In March, this blog provided readers with an update on the “Big GAAP” versus “Little GAAP” debate. We reiterated the Financial Accounting Foundation’s commitment to the challenging mission of balancing two critical, but sometimes, conflicting objectives as they relate to the needs of the users of private company financial statements. They are:
- Ensuring that its standard setting bodies develop high-quality accounting standards that provide all users with decision-useful financial information
- Ensuring that those standards take into account the individual needs and circumstances of the constituents of the disparate entities that issue financial statements.
The ongoing effort to reconcile the above two goals has continued for nearly 40 years and remains at the forefront today. At the time of our last blog on this subject, the Financial Accountants Standards Board (FASB) had recently added a program to its agenda whereby they were going to examine the definition of a “nonpublic entity”. This “defining” phase was deemed a necessary step in distinguishing between the different types of entities for standard-setting purposes.
The most recent news took place last week whereby the FAF voted to approve the establishment of a new body – the Private Company Council (PPC) to improve the standard-setting process for private companies.
The FAF has indicated that they believe the Plan approved by the Trustees strikes an important balance. As FAF President and CEO, Teresa S. Polley commented, on one hand, the plan recognizes that the needs of public and private company financial statement users, preparers, and auditors are not always aligned. But at the same time, the plan ensures comparability of financial reporting among disparate companies by putting in place a system for recognizing differences that will avoid creation of a “two-GAAP system.”
As outlined, the PPC will have two principal responsibilities:
- Based on criteria mutually agreed to with FASB, the PPC will determine whether exceptions or modifications to existing nongovernmental U.S. Generally Accepted Accounting Principles (U.S. GAAP) are necessary to address the needs of users of private company financial statements.
- The PPC will identify, deliberate, and vote on any proposed changes, which will be subject to endorsement by the FASB and submitted for public comment before being incorporated into GAAP. The PPC will also serve as the primary advisory body to the FASB on the appropriate treatment for private companies for items under active consideration of the FASB’s technical agenda.
Last week’s news signals progress on this front. Click on this blog in the weeks ahead for continuing developments in the “Big GAAP”/”Little GAAP” debate.
For interested readers, the complete report establishing the PPC, including background materials, key discussion issues considered by the Trustees, and PPC responsibilities and operating procedures, will be available on the FAF website this week.
Bev Linane, CPA, PSA.
The FASB Nears Release of Invitation to Comment on Disclosure Framework–and It’s High Time They Did!
An article that was published in the Journal of Accountancy on May 17th indicated that a disclosure framework project that FASB has been developing for almost two years is scheduled to reach a milestone in June or July with the issuance of invitation for public comment, according to FASB Chairman Leslie Seidman.
The three main objectives of the framework project are determining what information is essential to investors, getting preparers to think about relevance, and organizing financial statements in a common sense way.
During the panel on “The Future of Financial and Business Reporting from a Standards-Setting and Regulatory Perspective,” at the AICPA spring Council meeting in Washington, Seidman explained that the disclosure framework is an answer to one of the most common complaints she hears from all sectors.
Business leaders, investors and auditors have all expressed concerns about disclosure overload and ineffectiveness to Seidman.
“We know that people would really like to take out the red pen right now and start slashing through the footnotes and other elements of the financial statements,” Seidman said, “but actually the resource group we set up to advise us on this advised against that.”
The project was added to FASB’s agenda in July 2009 in an effort to create a framework that would make financial statement disclosures more effective, coordinated and less redundant. Reducing the volume of footnotes to financial statements is not the primary focus, but FASB hopes that focusing on important information will cut down on footnotes in most cases.
The standards overload is one of the big time problems facing accountants and auditors, so when this does come out for public comment, please make sure that you make your voice heard. Financial statement disclosure does need to be streamlined and financial statements need to be better organized, and this is going to help.
In this auditor’s opinion, it is one of the most important things that is coming out from the FASB in many years!
Leonard Hecht, CPA
FASB Formally Ends Going Concern Proposal
At its January 11, 2012 meeting the FASB formally terminated the “Going Concern” project. In its place the FASB has opted for issuing guidance to organizations on the use of the liquidation basis of accounting. Such guidance will focus on when it is appropriate for an entity to use the liquidation basis of accounting and how that basis of accounting is applied.
