How to Understand the New Lease Accounting Standard
Dec 09

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; codified as 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. (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.

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.

ASC 842 is effective for the annual reporting periods of private companies and nonprofit organizations beginning after December 15, 2021.

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.

Lease Standard
Dec 05

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 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:

  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).

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:

  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 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)
  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.

ASC 842 is effective for the annual reporting periods of private companies and nonprofit organizations beginning after December 15, 2021.

Early implementation is permissible for all entities.

More Lease Information Coming

See How to Account for Finance and Operating Leases.

Thefts of cash
Nov 14

Thefts of Cash From Local Governments

By Charles Hall | Asset Misappropriation , Local Governments

Thefts of cash from local governments is common.

How many times have you seen a local newspaper article like the following?

Johnson County’s longtime court clerk admitted today to stealing $120,000 of court funds from 2019 through 2021. Becky Cook, 62, faces up to 10 years in federal prison after pleading guilty to federal tax evasion and theft.

Thefts of cash

Thefts of Cash from Local Governments

Usually, the causes of such cash thefts are (1) decentralized collection points and (2) a lack of accounting controls.

1. Decentralized Collection Points

First, consider that governments commonly have several collection points.

Examples include:

  • Recreation department
  • Police department
  • Development authority
  • Water and sewer department
  • Airport authority
  • Landfill
  • Building and code enforcement
  • Courts

Many governments have over a dozen receipting locations. With cash flowing in so many places, it’s no wonder that thefts of cash are common. Each cash receipt area may have different accounting procedures – some with physical receipt books, some with computerized receipting, and some with no receipting system at all. 

A more centralized receipting system reduces the possibility of theft, but many governments may not be able to centralize the receipting function. Why? Here are three reasons:

  1. Elected officials, such as tax commissioners, often determine how monies are collected without input from the final receiving government (e.g., county commissioners or school). Consequently, each elected official may decide to use a different receipting system.
  2. Customer convenience (e.g., recreation centers and senior citizen centers) may drive the receipting location decision.
  3. Other locations, such as landfills, are purposely placed on the outer boundary of the government’s geographic area.

What’s the result? Widely differing receipting systems. Since these numerous receipting locations have varying controls, the risk of theft is higher. 

Cash theft

2. Lack of Accounting Controls

Second, consider that many governments lack sufficient accounting controls for cash.

It’s more likely cash will be stolen if cash collections are not receipted. If the transaction is recorded, then the receipt record must be altered, destroyed or hidden to cover up the theft. That’s why it’s critical to capture the transaction as early as possible. Doing so makes theft more difficult.

Additional steps that will enhance your cash controls include the following:

  1. If possible, provide the government’s administrative office (e.g., county commissioners’ finance department) with electronic viewing rights for the decentralized receipting locations (e.g., landfill).
  2. Require the transfer of money on a daily basis; the government’s administrative office (e.g., county commissioners’ finance department) should provide a receipt to each transferring location (e.g., landfill).
  3. Limit the number of bank accounts.
  4. Deposit funds daily.
  5. Periodically perform surprise audits of outlying receipting areas.
  6. Use a centralized receipting location (and eliminate the decentralized cash collection points).
  7. Persons creating deposit slips and handling cash should not key those receipts into the accounting system.
  8. The person reconciling the bank statements should not also handle cash collections.
  9. Don’t allow the person billing customers to handle cash collections.

If segregation of duties is not possible (such as 7., 8. and 9. above), consider having a second person review the activity (either an employee of the government or maybe an outside consultant).

Final Thoughts About Fraud Prevention for Cash

When possible, use an experienced fraud prevention specialist to review your cash collection procedures. Can’t afford to? Think again. The average incidence of governmental fraud results in a loss of approximately $100,000.

Finally, make sure your government has sufficient fidelity bonding. If all else fails, you can recover your losses through insurance.

For more fraud prevention guidance, check out my book on Amazon: The Little Book of Local Government Fraud Prevention. Additionally, here’s a post telling you how to audit cash.

