How to Write Clear Financial Statement Disclosures

Tips on clarifying your narrative communications

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

Financial Statement Disclosures

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Clear Financial Statement Disclosures

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. Accountants’ brains are wired that way—at least that’s my 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–10s everywhere. May you hear your national anthem and glow in the success of clear communication.

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

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 dateAR-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

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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

FASB Issues New Not-For-Profit Financial Standard

The FASB has issued the new not-for-profit standard ASU 2016-14, Presentation of Financial Statements of Not-for-Profit Entities. Click here to see an AICPA overview.

Get Ready for Changes in Leases and the Leasing Industry

Lease post #2: The new lease standard will affect accounting and the lease industry

The Leasing Industry will Change

In my last lease post, we saw that bright-line criteria (e.g., lease terms of 75% or more of economic life and minimum lease payments of 90% or more of fair market value) are eliminated in the new lease standard. Consequently, almost all leases—including operating leases—will create lease liabilities. This accounting change will alter the leasing industry.

Lease Standard

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Lessees are presently paying high lease interest rates to obtain operating lease treatment (no lease debt is recorded). Now—with the new lease standard—those same operating leases will generate lease liabilities. So why would the lessee pay the higher interest rate? There is nothing to be gained. Lessees will begin to borrow money from banks (at a lower rate). And they will buy the formerly leased asset, or they will demand lower interest rates from the lessor. Lessees, I think, will obtain better interest rates.

Scope of the Lease Standard

What does the lease standard apply to? It applies to leases of property, plant and equipment (identified asset) based on a contract that conveys control to the lessee for a period of time in exchange for consideration. The period may be described in relation to the amount of usage (e.g., units produced). Also, the identified asset must be physically distinct (e.g., a floor of a building).

Control over the use of the leased asset means the customer has both:

  1. The right to obtain substantially all of the economic benefits from the use of the identified asset
  2. The right to direct the use of the asset

What does the standard not apply to?

The lease standard does not apply to the following:

  1. Leases of intangible assets, including licenses of internal-use software
  2. Leases to explore for or use minerals, oil, natural gas, and similar resources
  3. Leases of biological assets
  4. Leases of inventory
  5. Leases of assets under construction

Operating or Finance Lease

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.

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

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

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 will be different (a topic we’ll cover in my next lease post).

Related Party Leases

Leases between related parties will be classified just as any other lease will be. Companies will look to the legally enforceable terms and conditions of the lease to determine the whether a lease contract exists. If a lease contract exists, the agreement will be treated as a lease with the lessor reflecting a sale and the lessee capitalizing the related lease liability and right-of-use asset.

Are there any leases that will not result in a right-of-use and lease liability. Yes, those with terms of twelve months or less.

Leases of Less Than 12 Months

Companies do have the option to not capitalize a lease of 12 months or less. To do so, the company must make an accounting policy election (by class of the underlying leased asset). Companies who use this election will recognize lease expenses on a straight-line basis, and no right of use asset or lease liability will be recorded. If, however, the terms of the short-term lease change, the agreement could become one in which the lease is capitalized, for example, the lessee can exercise a purchase option or the lease term extends to beyond twelve months. (Expect to see plenty of leases with lives of twelve months or less.)

More Lease Information Coming

We’ll continue this series of lease posts next week. So stay tuned. I invite your comments and questions.

To see my first lease post, click here.

Fraud Risk Assessments: How to Perform

A new fraud brainstorming idea guaranteed to generate better results

Do your fraud brainstorming sessions lack vigor. In this video, I provide an idea that will liven up your discussions and result in better identification of potential thefts. I also discuss auditor’s responsibilities with regard to fraud and–as you perform risk assessments–ways to score points with your clients.

To see my previous (written) post about how to perform fraud risk assessments, click here.

How to Understand the New Lease Accounting Standard

Lease post #1: The first in a series of posts concerning the new lease standard

FASB issued a new lease accounting standard.

The existing lease guidance (FAS 13; now ASC 840) came out in 1976. In that standard, FASB defines capital leases with criteria such as minimum lease payments of at least 90% of fair market value or lease periods of at least 75% of the economic life of the asset. Given the bright-line criteria, lessees have asked lessors to construct leases so that they are considered operating and not capital. Why?

