Expecting Before Inspecting

Have you ever reviewed audit planning analytics and thought, “this work paper has no meaning – it is just rows of numbers side-by-side with no explanations or expectations.”

Expectations and Planning Analytics

The purpose of planning analytics is to identify potential risk so that appropriate audit responses can be planned. But before you can look for risk, you should first ask, “what do I expect to see?”


You are developing context prior to seeing content. You are expecting before inspecting.

But where do my expectations come from?

Your expectations are informed by your prior knowledge of the client and conversations you’ve had with management. If you’ve had no conversation with management, then consider doing so before you develop your expectations.

Peer Review Finding

One common peer review finding is that auditors don’t document their analytic expectations prior to creating planning analytics.

You need not document an expectation for every balance or ratio; simply document your expectations about significant areas. An example follows:

I expect debt to increase by approximately $1 million due to current year borrowings to expand the central-store building. I expect buildings to increase by $500,000 since the related construction project is 50% complete at year-end.

Once you complete the comparative analytics, reference the accounts to the expectation memo. For example, you would reference your comparison of this year’s debt with last year’s debt to the expectation memo. Your analytics should agree with the expectations; another common peer review finding is the planning analytic, once created, are not compared to expectations.

The process is as follows:

  1. Document expectations
  2. Create analytics
  3. Compare analytics to expectations

Presentation of Comprehensive Income

ASU 2011-05 is effective for companies with fiscal years ending December 31, 2012 and impacts the manner in which comprehensive income is presented. (For public companies, the standard was effective for interim statements after December 15, 2011.)

Purpose of Comprehensive Income

The purpose of presenting comprehensive income is to communicate the total of all changes in equity during the period, exclusive of transactions with owners.

Presenting Comprehensive Income

Companies with comprehensive income are required to present the following information:

Net Income (Revenues – Expenses)            $XX

Other Comprehensive Income                       $XX

Comprehensive Income                                   $XX

Permissible Comprehensive Income Statements

ASU 2011-05 restricts presentation options to the following alternatives:

  1. A single, continuous Statement of Comprehensive Income or
  2. Two separate but consecutive statements:

a. Income Statement

b. State of Comprehensive Income

These two alternatives have always been allowed.

What Changed?

The presentation of comprehensive income may no longer be included in the Statement of Changes in Stockholders’ Equity.

The standard should be applied retrospectively.

Common Components of Other Comprehensive Income (OCI)

OCI includes the following types of changes:

  • Changes in the unrealized gains and losses related to available-for-sale securities
  • Changes in the value of designated cash flow hedges
  • Changes in the pension or other post-retirement benefits (that are not recognized immediately as net periodic benefit costs)

What About Tax Effects?

Each element of OCI can be presented in the following manner:

  • Net of tax for each item or
  • At gross for each item with one aggregate amount for the tax benefit or expense related to all OCI items

Presenting Accumulated OCI on the Statement of Financial Condition

Accumulated OCI must be presented on the face of the statement of financial condition with a title such as accumulated other comprehensive income (separate from other equity accounts such as retained earnings and additional paid-in capital).

Changes in Components of Accumulated OCI

The financial statements should contain disclosure of changes in the balances of each component of accumulated other comprehensive income in the notes or, alternatively, the changes in the accumulated balances can be presented as a reconciliation in a statement of changes in stockholders’ equity. (Remember comprehensive income cannot be presented in the statement of changes in stockholders’ equity but the changes in accumulated OCI can be.)

The presentation of changes in accumulated balances – whether in the notes or the statement of changes in stockholders’ equity – should correspond to the components of other comprehensive income in the statement where other comprehensive income for the period is presented (e.g., the single continuous statement of comprehensive income).

Stay Tuned – OCI Changes in the Making

FASB deferred certain reclassification provisions of 2011-05 and is presently reviewing potential reclassification disclosure requirements; these requirements may be effective for public companies with years ending December 31, 2012 and for nonpublic companies with years ending December 31, 2013.

The proposed amendments would not change the current requirements for reporting net income or other comprehensive income in financial statements. However, the proposed amendments would require an entity to provide enhanced disclosures to present separately by component, reclassifications out of accumulated other comprehensive income.

