Day's Outline
l
Accounting and Auditing
Day's Outline
l
Accounting and Auditing
l Outline of Accounting & Auditing
l Accounting and Reporting Issues
l Example Audit Program Highlights
l Example Disclosure Checklist
l Internal Controls
l Example Statements
l Issue of Going Concern
Day's Outline
l
Income Tax Issues
l Overview
l Cost properly allocable to contracts
l Capitalization of production period interest
l Methods of Accounting—Other than “Long-Term”
Contracts
l Completed Contract Method
l Percentage of Completion Method
Day's Outline
l
Income Tax Issues
l Changing Accounting Methods
l AMT Considerations
Accounting & Auditing
l
Authoritative Literature
l
Industry Background
l
Accounting for Construction Contractors
l
Other Issues
l Joint Ventures
l Tax vs. Book
l Financial Statement Presentation
l Homebuilders Issues
l Auditing Contractors
Authoritative Literature
l
ARB No. 45, Long-Term Construction Type
Contracts (1955)
l
AICPA Statement of Position 81-1 (1981)
l
AICPA Audit and Accounting Guide: Construction
Contractors (2010 Revision)
l
AICPA Audit Risk Alert and Accounting Reporting
Alerts (2010)
l
FASB Codification Project
FASB Codification
• 605 – Revenue Recognition
• 35 – Construction-Type and Production-Type Contracts
• 00 – Status
• 05 – Overview and Background • 15 – Scope and Scope Exceptions • 20 – Glossary
• 25 – Recognition
• 45 – Other Presentation Matters • 50 – Disclosures
• 55 – Implementation Guidance and Illustrations • 75 – XBRL Elements
FASB Codification
• 910 – Contractors – Construction
• 10 – Overall
• 20 – Contract Costs
• 235 – Notes to Financial Statements • 310 – Receivables
Construction Industry Background
l
Accounting Standards vs. Reporting Standards
l
Types of Contractors
l General Contractors l Subcontractors l Construction ManagerCharacteristics of Contractors
ASC 90-10-15-3
Although the construction industry is difficult to define
because of its diversity, certain characteristics are
common to entities in the industry. The most basic
characteristic is that work is performed under
contractual arrangements with customers. A
contractor, regardless of the type of construction
activity or the type of contractor, typically enters into
an agreement with a customer to build or to make
improvements on a tangible property to the
Characteristics of Contractors
ASC 90-10-15-3
The contract with the customer specifies the work to
be performed, specifies the basis of determining the
amount and terms of payment of the contract price,
and generally requires total performance before the
contractor's obligation is discharged. Unlike the work
of many manufacturers, the construction activities of a
contractor are usually performed at job sites owned
by customers rather than at a central place of
business, and each contract usually involves the
production of a unique property rather than repetitive
production of identical products.
Other Characteristics
ASC 90-10-15-3
A contractor normally obtains the contracts that
generate revenue or sales by bidding or negotiating
for specific projects.
Other Characteristics
ASC 90-10-15-3
Customers (usually referred to as owners) frequently
require a contractor to post a performance and a
payment bond as protection against the contractor's
failure to meet performance and payment
requirements.
The costs and revenues of a contractor are typically
accumulated and accounted for by individual
contracts or contract commitments extending beyond
one accounting period, which complicates the
management, accounting, and auditing processes.
Other Characteristics
ASC 90-10-15-3
Types of Contracts
ASC 605-35-15-4
l
A fixed-price contract is an agreement to perform
all acts under the contract for a stated price.
Types of Contracts
ASC 605-35-15-4
l
A fixed-price contract is an agreement to perform
all acts under the contract for a stated price.
l
A cost-type (including cost-plus) contract is an
Types of Contracts
ASC 605-35-15-4
l
A time-and-material contract is an agreement to
perform all acts required under the contract for a
price based on fixed hourly rates for some measure
of the labor hours required (for example, direct
labor hours) and the cost of materials.
Types of Contracts
ASC 605-35-15-4
l
A time-and-material contract is an agreement to
perform all acts required under the contract for a
price based on fixed hourly rates for some measure
of the labor hours required (for example, direct
labor hours) and the cost of materials.
