Preplanning Phase: - AccountingWEB
AUDITS OF SPECIAL PURPOSE FRAMEWORK FINANCIAL STATEMENTS
(Illustrating the AICPA’s FRF for SMEs basis)
By Larry L. Perry, CPA
CPA Firm Support Services, LLC
LEARNING OBJECTIVES
• To understand the requirements of AU-C 800.
• To identify major accounting policies and principles for the FRF for SMEs.
• To design and perform appropriate auditing procedures for applications of FRF for SMEs policies and principles.
• To be able to integrate required auditing procedures for special purpose frameworks into a normal audit process.
INTRODUCTION
AU-C Section 800, Special Considerations—Audits of Financial Statements Prepared in Accordance With Special Purpose Frameworks, was effective, along with other Clarified Auditing Standards, for periods ending after December 15, 2012. This standard applies to audit engagements for reporting entities preparing financial statements in accordance with special purpose frameworks. These materials illustrate the audit procedures applicable to financial statements prepared using the AICPA’s Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs).
These materials present an outline and summary of the typical procedures and activities for an audit engagement with the requirements of AU-C 800 for auditing special purpose frameworks interfaced into applicable sections of the outline. Key auditing issues in the FRF for SMEs that differ from U.S. GAAP are discussed following the outline of the audit process.
THE AUDIT PROCESS
A. Pre-planning Phase:
1. Obtain the prior year’s permanent, tax, correspondence and current files.
a. Become familiar with the prior period’s auditor’s report, financial statements and footnotes.
b. Determine that the reporting framework is appropriate given the nature, size, and complexity of the client.
c. If a change to a special purpose framework has been made or is planned, such as the AICPA’s Financial Reporting Framework for Small- and Medium-Sized Entities, and it can save financial statement preparation and audit time, consult with reporting entity management and the user of the financials to determine if a special purpose framework can appropriately present financial position and results of operations of the entity. Determine if comparative statements will be required by management or financial statement users and, if necessary, the degree of restatements that will be required for the prior period.
d. Review the prior year’s risk assessment procedures, levels of assessed risk, audit strategy and audit plan (program) to determine if there are opportunities for changes that will save audit time charges in the current year.
e. Review the key forms, practice aids, working papers, and other documentation in last year’s current file to determine any client documents, unnecessary working papers or correspondence that can be eliminated this year.
f. Determine if it is possible to use the prior year’s control risk assessment in the current year and if doing so can reduce the current year’s risk assessment procedures and other substantive tests.
g. Read the prior year’s internal control communication letter and investigate the current status of significant deficiencies and material weaknesses and their affects on the current year’s auditing procedures.
h. Prepare a list of procedures and activities that can be performed during interim work, make staffing requests and schedule the interim work
i. Determine if specialists will be needed, e.g., IT persons, attorneys, valuation experts, actuaries, etc.
j. Prepare a list of schedules and other assistance to request from client and deliver at least 30 days before the reporting date.
k. Begin a Planning Document or prepare a separate memo documenting procedures and findings.
Special Purpose Framework Audit Procedures
Auditors are responsible for evaluating the appropriateness of an entity’s applicable financial reporting framework. The evaluation should take into account financial statement users’ needs and whether or not the framework appropriately presents the entity’s financial position and results of operations. Here are some general questions management, users and auditors may ask when considering the appropriateness of using the FRF for SMEs or another special purpose framework:
• Is U.S. GAAP required by financial statement users? Obviously, a “yes” answer to this question would preclude the use of a special purpose framework.
• Are prescribed-format financial statements required by users? This also would prevent the use of a special purpose framework.
• Does the current financial reporting framework meet the needs of users or would another special purpose framework be more appropriate? This question will focus attention on the accounting policies and principles of various special purpose frameworks. A document entitled Financial Reporting Framework for Small- and Medium-Sized Entities containing accounting policies and principles is available for free download from the AICPA ( ).
• Would a special purpose framework, such as the FRF for SMEs, be cost-efficient for financial reporting? If the questions above indicate a special purpose framework can appropriately present the financial position and results of operations of a reporting entity, accounting and reporting under the special purpose framework should also create efficiencies in the financial statement and footnotes preparation process to be an appropriate choice by management.
A detailed Decision Tool, including additional questions for considering changes to the FRF for SMEs, cash, modified cash and income tax bases of accounting, is also available for free download from the AICPA. Management and auditors should document the decision making for selecting a special purpose framework.
2. Hold pre-planning meeting with the in-charge accountant and engagement leader (partner, shareholder, sole practitioner).
a. Discuss client changes in business, organization, accounting, financial reporting framework, internal control, personnel and current events that may affect this year’s audit.
b. Discuss any effects of the current economic climate, any going concern issues and the need for management to develop plans to overcome potential threats to the continuing existence of the entity.
c. Discuss findings, questions and other issues from the review of the prior year’s working papers (outlined above).
d. Schedule due dates, interim and year-end fieldwork and assign staff personnel.
e. Discuss fees, billing policies, budgets and other administrative issues.
f. Begin engagement leader participation memo documenting involvement and supervision or plan to describe involvement in more detail on electronic time slips or timesheets.
Special Purpose Framework Audit Procedures
When U.S. GAAP or a special purpose framework is being used as the applicable financial reporting framework, all engagement personnel must understand applicable accounting principles. For the FRF for SMEs, toolkits have been made available by the AICPA for statement preparers, users and CPA firms containing these documents:
• Introduction to the Financial Reporting Framework for Small- and Medium-Sized Entities (a 200+ page documentation of framework policies)
• Illustrative Financial Statements
• Presentation and Disclosure Checklist for FRF for SMEs
• Numerous other aids to facilitate understanding of the framework and to communicate it to clients and others, such as bankers and lawyers.
3. Schedule time for engagement leader to meet with the management or governance person that engaged the firm to deliver the engagement letter.
a. Reach an understanding about the nature of the engagement, as well as client and CPA firm responsibilities. Discuss management’s responsibility to select the most appropriate financial reporting framework.
b. Discuss current client issues, including any affects of economic climate
c. Make fraud inquiries.
d. Arrange for proper workspace.
e. Arrange for client assistance.
f. Finalize dates for interim and year end fieldwork.
g. Discuss target dates.
h. Discuss range of audit fees and affects of variables (problems, no client assistance, etc.).
i. Document discussions in the leader participation memo, on electronic time slips or in some other way.
4. If possible, prepare a rough draft or block out financial statements and footnotes.
Special Purpose Framework Audit Procedures
In addition to the items above that should be discussed in a meeting (or other means of oral communication such as Skype, Face Time or telephone) between the engagement leader and the client management and governance persons, financial statement users’ reporting requirements should be discussed. The pre-planning discussions and evaluation of an applicable reporting framework should include discussions with financial statement users. Their needs and preferences should be given priority in management’s decisions to use a special purpose framework. As mentioned above, a special purpose framework will not be acceptable when the user requires a U.S. GAAP or prescribed format financial reporting framework.
B. Planning Phase:
1. Complete or update basic documentation necessary to demonstrate an understanding of the client’s business and environment, financial reporting framework and internal control.
a. Client Acceptance and Continuance Form
b. General Ledger Analysis Worksheet
c. Internal control flowcharts, Internal Control Questionnaire and systems walk-through memo or other documentation
d. Documentation of any and all inquiries of management or client personnel
2. Assess control risk by financial statement classifications, combine with inherent risk documentation, and assess level of risk of material misstatement.
3. Use assessed risk at financial statement level from Client Acceptance and Continuance Form (illustration attached at the end of these materials) and other documentation to establish planning materiality, tolerable misstatement, and the lower limit for individually significant items at the financial statement level.
4. Use assessed risk of material misstatement at the assertion (financial statement classification) level to establish tolerable misstatement and the lower limit for individually significant items at the financial statement classification level.
5. Design a sampling or non-sampling plan using materiality levels for financial statement classifications.
6. Document planning activities and decisions in a Planning Document (illustrated at the end of the materials).
7. Hold meeting with in-charge accountant and engagement leader to discuss planning results and finalize audit strategy.
8. Tailor the audit program.
9. Make work assignments and provide necessary training for staff personnel.
10. Hold planning and brainstorming meeting with all engagement personnel.
11. Prepare planning communication with persons charged with governance.
Special Purpose Framework Audit Procedures
The accounting policies and procedures applicable to financial statements prepared under a special purpose framework must be documented in engagement files. The documentation should include both the basic policies and procedures of the framework applicable to the entity’s financial statements, as well options management may have elected under the applicable financial reporting framework.
