of costs incurred, you’ll report an asset for costs in excess of billings. Conversely, if you overbill based on the costs incurred, you’ll report a liability for billings in excess of costs.

Syncing financial statements and tax records

Starting in 2018, 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. Under Sec. 451(b), taxpayers that use the accrual method of accounting will meet the “all events test” no later than the taxable year in which the item is taken into account as revenue in a taxpayer’s “applicable financial statement.”

So, if your business uses the PCM for financial reporting purposes, you’ll generally need to follow suit for tax purposes (and vice versa).

In general, for federal income tax purposes, taxable income from long-term contracts is determined under the PCM. However, there’s an exception for smaller companies that enter into contracts to construct or improve real property.

Under the TCJA, for tax years beginning in 2017 and beyond, construction firms with average annual gross receipts of $25 million or less won’t be required to use the PCM for contracts expected to be completed within two years. Before the TCJA, the gross receipts test limit for the small construction contract exception was $10 million.

Got contracts?

Compared to the completed contract method, the PCM is significantly more complicated. But it can provide more current insight into financial performance on long-term contracts, if your estimates are reliable. We can help determine the appropriate method for reporting revenue and expenses, based on the nature of your operations and your company’s size.

© 2018

Posted on

It’s Not Too Late: You Can Still Set Up a Retirement Plan for 2018

If most of your money is tied up in your business, retirement can be a challenge. So if you haven’t already set up a tax-advantaged retirement plan, consider doing so this year. There’s still time to set one up and make contributions that will be deductible on your 2018 tax return!

More benefits

Not only are contributions tax deductible, but retirement plan funds can grow tax-deferred. If you might be subject to the 3.8% net investment income tax (NIIT), setting up and contributing to a retirement plan may be particularly beneficial because retirement plan contributions can reduce your modified adjusted gross income and thus help you reduce or avoid the NIIT.

If you have employees, they generally must be allowed to participate in the plan, provided they meet the qualification requirements. But this can help you attract and retain good employees.

And if you have 100 or fewer employees, you may be eligible for a credit for setting up a plan. The credit is for 50% of start-up costs, up to $500. Remember, credits reduce your tax liability dollar-for-dollar, unlike deductions, which only reduce the amount of income subject to tax.

3 options to consider

Many types of retirement plans are available, but here are three of the most attractive to business owners trying to build up their own retirement savings:

1. Profit-sharing plan. This is a defined contribution plan that allows discretionary employer contributions and flexibility in plan design. You can make deductible 2018 contributions as late as the due date of your 2018 tax return, including extensions — provided your plan exists on Dec. 31, 2018. For 2018, the maximum contribution is $55,000, or $61,000 if you are age 50 or older and your plan includes a 401(k) arrangement.

2. Simplified Employee Pension (SEP). This is also a defined contribution plan, and it provides benefits similar to those of a profit-sharing plan. But you can establish a SEP in 2019 and still make deductible 2018 contributions as late as the due date of your 2018 income tax return, including extensions. In addition, a SEP is easy to administer. For 2018, the maximum SEP contribution is $55,000.

3. Defined benefit plan. This plan sets a future pension benefit and then actuarially calculates the contributions needed to attain that benefit. The maximum annual benefit for 2018 is generally $220,000 or 100% of average earned income for the highest three consecutive years, if less. Because it’s actuarially driven, the contribution needed to attain the projected future annual benefit may exceed the maximum contributions allowed by other plans, depending on your age and the desired benefit.

You can make deductible 2018 defined benefit plan contributions until your tax return due date, including extensions, provided your plan exists on Dec. 31, 2018. Be aware that employer contributions generally are required.

Sound good?

If the benefits of setting up a retirement plan sound good, contact us. We can provide more information and help you choose the best retirement plan for your particular situation.

© 2018

Posted on

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.

Inventory ratios

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.

Product mix

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.

Reorder point

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.

© 2018

Posted on

Use Pay-Ratio Disclosures with Caution

Starting in 2018, certain public companies must disclose the ratio of their CEO’s annual compensation to that of its “median employee.” The rule allows for significant flexibility in calculating these ratios, leading to widely divergent ratios within the same industry. Therefore, public companies and their investors should tread carefully before they rely on these metrics.

Complying with the rule

The pay-ratio disclosure rule applies to all U.S. public companies required to provide Summary Compensation Table disclosures. With limited exceptions, covered companies must disclose pay ratios in annual reports, on Form 10-K, in proxy and information statements, and in registration statements — if these filings require executive compensation disclosures.

The rule doesn’t apply to the following companies:

Smaller reporting companies (SRCs). The Securities and Exchange Commission (SEC) voted unanimously in June 2018 to increase the public float threshold for SRCs to $250 million.

Emerging growth companies (EGCs). This term generally refers to new public companies with gross revenues under $1 billion in the most recent fiscal year. (The SEC allows a transition period for newly public companies.)

The rule also exempts registered investment companies, foreign private issuers and Canadian companies filing in the United States pursuant to the Multijurisdictional Disclosure System.

Calculating pay ratios

The SEC allows significant leeway in calculating pay ratios to ease the burden of complying with the rule. Companies may choose a process that fits their structure and compensation programs. But they must disclose the methodology used to determine the median employee pay and the estimates used in calculating the pay ratio.

For example, a company could use a statistically representative sample of its workforce rather than the entire population. Or they could compare only base salary or W-2 wages, excluding from their computations bonuses, overtime, stock options and other forms of compensation.

