OCBOA FINANCIAL STATEMENTS: ACCOUNTING AND REPORTING ISSUES

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OCBOA FINANCIAL STATEMENTS: ACCOUNTING AND REPORTING ISSUES

  1. 1. OCBOA FINANCIAL STATEMENTS: ACCOUNTING AND REPORTING ISSUES While there is an increase in the use of financial statements prepared on an other comprehensive basis of accounting [OCBOA], there is little professional guidance related to accounting and reporting issues for these non-GAAP statements. The guidance that does exist is found primarily in the auditing literature [rather than the accounting literature, which focuses on GAAP-based financial statements], mainly in the following documents: • SAS No. 62, entitled Special Reports. • SSARS No. 7, entitled Omnibus Statement on Standards for Accounting and Review Services—1992. • AICPA Technical Practice Aids [TPA], Sections 1500 and 9000. • AICPA Practice Aid Series document [hereinafter, PAS document], entitled Preparing and Reporting on Cash and Tax Basis Financial Statements. • SAS No. 62/Interpretation No. 14, entitled Evaluating the Adequacy of Disclosure in Financial Statements Prepared on the Cash, Modified Cash, or Income Tax Basis of Accounting. Practice Note #1: On December 1, 2006, the AICPA Accounting and Review Services Committee [ARSC] issued an Exposure Draft [ED] of a proposed SSARS, entitled Elimination of Certain References to Statements on Auditing Standards and Incorporation of Appropriate Guidance into Statements on Standards for Accounting and Review Services. In deliberating issues related to the “elimination” ED, the ARSC noted that there will be a “hole” in the compilation/review engagement literature if/when the ED becomes a final document. Reason = As currently written, the SSARSs include cross-references to many auditing standards where one of those auditing standards [SAS No. 62 and the related interpretive guidance] is the substantive OCBOA financial statement guidance when financial statements have been compiled/reviewed. Given the “hole” in the literature, the ARSC has a plan [for 2007] to develop a “separate document” for compilation/review engagements when financial statements that are being compiled or reviewed are OCBOA financial statements.
  2. 2. Practice Note #2: In October 2003, we had the honor of writing a “popular” article for The Journal of Accountancy where we discussed many of the substantive issues associated with OCBOA financial statements. For those who would like to have “quick access” just “click-on” the following link Overview of Some Substantive Issues Associated with OCBOA Statements Practitioners encounter a variety of different issues when preparing/reporting on OCBOA financial statements where there is limited/no authoritative guidance. Some of the more common issues addressed in this course relate to measurement, presentation, disclosure, and reporting issues. Many of these issues are discussed in these materials, but some examples of the issues/questions are as follows: OCBOA Financial Statement Measurement Issues • Should nontaxable income/expenses be included in tax basis financial statements? • What cash-basis modifications are considered to have substantial support? • At what point do cash-basis modifications become so extensive that the financial statements really are GAAP-basis statements with a GAAP departure? OCBOA Financial Statement Presentation Issues • OCOBA financial statements are not required to exactly follow the presentation requirements associated with GAAP-basis statements. Rather, OCBOA statements can “communicate the substance” of these GAAP requirements. What are some of the alternatives to GAAP presentation requirements that communicate the “substance” of these requirements? • What are “suitably titled” OCBOA financial statements? • How should the financial statements display a change in the basis of accounting from GAAP-basis statements to OCBOA statements? OCBOA Financial Statement Disclosure Issues • SAS No. 62/Interpretation No. 14 contains the primary disclosure guidance when practitioners are preparing/reporting on OCBOA financial statements. The “communicate the substance” rules appear to provide a significant amount of latitude for reporting entities [and practitioners associated with those entities]. When would disclosures in OCBOA financial statements communicate the substance of GAAP-basis disclosures?