All engagement personnel must be familiar with the general and specific policies and procedures of the applicable reporting framework prior to the engagement team’s brainstorming/planning meeting to properly identify and consider potential risks of material misstatement due to error or fraud. Engagement files should contain documentation of each engagement team member’s understanding of the applicable reporting framework.
For the FRF for SMEs, the resource material made available by the AICPA that was mentioned above should be read, discussed among team members and applied to the financial reporting system of the entity subjected to audit. Documentation of an internal CPA firm training meeting for special purpose frameworks is one way to evidence the understanding of special purpose frameworks by engagement team members.
C. Performance Phase:
1. Perform the maximum amount of interim work that is practical before client’s fiscal yearend.
a. Risk assessment procedures
b. Reading minutes of meetings of board of governance
c. Substantive tests for property, plant and equipment, debt and expenses
d. Interim analytical procedures—reading general ledger
e. Cycle counts of perpetual inventories
f. Receivables confirmations
g. Loan files exams--banks
h. Site inspections--contractors
i. Other planning activities
j. Oversee client working paper preparation
k. Block out or replicate audit documentation
l. Other work
2. Perform highly-effective analytical procedures whenever possible that can generate evidence for evaluating all financial statement assertions for accounts such as sales and revenues, certain salaries and wages, payroll taxes, depreciation, interest income and expense, etc.
3. Complete audit program procedures and prepare supporting audit documentation.
Special Purpose Framework Audit Procedures
Performance of auditing procedures for financial statement classifications and other issues applicable to the FRF for SMEs is discussed after the following summary of completion phase activities.
D. Completion (Wrap-Up) Phase:
1. Complete in-charge accountant’s review of assistant’s work as soon as it is completed and clear review points as soon as possible.
2. Plan to clear open items early (do not leave items to last minute).
3. Draft audit report, financial statements and footnotes (finalize if client prepares).
4. Prepare a list to facilitate engagement leader’s final review.
a. Identify any significant issues not discussed with the leader and their resolution.
b. Identify specific documentation prepared by the in-charge accountant that needs the leader’s review.
5. Schedule leader’s review (and all other required reviews) in the field whenever possible (otherwise schedule staff time to complete in-office wrap-up and review).
6. Obtain leader’s final review of working papers, audit report and financial statements and footnotes and clear review points and open items as soon as possible.
7. Prepare internal control communication letter and obtain leader’s review.
8. Obtain client’s approval of a draft of the financial statements, present a draft of the internal control communication letter and get management’s representation letter signed.
9. Meet and communicate with persons charged with governance.
10. Perform the administrative wrap-up procedures.
a. Furnishing clients with proposed adjustments, discussing their content and documenting client responses.
b. Obtaining all signed correspondence.
c. Making sure all review notes and open items lists are cleared and destroyed.
d. Preparing a list of time savings issues for next year.
e. Preparing, reviewing and completing all necessary tax returns.
f. Completing final time accumulation schedules and comparing with budgets (if required by firm policy).
11. Hold post-engagement training meeting with engagement personnel.
12. Complete final quality control procedures, document report release date and lock or secure audit documentation.
13. Evaluate the CPA firm’s client service.
14. Identify, discuss, and communicate to the client any additional services that could help the client accomplish its operational objectives.
KEY ISSUES RELATED TO AUDITING FINANCIAL STATEMENT CLASSIFICATIONS UNDER THE FRF FOR SMEs
CASH CLASSIFICATIONS
Accounting Standards
Demand and time deposits in banks, credit unions and other depositories, cash on hand and cash equivalents are included in this classification. The accrual basis of accounting is used for the FRF for SMEs. Cash equivalents are highly liquid investments that usually have a maturity of less than three months from date of acquisition by an investor. Cash and any cash equivalents should be classified together with the description of “Cash and Cash Equivalents” in both the statement of financial position and statement of cash flows.
Cash balances that are restricted because of withdrawal restrictions should be classified separately. Depending on the nature of the restrictions, these balances may be classified as current or non-current.
Negative cash balances, i.e., bank overdrafts, should be classified as current liabilities unless the legal right of offset relates to these and other accounts at the same financial institution. Also, any material amounts of written and held checks should be reclassified as current liabilities.
Auditing Standards
Audit strategies are based on the standards issued by the Auditing Standards Board of the AICPA, specifically the clarified risk assessment standards which are referred to in the Planning Section above. These standards indicate that all risk assessment procedures, tests of controls, analytical procedures and tests of balances produce substantive evidence that enables an auditor to design the most cost-beneficial audit strategy on every audit engagement. Risk assessment, based on an auditor’s professional judgment and professional skepticism, is required on all audits to indentify potential risks of material misstatement due to error or fraud and to design audit responses that will prevent such risks from causing the audited financial statements from becoming misleading. These standards apply to audits of all financial reporting frameworks, including special purpose frameworks such as the FRF for SMEs.
COMMON SUBSTANTIVE TESTS OF BALANCES PROCEDURES FOR CASH
Analytical Procedures
For all levels of risk of material misstatement, some specific analytical procedures normally performed for cash would include:
• Compare account balances with the preceding year or years. Investigate significant changes in amounts or deviations from trends.
• Investigate accounts opened or closed during the year.
• Investigate credit balances to determine if they represent actual bank overdrafts.
• Compute quick current ratio (cash and net receivables to current liabilities) and compare among years.
Other Substantive Tests of Balances Procedures for Cash
The nature, extent and timing of detailed tests of balances procedures should be determined based on the assessed level of risk of material misstatement for each financial statement classification (assertion level). The assessed level of risk should be determined based on the documentation of the auditor’s risk assessment procedures. There are no special issues in designing auditing procedures for cash under the FRF for SMEs. Basic auditing procedures for the applicable assessed levels of risk of material misstatement would include proving bank reconciliations, obtaining confirmation of bank balances and determining interbank and intrabank transfers before and after the reporting date. The Tests of Balances Procedures Schedule at the end of these materials illustrates the affects of the assessed levels of risk of material misstatement on tests of balances auditing procedures.
ACCOUNTS AND NOTES RECEIVABLE
Accounting Standards
Since the FRF for SMEs is based on the accrual basis of accounting, revenues and related accounts receivable are recorded based on performance, i.e., delivery of a product or performance of a service. Notes receivable would be recorded when they are issued and signed by the counterparty. An allowance for uncollectible accounts is ordinarily required, unless management elects the direct write-off method, and the results of that method are comparable to the allowance method.
Auditing Procedures
For all levels of assessed risk of material misstatement, other analytical procedures normally performed for accounts receivable would include:
• Compare account balances in accounts, loans and notes receivable with the preceding year or years. Investigate significant changes in amounts or deviations from trends.
• Investigate large and/or unusual balances classified as other accounts receivable.
• Consider computing the following ratios and comparing to the prior year or years to assist in evaluating the existence and valuation (collectability) assertions:
o Number of days net revenues in accounts receivable
o Yearend receivables as a percent of gross revenues
o Bad debts as percentage of gross revenues
o Allowance for doubtful accounts as a percentage of accounts receivable
o Aged categories as a percentage of total accounts receivable
o Interest income as a percentage of the average balance of notes receivable outstanding
The nature, extent and timing of detailed tests of balances procedures should be determined based on the assessed level of risk of misstatement for each financial statement classification (assertion level) after considering the results of risk assessment and analytical procedures. The assessed level of risk should be determined based on the documentation of the auditor’s risk assessment procedures. These accompanying illustrative practice aids for the Always Best Corporation contain an example of the documentation of risk assessment procedures and the assessment of the level of risk of material misstatement by financial statement classification.
Common tests of balances auditing procedures, based on assessed levels of risk, include confirmations of account balances, sales cutoff tests, inspecting subsequent collections documentation and determining the appropriateness of the recorded allowance for uncollectible accounts by reviewing and discussing the aged trial balance of accounts receivable with management. When management elects the direct write-off method for uncollectible accounts under the FRF for SMEs, the auditor will ordinarily make more detailed inquiries and inspect more documentation of older accounts on the entity’s aged trial balance of accounts receivable.
