How Your Technical Accounting Leads to Audit Preparation Success…or Failure

 There are many ways that a financial statement audit can go off the rails, leading to significant delays and/or costly overruns. Additional information on some of these top pitfalls leading to audit overruns can be seen in our separate article. 

One of the top causes for audit overruns relates to the level of technical accounting evaluation performed. When you account for your company’s financials under the more complex accounting standards of US GAAP (or IFRS), these frameworks bring a wide range of topics that requires a specific way of accounting for most areas of a business. Understanding the correct accounting guidance, and interpreting how it applies to your company, often results in a major change beyond basic bookkeeping and/or cash-basis accounting. 

As a former auditor and a current technical accounting specialist, my goal is to make you aware of some of the most common areas of a company that require technical accounting evaluation, and what auditors expect when it comes to their review. 

Revenue Recognition (ASC 606) 

Nearly every company audit will have its revenues as a focus area, with significant technical review and audit testing procedures. For all of your revenue transactions, US GAAP requires a specific accounting standard commonly known as “ASC 606.” It requires companies to review their contracts with customers, run those contracts through a rigid 5-step framework, and evaluate that framework in a way that is consistent with similar companies in your industry. 

Coming into an audit, an auditor will be looking to gain a comprehensive understanding of the Company and how it evaluates its own revenue streams. Having an organized breakdown of revenues by key factors for a business, which can include factors such as revenue stream, product/service type, geography, customer type, contract type, etc., helps an auditor understand how to scope their testing procedures. A detailed technical write-up of each major type of revenue, taking the related contract through the 5-Step Model of ASC 606, and related disclosures that meet the necessary financial statement requirements, are considered core audit requirements for a company. 

Leases (ASC 842) 

Accounting for a lease is as simple as expensing the related rent invoice, right? WRONG. A recent accounting standard, commonly known as “ASC 842”, brings its own specific framework for what qualifies as a lease, how to evaluate it, and the resulting accounting treatment. For most leases, this requires a company to record a Right-of-Use Asset and corresponding Lease Liability, and a specific way to handle any income/expense for those assets and liabilities. 

An auditor will look to obtain a comprehensive listing of a company’s contracts that qualify as a lease under ASC 842; it will also want to understand any other potential contracts that were reviewed and evaluated not to fall within scope. Each lease may be reviewed to understand the calculations, as well as the underlying inputs, and that each lease contract was reviewed in detail to capture all related terms and conditions. A technical policy is often needed to ensure proper lease accounting on a go-forward basis, and disclosure information will be needed to ensure it meets ASC 842 requirements. 

Business Combinations 

Each time your company makes an acquisition (or merger), US GAAP requires a specific accounting exercise for the acquired business. This involves a revaluation of many assets/liabilities as of the acquisition date, complex valuation of certain assets/liabilities and consideration paid, and specific accounting/disclosures for things such as transaction costs. 

An auditor will require a comprehensive acquisition-date opening balance sheet, as well as underlying information such as supporting reconciliations for key balance sheet accounts, a purchase price allocation and valuation report (often required by a valuation specialist), and the necessary purchase price accounting adjustments. A technical memorandum is generally needed to ensure all relevant considerations under US GAAP guidance were evaluated. 

New/Amended Equity or Debt Financing  

Any new debt or equity financing needs to undergo a technical evaluation under US GAAP. This evaluation includes identifying what instruments were issued (e.g. if a single debt instrument was issued or if multiple debt arrangements or additional warrants were included), whether any derivatives exist, the type and classification of each instrument, how proceeds and related costs are allocated, and the resulting accounting treatment and disclosure of each instrument. 

Technical write-ups are generally requested for each major financing instrument to ensure all relevant considerations under US GAAP guidance were evaluated. Accompanying workbooks to ensure the correct allocations and journal entries are required as well. 

Stock Compensation  

Any employee compensation (or consultant) awards that are stock-related (e.g., stock options, restricted stock, profit interests, etc.) are required to undergo a specific accounting evaluation, which should be documented in a technical memorandum/policy. The write-up should include the guidance scope for each award, how they are classified (i.e., liabilities vs. equity), how their fair value is determined, and how they are accounted for. Many companies require complex stock compensation calculation workbooks, or a system that handles these calculations. And, yep you guessed it, there are substantial disclosure requirements to include in the financial statements. 

Conclusion 

Most companies and their accounting teams don’t have the experience or the resources to do this technical accounting evaluation, and many companies may not even know what need to be considered for technical evaluation. But these tend to the most complex areas of an audit, and the areas where an auditor will require consultation with their own technical experts, to ensure the right accounting treatment.  

If you don’t have an evaluation completed and ready for audit, or if not properly prepared with the right expertise, this can be extremely costly. It requires significant time spent by the most specialized roles of an accounting firm, with some of these resources having hourly billing rates up to $1,000 or higher. If they must do their own evaluation from scratch, rather than just reviewing yours, those overruns build up fast.  

Engaging a technical accounting expert can save you and your company costly audit overruns. For a better understanding of where you and your company stand on the technical accounting front, connect with one of our experienced technical accounting professionals.