Does your company use supplier finance programs to buy goods or services? If so, and if you must adhere to U.S. Generally Accepted Accounting Principles (GAAP), there will be changes starting next year. At that time, you must disclose the full terms of supplier finance programs, including assets pledged to secure the transaction. Here are the details of this new requirement under GAAP.

Gap in GAAP

Supplier finance programs — sometimes called “structured payables” and “reverse factoring” — are popular because they offer a flexible structure for paying for goods and services. In a traditional supplier arrangement, the buyer agrees to pay the supplier directly within, say, 30 to 45 days.

Conversely, with a supplier finance program, the buyer arranges for a third-party finance provider or intermediary to pay approved invoices before the due date at a discount from the stated amount. Meanwhile the buyer receives an extended payment date, say, 90 to 120 days, in exchange for a fee. This enables the buyer to keep more cash on hand. However, many organizations haven’t been transparent in disclosing in their financial statements the effects those programs have on working capital, liquidity and cash flows.

That’s the reason the Financial Accounting Standards Board recently issued Accounting Standard Update (ASU) No. 2022-04, Liabilities — Supplier Finance Programs (Subtopic 405-50): Disclosure of Supplier Finance Program Obligations. It will require buyers to disclose the key terms of supplier finance programs and where any obligations owed to finance companies have been presented in the financial statements.

More details

Supplier finance programs are a relatively new form of arrangement that continues to evolve and grow in popularity. Even after this ASU becomes effective, GAAP doesn’t provide any specific guidance on where to present the amounts owed by the buyers to finance companies. It’s up to the buyer to decide whether these obligations should be presented as accounts payable or short-term debt.

However, the updated guidance does require that in each annual reporting period, a buyer must disclose:

• The key terms of the program, including a description of the payment terms and assets pledged as security or other forms of guarantees provided for the committed payment to the finance provider or intermediary, and
• For the obligations that the buyer has confirmed as valid to the finance provider or intermediary 1) the amount outstanding that remains unpaid by the buyer as of the end of the annual period, 2) a description of where those obligations are presented in the balance sheet, and 3) a roll-forward of those obligations during the annual period, including the amounts of obligations confirmed and obligations subsequently paid.

In each interim reporting period, the buyer must disclose the amount of obligations outstanding that the buyer has confirmed as valid to the finance provider or intermediary as of the end of the period.

Ready, set, go 

The new rules take effect for fiscal years beginning after December 15, 2022, including interim periods within those fiscal years, except for the amendment on roll-forward information. That provision is effective for fiscal years beginning after December 15, 2023. Early adoption is permitted. Contact us for more information or help implementing the changes.

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One of the best ways to tackle financial statement fraud is to conduct periodic surprise audits. In fact, surprise audits were associated with at least a 50% reduction in both median loss and median duration, according to Occupational Fraud 2022: A Report to the Nations published by the Association of Certified Fraud Examiners (ACFE) earlier this year.

Surprisingly, however, less than half of respondents (42%) conduct surprise audits. So, numerous organizations have an opportunity to add this highly effective tool to their antifraud arsenal.

Cost of financial misstatement

Financial statement fraud happens when “an employee intentionally causes a misstatement or omission of material information in the organization’s financial reports.” Examples include a salesperson who prematurely reports sales to boost commissions or a controller who books fictitious revenue to hide theft — or lackluster financial performance.

These types of schemes can be costly. The ACFE’s survey found that the median loss from misstated financial results is roughly $593,000.

Element of surprise

Routine financial statement audits don’t provide an absolute guarantee against financial misstatement and other fraud schemes. In fact, external audits were the primary detection method in just 4% of the cases reported in the ACFE study. Although a financial statement audit serves as a vital role in corporate governance, the ACFE advises that it shouldn’t be relied upon as an organization’s primary antifraud mechanism.

By comparison, a surprise audit more closely examines the company’s internal controls that are intended to prevent and detect fraud. Here, auditors aim to identify any weaknesses that could make assets vulnerable and to determine whether anyone has already exploited those weaknesses to misappropriate assets. Auditors show up unexpectedly — usually when the owners suspect foul play, or randomly as part of the company’s antifraud policies — to review cash accounts, bank statements, expense reports, payroll, purchasing, sales and other areas for suspicious activity.

The element of surprise is critical. Announcing an upcoming audit gives wrongdoers time to cover their tracks by shredding (or creating false) documents, altering records or financial statements, or hiding evidence.

Perpetrators are likely to have paid close attention to how previous financial statement audits were performed — including the order in which the auditor proceeded. But, in a surprise audit, the auditor might follow a different process or schedule. For example, instead of beginning audit procedures with cash, the auditor might first scrutinize receivables or vendor invoices. Surprise audits focus particularly on high-risk areas such as inventory, receivables and sales. In the course of performing them, auditors typically use technology to conduct sampling and data analysis.

