Auditing Special Purpose Frameworks--Business Combinations, Consolidation

Continuing to lay a foundation for developing audit strategies and audit plans, this article presents more comparisons of significant requirements in U.S. GAAP and the AICPA’s Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs). http://www.aicpa.org/InterestAreas/FRC/AccountingFinancialReporting/PCFR/Pages/Financial-Reporting-Framework.aspx  

This article presents comparisons of these topics:

·      Stock-Based Compensation Plans

·      Consolidation and Subsidiaries

·      Business Combinations

·      Push-Down Accounting

Stock-Based Compensation Plans

U.S. GAAP:

This form of compensation may be accounted for as either a liability or equity amount, depending on management’s intentions, at fair values.   Fair value will be determined based on this hierarchy: 1) a fair value accounting method when it can be reasonably determined, 2) calculated-value method if it can be reasonably estimated or 3) intrinsic value method when neither of these methods can be used.

FRF for SMEs:

This framework requires only footnote disclosures for such plans.  The disclosures include:

·      The terms of awards under the plan.

·      Vesting requirements.

·      The maximum terms of options granted.

·      Separate disclosures for multiple plans.

Consolidation and Subsidiaries

U.S. GAAP:

An entity having a controlling financial interest (normally more than 50% ownership) in another entity is required to consolidate the subsidiary. When the entity cannot maintain significant influence over the operation of the subsidiary, such as in the case of external events like bankruptcy, the subsidiary would not be consolidated.  For investments in variable interest entities, investors that have the power to significantly influence the operations of such entities will usually be deemed “primary beneficiaries.”  In such circumstances, primary beneficiaries are required to consolidate variable interest entities. Either the equity method or cost method would be used otherwise.

FRF for SMEs:

Management can elect to consolidate more than 50%-owned subsidiaries or account for them using the equity method (if it exercises significant influence over the entity).  When significant influence is not exercised over the subsidiary, the cost method should be used to report the investment.  Equity and debt securities that are available for sale, however, should be recognized at market values with changes in such values included in periodic net income.  General disclosures include:

·        Consolidation policy.

·        When consolidated, the names of all subsidiaries, income from each and the percentage of ownership.

·        Descriptions of the periods for subsidiaries’ financial statements that don’t coincide with the parent’s reporting date, along with any significant events or transactions in the intervening periods.

·        When financial statements are not consolidated, method of accounting for its subsidiaries, descriptions, names, carrying amounts, income and percentage of ownership for each.

Business Combinations

U.S. GAAP:

The acquisition method of accounting is required.  The acquisition-date fair values of assets, liabilities, goodwill and non-controlling interests in an acquired entity are used for measurement in financial reporting.

FRF for SMEs:

This framework essentially requires the acquisition method of accounting using acquisition-date market values.  It permits, however, management to elect to account for an intangible asset either separately or as a part of goodwill. General disclosures similar to U.S. GAAP are required for material and immaterial business combinations. 

Push-Down (New Basis) Accounting

U.S. GAAP:

There is no requirement to permit new-basis accounting for acquired entities.

FRF for SMEs:

When an acquirer gains more than 50% control of an entity, the assets and liabilities of the acquired entity may be comprehensively revalued in its financial statements, assuming the new values are reasonably determinable.  This results in similar values being used in the acquired entity’s financial statements and the acquirer’s consolidated statements.  General disclosures include:

·        First applications:

o       Date push-down accounting was first applied and the date of the related purchase transaction.

o       Description of the situation resulting in push-down accounting and the amounts of changes to major classes of assets, liabilities and equity.

·        In addition for the following fiscal period:

o       Amount of the revaluation adjustment and the equity account in which it was recorded.

o       Amount of reclassified retained earnings and the equity account in which it was recorded.

The next article in this series will begin a step-by-step approach to performing small audits of special purpose frameworks, focusing primarily on the FRF for SMEs.  

Auditing Sprecial Purpose Frameworks--Pension Accounting, Revenue Recognition

The foundation for a cost-beneficial audit strategy is an auditor’s knowledge of the principles in a reporting entity’s applicable financial reporting framework, the framework selected and used in its financial reporting system. Clarified Audit Standards, first of all, require the auditor to evaluate the applicable framework to determine if it results in financial statement and footnote presentations of financial position, results of operations and cash flows that are appropriate and reasonable.

