Why Pricing for Risk is So Important

Why discounting bids harms CPA firms

Insurance companies understand something that many CPAs do not. Pricing for risk.

Pricing for Risk

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Pricing for Risk

Let’s consider the following bid situations.

1. The company is 30 years and has had steady profits for the last decade. It is owned by two brothers who are compatible. The company has one loan for $5 million that requires an audit. Total assets are $500 million. The bookkeeper has been with the organization for twenty years, and the auditors have proposed less than three journal entries for the last five years. The year-end for the company is September 30, a time when the audit firm is moderately busy. Estimated time for the engagement is 200 hours.

2. This company is two years old and has total assets of $50 million. They’ve changed bookkeepers twice since the company started. The company has a line of credit for $5 million that is fully drawn and a long term loan for $25 million. Working capital is negative and cash flows from operations was negative ($5 million) in year two. The former auditors are not bidding on the engagement. The former auditors proposed forty-five journal entries. The year-end for the company is May 31, a time when the audit firm is not busy. Estimated time for the engagement is 200 hours.

Since the estimated time for the engagements is the same, should the fee be the same? No. And yet I have witnessed the bidding process long enough to know that at least one firm will discount the second engagement, possibly substantially. The audit firm desires the engagement because it fits their work calendar. It comes at a time when the audit firm is not busy. But does it make sense to discount high-risk work, even if it fits the calendar?

Discounting high-risk work creates two potential problems:

  • Sufficient time is not invested
  • Litigation exposure increases

Sufficient Time is Not Invested

Some auditors will cut corners when faced with limited time budgets. Why? The engagement partner might push the audit team to stay within budget, even though he or she chose to discount the bid. The partner desires to make a profit even though the original thought was, “I’ll bid low so we’ll have something to do.” And when sufficient time is not invested in a high-risk engagement, litigation exposure increases.

Litigation Exposure Increases

So you decide to accept the high-risk engagement and the audit team delivers the discounted job within budget, but two years later your firm is slapped with a lawsuit. It seems the auditee was playing loose with the numbers, intentionally inflating numbers to satisfy the debt covenants (on the $25 million loan). The company did not make loan payments and the bank called the loan. The owners just walked away from their business leaving the keys with the bank—and you with a lawsuit. The bank believes it will suffer a loss of $7 million, and they are now looking to you to make up the difference.

Price for Risk Regardless

Always increase risk-adjust your price—even if you don’t get the work. You need sufficient time to address the increased risks. Alternatively, walk away from the work. It may be the better part of wisdom.

Rating New Work

Consider risk rating for all new work. You can use a scale as simple as one to five with five being high. Your firm might decide to never seek five-rated work, for example. If you decide to go after the high-risk work, consider adding a pricing premium. For five-rated engagements, you may choose to add 20%—for example—to your estimated time budget.

Think about your existing portfolio of work. Do you have any five-rated engagements? Might it be prudent to let one or two of those go? The continuance decision is just as important as acceptance. For more information about continuance decisions, click here.

How Accountants Can Save Time with Online Meetings

My first online meeting sold me

Are you tired of driving hours to see clients? Do you find it awkward to share information from your laptop? Or maybe you drive two hours to meet with a customer and–after arriving–realize you need additional information (but it’s back at your office). Online meetings solve these problems.

Accountant's Online Meetings

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Pick an Online Meeting Solution

First, you need to choose a video conferencing solution. Some popular alternatives include:

Here is a PC Magazine article that compares many of these products. All of the video conferencing packages offer free versions for testing. After using four different online meeting products, I found they provide similar abilities–the sharing of my computer screen and audio features.

What video conferencing software do I use? Zoom. It is easy to use and reliable. Here’s a summary of plan options, and yes, the free version works well.

The point of this article is not to sell you on a particular online meeting product, but to sell you on the concept. I have spent years of my life (at least it feels that way) driving to and from client’s offices. So when I heard about online meetings, I gave it a try.

