Category: Accounting

Auditing investments

~ C.O.R.E. Beliefs ~ Leave a comment

It is always refreshing to see associations which take responsibility for their future replacements by trying to find investments which can actually grow beyond the rate of inflation.  A solid investment plan can help them ease the burden of reserve assessments by using collected funds to grow at an accelerated, but reasonably safe, rate of return.

Auditing these investments is challenging though.

Conceptually, auditing investments is not any harder than auditing cash.  Except that investments carry certain additional disclosure requirements and the treasurer typically has little to no exposure on how to record the transactions let alone report them to be audited.  Which means that our work as the auditor grows significantly.

You see, Generally Accepted Accounting Principles (GAAP) requires that the investments be reported as either trading, available for sale or held to maturity.  How many investment advisors even understand what can be assigned to these categories?  And our role, as auditor, is to make sure that the investments are properly categorized and that the related gains, losses, and earnings is properly reported in the statement of activity; i.e. the profit and loss statement.  To ensure that they are properly recorded in the period, the accounting department has to know the difference between realized and recognized gains and losses, temporary impairment, other than temporary impairment and put those in the right reporting areas.

Which of course leads to another big accounting issue, accumulated other comprehensive income.  This is the series of holding accounts for the unrealized gains.  You have to know how to close out the transaction to recognize the ultimate sale of the investment.

Did I mention that you have to also track bond premiums and discounts and do some accounting work to get the amortization right?  Again, all this has to be tracked correctly to report in accordance with GAAP.

The rub is that treasurers and boards don’t really understand the complexity of this and often don’t really care.  Their issue is the investment and the return, not its reporting.  Which brings us to our dilemma.

Trying to account for, and then audit, investments can add a substantial cost to the engagement.  It is a cost that probably won’t be valuable to the board and owners in the association.  So, do we allow for a GAAP departure on the investments and simply say they are recorded at cost and have associations report gains and losses at the time of sale?

It is a difficult position.  On the one hand we want the statements to fairly represent the financial activity of the association but on the other hand we don’t want to drive up the cost of the engagement to the point where they find another auditor.  One who perhaps will take huge shortcuts on the reporting and auditing side.  Yes, we see that far too often as well.

So, putting your reserve fund to work by investing it strategically and at reasonable risk is a fair approach to managing the money.  But there are other things to consider besides the actual investing and you, as a board, need to be aware of these issues and take a position on how to report this to the owners in your association financial statement.

Have a great day and an awesome weekend.  And, if you are looking for an experienced audit team to help you maintain effective controls over your association’s finances, feel free to contact us anytime.  We look forward to the opportunity to be of service to you.

New Rules for Leases

~ C.O.R.E. Beliefs ~ Leave a comment

For decades now, businesses have been able to treat certain capital transactions as “off-the-books”, meaning that they didn’t have to record the debt and capitalize the asset. This method of treating leases was codified in ASC 840.   This is all about to change for leases beginning in the year 2020 for small businesses.  Beginning in 2020, (2019 for publicly traded companies) lease transactions will follow ASC 842.

The new lease rules will hit lessee’s hardest.  Lessor’s will see some new disclosure requirements but their accounting treatment will remain similar to what they do now.

The biggest change?  Beginning in 2020, you will be required to show a debt for the lease commitment and related asset for the “Right of Use” of the leased asset.  This means all that equipment you have been leasing will now show up on the balance sheet and run up the amount of debt you have on the books.

This may well have a major impact on businesses with loan covenants which restrict the amount of debt that the Company can incur.  If you are a business, such as a highway contractor, who leases equipment, you will want to start talking with your lender and bonding agent about the potential impact of this new accounting standard.

As for the technical details of the new standard, one thing that changes is in the definitions.  Property and buildings are now the only things considered operating leases.  Almost every other asset lease will be considered a financing lease.  The split is based on the “Consumption (usage and wear) of the underlying lease asset”.  If the lessee “consumes” a significant portion of the asset, it is considered a financing lease.  If it doesn’t, it is a capital lease.

An example might help.

You need warehouse space.  You find 5,000 square feet of warehouse space and lease it for $12.00/sf for a 5 year term.  At the end of the lease you will turn it back to the lessor in the same condition you originally found it.