  3. 3. OCBOA Financial Statement Reporting Issues • The auditing and compilation/review engagement literature provides guidance on “standard” audit/review/compilation reports. How are inconsistency issues treated in reports on OCBOA financial statements when compared to GAAP statements? • How are material uncertainty issues handled in reports on OCBOA financial statements when compared to GAAP statements? • How are going concern issues handled on OCBOA financial statements when compared to GAAP statements? Pursuant to the provisions of SAS No. 62, OCBOA financial statements would exist when the basis of accounting is any one of the following: • A basis of accounting that the reporting entity uses to comply with the requirements or financial reporting provisions of a governmental regulatory agency to whose jurisdiction the entity is subject [e.g., a basis of accounting insurance companies use pursuant to the rules of a state insurance commission]. • A basis of accounting that the reporting entity uses or expects to use to file its income tax return for the period covered by the financial statements. • The cash receipts and disbursements basis of accounting, and modifications of the cash basis having substantial support [e.g., recording depreciation on fixed assets or accruing income taxes]. • A definite set of criteria having substantial support that is applied to all material items appearing in the financial statements [e.g., the price-level basis of accounting]. Practice Note #1: Current-value financial statements are not appropriate for general use unless they are presented as a supplement to historical financial statements. Therefore, it is recommended that the current value not be regarded as an OCBOA. Generally accepted accounting principles require the use of the current value basis of accounting for certain entities, such as investment companies, employee benefit plans, personal financial statements, and mutual and common trust funds. Practice Note #2: Typically, financial statements prepared on a regulatory basis should be limited to those that are filed with the applicable regulatory agency. Pursuant to SAS No. 62, reports on financial statements prepared in compliance with requirements of a regulatory agency must be restricted to use by the entity and the regulatory agency. SAS No. 62 specifies certain bases of accounting that are not considered to be OCBOA bases of accounting. These include:
  4. 4. • A loan agreement that requires the borrower to prepare consolidated financial statements in which assets [e.g., inventory] are presented on a basis that is not in conformity with GAAP or an other comprehensive basis of accounting. • An acquisition agreement that requires the financial statements of the entity being acquired to be prepared in conformity with GAAP except for certain assets [e.g., receivables, inventories, and properties] for which a valuation basis is specified in the agreement. Practice Note: The situations outlined above are not considered to result in OCBOA statements because the criteria used to prepare the financial statements are not considered to be "criteria having substantial support," even though the criteria are “definite” [both of these criteria would need to be met and only one of the criteria would be met!]. The major advantage of OCBOA financial statements over GAAP-based statements is that they are generally less costly to prepare. For tax basis financial statements, the cost reduction results primarily because the tax returns and the financial statements are prepared from the same information. Cash basis statements are less costly because the detailed records needed to comply with GAAP reporting are unnecessary. While generally a cost-effective alternative, a question still needs to be asked related to whether it is appropriate to use the OCBOA financial statement reporting alternative to GAAP financial statement reporting. Generally, OCBOA financial statements would be considered appropriate when: • There is active involvement by the owner/manager who understands the financial condition of the reporting entity. • The reporting entity is a small, closely-held business with little or no unsecured debt. • The reporting entity is not highly leveraged. OCBOA financial statements would not be appropriate when the entity: • Anticipates going public. • Has loan covenants requiring GAAP-based statements. • Has numerous absentee owners. • Has substantial unfunded obligations, commitments, and contingent obligations that would not be recorded in OCBOA statements. As mentioned previously, the major advantage of OCBOA financial statements over GAAP-based statements is that they generally are less costly to prepare. The reduction in cost primarily results from the ability to prepare financial statements using simpler measurement principles [e.g., cash and modified-cash basis statements] or measurement principles that already have been incorporated into another document [e.g., a tax return].
