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; codified as ASC 840) came out in 1976. In that standard, FASB defines capital leases with criteria such as minimumlease 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.”
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. (I am speaking generally here. There are other requirements such as the lessee must control the asset and reap the benefits of the arrangement.) 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 (ROU) is recorded on the balance sheet at the amount of the lease liability (there can be some adjustments to the ROU as it is initially recorded, so I am speaking generally here). 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 that are reasonably certain). 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.
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.
Picture from AdobeStock.com
Lessees have historically paid 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. I think 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:
The right to obtain substantially all of the economic benefits from the use of the identified asset
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:
Leases of intangible assets, including licenses of internal-use software
Leases to explore for or use minerals, oil, natural gas, and similar resources
So what is a finance lease? A lease is considered a finance lease if it meets any of the following criteria:
The lease transfers ownership of the underlying asset to the lessee by the end of the lease term
The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise
The lease term is for the major part of the remaining economic life of the underlying asset (today we use the 75% rule)
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)
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).
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.)
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:
Take an educational class that explains the particulars of the lease standard
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)
Obtain copies of all lease agreements to support the inventory of leases (note–some verbal lease contracts are enforceable)
Determine the terms of the leases (see ASC 842-10-30-1 above)
Segregate the lease and non-lease (e.g., maintenance, cleaning) components in the lease contracts (companies can 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)
Document judgments made such as whether the lessee is reasonably certain to exercise a renewal extension
Compute all lease liabilities and right-of-use asset amounts
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.
Segregation of duties is key to reducing fraud. But smaller entities may not be able to do so. Today, I tell you how overcome this problem, regardless of the entity’s size.
The Environment of Fraud
Darkness is the environment of wrongdoing.
Why?
No one sees us. Or so we think.
Fraud occurs in darkness.
In J.R.R. Tolkien’s Hobbit stories,Sméagol, a young man murders another to possess a golden ring, beautiful in appearance but destructive in nature. The possession of the ring transforms Sméagol into a hideous creature–Gollum.
And what does this teach us? That which is alluring in the beginning can be destructive in the end.
Fraud opportunities have those same properties: they are alluring and harmful. And, yes, darkness is the environment where fraud happens.
What’s the solution? Transparency. It protects businesses, governments, and nonprofits.
But while we desire open and understandable processes, our businesses often have just a few employees that perform the accounting duties. And, many times, no one else understands how the system works.
It is desirable to divide accounting duties among various employees, so no one person controls the whole process. This division of responsibility creates transparency. How? By providing multiple eyes to see what’s going on.
But this segregation of duties is not always possible.
Lacking Segregation of Duties
Some people says here are three key duties that must always be separated under a good system of internal controls: (1) custody of assets, (2) record keeping or bookkeeping, and (3) authorization. I add a fourth: reconciliation. The normal recommendation for lack of segregation of duties is to separate these four accounting duties to different personnel. But many organizations are unable to do so, usually due to a limited number of employees.
Some small organizations believe they can’t overcome this problem. But is this true? I don’t think so.
Here’s two easy steps to create greater transparency and safety when the separation of accounting duties is not possible.
1. Bank Account Transparency
First, consider this simple control: Provide all bank statements to someone other than the bookkeeper. Allow this second person to receive the bank statements before the bookkeeper. While no silver bullet, it has power.
Persons who might receive the bank statementsfirst (before the bookkeeper) include the following:
A nonprofit board member
The mayor of a small city
The owner of a small business
The library director
A church leader
What is the receiver of the bank statements to do? Merely open the bank statements and review the contents for appropriateness (mainly cleared checks).
In many small entities, accounting processes are a mystery to board members or owners. Why? Only one person (the bookkeeper) understands the disbursement process, the recording of journal entries, billing and collections, and payroll.
Fraud decreases when the bookkeeper knows someone is watching. Suppose the bookkeeper desires to write a check to himself but realizes that a board member will see the cleared check. Is this a deterrent? You bet.
Don’t want to send the bank statements to a second person? Request that the bank provide read-only online access to the second person. And let the bookkeeper know.