l
A unit-price contract is an agreement to perform
Bonding
l
Referenced at ASC 910-10-15-4
l
Principal reason contractors require financial
statements with attest reports
l
Post a bond equal to percentage of cost to
complete contract
Types of Bonds
l
Bid bond
l
Performance bond
Purpose of Bond
l
Protects buyer from certain types of damages from
nonperformance
l
Surety provides that assurance to the buyer
l Investigates the contractor
l Primary interest is in contractor's ability to fulfill his
obligations
l Sureties place great reliance on the outside
accountants' report and abilities
Bonding Agents and Sureties
l
Bonding agent works to finds a surety for the
contractor
l
CPA can assist by
l Educate client
l Job cost system
l Issuance of financial statements
l Helping to assure are providing information the surety
wants
Analysis of the Statements
l
Looking to determine “bonding capacity”
l
Looks at maximum per job, and maximum for all
jobs
l
Key interest in contractor's net working capital
l Adjusted current assets less
l Current liabilities
Adjustments to Current Assets
l
Remove assets not recoverable in cash if contractor
liquidates
l
Reduce to a (potentially mechanical) estimate of
Adjustments to Current Assets
l
Assets normally adjusted or removed
l Receivables from shareholders
l Receivables from employees
l Retainage receivable
l Other receivables over 90 days old
l Inventories
l Prepaid expenses
Bonding Capacities
l
Rules of thumb
l Maximum single job bond: 10-20 times net working
capital
l Maximum total bonding: 10-20 times adjusted net
equity
l For net equity can look at revaluing other assets
l Can assist in providing information for calculating adjustments, again subject to EI 101-3 issues
Other Items Considered
l
Gross profit in backlog
l
Amount of underbillings
l
Quick ratio of more than 1:1
Lien Rights
l
Contractor is working on someone else's property
l
State law generally grants lien rights
l However, must be handled properly
l Rules vary from state to state (don't presume home
state rules)
l Contractor needs to get this right
Contract Changes
l
Change order (ASC 650-35-25-25 to 28)
l
Claim (ASC 650-35-25-30)
l
Extras (Contract Option and Addition – ASC
650-35-25-29)
Billing Practices
l
Based on contract terms for specific contract
l
Example billing systems
l Completion of stages of the contract
l Costs incurred on the contract
l Architect/engineer estimates of completion
l Specific time schedules
l Quantity measure of unit price
l
Front end loading is a financing technique (and lack
of same may be indicative of “optimistic”
accounting)
Front End Loading
l
Helps with cash up front
l
Contractor must be aware of dearth of cash at the
end of the job
l
Retentions create opposite issues
Joint Ventures
l
Regular feature for many construction contractors
l
Business entity owned by a group of businesses
l
Normally LLCs today unless state law has anti-LLC
bias (California and Texas, for instance)
Financial & Tax Reporting
l
Financial statements required
l Financing
l Bonding
l
Income tax methods
l Differ from GAAP
l Deferred tax issues
l
Different goals for each type of reporting for both
GAAP/Tax Diffrences
l
Note that in real world both are often compromised
l
Example to illustrate differences even when using
the “same” method
ASC 605-35-25-85
Adjustments to the original estimates of the total
contract revenue, total contract cost, or extent of
ASC 605-35-25-85
Additional information that enhances and refines the
estimating process is often obtained after the balance
sheet date but before the financial statements are
issued or are available to be issued (as discussed in
Section 855-10-25); except as indicated in paragraph
605-35-50-10, such information should result in an
adjustment of the unissued financial statements.
ASC 605-35-25-85
Additional information that enhances and refines the
estimating process is often obtained after the balance
sheet date but before the financial statements are
issued or are available to be issued (as discussed in
Section 855-10-25); except as indicated in paragraph
605-35-50-10, such information should result in an
adjustment of the unissued financial statements.
605-35-50-10 Events occurring after
the date of the financial statements that are outside the normal exposure and risk aspects of the contract shall not be considered refinements of the estimating process of the prior year but should be disclosed as
IRS Notice 89-15
Q-24: In determining percentage of completion for a
particular taxable year, when are total contract costs
and total contract revenues to be estimated?
A-24: Total contract revenue and total contract costs are
to be estimated based on the facts and reasonable
estimates as of the last day of the taxable year. Events
Construction Industry Operations
l
Preparing Cost Estimate and Bids
l
Entering into a Contract
Cost Estimate and Bids
l
Crucial for contractors
l Overestimate costs and won't get job
l Underestimate costs and may bankrupt the contractor
l
Influence issues
l Complexities of the job
l Labor and material market and supplies
l Experience doing similar work
l Reputation of engineer or architect
l Season, weather and timing
Cost Estimate and Bids
l
Influence issues
l Reputation of the owner
l Opportunities to add change orders
l Specifications of the plan
Entering Into Contract
l
Owner selects a contractor from the bids received
l
Formal agreement reached
l
Due to change orders, initial agreement represents
only starting understanding
l
So must understand this will very likely not be the
final outline of what happened
Planning & Starting Job
l
Contractor needs to plan the job itself, move
equipment into place, order materials, establish job
site office, contract with subcontractors and hire
labor
l
Job cost system in place
l Solid estimates documented and in place
l Control system in place to assure proper job cost
capture
l
Consider contractor size and methods of operation
Accounting For Construction
Contractors
l
Main standards came from SOP 81-1 (Now
effectively in ASC 910)
l
Very strong preference for Percentage of
Completion (ASC 605-35-25-57)
l
Types of Contracts Covered
l Fixed price/lump sum
l Cost type products (including cost plus)
l Time and material
l Unit price
Accounting for Construction
Contractors
l
Profit Center Accounting
l Job cost system
l May combine small contracts or, if reasonable, related
contracts
Percentage of Completion Method
l
Reasonably Dependable Estimates
l
Hazards of Estimates
l Control based on reliability of job cost system
l Need to evaluate how good estimates have been in the
past
l
Can find inability to produce estimates as reason
not to use percentage of completion
(ASC 605-35-25-57)
ASC 605-35-25-62
Past Accuracy – ASC 605-35-25-63
Ability to estimate covers more than the estimating anddocumentation of contract revenues and costs; it covers a contractor's entire contract administration and management control system. The ability to produce reasonably dependable estimates depends on all the procedures and personnel that provide financial or production information on the status of
contracts. It encompasses systems and personnel not only of the accounting department but of all areas of the entity that
participate in production control, cost control, administrative control, or accountability for contracts. Previous reliability of a
contractor's estimating process is usually an indication of continuing reliability, particularly if the present
ASC 605-35-25-57
The percentage-of-completion method is considered preferable
as an accounting policy in circumstances in which reasonably dependable estimates can be made and in which all the following
conditions exist:
ASC 605-35-25-57
The percentage-of-completion method is considered preferable as an accounting policy in circumstances in which reasonably dependable estimates can be made and in which all the following conditions exist:
1. Contracts executed by the parties normally include provisions that clearly specify the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement.
