Acuity Advisors

How do your accounting estimates measure up?

Today’s businesses face unprecedented uncertainty — from geopolitical risks and cyberthreats to tax and regulatory reforms. So, management’s historical means of addressing uncertainty in accounting estimates may not pass muster in the coming audit season.

Accounting for uncertainty

Some financial statement items are relatively cut-and-dried. But others can’t be measured precisely and, instead, are based on what management expects to happen in the future.

Examples of accounting estimates include:

Allowance for doubtful accounts,
Work-in-progress inventory,
Warranty obligations,
Depreciation method or asset useful life,
Recoverability provision against the carrying amount of investments,
Fair value of goodwill and other intangibles,
Long-term contracts,
Uncertain tax positions, and
Costs arising out of litigation settlements and judgments.

Accounting estimates may be based on subjective or objective information (or both) and involve a level of measurement uncertainty. Each accounting estimate is subject to its own level of uncertainty — and highly uncertain outcomes can lead to unintentional errors or, worse, intentional misstatement.

Use of specialists

Some estimates are easily determinable and may be made by in-house personnel with a fair degree of accuracy. This is especially true for estimates that can be made based on objective inputs (like published interest rates or percentages observed in previous reporting periods).

Other estimates are inherently subjective or complex — and may be derived from speculative inputs. Examples include share-based payments, goodwill and impairment write-offs. Managers are champions of the company’s products and strategies and, therefore, may have unrealistic expectations. To avoid painting a rosier picture than reality, companies often use outside specialists, such as business appraisers or actuaries, to independently estimate complex items.

Ready for audit season?

Audit season is right around the corner for calendar-year-end businesses. In light of today’s volatile marketplace, expect auditors to give renewed attention to your accounting estimates. For example, they may ask more in-depth questions or perform additional testing procedures. You can facilitate audit fieldwork and minimize audit adjustments by identifying accounts that are based on management’s estimates and reviewing the procedures used to make the estimates. Some items may require a different measurement technique than you’ve used in the past.

If you’re uncertain about how marketplace uncertainty could affect your estimates, contact us to help you get a timely, accurate assessment of financial performance before the start of audit season.

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Accelerate your retirement savings with a cash balance plan

Business owners may not be able to set aside as much as they’d like in tax-advantaged retirement plans. Typically, they’re older and more highly compensated than their employees, but restrictions on contributions to 401(k) and profit-sharing plans can hamper retirement-planning efforts. One solution may be a cash balance plan.

Defined benefit plan with a twist

The two most popular qualified retirement plans — 401(k) and profit-sharing plans — are defined contribution plans. These plans specify the amount that goes into an employee’s retirement account today, typically a percentage of compensation or a specific dollar amount.

In contrast, a cash balance plan is a defined benefit plan, which specifies the amount a participant will receive in retirement. But unlike traditional defined benefit plans, such as pensions, cash balance plans express those benefits in the form of a 401(k)-style account balance, rather than a formula tied to years of service and salary history.

The plan allocates annual “pay credits” and “interest credits” to hypothetical employee accounts. This allows participants to earn benefits more uniformly over their careers, and provides a clearer picture of benefits than a traditional pension plan.

Greater savings for owners

A cash balance plan offers significant advantages for business owners — particularly those who are behind on their retirement saving and whose employees are younger and lower-paid. In 2017, the IRS limits employer contributions and employee deferrals to defined contribution plans to $54,000 ($60,000 for employees age 50 or older). And nondiscrimination rules, which prevent a plan from unfairly favoring highly compensated employees (HCEs), can reduce an owner’s contributions even further.

But cash balance plans aren’t bound by these limits. Instead, as defined benefit plans, they’re subject to a cap on annual benefit payouts in retirement (currently, $215,000), and the nondiscrimination rules require that only benefits for HCEs and non-HCEs be comparable.

Contributions may be as high as necessary to fund those benefits. Therefore, a company may make sizable contributions on behalf of owner/employees approaching retirement (often as much as three or four times defined contribution limits), and relatively smaller contributions on behalf of younger, lower-paid employees.

There are some potential risks. The most notable one is that, unlike with profit-sharing plans, you can’t reduce or suspend contributions during difficult years. So, before implementing a cash balance plan, it’s critical to ensure that your company’s cash flow will be steady enough to meet its funding obligations.

Right for you?

Although cash balance plans can be more expensive than defined contribution plans, they’re a great way to turbocharge your retirement savings. We can help you decide whether one might be right for you.

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Strong internal controls help reduce restatements

A recent study has found that fewer public companies are reissuing financial statements due to errors or omissions, in large part due to stronger internal controls. Want to upgrade your controls and reduce your risk of restatement? Savvy business owners and managers borrow best practices from the framework auditors use to evaluate their clients’ internal controls.

Drop in restatements

Research firm Audit Analytics found that the total number of restatements dropped to 6.83% (or 671 of 9,831 companies) in 2016. That’s the lowest number of restatements in 15 years. Why? The Audit Analytics study attributes the decrease in restatements, at least partially, to regulatory oversight.

“I believe that the decrease in the number of restatements … is a result, to some extent, of improved internal controls over financial reporting,” said Don Whalen, director of research at Audit Analytics. Companies institute internal controls primarily to deter accounting fraud.