Even the appearance of transparency creates (at least some) safety. Suppose the second person reviewer opens the bank statements (before providing them to the bookkeeper) and does nothing else. The perception of a review enhances safety. I am not recommending that the review not be performed. Butif the bookkeeper even thinks someone is watching, fraud will lessen.
When you audit cash, see if these types of controls are in place.
Now, let’s look at the second step to overcome a lack of segregation of duties. Surprise audits.
2. Surprise Audits
Another way to create small-entity transparency is to perform surprise audits. These reviews are not opinion audits (such as those issued by CPAs). They involve random inspections of various areas such as viewing all checks clearing the May bank statement. Such a review can be contracted out to a CPA. Or they can be performed by someone in the company. For example, a board member.
Additionally, adopt a written policy stating that the surprise inspections will occur once or twice a year.
The policy could be as simple as:
Twice a year a board member (or designee other than the bookkeeper) will inspect the accounting system and related documents. The scope and details of the inspection will be at the judgment of the board member (or designee). An inspection report will be provided to the board.
Why word the policy this way? You want to make the system general enough that the bookkeeper has no idea what will be examined but distinct enough that a regular review occurs.
Surprise Audit Ideas
Here are some surprise audit ideas:
Inspect all cleared checks that clear a particular month for appropriate payees and signatures and endorsements
Agree all receipts to the deposit slip for three different time periods
Review all journal entries made in a two week period and request an explanation for each
Inspect two bank reconciliations for appropriateness
Review one monthly budget to actual report (look for unusual variances)
Request a report of all new vendors added in the last six months and review for appropriateness
The reviewer may not perform all of the procedures and can perform just one. What is done is not as important as the fact that something is done. In other words, the primary purpose of the surprise audit is to make the bookkeeper think twice about whether he or she can steal and not get caught.
I will say it again. Having multiple people involved reduces the threat of fraud.
Segregation of Duties Summary
In summary, the beauty of these two procedures (bank account transparency and surprise audits) is they are straightforward and cheap to implement. Even so, they are powerful. So shine the light.
Unpaid fees can impair your independence in attest engagements. This article explains changes in the Unpaid Fees interpretation in the AICPA Code of Conduct.
Peer review checklists ask if fees have been paid prior to issuance of attest reports. Why? A loan to an attest client can impair independence. The thought here is that the CPA may have a self-interest in the client; namely, the collection of unpaid fees. And this self-interest could potentially lead the CPA to assist the client by issuing inappropriate attest reports.
So, has there been a change in the unpaid fees section of the Code of Conduct? Yes.
The old rule of just looking back one year is no longer the sole consideration in determining your independence in regard to unpaid fees; current year fees, if significant, can also affect independence.
The bolded fonts and underlines below are added by the blogger.
Unpaid Fees Interpretation
The independence interpretation (1.230.010) in the Code of Conduct says:
Threats to the covered member’s compliance with the “Independence Rule” [1.200.001] are at an acceptable level if, when the current-year attest report is issued, unpaid fees are both clearly insignificant to the covered member and relate to professional services provided less than one year prior to the date of the current-year attest report.
Alternatively, threats would not be at an acceptable level if, when the current-year attest report is issued, unpaid fees are both significant to the covered member and relate to professional services provided more than one year prior to the issue date of the current-year attest report.
That guidance provides factors to consider in evaluating your independence.
Unpaid Fees Factors to Consider
Factors to consider (ET 1.230.010.02) when evaluating whether threats are at an acceptable level include the following:
a. The significance of the unpaid fees to the covered member
b. The length of time the fees have been due from the attest client
c. The attest client’s agreement to pay the unpaid fees
d. The covered member’s assessment of factors affecting the ability of the attest client to pay the fees
So, what should you do if a significant threat is present? Consider safeguards.
Unpaid Fees Safeguards
You may use safeguards (ET 1.230.010.04) to mitigate the independence threat:
a. Have an appropriate reviewer who has not provided attest or nonattest services to the attest client review the attest work performed before the current-year attest report is issued.
b. Obtain partial payment of the unpaid fees balance before the current year attest report is issued such that the remaining unpaid balance is insignificant to the covered member.
c. Obtain an agreement from the attest client to a payment schedule before the current-year attest report is issued.
d. Suspend further work on current attest engagements and not accept new engagements with this attest client.