2. The buyer can be expected to satisfy all obligations under the contract.
3. The contractor can be expected to perform all contractual obligations.
ASC 605-35-25-57
The percentage-of-completion method is considered preferable
as an accounting policy in circumstances in which reasonably dependable estimates can be made and in which all the following conditions exist:
1. Contracts executed by the parties normally include provisions that clearly specify the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement.
2. The buyer can be expected to satisfy all obligations under the contract.
ASC 605-35-25-57
The percentage-of-completion method is considered preferable as an accounting policy in circumstances in which reasonably dependable estimates can be made and in which all the following conditions exist:
1. Contracts executed by the parties normally include provisions that clearly specify the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement.
2. The buyer can be expected to satisfy all obligations under the contract.
3. The contractor can be expected to perform all contractual obligations.
ASC 605-35-25-57
The percentage-of-completion method is considered preferable
as an accounting policy in circumstances in which reasonably dependable estimates can be made and in which all the following conditions exist:
ASC 605-35-25-57
The percentage-of-completion method is considered preferable as an accounting policy in circumstances in which reasonably dependable estimates can be made and in which all the following conditions exist:
1. Contracts executed by the parties normally include provisions that clearly specify the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement.
2. The buyer can be expected to satisfy all obligations under the contract.
3. The contractor can be expected to perform all contractual obligations.
ASC 605-35-25-58
For entities engaged on a continuing basis in the production and delivery of goods or services under contractual arrangements and for whom contracting represents a significant part of their
operations, the presumption is that they have the ability to make estimates that are sufficiently dependable to justify the use of the percentage-of-completion method of accounting. Persuasive
evidence to the contrary is necessary to overcome that presumption. The ability to produce reasonably dependable
ASC 605-35-25-58
For entities engaged on a continuing basis in the production and delivery of goods or services under contractual arrangements and for whom contracting represents a significant part of their
operations, the presumption is that they have the ability to make estimates that are sufficiently dependable to justify the use of the percentage-of-completion method of accounting. Persuasive evidence to the contrary is necessary to overcome that presumption. The ability to produce reasonably dependable estimates is an essential element of the contracting business. Accordingly, entities with significant contracting operations generally have the ability to produce reasonably dependable estimates and for such entities the percentage-of-completion method of accounting is preferable in most circumstances.
ASC 605-35-25-58
For entities engaged on a continuing basis in the production and delivery of goods or services under contractual arrangements and for whom contracting represents a significant part of their
operations, the presumption is that they have the ability to make
estimates that are sufficiently dependable to justify the use of the
ASC 605-35-25-61
An entity using the percentage-of-completion method as its basic accounting policy shall use the completed-contract method for a single contract or a group of contracts for which reasonably dependable estimates cannot be made or for which inherent hazards make estimates doubtful.
ASC 605-35-25-61
An entity using the percentage-of-completion method as its basic
accounting policy shall use the completed-contract method for a
single contract or a group of contracts for which reasonably
ASC 605-35-25-61
An entity using the percentage-of-completion method as its basic accounting policy shall use the completed-contract method for a single contract or a group of contracts for which reasonably dependable estimates cannot be made or for which inherent hazards make estimates doubtful.
ASC 605-35-25-61
An entity using the percentage-of-completion method as its basic
accounting policy shall use the completed-contract method for a
single contract or a group of contracts for which reasonably
Combining Contracts
l
Closely related contracts that represent a single
project can be combined for GAAP purposes
l
Presumption of uniform reporting of revenue and
profit for combined contracts
l
Requirements to combine (GAAP)
l ASC 605-35-25-8 (Main)
l ASC 605-35-25-9 (Production style contracts only)
605-35-25-8
A group of contracts may be combined for accounting
purposes if all the following conditions exist:
a. The contracts are negotiated as a package in the same economic environment with an overall profit margin
objective. Contracts not executed at the same time may be considered to have been negotiated as a package in the same economic environment only if the time period between the commitments of the parties to the individual contracts is reasonably short. The longer the period between the
commitments of the parties to the contracts, the more likely it is that the economic circumstances affecting the
605-35-25-8
A group of contracts may be combined for accounting
purposes if all the following conditions exist:
b. The contracts constitute in essence an agreement to do a single project. A project for this purpose consists of
construction, or related service activity with different elements, phases, or units of output that are closely interrelated or interdependent in terms of their design, technology, and function or their ultimate purpose or use. .