Segregation of Duties
Sep 30

Segregation of Duties: How to Overcome

By Charles Hall | Auditing , Fraud

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.

Segregation of duties

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 statements first (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.

Relying on a trusted bookkeeper is not a good thing. So how can you shine the light?

Allow a second person to see the bank statements.

Segregation of duties

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. But if 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. 

Segregation of duties

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.

What other procedures do you recommend?

For more information about preventing fraud, check out my book: The Little Book of Local Government Fraud Prevention.

AR-C 90 review engagements
Sep 14

AR-C 90: Definitive Guide to Review Engagements

By Charles Hall | Preparation, Compilation & Review

Review engagements provide limited assurance using AR-C 90, Review of Financial Statements. And these engagements can be done with much less effort than audits.

So, what are the requirements of a review engagement? When might a review be preferable to an audit? Must the CPA be independent? Can the CPA prepare the financial statements and perform the review engagement? Can a special purpose reporting framework be used? Who might desire a review report (rather than an audit or a compilation report)?

I'll answer these questions below, but, first here's a quick video introduction to the post.

Review Engagement Guidance

The guidance for reviews can be found in AR-C 90, Review of Financial Statements. AR-C 90 is part of  the AICPA's Statements on Standards for Accounting and Reporting Services (SSARS)..

Though this article is long, it's not intended to be comprehensive. It's an overview.

Applicability of AR-C 90

You should perform a review engagement when engaged to do so. If your client asks for this service and you accept, you are engaged.

A review engagement letter should be prepared and signed by the accountant or the accountant’s firm and management or those charged with governance. See engagement letter guidance below.

AR-C 90 Objectives

The objective of the accountant in a review engagement is to provide limited assurance regarding the financial statements. Other historical information such as supplementary information can also be included.

So how does an accountant perform a review engagement? Primarily with inquiries and analytics.

How does the limited assurance in a review engagement compare with compilations and audits?

In a compilation engagement, no assurance is provided. What procedures are employed in a compilation? Primarily, the accountant reads the financial statements for appropriateness. Why perform a compilation rather than a review? Economy and cost. Since procedures are minimal, it's easier to perform a compilation and less costly to the client.

In an audit, the accountant provides a high level of assurance. The accountant performs procedures beyond inquires and analytics such as confirmations. Audit risk assessment and planning requirements are much more rigorous than that of a review. While audits provide a higher level of assurance, they are more time-consuming. Consequently, the additional time raises the cost for the client. This is why reviews are sometimes performed rather than an audit.

Prior to performing a review engagement, make sure all stakeholders will accept this product. Some lenders might require an audit.

Review Reports

A review report is always required in a review engagement.

The standard review report states that no material modifications are necessary for the financial statements to be in accordance with the reporting framework. (See a sample review report below.)

If material misstatements are identified and relate to specific amounts in the financial statements, you will issue a review report with a basis for qualified conclusion paragraph and you'll have a qualified conclusion. See Exhibit C, illustration 5 in AR-C 90 for a sample review report with a departure from GAAP.  If the effects of the departure are determined, they are disclosed in the report. If not known, the paragraph states that the effects have not been determined.  

If misstatements are material and pervasive, an adverse conclusion is appropriate. The review report will also have a basis for adverse conclusion paragraph. See Exhibit C, illustration 7 in AR-C 90 for a sample review report with an adverse conclusion.

Review Financial Statements

The accountant prepares financial statements as directed by management or those charged with governance. The financials should be prepared using an acceptable reporting framework including any of the following:

All of the above bases of accounting, with the exception of GAAP, are referred to as special purpose frameworks. When such a framework is used, a description is required and can be included in:

  • The financial statement titles
  • The notes to the financial statements, or
  • Otherwise on the face of the financial statements

The financial statement should disclose how the special purpose framework differs from generally accepted accounting principles. If, for example, a company uses accelerated depreciation in tax-basis statements, the financial statements should disclose how this method differs from straight-line (the usual GAAP method). 