Since the issuance in October 2008 of its proposed statement Going Concern, the FASB has dragged its feet over this seemingly innocuous issue. This proposed statement was designed to incorporate the auditing concept of “going concern” into the accounting literature. In short, the proposal sought to make management the initial, and primary, responsible party for determining whether there is substantial doubt about the entity’s ability to continue as a going concern. The proposal made sense because who, better than management, has greater insight into an entity’s future operations? The proposal had the added benefit of aligning US GAAP with IFRS where the going concern concept has been incorporated into the accounting literature. Furthermore, both the PCAOB and the AICPA (who set auditing standards for issuer and non-issuers, respectively) indicated to the FASB that they would adjust the auditing standards to conform to the language the FASB promulgated in the accounting standard. Neither of the two audit standards setters intends to relieve the auditor of his responsibility for making a determination as to an entity’s ability to continue as a going concern.
The Going Concern exposure draft received 29 responses, most of which were favorable. The responses did raise questions about a) the definition of “going concern” b) the meaning of “substantial doubt” and c) the look ahead period for the going concern determination. The FASB debated these issues over the better part of a year and, in a perfect example of over thinking, talked itself into the position that the terms were vague and might result in too many entities getting a going concern label! Really? As a result, the FASB opted, at its January 2012 meeting, not to require management to make an assessment as to whether the entity it works for will be able to continue as a going concern. Instead, as indicated previously, the FASB will issue a new proposal on the use of liquidation accounting. Furthermore, the FASB reasoned that additional disclosures regarding an entity’s liquidity, which may be required as part of a separate, on-going liquidity project, will enable financial statement readers to, themselves, better predict an entity’s ability to continue as a going concern! So, everyone will be able to determine that there is substantial doubt about an entity’s ability to continue as a going concern except the entity’s management. Makes sense?
In this auditor’s opinion , the FASB decision seems silly. Its inability to come to terms with the definitions of “going concern” and “substantial doubt” is beyond puzzling when one considers the fact that auditors have been working with these terms ever since the promulgation of SAS 59 – “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern” which was effective in 1989. Furthermore, as previously indicated, both the AICPA and the PCAOB indicated a willingness to conform their auditing language regarding the going concern issue to the accounting standard promulgated by the FASB. It is not clear to me why these terms are able to be understood and applied to an entity by its auditor but not by its management.
Furthermore, the decision by the FASB represents a missed opportunity to align US GAAP with IFRS. Members of the IASB have no qualms about management’s ability to make a going concern determination and the FASB, through its action, has created one more permanent (and needless) difference between the two accounting frameworks.
On the other hand, every cloud has a silver lining as they say. What we will get is some (apparently badly needed) guidance on when and how to apply the liquidation basis of accounting. It is this auditor’s fervent hope that you will never have to apply such guidance to any client’s financial statements!
Brian Gibney, CPA, CIRA
The United States Better Business Bureau has established 20 standards of charity accountability wi
th which all not-for-profits should be familiar. These standards were designed to:
- Help donors make sound giving decisions when considering a gift to a charity
- Increase public confidence in charities by promoting fair solicitation practices
- Promote ethical conduct by charitable organizations
The standards address the following areas:
Governance and oversight (5 standards)
These standards discuss the need for independent board oversight and provide guidance related to minimum board size, the number of board meetings, board compensation arrangements and board conflict-of-interest policies.
Measuring effectiveness (2 standards)
These standards discuss the need to implement a process of self-evaluation.
Finances (7 standards)
The finance standards provide guidance related to recommended amounts of program expenses and fund raising expenses, the accumulation of unrestricted funds and audit and disclosure policies.
Fund raising (6 standards)
The fund raising standards provide guidance related to fund raising activities including a requirement that fund raising appeals include an accurate (and complete) description of the programs for which funds are solicited. These standards emphasize a charity’s need for prompt and full disclosure of specific types of information requested by potential donors or others.
