Using the work of an expert

In audit, it is not uncommon for management to rely on the work's of expert to assist in preparing the financial statement of the Company. The common work of experts relied by management are as follows:

- engaging external valuer to perform valuation of property ( for impairment assessment of the property)
- engaging corporate finance expert to assist in Purchase Price Allocation review
- engaging actuary to estimate the defined benefit plan of the Company
- engaging corporate finance expert to assist in impairment assessment of goodwill / brand / etc

Generally, management relied on the subject matter expert to provide their opinion on certain aspects.What did we do as an auditor to address this matter?

International Standard of Auditing specifically mention that we need to review and/or evaluate the independence, competency and objectivity of these experts. It is important for us to carry a rigid assessment on the external valuer and its work to ensure that the results is not unreasonable. For instance, we need to check that the valuer is independent from management, such that the opinion provided by expert is independent and not under the influence of management.

When the work performed by subject matter expert become very technical, we may consider to consult our in-house expert (e.g. transaction service department/ valuation team). This is to check that the methodology / work performed by subject matter expert is not unreasonable. The opinion provided by subject matter expert could affect our audit opinion directly. Hence, we urge all auditors to ensure that all mandatory procedures are performed and all factors are consider to deal with this.

Can Accounting Systems be TOO Integrated?

Systems like SAP, Oracle Financials and PeopleSoft attempt to integrate all aspects of a business, regardless of the number of countries, industries, product lines they operate in.  They address all areas of the business, from accounting, to manufacturing, to planning, to human resources, to management.  There is no question that large corporations have benefited from this integration, but is it possible that we’ve gone too far?

The larger the computer system, the higher the cost of change.  For example, one of my clients was an international oil company which wanted to experiment with a new subsidiary.  The company found it cost effective to do a whole installation of Microsoft Dynamics (and throw it away when the experiment proved to be a success) than to integrate the new subsidiary into their main system right away.

But, more importantly, large systems become increasingly complex, reducing their ability to adapt to change.  I don’t have an inside track, but I have noticed that my telephone company’s billing system seems to be unable to keep up with changes in cellphone services and fees.  In any competitive industry, even large companies need to be nimble and respond to changes in the marketplace quickly.

Finally, there is the “best of breed” problem.  You may have the biggest, most integrated system, but there are other systems that handle specific functions better.  You then are faced with the choice of the one-vendor-solution versus assembling a system from the best of breeds by several vendors.  So, you get your basic General Ledger, Accounts Payable, Banking and Accounts Receivable from one vendor, your Point-of-Sale system from another and your document imaging from a third.

A good example of this type of thinking was a client who wanted to connect his ordering system to his web site.  Both systems claimed to be able to handle the sales tax, but in testing, the engine in the accounting system proved to be more robust than the web site.  The client decided to process the order in the web site, but have it pass the information to the accounting engine to calculate the taxes and send the result back to the web site.  The result was a better system with no tax discrepancies.

Transfer pricing: inter-company charges/ inter-company sales or purchases/ management fees/

Transfer pricing is a hot topic among accountant in almost every countries. Transfer pricing become a significant topic following the globalization foot-step, where cross-border transactions become more and more common. Your audit client may have a head office in Singapore, a packaging plant in Malaysia, while a main manufacturing plant in China. The supply chain of the audit client can span accross different countries.

Of course, when a inter-company / related company rendered service for other inter-companies / related companies, a price will be charged. The question is: how much to be charged? on what basis should the audit client determine the pricing / gross margin ( in circumstances of cost plus company) on inter-company transactions.

It is important for us to highlight to client to have a basis on determining the inter-company charges (including: sales transaction, purchase transaction). The inter-company transactions should be conducted on an arms length basis (i.e. the pricing should not differ materially from the market price). This is because local tax authority is concern on potential tax manipulation to record higher margin at lower tax rate country / region.

Hence, a proper documentation on transfer pricing is important to support all inter-company transaction. Management should always make reference to market price to assess if transfer pricing is conducted on an arms length basis.

In addition, it is common for holding company / other entities within the Group to charge managment fee to other inter-companies for certain centralised function  (e.g. shared service centre)/ corporate service. Likewise, a proper documentation and computation is required to support the basis of determining the management fee.

As auditor , we need to understand the basis of management in coming up the transfer pricing documentation and  to reivew for high level reasonableness.

Not JUST an Accounting System

Alice* shared one of her constant frustrations in a meeting about their accounting system.  She is an accounting supervisor in a medium sized company with offices across the country.  Her problem is the staff in other departments saying that the computer system belongs to the Finance department, so they don’t have to take responsibility for the quality of the information.  It’s not their responsibility if the information in the accounting system is wrong or out of date.

Accounting systems used to be confined to recording entries, producing invoices and making payments.  Current accounting systems integrate into other business software, so that the Sales, Purchasing, Manufacturing, Distribution and Human Resources systems are now part of the “Accounting System.”  More and more, other systems, such as Document Imaging and Customer Relationship Management, are integrating with the accounting system.

In a world where computer reporting is expected to be detailed and instantaneous, there is no room for error.  In short, EVERYONE owns the data.

By the same token, information needs to be shared.  There should be no arguments about who “owns” the data.  If it is needed in decision making, it needs to be made available to the decision makers, regardless of their department.

The more that operational data gets married to the financial data, the more focused the reports and the better the decision making.  The more integrated the systems, the easier it is to marry the data.  But can systems be too integrated?  Stay tuned for the next blog!  


* Not her real name.

IFRS 7: Financial Instruments- Disclosure: Receivables that are past due but not impaired

IFRS 7 set out certain disclosure requirements relating to financial instrument of the entity. One of the key requirements is: our audit client is require to disclose the analysis of the age of the financial assests that are past due but not impaired.

In general, this relates to trade receivables / other receiables from custoemrs or other third parties. This disclosure allowed financial statement users to have more information relating to the aging profile of the Company, especially those debts that are past due, but not impaired.

A general things to highlight to audit client is to emphasize that the aging table should be prepared based on the due date of the debts, instead of the age of the invoice. Auditor is required to perform testing ot the aging profile, as well as performing high level review on the aging profile prepared by client. This shall be cross checked against the debtors' turnover of the Company.

To illustrate, if our audit client has a debtors' turnover of 90 days, we will then expect the aging profile to have certain debts that are more than 90 / 120 days.

Please feel free to contact us at myauditing@gmail.com if you need more insight on this.

Internaitonal Standard on Auditing: Communication with those charged with governance

International Standard on Auditing ("ISA") 260 deals with the "Communication with those charged with governance".

For the purpsoe of ISA 260, the standard has defined the following:


10. For purposes of the ISAs, the following terms have the meanings attributed below:

(a) Those charged with governance – The person(s) or organization(s) (for

example, a corporate trustee) with responsibility for overseeing the

strategic direction of the entity and obligations related to the

accountability of the entity. This includes overseeing the financial

reporting process. For some entities in some jurisdictions, those charged

with governance may include management personnel, for example,

executive members of a governance board of a private or public sector

entity, or an owner-manager. For discussion of the diversity of

governance structures, see paragraphs A1-A8.

(b) Management – The person(s) with executive responsibility for the conduct

of the entity’s operations. For some entities in some jurisdictions,

management includes some or all of those charged with governance, for

example, executive members of a governance board, or an owner-manager.   ISA 260 has stated the matters required to be communicated to those charged with governance, as below: - Auditor's responsbilities in relation to the financial statement audit; - planned scope and timing of the audit; - significant findings from the audit; - Auditor independence   This is a very important auditing standard, whereby all the audit team members, especially audit executive need to master. This standard clearly defines on the audit matters to be communicated, to whom to be communicated, and the communication process. Hence, we suggest all audit executives to read through this ISA 260 to ensure that the audit team has complied with the standard.

Purchase Price Allocation Review- Intangible Assets- A Cross Check

Meger & acquisition activities never disappear, even when the economy appears to be slowed down. Entity with strong balance sheet and with huge cash on hand will acquire certain companies when the valuation is relatively cheaper.

When your audit client acquire a company. They are required to perform Purchase Price Allocation review, which allocates the consideration to the relative fair value of the tangible and intangible assets / liabilities acquired, with the remaining amounts recorded as goodwill/ bargain purchase.

Usually, an audit client will engage an external valuer to value the tangible assets / liabilities and intangible assets acquired. In general, intangible assets (such as: brand name/ customer list) is not recorded on acquiree' balance sheet.

We will talk more about the details of purchase price allocation review in our future posts. A very way to understand the business rationale of acquiring the target is to compare the net asset of the target company to total consideration paid by your audit client.