My First Online Meeting

My first online meeting sold me. A few years ago I was assisting an attorney with a forensic project. My final report was several hundred pages long. The supporting files (not included in the report) were also voluminous. Rather than making a 4.5-hour trip, I did the following:

  • Opened the draft report on my center computer screen
  • Opened supporting documents on my two side computer screens
  • Shared my screen center computer screen using my online meeting software—the attorney, once he clicked the link in the next bullet, could see the information
  • Sent the attorney an email (with a hyperlink) to join the meeting—my online software automatically creates the email (which can be amended)
  • Called the attorney with my cell phone and went hands-free so I could use my mouse (you can use audio in your online software, I just prefer using my phone)
  • When the attorney answered my call, I told him I had sent him an invitation email, and I walked him through connecting (which took less than two minutes)
  • We reviewed the draft report from my center computer screen
  • When needed, I moved supporting documents from my two side screens to the center display (and then moved them off as needed)—think of this as moving information on and off stage

The meeting lasted one hour. Once done, the attorney said to me, “This is one of the best meetings I’ve ever attended.” 

Saving Four Hours

So rather than taking 5.5 hours (4.5 hours of driving and the 1-hour session), the meeting took 1.5 hours (including setup time). I saved four hours—and I didn’t even have to sit in the attorney’s lobby and wait for him. Also, I didn’t have to stop and refuel my vehicle, and I didn’t have to file an expense report.

Online Conferencing in My Office

Since that first online meeting, I realized that it’s more efficient for me to do the same with my firm personnel. So am I saying I have online meetings with people in my office? Yes. Why? It takes less time—and again, I have access to any file I need. Additionally, we are not crowded around one small computer screen, trying to see everything. (Note: We have 120 people located on three floors.)

Other Thoughts

Though I don’t often do so, you can backup your online meetings. Then if you need to refer back to the session, you can watch the video.

Some people don’t want to be seen. Perhaps they are working from home and are still in their pajamas. If they have their camera on, you will see them, and they will see you. So be mindful of this dynamic. (You can turn your camera off, and they can as well.)

For a more professional look, consider buying a video camera. I use a Logitech device. Why? Laptop cameras (those built into your computer) often project grainy pictures.

Stay Tuned for Video Example

I’ll soon share a video of how I set up and conduct online meetings. So stay tuned.

Do you already use online meeting software? If yes, what solution do you use? What video conferencing suggestions do you offer?

Episode 8 – An Auditor’s Cell Phone

How I use my cell phone in performing audits

Are you an auditor looking for new ways to be more efficient. The answer may be in your pocket or purse. A cell phone is a powerful audit device–and it’s fun to use. Here are ideas and apps that I use as an auditor.

An Auditor’s Cell Phone

How I use my cell phone as an auditor

A cell phone is an auditor’s Swiss knife. And with all the options, I am constantly looking for another way to use mine. So I’m sharing my ideas with the hope that you will likewise share yours. While I use an iPhone, I realize there are plenty of other nifty cell phones; my comments below are directed not at a particular phone but how I use mine as an auditor.

Below you will see a screenshot of my cell phone home screen and then information concerning how I use various apps.

Auditor's Cell Phone

An Auditor’s Cell Phone

 

Camera

I use this iPhone app to capture pictures of documents as I perform internal control walkthroughs. I embed these pictures in my walkthrough documentation. A picture says a thousand words. If the person explaining the accounting system creates pictures on a whiteboard, I take pictures of the drawings.

Sometimes I need a copy of a page from a hardback book (e.g., research); rather than using the copy machine, I take a picture of the page and email it.

Keynote

Keynote is Apple’s version of Powerpoint. I build the Keynote slide deck for presentations and use my phone to present. If you use iCloud, the slide deck you build on your iPad will automatically appear on your iPhone (if your settings are right).