605-35-25-8
A group of contracts may be combined for accounting
purposes if all the following conditions exist:
605-35-25-8
A group of contracts may be combined for accounting
purposes if all the following conditions exist:
e. The contracts constitute in substance an agreement with a single customer. In assessing whether the contracts meet this criterion, the facts and circumstances relating to the other criteria should be considered. In some circumstances different divisions of the same entity would not constitute a single customer if, for example, the negotiations are
conducted independently with the different divisions. On the other hand, two or more parties may constitute in substance a single customer if, for example, the negotiations are conducted jointly with the parties to do what in essence is a single project.
605-35-25-8
Contracts that meet all of these criteria may be
Segmenting a Contract
l
Two sets of criteria for other than units of
production
l Normal criteria (ASC 605-35-25-12)
l Special criteria (ASC 605-35-25-13)
Normal Criteria ASC 605-35-25-12
A project may be segmented if all of the following steps
were taken and are documented and verifiable:
a. The contractor submitted bona fide proposals on the
separate components of the project and on the entire
project.
Alternative Criteria 605-25-35-13
25-13 A project that does not meet the criteria in the precedingparagraph may be segmented only if it meets all of the following criteria:
a. The terms and scope of the contract or project clearly call for separable phases or elements.
b. The separable phases or elements of the project are often bid or negotiated separately.
c. The market assigns different gross profit rates to the segments because of factors such as different levels of risk or differences in the relationship of the supply and demand for the services provided in different segments.
Alternative Criteria 605-25-35-13
25-13 A project that does not meet the criteria in the preceding paragraph may be segmented only if it meets all of the following criteria:
Alternative Criteria 605-25-35-13
25-13 A project that does not meet the criteria in the precedingparagraph may be segmented only if it meets all of the following criteria:
e. The significant history with customers who have contracted for services separately is one that is relatively stable in terms of pricing policy rather than one unduly weighted by erratic pricing decisions (responding, for example, to extraordinary economic circumstances or to unique customer-contractor relationships).
Alternative Criteria 605-25-35-13
25-13 A project that does not meet the criteria in the preceding paragraph may be segmented only if it meets all of the following criteria:
f. The excess of the sum of the prices of the separate elements over the price of the total project is clearly attributable to cost savings incident to
Alternative Criteria 605-25-35-13
25-13 A project that does not meet the criteria in the precedingparagraph may be segmented only if it meets all of the following criteria:
g. The similarity of services and prices in the contract segments and services and the prices of such services to other
customers contracted separately should be documented and verifiable.
Segmenting a Contract
l Again, special unit of production option available
l Found at ASC 605-25-14
Example of Effects of Combining
vs. Segmenting
l
See example
l
Note that results may vary depending on which
costs on incurred on which portion of contract
(neither one is necessarily always best)
l
Concern if client always makes this call in the way
Methods of Measuring Progress
l
ASC 605-35-25-79
l
Cost to cost
l
Variations of cost to cost
l
Efforts expended
l
Units of delivery
l
Units of work performed
l
Cost to cost most often used
Customer Furnished Materials
l
ASC 605-35-25-22 through 24
l
Generally, if customer furnishes the materials, it
should not be counted in the cost or revenue
equation
l
Exceptions
l Contractor responsible for nature, type, characteristics
or specification of material or
l Contractor ultimately responsible for acceptability of
performance based on the material
Change Orders
l
ASC 605-35-25-25 through 28
l
Modification of the original contract that effectively
changes the contract without adding new provisions
l
Unpriced change order costs (ASC 605-35-25-28)
l Contract costs when incurred if it is not probable will be
recovered through price change
l If is probable will be recovered, costs deferred and/or
equal amount of revenue recognized until pricing agreed upon
Change Orders
l
Unpriced change orders
l If probable will recover in excess of costs and amount
can be reliably estimated, adjust contract price when costs are recognized
l
If change orders are in dispute or are unapproved
Contract Option or Addition
l
Treated as separate contract if (ASC 605-35-25-29)
l Delivered item differs significantly from original item
l Price negotiated without regard to original item or
l Deliverable similar, but price and cost relationship
significantly different
l
If fail tests
l Combined if meet proper criteria or
l Treated as change order on original contract
Claims
l
ASC 605-35-25-30
l
Contractor seeks to collect amount in excess of
contract price
l Delays
l Errors in specifications and designs
l Contract terminations
l Disputed change orders
l
Revenue recognized only when
l Probable claim will result in additional revenue and
Claims
l
Probability established by existence of all of the
following conditions (ASC 605-35-25-31)
l Clear legal basis for the claim
l Additional costs triggered by events unforeseen at
contract date and not due to deficiencies of contractor’s performance
l Costs associated with claim determinable and are
reasonable in view of work performed
l Evidence supporting claim objective and verifiable
(management’s “feel” for the situation doesn’t qualify)
Claims
l
Can decide to record only when claim has been
received or awarded
l
Methods of claim recognition should be disclosed in
l
ASC 605-35-25-37
l
Direct costs incurred
l
Indirect costs (overhead) incurred
l
Estimated remaining costs to complete the job (both
direct and indirect) (ASC 605-35-25-44)
l Most significant variable impacting income earned
l Most vulnerable to manipulation (and it's rather
obvious how to manipulate)
l May be combined with misclassifying costs incurred
and/or otherwise overstating costs incurred
l Must be regularly reviewed
Estimated Costs to Complete
25-44 The estimated cost to complete (the other component of total estimated contract cost) is a significant variable in the process of determining income earned and is thus a significant factor in accounting for contracts. The latest estimate may be determined in a variety of ways and may be the same as the original estimate. The following approaches should be followed:
a. Systematic and consistent procedures that are correlated with the cost accounting system should be used to provide a basis for periodically comparing actual and estimated costs.