This article continues to lay such a framework by comparing significant principles in U.S. GAAP with the AICPA’s Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs).  These topics are discussed below:

·      Retirement and Postemployment Benefits

·      Comprehensive Income

·      Revenue Recognition

Retirement and Postemployment Benefits

U.S. GAAP:

Accounting standards use a projected benefit obligation model that requires accounting for the aggregate of periodic pension costs and the overfunded and underfunded status of defined benefit and post-retirement benefits plans.  Defined contribution plans’ costs are accounted for as period expenses.

FRF for SMEs:

Management may elect to account for plans using a current contribution payable method or one of the accrued benefit obligation methods similar to U.S. GAAP.  General disclosures include:

·        Description of the plan and the period cost recognized.

·        Multi-employer plans description, period cost and any liability that would result from a probable withdrawal.

·        Description of deferred compensation plans, their participants and how payments are determined.

·        For defined benefit plans:

o       Description, plan participants and how benefits are determined.

o       Funded status information including benefit obligation, market value of plan assets and the under-funded or over-funded status at the reporting date.

o       Under the current contribution method, the current and following years contributions.

o       Expected rate of return on assets and the discount rate used to determine the benefit obligation.

o       Any current period termination benefits.

Comprehensive Income

U.S. GAAP:

Items of comprehensive income, such as the unrealized appreciation on available for sale securities and prior service costs for defined benefit pension plans, are reported in a separate statement of comprehensive income or a single statement combined with operating income.

FRF for SMEs:

This framework does not recognize items of comprehensive income.

Revenue Recognition

U.S. GAAP:

Revenue is recognized when it is earned or realized based on evidence of the arrangement, the occurrence of a point of sale or delivery, a fixed sales price and reasonable assurance of collectability.  Contracts for production or construction are accounted for currently under the percentage of completion or completed contract methods.  Future standards for recognizing revenue under the contract method will likely require revenue recognition as performance obligations are completed.

FRF for SMEs:

Revenue recognition is more principles-based and revenues will be recorded based on performance and reasonable assurance of collectability.  When the risks and rewards of ownership of goods are transferred to a customer, performance of a transaction is accomplished.  For services in long-term contracts, such as construction or production contracts, the percentage of completion or completed contract methods may be used.  The consideration received for the service will indicate accomplishment of stages of performance of a service.  General disclosures include:

·        Revenue recognition policy for all types of transactions in Note A.

·        Accounting policies for multi-deliverables.

·        Explanation of why the completed contract method is used instead of the percentage-of-completion method, if applicable.

·        Revenue and contingent assets from any contract-related claim.

·        Major categories of revenue disclosed on the statement of operations.

·        Any unrecorded claims if claims are not recorded until received or awarded.

My series of four live two-hour webcasts with CPE credit covering the AICPA’s FRF for SMEs can be accessed by clicking the applicable link on the left side of my home page, www.cpafirmsupport.com.

Auditing Special Purpose Frameworks--Leases and Income Taxes

As auditors prepare to audit special purpose frameworks, knowledge of underlying principles in commonly used frameworks is a prerequisite.  Previous articles presented a comparison of some of the basic principles in the AICPA’s Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs) with U.S. GAAP.  This article continues this comparison.  You may obtain the AICPA’s free Toolkits for the FRF for SMEs on its website. http://www.aicpa.org/interestareas/frc/accountingfinancialreporting/pcfr/pages/frf-smes-cpas.aspx

Accounting principles for these topics are discussed below:

·      Lease Accounting

·      Income Tax Accounting

Lease Accounting

U.S. GAAP:

Traditionally, a lessee treats leases as capital or operating leases depending on certain criteria.  Capital leased assets and capital lease obligations are recorded in financial statements.  Operating leases are disclosed.  A lessor treats leases as sales type, direct financing or operating leases.

FRF for SMEs:

Accounting approaches are generally similar to traditional U.S. GAAP.  A lessee either records capital leases or discloses operating leases. A lessor either records sales type or financing leases or discloses operating leases. General disclosures include:

·        Capital Leases—Lessees:

o       Cost of the leased asset, accumulated amortization and the amortization method used.

o       Interest rate, maturity date and the outstanding balance of the obligation.

o       Any security for the lease.

o       Interest expense related to lease obligations.

o       Aggregate payments in each of the five years after the reporting date.