The governance and oversight, measuring effectiveness and finance standards provide both general and specific recommendations applicable to all not-for-profits regardless of their funding sources. As one might expect, the fund raising standards are more applicable to those entities engaged in significant fund raising activities.
Regardless of the type of NFP you are involved with, review, and adherence to, the USBBB’s Standards for Charity Accountability is highly recommended. For a full description of these important standards visit the USBBB’s website here.
In addition to the standards discussed above, the USBBB also has, at this same website, an Implementation Guide available to assist NFPs to effect the standards of accountability.
Brian Gibney, CPA, CIRA
Understanding the relationships in our lives, and how they function, is a life skill that can be invaluable. Likewise, understanding financial relationships is a powerful tool for those who rely on financial information whether for business or personal use.
In preparing reviewed or audited financial statements, an accountant will look to the relationship between certain financial information and evaluate the results. To a large degree, understanding and evaluating these results provides more reliable information that just ticking and tying account balances. This process is called analytical review and the ability to adequately perform such review depends on the level of precision that the accountant can bring to the task.
During fieldwork, the accountant/auditor will have discussions with various client personnel and ask questions about relationships between certain financial information and variances therein. If engagement staff do not fully understand the client’s business, they can be uncomfortable having these conversations. Conversely, while client personnel usually have a full understanding of their company’s business, they are not always able to articulate their responses to their auditor’s questions. This situation can lead to conclusions or answers that are weak at best.
For example, an analysis of a company’s year to date operating results indicates a large increase in sales revenue, payroll expense, and depreciation. When asked by a member of the engagement team, the CFO indicates that business was good, more employees were hired and they bought some new equipment last year so there was more depreciation expense this year. End of story for both the auditor and the client.
Not so fast. What was missing from above the analytical process was both an expectation of what should have occurred and a level of precision to further analyze the identified variances. This is where the engagement team stumbled. However, before we identify how to improve this process of analytical review, we suggest a parallel to everyday life.
A simple example – a family of five decides to go to a local restaurant for dinner on a Tuesday evening. They have invited two of their children’s friends to join them. The family has eaten at this restaurant before, the food is quite good, service is excellent, the restaurant is tolerant of young children, close to home and it has been affordable. These are their expectations. When the family returns home a few hours later, they cannot figure out why there were not happy with their dining-out experience.
What was different? Why was it not their typical dining experience? While one parent declares they will never return to the restaurant again, the other is interested in why they were so disappointed. Hence, a comparison of expectations to results. The food was not as good as in the past, service was poor, the children were fussy, and it took way longer for the dining adventure than they planned.
The first thing noted was that the tab for dinner was about thirty percent higher than in the past. On analysis, it was determined that on Tuesday evenings, the restaurant changes its menu to offer various ethnic cuisines, therefore, the price of dinner was much higher due to the specialty menu. In addition, the family included two of their children’s friends so it should have been expected that the total cost would be greater. Service was extremely slow, and the children became impatient and fussy. This was caused by the complexity of the menu as the wait-staff were overworked. The children were unhappy with their food selections from the specialty menu although their parents had cautioned them to order their favorites. Hence, their failure to meet their dining expectations was understood providing them with an opportunity to change future behavior which may lead them to skip dining out on Tuesday evenings and/or leaving the children home so that they could enjoy the varying cuisines.
The parallel to analytical review in the financial sense is no more complicated. One of the first conversations the engagement team should have with their client is what is new with their business and what has remained unchanged. Armed with that knowledge and expectations, an analysis of variances in certain financial relationships will be developed and a conversation as to the results should be forthcoming between client and accountant. One tool is ratio analysis: i.e. what is the ratio of certain costs (such as cost of goods sold) to sales revenue; what is the ratio of accounts receivable or inventory to sales revenue or what is the usual ratio of salaries and benefits to total expenses. The acceptability of responses to variances in these ratios depends on the level of precision brought to the task.
For example:
- One key financial relationship is cost of goods sold and sales revenue. If cost of goods sold is historically 40% of sales revenue but it increased to 55% in the current period, one answer might be that materials and supplies increased. The key question – what did we expect in the way of change and by how much? A review of invoices indicates that indeed supplies expense increased by 11% and the 4% remaining increase then appears reasonable. While management knew that such costs had increased, they had not realized by how much.