ET 1.230.010.05 goes on to say:
Communication with those charged with governance regarding evaluation of the unpaid fees and safeguards applied is not a sufficient safeguard when applied alone; however, it may be considered a safeguard when supplemented by other safeguard(s).
If the safeguards are not sufficient, you are not independent.
So, how do we define unpaid fees?
Unpaid Fees Defined
Unpaid fees include billed and unbilled services.
If you provide a service whereby you expect payment, it’s a fee–whether you billed it or not. The issue is whether the client owes you for the service.
Not Applicable for Attest Clients in Bankruptcy
ET 1.230.010.06 says that this interpretation does not apply to attest clients in bankruptcy.
Collection Incentive
Oddly, the potential impairment of independence may assist you (the CPA) in collecting past-due accounts. If the client needs the current year attest report, and the CPA can’t provide it without payment, then the client may find a way to come up with the money for past fees.
Still Not Sure
If after doing the above, you’re still not sure whether your independence is impaired, consider contacting the AICPA to get their thoughts. You can email them at ethics@aicpa.org.
Auditors often fail to capture and communicate internal control weaknesses, even though such communications are required by the audit standards.
But making our clients aware of control weaknesses can help them. How? It allows them to improve their accounting system. The result: prevention of future fraud and errors.
In this article, I’ll show you how to capture and communicate internal control deficiencies. By doing so, you’ll add value to your audit servicesand you’ll help your client protect their business.
At the end of the post, you’ll also see a video that summarizes this information.
A Common End-of-Audit Problem
You are concluding another audit, and it’s time to consider whether you will issue a letter communicating internal control deficiencies. A month ago you noticed some control issues in accounts payable, but presently you’re not sure how to describe them. You hesitate to call the client to rehash the now-cold walkthrough. After all, the client thinks you’re done. But you know that boiler-plate language will not clearly communicate the weakness or tell the client how to fix the problem. Now you’re kicking yourself for not taking more time to document the control weakness (back when you initially saw it).
Here’s a post to help you capture and document internal control issues as you audit.
Capture and Communicate Internal Control Deficiencies
Today, we’ll take a look at the following control weakness objectives:
How to discover them
How to capture them
How to communicate them
As we begin, let’s define three types of weaknesses:
Material weaknesses – A deficiency, or a combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected, on a timely basis.
Significant deficiencies – A deficiency, or a combination of deficiencies, in internal control that is less severe than a material weakness yet important enough to merit attention by those charged with governance.
Other deficiencies – For purposes of this blog post, we’ll define other deficiencies as those less than material weaknesses or significant deficiencies.
Now let’s take a look at discovering, capturing, and communicating control weaknesses.
1. Discover Control Weaknesses
Capture control weaknesses as you perform the audit. You might identify control weaknesses in the following audit stages:
Planning – Risk assessment and walkthroughs
Fieldwork – Transaction-level work
Conclusion – Wrapping up
A. Planning Stage
You will discover deficiencies as you perform walkthroughs which are carried out in the early stages of the engagement. Correctly performed walkthroughs allow you to see process shortcomings and where duties are overly concentrated (what auditors refer to as a lack of segregation of duties).
Notice the first letters of these words spell CRAB (I know it’s cheesy, but it helps me remember).
Auditors often make statements such as, “Segregation of duties is not possible due to the limited number of employees.”
I fear such statements are made only to protect the auditor (should fraud occur in the future). It is better that we be specific about the control weakness and what the potential impact might be. For example:
The accounts payable clerk can add new vendors to the vendor file. Since checks are signed electronically as they are printed, there is a possibility that fictitious vendors could be added and funds stolen. Such amounts could be material.
Such a statement tells the client what the problem is, where it is, and the potential damage.
Fraud: A Cause of Misstatements
While I just described how a lack of segregation of duties can open the door to theft, the same idea applies to financial statement fraud (or cooking the books). When one person controls the reporting process, there is a higher risk of financial statement fraud.Appropriate segregation lessens the chance that someone will manipulate the numbers.
Within each transaction cycle, accounting duties need to be performed by different people. Doing so lessens the possibility of theft. If one person performs multiple duties, ask yourself, “Is there any way this person could steal funds?” If yes, then the client should add a control in the form of a second-person review.