·        Direct Financing and Sales-Type Leases—Lessors:

o       Net investment in each type of lease and implicit interest rates.

·        Operating Leases

o       Lessees—future minimum lease payments in total and for each of the five years after the reporting date.

o       Lessors—cost of assets held for leasing and the related accumulated amortization.

Income Tax Accounting

U.S. GAAP

A deferred income tax method is use to determine the effects of temporary differences between financial and tax reporting.  The standards require management to evaluate and disclose uncertain tax positions for all open tax years, for all taxing jurisdictions. Any estimated liabilities for unsustainable positions should be recorded in the financial statements.

FRF for SMEs:

Management may elect either an income taxes payable method or the deferred income taxes method.  Uncertain tax positions are not required to be evaluated or accrued.  General disclosures include:

·        The accounting policy—income taxes payable or deferred taxes method.

·        For the income taxes payable method:

o       Provision for income tax expense or benefit include in net income or loss before discontinued operations.

o       Explanation or reconciliation of the differences between statutory rates and the effective rate.

o       Unused loss or tax credit carryforwards.

o       Any allocation of expense or benefit to equity transactions.

·        For the deferred taxes method:

o       Current and deferred income tax expense or benefit included income or loss before discontinued operations.

o       Any allocation of expense or benefit to equity transactions.

o       Total amount of unused tax losses and credits and amounts of any temporary differences for which no deferred tax asset has been recognized.

o       Explanation or reconciliation of the differences between statutory rates and the effective rate.

o       Unused loss or tax credit carryforwards.

·        Pass-through entities will disclose they are not subject to income taxes.

A series of four live webcasts on the AICPA’s FRF for SMEs can be accessed by clicking the applicable link on the left side of my home page, www.cpafirmsupport.com.

Auditing Special Purpose Frameworks—Part 5

As auditors prepare to audit special purpose frameworks, knowledge of underlying principles in commonly used frameworks is a prerequisite.  Previous articles presented basic principles for the income tax basis of accounting and began a comparison of the AICPA’s Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs) with U.S. GAAP.  This and several future articles will continue this comparison.  The AICPA has provided various Toolkits for the FRF for the FRF for SMEs on its website. http://www.aicpa.org/interestareas/frc/accountingfinancialreporting/pcfr/pages/frf-smes-cpas.aspx

Accounting principles for these topics are discussed below:

·      Investments

·      Fair Value Accounting

·      Derivatives

Investments

U.S. GAAP:

Financial assets and liabilities are classified in the balance sheet based on managements intentions, i.e., to trade, hold for sale or retain until maturity.  Trading securities and available-for-sale securities are valued at fair value.  Unrealized appreciation or depreciation for trading securities is recorded in operating income; for available-for-sale securities such amounts are recorded in comprehensive income.  Held-to-maturity securities are carried at amortized cost.

FRF for SMEs:

Investments in entities over which a company has significant influence are accounted for under the equity method.  All other investments are accounted for based on historical cost, except for securities held for sale which are valued at market value (changes are included income). Income from investments should be presented separately or disclosed in the footnotes.  Equity method investees should follow the same method of accounting as the as the investor.  An entity’s share of any discontinued operations, changes in accounting policies or corrections of errors and capital transactions of an equity method investee should be presented and disclosed separately.  General disclosures are:

·      Accounting basis for all classes of investments.

·      Events and transactions occurring between different reporting periods for the entity and equity-method investees should be disclosed or recorded by the investor.

·      Name, description, carrying amount and ownership percentage for each significant investment.

Fair Value Accounting

U.S. GAAP:

The definition of fair value in the accounting standards is “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”  The standards provide guidance on valuation techniques (market approach, income approach, cost approach) and the hierarchy of inputs (levels one, two, three) for determining fair value.

FRF for SMEs:

The term “market value” is used instead of fair value.  The definition is: “The amount of the considerations that would be agreed upon in an arm’s length transaction between knowledgeable, willing parties who are under no compulsion to act.”  Since the FRF for SMEs uses a cost approach primarily, measurement using market values is limited to business combinations, some non-monetary transactions and marketable equity and debt securities that are available for sale.