The review report language changes when a company uses a special purpose reporting framework. See Exhibit C, illustration 3 in AR-90 for a tax-basis review report. 

Which Financial Statements?

Management specifies the financial statements to be prepared. Normally a company desires a balance sheet, an income statement, and a cash flow statement. The accountant can, however, issue just one financial statement (e.g., income statement). 

Who prepares the financial statements? The company or the CPA firm can prepare them.

Can the cash flow statement be omitted? GAAP requires a cash flow statement when a statement of financial condition and an income statement are included. Compilation standards allow for the omission of the GAAP cash flow statement if the omission is noted in the compilation report. Not so in a review engagement. The cash flow statement must be included when GAAP is used.

But is the cash flow statement required when the tax-basis of accounting is used? No, the cash flow statement can be omitted when the financial statements are tax-basis.

Disclosures in Reviewed Financial Statements

What about disclosures? Are they required in a review engagement?

In compilation engagements, disclosures can be omitted. Not so in a review engagement. Full disclosure is required, regardless of the reporting framework.

References to Review Report and Notes

Should a reference to the review report and the notes be included at the bottom of each financial statement page? While not required by the SSARS, it is acceptable to add a reference such as:

  • See Accountant’s Report and accompanying notes
  • See Accountant’s Review Report and accompanying notes, or
  • See Independent Accountant’s Review Report and accompanying notes

Review Engagement Documentation Requirements

The accountant should prepare and retain the following documentation:

  • Engagement letter
  • A copy of the reviewed financial statements 
  • Accountant’s review report 
  • Communications with management and those charged with governance about significant matters arising during the engagement
  • Communications with other accountants that reviewed or audited financial statements of significant components 
  • Emphasis-of-matter or other-matter paragraph communications with management or others
  • The representation letter (see Exhibit B of AR-C 90 for sample wording)
  • Information about how any inconsistencies were addressed when the accountant identified information that was inconsistent with the accountant's findings regarding significant matters affecting the financial statements

The review documentation should be sufficient to enable an experienced accountant, having no previous connection to the engagement to understand:

  • the nature, timing, and extent of the review procedures,
  • the evidence obtained and the accountant's conclusions based on that evidence
  • significant matters and the related conclusions and judgments

Review Engagement Letter

AR-C 80

While it is possible for the accountant to perform only a review and not prepare the financial statements, most review engagement letters will state that the following will be performed by the accountant:

  1. Preparation of the financial statements (a nonattest service)
  2. A review engagement (an attest service)

Since a nonattest service and an attest service are being provided, the accountant will add language to the engagement letter describing the client’s responsibility for the nonattest service. 

See illustrative engagement letters in Exhibit A of AR-C 90.

AICPA independence standards require the accountant to consider whether he is independent when the CPA performs an attest service (e.g., review) and a nonattest service (e.g., preparation of financial statements) for the same client. If management does not possess the skill, knowledge, and experience to oversee the preparation of the financial statements and accept responsibility, the accountant may not be independent.

So, must the accountant be independent? Yes, independence is required in review engagements.

AR-C 90 Review Procedures

The accountant should:

  1. Make inquiries,
  2. Perform analytical procedures, and
  3. Perform other procedures, as appropriate

Direct your procedures to areas with increased risks of material misstatement. An understanding of the entity and the industry in which the entity operates will better enable you to identify potential misstatements.

1. Review Inquiries

AR-90.29 provides a series of inquiries that should be made of management and others. Those questions include matters such as fraud, subsequent events, related party transactions, and litigation. Additionally, once you create your analytical procedures, you may have questions regarding unexpected changes.

The accountant should remain alert for related party transactions outside the normal business course. Inquiries should be made about such transactions. 

2. Review Analytical Procedures

Apply analytical procedures to the numbers. What kind? Well, that depends. What numbers are most important? What numbers are most likely to be misstated? What types of analytics illuminate the client's business? Consideration of such factors will lead you to the right analytics.