The Clarity Project – Sending an Attorney Letter

When are auditors required to send an attorney letter (request to client’s attorney requesting information about litigation, claims, or assessments – actual or potential)?

AU-C 501 requires the auditor to send an attorney letter only if he or she believes actual or potential litigation, claims, or assessments may give rise to a risk of material misstatement.

How is AU-C 501 different from prior audit requirements?

Prior to the Clarity standards, if the client paid an attorney or consulted with an attorney on any potential litigation (even if no losses were expected), the auditor generally sent an attorney letter.

Now the auditor is required to send the attorney letter only if he or she believes there is a risk of material misstatement.

What are the documentation requirements?

The auditor must document the basis for any decision not to seek direct communication with legal counsel. If the auditor does not send an attorney letter, then the auditor should document the reasons for not doing so.

What if management has not consulted with counsel regarding litigation, claims, or assessments?

The auditor would document his or her reasons for not sending the attorney letter – e.g., The client had no contact with an attorney, and the client represents there is no existing litigation or other potential losses from legal issues.

Consider including such verbal client assertions in the client representation letter.

What procedures should the auditor perform to identify litigation, claims, or assessments?

  • inquire of entity management (including in-house counsel, if any),
  • obtain a description of litigation, claims, and assessments through the year-end to the date the description is furnished,
  • review relevant minutes, documents, and correspondence, and
  • review legal expenses

What if the auditor identifies potential litigation, claims or assessments?

The auditor must obtain evidence regarding:

  • the period in which the event occurred,
  • the probability of an unfavorable outcome, and
  • the potential loss

What if procedures indicate a risk of material misstatement (related to litigation, claims, or assessments)?

Then, an attorney letter should be sent (this is a presumptively mandatory requirement); if the auditor decides to not send the attorney letter – though required – he or she should document the following:

  • the justification for not sending the letter, and
  • how the intent of the requirement was met by other means


Here’s a form I’ve created to assist with the decision to send or to not send the attorney’s letter.

Use of Financial Reporting Framework for Small- and Medium-Sized Entities

The draft of the Financial Reporting Framework for Small- and Medium-Sized Entities (FRF-SME) has been issued, and the AICPA has published a frequently asked questions (FAQ) document to support its issuance.

The following comments are made in light of the draft framework.

Who should use the FRF-SME?

The framework is designed to be used by owner-managed for-profit companies. The FAQ states that the term owner-managed is used to describe businesses where the majority-owners run the business.

The other term to note is for-profit; the standards are being created for small businesses. Nonprofit entities do not appear to be excluded, but the framework is not designed for nonprofits.

Are there any entities prohibited from using the framework?


How does the FRF-SME compare with IFRS for SMEs (international standards)?

The FRF-SME is being created to more closely align with the U.S. tax code. LIFO will be permitted.

How will FRF-SME be simpler than U.S. GAAP?

The following are examples of the simplification:

  • FRF-SME will use historical costs
  • FRF-SME will not require consolidation of variable interest entities
  • FRF-SME will use reasonable lease accounting (and not the proposed FASB lease requirements)
  • Goodwill will be amortized (normally using tax guidance or a period of ten years)
  • No complicated accounting for hedges, derivatives or stock compensation
  • Disclosure requirements will be reduced (as compared to GAAP)

Can companies create financial statements using FRF-SME knowing the statements will be compiled, reviewed or audited by a CPA firm?


How often will FRF-SME change?

The framework will change infrequently, thus companies will have more stable standards to follow (and the cost of developing financial statements should decrease relative to GAAP statements).

Who will accept FRF-SME statements?

Companies will need to check with external users (e.g., banks, bonding companies) to see if they will accept FRF-SME financial statements.

I believe in many cases banks will accept the FRF-SME statements (especially if collateral is sufficient).


AICPA Proposes Financial Reporting Framework for SME

The AICPA has issued the draft of the Financial Reporting Framework for SME (small and medium entities) which represents the Institute’s promise of a private-company alternative to GAAP.

Click here for prior post explaining how we got to this point.

Click here for a Journal of Accountancy article announcing the issuance of the draft.

Click here for the draft of the FRF-SME.

Click here for AICPA web page dedicated to FRF-SME.

I will be reading and providing you with a summary of FRF-SME.