b. In estimating total contract costs, the quantities and prices of all significant elements of cost should be identified.
c. The estimating procedures should provide that estimated cost to complete includes the same elements of cost that are included in actual accumulated costs. Also, those elements should reflect expected price increases. d. The effects of future wage and price escalations should be taken into account in cost estimates, especially when the contract performance will be carried out over a significant period of time. Escalation provisions should not be blanket overall provisions but should cover labor, materials, and indirect costs based on percentages or amounts that take into consideration experience and other pertinent data.
Calculation under PCM
l
Estimate gross profit on entire contract
l Revenue
l Cost of Contract Revenue
l Gross Profit from Contract
Estimating Revenue
605-35-25-15
605-35-25-15
a. The basic contract price
b. Contract options
c. Change orders
d. Claims
e. Contract provisions for penalties and incentive
payments, including award fees and performance
incentives.
Estimating Revenue
605-35-25-15
All those factors and other special contract provisions
shall be evaluated throughout the life of a contract in
estimating total contract revenue to recognize revenues
in the periods in which they are earned under the
Calculation under PCM
l
Estimates must be constantly revised using the best
available information
l Affects financial reporting
Joint Ventures
l
Be aware of FASB Interpretation No. 46—may
require consolidation (post-Enron situation) where
in the past would not have been consolidated
l
Capital contributions
l Cash recorded at value contributed
l Other assets recorded at book value
l Capital adjusted based on accounting method used
(cost, equity or consolidation—see reference to ASC 323-10 provisions on corporate investments in ASC 323-30—treatment is similar)
Joint Ventures
l
Transactions with venture
l Normally not revenue or income until realized through
transaction with 3rd party, however can be deemed
“arms length if all of the following met
l Transaction actually entered into at a verifiable arms length amount (not just an assertion)
l No substantial uncertainties regarding venturer's ability to perform
Joint Ventures
l
Presentations, depending on size of investment,
percentage controlled, ownership interests and
Interpretation 46 tests
l Consolidation (full or partial)
l Expanded equity
l Equity method
l Cost
l
Disclosure issues presented in checklist
Accounting/Tax Differences
l
For GAAP, generally only PCM is allowed
l
Income taxes may allow
l Cash
l Standard accrual (with or without counting retentions)
Accounting/Tax Differences
l
Financial statement method may not be allowed for
tax purposes (and vice versa)
l
Joint venture is often its own tax reporting entity,
with its own elections, methods, etc.
l
Expected losses must be recorded immediately for
tax purposes, but not currently deductible in full for
income tax purposes
l
Leads to deferred tax issues under SFAS No. 109
(now ASC 740)
Financial Statement Presentation
Issues
l
Classified vs. Unclassified Balance Sheet
l Classified preferable for entities with one year or less
operating cycle
l Unclassified preferable for entities with operating
cycles in excess of one year
l
If normal cycle is less than a year, but have a few
longer contracts, can separately classify the long
contracts
l
If operating cycle > one year or use unclassified
Classified Balance Sheets
l
Current contract related assets
l Accounts or retentions receivable
l Unbilled contract receivables
l Costs in excess of billings and estimated earnings on
uncompleted contracts (underbillings)
l Other deferred contract costs
l Equipment specifically purchased for, or expected to
be used solely on an individual contract
Classified Balance Sheets
l
Current contract related liabilities
l Accounts and retentions payable
l Accrued contract costs
l Billings in excess of costs and estimated earnings on
uncompleted contracts (overbillings)
Classified Balance Sheets
l
Other Balance Sheet Accounts
l Retentions receivable or payable not realized or paid
within a normal operating cycle should be classified as noncurrent
l Joint venture investments are normally noncurrent
unless venture expected to be completed and liquidated within the operating cycle
l Equipment that will be consumed during the life of the
contract or abandoned at the end of the contract should be a contract cost
Classified Balance Sheets
l
Other Balance Sheet Accounts
l Excess billings
l Normally classified as work to be performed and classified as current liabilities
Offsetting and Netting
l
Generally not allowed unless an actual right of
offset exists ASC 210-20-05-1 (big surprise)
l
Do not offset underbillings and overbillings
l
Advances on cost plus contracts not normally offset
against costs unless the payment is definitely
regarded as a payment on account of work in
progress
Disclosures in Financial
Statements
l
A number of disclosures are required in the
financial statements
l
See disclosure checklist
l
Remember, user generally has a right to presume
Homebuilders
l
Contractor vs. Manufacturer
l
Special treatment for those that build home on land
it owns
l
If build on customer's land, same treatment as other
contracting
l
However, if build on own land, then FASB 67 & 68
apply, and not SOP 81-1 (ASC 360-20-55-18 and
970-360-55-4 & 5)
Homebuilder Accounting
l
Deposit Method of Accounting
l All revenues and costs deferred until closing
(ASC 360-20-40-5)
l Note subtle difference from completed contract/tax
treatment, where income recognized at substantial completion
l Accounting policy disclosure should describe deposit
method—see example disclosure
l
Remember, this applies only if builder is building on
Auditing Contractors
l
SAS 107 Audit Risk & Materiality in Conducting an
Audit (AU ¶312, AU-C ¶320)
l
Special risk areas for contractors
l Direct contract costs—both actual to date and
estimated costs to complete
l Measurement of progress towards completion
l Contract amounts (contract price, change orders,
billings to date and accounts receivable)
l Expected total gross profit
l
Reliance on estimate of costs to complete
Understanding Entity
lSAS No. 109 – Understanding the Entity
(AU-C ¶315)
- Requires understanding of internal control
- Cannot “skip” and evaluate at maximum
Auditing Contractors
l
Areas of control focus
l System of internal accounting controls
l Operating systems and procedures
l Project management systems
l Nature of contractor's activity
l History of performance and profitability
l Other relevant accounting and operating factors
l
Remember goal is to obtain sufficient evidence to
form a reasonable basis for an opinion
Auditing Contractors
l
FASB Statement of Financial Accounting Concepts
#2 Definition of Materiality
l “the magnitude of an omission or misstatement of
accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.”