Here are examples:

  • Comparing the current year's financial statement numbers with the prior year
  • Comparing the current year trial balance numbers with the prior year
  • Ratios such as debt/equity or current assets/current liabilities or depreciation/total depreciable assets
  • Computing numbers with nonfinancial information such as the number of units sold times the average price 
  • Comparing quarterly revenues by location

As you can see, judgment is required. Moreover, you need to develop expectations before computing the numbers. AR-C 90 says that the expectations should enable you to identify material misstatements. So the expectations have to be precise enough to yield that result. 

Here are the five steps I use:

  1. Develop expectations
  2. Compute the numbers
  3. See if the numbers align with expectations
  4. Follow up with additional inquiries if expectations are not met
  5. Develop a conclusion

I find that many accountants fail to document their expectations. Or if expectations are documented, a second problem occurs: The numbers don't align with the expectation and there's no documented follow-up. If the numbers don't align with expectations, make sure you determine why.

Expectations

How do we develop expectations?

It is helpful to discuss current operations with management before computing your numbers. You want to know, for example, if sales rose during the year or if there were reductions in the workforce. The conversation informs your expectations.

Also, if you've previously worked with the client, you are familiar with their profit margins or debt levels. This prior knowledge informs your expectations.

Finally, you might also read the minutes (if there are any) before computing your numbers.

3. Other Review Procedures

AR-C 90 states that procedures include inquiry, analytics, and other procedures. The third element--other procedures-- is a general category that encompasses reading the financial statements and responding to risks. You might, for example, identify potential misstatements as you perform analytical procedures. If revenues are up 25% but you expected them to be stable, you'll perform additional procedures to see why.

Interestingly (at least to me), AR-C 90.A45 states that you can perform audit procedures in a review engagement. Though your review engagement letter states you are not performing an audit, your review file can include audit procedures. Why would the AICPA provide this latitude? To give you the ability to reach beyond your typical review procedures (inquiry and analytics). You need a basis for the limited assurance you are providing. And in some situations, you may need audit procedures to get you there.

Materiality in Review Engagements

AR-C 90 requires accountants to determine and use materiality. This makes sense given the review report says the following:

Those standards require us to perform procedures to obtain limited assurance as a basis for reporting whether we are aware of any material modifications that should be made to the financial statements for them to be in accordance with accounting principles generally accepted in the United States of America.

You can't know what a "material modification" is without knowing what materiality is. So, the accountant should use materiality in the planning and conduct of the review engagement. AR-C 90 says the determination of materiality is a matter of professional judgment. 

Review Representation Letter

AR-C 90
 
 
 
 

A signed representation letter is required in all review engagements.

The date of the representation letter will agree with the date of the review report. In no event should the date of the representation letter precede the date of the review report. (The accountant is not required to have physical possession of the letter on the date of the review report. But the accountant should have the signed letter before releasing the financial statements.)

Provide the draft of the financial statements to the client promptly so they can review them and assume responsibility. Thereafter, the client can sign the representation letter.

Additionally, the representation letter should cover all financial statements and all periods in the report.

Exhibit B of AR-90 provides a sample representation letter.

Review Report Sample

The following is a review report sample (sometimes referred to as an accounting review report):

Independent Accountant's Review Report

[Appropriate Addressee]

I (We) have reviewed the accompanying financial statements of XYZ Company, which comprise the balance sheets as of December 31, 20X2 and 20X1, and the related statements of income, changes in stockholders' equity, and cash flows for the years then ended, and the related notes to the financial statements. A review includes primarily applying analytical procedures to management's (owners') financial data and making inquiries of company management (owners). A review is substantially less in scope than an audit, the objective of which is the expression of an opinion regarding the financial statements as a whole. Accordingly, I (we) do not express such an opinion.