  5. 5. Since disclosure requirements for OCBOA statements generally parallel disclosure requirements for GAAP-based statements, there usually will be only limited cost savings because of different disclosure requirements. Many practitioners believe that there is an increased disclosure advantage when they are compiling/reviewing OCBOA financial statements. In November 1992, when the ARSC of the AICPA issued SSARS No. 7, there was a “clear indication” that the disclosure requirements for OCBOA statements parallel the disclosure requirements for GAAP-based statements when financial statement components in OCBOA statements parallel financial statement components in GAAP-based statements and when other issues that typically are disclosed in GAAP-based statements exist for entities that prepare OCBOA statements. Essentially, the guidance in SSARS No. 7 made it clear that the same disclosure requirements exist for OCBOA financial statements that are compiled/reviewed when compared to disclosure requirements in OCBOA financial statements that are audited. Practice Note: Very importantly, OCBOA financial statements should be prepared/reported on by individuals [within the firm] who have an understanding of technical issues associated with GAAP-based financial statements. Without that knowledge, it is very difficult to comply with OCBOA reporting requirements [e.g., making disclosures that communicate the substance of GAAP disclosures]. In certain circumstances, financial statement users may be more inclined to accept OCBOA financial statements if the reporting entity [with help from practitioners] also provides additional information outside the basic financial statements. For example, if a limited partnership has a borrowing under a line of credit where the limit [on the line of credit] is established based on the level of the accounts receivable of the partnership, the lender might agree to accept tax basis financial statements [rather than GAAP- basis statements] if the partnership also provides an “aged” listing of receivables to supplement the OCBOA financial statements. Some Particular Issues Related to Cash/Modified-Cash Basis Statements Using the cash basis of accounting, transactions would be recorded on the basis of cash receipts and disbursements. As such: • Certain revenue and the related assets would be recognized when received rather than when earned. • Certain expenses would be recognized when paid rather than when the obligation is incurred.
  6. 6. Using the cash basis, long-term assets are not capitalized so there is no depreciation or amortization on those assets. Accruals are not made and prepaid assets are not recorded. Using the “pure” cash basis of accounting [rarely used in practice], the statement of assets and liabilities would include only cash and owners' equity. Practice Note: “Pure” cash basis financial statements may be appropriate for certain smaller companies when cash flow is of primary importance to management and to a limited number of users. Examples of some entities that may use the “pure” cash basis of accounting include estates and trusts, civic ventures, and student activity funds. Typically, a cash basis presentation consists of a summary of cash receipts and disbursements. In this form of presentation, cash receipts from sales, the incurrence of debt, contributions, etc., and disbursements for debt repayment, expenses, and the purchase of fixed assets are summarized to show the change in the cash balance for a reporting period. The modified-cash basis of accounting is a “hybrid” approach that combines elements of the cash and accrual basis of accounting. For example, a modified-cash basis balance sheet may include the capitalization of long-term assets and inventory, but no accrual of accounts receivable or recognition of prepaid assets. But, remember that modifications to the cash basis should have substantial support. Also, it is important to note that SAS No. 62 makes reference to only two modifications as having substantial support: depreciation on fixed assets and the accrual of income taxes. However, other modifications that can be considered to have substantial support have evolved through common usage and practice. Generally, modifications to the “pure” cash basis of accounting would have substantial support if the modifications: • Are equivalent to the accrual basis of accounting [e.g., capitalization of fixed assets and accrual of income taxes]. • Are logical [i.e., interrelated accounts should be reported on the same basis]. Examples of interrelated accounts that should be reported using the same basis of accounting include: • Plant and equipment, accumulated depreciation, depreciation expense, long-term debt, and interest expense. • Income taxes payable, income tax expense. • Inventory, cost of goods sold. • Prepaid expenses, expiration of prepayments. • Accrued liabilities, accrued expenses.
