All Posts by Charles Hall

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About the Author

Charles Hall is a practicing CPA and Certified Fraud Examiner. For the last thirty years, he has primarily audited governments, nonprofits, and small businesses. He is the author of The Little Book of Local Government Fraud Prevention and Preparation of Financial Statements & Compilation Engagements. He frequently speaks at continuing education events. Charles is the quality control partner for McNair, McLemore, Middlebrooks & Co. where he provides daily audit and accounting assistance to over 65 CPAs. In addition, he consults with other CPA firms, assisting them with auditing and accounting issues.

Lease Standard
Aug 17

Changes in Leases and the Leasing Industry

By Charles Hall | Accounting

The Leasing Industry will Change

In my last lease post, we saw that bright-line criteria (e.g., lease terms of 75% or more of economic life and minimum lease payments of 90% or more of fair market value) are eliminated with ASU 2016-02. Consequently, almost all leases—including operating leases—will create lease liabilities. This accounting change will alter the leasing industry.

Lease Standard

Picture from AdobeStock.com

Lessees are presently paying high lease interest rates to obtain operating lease treatment (no lease debt is recorded). Now—with the new lease standard—those same operating leases will generate lease liabilities. So why would the lessee pay the higher interest rate? There is nothing to be gained. Lessees will begin to borrow money from banks (at a lower rate). And they will buy the formerly leased asset, or they will demand lower interest rates from the lessor. Lessees, I think, will obtain better interest rates.

The Scope of the Lease Standard

To what does the lease standard apply? It applies to leases of property, plant, and equipment (identified asset) based on a contract that conveys control to the lessee for a period of time in exchange for consideration. The period may be described in relation to the amount of usage (e.g., units produced). Also, the identified asset must be physically distinct (e.g., a floor of a building).

Control over the use of the leased asset means the customer has both:

  1. The right to obtain substantially all of the economic benefits from the use of the identified asset
  2. The right to direct the use of the asset

To what does the standard not apply?

The lease standard does not apply to the following:

  1. Leases of intangible assets, including licenses of internal-use software
  2. Leases to explore for or use minerals, oil, natural gas, and similar resources
  3. Leases of biological assets
  4. Leases of inventory
  5. Leases of assets under construction

Operating or Finance Lease

Upon the commencement date of the lease, the company should classify the lease as either a finance or an operating lease. Under present lease standards, a finance lease is referred to as a capital lease.

So what is a finance lease? A lease is considered a finance lease if it meets any of the following criteria:

  1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term
  2. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise
  3. The lease term is for the major part of the remaining economic life of the underlying asset (today we use the 75% rule)
  4. The present value of the sum of the lease payments and residual value guarantee equals or exceeds substantially all of the fair value of the underlying asset (today we use the 90% rule)
  5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term

And what is an operating lease? It’s any lease that is not a financing lease.

Both operating and finance leases result in a right-of-use asset and a lease liability. The subsequent accounting for the two types of leases will be different (a topic we’ll cover in my next lease post).

Related Party Leases

Leases between related parties will be classified just as any other lease will be. Companies will look to the legally enforceable terms and conditions of the lease to determine whether a lease contract exists. If a lease contract exists, the agreement will be treated as a lease with the lessor reflecting a sale and the lessee capitalizing the related lease liability and right-of-use asset.

Are there any leases that will not result in a right-of-use asset and a lease liability? Yes, those with terms of twelve months or less.

Lease Terms of Less Than 12 Months

Companies do have the option to not capitalize a lease of 12 months or less. To do so, the company must make an accounting policy election (by class of the underlying leased asset). Companies that use the election will recognize lease expenses on a straight-line basis, and no right of use asset or lease liability will be recorded. If, however, the terms of the short-term lease change, the agreement could become one in which the lease is capitalized–for example, if the lease term changes to greater than twelve months. (Expect to see plenty of leases terms of twelve months or less.)

Month-to-month leases will usually not be capitalized if the accounting policy election is taken. Consider, however, any options to renew or if the leases contain “mutual” renewal options. Once the noncancelable period is over and the contract is no longer enforceable, the lease becomes an “at-will” arrangement.