To illustrate, audit client has paid US$10mil to acquire a target company with a net asset value of US$1mil. It appears to you that the Company has paid US$9mil to acquire certain intangible assets or certain items not recorded at fair value on target's balance. There is a number of possible reason:

- target company has strong brand name;
- target company has comprehensive list of customer relationship;
- land & building was recorded at cost and not at fair value (note: this is allowed under accounting standard);
- a goodwill the Company is willing to pay for; etc etc

By comparing the total consideration against the net asset of the target company, you will be able to find out the business rationale of acquiring the target company and assess if the acquisition fits into the client's long term business objective. Please, never fail to understand the business rationale while you perform the auditing.

Value of engaging Big 4 accounting firms

In previous post, we invited opinions/ comments from our reader to discuss the value of engaging Big 4 accounting firms. After considering the opinions/ comments received from Accounting & Auditing blog's reader, we would like to share with you our thought:

- established reputation / recognition by the financial markets ( majority of the Blue Chip companies appointed Big 4 as their auditor);
- established audit methodology developed by respective firms (i.e. existence of technical department, etc);
- stronger support from administrative department;
- integrated support from member firms globally to ensure that audit of foreign subsidiaries are carried out smoothly;
- internal quality review policy carried out to review that quality of the audit meet the firm standard

Of course, while there is a value of engaging Big 4, there is a premium need to be paid for. Fee charged by Big 4 accounting firms is, on average, higher than those medium tier audit firm (e.g. BDO, Horwath, etc). Please feel free to drop us an email at myauditing@gmail.com if you woud like to find out more from us.

Urgent vs. Important

Accounting is all about deadlines.  From the weekly cheque run to the monthly management reports, the quarterly shareholder reporting and the annual tax return, there is always something that has to be done NOW!

At the same time, there are those important initiatives that have no specific deadline but that will significantly impact the running of the department, like systems upgrades, staff development and departmental strategic planning.

Two things are clear:  you can’t manage what you can’t measure and it won’t happen unless you make time for it.

Measuring Success

When implementing accounting systems, I ask for an idea of transaction volumes:  how many accounts payable invoices are processed in a month, how many journal entries, etc.  Often it takes some digging to get the answers to those questions.  Controllers often don’t know how many transactions are being put into the system or, more importantly, how many entries one person can be expected to be able to do in a day.  Accounting managers often have a sense that some staff members are busier than others, but no hard statistics to back up their impressions.  Yet, this information can often be easily obtained.

Accounting systems usually tag each entry with some code for the person who created the transaction, as well as the date the entry was made, so you can create a report that summarizes the number of transactions entered by each person.  When I did this exercise for one company, some useful information resulted.  The report confirmed what the Controller already knew about how slow the summers were, but it also gave him some reasons to investigate the performance of the Purchasing staff.

When he found out the reason it took so long to create purchase orders was the amount of time they had to put in chasing department managers for their signatures, he decided to go ahead with the workflow software he had been considering.

Making Time

A hint about making time for important initiatives:  delegate!  Make it part of everyone’s job description that in addition to the regular routine, each member has a special project they are responsible for.  Emphasize how taking on this responsibility will enhance their career and that you will work with them to help them find ways to make time for the new project.  For example at one company, I knew that we were wasting time photocopying each cheque we received and that our payment encoding scanner was on its last legs, so I asked for a volunteer to research the latest technology.  An accounts payable clerk who loved technology offered to do it.  He did a more thorough job than I would have had time for and he enjoyed the challenge.

How do you make time for important initiatives in the middle of all of your urgent deadlines?

Nortel Accounting Fraud?

Take a darling of the stock market, add a spectacular fall, throw in a possible recovery and then sprinkle the whiff of scandal in the Executive Suite.  The newest Hollywood business blockbuster?  No, the Nortel fraud case.

In a nutshell, senior executives, including the Chief Financial Officer, have been charged with manipulating the company's earnings in order to earn themselves a bonus.

I don't know the facts of the case, as all I have read are the newspaper accounts.  The reality is that accounting involves estimating of the impact on future events on current operations.  For example, if you guarantee your products, you know that you will have to refund some amounts to customers in the future.  How much?  Only experience can tell, and even then, it's often wrong.  So, you estimate.  A technical person will give you some rule, like 1.25% of the products will fail, so you calculate how many you have sold and set aside 1.25% (or more if you will incur additional service costs).

As an accountant, my goal is that the financial statements of a company reflect the economic activity of that company over time, but please don't hold me to one specific number, particularly the Net Income.  That just isn't realistic.

What I want to know is:  who created a significant bonus scheme based solely on accounting income?  What were they thinking?

Whose System is it, Anyway?

There are many stages a computer system goes through during an implementation.  At first, it is just an idea perhaps starting with frustration with the current system or a sudden new requirement that the current computer (if there is one) can’t handle.  At this point, all you know is that you need a new system.

The Hunt

Then you start looking.  Maybe you ask colleagues.  Maybe you initiate a Request For Proposals (RFP), asking a number of vendors a series of questions about what their system can do, and inviting them to bid on your business.  Maybe the system has already been chosen for you by a parent company.

Then come the demonstrations and the system becomes more real.  You compare different products.  You talk to consultants and the customers they offer as reference sites.  You do your homework and you make your decision about which system to buy, but it’s not your system yet.  Even though you may have signed a contract, taken delivery of the software and paid for it, your staff has not taken ownership of the system.

The Implementation

Next comes the detailed planning, the configuration, the set-up, the training and the conversion of the data from the previous system.  What can the new system really do?  What fits and what doesn’t?  You add additional software.  Maybe the new system doesn’t have Electronic Data Exchange (EDI) for orders and payments to large retail companies, so you add an EDI package.  Maybe you need workflow to handle your online orders or document imaging to get rid of the tedious searches through filing cabinets, so you turn to iDatix.

At this point, you examine your internal processes.  You look for formerly manual steps that the system can now do.  With the workflow system now reminding people to submit their expense forms, move the person who used to phone all the salespeople to a higher value task, such as following up on customer payments.

By this time, your staff should start to feel like they own the system, that it is their responsibility to make it their own and work with its strengths and weaknesses.  Unfortunately, after many years of implementations, my experience has been that they often don’t.  All of a sudden, the old system looks better.  The new one seems clunky.  There’s always something that worked better before.  The staff doesn’t remember the issues they had when the old system was new.  They don’t remember the workarounds they had to come up with.  They don’t have enough time or patience for the new system.

Naming the Beast

Accounting systems are complex.  In a medium sized implementation, there may be over 500 data files.  In a large one, there are literally thousands.  When you layer on tax requirements, Generally Accepted Accounting Principles, industry standards, vendor/customer complexities, etc. etc. even the best planned systems require extensive work to fit.  One simple thing you can do to help your staff take ownership and really commit to the new system is to name it.  It sounds like a small step, but it underlines the fact that it has been customized for your company.  The system is no longer SAP, Oracle, Microsoft, Sage or even Quickbooks, it is yours.  So, if you were the Leamington Manufacturing Corporation for example, you might call your system Lexie (Leamington’s EXtended Information Environment) and have one of the more artistic members of staff find a suitable image.  Give the system a good start by throwing a party, and when people complain, make sure to take their complaints seriously, but also ask them to have patience with Lexie.  After all, she is the newest member of the team.

Re-posted with the kind permission of iDatix:  http://www.idatix.com/insider-perspective-whose-system-is-it-anyway/

Discussion: Value of engaging Big 4 audit firm as auditor

It is known in the commercial world that the auditing industry for the world is dominated by Big 4 audit firms, namely: Deloitte, Ernst & Young, KPMG and Pricewaterhouse Coopers (PWC). The number of listed companies (including most of the blue chip corporates) are audited by Big 4. The audit fees charged by Big 4 are usually higher than other non-big 4 audit firms (i.e. there is a premium on Big 4's audit fee).

What are the reasons for Big 4 to command a premium on its audit fees? Have you thought about it? We encourage our readers to submit their answers to us, such that we can discuss the value of engaging a Big 4 as audit firm together.

You may leave a comment to the blog post or send the email to our account: myauditing@gmail.com

Dividend income from subsidiary, and its withholding tax

We receive questions from a reader, who just started to learn the principle of consolidation.

"The question was will dividend income from subsidiary remain in the Group consolidation account"

The basis principle of consolidation is to prepare a consolidated account that captures the transactions of a Group with extrenal party. Any transaction within the Group will not be captured in the consolidation account.

To answer his/ her question: the dividend income received from a subsidiary by the holding company relates to a transaction within the Group. As such, this transaction will be eliminated during the consolidation process. Hence, the dividend income from a subsidiary will not be captured in consolidated account. However, we would like to highlight that, the holding company often suffer witholding tax while the subsidiary remit dividend to holding company, who might be at different country.