  7. 7. The PAS document indicates the modifications most commonly/rarely made in cash/modified-cash financial statements: Capitalizing expenditures for fixed assets = Frequently Recording liabilities for short-term/long-term borrowings = Frequently Capitalizing expenditures for inventory = Occasionally Reporting investments at fair value = Occasionally Accruing the current income tax liability = Rarely Establishing prepaid expenses = Rarely In those circumstances where modifications to cash basis statements are so extensive that the statements are equivalent to accrual basis financial statements, the statements should be considered GAAP basis statements with a departure [or departures]. For example, when certain modifications are made to cash basis financial statements, reporting entities [and practitioners associated with those entities] very likely are preparing [reporting on] GAAP-basis financial statements [that probably involve GAAP departures]. Practitioners should ask these questions: • Have trade accounts receivable/payable been accrued? • Have deferred taxes been recorded? • Have assets under capital leases [and the related obligations] been recorded? IMPORTANT = If the financial statement amounts agree with the tax return of the entity [except that financial statements may include nontaxable income items and nondeductible expenses], these statements should be designated as being on the income tax basis of accounting. Some Particular Issues Related to Income Tax Basis Statements The income tax basis of accounting is based on the principles and rules of accounting for transactions under the federal income tax laws and regulations. Few new measurement guidelines need to be established because the method is based on tax laws. The income tax basis of accounting covers a range of alternative bases, from cash to full accrual, depending on the nature of the taxpayer and [in some circumstances] elections made by the taxpayer. Generally, the tax basis of accounting is most useful for small, private entities where the cost of GAAP financial statements does not justify any incremental benefit received when compared to OCBOA statements. The fundamental difference between GAAP accounting methods and tax accounting methods is that GAAP methods measure revenue and expenses while tax methods measure gross income and deductions. In tax basis financial statements, revenues generally include items that are not
  8. 8. part of gross income and expenses generally include items that are not deductible [i.e., nontaxable/nondeductible revenues/expenses]. For GAAP purposes, revenue generally is recognized when earned. For tax purposes, gross income is defined by the Internal Revenue Code [IRC]. The application of GAAP results in the determination of net income while the application of tax laws results in the determination of taxable income. Though both GAAP and tax laws use an accrual method, the methods prescribed by GAAP often are not the same as those prescribed by tax law. Practice Note: It should be noted that tax returns are not considered financial statements and [therefore] there are no reporting requirements associated with the preparation of a tax return. Nontaxable Revenues and Nondeductible Expenses. Using the requirements associated with federal income tax laws, some transactions are not recognized [i.e., they are not taxable]. For example, receipts of interest on obligations of state and local governments and proceeds from life insurance policies are not included in revenue. Costs such as certain premiums paid on officer life insurance policies are not deductible. However [in practice], nontaxable revenues and nondeductible expenses generally are recognized in tax basis statements of revenue and expenses. Nontaxable revenues should be recognized when they are received [cash basis] or when they are earned [accrual basis]. Nondeductible expenses should be reported and charged to expense in the period in which they are paid [cash basis] or when they are incurred [accrual basis]. The PAS document indicates three equally-acceptable ways for reporting entities [and practitioners associated with those entities] to present nontaxable income/nondeductible expenses in tax basis statements: • As separate line-items in the revenue/expense sections of the statement of revenues and expenses [in practice, this is the most common presentation alternative]. • As additions/deductions to/from net income. • As a disclosure item in the notes to the financial statements. Additional Tax Assessments. An IRS examination may result in additional income taxes being assessed for prior years. Two alternative methods may be used to account for additional taxes for prior years. • The amounts may be charged to expense in the current period if there are no corresponding adjustments to the balance sheet for expenses capitalized or revenue recognized, and the amounts do not result from a “clear error” in the prior-year return.
  9. 9. • The amounts may be treated as a prior-period adjustment and charged to retained earnings if the assessment affects balance sheet amounts [e.g., by requiring disallowed expenses to be capitalized and amortized or by requiring recognition of previously-unreported revenue], or the amounts result from a “clear error” in the prior-year return. Practice Note: The IRS may disallow amounts charged to expense in prior years and require those amounts to be capitalized/amortized or may require recognition of previously-unreported revenue. These amounts [net of income tax adjustments] should be treated as prior-period adjustments. Otherwise, either of the above methods is considered acceptable. The method used should be disclosed in the notes to the financial statements. Basis of Accounting: Because of the potential adjustment that could result from an IRS examination, some reporting entities include a note disclosure to that effect in their tax basis financial statements. An example note [extending the basis of accounting policy note] that practitioners may consider utilizing is as follows: These financial statements were prepared on the basis of accounting the company uses for income tax purposes, which is a comprehensive basis of accounting other than generally accepted accounting principles. Because many types of transactions are susceptible to varying interpretations under federal and state income tax laws and regulations, the amounts reported in the accompanying