Companies also aren’t required to calculate the exact compensation when identifying the median. Rather, the SEC lets them use “reasonable estimates.” In addition, the rule allows companies to exclude up to 5% of their non-U.S. workers and to adjust foreign pay to account for differences in the cost of living between regions.

As a result, the initial round of pay-ratio disclosures published in early 2018 vary widely. For example, a recent study found that ratios disclosed by companies in the financial services industry ranged from 1:1 to 1:429.

Comparing apples to oranges

Before relying on pay-ratio disclosures to evaluate compensation practices or cost efficiency, it’s important to compare a company’s process for calculating pay ratios to others used in the same industry. Contact us for more information about pay-ratio disclosures and how a company’s compensation practices measure up.

© 2018

Posted on

Auditing the Use of Estimates and Specialists

Complex accounting estimates — such as allowances for doubtful accounts, impairments of long-lived assets, and valuations of financial and nonfinancial assets — have been blamed for many high-profile accounting scams and financial restatements. Estimates generally involve some level of measurement uncertainty, and some may even require the use of outside specialists, such as appraisers or engineers.

As a result, examining estimates is a critical part of an audit. Companies that understand the audit process are better equipped to facilitate audit fieldwork and can communicate more effectively with their auditors. Here’s what you need to know about auditing the use of estimates as we head into next audit season.

Audit techniques

Some estimates may be easily determinable, but many are inherently complex. Auditing standards generally provide the following three approaches for substantively testing accounting estimates and fair value measurements:

1. Testing management’s process. Auditors evaluate the reasonableness and consistency of management’s assumptions, as well as test whether the underlying data is complete, accurate and relevant.
2. Developing an independent estimate. Using management’s assumptions (or alternate assumptions), auditors come up with an estimate to compare to what’s reported on the internally prepared financial statements.
3. Reviewing subsequent events or transactions. The reasonableness of estimates can be gauged by looking at events or transactions that happen after the balance sheet date but before the date of the auditor’s report.

When performing an audit, all three approaches might not necessarily be appropriate for every estimate. For each estimate, the auditor typically selects one or a combination of these approaches.

Regulatory oversight

Accounting estimates have been on the agenda of the Public Company Accounting Oversight Board (PCAOB) since it was established by Congress under the Sarbanes-Oxley Act of 2002. Although the leadership of PCAOB changed hands in early 2018, proposals to enhance the auditing standards for the use of accounting estimates and the work of specialists remain top priorities.

Earlier this summer, Chairman William Duhnke told the PCAOB’s Standard Advisory Group (SAG) that he hopes to complete these projects in the coming months. The updated auditing standards would help reduce diversity in practice, provide more-specific direction and be better aligned with the risk assessment standards.

Prepare for next audit season

Improvements on the audit standards for the use of estimates and the work of specialists could be coming soon. As companies plan for next year’s audit, they should contact their audit partners for the latest developments on the standards for auditing the use of estimates and specialists to determine what (if anything) has changed.

We can help you understand how estimates and specialists are used in the preparation of your company’s financial statements and minimize the risk of financial misstatement.

© 2018

Posted on

What Businesses Need to Know About the Tax Treatment of Bitcoin and Other Virtual Currencies

Over the last several years, virtual currency has become increasingly popular. Bitcoin is the most widely recognized form of virtual currency, also commonly referred to as digital, electronic or crypto currency.

While most smaller businesses aren’t yet accepting bitcoin or other virtual currency payments from their customers, more and more larger businesses are. And the trend may trickle down to smaller businesses. Businesses also can pay employees or independent contractors with virtual currency. But what are the tax consequences of these transactions?

Bitcoin 101

Bitcoin has an equivalent value in real currency and can be digitally traded between users. It also can be purchased with real currencies or exchanged for real currencies. Bitcoin is most commonly obtained through virtual currency ATMs or online exchanges.

Goods or services can be paid for using “bitcoin wallet” software. When a purchase is made, the software digitally posts the transaction to a global public ledger. This prevents the same unit of virtual currency from being used multiple times.

Tax impact

Questions about the tax impact of virtual currency abound. And the IRS has yet to offer much guidance.

The IRS did establish in a 2014 ruling that bitcoin and other convertible virtual currency should be treated as property, not currency, for federal income tax purposes. This means that businesses accepting bitcoin payments for goods and services must report gross income based on the fair market value of the virtual currency when it was received, measured in equivalent U.S. dollars.

When a business uses virtual currency to pay wages, the wages are taxable to the employees to the extent any other wage payment would be. You must, for example, report such wages on your employees’ W-2 forms. And they’re subject to federal income tax withholding and payroll taxes, based on the fair market value of the virtual currency on the date received by the employee.

When a business uses virtual currency to pay independent contractors or other service providers, those payments are also taxable to the recipient. The self-employment tax rules generally apply, based on the fair market value of the virtual currency on the date received. Payers generally must issue 1099-MISC forms to recipients.

Finally, payments made with virtual currency are subject to information reporting to the same extent as any other payment made in property.

Deciding whether to go virtual

Accepting bitcoin can be beneficial because it may avoid transaction fees charged by credit card companies and online payment providers (such as PayPal) and attract customers who want to use virtual currency. But the IRS is targeting virtual currency transactions in an effort to raise tax revenue, and it hasn’t issued much guidance on the tax treatment or reporting requirements. So bitcoin can also be a bit risky from a tax perspective.

To learn more about tax considerations when deciding whether your business should accept bitcoin or other virtual currencies — or use them to pay employees, independent contractors or other service providers — contact us.

© 2018