You can also present a Keynote slide deck using your iPad as the presentation device and your iPhone as a remote. Your iPhone moves the slides of the iPad slide deck as you stand at a distance. Both devices (iPad and iPhone) must be on the same wifi for the remote feature to work.

Kindle

I buy most of my books using the one-click option in Amazon. Most books are 50% less in price (or more) than physical books. You can highlight books you read and then create a summary of those highlights (which I then place in my searchable Evernote account–see below); you can copy and paste these highlights to Word or other software.

If I am waiting on a plane, taxi, a friend, a doctor, etc., I have all my books handy for reading. You can even purchase my fraud prevention or SSARS 21 books (shameless advertising, yes I’m guilty).

Evernote

I love Evernote! It is my personal cloud storage, and at $70 per year for the premium version, it provides me with tremendous power. All the research I have performed and stored is available everywhere I go. All the articles I have stored are at my fingertips. (And it is so easy to store information in this application.) At present, I have thousands of screenshots, websites, articles, presentations, conversations, books, pictures, and answered research issues. It’s my personal knowledge library.

You can use this app to record conversations that are automatically loaded into Evernote.

Dropbox

I also use Dropbox to store some documents. There are many apps that connect well with this cloud storage space. I find Dropbox somewhat easier to use than Evernote since it has fewer features. I like the simplicity.

Stitcher

If you listen to podcasts, check out the Stitcher app. You can even hear me talk about accounting issues.

1Password

I store all my passwords in 1Password. No more wondering how I’m going to get into my own computer with a password I’ve forgotten–again (I know this never happens to you).

Messages

I text my audit team members to see how things are going. Messaging is much more efficient than calling if the communication is short. (You can also take a picture of anything with Camera and message the picture. If your audit team member needs to see something on your computer screen, take a picture of it and message the shot to them with comments.)

Don’t want to type the message? Just say it out loud and the app will record your words for sending.

Maps

I use Google maps to get to new audit locations.

Weather

I use the Weather Channel’s app to check the weather before I leave for trips so I can dress appropriately.

Pandora

Mozart or U2 makes my audit day go by much better. If you prefer music without ads, you can pay Pandora $3.99 a month. I love the variety.

Sharefile

Sharefile is my go-to app for sending sensitive client data. With hackers everywhere, I don’t risk sending sensitive client data in emails.

Digits

Looking for a nice easy-to-use calculator. I recommend Digits. You can add numbers, make notations beside particular numbers, and email the calculator tape with a couple of clicks.

Fantastical

My Fantastical calendar app syncs with my Outlook calendar, so regardless of where I am, I can check my appointments and schedule the same. I can also add reminders in Fantastical, so I don’t forget the milk.

ToDoist

Do I keep a to-do list? Yes, in my ToDoist app. This app integrates with Outlook.

Audible

When I am driving I listen to books using Audible. If you’re on the road a lot, this is a great way to redeem your time.

WSJ

I read the Wall Street Journal to keep abreast of current events. This WSJ app provides me access to one of the best newspapers in America (and there aren’t many these days).

Siri

While not an app, I push the button on my iPhone and Siri asks me what I want to do. This is how I make phone calls by simply saying, “call my wife,” for example. I also send texts (or emails) the same way by saying “send text to C.S. Lewis”; then I tell Siri what I want to say–works amazingly well; she even understands my southern accent (and that, my friends, is truly amazing).

What About You?

How do you use your cell phone at work? I would love to hear from you.

Which Special Purpose Reporting Framework Should I Use?

Choosing between cash, modified cash, and tax basis accounting

You’ve been contacted by your client to prepare their financial statements and issue a compilation report. At first, you think, “I’ll create the financials in accordance with GAAP,” but then you remember there are special purpose reporting framework options. Maybe the cash basis or tax basis is better for your client.