The with holding tax sufferred is not eliminated, as it represents the amonut payable to local tax authority of the subsidiary.

The Cost of Data Entry

 Ah, I remember those days well.  As a young auditor, looking a little uncomfortable wearing a suit every day, I was asked to audit the Accounts Payable department of a national retail chain.  The office was in a low rise building in the suburbs and the Accounts Payable department took up a whole floor.  That’s right, row after row of middle-aged women with comptometers, which were large, manual calculators.

Their job was to check all of the calculations on the invoices received from vendors and then batch the invoices for data entry.  The women (and they were all women in those days) down in data entry were not supposed to even think while they entered the invoices.  They were supposed to be like human computers and just key in the data, only looking at it if it didn’t agree to the comptometer total that came with the batch.

Funny story:  one of the older women in Accounts Payable liked me because I was careful about putting all of the invoices I selected for audit testing back into the right files.  She invited me out to lunch one Friday with “some friends from other departments.”  At the restaurant, she introduced me to the new credit manager, a woman about my age.  Then she looked at her watch and said that she had forgotten to do something important, and that we should go on without her.  Lunch turned out to be just the two of us.  The credit manager was deeply embarrassed and told me how the ladies in Accounts Payable thought she was much too pretty to be single, so they kept setting her up with eligible young men.  I’d love to be able to say that we were married the following year, but such was not to be.  The lunch ended quickly and we went our separate ways.

Data entry has changed a lot since those days too.  We expect the people who enter information to understand and correct the transactions, as well as flagging any that need further follow up.  Data entry is a more responsible position than it used to be.  Personally, I think that’s a good thing.  It’s a more rewarding experience to be involved in the business than to just sit there doing mindlessly repetitive tasks.
Data entry is also disappearing.  When we receive cheques, for example, they are entered via a scanner, which reads the bank’s magnetic encoding, as well as attempting to read the sender’s address information.  The data entry clerk reviews and corrects the information before posting the cash receipts, a much faster process.  Other companies, more advanced than ours, get rid of paper altogether by using Electronic Data Interchange (EDI) where all of the payment information is received from the vendor and the payment is wired into the bank account, freeing up staff to do more value added work, such as following up on outstanding payments.  So, instead of having a room full of data entry clerks, you have none.

PCAOB in tentative deal to observe China official auditor' inspections

Chicago Tribune reported that the a tentative agreement has been reached by PCAOB of U.S. to observe official auditor inspection in China.


(http://articles.chicagotribune.com/2012-09-21/business/sns-rt-us-usa-audit-watchdogbre88k1bi-20120921_1_audit-firms-pcaob-scandals-at-chinese-companies),

After the infamous Sino Tech Engergy Ltd incident, US investors are cautious in dealing with the trading of China-based companies listed on U.S. Exchanges. PCAOB announced that “We are working toward and have tentatively agreed on observational visits".

This is a move for PCAOB to observe the audit firms’ quality control over the auditing industry within China.



We, Accounting & Auditing blog, view this move positively. As the observation will allow PCAOB to develop understanding of the audit firms’ quality, high level understanding of audit procedures’, controls exercised by China relevant regulatory authority. Any difference in expectation may be communicated by PCAOB to China authority, in order to allow the China authority to close any gap.



In the long term, we expect close border listing to become more common and frequent, an overview by the authority from U.S. stock exchange may assist in clearing the obstacles / anxiousness the market may have towards the China-based company. We hope to hear more good progress in the future.

Critical review of Gross Margin Analysis

Dealing with gross margin analysis, academic often provide the following guidances for analyst / auditor in the approach on how to analyse:
- compare gross margin of a subject company to competitors within the industry
- compare gross margin of a subject company to prior period
- compare gross margin of a subject company to our expectations (i.e. increase in fuel costs would likely result in the decrease in the subject company's gross margin)

The above analysis is fundamental and provide insight for analyst / auditor of the subject Company. We, Accounting & Auditing blog, propose the auditor to critically review the component of gross margin and the movement within each key compoent, to reflect the gross margin of the Company factually and within reasonable expectation of a financial statement user.

Gross margin represents the difference between sales revenue and cost of goods sold. Sales revenue represents the revenue the Company generated after transferring the significant risk and rewards/ title of the goods. Cost of goods sold include all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. Costs of goods made by the business include material, labor, and allocated overhead.

Management may have incentive to change the classification of its cost component, such that the gross margin appears to be favorable. For instance, management of a manufacturing may decide to include freight inward as selling and distribution costs, while in fact, freight inwards is the cost incurred in bringing in raw materials for its production purpose. By excluding freight inward from being a component of cost of goods sold, the gross margin will appear to be higher.

As the auditor, it is recommended to review through the cost of goods sold component of our audit client, to critically review the reasonableness of the cost of goods solds. The analysis need to be supplemented by our understanding of the business and discussion with management. Engaging different client personnel from different departments/ operations assist in developing our understanding of the business better.

Gross margin analysis should not be limited to comparing to prior period, comparing to industry norm, as this is not sufficient to understand a business better. We, as the auditor, has the responsibility to re-assess what we have done in the past and critically review the existing account against the changing business environment to make sure that the financial statment reflect the financial affair of the audit client reasonably within the current business context.

It's Nice to be Recognized

Today's email contained a nice surprise:  a message from Bisk Education, a CPA preparation school in Florida.  Grant Webb, one of Bisk's learning facilitators, had this to say:

Our accounting students as well as myself have been following your Energized Accounting blog and have used your content in our classroom discussions. Most recently, we discussed your post on “Habits of Successful Accountants”. This post was highly relevant to our topic of the day.  Thank you.

As we train our accounting students to become CPAs, we often search for scenarios online to supplement our classroom discussion. Your post was exactly the type of information our CPAs in training use to build a more well-rounded knowledge base and understanding as well as preparing to be successful as an accountant CPA.

 I don't get much fan mail, nor do I get a lot of commentary on my posts (a subtle hint to Bisk students!), so it was nice to get this recognition.

 Thank you, Bisk Education!

Habits of Successful Accountants #5 – Upgrading

Personal professional development is very important for accountants, but have you noticed how often the accounting system languishes, still at the version that was installed years ago?  As an implementation consultant, I would talk to clients about features they were missing because they were on an old version of the software.  The answer was often that they didn’t have the budget for an upgrade.

Budgeting For Success

Finding the money to invest in your system can be problematic, particularly in these days of economic uncertainty.  At the same time, it is often an excuse.  There’s no money in the budget for system upgrades because nobody budgeted for a system upgrade.  It can turn into a vicious circle!

Yes, a complete system upgrade can be expensive, but who says you have to take on everything at once?

Making a List

Remember back to when you installed your current accounting system.  What features made you decide on the one you chose?  What cool stuff were you looking forward to?  Chances are, the cool stuff never got fully implemented.  Why?  Because of the time and expense involved in just getting the basic system going.  Accounting systems are complex and the process of converting the data from an old system to a new one often takes a lot longer than expected.  As the deadline to go live approaches, optional features are deferred so that the team can focus on the basics.  And the cool stuff is often optional.  The sad thing is that the deferred features are often never implemented.

So, make yourself a little list of what you want in your system.  It doesn’t have to be all accounting software.  If your accounting department is like many of the ones I see, it can get pretty cramped.  Imagine how spacious it would be if half of the filing cabinets were removed and the paper scanned instead of filed.

New Year’s Resolution

What about adding this to your new year’s resolutions?  “I will improve my system every year.”  Accounting software packages tend to have at least one major upgrade per year, and they encourage their customers to stay on the current version.  What we used to advise clients was to upgrade every other year, unless there was a feature in the new version that they particularly liked.  This kept them reasonably up to date at a reasonable cost.  What I would add to that advice is to do the next item on your list in the years that you don’t do a software upgrade.  That way, you are always getting better!

Reprinted with the kind permission of Idatix Inc:  http://www.idatix.com/insider-perspective-habits-of-very-successful-accountants-upgrading-annually/

Pushback, and pushed back

Opposition to the Revised Exposure Draft (RED) of the lease accounting standard is starting to build. Asset Finance International is reporting that the FASB's Investors Technical Advisory Committee (ITAC), at a meeting on July 24, unanimously disagreed with the boards' new approach to lease accounting, though the committee split three ways on their preferred methodology (capitalize all leases using the current methodology, use the new SLE (straight line expense) methodology for all leases, or keep current accounting but with more disclosure). "At the meeting FASB chairman Leslie Seidman acknowledged: 'I can hear that none of you think that we got it right.' "

Bill Bosco, a well-known leasing consultant and member of the boards' Leases Working Group advisory group, sent the boards a letter disagreeing with the proposals as well, though for different reasons. He is particularly concerned with the disparate treatment of equipment and real estate leases.

