The Dilemma of the Review Engagement

GAAP can be incredibly complex.  A review engagement under SSARS requires the independent accountant perform analytical tests to determine if GAAP is being complied with.   A review is not an Audit.  It is “substantially less in scope than an audit…” which is a fancy way of saying that the reviewer is not looking deeply into the financial statements.  This means that some complex GAAP issues can be overlooked during a review because the analytic procedure may not discover the problem.

Case in point:

Alpha Condo Association was faced with a dilemma.  The 20 unit complex had substantial leaking through the roof last winter.  Sadly the roof was at its end of life and was going to cost $200,000 to tear-off and replace and also upgrade their elevator and HVAC system.  The association had only $50,000 in their reserve fund.

No, I am not going to rant about the lack of foresight by the board.  My other blog is addressing that issue.  What I am going to discuss is how things can go sideways and it might take years to discover.

Back to the issue at hand.  The board votes to have a special assessment for $10,000 per unit to deal with the problem.  The owners approve the special assessment 13 to 7.  Here is where things go wrong.

The board apparently provided owners two payment options.  Full payment within 30 days or payment over 10 years with interest.  The resolution which passed stated the interest rate charged was going to be equal to the interest rate on any bank loans taken out.

Five owners paid the $10K within 30 days.  The remainder took the payment option and the board borrowed $200,000 from the bank to do the work.

Apparently the board decided that, to make things easier, they would include the interest due from the owners in the initial assessment.  So, instead of their special assessment being $10K, it was $16,000.  Yes, that’s right.  The bank’s interest rate times the ten years for the repayment term of the special assessment.  The actual interest ended up being about 9.6%.

Ignore, for the moment, the fact that this does not calculate out to 6.0% interest, the real problem is that the management company recorded a receivable of $290,000 and special assessment revenue of $290,000.  The special assessment of $200,000 and the interest charge of $90,000.

The financial statements were reviewed by several different independent CPA’s (not us) over the years which reported the financial statements were prepared according to GAAP.

No they weren’t.  The original entry was incorrect by treating the interest as special assessment revenue.

Today’s missive is not about GAAP per se, it is about the inherent risk of a reviewed financial statement.

I am not trying to defend the fact that the CPA’s overlooked the problem.  In hindsight it is obvious that the $90,000 was not “earned” as special assessment but it was rather unearned interest on the special assessment receivable.  Now, almost a decade past the original special assessment we are performing the review and we stumbled across this matter.

Of course, like any good story there is lots of murkiness.  Like the fact that the unit owners voted to pass on having a review in the year of the special assessment as well as the two years after.  It wasn’t until 3 years after the transaction that the CPA was asked to review the financial statements.  And sadly, this issue was overlooked.

Again, this isn’t about GAAP; directly.  This is about the fact that the owners decided against spending money on an assurance service.  That’s right, hiring a CPA to perform an attest function on your financial statements is a means to ensure that what you are being told in those statements is prepared according to the rules everyone agreed to.

Most state condominium laws require at least a review of the association’s financial statements.  The law also typically requires that the financial statements be prepared according to GAAP.  But the law also typically gives boards and/or owners the right to waive compliance with the attest of the financial statements.

The owners agreed to waive the preparation of the financial statements for three straight years.  For three straight years the presumption is everyone was cool with how the accounting was done.  Finally a review is done and, because the reviewing CPA missed the original transaction, they want the CPA’s head on a platter.  Talk about shooting the messenger.

If you, as a non-profit board, as a business owner, as an investor, take a pass on hiring an independent CPA to perform an attest service, don’t blame the CPA when things don’t go right.  And, if you think saving money by having a review instead of a very painful (and valuable but costly) audit performed is a great idea, don’t be surprised when things are not working like you were lead to believe.  After all, the accountants’ report clearly states that a review is substantially less in scope than an audit… buyer beware.

No one likes to make mistakes but it happens.  As professionals we are ok with being held accountable for our work.  But when you elect to take the cheap route and things are wrong, don’t go looking to blame the professionals when it suddenly comes to bite you in the butt.

We haven’t worked out yet how we are going to handle this.  It is a problem to be sure – on several levels.  But the point is, don’t skimp on an audit if you want reasonable assurance that the financial statements are prepared correctly; and don’t skimp on a review if you are not involved in the day-to-day operation of the entity.  Neither service will catch everything that might be wrong but, what doesn’t get told in a financial statement is often worse than what is in there.

Have a great day.