INVENTORIES
Accounting Principles
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.
Auditing Procedures
Specific Auditing Standards for inventory are published in the AICPA Professional Standards, AU Section 331 / Research / Standards / AuditAttest / DownloadableDocuments / AU-00331.pdf . Some of the key issues in this section include:
• Inventory observation is a generally accepted auditing procedure (before the McKesson Robbins fraud in 1938 inventories could simply be confirmed by auditors).
• For physical counts of inventory, the auditor must usually be present at the time of the count to observe count procedures, make test counts and inquire about potential risks of material misstatement.
• For accurate perpetual inventory records, the auditor’s observation procedures may be performed on a cycle basis during the reporting period.
• For statistical methods of sampling inventory, the auditor must be satisfied that the client’s methods produce reliable results that are substantially the same as a count of all items. The auditor must be present for representative counts and must evaluate the sampling plan and its application to determine results are reasonable and statistically valid.
• For inventories held in public warehouses, quantities may be confirmed but additional procedures are usually necessary, such as obtaining an audit report on the warehouseman’s internal control or applying appropriate procedures at the warehouse to determine confirmed information is reliable.
Based on assessed levels of risk of material misstatement, common tests of balances procedures include test counts made during observations of physical inventories counts, tests of prices assigned to inventory quantities and clerical tests of the compilation of dollar values of inventory components.
Slightly different from the U.S. GAAP method of determining the “lower of cost or market,” as described above the FRF for SMEs requires net realizable value to be calculated as the selling price less estimated costs of completion and disposal. Auditing procedures should include tests of a reporting entity’s application of this pricing rule.
INVESTMENTS
Accounting Principles
Investments:
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 in current 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 (or their financial statements should be adjusted to the investor’s method before determining equity changes). 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.
Consolidation and Subsidiaries:
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.
Business Combinations:
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 depending on circumstances. General disclosures similar to U.S. GAAP are required for material and immaterial business combinations.
Goodwill:
Goodwill may be amortized using either the federal income tax amortization period or 15 years. No tests for impairment are required for long-lived assets, tangible or intangible, unless a triggering event occurs that indicates an asset may be impaired.
Intangible Assets:
All intangible assets will be assigned estimated useful lives and amortized over that period. In additional to any triggered tests for impairment, any long-term assets no longer used should be written off. Management may elect either to expense development phase intangibles or to capitalize their costs. Start-up costs and research expenses are expensed as period costs.
Market Value Accounting:
The term “market value” is used instead of U.S. GAAP “fair value” requirements. The definition is: “The amount of the consideration 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 basis primarily, measurement using market values is generally limited to business combinations, some non-monetary transactions and marketable equity and debt securities that are available for sale.
Derivatives:
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.
Push-Down (New Basis) Accounting:
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.
Auditing Procedures
Goodwill and Intangibles:
Auditing goodwill and intangibles will include two significant steps:
• Determining any triggering events that could cause impairment of the assets.
• Evaluating the assets useful lives and amortization methods.
Determining events triggering impairment will likely occur as a result of performing these and other auditing procedures:
• Delivery and discussion of the engagement letter by the engagement leader. In addition to other questions about the reporting entity’s overall business and environment, the engagement leader will normally make inquiries about the current operating results of acquired entities from which the intangibles were acquired. Current financial statements of the acquired entities should be reviewed during these discussions.
• Amortization rates and methods should be tested in accordance with the engagement audit strategy.
• The accounting for any business combinations during the period should be audited to determine that tangible assets, liabilities, goodwill and intangibles are calculated and recorded properly in accordance with the principles of the FRF for SMEs.
Investments:
Investments accounted for under the cost method are recorded at their purchase costs. Dividends, interest or other income is recorded in income as received or accrued. As it would be for any reporting framework, brokers’ statements, purchase receipts, contracts or other documentation would be inspected by the auditor in the period of acquisition; evidence of continuing ownership should be inspected in subsequent years. Income received or receivable should be traced to appropriate support. Any dividends issued out of investee capital should be recorded as reductions of the cost of the investment. The auditor should also make inquiries of management and persons charged with governance and perform appropriate research to determine there are no triggering events that could cause the carrying amount of the investments to be permanently impaired.
For investments accounted for under the equity method, auditors should inspect documentation supporting the purchase cost in the year of acquisition of the investment. Since the equity method can only be used when the investor has significant influence over the investee, the auditor should consider these and other matters:
• Representation on the board of directors of the investee.
• Participation in policy making processes.
• Material intercompany transactions.
• Interchange of managerial personnel.
• Technological dependency.
• Concentration of other shareholdings (like a larger number of smaller shareholders).
When the investor has significant influence over the investee, normally an investment interest of 20%-50%, the equity method may be used under the FRF for SMEs. Under the equity method, the investor’s proportionate share of the investee’s periodic income should be recognized in its statement of operations. Depending on the materiality of the investor’s share of investee income reported in its statement of operations, the auditor should perform appropriate procedures to audit the income amount.
For less material amounts of income, at a minimum, the auditor should read financial statements of the investee to determine they are appropriate in accordance with the investee’s applicable financial reporting framework. For material amounts of investee income recorded in the investor’s income, a review or audit of the financial statements may be required.
The auditor should also determine that appropriate adjustments have been made to income amounts, including eliminating intercompany gains and losses, amortizing any difference between the investor’s cost and the underlying equity in the net assets of the investee and adjustments of differences in the investee’s applicable reporting framework for both the equity and consolidation methods if necessary. As under the cost method, the auditor should also determine if any triggering events have occurred that could cause impairment of the carrying amount of the equity method investment.
Consolidations:
When the entity elects the consolidation method for 50+% owned subsidiaries, the requirements in AU-C 600, Audits of Group Financial Statements, are applicable. Under this standard, the group audit partner has responsibility for either 1) re-performing or reviewing component auditors’ work or 2) referring to component auditors in the group audit report.
Business Combinations:
Since accounting principles are similar to those for U.S. GAAP, auditing procedures are also similar. The determination of acquisition date market values assigned by management should be evaluated by the auditor. Market values are considered to be those which are most readily accessible and reliable and, as a last resort, estimates based on some form of objective evidence may be used. As discussed above, intangibles can only be recorded if they are separable, have a definite used life and have a determinable value.
Derivatives:
Reviewing derivatives’ contracts or agreements and statements from investment brokers or managers will be necessary to determine and support appropriate amounts for disclosure. Confirmations of current settlement values or alternative procedures will also be necessary.
PROPERTY AND EQUIPMENT
Accounting Principles
Property, plant and equipment is recorded under the FRF for SMEs similar to U.S. GAAP, i.e., at acquisition costs. Acquisition costs gnerally include:
• Purchase prices.
• Shipping charges.
• Installation and testing costs.
• Real estate commissions and legal fees.
• Other costs related to acquiring and preparing fixed assets for use.
• Market values of assets received in non-monetary exchanges.
For fixed assets constructed or developed by an entity, all direct costs, overhead costs and interest or carrying costs related to the fixed asset are capitalized as its carrying amount.
Similar to the “improvement or betterment rule” used in practice under U.S. GAAP, costs incurred to increase the life or capacity of a fixed asset are considered improvements and, along with the remaining carrying amount of the asset, are depreciated over its extended useful life; this change is accounted for prospectively as a change in accounting method. Costs to maintain the service potential of a fixed asset are recorded as repairs and maintenance in the period incurred.
Depreciation expense of the carrying amount is calculated in a systematic and rational way over an asset’s useful life. The useful life of an asset is limited to the shortest of its physical, technological, commercial or legal life. Straight-line and variable methods of depreciation may be used, provided they are representative of a fixed asset’s economic return or use in the operations of an entity. Depreciation methods and the lives of property, plant and equipment should be reviewed periodically to determine any changes in the use of an asset, changes in technology affecting productivity, impairments to the operation or use of the asset and other events that could change the expected use of fixed assets. Depreciation methods and useful lives should be adjusted prospectively.
Asset retirement obligations should be included in the carrying amounts of property, plant and equipment in a business combination transaction, even though not recorded in the financial statements of an acquired entity. For example, the cost of replacing underground gasoline storage tanks as required by a state law, if probable and estimatible, should be included in the acquisition costs of a convenience store.
