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!

Auditing Special Purpose Frameworks--Part 1

Section AU-C 800 of the AICPA Professional Standards includes the Clarified Auditing Standard, Special Consideration—Audits of Financial Statements Prepared in Accordance With Special Purpose Frameworks.  Special purpose frameworks (SPF) include:

• Cash or modified cash basis
• Tax basis
• Regulatory basis
• Contractual basis
• AICPA’s FRF for SMEs
• Other commonly accepted basis of accounting

 This series of blogs will discuss special considerations concerning:

• Engagement acceptance.
• The planning and performance phase of this type of engagement.
• Determining an opinion and reporting on the audit.

 Engagement Acceptance

This standard references the clarified SAS, Terms of Engagement, which requires and auditor to evaluate the appropriateness of an entity’s applicable financial reporting framework.  For special purpose frameworks, this requires an auditor to consider the purpose for which the financial statements are prepared, the known users of the financial statements and what management has done to determine the applicable reporting framework is appropriate for these circumstances.

In an engagement letter, the auditor should obtain management’s agreement that it is responsible for all providing all informative disclosures (a fair presentation framework) in the financial statements and footnotes applicable to the financial reporting framework it has decided to use (its applicable reporting framework).  Among those disclosures are:

• A description of the SPF, its significant accounting policies and the main differences from U.S. GAAP.
• Informative disclosures similar to those required by U.S. GAAP.
• Contractual frameworks, in addition, would include any significant interpretations of the contract used in preparing the financial statements.
• Any additional disclosures necessary to comply with the requirements for a fair presentation framework in the clarified auditing standards.

 The client acceptance and continuance decision-making requirements originated in the quality control standards first published in the 1980’s and are now required by current auditing standards.  Obtaining and documenting relevant organizational, environmental and operating information as a part of engagement acceptance or continuance is, of course, a condition precedent to obtaining an engagement letter and planning an engagement.  

As for audits of any framework, the engagement leader (sole practitioner or partner) should deliver and discuss the engagement letter contents, along with other engagement planning subjects, with the management or governance person of the reporting entity that has engaged the CPA firm.  Performing a client acceptance and continuance evaluation and delivering an engagement letter are often the first steps for compliance with the leadership involvement requirements of the AICPA’s Statement of Quality Control Standards No. 8.

My next blog will begin discussing considerations for planning and performing an audit of a special purpose framework.