Audit committees act as gatekeepers over the accounting and financial reporting processes, including the effectiveness of the company’s control environment. However, as the regulatory landscape becomes increasingly complex and organizations face evolving risks, the scope of an audit committee’s responsibilities may extend beyond traditional financial reporting.

Top-of-mind list

In March 2024, a survey entitled “Audit Committee Practices Report: Common Threads Across Audit Committees” was published by Deloitte and the Center for Audit Quality, an affiliate of the American Institute of Certified Public Accountants. The survey analyzed 266 responses, including many from people who served on audit committees of public companies.

Respondents identified the following five priorities over the next 12 months:

1. Cybersecurity. This was listed as a top-three concern by a majority (69%) of audit committee members surveyed. The focus on cybersecurity is, in part, caused by a new regulation from the U.S. Securities and Exchange Commission. It requires public companies to 1) report material cybersecurity incidents, 2) disclose cybersecurity risk management and strategy, and 3) explain their board and management oversight processes. Surprisingly, only 24% of respondents said their audit committees had sufficient levels of expertise in this area. So additional resources may be needed to hire external cybersecurity advisors or invest in educational programs to bridge the knowledge gap.
2. Enterprise risk management (ERM). Nearly half (48%) of respondents listed ERM as a top-three concern. This refers to the processes an organization uses to identify, monitor and assess enterprise-wide risks. Audit committees have been tasked with ERM for many years, but extra attention may be warranted as new threats emerge. Examples include pandemics, large natural and climate-related disasters, and global conflicts. It’s important for audit committees to evaluate whether their organizations’ ERM processes can handle new threats efficiently and effectively.
3. Finance and internal audit talent. More than one-third (37%) of respondents put this concern on their top-three list. Audit committees frequently work closely with in-house finance and internal audit teams. While most respondents (89%) agree or strongly agree that their internal auditors possess a high-level understanding of the companies’ operations, there may be opportunities to upskill in-house staff and use artificial intelligence (AI) to streamline routine tasks, eliminate redundancies, and identify opportunities to operate more efficiently. Audit committees should oversee succession planning for finance and internal audit teams, particularly if their companies’ CFOs are planning to retire soon.
4. Compliance with laws and regulations. More than one-third (36%) of respondents are focused on the heightened complexity of the regulatory environment. Compliance issues are especially prevalent in heavily regulated industries, such as banking, food services, and aviation.
5. Finance transformation. Listed as a top-three concern by 33% of respondents, finance transformation refers to revamping the finance department to better align with the company’s overall strategy. It may entail changes to the department’s operating model, staffing, processes, and accounting systems. The goals are to simplify, streamline, and optimize the organization’s finance function. Audit committees can help finance teams implement transformation initiatives by understanding the human and technological resources needed. Many are considering possible AI solutions, for example, to expedite closing the books at the end of the reporting period, improve financial planning and detect impending risks.

Collaborative approach

External auditors communicate frequently with audit committees about top concerns, emerging risks, impending regulations, and other matters so they can help each other in performing their respective roles. Contact us. We design audit procedures, draft financial statement disclosures, and provide guidance to help address the challenges audit committees face today.

Interim financial reporting is essential to running a successful business. When reviewing midyear financial reports, however, you should recognize their potential shortcomings. These reports might not be as reliable as year-end financials, unless a CPA prepares them or performs agreed-upon procedures on specific accounts.

Realize the diagnostic benefits

Monthly, quarterly and midyear financial reports can provide insight into trends and possible weaknesses. Reviewing interim results is particularly important if your business fell short of its financial objectives in 2023.

For example, you might compare year-to-date revenue for 2024 against 1) the same time period for 2023, or 2) your annual budget for 2024. If your business isn’t growing or achieving its goals, find out why. Perhaps you need to provide additional sales incentives, implement a new marketing campaign or adjust your pricing.
You can also review your gross margin [(revenue – cost of goods sold) ÷ revenue]. If your margin is slipping compared to 2023 or industry benchmarks, find out what’s going wrong and take corrective actions.

Don’t forget the balance sheet. Reviewing major categories of assets and liabilities can help detect working capital problems before they spiral out of control. For instance, a buildup of accounts receivable may signal collection problems. Or, if your company is drawing heavily on its line of credit, operations might not be generating sufficient cash flow.

Proceed with caution

If your company’s interim financial health seem out of whack, don’t panic. Some anomalies may not necessarily be related to problems in your daily business operations. Instead, they might be caused by informal accounting practices that are common midyear (but are corrected by your CPA at year-end). Remember that, unlike year-end reports, interim reports for private companies are seldom subject to an external audit or rigorous internal accounting scrutiny.

For example, some controllers might loosely interpret period “cutoffs” or use subjective estimates for certain account balances and expenses. In addition, interim financial statements typically exclude major year-end expenses, such as profit sharing and shareholder bonuses. As a result, interim financial statements tend to paint a rosier picture of a company’s performance than its year-end report may.

