In July 2023, the Public Company Accounting Oversight Board (PCAOB) published a report that highlights common areas of audit deficiencies for public companies. Private companies face similar challenges when reporting their financial results. Internal accounting personnel and external auditors can use the PCAOB’s report to identify high-risk areas in financial reporting that may warrant additional attention.

The PCAOB recently inspected portions of financial statement audits for public companies. The findings were published in a new PCAOB Spotlight report, Staff Update and Preview of 2022 Inspection Observations.

Many of the deficiencies found in 2022 are in inherently complex areas that have greater risks of material misstatement. The top seven financial statement deficiency areas were:

Auditors may find this information useful as they plan and perform their audits. Likewise, managers and in-house accounting personnel may benefit from a review of these findings to help improve financial reporting, minimize audit adjustments and use as a reference point when engaging with external auditors.

The PCAOB report also highlights an emerging area of concern: cryptocurrency transactions. Examples of these transactions include:

The PCAOB notes that companies with material digital asset holdings and/or that engage in significant activity related to digital assets present unique audit risks. This was evidenced by the high-profile collapse of crypto asset trading platform FTX. The risks associated with crypto assets may be elevated due to high levels of volatility, lack of transparency regarding the parties engaging in the transactions and the purpose of such transactions, market manipulation, fraud, theft, and significant legal uncertainties. The PCAOB recommends using specialists and technology-based tools to help audit these transactions in certain situations.

Regardless of whether they’re public or private, companies should take proactive measures to ensure their financial reporting is accurate and transparent. These measures may include providing accounting personnel with additional training and assistance, increasing management review and staff supervision, and beefing up internal audit procedures in relevant high-risk areas.

Also, expect external auditors to focus on these high-risk areas. For your next audit, prepare to provide additional documentation to back up your accounting estimates, reporting procedures and account balances for high-risk items.

© 2023

With the COVID-19 pandemic well into its second year and the start of planning for the upcoming audit season, you may have questions about how to evaluate your company’s going concern status. While some industries appear to have rebounded from the worst of the economic downturn, others continue to struggle with pandemic-related issues, such as rising inflation, along with labor and supply shortages. For some businesses, pre-pandemic conditions may never return, which can make it exceptionally difficult to project future performance.

How auditing standards have changed

Financial statements are generally prepared under the assumption that the entity will remain a going concern. That is, it’s expected to continue to generate a positive return on its assets and meet its obligations in the ordinary course of business.

Under Accounting Standards Codification Topic 205, Presentation of Financial Statements — Going Concern, the continuation of an entity as a going concern is presumed as the basis for reporting unless liquidation becomes imminent. Even if liquidation isn’t imminent, conditions and events may exist that, in the aggregate, raise substantial doubt about the entity’s ability to continue as a going concern. Today, the responsibility for the going concern assessment falls on management, not the company’s external auditors.

In addition, the time period that the assessment must cover has been extended. Previously, the determination of an entity’s ability to continue as a going concern was based on expectations about its performance for a one-year period from the date of the balance sheet. Now, under Accounting Standards Update No. 2014-15, Presentation of Financial Statements — Going Concern: Disclosure of Uncertainties About an Entity’s Ability to Continue as a Going Concern, the assessment is based upon whether it’s probable that the entity won’t be able to meet its obligations as they become due within one year after the date the financial statements are issued — or available to be issued — not the balance sheet date. (The alternate date prevents financial statements from being held for several months after year end to see if the company survives.)

When disclosures are required

In situations where substantial doubt exists, management then must evaluate whether its plans will alleviate substantial doubt. That is, is it probable that the plans will be implemented, and if so, will they be effective at turning around the company’s financial distress?
Disclosures are required indicating that either:
• The plans will mitigate relevant conditions and events that have caused substantial doubt, or
• The plans won’t alleviate substantial doubt about the entity’s ability to continue as a going concern.

Though management is responsible for making this assessment, auditors will request appropriate evidence to support the going concern disclosure. For example, detailed financial statement projections or a written commitment from a lender or affiliated entity to fully cover the entity’s cash flow requirements might help substantiate management’s assessment. If management doesn’t perform a sufficient evaluation, the auditing standards may require the auditor to report a significant deficiency or a material weakness.

We can help

If your business is continuing to struggle during the pandemic, contact us to discuss your going concern assessment for 2021. Our auditors can help you understand how the evaluation will affect your balance sheet and disclosures.