Management's Responsibility for the Financial Statements

Management (Owners) is (are) responsible for the preparation and fair presentation of these financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of financial statements that are free from material misstatement whether due to fraud or error.

Accountant's Responsibility

My (Our) responsibility is to conduct the review engagements in accordance with Statements on Standards for Accounting and Review Services promulgated by the Accounting and Review Services Committee of the AICPA. Those standards require me (us) to perform procedures to obtain limited assurance as a basis for reporting whether I am (we are) aware of any material modifications that should be made to the financial statements for them to be in accordance with accounting principles generally accepted in the United States of America. I (We) believe that the results of my (our) procedures provide a reasonable basis for my (our) conclusion.

We are required to be independent of XYZ Company and to meet our ethical responsibilities, in accordance with the relevant ethical requirements related to our reviews.

Accountant's Conclusion

Based on my (our) reviews, I am (we are) not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in accordance with accounting principles generally accepted in the United States of America.

[Signature of accounting firm or accountant, as appropriate]

[Accountant's city and state]

[Date of the accountant's review report]

Exhibit C of AR-C 90 provides seven review report illustrations.

Reporting When There are Other Accountants

What are your responsibilities if you are performing the review of a consolidated entity that includes a subsidiary audited or reviewed by another accountant? 

First, obtain and read the subsidiary report.

Second, decide whether to refer to the other accountants in your review report. If reference is made, AR-C 90.122 states the accountant should clearly indicate in the accountant's review report that the accountant used the work of other accountants. The report should also include the magnitude of the portion of the financial statements audited or reviewed by the other accountants." See Illustration 6 in Appendix C of AR-C 90 for sample report language. If you refer to the other accountant, you will state that your conclusion, as it relates to the entity reviewed by the other accountants, is based solely on their report.

Third, regardless of whether you decide to refer to the other accountants, communicate with the other accountants. Determine the following:

  • That the other accountants are familiar with the relevant reporting framework and review or auditing standards, as applicable. 
  • Advise them that you are including the subsidiary's financials in the consolidation and that their report will be relied upon, and when applicable, that the other accountant's report will be referred to in your review report. 
  • Communicate the ethical requirements of the engagement, mainly independence. 
  • And finally, advise them that you are reviewing matters affecting the intercompany eliminations.

Going Concern in Review Engagements

If the reporting framework requires that management evaluate going concern (FASB has such a requirement), then you should perform going concern review procedures. Those procedures include:

  1. Determining whether the going concern basis of accounting is appropriate
  2. Reviewing management's evaluation of whether substantial doubt exists
  3. When there is substantial doubt, reviewing management's plans to mitigate the conditions
  4. Reviewing going concern disclosures

See my article about going concern in relation to FASB standards. 

If the applicable reporting framework does not require management to evaluate going concern but you become aware of conditions or events that raise substantial doubt about the entity's ability to continue as a going concern, do the following:

  1. Ask management if the going concern basis of accounting is appropriate
  2. Ask management about their plans to address the adverse effects of the conditions or events
  3. Review the going concern disclosures to see if they are appropriate

Other Historical Information in Review Engagements

In addition to historical financial statements, AR-C 90 may be applied to the following:

  • Specified elements, accounts, or items of a financial statement, including schedules of:
    • Rents
    • Royalties
    • Profit participation, or
    • Income tax provisions
  • Supplementary information
  • Required supplementary information
  • Tax return information

Review Engagements Conclusion

There you have it. Now you know how to perform a review engagement.

The main purpose of a review is to provide limited assurance in regard to the information. Inquiries and analytics are required. A signed representation letter is also required.

If you desire to issue financial statements without a compilation or review report, consider the use of AR-C 70, Preparation of Financial Statements.

If you desire to issue financial statements without a review report, consider using AR-C 80, Compilation Engagements.

The AICPA provides the full text of AR-C 90 online. You can download the PDF if you like. Once you download the document, you can use control-f to find particular words. I find this useful.

For additional SSARS-related articles see:

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