Furthermore, many companies perform time-consuming physical inventory counts exclusively at year-end. Therefore, the inventory amount shown on the interim balance sheet might be based solely on computer inventory schedules or, in some instances, the controller’s estimate using historic gross margins. Similarly, accounts receivable may be overstated because overworked controllers may lack time or personnel to adequately evaluate whether the interim balance contains any bad debts.

Finish the year strong

It’s hard to believe that 2024 is almost half over! Once your staff generates your business’s midyear financial health reports, contact us for help interpreting them. We can help you detect and correct potential problems. We also can help remedy any shortcomings by performing additional testing procedures on your interim financials — or preparing audited or reviewed midyear statements that conform to U.S. Generally Accepted Accounting Principles.

Many businesses focus on selling more products and services to boost profitability. But sales volume alone doesn’t necessarily raise profits. In fact, pushing more sales through a bloated expense structure can result in lower net profits.

That’s why it’s important to look at the other side of the ledger — expenses — as you aim to increase profits. A thoughtful way to cut expenses is to conduct a formal expense review. Here are four areas to focus your cost-cutting efforts on:

1. Labor costs. Evaluate your total employment costs. These include not only salaries and wages, but also employee benefits, such as health insurance and retirement plan contributions. Benefits account for more than one-third of total employee compensation, according to the U.S. Bureau of Labor Statistics.

In today’s tight job market, you want to offer competitive pay and benefits. So, it’s important to compare the total compensation paid for each position to what others in your industry are paying workers in similar roles. If your compensation is significantly higher or lower than these benchmarks, adjust accordingly. If you decide to reduce salaries or forgo raises this year, consider adding cost-effective benefits and perks that your workers might value — such as flexible work hours or employer-provided lunches — to help maintain morale and minimize turnover.

2. Vendor relationships. Gather all your vendor contracts so your management team can review them together. These may include contracts with suppliers, insurers, professional service providers, cleaners, landscaping companies, and technology firms. Determine if you’re paying for overlapping services from multiple vendors. If so, eliminate unnecessary vendors or services. Next, evaluate the services you’re purchasing from each vendor and how necessary they are. For instance, you might be paying a vendor to perform a service that your staff could do.

Finally, designate a preferred provider in each expense category and negotiate the best price with this vendor. Require employees to use preferred vendors unless there are extenuating circumstances that are approved by a manager. Also consider leases for equipment and property that could be renegotiated at more favorable terms.

3. Advertising. Work closely with your advertising agency to measure the effectiveness of your current campaigns. Some businesses waste thousands of dollars a month on ads that deliver little, if any, results. Your agency should be able to give you a good idea of the return on investment (ROI) of all your programs. Based on this analysis, reduce or eliminate spending on ineffective campaigns and consider diverting these funds to campaigns with stronger ROIs.

Also think about putting your advertising account out for bid if you haven’t done so in the past year or two. Many agencies automatically increase their rates annually, which can raise costs drastically after a few years. Tell your current agency that you’re shopping around and ask them to give you their best price. If you decide to switch to a new agency, you might benefit from fresh ideas and new perspectives on how to increase sales.

4. Interest. If your business borrows money for equipment, real property, or working capital needs, interest expense is probably a significant item on your income statement. Thanks to rising commercial interest rates, this expense has likely increased in recent years if you have variable-rate loans.

Your business operations should generate a higher return than the cost of your debt. If not, high-interest costs could lead to financial distress. To avoid this pitfall, brainstorm ways to lower borrowing costs.

For instance, you might be able to lower your interest rate by shopping around for loans with shorter terms or fixed rates (to hedge against further rate increases). Alternatively, you may need to draw less from your line of credit if you manage inventory and receivables more efficiently. Also, consider setting aside some operating cash to pay down your outstanding loans rather than taking dividends or paying bonuses.

Continuous improvement process

It pays to be cost-conscious. When reviewing the expense side of your operations, look at each expense line on your income statement to assess whether it’s reasonable. Every dollar of excess expense you slash should, in theory, drop straight to your bottom line. However, haphazard cost-cutting could impair future sales or productivity. So, cost-cutting requires a delicate balance.

 

Contact us for help performing a formal expense review to identify cuts that make sense for your business over the long run.

Accurate, timely financial information is key to making good decisions for executives, board members, investors, and other stakeholders. But not everyone who reads your financial statements will really understand the numbers they receive and what they mean to your organization. Here are some ways to present your financial results in a reader-friendly manner.

Consider your audience

The people who rely on your organization’s financial statements probably come from different walks of life and different positions. Some may have financial backgrounds, but others might not. And it’s this latter group you need to keep in mind as you supply financial data.

This is especially true for nonprofits, such as charities, religious organizations, recreational clubs and social advocacy groups. Their stakeholders may include board members, volunteers, donors, grant makers, watchdog groups and other people in the community. But it also may apply to for-profit businesses that share financial data with their boards, employees and investors who don’t have a controlling interest in the organization.