- The balance in accounts receivable and total sales revenue is another financial relationship. The accounts receivable balance is typically 18% of revenue but at the reporting date is 24% of revenue. The key question – what did we expect in the way of change and by how much? An off-the-cuff response might be the poor economy, etc. but the variance can be further explained. A look at the accounts receivable aging indicates that sales increased dramatically in the last quarter, by approximately 6% attributable mostly to one large new customer thus increasing the balances in the 30, 60 and 90 day aging categories. Further, the overall balances in the 90+ day aging category have increased – most likely due to the poor economy.
- The balance in salaries and wages to overall expenses and/or revenue is another key financial relationship. These costs typically represent 45% of total expenses, and this reporting period they have actually increased by 10% to 55% of total expenses. Management had previously indicated that they hired some new people but raises were small. The result then, is not consistent with our expectation. Such changes would not have increased expenses by 10%. However, on analysis, it was learned that 5 new employees had been hired, but 4 were terminated, and that salary increases were minimal. This clearly did not meet expectations. Upon further analysis, it was learned that the cost of outside professional services had incorrectly been included in the salaries and wages category skewing the overall account balance for most of the difference.
The three examples listed above are illustrations of how analytical review and/or ratio analysis serve as a business tool. This is a function that should be performed by management on a regular basis regardless of when they will be having such dialogue with their auditor. In this auditors’ opinion, we would welcome clients being prepared for this part of our audit or review engagement.
Therefore, we urge you to get analytical!
Comparison of Compilations, Review and Audits
Your business has just obtained new financing and your lender indicates that in the future, as a condition of such financing, that you will need to provide copies of your annual financial statements, prepared by an outside certified public accountant. You know that there are different types of reports but are not sure of how they differ. If you are not sure, and many people are confused about this, we have included a comparison for your review.
Compilation
Through compilation services, a CPA prepares monthly, quarterly or annual financial statements. In preparing a compilation, the accountant simply “compiles” or arranges financial data into conventional financial statement form. No assurance is given as to whether material, or significant, changes are necessary for the statements to be in accordance with generally accepted accounting principles or another comprehensive basis of accounting (other than GAAP). A compilation is the only financial statement that can be prepared by a CPA who is not independent.
When preparing a compilation report, the accountant becomes familiar with the accounting principles and practices common in the client’s industry and acquires a general understanding of the client’s transactions and how they are recorded. After compiling the financial statements, the CPA is required to read them and consider whether they are appropriate in form and free from obviously material errors. The CPA will issue a standard report that says that the financial statements were compiled, but because they were not audited or reviewed, no opinion is expressed. Compilation standards permit financial statements to omit footnote disclosures as long as the omission is clearly indicated in the report and there is no intent to mislead users.
A compilation is sufficient for some private companies. However, if a business needs to provide some degree of assurance that its financial statements are reliable, it may be necessary to engage a CPA to perform a review or audit.
Review
A private entity may engage a CPA to perform a review of its financial statements and issue a report that provides limited assurance that material changes are not necessary. With respect to reliability and assurance, a review falls between a compilation (which provides no assurance) and the more extensive assurance of an audit. Before issuing reviewed financial statements, the CPA might have to compile the financial statements but the financial statements are those of management who must have sufficient understanding of the financial statements to assume responsibility for them. Two other distinguishing characteristics of reviewed financial statements include the fact that the CPA must be independent in order to perform a review and all necessary footnotes must be included in the reviewed financial statements.
As in a compilation, the CPA obtains knowledge of the industry in which the client operates and acquires information on key aspects of the organization. The CPA will make inquiries as to financial statement related principles and practices and perform analytical procedures designed to identify unusual items or trends in the financial statements that may need explanation. In essence, a review is designed to see whether the financial statements “make sense” without applying audit-type procedures.
A review, with limited assurance, is often adequate for a small business. If more assurance is required, then the organization may need to engage a CPA to perform an audit.