ASC 842-10-30-1 defines the lease term as the noncancelable period of the lease together with all of the following:

  • Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
  • Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
  • Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor

Getting Ready for the New Lease Standard

Companies can ready themselves for implementation of the new lease standard by doing the following:

  1. Take an educational class that explains the particulars of the lease standard
  2. Create an inventory of all leases (I would use an Excel spreadsheet and create a worksheet summarizing financing leases and another worksheet for operating leases)
  3. Obtain copies of all lease agreements to support the inventory of leases (note–some verbal lease contracts are enforceable)
  4. Determine the terms of the leases (see ASC 842-10-30-1 above)
  5. Segregate the lease and non-lease (e.g., maintenance, cleaning) components in the lease contracts (companies will usually capitalize just the lease portion, though ASC 842-10-15-37 allows a lessee to make an election to not separate the non-lease component)
  6. Document judgments made such as whether the lessee is reasonably certain to exercise a renewal extension 
  7. Compute all lease liabilities and right-of-use asset amounts 
  8. Determine whether the implementation of the standard might adversely affect the company’s compliance with debt covenants (you may want to discuss the impact with your lenders)

While this list is not comprehensive, performing these actions will assist you in preparing for implementation of the lease standard.

Effective Dates for New Lease Standard

ASC 842 (ASU 2016-02), Leases, replaces ASC 840, Leases.

The effective dates for 842 are as follows:

For public entities, the standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those years.

For all other entities, the standard is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.

Early implementation is permissible for all entities.

More Lease Information Coming

We’ll continue this series of lease posts next week. So stay tuned. 

See How to Account for Finance and Operating Leases.

How to Understand the New Lease Accounting Standard
Aug 11

How to Understand the New Lease Accounting Standard

By Charles Hall | Accounting

Do you need help in understanding the new lease accounting standard? This article provides you with a basic understanding of the new guidance.

The existing lease guidance (FAS 13; now ASC 840) came out in 1976. In that standard, FASB defines capital leases with criteria such as minimum lease payments of at least 90% of fair market value or lease periods of at least 75% of the economic life of the asset. Given the bright-line criteria, lessees have asked lessors to construct leases so that they are considered operating and not capital. Why?

Most lessees don’t desire to reflect capital lease liabilities on their balance sheets. So for forty years, lessees have controlled assets with a lease agreement and not recorded them on their balance sheets—sometimes called “off-balance-sheet financing.”

How to Understand the New Lease Accounting Standard

The Problem: Tailored Leases

As an example under present lease standards, a company leases a building with an economic life of 40 years and desires a lease term of 28 years. Why? Well, 75% of 40 years is 30. Since the lease is less than 30 years, it is an operating lease—one not capitalized, one not recorded on the balance sheet.

What happens if the lease term is 30 years? Then it is a capital lease, and the company records the building and the related debt on the balance sheet. The lessee is fine with the recording of the asset (the building) but wants to keep the debt off the books. However, if a capital lease criterion is triggered, the asset and the debt are recorded on the balance sheet.

The New Trigger: Is This a Contract?

Under existing lease accounting rules, bright-line criteria are used to make the capitalization decision, for example, lease terms of 75% or more of the economic life or lease payments of 90% or more of the fair market value.

But the bright-line criteria is being replaced with a question: Is it a contract? If the lease is a contract, it goes on the balance sheet. If it is not a contract, it does not go on the balance sheet.

Result: Most operating leases will now be recorded on the balance sheet at the inception of the lease.

Recording Leases Under the New Lease Accounting Standard

So what is the accounting entry to record leases under the new standard?

A right-of-use asset is recorded on the balance sheet at the amount of the lease liability. Also, a lease liability is concurrently recorded.

What’s the amount of the lease liability? It is the present value of the lease payments (including options). So, what is a right-of-use asset? It is an intangible that represents the lessee’s right to use the underlying asset. (The right-of-use asset will be amortized over the life of the lease.)

Is there any theory that supports this type of accounting? Yes, in FASB’s conceptual statements.

Congruence with FASB Conceptual Statement

FASB Concept Statement 6 says that assets are probable future economic benefits obtained or controlled by an entity as a result of past transactions or events. Liabilities are probable future sacrifices of economic benefits arising from present obligations to transfer assets or provide services to other entities in the future as a result of past transactions or events.

Under the new lease standard, the right-of-use asset and the lease liability are congruent with the definitions in Concept Statement 6. So, if a company leases a truck for three years and the economic life of the vehicle is seven years, it has obtained “probable future economic benefits…as a result of past transactions.” And the company has “probable future sacrifices of economic benefits” arising from the lease obligation. Therefore, the lease should be booked on the balance sheet.

Effective Dates for New Lease Standard

ASC 842 (ASU 2016-02), Leases, replaces ASC 840, Leases.

The effective dates for 842 are as follows:

For public entities, the standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those years.

For all other entities, the standard is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.

Early implementation is permissible for all entities.