Big benefits

In the ACFE survey, the median loss for organizations that conducted surprise audits was $75,000, compared with a median loss of $150,000 for those organizations that didn’t perform this measure — a 50% difference. This discrepancy is no surprise in light of how much longer fraud schemes went undetected in organizations that failed to conduct surprise audits. The median duration in those organizations was 18 months, compared with only nine months for organizations that performed surprise audits.

Such audits can have a strong deterrent effect as well. While surprise audits, by definition, aren’t announced ahead of time, companies should state in their fraud policies that random tests will be conducted to ensure internal controls aren’t being circumvented. If this isn’t enough to deter would-be thieves or convince current perpetrators to abandon their schemes, simply seeing guilty co-workers get swept up in a surprise audit should do the trick.

Additional investigation

As with financial statement audits, an auditor’s finding of suspicious activity in a surprise audit will likely require additional forensic investigation. Depending on the type of scheme, an auditor might conduct interviews with suspects and possible witnesses, scour financial statements and records, and perform in-depth data analysis to get to the bottom of the matter. Contact us to schedule a surprise audit for your organization.

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What do you do with your financial statements when your auditor delivers them? Resist the temptation to just file them away — they’re more than an exercise in compliance. With a little finagling, you can calculate key financial ratios from line items in your company’s financial statements. These metrics provide insight into historical trends, potential areas for improvement and how the business is likely to perform in the future.

Financial ratios are generally grouped into the following four principal categories:

1. Operating

Operating ratios — such as the gross margin or earnings per share — evaluate management’s performance and the effects of economic and industry forces. Operating ratios can illustrate how efficiently a company is controlling costs, generating sales and profits, and converting revenue to cash.

This analysis shouldn’t stop at the top and bottom of the income statement. Often, it’s useful to look at individual line items, such as returns, rent, payroll, owners’ compensation, interest and depreciation expense.

2. Asset management

Asset management ratios gauge liquidity, which refers to the ability of a company to meet current obligations. Commonly used liquidity ratios include:

• Current ratio, or the ratio of current assets to current liabilities,
• Quick ratio, which only considers assets that can be readily liquidated, such as cash and accounts receivable,
• Days in receivables outstanding, which estimates the average collection period for credit sales, and
• Days in inventory, which estimates the average time it takes to sell a unit of inventory.

It’s also important to consider long-term assets, such as equipment, with the total asset turnover. This ratio tells how many dollars in revenue a company generates from each dollar invested in assets. Management must walk a fine line with 1) efficient asset management, which aims to minimize the amount of working capital and other assets on hand, and 2) satisfying customers and suppliers, which calls for flexible credit terms, ample safety stock and quick bill payment.

3. Coverage

Coverage ratios measure a company’s capacity to service its debt. One commonly used coverage ratio is times interest earned, which measures a firm’s ability to meet interest payments and indicates its capacity to take on additional debt. Another is current debt coverage, which can be used to measure a company’s ability to repay its current debt.

Before a company that already has significant bank debt seeks further financing, it should calculate its coverage ratios. Then it should consider what message management sends to potential lenders.

4. Leverage

Leverage ratios can indicate a company’s long-term solvency. The long-term debt-to-equity ratio represents how much debt is funding company assets.

For example, a long-term debt-to-equity ratio of five-to-one indicates that the company requires significant debt financing to run operations. This may translate into lower returns for shareholders and higher default risk for creditors. And, because the company needs to make considerable interest payments, it has less cash to meet its current obligations.

Basis of comparison 

Ratios mean little without appropriate benchmarks. Comparing a company to its competitors, industry averages and its own historical performance provides perspective on its current financial health. Contact us to help select relevant ratios to include in your analysis. We can help you create a scorecard from your year-end financial statements that your in-house accounting team can recreate throughout the year using preliminary financial numbers.

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Securities and Exchange Commission (SEC) Chair Gary Gensler spoke during a recent webcast to commemorate the 20-year anniversary of the Sarbanes-Oxley Act. Gensler recommended that the SEC take a “fresh look” at its rules on the issue of auditor conflicts of interest. He also asked the Public Company Accounting Oversight Board (PCAOB) to add auditor independence standards to its 2023 agenda.

Here’s why independence matters for public and private entities alike and what you can do to identify and minimize potential conflicts of interest.

SEC oversight

Enacted in the aftermath of the Enron and WorldCom accounting scandals, the Sarbanes-Oxley Act directed the SEC to create barriers between auditors and other parts of their firms. This caused many firms to spin off their consulting businesses into separate entities. “Over the past 20 years, however, many of these firms went on to rebuild them again. PCAOB inspections continue to identify independence — and lack of professional skepticism — as perennial problem areas,” said Gensler.

Under Rule 2-01 of Regulation S-X, when investigating auditor independence, the SEC considers whether an engagement:

• Creates a mutual or conflicting interest,
• Puts the auditor in a position of auditing his or her own work,
• Results in the auditor acting as a member of management or an employee of its audit client, or
• Puts the auditor in a position of being the client’s advocate.