© 2021

An external audit is less stressful and less intrusive if you anticipate your auditor’s document requests. Auditors typically ask clients to provide similar documents year after year. They’ll accept copies or client-prepared schedules for certain items, such as bank reconciliations and fixed asset ledgers. To verify other items, such as leases, invoices and bank statements, they’ll want to see original source documents.

What does change annually is the sample of transactions that auditors randomly select to test your account balances. The element of surprise is important because it keeps bookkeepers honest.

Anticipate questions

Accounting personnel can also prepare for audit inquiries by comparing last year’s financial statements to the current ones. Auditors generally ask about any line items that have changed materially. A “materiality” rule of thumb for small businesses might be an inquiry about items that change by more than, say, 10% or $10,000.

For example, if advertising fees (or sales commissions) increased by 20% in 2021, it may raise a red flag, especially if it didn’t correlate with an increase in revenue. Be ready to explain why the cost went up and provide invoices (or payroll records) for auditors to review.

In addition, auditors may start asking unexpected questions when a new accounting rule is scheduled to go into effect. For example, private companies and nonprofits must implement new rules for reporting long-term lease contracts starting in 2022. So companies that provide comparative financial statements should start gathering additional information about their leases in 2021 to meet the disclosure requirements for next year.

Minimize audit adjustments

Ideally, management should learn from the adjusting journal entries auditors make at the end of audit fieldwork each year. These adjustments correct for accounting errors, unrealistic estimates and omissions. Often internally prepared financial statements need similar adjustments, year after year, to comply with U.S. Generally Accepted Accounting Principles (GAAP).

For example, auditors may need to prompt clients to write off bad debts, evaluate repair and supply accounts for capitalizable items, and record depreciation expense and accruals. Making routine adjustments before the auditor arrives may save time and reduce discrepancies between the preliminary and final financial statements.

You can also reduce audit adjustments by asking your auditor about any major transactions or complicated accounting rules before the start of fieldwork. For instance, you might be uncertain how to account for a recent acquisition or classify a shareholder advance.

Plan ahead

An external audit doesn’t have to be time-consuming or disruptive. The key is to prepare, so that audit fieldwork will run smoothly. Contact us to discuss any concerns as you prepare your preliminary year-end statements.

© 2021

On October 25, the Financial Accounting Standards Board (FASB) issued a simpler accounting option that will enable private companies to more easily measure certain types of shares they provide to both employees and nonemployees as part of compensation awards. Here are the details.

Complex rules

Many companies award stock options and other forms of share-based payments to workers to promote exceptional performance and reduce cash outflows from employee compensation. But accounting for these payments can be confusing and time-consuming, especially for private companies.

To measure the fair value of stock options under existing U.S. Generally Accepted Accounting Principles (GAAP), companies generally use an option-pricing model that factors in the following six variables:
1. The option’s exercise price,
2. The expected term (the time until the option expires),
3. The risk-free rate (usually based on Treasury bonds),
4. Expected dividends,
5. Expected stock price volatility, and
6. The value of the Company’s stock on the grant date.

The first four inputs are fairly straightforward. Private companies may estimate expected stock price volatility using a comparable market-pricing index. But the value of a private company’s stock typically requires an outside appraisal. Whereas public stock prices are usually readily available, private company equity shares typically aren’t actively traded, so observable market prices for those shares or similar shares don’t exist.

To complicate matters further, employee stock options are also subject to Internal Revenue Code Section 409A, which deals with nonqualified deferred compensation. The use of two different pricing methods usually gives rise to deferred tax items on the balance sheet.

Simplification measures

Accounting Standards Update (ASU) No. 2021-07, Compensation-Stock Compensation (Topic 718): Determining the Current Price of An Underlying Share for Equity-Classified Share-Based Awards, applies to all equity classified awards under Accounting Standards Codification Topic 718, Stock Compensation.

The updated guidance allows private companies to determine the current price input in accordance with the federal tax rules, thereby aligning the methodology used for book and federal income tax purposes. Sec. 409A is referenced as an example, but the rules also include facts and circumstances identified in Sec. 409A to consider for reasonable valuations. The practical expedient will allow private companies to save on costs, because they’ll no longer have to obtain two independent valuations separately for GAAP and for tax purposes.

Right for your Company?

Private companies that take advantage of the practical expedient will need to apply it prospectively for all qualifying awards granted or modified during fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. Early application, including application in an interim period, is permitted for financial statements that haven’t yet been issued or made available for issuance as of October 25, 2021. Contact your CPA for more information.

© 2021