Special Purpose Reporting Frameworks

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Special Purpose Reporting Frameworks

What is a special purpose reporting framework?  It is a reporting framework other than generally accepted accounting principles (GAAP) that is one of the following:

  • Cash basis
  • Tax basis
  • Regulatory basis
  • Contractual basis
  • Other basis (as long as the basis uses reasonable, logical criteria that are applied to all material items)

Let’s begin our exploration of special purpose reporting frameworks by examining the simplest basis: the cash basis.

Cash Basis

While a pure cash basis financial statement is the easiest to create, it may be too simple. After all, you only create one financial statement. For example:

ABC Company

Statement of Cash Receipts and Disbursements

For the Year Ended December 31, 2016

Receipts

Rent                                                                                                                      $XX

Sales                                                                                                                        XX

Other                                                                                                                       XX

Total Receipts                                                                                                       XX

Disbursements

Supplies                                                                                                                  XX

Wages                                                                                                                      XX

Utilities                                                                                                                   XX

Total Disbursements                                                                                            XX

Increase in Cash                                                                                           XX

Beginning Cash                                                                                                 XX

Ending Cash                                                                                                     $XX

Notice there are no accruals and no balance sheet. When the company spends and receives cash, the transaction is recorded; otherwise, there is no entry. So who might benefit from the pure cash basis? The cash basis might be useful for a small nonprofit, a trust, or a student activity fund.

If the cash basis is not an appropriate solution, then consider another special purpose reporting framework: the modified cash basis.

Modified Cash Basis

Using the modified cash basis, you can present a balance sheet, an income statement, and a cash flow statement. It is, however, permissible to create just one statement–such as the income statement–and issue a compilation report. If you present a balance sheet and an income statement, the cash flow statement is optional.

What Modifications to Cash are Permissible?

SSARS 21 defines cash basis as a basis of accounting that the entity uses to record cash receipts and disbursements and modifications of the cash basis having substantial support (for example, recording depreciation on fixed assets). So we see that modifications to the cash basis are permissible under SSARS 21.

A modification to the cash basis is considered to have substantial support if it is equivalent to GAAP and is not illogical. What is an example of an illogical modification? The balance sheet includes accrued receivables but no payables are recorded. If such a presentation were allowed, the company’s financial health would appear stronger than it is.

Difference in Cash Basis and Modified Cash Basis

So how does the modified cash basis differ from the cash basis? Using the modified cash basis, you can record an item on a balance sheet when the transaction involves cash. So if a company loans cash to an outside party, a loan receivable could be recorded on the balance sheet. (If the cash basis is used, the loan is reflected as a disbursement.) The accounting entry for the loan is as follows:

                                                  Dr.      Cr.

Loans Receivable                  XX

Cash                                                    XX

Since cash is a part of the entry, it is okay to record the loan on the balance sheet using the modified cash basis.

But if a company sells inventory on credit it would not record the transaction–no cash is involved in the transaction. The same is true of payables–they are not booked since cash is not a part of the entry. To accrue a payable (amount owed to vendors), the entry is as follows:

                                                 Dr.     Cr.

Supplies Expense                 XX

Accounts Payable                          XX

We do not record the payables on the balance sheet. Why? Because cash is not a part of the entry.

So when a company pays cash for inventory or plant, property, and equipment, then those assets can be reflected on the balance sheet. (Also, plant, property, and equipment can be depreciated.) The same is true when the company obtains a loan–cash is received, so the debt can be recorded on the balance sheet.

Transactions that Should Not be Recorded

What are some examples of transactions that should not be recorded using the modified cash basis? Here are a few:

  • Purchase of assets with a capital lease
  • The receipt of donated equipment
  • The receipt of donated investments
  • Receivables when cash is not loaned (e.g. accounts receivable)
  • Payables when cash is not received (e.g., accounts payable)
  • Accrued interest

Ill-Defined Recognition Criteria

The modifications of the cash basis are not defined in auditing or SSARS guidance. In other words, there is judgment in selecting the modifications. Does this make you uneasy? Is the modified cash basis too ill-defined for you? If yes, you may find the tax basis of accounting a better option.