Derivatives

U.S.GAAP:

Generally, derivatives are accounted for as assets or liabilities and are measured at their fair values; changes in fair values are accounted for based on the use of the derivative. An entity is permitted to use hedge accounting.

FRF for SMEs:

This framework requires a disclosure approach only with recognition at settlement on a cash basis.  Disclosures include:

·      The face, contract or notional principal amount (upon which payments are calculated).

·      The nature, terms, cash requirements and credit and market risks

·      The entity’s purposes in holding the derivatives.

·      At the reporting date, the net settlement amounts of the derivatives.

Hedge accounting is not permitted.

For more information about the FRF for SMEs, and to register for a series of my webcasts on this topic, click the appropriate box on the left side of my home page, www.cpafirmsupport.com.

Auditing Special Purpose Frameworks—Part 4

Previous articles in this series presented basic principles for the income tax basis of accounting.  To continue laying the foundation of principles for commonly used financial reporting frameworks, this and several future articles will present a comparison of key issues in U.S. GAAP to the AICPA’s Financial Reporting Framework for Smal-l and Medium-Sized Entities. Extensive documentation for the FRF for SMEs is available in various Toolkits on the AICPA’s website. http://www.aicpa.org/interestareas/frc/accountingfinancialreporting/pcfr/pages/frf-smes-cpas.aspx

FRF for SMEs Differences From U.S. GAAP

Inventories

U.S. GAAP:

Inventories are valued under FIFO, LIFO and average cost methods at the lower of cost or market.  While market is usually considered replacement cost it is not permitted to exceed the ceiling of net realizable value (selling price less costs of completion and disposal) or be less than the floor of net realizable value (ceiling of net realizable value less a normal profit margin).

FRF for SMEs:

Inventories are valued at the lower of cost or net realizable value (selling price less estimated costs of completion and disposal).  General disclosures are:

·      Accounting policies and costing method.

·      Carrying amounts of inventories in total and by appropriate classifications, e.g., raw materials, work-in-progress, finished goods, merchandise, supplies, etc.

·      Costs of goods sold for periods presented.

·      Unusual or material losses resulting from costing methods.

·      Material purchase commitments and any expected loss when the purchase price exceeds market value.

·      Any interest costs capitalized in inventories.

Goodwill

U.S. GAAP:

Goodwill is not amortized but, instead, is tested for impairment (by a qualitative or two-step quantitative method) at least annually or triggering event arises (such as going concern or other profitability issues affecting a subsidiary)

FRF for SMEs:

Goodwill may be amortized using the federal income tax time period or 15 years. No tests for impairment are required for long-lived assets, tangible or intangible. General disclosures are:

·      Aggregate carrying amounts of goodwill should be presented as a separate line item in the statement of financial position.

·      Aggregate amortization expense for the period and the amortization period and rate used.

Intangible Assets

U.S. GAAP:

Indefinite-lived intangible assets are tested for impairment with qualitative or two-step quantitative methods similar to goodwill.  Definite-lived intangible assets are amortized over their useful lives and long-lived intangibles are also tested for impairment as a result of certain triggering events indicating possible impairment.

FRF for SMEs:

All intangible assets will be assigned estimated useful lives and amortized over that period. No tests for impairment are required for long-lived assets, tangible or intangible.  Any long-term assets no longer used are written off.  Management may elect either to expense development phase intangibles or to capitalize their costs.  General disclosures are:

·      Aggregate carrying amounts of intangibles should be classified separately on the statement of financial position.

·      Aggregate amortization expense for the period and the amortization period and rate used.

·      Accounting policy elected for internally developed intangible assets including development costs.

Future articles will summarize more differences between U.S. GAAP and the FRF for SMEs.  For more information about the FRF for SMEs, and to register for a future series of webcasts on the FRF for SMEs, click on the applicable box on the left side of my home page, www.cpafirmsupport.com.

Auditing Special Purpose Frameworks—Part 3

In my previous article, I began discussing audit planning requirements.  Among those requirements is an auditor’s responsibility to understand an entity’s applicable financial reporting framework.  In this series of writings, the audit strategies discussed will apply to audits of all financial reporting frameworks but focus specifically on two special purpose frameworks, the income tax basis and the FRF for SMEs basis.