Don’t assume all your stakeholders understand accounting jargon. It may be helpful to provide definitions of certain financial reporting terms. For example, a nonprofit might explain that “board-designated net assets” refers to items set aside for a particular purpose or period by the board. Examples include safety reserves or a capital replacement fund, which have no external restrictions by donors or by law. While this definition might seem obvious to a nonprofit’s management team, stakeholders might not be familiar with it. You could also provide internal stakeholders with some basic financial training by bringing in outside speakers, such as accountants, investment advisors, and bankers.

Add pictures to get your message across

In addition to providing numerical information from your company’s income statement, balance sheet and statement of cash flows, consider presenting some information in a graphical format. Long lists of numbers can have a dizzying effect on financial statement readers. Pictures may be easier for laypeople to digest than numbers and text alone.

For instance, you might use a pie graph to show the composition of your company’s assets. Likewise, a line or bar graph might be an effective way to communicate revenue, expenses, and profit trends over time.

Present financial ratios

Financial ratios show relationships between key items on your financial statements. While ratios don’t appear on the face of your financial statements, you can highlight them when communicating results to stakeholders. For instance, you might report the days in receivables ratios (accounts receivable divided by annual revenue times 365 days) from the current and prior reporting periods to demonstrate your efforts to improve collections. Or you might calculate gross margin (revenue minus cost of goods sold) as a percentage of revenue from the current and prior reporting periods to show how increases in raw materials and labor costs have affected your business’s profitability.

Another useful tool is the “current ratio.” A comparison of current assets to current liabilities is commonly used as a measure of short-term liquidity. A ratio of 1:1 means an organization would have just enough cash to cover current liabilities if it ceased operations and converted current assets to cash.

It may also be helpful to provide industry benchmarks to show how your company’s performance compares to others in your industry. This information is often available from industry trade publications and websites.

Be transparent about non-GAAP metrics

One area of particular concern is how your organization presents financial information that doesn’t conform to U.S. Generally Accepted Accounting Principles (GAAP), such as earnings before interest, taxes, depreciation, and amortization (EBITDA). The use of non-GAAP metrics has grown in recent years. While non-GAAP metrics can provide greater insight into the information that management considers important in operating the business, take care not to mislead stakeholders by putting greater emphasis on non-GAAP metrics than the GAAP data provided in your financial statements.

For instance, EBITDA is often adjusted for such items as stock-based compensation, nonrecurring items, intangibles and other company-specific items. If you report EBITDA, you should clearly disclose how it was calculated, including any adjustments, and how it compares to earnings before tax on your GAAP income statement.

Use plain English

Regardless of your industry, stakeholders want accurate, transparent information about your organization’s financial performance. It’s up to you to supply them with information they fully understand so they can make informed decisions. Contact us for help communicating your results more effectively to give stakeholders greater confidence and clarity when reviewing your financial reports.

Many people dream of turning a hobby into a regular business. Perhaps you enjoy boating and would like to open a charter fishing business. Or maybe you’d like to turn your sewing or photography skills into an income-producing business.

You probably won’t have any tax headaches if your new business is profitable over a certain period of time. But what if the new enterprise consistently generates losses (your deductions exceed income), and you claim them on your tax return? You can generally deduct losses for expenses incurred in a bona fide business. However, the IRS may step in and say the venture is a hobby — an activity not engaged in for profit — rather than a business. Then you’ll be unable to deduct losses.

By contrast, if the new enterprise isn’t affected by the hobby loss rules, all otherwise allowable expenses are deductible, generally on Schedule C, even if they exceed income from the enterprise.

Important: Before 2018, deductible hobby expenses could be claimed as miscellaneous itemized deductions subject to a 2%-of-AGI “floor.” However, because miscellaneous deductions aren’t allowed from 2018 through 2025, deductible hobby expenses are effectively wiped out from 2018 through 2025.

How to NOT be deemed a hobby

There are two ways to avoid the hobby loss rules:

1. Show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing, or racing horses).
2. Run the venture in such a way as to show that you intend to turn it into a profit maker rather than a mere hobby. The IRS regs themselves say that the hobby loss rules won’t apply if the facts and circumstances show that you have a profit-making objective.

How can you prove you have a profit-making objective? You should operate the venture in a businesslike manner. The IRS and the courts will look at the following factors:

• How you run the activity,
• Your expertise in the area (and your advisors’ expertise),
• The time and effort you expend in the enterprise,
• Whether there’s an expectation that the assets used in the activity will rise in value,
• Your success in carrying on other activities,
• Your history of income or loss in the activity,
• The amount of any occasional profits earned,
• Your financial status, and
• Whether the activity involves elements of personal pleasure or recreation.

Case illustrates the issues

In one court case, partners operated a farm that bought, sold, bred, and raced Standardbred horses. It didn’t qualify as an activity engaged in for profit, according to a U.S. Appeals Court. The court noted that the partnership had a substantial loss history and paid for personal expenses. Also, the taxpayers kept inaccurate records, had no business plan, earned significant income from other sources, and derived personal pleasure from the activity. (Skolnick, CA 3, 3/8/23)

Contact us for more details on turning a hobby into a business, including whether you may be affected by the hobby loss rules and what you should do to avoid tax problems.