Tax Basis

In using the tax-basis, the transaction recognition criteria is simpler than that of the modified cash basis of accounting. Just ask, “Is this transaction recognized on the tax return?”

What financial statements can be presented using the tax basis? You can present just one financial statement (e.g., balance sheet), or you can present the balance sheet (referred to as the statement of assets, liabilities, and equity-tax basis) and the income statement–with or without the cash flow statement.

What entities can use the tax basis of accounting? Any entity that files a return with the IRS–either an income tax return or an information return. So a nonprofit that pays no taxes can use the tax basis, but a government that files no return could not. Those entities that can use the income tax basis include:

  • C corporation
  • S corporation
  • LLC
  • Partnerships
  • Nonprofit corporations
  • Sole proprietors

As we have seen in an earlier post, if you prepare a tax return for a client, then tax basis is the most efficient way to deliver financials.

Advantages of Special Purpose Frameworks

Special purpose reporting frameworks provide certain advantages including:

  • If the tax basis is used and you prepare the tax return, there is no conversion to GAAP
  • No cash flow statement is required
  • Special purpose frameworks are often easier to prepare (e.g., no accruals for the cash basis)

Reference Books

Are there reference guides for special purpose reporting frameworks? Yes. The two I use are:

Cash, Tax and Other Bases of Accounting — Thomson Reuters

Accounting and Financial Reporting Guidelines for Cash- and Tax-Basis Financial Statements–AICPA

While both publications provide sample financial statements, the Thomson Reuters guide has several sample statements and checklists.

How to Build an Accountant’s Scanning System

Corralling your paper monster and getting control

Are you overwhelmed by stacks of paper? Do you find it difficult to locate information you know you have? Well, here’s a scanning system that will help.

I have the privilege of visiting other CPA firms, and we have about 120 people in my company, so I have the opportunity to see plenty of offices. It is my observation that some CPAs are paperless, but many are not.

Scanning System for CPAs

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One problem with “paper everywhere” is we can’t find what we need. We have it (somewhere), but we can’t find it. Scanning is the easiest way to capture and organize the paper monster.

To create order, take three steps:

  1. Buy a scanner
  2. Build a scanning structure
  3. Build scanning habits

1. Buy a Scanner

My scanner is a Fujitsu iX500. It sits just to my right in my office (see picture below), so I don’t have to leave my desk to scan. Convenience is key to creating order. Otherwise, you will think, “I’ll scan that later,” which doesn’t happen. Then the paper is littering your desk–and distracting you.

CPA's office

Picture of my office

The iX500 costs less than $425, so it’s not a huge cash outlay. The scanner’s footprint is small (the dimensions are 6.1 x 11.4 x 6.6 inches) and it only weighs six pounds. Also, the scanner comes with  software (ScanSnap) that offers you destinations such as these:

Scansnap Software

ScanSnap File Locations

I often scan to Evernote, my cloud-based library. Another favorite destination: Caseware, our paperless engagement software. These end locations are my digital scan structure.

2. Build a Scanning Structure

So, of course, when you scan, you need final resting places for your documents.

My two primary file locations are:

  • Evernote for non-engagement documents
  • Caseware for engagement documents

Non-Engagement Documents

If you’ve followed my blog, you know I’m a raving Evernote lunatic. Why? Here are just a few reasons:

  • Ease of use (it’s intuitive, making it easy to understand)
  • Notebooks (you use notebooks to organize your documents)
  • Tags (you can tag each note with multiple tags, making it easy to find the material)
  • Feed-ability (I can feed Evernote from my scanner, email, clip-apps, drag and drop, and many other ways)
  • Find-ability (Evernote even recognizes hand-written notes making it possible to search electronically and find a keyword–even if written)
  • Accessibility (I can access Evernote from my iPhone, iPad, and desktop)
  • Cost (about $60 per year; they do offer a free version but with limitations)
  • Allows storage of a variety of documents (including Excel, Word, PDF, Audible files)

There are other cloud-based storage systems such as OneNote and Dropbox. Pick one and learn it well.