financial statements may be subjected to change at a later date upon final determination by the taxing authorities. Accounting changes and errors: For GAAP purposes, changes in accounting methods [e.g., change in depreciation method] are permitted if the changes are justified so that the “new” method is preferable to the “old” method. Changes in estimates are permitted when new information will improve the estimate. The provisions of SFAS No. 154, entitled Accounting Changes and Error Corrections, should be followed for GAAP purposes. For tax purposes, changes in accounting methods cannot be made without permission from the IRS. Generally, the effect of an accounting change is “spread” over several future years for tax purposes. S Corporations: Income of an S Corporation is taxable to its shareholders. Consequently, these type corporations may be required to maintain information on distinct classes of retained earnings. However, in tax basis financial statements, S Corporations usually report retained earnings as a single amount. When an S Corporation has accumulated earnings and profits from C Corporation years, there are separate accumulations for:
  10. 10. • Accumulated adjustments account. • Previously-taxed income from pre-1983 years. • Accumulated earnings and profits. IMPORTANT: These three “separate” amounts typically are “combined” in tax basis financial statements. Recognition of Revenue – GAAP Statements Versus Tax Statements Some of the differences between “how” revenue should be recognized in GAAP-based statements when compared to financial statements prepared using an income tax basis are discussed in this section of these materials. These are just “some” of the differences where “other” differences certainly exist. Installment sales: In general, the installment method is not acceptable under GAAP unless the sales price is not reasonably assured. Thus, collectibility of the sales price is an issue for GAAP purposes. For tax purposes, the gross income from an installment sale made by a dealer is recognized when it is fixed, determinable, and all events have occurred. Since potential deductions for bad debts are not known at the time of sale, deductions are permitted late if the sale becomes uncollectible. Sales with right of return: For GAAP purposes, revenue recognition is allowed even when customers have the right to return products as long as the conditions defined in SFAS No. 48, entitled Revenue Recognition When Right of Return Exists, are met. The conditions for recognition of gross income for tax purposes are not the same as those defined in SFAS No. 48. For sales on approval, both GAAP and tax laws do not permit recognition of revenue/gross income until approval occurs. Unrealized gains and losses on investments: For GAAP purposes, unrealized gains and losses associated with trading securities are recognized in current income. For tax purposes, gains and losses associated with investments are included in gross income when those gains and losses are realized. Equity method: For GAAP purposes, the equity method is used to account for investments where the investor can exercise significant influence over the investee. For tax purposes, the equity method does not exist. Recognition of Expenses – GAAP Statements Versus Tax Statements Some of the differences between “how” expenses should be recognized in GAAP-based statements when compared to financial statements prepared
  11. 11. using an income tax basis are discussed in this section of these materials. These are just “some” of the differences where “other” differences certainly exist. Vacations: For GAAP purposes, companies are required to accrue vacation expense when the conditions established in SFAS No. 43, entitled Accounting for Compensated Absences, are met. For tax purposes, vacation expense generally is not deductible until paid or taken within a certain period of time. Pensions: For GAAP purposes, actuarial computations are used to determine the amount of expense for defined benefit plans. For tax purposes, contributions [often actuarially determined] to a pension plan are allowed as deductions. The expense for GAAP purposes and the contributions for tax purposes rarely equal. Impairments of long-lived assets: For GAAP purposes, impaired assets must be written down to their market value [or present value of expected cash flow]. For tax purposes, losses are not allowed for impaired assets. Impairments of loans: For GAAP purposes, lenders are required to recognize losses for impaired loans. For tax purposes, losses on loans generally are not deductible until the amounts due are written-off as uncollectible. Uncollectible receivables: For GAAP purposes, allowances are recorded for uncollectible accounts receivable. For tax purposes, deductions related to uncollectible accounts are not allowed until all events have occurred that make the expense fixed and determinable. Allowances for sales returns: For GAAP purposes, an allowance for estimated returns must be recorded when customers have the right to return products. For tax purposes, no allowance for sales return is allowed until all events have occurred that make this expense fixed and determinable. Loss contingencies: For GAAP purposes, loss contingencies are recorded when the loss is probable and estimable. Loss contingencies are not recorded for tax purposes. Start-up costs and organization costs: For GAAP purposes, organizational cost and start-up costs typically are expensed as incurred. For tax purposes, these costs may need to be amortized of several years. Leases: For GAAP purposes, a lease is considered to be a capital lease when the criteria established in SFAS No. 13, entitled Accounting for