l Viewpoint of the decision maker reading the
statements
Auditing Contractors
l
SAS 107's List of Misstatements (AU-C ¶450)
l An inaccuracy in gathering or processing data from
which financial statements are prepared
l A difference between the amount, classification, or
presentation of a reported financial statement element, account, or item and the amount, classification, or presentation that would have been reported under generally accepted accounting principles
l The omission of a financial statement element,
account, or item
l A financial statement disclosure that is not presented
in conformity with generally accepted accounting principles
Auditing Contractors
l
SAS 107's List of Misstatements
l The omission of information required to be disclosed in
conformity with generally accepted accounting principles
l An incorrect accounting estimate arising, for example,
Auditing Contractors
l
Remember SAS 99 consideration of possible
methods for fraud
l
Manipulation of PCM items would be attractive to
someone looking to manipulate the financial
statements
Auditing Contractors
l
Have Internal Control Checklist beginning at page
9-1
l
Note that this would be a “dream” set of controls
l
Evaluate the reasonability given the client's overall
size and operation
l
But remember the risks that exist when have a
“suboptimal” system
l
As well, remember that top management always
Audit Procedures
l
Consider whether some controls can be relied upon
(or the issues if none can)
l Note that are now required to evaluate internal control
l Not allow to “rubber stamp” setting control at maximum
and doing only substantive tests since SAS 109/110
l In construction, wasn't really a good idea even before
changes
l
Consider detailed review of selected job
administration files
Accounting and Reporting Issues
l
Reporting Issues
Reporting Issues
l
Management's Assertions
l Existence or occurrence
l Completeness
l Rights and obligations
l Valuation or allocation
l Presentation and disclosure
l
All financial statements embody those assertions
l
CPA duty to disclose knowledge of error in
assertions
Outside Accountants Reports
l
Nonpublic Companies (SSARS)
l Audit
l SSARS Review
l Compilation (including “no report” compilations)
l
Other Entities
l Audit
l SAS Review (in theory SSARS Review, but...)
Independence
l
Required for review (and essentially for an audit)
l
Ethics Interpretation 101-3 creates problems
Ethics Interpretation 101-3
l
Last revised January 27, 2005
l
Regulates provision of “nonattest” services,
including
l “Other accounting services”
Ethics Interpretation 101-3
l
Client must agree to
l Make all management decisions and perform all
management functions;
l Designate an individual who possesses suitable skill,
knowledge, and/or experience, preferably within senior
management, to oversee the services;
l Evaluate the adequacy and results of the services
performed;
Ethics Interpretation 101-3
l
Client must agree to
l Accept responsibility for the results of the services; and
l Establish and maintain internal controls, including
Ethics Interpretation 101-3
l
Must document in writing the understanding on the
following with the client:
l Objectives of the engagement
l Services to be performed
l Client's acceptance of its responsibilities
l Member's responsibilities
l Any limitations of the engagement
Ethics Interpretation 101-3
l
Booking activities that would impair independence
regardless of agreement
l Determine or change journal entries, account codings
or classification for transactions, or other accounting
Ethics Interpretation 101-3
l
Payroll and disbursement impairment activities that
impair regardless of agreement
l Accept responsibility to authorize payment of client
funds, electronically or otherwise, except as specifically provided for with respect to electronic payroll tax payments.
l Accept responsibility to sign or cosign client checks,
even if only in emergency situations.
l Sign payroll tax return on behalf of client management.