Audit
An audit includes procedures that involve confirmation with outside parties, observation of inventories, and testing of selected transactions by examining supporting documentation. A public or private company may engage a CPA to audit its financial statements and to issue a report that provides the highest level of assurance that the financial statements are presented fairly in conformity with accounting principles generally accepted in the United States of America. To perform an audit, a CPA must be independent. The financial statements must also include all required footnotes.
During the performance of an audit engagement, the CPA will gather information from outside sources that may be more objective than information obtained from internal sources. The CPA may confirm accounts receivable balances with customers, or accounts payable balances with vendors. The CPA may additionally confirm balances with lenders. These procedures are intended to reduce the risk of material misstatement in the financial statements. While the CPA will design the audit to provide what is known as reasonable assurance that material errors or fraud will be detected, he or she is not responsible for detecting immaterial instances of fraud. The CPA will also obtain an understanding of the internal controls of the organization sufficient to perform the audit but will not issue an opinion on such controls.
An audit provides a reasonable level of assurance that financial statements are free of material errors or fraud but does not, however, provide a guarantee of absolute assurance.
You might ask why it is important to understand the differences in how your financial information is reported. The answer is that you want to make sure that you are obtaining the level of service (reporting) that will meet your needs… whether they are for the internal use of management or for external purposes such as the requirements of your bank lender.
Bev Linane, CPA, PSA
Acceptance of Government Endowments Requires Consideration
The Auditor’s Opinion has previously addressed the issue of whether not-for-profit organizations ( NFPs) should pursue endowments. This discussion will focus on a particular class of endowments – those provided through government funding.
Some federal (and state) agencies, particularly those active in the arts and humanities area, provide endowment funding to NFPs. This funding can be in the form of a straight grant or a matching grant whereby the funding agency matches contributions received from third-party donors at a specified rate up to the maximum available under the grant. For example, a funding agency may agree to give $1 in endowment money, up to a maximum of $1 million, for every $3 contributed by third parties. Thus, if the NFP raises $1.8 million from private donors the grant will pay an additional $600,000 towards the specified endowment. Matching government grants may restrict the use of the corpus for a specific term or on a permanent basis.
It is fairly common in the NFP industry for one donor to entice others to contribute to a program or an endowment by promising to match each contribution. Whether the matching contribution comes from a private donor or a government agency, such a funding mechanism can be a wonderful way to jumpstart a new endowment or augment an existing one.
Prior to solicitation and acceptance of an endowment grant, NFPs should give consideration to the following:
Reporting requirements
Government funding usually entails increased reporting requirements – usually for the duration of the funding. Ascertain what these requirements are and consider whether compliance is sustainable.
Audit requirement
The awarding agency may require that the NFP provide audited financial statements as a pre-condition to receiving the grant and as a condition for maintaining it. More importantly, subsequent to the receipt of the endowment funding, the NFP may be subject to the federal (and state) single audit requirement. Under OMB Circular A-133, a NFP would need a single audit for each period in which the federal portion of the funds remain restricted, assuming the cumulative federal portion of the endowment exceeded $500,000 (the current threshold for a single audit). Thus, in the example above, a NFP that received a $600,000 federal matching grant for a permanent endowment would have a single audit requirement for all future periods where the single audit threshold remained below $600,000. If a NFP is not already subject to the single audit requirement, consideration should be given to the additional audit fees to be incurred, potentially in perpetuity.
Grant and Endowment Provisions
NFPs should have a clear understanding of the intentions of the funding agency with respect to endowment spending and accumulation policies either required by state law or set by the NFP’s governing body. Issues such as this should be settled in the grant application and award process. For example, it would be helpful to establish up-front whether the funding agency considers endowment fund accumulation attributable to the grant money as part of the federal award. Further, it is important to ensure that provisions of the actual award are compatible with the intent of the overall endowment.
Conclusion
Obtaining federal and state endowment funding can be extremely beneficial and, in this auditor’s opinion, should be pursued. It is, however, not without potential pitfalls, and NFPs should be cognizant of their responsibilities before signing on the dotted line.
Brian Gibney, CPA, CIRA