Understanding risk

We were asked to propose on a review engagement about 10 days ago.  This is for a commercial business doing about $20 million in revenue.  Their prior accountant got out of doing attest work – it seems the peer review burden and trying to stay in compliance with the standards was more than he wanted to undertake.

We asked for and received copies of their past two year financial statements as well as their interim statements.

  • Significant losses in 2015
  • Significant losses in 2016
  • Significant profits in 2017

We started asking some high level questions of the controller and her response bothered us.  She started by asking if we were accusing her of “cooking the books”.

If you own a business, or are the responsible accounting person, you need to understand how this goes.  It is all about risk and from the independent accountant’s perspective, the risk is based on who reads your financial statement – so our job (in a review) is to make sure that nothing comes to our attention to make us think the financial statements are not correct.

When we see a pattern like this, we are skeptical.  Believe it or not, skepticism is a job requirement.  The code of professional conduct requires us to be skeptical.  But skepticism is not cynicism and automatically assuming the worse, it is thinking that maybe something is overlooked.

Imagine your teen brings home 2 progress reports in a row which say that homework is not being turned in.  You walk into his room while he is playing video games and ask if he completed his homework.  He says “Yeah of course.”

It isn’t that you don’t believe him.  But lets face it, history isn’t kind and he does have a track record of not doing it.  So what do you do?

Ask if you can see it of course.  You are skeptical.  You are not accusing him of not doing it, you are simply verifying that it is complete and ready to be turned in.

If it is done, great!  Pat on the head and maybe even a hint on how to beat the level.  If it isn’t, well I wouldn’t say he lied, I would say that no doubt the game is interfering with his memory and say that perhaps it is better off in your closet.  Until his memory improves and the homework is done.

It’s a silly analogy but true.  As the independent accountant, we are concerned with risk.  Risk to ourselves naturally, but also the risk that might be taken by the reader of the financial statement if it turns out it isn’t accurate.  We are proud of our independence and objectivity.  And this requires us to ask questions which make people uncomfortable.

Keep in mind, most of us who still perform attest services have seen a thing or two, so we know a thing or two. (Sorry Farmers, I owe you two cents) We realize that the bank is probably paying very close attention to your numbers.  We are pretty certain that another year of losses could end up with you in special assets.  We know that some peoples jobs are potentially on the hook if profits don’t improve.

We have seen it before.  But it isn’t cynicism, it is skepticism.  The patterns are there so we have to reduce the risk that the pattern is real.  And we do this by asking questions.  Sometimes painful questions.

We have to learn your business, your processes.  We have to understand the industry you compete in and sometimes the multiple industries you try to make a profit in.  We have to know what others in your industry do when it comes to capitalizing assets and recording liabilities.  We have to understand your motivation and tolerance for risky behavior.

Keep this in mind when your independent accountant starts asking questions.  And, if your accountant isn’t asking questions, maybe it is time for you to get another accountant.

Have a great day.  If you have a need for an audit or review in Washington or Oregon, feel free to learn more about us on our website and contact us for more information.  We are here to be of service to you.

The Importance of Independence

Yesterday, Doug and I discussed taking on a new client.  It is not an HOA or condo but a for-profit business.  Yes, even though we focus primarily on HOA audits and condominiums, we do the for-profit financial statement attest as well.  It is with for-profit businesses that our focus on remaining independent really helps.

With HOA’s and condo audits, the boards typically change every few years so we are pretty confident that we can remain independent.  The one class of client we will never do any work for is community management companies – as we firmly believe that this would impair our independence.  We are, after all, passing judgement on their work as it relates to their associations and we believe nothing impairs independence better than taking money from the watchdog.

The biggest independence issue with for-profit companies is that we typically do work for both the owner/shareholders and then perform the attest service on the business.  In most cases, this isn’t a big problem but occasionally, like the engagement we are evaluating now, the two may end up at odds.

Obviously this client does not want a review of its financial statements for its own benefit – although I think it is smart for every business to prepare financial statements and have them reviewed by an independent CPA.  In this case, they have bank covenants that require a reviewed financial statement.  And our independence issue is that we both have social contact with several of the shareholders and actually enjoy their friendship – which, by the way, is what provided us the opportunity to propose our review service.

The ethics rules don’t prohibit a CPA from being friendly with shareholders and management – I mean, lets face it, accountant’s are not the most likeable people on the planet so to deny us the few close friends we MAY be able to conjure would be cruel.  But we look at the independence issue a little deeper.  Is a friendship more important than our objectivity?

It is easy to say that “No, I would never let my friendship get in the way of doing my job!”  But when push comes to shove, are you willing to speak objectively about your friend’s job performance?  Do you have such a strong enough moral compass that you can deal with the glares and whispers from people you both know who have heard one side of the story, because yours has to remain silent?