Assets may be leased under operating or capital lease agreements. Leased assets meeting the criteria for capital leases under the FRF for SMEs (which are similar to current U.S. GAAP requirements) should be capitalized and carried at the discounted present value of future minimum payments.
Auditing Procedures
The Clarified Auditing Standard specifically applicable to property and equipment is included in AU-C 540, Auditing Accounting Estimates, including Fair Value Accounting Estimates, and Related Disclosures, The principal issues in AU-C 540 affecting property and equipment recorded under the FRF for SMEs would be connected with the valuation of assets received in non-monetary exchanges and with the determination of market values for comparison to carrying amounts when a triggering event occurs, such as a technological change. The auditor must evaluate the reasonableness of management’s determination of market values assigned to assets and determine any impairment loss in these circumstances. Other principal audit issues for property and equipment relate to the useful lives and residual values of depreciable assets and their depreciation and amortization methods. The auditor must determine that these estimates are reasonable and appropriate under the FRF for SMEs accounting principles adopted by a reporting entity.
Other customary auditing procedures for property and equipment include the following:
• Determining acquisition costs are recorded properly, including costs assigned to internally-constructed fixed assets.
• Inspecting property and equipment to gather evidence for the existence assertion and to identify any unrecorded equipment (completeness assertion).
• Determining if any repairs of assets meet the improvement or betterment rule and should be capitalized.
• Analyzing repairs and maintenance, supplies, small tools and other related accounts to determine capitalization limits have been met.
• Reviewing management’s depreciation methods and rates.
• Identifying any idle equipment, fully depreciated equipment or property related to discontinued operations for separate accounting and reporting.
• Reading lease agreements to identify any capitalizable leased assets and to evaluate management’s applicable accounting policies.
• Analyzing rental income and expense for the existence of other leases and subleases.
• Reviewing the calculations of gain or loss on any disposals of property and equipment.
ACCOUNTS PAYABLE, ACCRUED EXPENSES, LONG-TERM DEBT AND PENSION PLANS
Accounting Principles
Accounts Payable and Accrued Expenses:
The AICPA’s Financial Reporting Framework for Small- and Medium-Sized Entities is based on the accrual basis of accounting. Expenses and related liability accounts, therefore, are recorded as accounts payable or accrued expenses when the expenses are incurred. Unless affected by other principles in the FRF for SMEs, such as accounting for goodwill and intangibles discussed above, there are no significant differences from U.S. GAAP.
Long-Term Debt:
Accounting for long-term debt and footnotes disclosures under the FRF for SMEs is also similar to U.S. GAAP. Differences may arise in the future for capitalized lease obligations, however, when the Financial Accounting Standards Board issues an Accounting Standard Update changing the criteria for lease capitalization to “use of an asset.” Currently, lease accounting principles under the FRF for SMEs are similar to the principles that originated under SFAS No. 13 (ASC Topic 840).
Retirement and Postemployment Benefits:
Under U.S. GAAP, a projected benefit obligation model with accounting for the aggregate of periodic pension costs and the overfunded and underfunded status of defined benefit and post-retirement benefits plans is required. Defined contribution plans’ costs are accounted for as period expenses.
For the FRF for SMEs, management may elect to account for defined benefit plans using a current contribution payable method or one of the accrued benefit obligation methods similar to U.S. GAAP. From paragraph 20.32 of the AICPA’s Financial Reporting Framework for Small- and Medium-Sized Entities, “an entity should determine its accrued benefit obligation using:
• the projected benefit method prorated on services, when future salary levels or cost escalation affect the amount of the retirement and other postemployment benefits or
• the accumulated benefit method, when future salary levels and cost escalation do not affect the amount of the retirement and other postemployment benefits.”
Detailed guidance for application of these methods is included in the above-mentioned publication.
Auditing Procedures
Accounts Payable, Accrued Expenses and Long-Term Debt:
Since there are no significant differences in accounting principles from U.S. GAAP, auditing procedures for accounts payable, accrued expenses and long-term debt for the FRF for SMEs will generally be the same. Since completeness of account balances and related disclosures is the primary financial statement assertion for audit evaluation of liabilities, searching subsequent disbursements for liabilities that should be recorded at the reporting date will be the primary auditing procedure. Inquiries of management and persons charged with governance, scanning general ledger account activity, correspondence with financial institutions and Uniform Commercial Code confirmations will guide the search of unrecorded debt obligations.
Retirement and Postemployment Benefits:
When management elects the contribution payable method for defined benefit plans, as it is for defined contribution plans, inspection of plan statements will be necessary to support the amounts payable and related pension expense for the reporting period. When the accrued benefit obligation model is elected, basic auditing procedures will include confirmations of plan details with actuaries, reviewing actuaries’ processes and their computations of pension costs, and determining that over- and under-funded status of the plans is properly recorded in the financial statements. Other specific accounting principles and financial statement disclosures required by the FRF for SMEs should also be considered when performing auditing procedures.
INCOME TAXES
Accounting Principles
The FRF for SMEs offers entities subject to income taxes a choice of two methods for accounting for income taxes:
1. The taxes payable method.
2. The deferred income taxes method.
A brief summary of the two methods follows.
Taxes Payable Method:
An asset or liability will be recognized to the extent of refundable and unpaid income taxes, which unpaid taxes should include any from prior years. Carrybacks of tax losses should be recognized as a current asset and tax benefit in the period the tax loss occurs. Income taxes refundable or payable are calculated in accordance with the applicable capital gains or ordinary income tax rates and laws in effect at the date of the statement of financial position.
Deferred Income Taxes Method:
Similar to U.S. GAAP, deferred tax assets and deferred tax liabilities are recognized for future deductible amounts and future taxable amounts, respectively. Differences in the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes are called temporary differences. Temporary differences may be future taxable or deductible differences. Deferred tax assets result from amounts that will be deductible for tax reporting in the future. Deferred tax liabilities result from amounts that will be taxable in the future.
Deferred income tax calculations under the FRF for SMEs do not require consideration of uncertainties in income tax positions, as does U.S. GAAP. Other than this exception, deferred tax calculations are similar to those under U.S. GAAP.
Auditing Procedures
Auditors are responsible for evaluating the appropriateness of management’s calculations of income taxes currently payable and, if the deferred taxes method is elected, deferred tax calculations in accordance with the principles of the FRF for SMEs. For small- to medium-sized entities, auditors often assist management with these calculations or, in some cases, make the calculations. When this occurs, this becomes a non-attest service subject to the provisions of ET 101-3 and management must assign a person with suitable skill, knowledge or experience to review, accept and take responsibility for the non-attest services.
AU-C 250, Consideration of Laws and Regulations in an Audit, requires an auditor to collect evidence to evaluate management’s calculations under laws and regulations that have a direct, material effect on the financial statements. Income taxes are classified as direct effect laws and regulations. Engagement files should contain evidence of the auditor’s knowledge of the laws and regulations, as well as tests of balances for affected accounts, e.g., income taxes payable or refundable, current and non-current deferred income taxes and current and non-current income tax provision or benefit.
COMMITMENTS AND CONTINGENCIES
Accounting Principles
Commitments:
Future material commitments should be disclosed in the footnotes. This may include facilities or major assets’ purchase or construction, debt reduction or refinancing, restrictive covenants in debt agreements and purchase commitments.
Contingencies:
Contingencies may arise in connection with guarantees of obligations of others, threatened litigation or other matters. Accounting for contingencies, similar to U.S. GAAP, depends on the probability of occurrence of an event causing the contingency and whether the amount is determinable. Professional judgment should be used to determine appropriate amounts. Uncertainties about an event are categorized as:
• Probable of occurrence—the event is likely to occur; a greater likelihood than “more likely than not” (generally considered 50+%) but not absolutely certain.
• Remote—a slight chance of occurrence exists.
• Reasonably possible—the chance of occurrence is greater than remote and less than probable or likely.
Contingent losses should be recorded when it is probable future events confirm that the carrying amount of an asset has been impaired or a liability has been incurred the amount of the loss is reasonably determinable. Contingent gains normally would not be recorded because they do not meet the requirements for revenue recognition; namely, they may never be realized.
When it is probable a future event will result in the acquisition of an asset or reduction of a liability producing a contingent gain, a footnote should disclose the nature of the contingency and an estimate of its amount or a statement an estimate is not determinable.
