Review Procedures

I was asked yesterday to explain my blog about reviews the other day and how the CPA overlooked the fact that the manager recorded the full special assessment instead of unearned interest income.  It was a great question.

What actually tipped us was the foot note for the receivable.  It said, in part, that monthly payments were required by owners (including interest).

When we looked at the manager’s profit and loss statement for the special assessment fund, it showed

Interest income $0
Interest expense $20,000

The second clue was looking back at the special assessment fund balance.

2014 $80,000
2015 $65,000
2016 $50,000

Each year the equity is being reduced because the interest expense was being recorded but there was no offsetting interest income.  Since there was a special assessment receivable, an effective review test would be multiplying the average receivable balance by the stated interest rate.

In this case, the average receivable balance was $300,000.  This multiplied by the 6.0% interest rate meant $18,000 of interest income would be expected.  The association recorded no interest income.  This is a very large deviation from expectations.

Under SSARS, Statement on Standards for Accounting and Review Services, the accountant performs certain analytical tests and compares those to industry standards, historical evidence and certain expectations driven by experience with both the client and the particular industry.  In this case, our experience with special assessment receivables led us to believe that there should have been interest income.  Although if the accountant simply compared it to the prior year, then the zero matched the zero in the prior year and even the year before that.

This would be incorrect though.  Another requirement of SSARS and GAAS is to maintain professional skepticism, or the willingness to look beyond the assumption that an explanation may be correct.

So, we said, “Wait a second, how can it be zero if we calculate $18,000?  How could the prior year be zero when the average receivable was $400,000?  We then asked the question of management and they said it was always zero.

And our response was, so what?  It didn’t feel right.  In short, we were skeptical that their explanation was sufficient.  Remember, the foot note said each payment included interest.  This meant that somewhere along the way the preparer of the financials read a document that stated this.

Sure enough we found that document.  Sure enough we found the next document which showed the original entry and that it included the full amount of the special assessment – including interest.  That is, by the way, why the fund balance had a positive balance all the way back when it was created.  The special assessment “revenue” was higher than the costs of the renovation project.  It should have, at best, been a  break even.

We could then model it and show the board how the financial statements were incorrectly reporting the special assessment.  We then showed them how it was supposed to be.

No, it hasn’t been cheap for the association.  It was all driven, unfortunately, by not having the financial statement reviewed in the year of the special assessment.  Having the statements reviewed years later almost guaranteed that it would be overlooked.  It is possible that it could have been overlooked in a review of that year too, I am not saying that it would have been caught necessarily, but the odds would have definitely been improved.

So yes, board members, especially treasurers, you can run your own analysis.  If you would like, I can send you a spreadsheet with some of the more common ratios and analysis to help you get a good overview of your financial statements before your accountant sets in on the review.  It can’t hurt and could potentially head off a disaster.

Have a great day.  If you would like to learn more about how to analyze your non-profit, business, or property association, feel free to contact me and request the spreadsheet.  C.O.R.E. Services is here to be of service to you.

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The Dilemma of the Review Engagement

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

Case in point:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Have a great day.

Cash Flow and Investors

I am occasionally asked to provide guidance to developers on how best to structure cash flows and how to present the information so that their investors can see what is happening.  Unfortunately, GAAP is somewhat weak in this area so we fall back on good old fashioned sources and uses statements.

Of course, these become a little more challenging when the project has multiple classes of ownership, each with their own return on investment (ROI) expectation.  And they become really hard when the cash flows are no where near expectations.

Naturally, developers don’t turn to the accountant when things are going well – invariably we are asked to weigh in when things are not working as expected.  In the most recent case, the investors are bothered by cash being paid to the developer and they think it should be paid to them.  This is a pretty common theme.

Changing the facts and circumstances a little, lets say you developed a commercial building.  To keep it somewhat simple there are 3 investors and a lender, A, B Developer and Bank.

  • A invested $5,000,000 with a guaranteed 10% return and is supposed to receive the first $500,000 in cash annually after debt service
  • B invested 5,000,000 with a guaranteed 15% return and is scheduled to receive their payment after a $100,000 developer payment to Developer
  • Developer receives their $100,000 payment and then can receive any residual cash
  • The developer predicted about $1.5 Million in annual cash flow after debt service

Cash flow after debt service is $900,000.   Obviously this is somewhat disappointing, especially for B.  According to the accounting,

  • A receives their $500,000
  • Developer receives their $300,000
  • B only receives $250,000 out of their $750,000

B thinks that developer is taking more money than allowed for.  From B’s perspective, Developer received $300K when they should have only received $100K and the other $200,000 belongs to B.