The SEC’s guidance applies to audit firms, covered people in those firms and their immediate family members. The concept of “covered people” extends beyond audit team members. It may include individuals in the firm’s chain of command who might affect the audit process, as well as other current and former partners and managers.

For example, an audit firm might not be independent if, at any time during the audit engagement, a former partner or professional employee is in an accounting or financial reporting oversight role at an audit client. Such an arrangement may be particularly problematic if the former partner has a buyout arrangement that’s contingent on the firm’s operating results.

AICPA guidance

Conflicts of interest are an area of concern for all organizations, not just public companies. According to the American Institute of Certified Public Accountants (AICPA), “A conflict of interest may occur if a member performs a professional service for a client and the member or his or her firm has a relationship with another person, entity, product or service that could, in the member’s professional judgment, be viewed by the client or other appropriate parties as impairing the member’s objectivity.” Management should be on the lookout for potential conflicts when:

• Hiring an external auditor,
• Upgrading the level of assurance from a compilation or review to an audit, and
• Using the audit firm for a nonaudit purposes, such as investment advisory services and human resource consulting

Determining whether a conflict of interest exists requires an analysis of facts. Some conflicts may be obvious, while others may require in-depth scrutiny.

For example, suppose a company asks its audit firm to provide financial consulting services in a legal dispute with another company that’s also an existing audit client. Here, given the inside knowledge the audit firm possesses of the company it audits, a conflict of interest likely exists. The audit firm can’t serve both parties to the lawsuit and comply with the AICPA’s ethical and professional standards.

Diligence is critical 

Before the start of audit season, it’s important to re-evaluate whether there’s been any change in circumstances this year between your organization and your audit firm that could create potential conflicts of interest. Examples include staffing changes, M&A activity and new service offerings. This is a matter our firm takes seriously and proactively safeguards against. If you suspect that a conflict exists, contact us to discuss the matter and determine the most appropriate way to handle it.

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Accounting Standards Codification Topic 842, Leases, requires organizations to report the full magnitude of their long-term lease obligations on their balance sheets — a historic first. For private companies and nonprofits, the changes take effect this year. Public entities adopted the rules in 2019. While the Financial Accounting Standards Board (FASB) conducts its post-implementation review of the new-and-improved lease standard, the guidance is concurrently being adopted by private organizations.

A major issue that has surfaced relates to leases under common control. In a surprise move, the FASB voted on September 21 to propose changes to address stakeholder concerns.

 

Practical expedient for related-party leases

Topic 842 requires an organization to account for a lease that’s under common control on the basis of the legally enforceable provisions. Problems arose for private companies because some don’t have written documentation of related-party leases, and they’re confused about what’s “legally enforceable.”

FASB members unanimously agreed to propose a practical expedient for private entities to simplify the guidance for determining whether a lease exists for arrangements between entities under common control. A practical expedient is an accounting workaround with a simpler approach to arriving at the same answer as the initial rule.

The proposal specifies that entities would only consider the written terms and conditions when determining whether a lease exists, and the classification and accounting for that lease. Entities wouldn’t be required to determine whether those written terms and conditions are legally enforceable. Moreover, if no written terms and conditions exist, an entity would apply Topic 842 to any verbal or implicit terms and conditions. If no lease exists, other rules would apply.

 

Clarity on leasehold improvements

An affiliated issue that came up during the FASB’s review of Topic 842 is how to handle the treatment of leasehold improvements when there’s a verbal related-party transaction. In many cases, the life of the related-party lease could substantially differ from the actual life of the underlying lease asset.

The term “leasehold improvement” generally refers to changes, buildouts or upgrades to real property made by a commercial tenant. For example, you might paint, update lighting, install new carpet or make repairs to a space.

FASB members voted 4-3 to propose an amendment to Topic 842 that would specify that leasehold improvements associated with leases between entities under common control be “amortized by the lessee over the useful life of the improvements (regardless of the lease term) as long as the lessee continues to use the underlying asset.” If the lessee stops using the leased asset, it would then be “accounted for as a transfer between entities under common control.”

To be clear, if approved, this change would apply to both public and private entities. Public companies already implemented the updated standard in 2019.

It’s important to note that three FASB members dissented to proposing changes to leasehold improvement rules. The dissenters said that they didn’t have enough information to vote to propose changes for public companies and were uncertain about any secondary or indirect implications of the proposal. The members who were in favor of the proposal indicated that public companies would largely be unaffected by the changes. Their leases tend to be arm’s length, written agreements, regardless of whether the lessors are third parties or under common control.

 

Stay tuned

Since the updated lease guidance was issued in 2016, it has been deferred twice and amended five times. Once these two last-minute proposals are issued, there will be a 45-day comment period. In the meantime, private organizations must continue pushing forward with adopting the updated guidance for 2022. Contact us for help onboarding the changes, including any amendments for leases under common control.

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