  12. 12. Leases, are met. Significant differences [when compared to GAAP] exist using the requirements associated with tax issues. Other Issues – GAAP Statements Versus Tax Statements Just “some” of the “other” differences between GAAP and tax requirements are discussed in this section of these materials. It is important to remember that there is no objective [from my perspective!] to have “all” of the differences included in these materials because we are not even aware of “all” of the differences between GAAP and tax [the “last one” is the part of this stuff that gives us difficulty in understanding “all” of the issues!]. Inventory: For GAAP purposes, when inventory is worth less than its cost, it is “written down” to its market value. For tax purposes, when inventory is worth less than its cost, it may not be written down unless it is actually offered for sale at the lower value within a certain period of time. Depreciation: For GAAP purposes, the costs of fixed assets, less any applicable residual values, are depreciated over a period that management estimates the company will derive benefit from using the assets. For tax purposes, lives are assigned to assets regardless of how many years management expects the reporting entity to derive a benefit from using the assets. Disclosure Issues in OCBOA Financial Statements Subsequent to the issuance of SAS No. 62, “questions have been raised” in practice concerning the required disclosures in OCBOA financial statements as compared to the disclosure requirements associated with GAAP-based financial statements. While there is no doubt that there are measurement advantages associated with OCBOA financial statements when compared to GAAP-based financial statements, some practitioners believe that there are significant disclosure advantages associated with OCBOA financial statements as well. Because there was limited guidance in the technical literature related to disclosure requirements in OCBOA financial statements, the Auditing Standards Board [ASB] issued SAS No. 62/Interpretation No. 14 to clarify disclosure responsibilities when reporting entities are preparing and practitioners are reporting on these widely-used financial statements. Paragraph 7 of SAS No. 62 provides guidance concerning appropriate titles for OCBOA statements as follows: Terms such as balance sheet, statement of financial position, statement of income, statement of operations, and statement of cash flows, or similar unmodified titles are generally understood to be applicable only to financial statements that
  13. 13. are intended to present financial position, results of operations, or cash flows in conformity with generally accepted accounting principles. Consequently, the auditor should consider whether the financial statements that he or she is reporting on are suitably titled. For example, cash basis financial statements might be titled statement of assets and liabilities arising from cash transactions, or statement of revenue collected and expenses paid, and a financial statement prepared on a statutory or regulatory basis might be titled statement of income--statutory basis. If the auditor believes that the financial statements are not suitably titled, the auditor should disclose his or her reservations in an explanatory paragraph of the report and qualify the opinion. The titles used for OCBOA financial statements should be descriptive of the accounting basis used. In addition, the titles should avoid the implication that the financial statements are presented in accordance with GAAP. The authoritative literature makes it clear that OCBOA financial statements should be titled appropriately so as not to imply that they are GAAP-basis statements. Limited examples of appropriate titles are given. The literature is silent as to appropriate captions within the financial statements. For example, “statement of income” is not an appropriate OCBOA financial statement title, but within the statement itself, is it appropriate to use the caption “net income” [as a caption within, not as a title to, a statement]? Would it be better to use captions such as “excess of revenue collected over expenses paid,” “excess of expenses paid over revenue collected,” and/or “accumulated excess of revenue collected over expenses paid" in the OCBOA financial statements? In practice, GAAP- basis financial statement captions commonly are presented in OCBOA financial statements. The most frequently-used financial statement titles in OCBOA financial statements may be summarized as follows: Cash Basis Balance Sheet Titles Statement of Assets and Liabilities -- [Modified] Cash Basis = Frequently Statement of Assets/Liabilities from Cash Transactions = Occasionally Balance Sheet--[Modified] Cash Basis = Rarely Cash Basis Income Statement Titles Statement of Revenues/Expenses -- [Modified] Cash Basis = Frequently Statement of Revenues Collected and Expenses Paid = Occasionally Statement of Cash Receipts and Disbursements = Rarely Statement of Income--[Modified] Cash Basis = Rarely
