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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Your CPA offers a wide menu of services. One flexible offering, known as an “agreed-upon procedures” engagement, provides limited assurance on a specific aspect of an organization’s financial or nonfinancial information.

What’s covered?

Agreed-upon procedures can cover various items. For example, a CPA could provide a statement about the reliability of a company’s accounts receivable, the validity of the sales team’s credit card payments, the effectiveness of the controls for the security of a system and even greenhouse gas emissions.

Lenders may request these types of engagements before they’ll approve a new loan application or an extension of credit for an existing customer — or they might want one if a borrower defaults on its loan covenants or payments. These engagements can also be useful in M&A due diligence, by franchisors or when a business owner suspects an employee of misrepresenting financial results.

Stakeholders don’t necessarily like waiting until year end to see how an organization is faring in today’s uncertain markets. Agreed-upon procedures can be done at any time, so they can provide much-needed peace of mind throughout the year.

What’s reported?

These engagements are based on procedures similar to an audit, but on a limited scale. When performing agreed-on procedures, CPAs issue no formal opinions; they simply act as fact finders. The report lists:

• The procedures performed, and
• The CPA’s findings.

Agreed-upon procedures can be relied on by third parties. But it’s the user’s responsibility to draw conclusions based on the findings.

What’s new? 

Agreed-upon procedures are usually a one-time engagement, so you might not know much about them — or how the rules that apply to them changed a few years ago. A revised standard was published in 2019, bringing several key changes. Most notably, an accountant is now allowed to report on a subject matter without obtaining a written assertion from the responsible party that the responsible party complies with an underlying criterion, such as laws or regulations. This gives CPAs more flexibility when examining or reviewing certain documents if the engaging party can’t appropriately measure or evaluate them.

The revised standard also:

• Enables CPAs to develop procedures over the course of the engagement,
• Allows CPAs to develop or assist in developing the procedures,
• Removes the requirement for intended users to take responsibility for the sufficiency of the procedures and, instead, requires the engaging party to simply acknowledge the appropriateness of the procedures before the issuance of the practitioner’s report, and
• Permits the CPA to issue a general-use report.

The new guidance went into effect for reports dated on or after July 15, 2021, although early implementation was permitted.

Contact us

In today’s uncertain marketplace, agreed-upon procedures can provide much-needed peace of mind throughout the year. We can help you customize procedures that fit the needs of your organization and its stakeholders.

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Auditing standards require financial statement auditors to identify and assess the risks of material misstatement due to fraud — and to determine overall and specific responses to those risks. Here’s why face-to-face meetings are essential when assessing these risks.

Audit inquiries

Fraud-related questions are a critical part of the audit process. The AICPA requires auditors to identify and assess the risks of material misstatement due to fraud and to determine overall and specific responses to those risks under Clarified Statement on Auditing Standards (AU-C) Section 240, Consideration of Fraud in a Financial Statement Audit.

Specific areas of inquiry under AU-C Sec. 240 include:

• Whether management has knowledge of any actual, suspected or alleged fraud,
• Management’s process for identifying, responding to and monitoring the fraud risks in the entity,
• The nature, extent and frequency of management’s assessment of fraud risks and the results of those assessments,
• Any specific fraud risks that management has identified or that have been brought to its attention,
• The classes of transactions, account balances or disclosures for which a fraud risk is likely to exist, and
• Management’s communications, if any, to those charged with governance about its process for identifying and responding to fraud risks, and to employees on its views on appropriate business practices and ethical behavior.

Interviews must be conducted for every audit — auditors can’t just assume that fraud risks are the same as those that existed in the previous accounting period.

Beyond words

Although many audit procedures have been done remotely during the pandemic, auditors are now resuming face-to-face meetings with managers and others to discuss fraud risks. Why? Psychologists estimate that 7% of communication happens through spoken word, 38% through tone of voice and 55% through body language. So, when evaluating fraud risks during an audit, a face-to-face interview is critical to help pick up on nonverbal clues.

Nuances such as an interviewee’s tone and inflection, the speed at which he or she responds, and body language provide important context to the words being spoken. The auditor will also watch for signs of stress on the part of the interviewee in responding to questions, including long pauses before answering, starting answers over, profuse sweating or tapping feet.

In addition, in-person interviews provide opportunities for immediate follow-up questions. When it isn’t possible to have a face-to-face interview, a videoconference or phone call is the next best option because it provides the auditor many of the same advantages as meeting in person.

Let’s work together

External audits don’t provide an absolute guarantee that dishonest behaviors will be detected, but they can be an effective antifraud control. According to Occupational Fraud 2022: A Report to the Nations, companies that were audited lost one-third less from fraud than those that weren’t audited — and audited companies were able to detect fraud 33% faster than those without audited financial statements.

You can facilitate our efforts to assess your company’s fraud risks by anticipating the types of questions we’ll ask and the source documents we’ll need. Forthcoming, prompt responses help ensure that your audit stays on schedule and minimizes any unnecessary delays.

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