ELFA, the primary trade organization for equipment lessors in the U.S., has also weighed in with an unsolicited comment letter to the boards. They had been broadly in favor of the idea of revising the lease accounting standard, particularly to put leases on the lessee's balance sheet, but now are considering withdrawing support of the proposed standard, primarily because of the standard's presumption that virtually all equipment leases are essentially purchases (and thus merit finance lease accounting).

The boards are meeting this week to discuss sale/leaseback details (in particular, how to coordinate lease accounting with revenue recognition accounting to make them as consistent as possible), as well as handling impairment of SLE leases, whether to allow another systematic basis other than straight line, whether finance vs. SLE classification is subject to revision after commencement, and how to handle classification of a sublease.

The documents posted for this week's meeting indicate that the delivery date for the RED has been pushed back to first quarter 2013. It was previously expected in November.

International Standard on Auditing 540: Auditing Accounting Estimates

International Stanard on Auditing ("ISA") 540 discuss about the auditing of accounting estimates, including fair value accounting estimates and related disclosures. This is a crucial auditing standard for all auditors as auditing accounting estimates is not straight forward, involve critical review of assumptions and management's assessment, and the results have a significant impact on the financials of our audit client.

ISA 540 defines the natuer of accounting estimates as follows: Some financial statement items cannot be measured precisely, but can only be estimated.The nature and reliability of information available to management to suport the making of an accounting estimate varies widely, which thereby affects the degree of estimation uncertainty associated with accounting estimates. The degree of estimation uncertainty affects, in turn, the risks of material misstatement of accounting estimates, including their susceptibility to unintentional or intentional management bias.

To illustrate, while reviewing through the debtors' aging summary of your audit client, you noted a number of debtors has long outstanding debts overdue more than 120 days. Based on your understanding of the industry, the norm of the debtors' turnover is about 90 days. Management need to make an estimation on the provision for doubtful debts. The estimations based on a number of factors: repayment history of the particular customer, financial position of the customer, availability of repayment plan, etc. Auditor, need to carry out the review objectively to review for the reasonableness of management's estimation assessment.

Management may have incentive of not providing provision in order to make sure that their profitability appears to be favorable. As a result, a thorough review need to be carried out.

ISA 540 also mentions that the measurement objective for certain accounting estimates if to forecast the out come of one or more transactions, events or conditions giving rise to the need for the accounting estimate. For other accounting estimates, including many fair value accounting estimates, the measurement objective is different, and is expressed in terms of the value of a current transaction or financial statement item based on conditions prevalent at the measurement date.

What is accounting?

Some non-business friends of mine came to me and ask me: what is accounting?

Accounting is a system/ mechanic used to record (i.e. account) transactions of a business. To illustrate, an owner of a small-business-enterprise records its daily revenue information. At the end of every period (e.g. end of every month, end of every year), the accounting information is accumulated and summarised in a report, i.e. balance sheet statement, income statement, cash flow statement.

Management can determine business decision based on balance sheet statement/ income statement. The financial statements prepared reflect the financial state of affairs and performance of a business. Financial statement users make decisions based on the financil statements

There is a systematic method to account for the transactions to ensure consistencies in recording the transactions. Consistency allowed the readers of accounting records to make useful comparison to understand the changes of a business between the comparative period.

Understanding accounting / financial statements is crucial in understanding a business crucially. It is important for every single investor to appreciate the accounting.

What do you do when you noted overprovision/underprovision for prior years' tax

While reviewing through financial statement or tax schedule, you may note overprovision/ underprovision for prior years' tax. What will you do as an auditor?

First let us understand, what will trigger the accounting entries for over / underprovision for tax:

The over / under provision maybe resulted from:
- tax correspondences (i.e. notice of assessment) from tax authority showing a revised tax payable
- tax agent / client a computation error in prior year tax computation
- tax agent/ client become aware of new evidences which may suggest that prior tax computation need to be revised
- clarification of new ruling being published recently
- etc

It is important for an auditor to understand the nature of overprovision/ underprovision. Why?

By understanding the nature of overprovision/ underprovision, we can cross-check to current year tax computation to make sure that the basis of computation has been rectified such that current year tax computation is in line with appropriate ruling/ basis. For instance, during the year, tax authority may disagree with claiming professional fee as deductible expense. As such, it will result in underprovision in respect of prior year tax. In current year tax computation, management should deem the same nature of professional fee to be non-deductible expense. This will prevent the underprovision of tax in the future.

In short, it is important to understand the nature of any over/underprovision of tax, and check that the basis of current year tax computation has been updated such that it is in accordance with latest tax ruling.

Swimming With Sharks 1

As a small manufacturer, getting your first order from a giant company like Walmart or Sears can be a dream come true.  But that dream can turn into a nightmare if you don’t have the right systems in place.

I worked with a company that landed a contract with an international department store chain.  One month’s order from them involved more of my client’s product than they had sold in the whole previous year.  It was a cause for celebration and the sales team threw a party.

Then the realities of all the logistical requirements hit home.  All of the skids had to include an RFID tag (radio frequency identification) to identify the contents of the skid to the department store’s computer system.  The truck had to show up at the receiving dock at exactly the right time.  All of the shipping documentation had to be sent electronically (by EDI – Electronic Data Interchange).  If anything went wrong, the department store would reduce its payment to my client by a pre-set penalty.

That may not sound like much.  Just a few extra steps with each shipment, right?  Wrong.  Another part of the agreement had the six different ways the company forecasts demand and replenishes stock.  They want to keep the minimum quantity on hand and avoid out of stock situations, meaning that suppliers have to be on their toes and respond immediately to new orders.

If my client had had a full featured ERP (Enterprise Resource Planning) system like Oracle or SAP, all of this would have been routine, but they were just a small operation.  So we modified Microsoft Dynamics GP to create special reports that could be downloaded from the accounting system and made a big list in Excel for the staff to follow.  But it would have been so much better, if the client could have had a workflow system that would have sent email reminders to all of the staff about what steps they had to follow for each shipment.

So, let’s stand back a little and look at the best strategy for your systems if you are a medium sized company swimming with sharks.  You have your toe in the door, but have no way of knowing whether this is a one-shot deal or the start of something big.  In the long run, you would like to be able to ramp up your sales, production and systems so that you move up, but in the short run, that strategy is time consuming and expensive.  A good starting point is to upgrade one piece at a time, making sure that anything new you add will work to meet the current demand AND grow with you as you upgrade.  In this case, a work flow system would keep the staff on top of the vendor requirements, as well as supporting the company’s operations regardless of what the future holds.

Reposted with the kind permission of iDatix:  http://www.idatix.com/insider-perspective-swimming-with-sharks-what-to-do-when-dealing-with-large-retailers/

Accounting for intangible assets - Self-generated intangible assets

Recently, while browing through the financial article, we noticed one interesting article from www.investopedia.com relating to intangible assets. We have extracted some paragraphs as below:

"Any business professor will tell you that the value of companies has been shifting markedly from tangible assets, "bricks and mortar", to intangible assets like intellectual capital. These invisible assets are the key drivers of shareholder value in the knowledge economy, but accounting rules do not acknowledge this shift in the valuation of companies. Statements prepared under generally accepted accounting principles do not record these assets. Left in the dark, investors must rely largely on guesswork to judge the accuracy of a company's value.
But although companies' percentage of intangible assets has increased, accounting rules have not kept pace. For instance, if the R&D efforts of a pharmaceuticals company create a new drug that passes clinical trials, the value of that development is not found in the financial statements. It doesn't show up until sales are actually made, which could be several years down the road. Or consider the value of an e-commerce retailer. Arguably, almost all of its value comes from software development, copyrights and its user base. While the market reacts immediately to clinical trial results or online retailers' customer churn, these assets slip through financial statements.

As a result, there is a serious disconnect between what happens in capital markets and what accounting systems reflect. Accounting value is based on the historical costs of equipment and inventory, whereas market value comes from expectations about a company's future cash flow, which comes in large part from intangibles such as R&D efforts, patents and good ol' workforce "know-how". "

Our audit client may have invested research & development costs, payroll costs in developing intangible assets, e.g. new drugs, software, new machines. The invention may subsequently lead the Company to apply for patents, which is essentially the intangible assets of the Company. According to IFRS, internally generated goodwill should not be recognised on the balance sheet of the Company. Some of the readers may wonder why this asset should not be recognised on the balance sheet of the Company.

Let us answer this question by giving you a scenario by assuming intangible assets can be recognised. The Company would capitalise the costs incurred as an intangible assets, i.e.