Engagement Documents

If your firm is not already paperless, consider making the leap. We have used Caseware for years and, personally, I love it. We use this software for storage of the following engagement files:

  • Tax
  • Audit
  • Reviews
  • Compilations
  • AUPs

My firm has built templates for each of these services, so everyone in our firm knows where documents (including scans) belong.

To scan promptly, you need to build habits, so creating a repeatable, mental system is critical to the process.

3. Build Scanning Habits

Build your scanning habits. My system is as follows:

  • If it takes less than two minutes to scan, scan now
  • If it takes more than two minutes, I place the paper in a file tray where I will later batch process
  • Scan all paper by the end of the day
  • Don’t leave unscanned paper on my desk (it’s a distraction)
  • Keep a shred box just below my scanner (where I place sensitive paper documents)
  • For long documents (e.g., CPE workbook), ask an assistant to break down the paper copy, scan it, and email it to me (I don’t use my Fujitsu scanner for heavy-duty scanning. We have a copy machine that will convert large scans to PDF.)

Like any new habit, new scanning actions will–at first–feel awkward and inconvenient. But push through the pain and the actions will become routine.

Act Now

You may feel like the above will take too much time to implement, especially if you have lots of paper. So how do you eat an elephant? One bite at a time.

Schedule your scanning plan. Pick two days a week and put one hour a day on your calendar. Then attack. Slay your paper monster. I dare you.

Click the scanner image below to see the Fujitsu scanner on Amazon.

More Evernote Information

For more information about Evernote, check out these posts:

Evernote for CPAs

Seven Ways to Feed Evernote

Tips on Searching Your Evernote Account

 

How to Write Clear Financial Statement Disclosures

Tips on clarifying your narrative communications

Creating clear note disclosures is not always easy. Creating (unintentional) confusion? Well, that’s another matter.

Financial Statement Disclosures

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Let’s pretend that Olympic (CPA) judges rate your most recent note disclosures, flashing scores to a worldwide audience. What do you see? Tens everywhere—or something much less?

Balance sheets tend to be clear. Why? The accounting equation. Assets always equal liabilities plus equity. But there is no disclosure equation (darn it) and without such, we flounder. 

Since we tend to be linear thinkers, we enjoy Pascal more than Hemingway, numbers more than words, debits and credits more than paragraphs. It’s the way our brains are wired—at least I offer myself that excuse.

I recall—in 1983—English teachers coming to my University of Georgia accounting classes. At the time, I thought, “What a waste!” Now decades later, I see the wisdom. Accounting is more than just numbers. It is a communication made up of financial statements and narratives. So, in the name of clearer disclosures, I offer these suggestions.

Consider Your Readers

Who will read the financial statements? Owners, lenders, and possibly vendors. Owners—especially those of smaller businesses—may need simpler language. Some CPAs write notes as if CPAs (alone) will read the financial statements. While accounting is technical, we need—as much as possible—to simplify.  

Use Short Paragraphs

Some lengthy paragraphs choke the reader and cause confusion. Breaking long paragraphs into shorter ones makes the print more accessible. And the shortening of paragraphs transforms overwhelming mouthfuls into bite-sized morsels. 

Then say what needs to be said, and get out of there. Less is more in many instances. When we try to say too much, we sometimes say…too much. Additionally, short sentences are helpful.   

Use Short Sentences

I’m not sure, but CPAs may have invented the run-on sentence. As I read one of those beauties, I feel as though I can’t breathe. And by the end, I’m gasping. Breaking long sentences into shorter ones makes your reader more comfortable. And she will thank you. And while we are addressing more succinct language, how about using more concise words?

Use Shorter Words

CPAs don’t receive merit badges for long, complicated words. Our goal is to communicate, not to impress. For example, split is better than bifurcate.  