As CFO for ABC Corporation, assume you are evaluating the necessary disclosures for a contingent loss. Your attorney has informed you that a settlement of $30,000 is probable for a $100,000 lawsuit against your company, although certainty of the amount is about 60%. What is your suggested accounting treatment for this contingency?
________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________
Guarantees:
Accounting treatment for guarantees should be the same as for contingent losses. Disclosures, even for a remote likelihood the guarantor will become obligated, are as follows:
• The nature and approximate term of the guarantee, how it arose and circumstances triggering performance.
• The maximum, undiscounted amount of future payments that could be required or a statement that the amount can not be determined.
• The amount of any currently existing recorded liability.
• Recourse provisions that enable the guarantor to recover any amounts paid on behalf of a guaranteed party.
• Any assets held as collateral by third parties which can be liquidated by the guarantor.
Auditing Procedures
Delivery and discussion of the engagement letter and the management representation letter, reading and excerpting minutes of meetings of boards of governance and committees, reading and excerpting loan agreements and other contracts and communications with management and members of boards of governance, reviewing and discussing lawyers’ letters and reviews of subsequent events, among other engagement performance procedures, produces audit evidence regarding the existence of commitments and contingencies. While proper presentation and disclosure of commitments and contingencies is the primary responsibility of reporting entity management, all such circumstances should be evaluated by the auditor.
STOCKHOLDERS’ EQUITY
Accounting Principles
When an entity redeems or acquires shares of its own stock, the transactions are recorded as capital transactions. Management can elect one of two methods of accounting:
• Cost method.
• Constructive retirement method.
The cost method is similar to the treasury stock method under U.S. GAAP in that shares are carried at cost and reported as a deduction from stockholders’ equity or as treasury stock. When reacquired shares are sold, amounts received in excess of cost are treated as paid-in capital. Any deficiency should be charged to additional paid-in capital related to the previous issuance of the stock with any excess amounts charged to retained earnings. If shares are retired or cancelled, their cost is allocated to the appropriate capital stock or additional paid-in capital accounts.
Under the constructive retirement method, the aggregate par or stated value of the acquired shares reduces the capital stock account with any excess amounts paid charged against paid-in capital. Subsequent retirement or cancellation of the shares would require no further accounting.
Dividends should be recognized when declared and should only be provided for outstanding shares.
Accounting for Stock and Equity Compensation:
The FRF for SMEs does not recognize compensation expense when stock or other equity compensation is issued. Certain disclosures are required however. When options are exercised, they are recorded as a normal stock issuance, i.e., an equity transaction.
Equity transactions with non-employees are recognized when goods or services are received by an entity. Such transactions are measured based on either the value of the goods or services received or the equity instruments exchanged, whichever valuation is most appropriate.
Auditing Procedures
Auditing equity transactions under the FRF for SMEs will be similar to auditing equity under other financial reporting frameworks. Beginning with confirmations with registrars or inspections of stock record books, support for all transactions will be inspected (sampled if they are numerous) to determine either the cost method or constructive retirement method has been accounted for properly. Reading and excerpting minutes of directors’ meeting and reading other correspondence with shareholders and employees may identify equity transactions that have not been recognized in the accounting records. Reading any stock compensation agreements will provide information for disclosure of these arrangements.
REVENUES
Recognizing Revenues
Recognizing revenue under the FRF for SMEs requires completion of performance of a transaction and reasonable assurance of collection of invoices and billings. Similar to U.S. GAAP, revenue must be earned or realizable to be recognized.
Specifically for the sale of goods, performance is achieved when the seller has transferred ownership of the goods to the buyer and the seller retains no continuing involvement in the goods transferred.
When services are provided under long-term contracts, performance should be determined under the percentage of completion method or the completed contract method. The method that best relates the revenue to the work performed should be used.
Achievement of performance occurs when:
• There is persuasive evidence of an arrangement.
• Goods have been delivered or services have been provided.
• The seller’s price is fixed or determinable.
Evidence of an arrangement: Business practices or prior transactions with a customer, side agreements, consignment sales, the right to return a product or requirements to repurchase a product may be indicators of whether an arrangement exists.
Delivery: Delivery generally occurs when a product is delivered to a customer’s facility or another specified site. As it is when recognizing revenue under other reporting frameworks, consideration of several factors may be necessary. Such factors include bill and hold agreements, required customer acceptance, layaway sales, non-refundable fees, licensing and other fees and who bears the risk of loss.
Seller’s price: Factors that should be considered to determine if a price if fixed or determinable include cancellable provisions, the right of return of a product, price protections or inventory credit arrangements and refundable fees for service agreements.
Generally, performance of a transaction determines when revenue is earned and recognized. For the sale of goods or providing services, performance is considered achieved when a seller has transferred goods to a buyer or provided services, i.e., a point of sale or delivery has occurred, when the buyer assumes the risks and rewards of ownership of a product or accepts the services, when there is reasonable assurance a specified amount of consideration will be received (collectability) in return and when an appropriate allowance for returns of products has been determined. A sale would not be recorded when the seller retains significant risks of ownership, such as in the case of consignment sales. An appropriate allowance for uncollectible accounts should be provided based on the evaluation of collectability.
For long-term contracts or rendering services, performance should be determined under either the percentage of completion method or the completed contract method, whichever best presents revenues in relationship to the work that has been accomplished. Revenue should be recognized under the percentage of completion method base on some systematic, rational and consistent basis such as sales value, related costs, and extent of progress or number of acts. Amounts billed are an appropriate basis only if they are indicative of work completed.
The completed contract method normally should be used when the extent of progress cannot be reasonably estimated. Management may elect to use the completed contract method when it is used for income tax reporting or when the financial position and results of operations are similar to the percentage of completion method. This may occur when an entity performs numerous short-term contracts or in other situations.
Contract claims may be recorded when amounts have been awarded or received or at times when it becomes probable the claims will result in additional contract revenue (if amounts can be reasonably estimated). In the latter case, revenue should be recorded only to the extent related costs are incurred.
Multiple Deliverable Arrangements:
For multiple deliverable arrangements, performance of transactions should be considered separately in accordance with the recognition criteria above. An example would be the sale of software with separately priced installation, training, maintenance and warranty agreements. Revenue from elements such as maintenance and warranty agreements will normally be recognized on a straight-line basis over the term of the agreement unless the services are provided in an identifiable, significantly different pattern.
U.S. GAAP includes provisions for recognizing revenues in connection with arrangements that have multi-deliverables. ASU 2009-13 clarified those requirements by requiring a sales price to be assigned to each of the deliverables at the inception of an arrangement.
Under the FRF for SMEs, similar provisions will apply. When a sales transaction includes the delivery or performance of multiple products, services or rights to use assets, and the delivery or performance occurs at different times, revenue recognition criteria will be applied to each of the deliverables. A vendor of large appliances, for example, will ordinarily sell the product, charge additionally for delivery, and make warranty and/or maintenance agreements available for separate purchase. Separate revenue recognition criteria would be applied to each of these deliverables. For fixed fee warranty or maintenance agreements, revenue would be recognized over the term of the agreement, ordinarily on a straight line basis.
Other Income
Investment income is recognized similar to U.S. GAAP. Interest is recognized over time, royalties are recognized as they accrue under an agreement and dividends are recognized when a shareholder has the right to receive payment.
Principal vs. Agent
Also like U.S. GAAP, an agent in a transaction will report only commissions as revenues.
Companies that conduct business as agents rather than as principals sometimes face a dilemma as to how to record revenues, gross amount of billings or net amounts of commissions. Judgment based on facts and circumstances should guide resolution.
Indicators of gross revenue reporting by principals include whether the entity:
• Is the primary obligor in the arrangement.
• Has general inventory risk.
• Has latitude in establishing price.
• Changes the product or performs part of the service.
• Has discretion in supplier selection.
• Is involved in the determination of product or service specifications.
• Has physical loss inventory risk.
• Has credit risk.
Indicators of net commission reporting include:
• The supplier, not the entity, is the primary obligor in the arrangement.
• The amount the company earns is fixed.
• The supplier has credit risk.
Improper Revenue Recognition
For the FRF for SMEs, improper revenue recognition may occur in any of these and other situations:
• Letters of intent are used in lieu of signed contracts.
• Products are shipped before the scheduled shipment date without the customer’s approval.
• Products can be returned without obligation after a free “tryout” period.