Dr. Intangible Assets
Cr. Costs (i.e. R&D costs, payroll costs)

By capitalising the intangible assets, the Company will be able to reduce the costs and increase the profitability. There's a incentive for certain Company to capitalise intangible assets as much as possible, in order to reduce the costs incurred, even for certain costs that may not yiled economic benefits to the Company.

Sometimes, it is hard to measure the real economic benefit of an intangible assets. A Company should not recognise intangible assets if it is not econmical benificial to the Company. This is the issue with the recognition. Also, for the measurement, how should intangible assets be measured. Some might argue that, it should be the full amount of costs incurred. However, what if the full amonut of costs is not 100% beneficial to the Company? Do we still recognise the full amount?

It will be a challenge for the accountant, auditor, and even general invenstor to understand the nature or amount of the intangible assets being recognised on the balance sheet. Hence, in order to protect financial statement user, self generated intangible assets should not be recognised. However, this amount can be disclosed in the financial statement for financial statement user to understand the Company better.

At Long Last, A Sexy Accountant!

Accountants have not been treated well by Hollywood.  (I don't need to perpetuate the stereotype here.  Even non-accountants know what I'm talking about.)  So, it was good to see that the Toronto International Film Festival has a film about an accountant on a sexual adventure.  Here's the summary (with thanks to the Globe and Mail):

Jonas Chernick plays Jordan Abrams, a sexually inept accountant/dweeb from Winnipeg who, after getting the heave-ho from his long-time girlfriend (Sarah Manninen), flies to Toronto where he eventually meets Julia (Emily Hampshire), a stripper/lap dancer with a heart of gold, a mountain of debt and culinary ambitions.

Er . . . never mind.

Guarantee of inter-company's loans

It is common for our audit client to provide corporate guarantee to a bank in favour of related companies for the loan drawn down by the related companies. Generally, your audit client may guarantee timely repayment of interest and guarantee to repay amount due should the related company default in repaying.

A bank may ask for guarantee, if:
- the borrower is not in financially sound position; or
- the loan amount is substantial to the borrower perspective; or
- the borrower is trying to ask for a discount on its interest rate

This guarantee represents a potential / contingent exposure to our audit client. This has to be disclosed in the financial statement of our audit client. The disclosure should, at a minimal, include:
- the nature of the guarantee;
- the amount guaranteed; and
- contingent exposure as of balance sheet date (i.e. the amount guaranteed maybe US$100mil on a facility, while the outstanding loan amount drawn down by related company is US$80mil as of balance sheet date).

This disclosure helps to inform the financial statement user on the contingent libility the Company has, and this could be a key concern for some of the financial statement users.

Budgeting Blues

The Division Manager looked at me.  “Don’t ask me why we didn’t meet budget.  Those budget numbers aren’t mine.  They’re way too high.  I never agreed to that.”  If you are a financial analyst, that quote might be very familiar to you.  It should be so simple, right?  The division budgeted $X million in sales.  The year is half over, so they should have reached 50% of $X million, but they’re actually less than that.  All you want is a reasonable explanation.  Instead, you get an argument about the budget.

Sometimes, it’s a stalling tactic, but sometimes the person really doesn’t remember or doesn’t know where the budget numbers came from.  Budgeting is more of an art than a science.  In theory it’s easy.  Every division does some crystal ball gazing and submits their best forecast for the coming year.  The numbers are assembled for the whole company and after a negotiation about who gets what share of the available resources, the budget is set.

In reality, it can get a lot more complicated.  The negotiations can go back and forth.  Numbers get adjusted.  To understand the final number, you have to understand the history.  The problem with spreadsheets is that when you change a cell, whatever was there before is lost.  So there may be nothing to tell you that the final sales number was increased due to a sales promotion that actually never happened.

Some budgeting systems solve this by allowing you to enter a series of budget adjustments instead of changing the cells directly, but if you’re like most of us, still using spreadsheets, having a system that locks in previous versions of a spreadsheet can save you a lot of hassle later on.  If you have locked in versions of the budget, not only will you understand what’s in the numbers, you’ll be able to prove it.

Scaling the Document Mountain

We were standing in “The Archives”, looking at twelve-foot high shelves mounted on rollers so that they could be crammed together.  Each one was filled with row after row of filing boxes.  I had just asked the silly question of whether all of the documents could be scanned to save money on storage.  The Archivist informed me that scanning to Archive Standards would take 37 person-years.  Now, most people aren’t interested in preserving historical documents for future generations of scholars.  All we really want is access to the information on the documents.  Still, staring at row after row of filing cabinets can give you that unpleasant sinking feeling in your stomach.

When you’re faced with a mountain of documents, what do you do?  Here are five practical suggestions:

1. Clean House First – Some documents are more valuable than others.  If there’s anything that can be easily weeded out, start there.  Make sure you have a document retention / destruction policy.
2. Draw a Line in the Sand – Start now.  Maybe scanning all the history is too much work or too expensive right now.  You can still contain the problem by setting a date after which all documentation will be scanned.  Later, as you get to know the system, you can selectively go back into history and scan the most important documents.
3. Different Documents Different Strategies – Some documents are easier than others.  If you have standard forms, for example, where the same information appears in the same place, scanning can actually capture important information, such as company names, as text, as well as creating an image of the document.  That way, you can build a database as well as a library of scanned images.  You may also find that some documents don’t need to be scanned at all because you already have electronic versions that can be transferred, instead of being printed and scanned.
4. Pick the Low Hanging Fruit – Some departments’ documents are more easily scanned than others.  Accounting is usually well organized, with documents filed for later retrieval and an annual transfer of old documents to storage.  Start there and gain some experience.  Don’t take on the whole challenge at once.
5. Look for Golden Opportunities – You may actually get the most bang for your buck from the creative side of the business, which may have the most chaotic filing system.  Being able to browse through work done for previous customers can be a fertile source of new ideas for designers and salespeople.

Bottom line:  get someone who knows scanning in to take a look at your situation.  This is a growing area with lots of new ideas and fresh approaches.  When someone says, “It can’t be done,” don’t just take their word.  Do the research.

Accounting entries for share buy back

In today market, it is common for a listed company to buy back their own shares from the open, to the extent that it does not violate the rules of the listing authority. There is a number of reason why the management of listed companies want to buy back their own shares. It could be due to:

- the share price is deemed to be consistently lower than the intrinsic value (e.g. net tangible asset per share is greater than the share price);
- there is huge cash balances held by the holding company;
- share price is at exceptionall low level, and it is good to buy back the share from the market

What is the accounting entries for share buy-back then?

There are two possible answers for the question above, depends on management's intention:

<1> If the listed company want to buy back the share and cancel the share, the acconting entries are:

Dr. Share Capital
Cr. Cash

<2> If the listed company want to buy back the share for future re-issuance purpose (e.g. issue share option to employees):

Dr. Retained Earning- Treasury Shares
Cr. Cash

To clarify further: treausry shares account would be a debit balance. From legal perspective, it is a sub-set of Retained Earning. For financial statement disclosure purpose, it will be reflected separately from normal Retained Earning.

Please feel free to drop us an email at myauditing@gmail.com for further clarification.

Workflow Software

Downsizing, right-sizing, layoff, restructuring, whatever word you use, accounting departments have been consistently trimming staff for decades.  Computers are taking on more and more of the daily routine.  While this is good news for cost control and efficiency, it’s not so good for accounting controls and segregation of duties.  Where you used to be able to separate incompatible functions between different staff, now there may now be only one person available.

The Controls Environment – The Sarbanes-Oxely Act (affectionately known as “SOX”) enacted in 2002, was legislation designed to reassure the investing public in the integrity of financial statements after the accounting scandals of Enron, Tyco and WorldCom.  It imposes some strict requirements on not just the accuracy of financial statements but also the control systems behind them.  Those requirements aren’t going away any time soon.  In fact, the US Bureau of Labour Statistics has this to say about accounting clerical positions:

“As the number of organizations increases and financial regulations become stricter, there will be greater demand for these workers to maintain books and provide accounting services.”  (Source:  http://www.bls.gov/ooh/office-and-administrative-support/bookkeeping-accounting-and-auditing-clerks.htm)

So, not only are accounting departments being downsized, but they are also expected to meet increasingly strict requirements.  What are companies to do?

The answer may surprise you.  Most people don’t think you can automate accounting controls, but a computer approach called “workflow” can stop employees from shortcutting the internal control system and provide an evidence based audit trail that will stand up to outside scrutiny.  And the good thing is that it can be added to an existing system even if that system does not have the feature built in!