And attorneys are not our model. I sometimes see notes that are simply regurgitations of legal agreements, copied word for word—and you can feel the stiltedness. Do your reader a favor and translate the legalese into digestible—and might I say, more enjoyable—language. 

Use Tables

Long sentences with several numbers can be confusing. Readers comprehend tables more quickly than jumbled narratives.

Write Your Own Note

Too many CPAs copy note examples from the Internet without understanding whether the language fits the financial statements they are creating. Make sure the language is appropriate for your company.

Put Disclosures in the Right Buckets (or Reference)

Think of each disclosure header as a bucket. For example, if the notes include a related party disclosure, then that’s where the related party information goes. If the debt note includes a related party disclosure (and this may be necessary), then make reference–in the related party disclosure–to the debt note. You don’t want your reader to think all of the related party disclosures are in one place (the related party note) when one is somewhere else (the debt note). The same issue arises in subsequent event notes.

Have a Second Person Review the Notes

When writing, we sometimes think we are clear when we are not. Have a second person review the note for proper punctuation, spelling, structure and clarity. If you don’t have a second person available to review the notes, perform a cold review the next day—you will almost always see necessary revisions. I find that reading out loud helps me assess my writing’s clarity.

I also use Grammarly to edit documents. The software provides grammar feedback as you write. If you don’t have a second person to review your financials, I highly recommend this product.

Use a Current Disclosure Checklist

Vetting your notes with a disclosure checklist may be the most tedious and necessary step. FASB and GASB continue to issue new statements at a rapid rate, so using a checklist is needed to ensure completeness.   

Winning Gold

I hope these suggestions help you win gold. Tens everywhere. May you hear your national anthem and glow in the success of stellar communication.

By the way, FASB recently issued exposure drafts related to the materiality of disclosures. We need guidance that helps us assess when a disclosure is necessary—and when it is not. So hopefully, in the not-to-distant future, we’ll have standards that assist in determining when disclosures are needed—and when they are not.

When Should CPA Reports Be Dated?

When should reports be dated?

Type of ReportDate of ReportProfessional Reference
Preparation of Financial StatementsAR-C 70 does not address dating the disclaimer; sample disclaimer does include a date AR-C 70.A12
CompilationsThe date of the completion of the compilation proceduresAR-C 80.17
ReviewsThe date should be no earlier than the date on which the accountant completed procedures sufficient to obtain limited assurance as a basis for reporting whether the accountant is aware of any material modifications that should be made to the financial statements for them to be in accordance with the applicable financial reporting framework, including evidence that:
i. All the statements that the financial statements comprise, including the related notes, have been prepared and
ii. Management has asserted that they have taken responsibility for those financial statements
AR-C 90.39 i.
AuditsThe date that the auditors have obtained sufficient appropriate audit evidence to support the opinion on the financial statements including evidence that:
i. The audit documentation has been reviewed
ii. All the statements that the financial statements comprise, including the related notes, have been prepared; and
iii. Management has asserted that they have taken responsibility for those financial statements
AU-C 700.41
Agreed upon proceduresThe report should be dated as of the date that the agreed‐upon procedures are completedAT 201.34

How to Account for Finance and Operating Leases

Lease post #3: The lessee's point of view

Most CPAs grapple with leases from the lessee’s point of view, so in this post we’ll take a look at leases from the lessee’s perspective. Under the new lease standard, what are the types of leases? Does the accounting vary based upon the type of lease? Are lease expenses different?

Change in Lease Accounting

Picture from AdobeStock.com

First, let’s start by defining the types of leases and how to classify them.

The Types of Leases

Upon the commencement date of the lease, the company should classify the lease as either a finance or an operating lease. (Under present lease standards a finance lease is referred to as a capital lease.)