Since the land will last indefinitely and the structure 50 or more years, you are considered to not put significant wear and use (i.e. consume) on the leased asset.  Accordingly, you enter into a capital lease.

In comparison, you are going to lease 3 trucks for your business to deliver goods to customers.  These are 60 month leases for $1,000 each truck.  You could purchase the trucks new for $70,000 each.  Since the trucks have a typical economic life of 7 years and the lease payment represents a substantial portion of the asset’s value, these would be considered financing leases.

Why does it matter?  Well, as you might infer from the name, financing leases will report financing costs – interest expense.  Capital leases will only report lease expense.  However, both do require recording the lease asset – the Right of Use (RoU) and the corresponding liability at the present value of the lease payments.

To calculate the present value, you need to know 3 things: 1)The number of periods to make the payment;  2) the payment amount; and 3) the interest or discount rate.  Guess what, 2 of the 3 are provided but the interest rate? Typically not.

The interest rate to use will either need to be stated by the lessor or you as the lessee will need to impute your rate.  So, for the truck lease above, the capitalized value with an interest rate of 4.5% is $53,000; but if the interest rate is 9.0%, then the amount capitalized is only $47,000.  And if your only source of additional capital is your credit card at 18% interest, well, your capitalized value will be much lower but your interest cost will skyrocket.

Why does all this matter?  Because there is far too much debt off balance sheet and note disclosure, especially for small business, was typically weak on the subject of the lease contingency.  Although there is some additional work, it doesn’t take a huge amount of skill to set up a PV formula in Excel.  Obviously, the hard part will be in identifying the interest rate to use and also to account for step increases and other lease costs but it is not terribly complex.

As you approach 2020, make sure your accountant is up-to-speed on the new lease rules.  You as the business owner or bookkeeper will need to provide more information to the accountant so it is set up correctly and the asset and debt recorded.  And you will want to make sure you have a conversation with your lender well in advance of that financial statement as you do not want underwriting surprised by the sudden increase of debt that shows up on your financial statements.

Have a great day.  If you would like to know more about the details of the upcoming changes to the lease rules, you should discuss with your accountant or feel free to write me anytime.  And if you are looking for a more proactive accountant, feel free to contact me anytime for a free consultation.

 

Will You Need a Tax Preparer Next Year?

~ C.O.R.E. Beliefs ~ Leave a comment

One of the big “selling points” (to use the term very loosely) of the new tax act was that it would make tax filing simpler for the vast majority of people.  Oh, but if that were true.

Put it this way, if you are currently paying over $500 for tax preparation you will likely still need to see a professional to ensure that you are in compliance with tax law.  Your taxes are not simpler to calculate and you are likely faced with a monstrous number of choices that some professional guidance is warranted.

As discussed previously, if you are in business for yourself and live in a high tax state, It is unlikely that you can easily file your own taxes.  I mean, except for those engineers and frustrated accountants out there who think that the real magic is in dropping numbers into boxes and creating an Excel spreadsheet to do the calculations.  That is the easy part.

You are facing a daunting array of choices and options – from filing as a C Corporation to the amount of wages you should pay.  Do you take bonus depreciation or regular?  Each decision has current and future ramifications that can benefit or hurt you.

Will you need a tax preparer?  Most likely.  Oh, not if you are a W-2 employee for a company and have a modest lifestyle.  Let’s face it, $12,000 of itemized deductions is hard to get over as a single person.  Property taxes, state taxes and mortgage interest will likely be only about $10,000 at best.  Your taxable income will be higher but your bracket will likely be lower – which is the tax reduction you were promised.

If you are a sales professional who used to have a fairly outsized unreimbursed employee expense deduction you will likely no longer need an accountant to prepare your taxes.  You may want to talk with one though to help you renegotiate your compensation package because the loss of those deductions is going to sting.  Unless you can make it work as an independent distributor of the companies products – in which case, yes, you may want to work with a tax preparer.

You will adapt to the new tax law just like tax preparers will adapt.  I doubt that 2019 will see a dramatic reduction in the number of returns filed by paid tax preparers; perhaps by 2021.  Of course, that assumes we are not whipsawed by a change in congress which decides to change the tax code again.