The last article in this series summarized four basic principles for the income tax basis.  Other basic principles for this basis are presented below.

accounting classification	accounting policies
5. Property and Equipment	5. Fixed assets are recorded under both the accrual and cash methods of tax return preparation. Most fixed assets are depreciated using the accelerated tax methods resulting in more rapid depreciation.  Within certain limitations, the cost of IRC Section 179 property can be deducted on tax returns in the year of acquisition.  Owner’s asset contributions may be valued at the owner’s tax basis.  Capitalization of leases generally only occurs when ownership transfers at the end of the lease or there is a bargain purchase.
6. Intangible Assets	6. Generally, goodwill and other intangible assets are amortized over 15 years.
7. Liabilities	7. Liabilities (and receivables) are recorded if the entity’s tax return is prepared on an accrual basis.  Long-term obligations are recorded under both the accrual and cash methods of preparation.
8. Consolidation	8. Subsidiaries owned 80% or more may be consolidated.
9.. Other Basic Principles	9. The historical cost basis is used. Financial statements prepared under this framework must include appropriate disclosures of the basic accounting principles used and other disclosures of related party transactions, commitments and contingencies, threats to the going concern assumption and other matters necessary for it to be considered a “fair presentation framework.”

All financial reporting frameworks are required to be fair presentation frameworks.  Defined in the Clarified Auditing Standard, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance With Generally Accepted Auditing Standards (AU-C 200.14), http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-C-00200.pdf

a fair presentation framework includes all disclosures necessary to enable a user of the financial statements to effectively evaluate the financial position and results of operations of the reporting entity. To accomplish this objective for all financial reporting frameworks, required disclosures often extend beyond the basic principles of the framework.

While this list of tax basis principles is not exhaustive, it does underpin an auditor’s approach to planning and performing an audit.  In the next article in this series, some of the basic principles for the FRF for SMEs will be presented.  As always, I invite your questions and comments, either directly below the article or sent to my personal email address, larry@cpafirmsupport.com.

Auditing Special Purpose Frameworks—Part 2

Planning an Audit

AU-C Section 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Generally Accepted Auditing Standards, paragraph 20, http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-C-00200.pdf, requires an auditor to comply with all applicable AU-C sections when performing an audit.  AU-C Section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatements, paragraph 12c, http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-C-00315.pdf, requires the auditor to obtain an understanding of an entity’s selection and application of accounting policies.  These requirements apply to all financial reporting frameworks, including special purpose frameworks.

This series of blogs will focus both on general audit requirements applicable to all financial reporting frameworks, as well as specific requirements relevant to two special purpose frameworks, the income tax basis and the AICPA’s FRF for SMEs basis.  Because an auditor is required to understand the applicable financial reporting framework used by an entity as part of engagement planning, summaries of the basic accounting policies for these two special purpose frameworks will be presented to illustrate the first step of the planning process.  These part includes some of the significant tax basis policies which are summarized below.

Summary of Some Basic Principles for the Tax Basis of Accounting

Account classification	aCCOUNTING POLICIES
1. Accounts Receivable	1. The specific charge-off method is required uncollectible trade and notes receivable.  Uncollectible balances are charged to bad debt expense when they are considered worthless, ordinarily when no more collection efforts are possible.
2. Inventories	2. Inventories are generally valued at cost using the lower of cost or market method or the retail method.  Most cost flow methods can be used with a reasonable allocation of manufacturing overhead to inventories.  Losses are recognized when incurred.
3. Investments	3. The cost basis is used for investments in equity and debt securities.  Dividends are included in income when received and the equity method is not permitted.
4. Prepaid expenses	4. Advance payments of expenses generally are deductible in the period to which they apply unless the related services will be consumed within 12 months of the date of payment or within the next tax year.

More accounting policies for the income tax basis of accounting will be presented in the next part.  Since this series will cover all commonly applicable requirements of the auditing standards applicable to all financial reporting frameworks, with emphasis on special purpose frameworks, the materials will be useful for reference.  Storing each of the blogs in electronic or hardcopy format will facilitate their use as non-authoritative, practical guidance for auditing engagements.  Some practitioners may also find them useful for internal discussions or training within their CPA firms. As you read along with me through this series, I invite your questions and comments, either in the comment box or directed to my personal email address, larry@cpafirmsupport.com.  Thank you for joining me in this blog experience!