The Paper Trail – The basic building block of accounting control is the approved document.  Whether it is a supplier invoice, a customer purchase order or a government document, it follows a pre-set trail through the company’s approval process, depending on how much it is and what it is for.  For example, the purchasing manager may only approve invoices from preauthorized vendors under a certain dollar amount.  Anything from a new vendor or above his limit requires further authorization from a more senior corporate officer.  Workflow systems work on scanned images of the document and email.  The company’s rules are loaded into the software, so it can check if the document is from an approved supplier, as well as knowing the authorization of all of the staff.  This automation saves a lot of accounting staff time because they don’t even see the document until it has been properly approved.  No more squinting at illegible scrawls wondering if that’s the new division manager’s signature or turning the documents back because they aren’t approved.  The computer takes care of all that.

“He’s in Europe” – One of my first jobs in accounting was for a company with a head office in the United Kingdom.  The Vice President of Finance would let us know when he was going overseas and there would be a scramble to be sure that he had seen everything that needed to be approved.  And when he came back, there would be a stack of papers on his desk for approval.  No large transactions could be processed while he was away.  Because workflow is based on scanned images, they can be approved via a computer or even a smart phone at any time, anywhere in the world.  Now, isn’t that nicer than coming home to a stack of papers in your in-box?

What Keeps You Up at Night? Accounts Payable

Early in my consulting career, an Accounts Payable (AP) Supervisor set me straight.  She told me that AP is all about routine.  Expense reimbursements go out on Monday.  Domestic vendors on Tuesday.  International on Wednesday.  If this new system that I was training them on was going to work, it had to make it easier for them to keep on track.   That changed my view about AP.  It’s not just AR with the credits and debits reversed.  If there’s one thing that keeps an AP Supervisor up at night, it’s the sudden question that forces them to drop everything and go searching through the files, because vendors get cranky when their payments don’t come through.

So, what questions can cause AP to go scurrying to the files?  Well, anything that the computer system doesn’t capture, like:

• Who authorized this payment?  Someone may have exceeded their limit.  Someone may have authorized a payment without knowing all the facts.  There might have been a dispute with the vendor AP was unaware of at the time.
• Why did we do this?  Sometimes the simplest questions can be the hardest to answer.  Staff have to look at the invoice.  Maybe there’s a comment there.  Or maybe the Purchase Order has more detail.  Wasn’t there an email discussion about this, maybe six months ago?  You get the picture.
• Tax (or anything to do with the government).  Governments have an annoying habit of changing their minds.  What used to work has suddenly changed.  And guess what?  The change is retroactive to this time last year.  You have to pull all of the affected invoices and rework them using the new rules.  Good luck!
• Litigation.  Lawyers like to go fishing, hoping to catch something to their advantage.  When a requirement to produce documentation is received, not only do you have to pull and make copies of all of the documentation, but you also need to review it yourself to determine the impact of what you find.  I hope nobody had plans for the weekend.

You get the idea.  You need a central repository that will capture electronically everything at the time the transaction is done, including email exchanges, purchasing documentation, contracts and, of course, the approved invoice itself.  And for those people who can’t remember if they submitted this or that expense, wouldn’t it be cool to send them a link and say, “Feel free to browse the transactions yourself.”  Then your AP department will get a good night’s sleep and all your vendors will get paid on time.

Reposted with the kind permission of iDatix:  http://www.idatix.com/insider-perspective-what-keeps-you-up-at-night-in-accounts-payable/

Changing Accounting Standards

What are some of the biggest headaches in accounting?  I’m sure you have your favorites, but let me tell you about Doug.  I called him last week to see if he wanted to go for a drink, but he was still in the office late on a Friday evening.  It turns out his company adopted some of the new International Financial Reporting Standards, so he has to go back and restate the numbers, right back to his opening balance sheet at the end of 2009, and then carry the results forward using the new rules.

“As if that wasn’t enough,” he said.  “We’ve got a bunch of contracts that go back ten years or more.  The auditors now want proof of existence.  They never asked for that before and they don’t accept the fact that we get payments each month.  They want to see the actual paper.  I mean, I know we have them.  They’re piled up on skids at the back of the plant.  But it’s really dirty back there and it’s going to take days to find all the ones the auditors want to see.”

When rules change, they never get simpler.  So often you have to go back to the original transaction and interpret it in light of the new rules.  And it’s not like you can plan for the change.  I can’t tell you the number of times I have wished I had had the original documentation about a transaction so I could see who signed it and ask them what they were thinking at the time.  Or, better yet, if I could have the emails or memos that led up to the deal, so I could understand the intentions of the parties.

Wouldn’t it be nice if you could click a button and see the documentation?  Or what if charities and universities could track the trust documents and bequests in their endowments.  I know a church that wanted to consolidate its endowments because many of them were tiny.  The $5,000 that was a significant gift in 1960 was now almost more trouble than it was worth.  It would have been helpful to have all the original documentation, so that they could approach the surviving families and/or the public trustee.

Honestly, I don’t know which is Doug’s biggest headache, the changing rules or auditors’ demands, but I’ll let you know after we finally go for that drink.  What is your biggest accounting headache?  I’d be happy to feature some in future blogs.

Reposted with the kind permission of iDatix:  http://www.idatix.com/insider-perspective-changing-accounting-standards/

It's a wrap, finally

On July 17, the IASB & FASB met to make their last decisions before releasing a revised exposure draft (RED) for the new lease accounting standard. The following decisions were reached (according to meeting notes posted at IASPlus):

Lessee accounting

Statement of financial position (balance sheet)

Assets and liabilities for the two types of leases (finance, also called "interest and amortization" or I&A, and straight line expense (SLE)) will be reported separately, either on the SFP itself or in disclosure notes. Assets are to be presented based on the type of underlying asset.

Statement of cash flows

Cash paid for SLE leases will be reported as an operating activity. It was previously decided that cash paid for I&A leases will be reported as a financing activity for the principal portion, and in accordance with applicable IFRS or US GAAP standards for interest (IFRS permits it as either operating or financing, while US GAAP puts it in financing).

Several board members expressed interest in additional disclosure of cash paid for leases that would distinguish I&A, SLE, short-term leases, and variable lease payments. The staffs will review this and potentially provide a future staff paper for board action.

Disclosure

The maturity analysis (future rent commitments by year for at least 5 years, then combined to expiration) will not be separated between I&A and SLE leases. This was justified by the fact that the liability is calculated the same way for both types of leases. The FASB had previously decided that commitments for services and other non-lease components need to be disclosed; the FASB decided that this disclosure will also be a single report for all leases, not separated between I&A and SLE.

Reconciliation of the opening & closing balances on liabilities will be separated between I&A and SLE leases, because the liabilities themselves are being reported separately.

On the asset side, the boards disagreed. The FASB chose not to require a reconciliation at all. The IASB chose to require separate reconciliations for I&A and SLE leases.

The staff recommended a disclosure table for lease expenses, including amortization and interest for I&A leases, variable lease payments, short-term lease payments, SLE, principal & interest on I&A leases, and SLE cash paid. The boards thought this was overload, and decided only to require disclosure of variable lease payments.

Transition: SLE lease asset

The boards previously changed their approach for transitioning existing operating leases to the new regime: in the original exposure draft, they planned to make the asset and liability equal at the date of initial application, but because that would have front-loaded expenses for all leases, they decided to switch to a "modified retrospective" approach which results in an asset value largely similar to what one would have restating from inception (see my discussion of the details here). With SLE leases, however, front-loading isn't an issue, so the boards approved using the original methodology with the asset and liability equal at the date of initial application (though with an option for a fully retrospective application, which is also permitted for I&A leases). If there's a deferred rent liability/asset due to unequal lease payments, that is applied to the asset.

Lessor accounting

The boards decided that when a lease is terminated early and the lessor takes back the asset, the remaining receivable and the residual should be combined and set up as a re-recognized asset. No gain or loss would be reported on the transaction (though impairment might separately be recognized, if the remaining receivable that's being reclassified is less than the fair value of the leased portion of the asset plus any penalty payments made).

Interim disclosure

For both lessees and lessors, the boards decided that generally interim disclosures (that is, disclosures required during interim reporting periods, such as quarterly reports for US companies) should be handled consistently with existing standards (IAS 34, US GAAP Topic 270, and SEC Regulation S-X, Rule 10-01). However, an additional disclosure for lessors to detail components of lease income was approved. The FASB approved the proposal as presented by the staffs; the IASB preferred to permit a single lease income number in some cases. This leaves a rare non-convergent situation to be dealt with in the post-RED redeliberations.

Next steps

This isn't quite the end of the decision-making process. The FASB will be meeting next week to discuss a few FASB-only issues.