In the meantime, use your resources to engage the best professionals available.  If you are interested in starting a business then I suggest talking with a professional who can help you plan and grow your business profitably.  Too much of an emphasis on taxes minimizes your potential.  Trust me, there are lots of ways to use profits to improve your business but you have to make the money first.  The easiest tax planning is based on zero.  It is the absolute worst for planning your life though.

Time for the plug.  If you are looking for some solid planning feel free to contact me.  I enjoy working with small business owners who have dreams of making a ton of money and who want great advice for getting their business to the next level.  I am here to be of service to you.  Feel free to contact me anytime.

Have an awesome Tuesday.

Dad, What do you do?

~ C.O.R.E. Beliefs ~ Leave a comment

Brendan and I have been going to the gym 2-3 times a week and lifting weights.  He is starting to learn how to control free weights and he is enjoying charting his progress.  The other day, while we were between sets, he asked me, “What do you do as an accountant?”

One of those exciting moments every parent of a pre-teen lives for!

So I explain to him that I am an auditor, which is not really an accountant but a scientist.  He seemed puzzled but I pressed on.

“Do you remember learning about the scientific process?” I asked, he replied yes and then started to explain that you first set a hypothesis, test the hypothesis, and then draw a conclusion from your test.

I told him that is what makes an auditor a scientist.  We follow the exact same pattern.

Whenever an auditor begins work, we start by creating a hypothesis.  We changed it around a bit to state we test assertions but in reality we create the hypothesis about management’s assertions.  Ok, that is a little wonkish so perhaps an example.

The books show that the company has $100,000 in a bank account.  Management has made several assertions:

  • That the $100K Exists
  • That the Company has a Right to the money
  • That the $100K is Complete and all transactions are recorded
  • That it is actually Valued at $100K
  • That it is actually Classified as a bank account
  • And that management Cutoff all transactions on the right date

Six assertions on one little bank account but any one of them being an incorrect assertion possibly means that the $100K isn’t really.  So, as an auditor/scientist, the first thing we do is form the hypothesis; and our hypothesis is always a negative.  For instance, some of the hypotheses for this bank account could be

  • There really isn’t a bank account with $100K in it (it doesn’t Exist)
  • The bank account is in the name of another business (There is no Right to it).
  • Management failed to get checks signed and mailed by year end (The transactions are not Complete)
  • The account is in Peso’s in a Mexican bank (the Value is not $100K dollars but 100K Pesos)
  • The account is an investment account (it is not Classified correctly)
  • Management recorded deposits that were actually received later (they didn’t get a good Cutoff)

We create these hypothesis and then test them.  For a bank account, we have a ready-made solution – the bank confirmation.  We send out a letter to the bank and ask them to say they agree, or confirm, managements assertions.  The bank writes back and says, “Yes, there is $100K in the bank, it is actually in US Dollars and it is a demand deposit business checking account in the Company’s name.

One confirmation and poof, four assertions are taken care of.  Our hypotheses were disproven and we can safely say that, as far as those assertions go, management was correct.  As a matter of fact, one of the best forms of evidence for an auditor is when a third party can provide evidence that a transaction exists.  We can confirm a lot and prefer it whenever possible as it can help us with more than one assertion – other tests typically only go after one assertion at a time – which means we can spend hours trying to prove the remaining assertions.

Oh yes, by the way, I lost him at the six assertions – he is only 13 after all.  And, to be honest, he is far more curious about the times we catch people making poor choices and how we deal with it.

I told him to read my blogs.  No, he prefers Star War’s books.  But someday he will.  In the meantime, I hope you begin to have an appreciation of what steps we take as auditors to ensure that management is recording transactions to your books accurately.

An audit is designed to prove that the financial statements being presented are fair and accurate.  Management makes those six assertions on every account and ever dollar reported.  So, the next time you are meeting with your auditor, ask him about management assertions and how they design their hypothesis.  If nothing else, it is a great way to find out if they pay attention to their checklists!

Have a great day.  If you are looking for a firm to perform a review or audit of your financial statements, we would love the opportunity to be of service to you.  Go to our website, look us over and then click the Get a Quote tab.  We are a little wonkish but love to get the job done right and on budget.