If possible, the client should have a second person examine reports or other supporting documentation. How often should the review be performed? Daily, if possible. If not daily, as often as possible. Regardless, a company should not allow someone with the ability to steal to work alone without review. The fear of detection lessens fraud.
If a transaction cycle lacks segregation of duties, then consider the potential impact from the control weakness. Three possible impacts exist:
Theft that is material (material weakness)
Theft that is not material but which deserves the attention of management and the board anyway (significant deficiency)
Theft of insignificant amounts (other deficiency)
My experience has been that if any potential theft area exists, the board wants to know about it. But this is a decision you will make as the auditor.
Errors: Another Cause of Misstatements
While auditors should consider control weaknesses that allow fraud, we should also consider whether errors can lead to potential misstatements. So, ask questions such as:
Do the monthly financial statements ever contain errors?
Are invoices mistakenly omitted from the payable system?
Do employees forget to obtain purchase order numbers prior to buying goods?
Do bookkeepers fail to reconcile the bank statements on a timely basis?
B. Fieldwork Stage
While it is more likely you will discover process control weaknesses in the planning stage of an audit, the results of control deficiencies sometimes surface during fieldwork. How? Audit journal entries. What are audit entries but corrections? And corrections imply a weakness in the accounting system.
When an auditor makes a material journal entry, it’s difficult to argue that a material weakness does not exist. We know the error is “reasonably possible” (it happened). We also know that prevention did not occur on a timely basis.
C. Conclusion Stage
When concluding the audit, review all of the audit entries to see if any are indicators of control weaknesses. Also, review your internal control deficiency work papers (more on this in a moment). If you have not already done so, discuss the noted control weaknesses with management.
Your firm may desire to have a policy that only managers or partners make these communications. Why? Management can see the auditor’s comments as a criticism of their own work. After all, they designed the accounting system (or at least they oversee it). So, these discussions can be a little challenging.
Now let’s discuss how to capture control weaknesses.
2. Capture Internal Control Weaknesses
So, how do you capture the control deficiencies?
First, and most importantly, document internal control deficiencies as you see them.
Why should you document control weaknesses when you initially see them?
You may not be on the engagement when it concludes (because you are working elsewhere) or
You may not remember the issue (weeks later).
Second, create a standard form (if you don’t already have one) to capture control weaknesses.
Internal Control Capture Form
What should be in the internal control form? At a minimum include the following:
Check-mark boxes for:
Significant deficiency
Material weakness
Other control deficiency
Other issues (e.g., violations of laws or regulations)
Whether the probability of occurrence is at least reasonably possible and whether the magnitude of the potential misstatement is material
Description of the deficiency and the verbal or written communications to the client; also the client’s response
The cause of the condition
The potential effect of the condition
Recommendation to correct the issue
Person identifying the issue and the date of discovery
Whether the issue is a repeat from the prior year
An area for the partner to sign off that he or she agrees with the description of the deficiency and the category assigned to it (e.g., material weakness)
Reference to related documentation in the audit file
After capturing the weaknesses, it’s time to communicate them.
3. Communicate Control Weaknesses
Material weaknesses and significant deficiencies must be communicated in writing to management and those charged with governance. Other deficiencies can be given verbally to management, but you must document those discussions in your work papers.
Provide a draft of any written communications to management before issuing your final letter. That way if something is incorrect (your client will let you know), you can make it right–before it’s too late. Additionally, discuss the control weakness with relevant personnel when you initially discover it. You don’t want to surprise the client with adverse communications in the written internal control letter.
Internal Control Video Summary
Here’s a video that summarizes the information above.
Summary
The main points in capturing and communicating internal control deficiencies are:
Capture control weaknesses as soon as you see them
Develop a form to document the control weaknesses
Communicate significant deficiencies and material weaknesses in writing
These communications can be somewhat challenging since you’re telling management they need to make improvements. So make sure all information is correct and let your senior personnel do the communicating.
How Do You Capture and Report Control Deficiencies?
Whew! We’ve covered a lot of ground today. How do you capture and report control deficiencies? I’m always looking for new ideas: Please share.