With these decisions complete, the staffs will now assemble all the "tentative" decisions into the form of an exposure draft. The draft will then be circulated to the boards to make sure it accurately reflects the decisions reached, then released to the public. The expectation is that it will be released during Q4, probably in November. There will be a 120-day comment period, which thus would be expected to end in March 2013 (though that might get tweaked because it falls in the middle of annual reporting for companies on a calendar year basis). Once that's complete, figure a month or so for the staffs to compile the results of the comments, so probably in May the boards will start their review and redeliberations. One can expect that there is still going to be some controversy over the decisions, so redeliberations will probably take a few months. At the meeting, two members of each board indicated an intention to dissent from the exposure draft, with an additional member of each board considering dissent; concerns included complexity and cost/benefit, exclusion of variable lease payments, insufficient disclosure, maintaining two types of leases when unified accounting was a key objective originally, and inconsistency between lessor accounting and the concurrent revenue recognition project.

If there are no significant changes, it may be possible to get the final standard approved in 2013, but it would seem to me it's not likely to be out until late in 2013. Given that, it seems almost certain that implementation would be required for 2016 (with restatement of prior years going back two years for most U.S. firms). That makes a total of just under 10 years from the time the project was announced in July 2006 to final implementation; the original plan was to have the final standard released in 2009, with implementation in 2011.... In a webinar today (July 19), the staff indicated that they expect that earlier implementation will be permitted, while non-public entities may get additional time for implementation.

Two expense profiles

At the joint meeting of the IASB & FASB yesterday (June 13), the boards came to an agreement on the expense recognition patterns for lessee leases to be presented in the Revised Exposure Draft (RED). (My thanks to Asset Finance International for their summary of the board meeting.) If you're looking at the meeting papers prepared by the staff (available here), the choice made was for Approach 3, meaning that some leases will be accounted for using current finance/capital lease accounting (recognizing interest and depreciation expense, with the effect that expenses are higher at the beginning of the lease), while others will be accounted for with a single lease expense item which is recognized straight line over the life of the lease. If the rent payments are equal over the life of the lease, the asset and liability balances will be equal at any date. If they are unequal, the adjustment required to balance cash rent vs. accrual expense (what is shown under current operating lease accounting as a deferred rent liability) will be taken to the asset. The asset will also be adjusted for any initial direct costs or impairments, both of which are to be recognized over the life of the lease (or remaining life, for an impairment).

The second decision was where to draw the line between the two types of expense recognition. The boards opted for Option 3 (as described in agenda paper 3D/237):

(a) Leases of property (defined as land or a building – or part of a building – or both) should be accounted for using a straight-line presentation in the income statement ... unless:
(i) The lease term is for the major part of the economic life of the underlying asset; or
(ii) The present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset.

(b) Leases of assets other than property should be accounted for under Approach 1 [finance accounting] ... unless:
(i) The lease term is an insignificant portion of the economic life of the underlying asset;
(ii) The present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset.

The boards' push for convergence was in evidence in the voting. A solid majority of the IASB preferred a single methodology for all leases, using finance lease accounting. However, members of the FASB very strongly felt that straight line expensing was a necessary part of the standard, and the IASB agreed in the interest of having a common standard.

The implications are that virtually all equipment (except leases of 12 months or less, which have previously been excluded from the standard and will be treated like current operating leases) will use finance accounting, while the vast majority of property leases will use straight line accounting. Only when a property lease is for nearly all of an asset's useful life (or there is an ownership transfer or bargain purchase option) will finance accounting be used. We'll have to see how this sorts out in practice, but this probably means that a lease of a building for less than 30 or 40 years will use straight line unless there are very special circumstances.

Lessor accounting

Having made that decision, the boards discussed the implications for lessors. Since they previously decided that lessors of "investment property" could use operating lease accounting, and this would cover virtually all property lessors, the focus was on equipment lessors. The boards decided that they would use accounting more or less symmetrical with lessee accounting, so the "receivable and residual" model will apply to equipment leases unless the lease has an "insignificant" term or receivable. This is similar to current capital lessor accounting, but with the benefit to lessors that they are permitted to recognize a portion of profit at inception (proportional to the value of the receivable compared to the residual), whereas currently profit is recognized over the life of the lease.

Next steps

There will be some wrap-up decisions to make at the July joint boards meeting, related to the RED comment period, transition, and disclosure adjustments. After that, the staff will prepare the RED, with the expectation that it will be released in Q4 2012. (If no further hitches come up, early in the quarter would seem likely.) With an expected 4-month comment period, then time to redeliberate based on comments received, a mid-year 2013 release date of the new standard seems possible, unless there's strong pushback. However, the boards seem to have met the biggest objections, so I think any changes this time around are likely to be modest (tweaks of wording, adjustments of disclosures, etc.), not the wholesale rewrite that we got between the original ED and the RED.

At this point, I wouldn't expect an effective date before 2016, to allow companies time to update their systems and gather any needed information. However, the requirement to restate prior years remains, so U.S. companies will generally need to recalculate 2014 & 2015 when they first apply the standard in 2016. If early implementation is permitted, the recalculation period would move forward commensurately. In other words, 2016 isn't that far away.

EZ13

Here at Financial Computer Systems, we're finishing up the latest update of EZ13, which will be released this summer. We won't have the new level expense capital methodology in that version, but will be working on it later this year. We'll have it in place, including transitions from current accounting, long before implementation is required. We do right now provide for pro forma capitalizing operating leases according to current capitalization rules, so you can see what your balance sheet exposure is under the RED.

Presentation & Disclosure: Gross revenue vs net revenue - Principal vs Agency Relationship

Revenue recognition is a crucial and important topic in the auditing profession. One of the key challenges auditor face is: auditor need to review the substance of the transaction to determine if an entity is a principal or an agent in certain business arrangement. An entity need to present the revenue on a gross basis if the entity is deemed to be a principal, whereas an entity need to present the revenue on a net basis if the entity is deemed to be an agent.

To illustrate, insurance agent is selling insurance contract worth US$300 dollar. Insurance agent is able to earn a commission of US$20 dollar by selling such contract. What should be the revenue for insurance agent upon successful selling of this insurance contract ? US$300 or US$20? IAS18 states that 'in an agency relationship, the gross inflows of economic benefits include amounts collected on behalf of the principal and which do not result in increases in equity for the entity. The amounts collected on behalf of the principal are not revenue. Instead, revenue is the amount of commission.

Determining whether an entity is acting as a principal or as an agent requires judgement and consideration of all relevant facts and circumstances. An entity is acting as a principal when it has exposure to the significant risks and rewards associated with the sale of goods or the rendering of services.

Features that indicate that an entity is acting as a principal include: (a) the entity has the primary responsibility for providing the goods or services to the customer or for fulfilling the order, for example by being responsible for the acceptability of the products or services ordered or purchased by the customer; (b) the entity has inventory risk before or after the customer order, during shipping or on return; (c) the entity has latitude in establishing prices, either directly or indirectly, for example by providing additional goods or services; and (d) the entity bears the customer's credit risk for the amount receivable from the customer.

An entity is acting as an agent when it does not have exposure to the significant risks and rewards associated with the sale of goods or the rendering of services. One feature indicating that an entity is acting as an agent is that the amount the entity earns is predetermined, being either a fixed fee per transaction or a stated percentage of the amount billed to the customer. In the example above, insurance agent should recognise US$20 as its revenue (instead of US$300) as the insurance agent is not entitled to the full economic benefit of entire US$300.

"We need to be ready to make a decision"

The FASB & IASB had separate "education sessions" on June 6, to review the materials the staffs have prepared for next week's joint meeting regarding the new lease accounting standard (and other projects). The FASB session is available here; the discussion on leases starts at about 1 hour, 30 minutes in from the beginning. You can view the IASB session by clicking on the "Register" link on this page. The discussion won't make a lot of sense without having the agenda papers available to look at; those are available here (right-click to download the zip file).

The staffs have, as directed by the boards last month, prepared three possible approaches for expense recognition:

1. The current plan: All leases are treated using current finance lease accounting.
2. What was called "Approach D" last month: level expense recognition, with the asset and liability linked throughout the life of the lease (if rent payments are equal throughout the lease life, asset and liability will be equal at all times).
3. A combination of the two approaches, with the necessity to decide which leases need which treatment.

More information was provided about Approach D, now Approach 2. It hadn't been clear last month how to account for leases where the rents change over the life. I speculated that there might be a deferred rent liability, as with current operating lease accounting. Now the staff has clarified that such adjustment should be recognized in the asset, rather than in a separate account. Other adjustments to the asset could also result in assets and liabilities being unequal, such as initial direct costs (added) or impairments (subtracted).