More Information

This post is the first in a series concerning the new lease standard. See my other posts here:

If you’re an auditor, check out my post Auditing Debt: The Why and How Guide.

Reviewing workpapers
Jul 12

Reviewing Workpapers, Keeping Friends

By Charles Hall | Accounting and Auditing

Do you review workpapers? If yes, you’ll relate to the following story. 

Bill calls Janet saying, “You can review the workpapers. We’re two days past the deadline, so we need to turn this one around today. Sorry for the late notice.”

Reviewing workpapers

Janet feels her blood pressure rise. She taps her fingers on the desk. Her response: “I have three other audits queued up for review. Which partners do you want me to disappoint?”

The conversation goes silent. Tension fills the air. Still more silence.

“I’ll see what I can do, but please give me more notice. This is the third time this has happened.”

Janet begins reviewing the workpapers.

She starts with the engagement letter, but it’s nowhere to be found. She makes a review note. The risk assessment documentation looks good. She thinks to herself, “The walkthroughs have improved, analytics are better, and the planning document has a nice summary of risks and responses.”

She reviews the financial statements, seeing only one deficiency. The fair value note needs improvement.

She calls Bill to advise him of the disclosure change. He hears her words, still laced with tension. A pang of guilt washes over him. He wishes he would have completed this job sooner.

As Janet completes Bill’s review, she receives two phone calls concerning the other queued jobs. The caller says, “When will you be done? What’s taking so long?” I am well acquainted with her frustration. I feel her pain.

What can Bill do to make Janet’s life better?

How Bill Can Win Friends and Influence People

Bill needs to provide Janet with adequate time to review workpapers. Granted, timeliness can’t always happen. But give as much advance notice as possible. Bill knows the job is running late. Calling Janet two days earlier would have been a big help.

Bill should also let Janet know that certain documents–such as the engagement letter–are not in the file and why.

Bill may need some assistance in project management. If this is the third time, maybe Bill needs to take some continuing education regarding efficiency and organization.

What can Janet do to make everyone’s life better?

How Janet Can Win Friends and Influence People

Let’s face it. The pressure in public accounting is unrelenting, so finding the better angels of our nature can be challenging. But this we know: Janet will foster greater cooperation with patience. Friction is not your friend.

Few people enjoy having their work reviewed, so critique kindly. We need to be clear regarding suggested corrections, but more than anything, we need to be respectful.

While I understand Janet’s “this is the third time” comment. But for now, these words need to be avoided. Should Janet address the problem with Bill? Yes, but save the conversation for another day when tensions are not so high.

Where possible, emphasize improvements. Janet noticed the risk assessment documentation was better. Including this positive review note goes a long way in winning friends and influencing people.

Workpaper Review Policy

The firm needs a policy that clearly defines the review process. Generally, work should be reviewed on a first-in, first-out basis. There will be exceptions; but if people–like Bill–repeatedly turn work in late, the managing partner may need to provide direction. If there are multiple “Bills,” Janet’s review role can become overwhelming.

Here are some suggested guidelines firms can use:

  • Engagements will be reviewed on a first-in, first-out basis
  • Review comments will be in writing
  • Feedback will be respectful
  • File reviews must be timely (if the reviewer waits a week to complete a review, the audit team may not be available for clearing the comments)
  • Reviewers will accumulate summaries of findings on a firm-wide basis (then the firm can develop continuing education classes to remediate issues noted)
  • Reviewers will have sufficient industry knowledge (for the engagements reviewed)

Action to be Taken

If your firm doesn’t already have written review guidelines, consider developing those. Much confusion can be avoided by having a protocol. That way, everyone knows the drill.

If you do have written review guidelines, consider reviewing them for improvement.

Theft of government property
Jun 29

Theft of Government Property: Stealing Tax Money

By Charles Hall | Asset Misappropriation

Theft of government property happens. Cash. Equipment. Vehicles. Inventory. You name it. Today, we take a look at how one elected governmental official took a substantial amount of cash.

Theft of Government Property

Some twenty years ago, I was working on an audit of a county tax commissioner’s office. We were noticing differences in the receipts and the cash collections.

Theft of government property
So one day I walk into the Tax Commissioner’s office. As I step in, I see several thousand dollars of cash laying on her desk. So, I remarked to her, “Haven’t made a deposit lately?” She laughed and said, “No, I’ve been too busy lately.”

I thought to myself, “Strange. She knows we’re here for the annual audit, and she has all this undeposited cash in open view. It’s as though she has no fear.”