Perhaps an example will help.

Last year we were performing a review engagement and during the engagement found that the controller had taken an incorrect stance on a certain transaction.  Her stance led to the understatement of liabilities by about $5.0 Million.  with that additional debt recorded, the company would have blown through their loan covenants and probably been put in special assets.

We called the controller on it.  She fought back and said that we could issue our report with an “Except for” paragraph if we wanted but she was not willing to book the liability.  Our friendship, a very strong personal relationship was on the line and all we had to do was go along with the non-recording of the transaction and issue a modified review report.

Doug and I discussed it and agreed that the most appropriate response was to inform the board of the controllers decision, our understanding of the transaction and that we were not willing to allow the financial statements to be issued without the liability being booked.

This is one of the reasons, by the way, that I took the chance to start C.O.R.E. Services with Doug.  He agreed that, if push came to shove, it was far better to be fired by a client for keeping our integrity than cave in – because once we cave we can never regain our original position.

So yes, when you select your CPA for attest services, those pesky audits and reviews, pick one who is willing to stand up for what is right – and not just because the rules say so – but because in the end you want someone of the highest moral principal you can find standing behind your financial statements.

Have a great weekend.  And as always, if you are looking for a CPA to perform an audit or review, check our website and schedule a conversation with us.  I think you will be glad you did.

 

Financial Statement Compliance

Doug and I were primarily responsible for audits and reviews and Currie & McLain CPA’s and this has rolled over to our new venture C.O.R.E. Services, LLC .  While we focus our efforts almost exclusively on audits of condo and homeowner associations, we also provide review services for clients of smaller CPA firms in Oregon and Washington who prefer to focus on income taxes. We think it can be a great partnership all the way around.

We conducted many financial statement reviews during 2017.  And, as odd as it sounds, each of them was facing a going concern problem.  While this is not a rehash of the new accounting standards for going concern, we did want to point out what we look for and what management needs to consider.  This can be very important with your year-end possibly approaching and you want the review to be completed early.

For the clients whose financial statements we reviewed this year, the number one driver of the going concern evaluation was non-compliance with bank covenants. For instance, your loan agreement may state that your business must maintain a current ratio of 1.25:1.00.  This means that you must have $1.25 in current assets – cash, a/r, inventory to every dollar of current liabilities – a/p, accrued payroll, current maturities of debt.

Another covenant we typically see is some sort of debt coverage ratio.  This is typically calculated as the current debt obligation divided by earnings before interest, taxes, depreciation and amortization (EBITDA).  if it says you must have a coverage ratio of 1:1, then if you have $1.0 Million of current debt obligations you need to earn $1.0 Million in EBITDA.

The problems arise when one or both of these are missed and missed by a lot or for multiple years.  Most of the financial statements we reviewed reported a second or third year where the current ratio and/or the debt coverage ratio were well below the requirement.  The problem is that, technically, the bank can call the debt, forcing the owners into very painful decisions.

What can management do?  Well, the first step is to admit the problem.  Non-compliance with bank covenants should not be a surprise to management, the owners or the bank.  Typically, the bank will require some sort of plan to address the covenant violation.  This may be as simple as a cash flow projection to a complex plan to sell assets and lease them back to generate cash to pay down a line of credit.  Whatever you do, don’t bury your head in the sand.

The second step is to prepare a disclosure for your financial statement.  Now, I know that typically you expect your accountant to write up the notes but this is one where you may want to be involved.  Your company is on the line and the reader, i.e. the credit officer at the bank, may well decide that your plan can’t deal with the problem and start creating solutions for you.

If you would like some ideas of how to disclose the going concern issue and your plan, let us know  by writing to info@core-acct.com and we will be happy to send you an outline of the disclosure we have clients complete.  The vital thing though is to provide enough detail that the reader can see the issue and understand your plan without investing so many hours that it distracts you from the issue of running the business.

The third step is to get the bank to issue a waiver or forbearance on compliance.  Stay in control here because this can become a circular problem since the bank will want the reviewed financial statement to know where your business is and the accountant will not want to issue the reviewed financial statement without the forbearance.  It requires a good deal of communication to make this work and it is very helpful if you can get them together for a conversation.

A going concern issue is possibly the single biggest financial statement headache you are likely to ever have to address.  Get in front of it early and work closely with your bank on getting approvals in place and with your accountant to draft the plan for inclusion in the notes and it is very likely that you can still meet a respectable turnaround time for producing the financial statements.

Have a great Monday.