• Customers can unilaterally cancel a sale.
• Obligations to pay for products are contingent on a customer’s resale to a third party or on financing from a third party.
• Sales are billed for products being held by the seller before delivery.
• Products are shipped after the end of the period.
• Products are shipped to a warehouse (or other intermediate location) without the customer’s approval.
• Sales are invoiced before products are shipped.
• Part of a product is shipped and the part not shipped is a critical component of the product.
• Sales are recorded based on purchase orders.
• Obligations to pay for the product depend on the seller fulfilling material unsatisfied conditions.
• Products still to be assembled are invoiced.
• Products are sent to and held by freight companies pending return to the seller for required customer modifications.
• Products require significant continuing vendor involvement (such as installation or debugging) after delivery.
Auditing Procedures
Common Sense Questions about Assertions for Revenues
For revenues to be recognized properly in financial statements, all financial statement assertions will be considered by management and auditors. Here are some common sense questions that auditors should ask about the assertions for revenues:
• Were sales of products or services made to valid customers, do they meet the criteria for valid sales, and did they actually occur in the reporting period?
• Do other revenues represent legitimate income of the entity received or earned in the reporting period?
• Have all revenues of the entity been reflected in the financial statements?
• Are the sales or other revenues valued properly, i.e., do they reflect arms-length valuation for products, services or transactions recorded during the reporting period?
• Are the revenues presented in the proper account classifications and are all necessary disclosures included?
• Are revenues consistently recorded to reflect FRF for SMEs’ principles or principles for another special purpose framework?
• Are only revenues applicable to the reporting period presented in the financial statements?
AU-C 500 and AU-C 315 make clear that auditors must gather sufficient evidence to evaluate relevant assertions for all material financial statement classifications. The auditing standards also make it clear that some assertions, particularly the completeness assertion for revenues, may require procedures other than detailed tests of balances to reduce detection risk to an acceptably low level.
Evaluating the Completeness Assertion for Sales
When tests of balances or analytical procedures can be performed to efficiently evaluate the completeness assertion, tests of controls are not necessary for this purpose. Evaluating the completeness of sales and revenues through tests of balances, however, is difficult at best.
Examples of substantive tests that can be used to evaluate the completeness assertion for sales and revenues include examining contracts to determine all revenues that should be recorded are recorded (for the construction industry) or using predictive analytical procedures to determine the accuracy of recorded revenues or expenses, e.g., using copy machine meter readings for a copying business to compute copying revenues and copy machine rental expense. In other instances, limited tests of controls may be necessary to properly evaluate the completeness of revenues. Tracing, say, 10 to 15 or more documents originating sales transactions, e.g. customer orders or shipping reports, to the sales journal is an example of a limited test of control procedure for completeness. A systems walk-through procedure for the sales and collections cycle using 10-15 transactions may also provide sufficient evidence.
Matching Procedures with Financial Statement Assertions:
Recognizing that risk assessment procedures and analytical procedures are being performed for revenues, and that cash and accounts receivable tests of balances procedures contribute evidence for evaluating financial statement assertions for revenues, the question at this point is “What additional tests of balances are necessary for revenues?” The following table presents an analysis of evidence collected in carrying out the audit strategy.
Here’s how the evidence collected under an audit strategy will impact the financial statement assertions (x=a small contribution; X=a large contribution):
|AUDIT STRATEGY AND PROCEDURES |ASSERTIONS AFFECTED BY EVIDENCE FROM PROCEDURES |
|Risk Assessment Procedures | Complete/Occur/Value/Exist |
|1. Completing Client Acceptance and Continuance Form | |
| |x |
|2. Reading the general ledger. | X |
|3. Internal control flowchart for sales and collections | |
|cycle. |X X X X |
|4. Systems walk-through procedure with 10 sales transactions | |
|selected from shipping reports without bias. | |
| |X X X X |
|Analytical Procedures | |
|1. Number of days sales in accounts receivable. | |
| |x x x x |
|2. Gross margin by product line. | x x x x |
|3. Inventory turnover by product line. | x x x x |
|4. Dollar balances of sales by product line trend comparison for | |
|three years. |x x x x |
After assessing the contributions of substantive evidence from the risk assessment and analytical procedures, the question at this point is “What other substantive tests of sales and revenues are necessary?” Assuming no significant misstatements were found as a result of the procedures above, at the moderate risk level the answer to the question is likely “none” other than customary tests of balances for related receivables accounts, such as confirmation procedures, sales cut-off tests and tests of the allowance for uncollectible accounts at the beginning and end of the year.
If the auditor can perform a predictive analytical procedure for sales (such as the number of units sold times sale price) for comparison to recorded sales and results are as expected, and the results of other procedures for accounts receivable and cash accounts are acceptable, the substantive evidence will likely be more than sufficient, even for high risk! In other words, no other tests of balances for the sales account would ordinarily be necessary.
When significant misstatements are found in the risk assessment and/or analytical procedures, other tests of balances will be necessary. For the completeness assertion as an example, the auditor may need to select a sample of 25-40 shipping reports and trace them to their entry in the sales journal. It also may be necessary to compare sales by month with preceding years to identify any material variations. If material variations are identified, performing detailed support tests for a sample of recorded sales invoices may be necessary to further evaluate the existence assertion.
OPERATING EXPENSES
The matching of costs with revenues in the same reporting period is a basic principle for the accrual basis of accounting underlying the presentation of operating expenses. Costs of goods sold and other operating expenses should be recorded in the same period related revenues are recognized.
Generally, operating expenses are recognized on an accrual basis, when an expense is incurred. Fixed assets are depreciated over their useful lives. Intangible assets are amortized over their useful lives (or contractual periods as in the case of asset retirement obligations) or periods specified in the FRF for SMEs (goodwill is amortized over the period specified by the Internal Revenue Code or 15 years).
Lease Accounting
The FRF provides guidance for lessees’ accounting for capital and operating leases, and for lessors’ accounting for sales-type, direct financing and operating leases. The principles are based on the view that property has benefits and risks related to ownership. Further, the FRF takes the position that when a lease transfers substantially all the ownership benefits and risks it is essentially an acquisition of an asset and the incurrence of an obligation and should be accounted for as a capital lease by the lessee and either a sales-type or direct financing lease by the lessor.
This guidance does not apply to copyrights, patents and other licensing agreements which are accounted for as intangible assets. Following is a discussion of basic lease accounting principles under the FRF.
One or more criteria in a lease agreement indicating transfers of substantially all the benefits and risks of ownership to lessees, similar to currently applicable U.S. GAAP, include:
1. Transfer of ownership at the end of the lease term or a bargain purchase option (that would cause the lessee to purchase).
2. A lease term that will enable the lessee to receive substantially all the economic benefit from the asset. This would normally be a term that is 75% or more of the remaining useful life of the asset. This criteria normally would not apply to land unless there is reasonable assurance ownership will transfer at the end of the lease term.
3. The lessor has some assurance of recovering the cost of the assets and earning a return on that investment. This assurance exists if, at the inception of the lease, the present value of the minimum lease payments excluding executory costs is 90% or more of the market value of the asset. The discount rate that should be used to determine present value is the lower of the lessee’s incremental borrowing rate or the interest rate implicit in the lease if it can be obtained or estimated (the implicit rate will be used by a lessor).
For lessors, the benefits and risks of ownership normally are transferred when:
1. Any one of the criteria above is met.
2. Credit risk is similar to other receivables.
3. Non-reimbursable costs likely to be incurred by the lessor can be estimated to determine if substantial risks are retained, thereby preventing capitalization of the lease
Again, a lease of an asset that transfers substantially all the benefits and risks of ownership should be accounted for as a capital lease by the lessee and a sales-type or direct financing lease by the lessor.
Auditing Procedures
Upon completion of risk assessment procedures, analytical procedures and tests of balances procedures in major audit areas, most tests of balances for payroll and expense accounts should have been completed.
Analytical Procedures that Reduce Tests of Balances Procedures for Operating Expenses
The Clarified Auditing Standards require analytical procedures to be used as risk assessment procedures during the planning phase of an audit engagement, as well as during its completion phase. These and other analytical procedures performed during engagement performance contribute substantive evidence for evaluating financial statement assertions for revenues and expenses.