If Approach 3 is desired, then the boards need to decide where to "draw the line" to determine which leases get which treatment. Four options were presented:

1. Finance lease accounting when the lease transfers substantially all the risks and rewards of ownership (the language used currently in IAS 17, which is also the concept behind FAS 13; the determination, however, would be made using IAS 17 principles, rather than FAS 13's "bright lines" of 75% and 90%).
2. Finance lease accounting when the ROU asset represents the acquisition of a more than insignificant portion of the underlying asset.
3. Determination based on the nature of the underlying asset:
   
   • Property leases would use Approach 2 (straight line) unless the lease term is for the major part of the economic life of the underlying asset or the present value of the rent accounts for substantially all of the asset's fair value;
   • Equipment leases would use Approach 1 (financing) unless the lease term is an insignificant portion of the economic life of the underlying asset or the present value of the rents is insignificant relative to the asset's fair value. 
4. Determination based on the lessee’s business purpose for entering into the lease arrangement.

Most of the FASB board members (at least 5 of the 7) felt that it was appropriate to draw a line, considering that there are different purposes and intentions for different types of leasing transactions, and that it is appropriate to recognize those. Outreach indicated that virtually all property lessees see their transactions as generally not having a financing component; they see it as simply gaining use of an asset for a period of time. Equipment lessees are more split; some deny a financing component, but major aircraft lessees admit that that's part of the transaction.

Option 4 seemed to have the least support; while it seemed superficially to allow preparers to account for their actual intentions, there was substantial concern of gaming the system and a lack of comparability between different companies. Options 2 & 3 were seen as effectively the same, simply stated differently; Option 2 might be seen as more principles-based, while Option 3 is perhaps easier to put into practice. Some thought that Option 1 would be the simplest to apply, since everyone is familiar with the concept already; however, that would result in most aircraft leases getting straight-line rather than finance accounting, which was troubling. (Aircraft operating lease accounting is a poster child for the need for a new lease accounting standard.)

One board member indicated that he thought in-substance purchases were scoped out of the new lease standard. That's news to me; it had been discussed at one point, but I thought that was long since discarded. I don't see any support for that in the FASB's summary of tentative decisions to date.

During the outreach, most users of financial statements (i.e., financial analysts and investors) expressed a preference for a single approach to lessee accounting, but generally the more important issue to them was getting everything on the balance sheet. It was felt that proper disclosure could enable users who prefer to see leases a different way to make the adjustments they need.

There was some discussion regarding the implications for lessor accounting. Some board members consider symmetry important. Others consider the different business models and purposes on the two sides of the transactions sufficient that symmetry doesn't matter; at least one suggested that no change at all to lessor accounting from current practice is necessary.

The boards are concerned that their decision not seem arbitrary, recognizing that some people will be unhappy with whatever decision they make. They want to be able to defend it on a theoretical, not just practical, basis.

At the end of the session, a FASB board member asked the staff for what preferences had been expressed at the IASB education session held earlier in the day. It was reported that a majority of the IASB seems to have a first preference for Approach 1, but also that the strength of preference for that over Approach 3 would depend on where a line was to be drawn. So we have a difference of opinion between the boards; we know that they want very strongly to release a unified standard, so we'll have to see how that gets resolved.

To wrap up, though, the comment was, "We need to be ready to make a decision." The staff said a similar sentiment was expressed by the IASB. They've scheduled 5-1/2 hours of discussion for Wednesday & Thursday, June 13 & 14.

The staff expects this meeting to include the last substantive decisions on the new standard to be presented in the revised exposure draft (RED). They plan to follow up in July with wrap-up decisions, such as the comment period for the RED and interim disclosures, plus any decisions that may need to follow on from June decisions (such as adjusting disclosures if the approach to lessee accounting changes). After that, they would be ready to draft the RED and release it later in the year. The FASB Current Technical Plan is now reporting that the RED is expected to be released in Q4 2012 (that's a recent development; just a few weeks ago, it was simply "second half of 2012").

What is provision for reinstatement costs and how to account for it

It's common for an audit client to enter into rental lease agreement to lease the office building, warehouse, etc with the landlord of certain premises for certain period (e.g. 5 years). For operation purpose, the client may renovate the lease premises, such as installing cubicle in the said lease office.

 A landlord might require the our audit client (i.e. the audit tenant) to reinstate the office building upon moving out from the office while the lease has expired. Audit client may have to incur certain costs to reinstate the lease premises to its original state. Hence, a clause will be stated in the agreement to state cleary that the audit client is required to reinstate the lease premise to its original state. [ note: auditor must read the agreement in a cautiour manner to review of the obligations of our audit client].

In this instance, audit client is required to accrue for reinstatement cost. The question is, how to accrue for it, and who much to accrue for it? Audit client is required to obtain a quote from relevant contractor to estimate the reinstatement cost required to reinstate the premise to its original state (after factoring in the inflation in the future years till the end of the lease period). T

he following accounting entries need to be recorded: Dr. Reinstatement Cost (to be recorded in Fixed Asset) Cr. Provision for reinstatement cost (to be recorded in Accrual) The reinstatement csot capitalised as fixed asset need to be depreciated over the lease period. Consequently, it is evident that the reinstatement cost is expensed off on a straight line basis till the end of the lease period.

Approach D: Level expense recognition explained

As mentioned in prior posts, one of the options that the FASB & IASB are looking at for expense recognition under the new lease accounting standard is to have a single lease expense item in the income statement, which would be level over the life of the lease no matter what the cash flows. The following is my understanding of how the calculations would work.

We'll take three leases, each of which is five years long (1/1/2012 - 12/31/2016). Rent is paid monthly in advance (i.e., first payment is due the first day of the lease), and rent payments total $6,000 over the five years. All of them have an initial asset & obligation value of $5,000 (this requires different interest rates to deal with the different payment scenarios, which implies that the interest rate is the rate implicit in the lease.) Lease NoChange has rent of $100/month for the entire term. Lease Increase starts at $80/month for the first year, then increases by $10/month each year (i.e., $90/month in year 2, up to $120/month in year 5). Lease Holiday has no rent for the first year, then $125/month for the remaining 4 years.

The chart below shows the varied results for the asset and obligation with each scenario. Where the rent isn't equal over the life of the lease, there is also a deferred rent liability or asset (as with current operating leases that are leveled) and if the lease is early terminated, there will be a gain or loss.

"Straight line" is simply for reference purposes, to show what the profile would be with equal amortization each period. All of the examples would have slower amortization in the early months (the only way amortization would be faster than straight line in the early months would be if rent were higher at the beginning than at the end of the lease, which is rare; reduced rents for just a small portion of time at the end of the lease wouldn't change the overall picture).

How will the journal entries work? The following is my best guess, using the NoChange example above, for its first month (interest rate used is 7.69%):

 

Gross asset			5,000.00
	Current obligation			879.26
	Long term obligation			4,120.74
Setup of capital lease
Current obligation			100.00
	Cash capital rent payment			100.00
Capital lease rent payment
Long term obligation			73.59
	Current obligation			73.59
Reclassification of obligation from long term to current
Interest expense			31.40
	Accrued interest			31.40
Interest accrual
Depreciation expense			68.60
	Accumulated depreciation			68.60
Depreciation accrual
Lease expense			100.00
	Interest expense (reversal)			31.40
	Depreciation expense (reversal)			68.60
Reclassification to lease expense

While you might merge the last three transactions together, that's going to make it harder to see where the activity in interest and depreciation is coming from. Interest expense is calculated on the outstanding obligation after that month's payment (4900 x 7.69% / 12 = 31.40). Depreciation expense is plugged: 100 (average monthly rent) - 31.40 (interest expense) = 68.60.

Balances in the balance sheet accounts at the end of the first month:

Gross asset	5,000.00
Accumulated depreciation		68.60
Current obligation		852.85
Long term obligation		4,047.15
Accrued interest		31.40

You may notice that no interest is paid in the first rent payment. This is because with a lease that is paid in advance, as almost all leases are, the first payment is due the first day of a lease, before interest has had time to accrue. Interest expense accrues during the month and is paid the beginning of the following month. Unfortunately, while the journal entries example in FAS 13 shows this, all of the examples provided in the original exposure draft, and in all the discussion papers that I've seen generated by the staff, have used leases paid in arrears. That makes the calculations a bit simpler, but virtually no leases are written that way. I hope the staff will include a payments-in-advance example in the Revised Exposure Draft (and final standard), since this concept is often hard to get lessees and lessors to understand and accept. For leases paid in advance, the change in net asset for a period under Approach D equals the combined change in current obligation, long term obligation, and accrued interest.

The transactions wouldn't vary greatly for Increase and Holiday, but in those cases the Lease Expense won't match the current month's Cash Capital Rent Payment, and the depreciation expense will be smaller or even negative (for Holiday). The balancing entry would be booked to deferred rent liability.

I hope we'll see a more official presentation of how to account for leases using Approach D next month.