Ethics Interpretation 101-3
l
As well, watch out not to trip over “internal audit”
restrictions
l
Consulting theory of independence—plus
l
Note this has become a very significant issue for
peer reviews
Level of Reporting Issues
l
GAAP is GAAP regardless of level of assurance
l
CPAs prohibited from being knowingly associated
with misleading financial information
l
Active search standard for audits
l
Eyes open standard for compilations and review
l
Reviews necessitate inquiries and analytical review
procedures or competent alternative procedures
Compilation Standards
l
Must considered stated qualifications of accounting
personnel (AR §100.08) in gaining an
understanding of entity
l
Is required to consider the need to perform
Review and Audit
l
Remember EI 101-3 Issues
l
May find you need another firm involved under
current rules
l
Especially when considering the need to first
perform a compilation
l
Consider potential implications of SSARS exposure
draft on reviews—however, won't impact audit
issues
SOP 94-6 Issues
l
Section 6 of manual
l
Has been around for a while, but still often not
picked up
l
Is a hot button area in litigation, since it deals with
disclosures of risks and uncertainties
SOP 94-6 Disclosures
l
Nature of operations
l
Use of estimates
l
Certain significant estimates
l
Concentrations of risk
Nature of Operations
l
Description of major products or services
l
Principal markets
l
Location of those markets
l
If more than one line of business, relative
Use of Estimates
l
Explanation of the importance of estimates in
financial statements
l
Normally a “boilerplate” disclosure
Significant Estimates
l
Where we tell users which estimates are sensitive
in nature
l Reasonably possible the effect on financial will change
in the near term based on confirming events and
l The effect of the change would be material to the
financial statements
l
With PCM, estimates of costs to complete almost
Certain Concentrations
l
If all of these facts true, must disclose
l Concentration exists at balance sheet date
l Enterprise is vulnerable to a significant short term
impact
l It is reasonably possible an event might occur in the
near term
l
Note for some circumstances you must presume it's
reasonably possible
Example Audit Program Highlights
l
Found in Section 2 of manual
l
Should tailor audit program for specific client—not a
“cookbook” system
l
Remember “eyes open” standard for non-audit
FASB Interpretation 48
l
Module 3
Income Taxes
l
FIN 48 has been delayed twice for private entities
l
However, almost ended up with it being applied last
fall—was “on”, then two weeks later was “off”
l Indicated it wants to turn this one on
l But has also indicated reduced disclosures for
nonpublic companies
Contingency Special Case
l
Income taxes not governed by FASB 5
l
Rather, have to use “more likely than not” test for
each tax position
Covered Entities
l
Covers all potentially taxable entities
l
S Corporations
l Built in gains tax
l Excess passive income
FIN 48 Presumptions
l
Same as we had for tax law MLTN standards
l Position will be examined
l Will be fully litigated to final decision
l
However, will consider statute of limitations
l
Consider all taxing entities
FIN 48 Tax Positions
l
Everything is a tax position
l
Includes determination of need to file a return
l Nexus for states
l C Corporation return for an S corporation that
has a potentially invalid election
l LLC determined to be a foreign LLC with default
Illustration 1
Illustration 2
Illustration 3
Interest and Penalties
Subsequent Accounting
lMust continue to test positions
l
Can recognize benefit when
- MLTN threshold now met (say Supreme Court
rules in favor of taxpayer's position)
- Examination concluded in taxpayer's favor
- Statute expires
l
Tested at balance sheet date, not FS issuance date
Effect of Actual Exam
l
Proposed FSP FIN 48-1 record as effectively settled
when
- Taxing authority completed the examination
- No appeal is planned
- Based on widely understood policy, only remote
possibility year would be reopened
l
True even for positions not questioned on
examination
IRS Issues
l
IRS LMSB has issued guidance to agents to look at
FIN 48 disclosures
l
Concentrate on disclosures for benefits that were
FASB Activity
l
As of today, would be effective for December 31,
2008 annual statements
l
FASB moving to actually require nonpublic
companies this time (Lehman Brothers bankruptcy
and fallout may have contributed to last fall's change
of heart)
FASB Interpretation 46R
Consolidation Plus...
"
Enron “off balance sheet” financing response
"
FIN 46R issues
" Relationship with variable interest entity
" Consolidation of variable interest entity—are the
“primary beneficiary”
Determinations
"
Is contractor involved with this other entity
"
Is the entity a “variable interest entity”
"
If it is a VIE, is the contractor the prime beneficiary of
the
FIN 46R Involvement
"
Conditions for “Involvement”
" Agreement between contractor and the other entity
" Joint venturer
" Substantial control over activities or assets of the other
entity
" Leasing assets from the other entity
" Agreeing to provide services to other entity
" Guaranteeing debt of the other entity
" Involvement in structuring the entity
" Involvement must be significant to the other entity
FIN 46R Involvement
"
No involvement analysis stops
"
FIN 46R not relevant
"
Otherwise, on to next test to see if other entity is a
Variable Interest Entity
"
Meets one of four conditions
" Needs additional support to carry out its activity
" Any entity with less than 10% equity presumed to be a
VIE
" Analysis to show will not require additional subordinated
support
" Irrelevant if it will not come from contractor
" Owners not obligated to bear downside variability in
income or fair value
" Owners not have usual rights to upside or
" Owners unable to exercise voting rights
Variable Interest Entity
"
If we've gotten this, relationship must be disclosed
"
Next test is whether contractor is the primary
Primary Beneficiary
"
Meets any one of the following conditions
" Responsible for more than 50% of downside variability in
income or fair value of assets
" Expanded to include “related party group” (such as
individual owner of shares of entity)
" If all other members of related party group are not entities,
contractor will be the primary beneficiary
" Entitled to more than 50% of expected residual returns
" Expanded again to include “related party group”
" Again, if only entity, then will be primary beneficiary out of
the group
Examples of Possible
Consolidating Conditions
"
50/50 joint venture and receives management fee to
run venture
"
Involved with other entity controlled by owner and is
only entity in related party group
"
Owns significant (but not majority interest) in joint
venture and receives fees for guaranteeing the debt
or managing
"
Contractor advances funds to entity with negative
Recognition in Consolidation
"
Business combination under SFS 141 using fair
value unless
" Assets transferred to VIE just prior to being the primary
beneficiary or
" VIE under common control with the contractor
Reevaluation
"
Is it a variable interest entity?