Most lessees don’t desire to reflect capital lease liabilities on their balance sheets. So for forty years lessees have controlled assets with a lease agreement and not recorded them on their balance sheets—sometimes called “off balance sheet financing.”

New Lease Accounting

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The Problem: Tailored Leases

As an example under present lease standards, a company leases a building with an economic life of 40 years and desires a lease term of 28 years. Why? Well, 75% of 40 years is 30. Since the lease is less than 30 years, it is an operating lease—one not capitalized, one not recorded on the balance sheet.

What happens if the lease term is 30 years? Then it is a capital lease, and the company records the building and the related debt on the balance sheet. The lessee is fine with the recording of the asset (the building) but wants to keep the debt off the books. However, if a capital lease criterion is triggered, the asset and the debt are recorded on the balance sheet.

The New Trigger: Is This a Contract?

Under existing lease accounting rules, bright-line criteria are used to make the capitalization decision, for example, lease terms of 75% or more of the economic life or lease payments of 90% or more of the fair market value.

But the bright-line criteria is being replaced with a question: Is it a contract? If the lease is a contract, it goes on the balance sheet. If it is not a contract, it does not go on the balance sheet.

Result: Most operating leases will now be recorded on the balance sheet at the inception of the lease.

Recording Leases Under the New Lease Accounting Standard

So what is the accounting entry to record leases under the new standard?

A right-of-use asset is recorded on the balance sheet at the amount of the lease liability. Also, a lease liability is concurrently recorded.

What’s the amount of the lease liability? It is the present value of the lease payments (including options). So, what is a right-of-use asset? It is an intangible that represents the lessee’s right to use the underlying asset. (The right-of-use asset will be amortized over the life of the lease.)

Is there any theory that supports this type of accounting? Yes, in FASB’s conceptual statements.

Congruence with FASB Conceptual Statement

FASB Concept Statement 6 says that assets are probable future economic benefits obtained or controlled by an entity as a result of past transactions or events. Liabilities are probable future sacrifices of economic benefits arising from present obligations to transfer assets or provide services to other entities in the future as a result of past transactions or events.

Under the new lease standard, the right-of-use asset and the lease liability are congruent with the definitions in Concept Statement 6. So, if a company leases a truck for three years and the economic life of the vehicle is seven years, it has obtained “probable future economic benefits…as a result of past transactions.” And the company has “probable future sacrifices of economic benefits” arising from the lease obligation. Therefore, the lease should be booked on the balance sheet.

Effective Dates for New Lease Standard

ASC 842 (ASU 2016-02), Leases, replaces ASC 840, Leases.

The effective dates for 842 are as follows:

For public entities, the standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those years.

For all other entities, the standard is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.

Early implementation is permissible for all entities.

More Lease Posts

This post is the first in a series concerning the new lease standard. See my next post by clicking here.

 

Reading Roundup

Here are a few suggested reads

Here are a few reads that you will find of interest:

The Daily 30 Minute Hack that Makes Me Better at Learning – article

U.S. Accounting Salaries Continue to Escalate – article

The Next Frontier in Data Analytics – article

Alexander Hamilton – book

Moonwalking with Einstein: The Art and Science of Remembering Everything – book

Open Tax Years Disclosure May Not Be Required

Peer reviewers continue to wrongly critique open tax year disclosures

Are open tax year disclosures required?

ASC 740-10-50 Unrecognized Tax Benefit Related Disclosures does not require a disclosure when there is no “unrecognized tax benefit.” Many CPAs (including myself) believed that a disclosure of the open tax years was required, even when the entity had no unrecognized tax benefit (or uncertain tax position). An AICPA non-authoritative Technical Question and Answer (TPA 5250.15) had said that nonpublic entities should disclose open tax years regardless of whether the entity had uncertain tax positions; that guidance has been removed.

open tax years disclosure

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The AICPA clarified that the open tax years disclosure is not required for companies without unrecognized tax positions, but peer reviewers are still (incorrectly) writing MFCs and even FFCs related to financial statements without the open tax years disclosure, even for entities without unrecognized tax positions.