The following table illustrates the payroll and expense accounts affected by the analytical procedures in other major audit areas.
| |SUBSTANTIVE EVIDENCE PRODUCED FOR EXPENSES |
|ANALYTICAL PROCEDURE | |
|1. Highly effective predictive and corroborative analytical |1. Reasonableness tests may be performed for depreciation, |
|procedures during planning. |interest expense and payroll taxes. Comparison of all expense |
| |account balances with prior years. |
|2. Allowance for doubtful accounts. |2. Bad debt expense. |
|3. Inventories. |3. Purchases and costs of goods sold. |
|4. Investments. |4. Impairment losses. |
|5. Prepaid insurance. |5. Insurance expense. |
|6. Fixed assets. |6. Depreciation, amortization, repairs and maintenance, rents, |
| |supplies, small tools. |
|7. Accounts payable. |7. Purchases and all expense accounts. |
|8. Payroll and sales tax liabilities. |8. Payroll and sales tax expenses. |
|9. Notes payable and long-term debt. |9. Interest expense. |
Substantive Evidence from Tests of Balances in Other Audit Areas Affecting Operating Expenses
As auditing procedures are performed in other major audit areas, substantive evidence is produced that contributes to evaluating assertions for operating expenses. The following table illustrates the accounts that are affected.
EXPENSES SUBSTANTIVE EVIDENCE
|RISK ASSESSMENT, ANALYTICAL AND TESTS OF BALANCES PROCEDURES |SUBSTANTIVE EVIDENCE PRODUCED FOR EXPENSES |
|1. Cash. |1. Proving cash balances at the beginning and end of a year |
| |affects the completeness, occurrence and cutoff and existence |
| |assertions for expenses. |
|2. Allowance for doubtful accounts. |2. All assertions for bad debt expense are affected. |
|3. Inventories. |3. All assertions for purchases and costs of good sold are |
| |affected. |
|4. Prepaid insurance. |4. All assertions for insurance expense are affected. |
|5. Fixed assets. |5. Support tests for repairs and maintenance, rents, supplies, |
| |small tools, etc. evaluate all applicable assertions. Tests of |
| |depreciation and amortization evaluate all applicable assertions.|
|6. Accounts payable, accrued expenses and other liabilities. |6. Adjusted balances at the beginning and end of a year |
| |contribute evidence for the completeness, occurrence and cutoff |
| |and existence assertions for all affected accounts. |
|7. Note payable and long-term debt. |7. All assertions for interest expense are verified. |
From the risk assessment procedures, analytical procedures and tests of balances procedures illustrated above, it is apparent that sufficient evidence for evaluating financial statement assertions for operating expenses may have already been obtained. Specific differences under the FRF for SMEs accounting principles for pension and postretirement plans and income taxes were discussed in the liabilities section above.
DISCLOSURES
Management has primary responsibility for preparation of financial statements and footnotes. Auditors must evaluate the management’s presentation and disclosures to determine the requirements of AU-C 315 are met and assertions in financial statements and footnotes are appropriate and reasonable. The assertions pertaining to presentation and disclosure are:
• Occurrence and rights and obligations
Disclosed events, transactions, and other matters have occurred and pertain
to the entity.
• Completeness
All disclosures that should have been included in the financial statements have been included.
• Classification and understandability
Financial information is appropriately presented and described, and disclosures are clearly expressed.
• Accuracy and valuation
Financial and other information is disclosed fairly and in appropriate amounts.
The AICPA has provided a disclosure checklist among the downloadable materials for the FRF for SMEs. Among other documentation in its Toolkits, the Presentation and Disclosure Checklist for the FRF for SMEs provides detailed presentation and disclosure requirements. The free checklist can be downloaded at: .
CONCLUSION
As it is for audits of a U.S. GAAP financial reporting framework, audits of special purpose frameworks begin with an understanding of the accounting principles and their appropriate presentation in financial statements. This understanding and the auditor’s knowledge of an entity’s business, environment and internal control provides the foundation for development of a cost-beneficial audit strategy and audit plan (program). Performing procedures in the audit plan, analyzing results and performing any additional substantive procedures provides evidence for an engagement leader’s final determination that detection risk is a an acceptably low level, thereby enabling the expression of an unqualified or qualified audit opinion.
|CPA PRACTICE AIDS, LLC |
|ILLUSTRATIVE TESTS OF BALANCES PROCEDURES |
| |Reliance on TOB Procedures/RMM Result |
|Major Audit Area | High RMM |Slightly Less than High RMM |Low to Medium RMM |
|1. Cash | 1. Prove all major bank |1. Reduce the number of |1. Prove only major |
| |reconcliations at the engagement |reconciling items traced to |reconciliations at engagement date.|
| |date. Trace most reconciling items|subsequent month’s state-ment. No |No cutoff statements; use next |
| |to cutoff statements. Confirm all |cutoff statement. Search for |month statement. Search for |
| |accounts. Search for unrecorded |unrecorded transfers. Confirm all |unrecorded transfers. Confirm all |
| |transfers. |accounts, |accounts. |
| | | | |
| |2a. Send positive confirmations, |2a. Select fewer items as | |
|2. Trade accounts receivable and |and/or perform alternative |individually significant items for |2a. Send positive confirmations on|
|sales. |procedures, for individually |positive confirmation. Send some |ISI’s before engagement date. Send|
| |significant accounts comprising a |negatives on smaller balances. |some negatives on smaller balances.|
| |substantial portion of the account |Consider sending confirmations one | |
| |balances as of the engagement date.|month before engagement date. | |
| |Confirm as of the engagement date. | | |
| |Support non-replies and exceptions | | |
| |by reference to sales and cash | | |
| |receipts documents. Consider | | |
| |sending positive confirmations on a| | |
| |few representative remaining | | |
| |accounts. | | |
| | | | |
| |2b. Perform extensive sales cutoff| | |
| |test by reference to sales and |2b. Shorten test period or raise | |
| |shipping documents for a large |lower limit of items tested. |2b. Select a few sales before and |
| |period before and after engagement | |after year end and trace to |
| |date. | |support. |
| | | | |
| |2c. Compare sales by month, by |2c. Sales procedures basically the| |
| |product, to preceding year. Follow|same. | |
| |up on significant fluctuations by | |2c. None. Analytical procedure |
| |reviews of underlying records. | |only. |
| | | | |
| |3a. Consider observing inventory | | |
| |from start to finish. Make test |3a. Depending on client’s controls| |
| |counts of all individually |over count, raise the lower limit | |
| |significant items. |of |3a. Count fewer ISI’s. |
|3. Inventories and cost of sales. | |individually significant items for | |
| |3b. Perform inventory pricing and |test counts. | |
| |clerical tests for all individually|3b. Depending on client’s | |
| |signi- ficant items |double-check procedures for | |
| | |pricing, extending and footing the |3b. Reduce the number of ISI’s |
| | |inventory sheet, consider reducing |price tests and clerical tests. |
| | |the no. of individually | |
| | |significant items tested from 100%.| |
| |Reliance on Tests of Balances/ RMM Result |
|Major Audit Area |High RMM |Slightly Less than High RMM |Low to Medium RMM |
| | | | |
|4. Fixed assets. |4. Perform extensive vouching and |4. Raise the lower limit of | |
| |inspections. A significant portion|individually significant items |4. Reduce the number of ISI’s |
| |of the additions should be |subjected to vouching and |vouched. |
| |subjected to support tests. |inspection, i.e., vouch fewer | |
| | |items. | |
| | | | |
|5. Accounts payable. |5a. Perform an extensive search |5a. Same due to high inherent risk| |
| |for unrecorded liabilities |of unrecorded payables. | |
| |including subsequently recorded | |5a. Reduce the extent of the |
| |transactions, open invoices, | |search. No confirmations. |
| |receiving report and purchase order| | |
| |files. Lower limits for | | |
| |individually significant items |5b. Shorten test period or raise | |
| |should be used. Consider |lower limit of individually | |
| |confirming major suppliers, |significant items tested. | |
| |including zero balances. | | |
| | |6. Raise lower limit of | |
| | |individually significant items | |
| |5b. Perform extensive purchases |tested, i.e., support fewer items. | |
| |cutoff tests by reference to vendor|Consider omitting inspection of | |
| |invoices for a large period before |canceled checks. | |
| |and after engagement date. | |5b. Select a few purchases before |
| | |7. Basically the same procedures, |and after the yearend and trace to |
| | |except detailed tests can be |support. |
| |6. Perform extensive vouching |eliminated. | |
| |tests for all significant account | | |
|6. Expense accounts. |balances by examining canceled | | |
| |checks and supporting documents. | | |
| | | | |
| |7. Compare monthly payroll by | |6. None except for tax and |
| |labor category and follow up on | |reporting purposes. |
| |variations by reference to | | |
| |underlying records. Consider | | |
|7. Payroll accounts. |reconciling gross wages to payroll | | |
| |tax returns and , if necessary, | | |
| |detailed testing a few selected | | |
| |disbursements. | | |
| | | |7. None except for analytical |
| | | |procedures. |
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Planning Document for a Group Audit
Client: _________________________________________________________________
Engagement Date: _______________________________________________________
Instructions:
This document should be completed by the group engagement in-charge accountant and reviewed by the group engagement leader (partner, sole proprietor) before engagement personnel begin fieldwork. It should describe engagement procedures accomplished and/or planned for both the group and component audits. It may contain cross-references to other planning documentation as applicable.