" Changes in governing documents or contractual
arrangments
" Distributions to equity investors that causes other parties
to be exposed to losses
Reevaluation
"
Is contractor primary beneficiary
" Change in governing documents/contractual
arrangements
" Sells or reduces interest in entity
" Acquires additional interests in the entity
Disclosure if Not Primary
Beneficiary
"
Name, purpose, size and activities of VIE
"
Nature of involvement with VIE
"
When involvement began
"
Maximum exposure to losses due to involvement with
Disclosure if Primary Beneficiary
"
Name, purpose, size and activities of VIE
"
Carrying amount and classification of assets of
consolidated VIE that collateralize the VIE's
obligations
"
Restrictions on recourse from VIE's creditors to the
Effective Date
"
Effective currently for all entities, including private
companies/non-issuers
Example Disclosure Checklist
l
In Section 5
l
GAAP is GAAP regardless of reporting or inside vs.
Outside accountant
l
If doing OCBOA statements, remember similarity of
Internal Controls
l
Found at Section 9
l
Audit issues
l
As well, for consulting engagements to suggest
controls client should consider
Example Statements
l
Found in Section 7&8
l
Evaluate statements as
l Surety
l Audit issues
l
C Corporation
Tax Issues
l
Completed Contract Method
l
Percentage of Completion & Look-Back Calculation
l
Other than long term contracts
l
Section 199 construction activities
Tax Issues
l
AMT Considerations
l
General issues
l Allocation of costs
l Construction period interest
Long Term Contract Rules
l
Module 10
Introduction to Tax Issues
l
Section 460 governs taxation
l
Other Guidance
l Notice 89-15, as modified by Rev. Proc. 97-27 with
regard to Q&A 13
l Revenue Ruling 92-28
l Regulations §§1.460-0 – 1.460-6
l Regulations §§1.263A-8 and 1.263A-9 (capitalization
Accounting Methods
l
Cash Receipts and Disbursements
l
Standard Accrual (including treatment of retentions)
l
Hybrid
l
Completed Contract
l
Percentage of Completion
l Exempt PCM
l Cost to cost
l Simplified cost method
l PCM 10%
l PCM capitalized cost method
Section 460
l
Governs all “long term contracts”
l
Two day contract could be long term—does not
relate to longer than one year
l
Not completed in tax year contract entered into
Section 460
l
Applies on a contract by contract basis
l
Certain exceptions at §460(e)(3), but not full
exception (small contractor still has to apply interest
capitalization rules)
l
Construction contract involves real property (see
definitions at Reg. §1.103-13(e)(2)(i) and Reg.
§1.263A-8(c)(3))
Not Long Term Contracts
l
Architects (Rev Rul 70-67)
l
Engineers (Rev Rul 80-18)
l
Construction management services (Rev Rul
82-134)
l
Industrial and commercial painting (Rev Rul 84-32,
Related Party
l
Nevertheless rules apply for services for related
party
l If related party required to use PCM, then otherwise
exempt entity has to use PCM (Reg. §1.460-1(g)(1))
l Exemption if > 50% of average annual gross receipts
attributable to sale of item for 3 preceding tax years comes from unrelated parties
l
Using long-term contract method for other contracts
is an impermissible method of accounting
Small Contractor Exception
(§460(e)(1)(B))
l
Not subject to §460(a) & (b) (PCM), (c)(1) & (2)
(allocation of certain costs to contracts)--though is
subject to §460(c)(3) (interest capitalization)
l
Qualification
Two Year Completion Test
l
Based on facts and circumstances at time contract
is bid or entered into
l
Subsequent events do not change th result
l
Burden on taxpayer to show he expected contract
to be completed within two years
l Completion date per contract
l Scheduling commitments at time bid was made
l Period of time overhead is budgeted to job
Gross Receipts Test
l
See Notice 89-15
l
Gross Receipts:
l Receipts from active conduct of any trade or business
l Does not include interest, dividends, rents, royalties,
annuities or sale or exchange of property used in business or held for investment
l
Contract revenue determined under method of
Gross Receipts Test
l
If materials supplied by customer, do not have to
count unless the princpal purpose of arrangement
was to reduce gross receipts
l
Combined businesses under common control within
meaning of §52(b) (Work Opportunity Credit Rules
—expanded controlled group definition)
Gross Receipts Test
l
Also have attribution of construction receipts per
Regulation §1.460-3(b)(3)
l Requires attribution of construction gross receipts for