One resource used to improve internal controls is the Committee of Sponsoring Organizations of the Treadway Commission (COSO). COSO first published its Internal Control — Integrated Framework in 1992 to help prevent a repeat of the types of accounting frauds that occurred in the 1980s. In 2013, COSO revised its framework to reflect changes to business and financial reporting that have taken place over the last two decades.

COSO framework

The updated COSO framework outlines five basic components of internal controls, including:

Control environment. A set of standards, processes and structures is needed to provide the basis for carrying out internal controls across the organization.
Risk assessment. This dynamic, iterative process identifies stumbling blocks to the achievement of the company’s objectives and forms the basis for determining how risks will be managed.
Control activities. Policies and procedures are necessary to help ensure that management’s directives to mitigate risks to the achievement of objectives are carried out.
Information and communication. Relevant and quality information supports the internal control process. Management needs to continually obtain and share this information with people inside and outside of the company.
Monitoring. Management should routinely evaluate whether each of the five components of internal controls is present and functioning.

External auditors generally rely on the framework’s concepts when they assess internal controls. Likewise, business owners and managers can use the framework as a guide to establish, strengthen and assess their company’s controls. Following this framework can help safeguard your operations from inadvertent financial reporting errors and fraud.

Practical application

COSO offers 81 “points of focus” that provide practical guidance in designing and implementing effective internal controls. Our audit team can help you turn the framework’s abstract concepts into actionable items. Contact us for more details.

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Timing strategies could become more powerful in 2017, depending on what happens with tax reform

Projecting your business income and expenses for this year and next can allow you to time when you recognize income and incur deductible expenses to your tax advantage. Typically, it’s better to defer tax. This might end up being especially true this year, if tax reform legislation is signed into law.

Timing strategies for businesses

Here are two timing strategies that can help businesses defer taxes:

1. Defer income to next year. If your business uses the cash method of accounting, you can defer billing for your products or services. Or, if you use the accrual method, you can delay shipping products or delivering services.

2. Accelerate deductible expenses into the current year. If you’re a cash-basis taxpayer, you may make a state estimated tax payment before December 31, so you can deduct it this year rather than next. Both cash- and accrual-basis taxpayers can charge expenses on a credit card and deduct them in the year charged, regardless of when the credit card bill is paid.

Potential impact of tax reform

These deferral strategies could be particularly powerful if tax legislation is signed into law this year that reflects the nine-page “Unified Framework for Fixing Our Broken Tax Code” that President Trump and congressional Republicans released on September 27.

Among other things, the framework calls for reduced tax rates for corporations and flow-through entities as well as the elimination of many business deductions. If such changes were to go into effect in 2018, there could be a significant incentive for businesses to defer income to 2018 and accelerate deductible expenses into 2017.

But if you think you’ll be in a higher tax bracket next year (such as if your business is having a bad year in 2017 but the outlook is much brighter for 2018 and you don’t expect that tax rates will go down), consider taking the opposite approach instead — accelerating income and deferring deductible expenses. This will increase your tax bill this year but might save you tax over the two-year period.

Be prepared

Because of tax law uncertainty, in 2017 you may want to wait until closer to the end of the year to implement some of your year-end tax planning strategies. But you need to be ready to act quickly if tax legislation is signed into law. So keep an eye on developments in Washington and contact us to discuss the best strategies for you this year based on your particular situation.

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Ready for the new not-for-profit accounting standard?

A new accounting standard goes into effect starting in 2018 for churches, charities and other not-for-profit entities. Here’s a summary of the major changes.

Net asset classifications

The existing rules require nonprofit organizations to classify their net assets as either unrestricted, temporarily restricted or permanently restricted. But under Accounting Standards Update (ASU) No. 2016-14, Not-for Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities, there will be only two classes: net assets with donor restrictions and net assets without donor restrictions.

The simplified approach recognizes changes in the law that now allow organizations to spend from a permanently restricted endowment even if its fair value has fallen below the original endowed gift amount. Such “underwater” endowments will now be classified as net assets with donor restrictions, along with being subject to expanded disclosure requirements. In addition, the new standard eliminates the current “over-time” method for handling the expiration of restrictions on gifts used to purchase or build long-lived assets (such as buildings).

Other major changes

The new standard includes specific requirements to help financial statement users better assess a nonprofit’s operations. Specifically, organizations must provide information about:

Liquidity and availability of resources. This includes qualitative and quantitative information about how they expect to meet cash needs for general expenses within one year of the balance sheet date.

Expenses. The new standard requires entities to report expenses by both function (which is already required) and nature in one location. In addition, it calls for enhanced disclosures regarding specific methods used to allocate costs among program and support functions.

Investment returns. Organizations will be required to net all external and direct internal investment expenses against the investment return presented on the statement of activities. This will facilitate comparisons among different nonprofits, regardless of whether investments are managed externally (for example, by an outside investment manager who charges management fees) or internally (by staff).

Additionally, the new standard allows nonprofits to use either the direct or indirect method to present net cash from operations on the statement of cash flows. The two methods produce the same results, but the direct method tends to be more understandable to financial statement users. To encourage not-for-profits to use the direct method, entities that opt for the direct method will no longer need to reconcile their presentation with the indirect method.

To be continued

ASU 2016-14 is the first major change to the accounting rules for not-for-profits since 1993. However, it’s only phase 1 of a larger project to enhance financial reporting transparency for donors, grantors, creditors and other users of nonprofits’ financial statements. Contact us for help preparing or evaluating an organization’s financial statements under the new standard.

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