Finance Lease

So what is a finance lease? A lease is considered a finance lease if it meets any of the following criteria:

  1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term
  2. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise
  3. The lease term is for the major part of the remaining economic life of the underlying asset (today we use the 75% rule)
  4. The present value of the sum of the lease payments and residual value guarantee equals or exceeds substantially all of the fair value of the underlying asset (today we use the 90% rule)
  5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term

While the bright-line criteria (e.g., lease term of 75% or more of economic life) have been removed, the basis for conclusions in the new lease standard acknowledges some of the old rules of thumb.  It says that one reasonable approach to determining whether the lease is for a major portion of the asset’s life is the 75% threshold. The conclusion goes on to say that “90 percent or greater is ‘substantially all’ the fair value of the underlying asset.” So, in effect, FASB removed the bright-lines as a rule but not in principle–the conclusion says FASB “does not mandate those bright lines.”

Operating Lease

And what is an operating lease? It’s any lease that is not a financing lease.

Accounting Similarities and Differences

Both operating and finance leases result in a right-of-use asset and a lease liability. The subsequent accounting for the two types of leases is quite different.

Finance Lease Accounting

The accounting for a finance lease is similar to capital lease accounting under present standards.

When a company enters into a finance lease, it will record the right-of-use asset and the lease liability. The amortization of the right-of-use asset will be straight-line and the amortization of the liability will be accounted for using the effective interest method. Consequently, lease expenses are front-loaded (i.e., expenses will decline throughout the lease term). The amortization expense and the interest expense will be presented separately on the income statement.

As we are about to see, operating lease accounting is significantly different, particularly with regard to accounting for the lease expense and the amortization of the right-of-use asset.

Operating Lease Accounting

The primary change in lease accounting lies in the operating lease area. Under ASC 842 a company will book a right-of-use asset and a lease liability for all operating leases greater than twelve months in length. (Under current lease standards, no asset or liability is recorded.) Will the operating lease expense be any different than it has been? No. But the recording and amortization of the right-of-use asset and the lease liability is new.

The Initial Operating Lease Entries

Let’s say a company has a five year operating lease for $1,000 per month and will pay $60,000 over the life of the lease. How do we account for this lease? First, the company records the right-of-use asset and the lease liability by discounting the present value of the payments using the effective interest method.  In this example, the present value might be $54,000. As the right-of-use asset and lease liability are amortized the company will (each month) debit rent expense for $1,000—the amount the company is paying. So the expense amount is still the same as it was under ASC 840.

Amortizing the Right-of-Use Asset and the Lease Liability

Well, how does the company amortize the right-of-use asset and the lease liability? The lease liability is amortized using the effective interest method, and the interest expense is a component of the rent expense. What’s the remainder of the $1,000? The amortization of the right-of-use asset. The $1,000 rent expense is made up of two components: (1) the interest expense for the month and (2) the right-of-use amortization amount which is a plug to make the entry balance. Even though the rent expense is made up of these two components, it appears on the income statement as one line: rent expense (unlike the finance lease which reflects interest expense and amortization expense separately).

Potential Impairments

Due to the mechanics of the straight-line lease expense calculation, the right-of-use asset amortization expense is back-loaded (i.e. the amortization expense component is less in the early part of the lease). One potential consequence of this slower amortization is the right-of-use asset may be subject to impairment, especially toward the end of the lease. The impairment rules do apply to the right-of-use asset.

Your Thoughts

So, what do you think of the new lease accounting? Is it better? Worse?

You can see my first two lease posts here:

Post 1: How to Understand the New Lease Accounting Standard

Post 2: Get Ready for Changes in Leases and the Leasing Industry

How to Respond to Imposed Tight Deadlines

My twin brother, a project manager, offers insights into dealing with deadlines

Do you ever face tight project deadlines? Most accountants do. Tax accountants seem to have a new deadline every month and auditors have the same–new projects all the time, all demanding completion now. Here’s some sage project management advice from my twin brother, Harry Hall, a Certified Project Manager.

For more project management information, check out Harry’s blog here.