In the course of trying to explain this, we had to dig a little deeper.  We identified that Developer also invoiced for maintenance – $200,000.  The bookkeeper inadvertently recorded it to the wrong account but the damage is done.  B is threatening to sue for failure to perform.

This is where a good sources and uses statement comes in handy.  We were able to lay out how funds came in and how funds went out.  We started from the accrual basis  and created columns to eliminate the various transactions to get to the pure cash in and out.

By identifying how first funds, and then cash, were handled, B was able to understand that the transaction was first recorded incorrectly and second was not a cash transaction.  We actually pointed out that the invoicing for the maintenance was agreed to by the members and could have been paid out as an ordinary business expense but Developer felt it best to try and satisfy B first to the extent possible.  The remaining cash was actually being held onto as a reserve for some defects that were noticed

As powerful as full GAAP statements can be, sometimes it is the simplest statements, like a sources and uses that can make people understand what is actually going on.  Yes, had B read the full financial statement they might have seen what was going on, and yes B could have handled it better than assuming improper behavior on the part of Developer, but the truth is, when you think you are not received your due one tends to see only things from your own perspective.

So the next time you are facing a question over how money and value are coming and going from your activity try a sources and uses statement.  I think you will be surprised how well it might help the situation.

Have a great day.  If you have any questions about this topic or anything else related to business or management, feel free to contact us through our website.  We are here to be of service to you.

Impairment and the Balance Sheet

Typically it goes like this, “I googled this accounting term and it says that I am not required to do what you are saying.”  Ugh

Do not put your google search up against my accounting degree and constant hours of study of accounting principles.  Kubae actually saw that on a coffee cup and I thought it was pretty awesome.  Clichéd but awesome.

As I wrote on my other blog today GAAP is an accounting model that is selected by the organization.  If you elected to follow GAAP then, when a situation arises that GAAP covers, you are required to comply.

Or not.  Remember it is a choice.

We have worked with a few businesses recently who needed their financial statements reviewed.  They each have bank loans with covenants that require their financial statements to be prepared in accordance with GAAP.  And have those financial statements reviewed.

In each instance revenues are down year over year.  In each instance the companies have substantial non-cash assets: inventory, property, facilities and equipment, goodwill.  And we have asked each of them if they determined that their assets are impaired in value.

Sorry but this is a necessary question in a review.  GAAP requires that assets be tested for impairment, that is, loss of value.   And since you have a loan covenant requiring GAAP financial statements you have to follow the steps called for by GAAP.

Or you can say you are not going to follow GAAP.

By the way, you should be worried about value impairment in the situation where revenues are dropping and profits are slipping.  It is a sign that perhaps you have surplus inventory, desks that are not being used, expensive plant equipment that is sitting idle, shop space unused.  Why wait until the CPA says something?

That was a rhetorical question.  At this stage businesses have bigger problems than if their assets no longer have value.  Your bank moving you to special assets is chief among them.  You are focused on profitability because you think that is what the bank is concerned with.  And slamming more expenses into your fragile profit and loss statement is the last thing you want to happen.

Testing for impairment doesn’t necessarily lead to a write-off of value.  But if it does, so what?  If you are carrying inventory that you haven’t moved in a year then maybe adjusting its value to what you can get for it is a good move.  Think about it, you are trying to correct for past decisions and return to profitability.  Your inventory, and other assets, were a reflection of those past decisions and not dealing with them will actually hamper your turnaround.

Capitalized leasehold improvements has been a big issue for us on review.  What we find is that the accountant (even us) records the depreciation/amortization over 39 years.  Why?  because it fits with MACRS.  But it isn’t disclosed properly.  And then the problem is compounded by the fact that the company has a 5 year lease with one 5-year extension.

There are three years left on the extension.  Revenues and profits are down and management is looking for smaller, more affordable space.  And the company is sitting on $350,000 net book value of leasehold improvements.  It is painfully obvious isn’t it?

The value is impaired like it or not.  You don’t have a $350,000 asset, you have a huge rock tied to your ankles while you plummet the depth of the ocean.   Ignoring the problem isn’t going to help.  When it is time to move to the new facility the business will have to take a $300,000 write off for the inaccurate reporting of the economic life.  And that is the year your line of credit renews.

We know this isn’t an easy subject but you elected to follow GAAP.  Look at your assets and ask if it is still worth it.  You should do this even if you are vastly profitable since it is highly likely that there are assets or asset classes that you are no longer utilizing.

Or don’t follow GAAP.  The choice is yours.  Just don’t get mad at the CPA because she questions your balance sheet.

Have a great weekend.  If you would like more information about impairment or any other GAAP issue, feel free to contact us through our website.  We look forward to being of service to you.