I. Group Engagement Administration:
A. Delivery of Group Engagement Letter:
The engagement letter is one of the primary tools for obtaining client understanding of their responsibilities and auditors’ responsibilities. A good understanding before the engagement begins will prevent misunderstandings from arising later. To accomplish this, the group engagement leader should deliver the letter and discuss its contents with the group CEO and/or representative member of the board of group governance. The letter should indicate the components for which the group auditor is taking audit responsibility and the component auditors’ reports to which it will refer in the group audit report.
Discussion of the letter with the party or parties engaging the CPA firm should be one of the primary sources for discovering potential misstatements, fraud or illegal acts, as well as other information relevant to the group audit. The group audit partner should determine that component auditor partners have delivered and discussed their engagement letters with responsible management persons, even if the group auditor is not taking responsibility for the component auditor’s work.
B. Use of Client Assistance or Paraprofessionals:
Client assistance should be used to the maximum extent possible on every engagement. When client personnel are unavailable, consider using firm paraprofessionals to perform accounting services and clerical work in connection with the engagement.
C. Planning for Proper Workspace:
The group engagement leader has the responsibility to arrange adequate workspace before the fieldwork begins. Poor lighting, lack of adequate heat or air conditioning, desks or tables that are too small, or work locations that are not near client accounting personnel are examples of situations that hinder the efficient completion of an engagement.
D. Assignment of Staff Personnel:
Assigning the right people to engagements ensures high quality and helps complete the engagements in the minimum amount of time. SQCS No. 8, effective January 1, 2012, requires CPA firm documentation of this element of quality control. Personnel should be assigned to engagements and tasks that are commensurate with their experience and capabilities. When persons assigned don’t have experience and capabilities commensurate with engagement risks, more and more frequent supervision is required from the engagement leader. A primary audit response to risk at the financial statement level required by audit and quality control standards is to assign experienced staff persons to the high-risk area or provide more supervision to lesser experienced persons.
When the group auditor is taking responsibility for component auditor’s work, the component auditor should confirm compliance with this element of quality control and required audit standard, and that appropriate documentation has been included in its engagement documentation files.
E. Target Dates:
Timely engagement completion involves setting target dates during planning. These target dates should be entered in the firm’s staff scheduling system.
Communications to component auditors should include target dates for the group auditor’s involvement when taking responsibility for the component auditor’s work, as well as dates financial information is required by the group auditor from all components
F. Use of Specialists:
Consider using outside specialists whenever any auditing procedures outside the firm’s expertise are expected to be performed. Such circumstances may include actuarial computations for pension funds, questions of law, observations of inventories of products or materials, required tests of client accounting software, and complex accounting and auditing problem situations.
When the auditor outsources any services in connection with an engagement, the engagement letter should contain a paragraph notifying the client. The auditor is also required to obtain a confidentiality agreement from the person or organization performing outsourced services.
When group audit specialists are engaged to perform work that will also be applicable to components, the group auditor’s communication to component auditors should discuss the selection of the specialists and their processes.
G. Electronic Auditing Opportunities:
Trial balance and financial statement preparation software, electronic practice aids, file container software, spreadsheets, word processing software, document scanners, data extraction software (such as Idea, Monarch or ACL) and “cloud” services should be used to create efficiencies on the group and component audit engagements. List the specific, planned applications for discussion among the group engagement team and for communication to component auditors.
H Audit Budgets:
Prepare a group audit budget based on circumstances, not fees, during engagement planning. Summarize the budget here for discussion among the group engagement team. Include a separate section for involvement in the work of component auditors.
II. Group Technical Audit Planning Decisions:
A. Describe the process for selecting significant components.
Cross-reference this section to a separate memorandum or other documentation summarizing organizational, operational and financial information for all components. Summarize the components determined to be significant and whether the group engagement team will take responsibility for component auditors’ work or, instead, refer to component auditors in the group audit report.
B. Risk of misstatement at the group financial statement level:
Use of Group Statements:
Describe high-risk uses of statements.
Potential for Group Going-Concern Problems:
Describe continued losses, high debt and external situations that threaten the continued existence of the group or any of its components.
Integrity of Group Management:
Discuss specific information that could cast doubt on group or component management’s integrity.
Evaluate the risk of material misstatement at the group and component financial statement levels and document the subjective impact on audit responses and engagement procedures.
C. Document the group and components’ risk of misstatements evaluation at the assertion level (financial statement classification level for smaller entities), and the impact on the group and components’ audit strategy by major financial statement classification. This and other sections may be cross-referenced to other documentation.
D. Group Materiality Judgments:
Present a summary of the tolerable misstatement (performance materiality) and lower limit for individually significant items calculations and document group engagement team reasoning for group and component financial statements materiality levels.
E. Group Sampling and Non-Sampling Decisions:
Describe the reasons for making decisions to sample or not sample at the group and component levels. If decisions are made to sample, explain the rationale for sample size calculations.
F. Group Audit Strategies:
Describe the general group audit strategy including detailed substantive tests of balances, risk assessment procedures, tests of controls and/or extensive analytical procedures. Cross-reference this section to other group audit documentation for specific audit strategies at the group and component financial statement classification levels.
G. Nature of Group Audit Procedures:
Summarize the nature and extent of work for significant components and components to be referred to in the group audit report. Describe the nature, extent and timing of tests of balances procedures and analytical procedures for material financial statement classifications or cross-reference to other documentation describing planned procedures for material financial statement classifications at the group and component levels.
H. Significant Time-Savings Opportunities:
Describe here the opportunities to save time on the group and/or component audits not discussed elsewhere.
I. Group Engagement Team Meeting:
Summarize the significant potential risks of misstatement at the group and component levels due to error or fraud, planned audit responses and other matters discussed at the group engagement team meeting. All group engagement personnel, including partners or sole practitioners, are required to attend this meeting. Matters discussed affecting the work of component auditors should be communicated to them.
J. Planned Involvement with Component Auditors
Summarize here, if not present above, the extent of involvement in the work of component auditors when the group engagement team plans to take responsibility for their work and/or when component auditors reports will be referred to in the group audit report. This should include both administrative and technical activities similar to those summarized above for the group audit. This planned involvement should be part of the group engagement team’s communication to component auditors.
I. Potential Risks of Misstatement due to Errors or Fraud and Audit Responses—Group Audit:
From risk assessment procedures:
Document potential risks of misstatement discovered during the risk assessment procedures and the planned audit responses.
From scanning the general ledger account activity and performing other analytical procedures:
Document unusual matters, variances or other potential risks, and record the planned audit responses here.
Factors discovered throughout the engagement, along with audit responses and their results:
From inquiries of management personnel:
From inquiries of staff personnel:
From communication with persons charged with governance:
From performing fieldwork and other auditing procedures:
From performing subsequent events procedures:
J. Potential Risks of Misstatement due to Errors or Fraud and Audit Responses—Component Audits
Summarize the same information from involvement with the work of component auditors as presented above for group audits.
Prepared by:________________________________Date:_________________________
Reviewed by:_______________________________ Date:_________________________
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CPA PRACTICE AIDS, LLC
CLIENT ACCEPTANCE AND CONTINUANCE FORM
Name of Client: ALWAYS BEST CORPORATION
Engagement Date: DECEMBER 31, 2014
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