The next day a gentleman comes into the room where we (the auditors) were working and whispers to me, “The Commissioner has a cocaine habit.” I did not know the fellow, so I wondered if the assertion had any merit. Regardless, this was shaping up to be an interesting audit.

The Damages

Our audit disclosed unaccounted-for funds of over $300,000 in the year one. Year two, the differences continued and exceeded $500,000. After three years, the unaccounted-for amount was in the $800,000 range.

Why was she not removed? Tax Commissioners are elected in Georgia, so the only person that could remove her was the governor. The local county commissioners could not dismiss her.

Finally, the FBI was brought in. But even they could not prove who was stealing the money. Why? The tax office had two cash drawers and eight clerks. All eight worked out of both drawers. So when cash went missing, you could not pin the differences on any one person.

In addition, the books were a disaster, postings were willy-nilly. There was no rhyme or reason–what I call “designed smoke.” The smoke covers up theft of government property.

The tax commissioner eventually went to prison for tax evasion. She made the mistake of depositing some of the stolen cash into her personal bank account, and the Feds were able to prove she had not reported the income.

Control Weakness Allowing Theft of Government Property

The primary weakness was the lack of design in the collection process. Two or more people should never work from one cash drawer. Deposits were not timely made (and in many cases, not made at all). And then the books (mainly the tax digest) was not appropriately posted as collections were received.

So, let’s see how to lessen theft of government property.

Fixing the Control Weakness

The primary fix was to remove the tax commissioner.

Next, each cash drawer should be assigned to only one person at a time.

Cash receipts should be written and the tax digest should be posted as tax payments are received.

Finally, deposits should be made daily.

altered check payees
May 18

Altered Check Payees: A Fraud Scheme

By Charles Hall | Asset Misappropriation

Some fraudsters steal money with altered check payees.

As a kid I once threw a match in a half-gallon of gasoline—just to see what would happen. I quickly found out. In a panic, I kicked the gas container—a plastic milk jug—several times, thinking this would somehow kill the fire. But just the opposite happened. And when my father found out, something else was on fire.

Some accounting weaknesses create unintended consequences. Show me an accounting clerk who (1) can sign checks (whether by hand, with a signature stamp, or with a computer-generated signature), (2) posts transactions to the accounting system, and (3) reconciles the bank account, and I will show you another combustible situation. Here’s how one city clerk created her own blaze.

Altered Check Example

Using the city’s signature stamp, the clerk signed handwritten checks made out to herself; however, when the payee name was entered into the general ledger (with a journal entry), another name was used—usually that of a legitimate vendor.

altered check payees

 

For example, Susie, the clerk, created manual checks made out to herself and signed them with the signature stamp. But the check payee was entered into the accounting system as Macon Hardware (for example). Also, she allocated the disbursements to accounts with sufficient remaining budgetary balances. The subterfuge worked as the expense accounts reflected appropriate vendor activity and expenses stayed within the budgetary appropriations. No red flags.

The accounting clerk, when confronted with evidence of her deception, responded, “I don’t know why I did it, I didn’t need the money.” We do a disservice to accounting employees when we make it so easy to steal. Given human nature, we should do what we can to limit the temptation.

How?

Controls to Lessen Check Fraud

First, if possible, segregate the disbursement duties so that only one person performs each of the following:

• Creating checks
• Signing checks
• Reconciling bank statements
• Entering checks into the general ledger

If you can’t segregate duties, have someone (the Mayor, a non-accounting employee, or an outside CPA) review cleared checks for appropriateness.

Secondly, have a second person approve all journal entries. False journal entries can used to hide theft. With sleight of hand, the city clerk made improper journal entries such as:

                                                Dr.                 Cr.

Supply Expense              $5,234

Cash                                                        $5,234

 

The check was made out to Susie, but the transaction was, in this example, coded as a supply expense paid to Macon Hardware. You can lessen the risk of fraud by preventing improper journal entries.

Thirdly, restrict access to check stock. It’s wise to keep blank check stock locked up until needed.

Finally, limit who can sign checks, and deep-six the signature stamp.

A Fraud Test for Auditors

Here’s a word to external auditors looking for a fraud test idea (or those just looking for check fraud): Consider testing a random sample of cleared checks by agreeing them to related invoices.

Work from the cleared check to the invoice. It is best for the auditor to pull the invoices from the invoice file; if you ask someone in accounting to pull the invoices, that person might create fictitious invoices to support your list (not hard to do these days). If the payee has been altered, you will, in many cases, not find a corresponding invoice. Pay particular attention to checks with company employees on the payee line.

Click here for more white-collar crime examples.

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