  14. 14. Tax Basis Balance Sheet Titles Statement of Assets/Liabilities/Equity -- Income Tax Basis = Frequently Balance Sheet--Income Tax Basis = Rarely Tax Basis Income Statement Titles Statement of Revenue and Expenses -- Income Tax Basis = Frequently Statement of Income--Income Tax Basis = Rarely Statement of Cash Flows Issues Pursuant to the provisions of SFAS No. 95, entitled Statement of Cash Flows, when reporting entities provide a set of financial statements that report both financial position and results of operations, a statement of cash flows must be included in these statements for there to be a complete set of financial statements. Many reporting entities [and practitioners associated with those entities] believe the terms “financial position” and “results of operations” relate only to GAAP-basis statements and [as a result] they believe that a statement of cash flows is not required for OCBOA statements. Other practitioners believe that SFAS No. 95 is not exclusive to GAAP statements and [in fact] that statements of cash flows for OCBOA presentations often provide valuable information about investing and financing activities that is not readily apparent in the other financial statements. Presentations using the cash basis of accounting, the modified cash basis of accounting, or the cash basis used for income tax reporting often include a presentation consisting entirely [or at least primarily] of cash receipts and disbursements. SAS No. 62/Interpretation No. 14 includes the stipulation that OCBOA financial statements need not conform with the requirements for a statement of cash flows. While a statement of cash flows is not required for OCBOA financial statements, if a presentation of cash receipts and disbursements is presented in a format similar to a statement of cash flows [or if the reporting entity chooses to present a statement of cash flows], the statement either should conform to the GAAP-basis presentation requirements or communicate the substance of those requirements. Disclosure Issues Other Than “Title and Caption” Issues Paragraph 10/SAS No. 62 includes the requirement that financial statements prepared on an OCBOA include a summary of significant accounting policies that discusses the basis of presentation and describes how that basis differs from GAAP. Further, that same paragraph stipulates
  15. 15. that when OCBOA financial statements contain items that are the same as [or similar to] items included in GAAP-basis financial statements, the same [or similar] informative disclosures would be appropriate. For example, paragraph 10/SAS No. 62 contains the conclusion that disclosures for depreciation, long-term debt, and owners’ equity in OCBOA financial statements should be comparable to the disclosures for the same items in GAAP-based financial statements. Further, paragraph 10/SAS No. 62 contains the requirement that auditors consider the need for disclosure of matters that are not specifically identified on the face of the financial statements [e.g., related-party transactions, restrictions on assets and owners’ equity, subsequent events, and uncertainties]. The questions addressed in SAS No. 62/Interpretation No. 14 relate to how the guidance provided in paragraph 10 of SAS No. 62 should be applied in evaluating the adequacy of disclosure in financial statements prepared on an OCBOA basis. In OCBOA financial statements, the discussion of the basis of presentation need not be exhaustive. Policy notes to the financial statements simply may indicate that the accompanying financial statements present financial results on the accrual basis of accounting used for federal income tax reporting. Only the primary differences between GAAP and the particular OCBOA need to be described. An example policy note that would fulfill the disclosure requirements in this area is as follows: The financial statements present financial results on the basis of accounting that Richards Company uses for federal income tax reporting. That basis differs from generally accepted accounting principles primarily because rental income is recognized when due rather than evenly over the lease terms, the periods used to calculate depreciation under the straight- line method are as prescribed by the Internal Revenue Code rather than estimated useful lives, and marketable equity securities are reported at cost rather than fair value. It is not uncommon to encounter practice circumstances where several items may be accounted for differently using a particular OCBOA when compared to a GAAP-basis presentation. As an example, perhaps the only differences that are significant in tax based financial statements when compared to GAAP financial statements relate to different depreciation methods used for tax purposes when compared to depreciation methods that would be acceptable under GAAP. In these circumstances, only a brief description of the depreciation differences would be necessary, and the remaining differences need not be described at all. In other cases, significant differences tax versus GAAP might relate to the particular accounting for bad debts and/or investments in securities. So, the “brief”
  16. 16. description might need to be “expanded” to incorporate multiple differences between GAAP and the OCBOA. Practice Note: See the important reminder about variable interest entities [below] where it would not be unexpected for this issue to result in another significant difference between GAAP and the OCBOA that would need to be included in the “expanded” policy note that describes these differences. IMPORTANT: There is no requirement related to quantifying differences between the OCBOA presentation and the GAAP basis of accounting. IMPORTANT REMINDER ABOUT THE VARIABLE INTEREST ENTITY ISSUE: In April 2006, the AICPA released some TPA guidance [Section 1500.06] that specifically addresses the issue associated with whether the consolidation provisions in FIN 46R, entitled Consolidation of Variable Interest Entities, would be applicable in financial statements that are prepared on a tax basis. In particular, the question addressed in this guidance relates to how the consolidation issue and the disclosure issue associated with variable interest entities [VIEs] should be addressed in OCBOA financial statements. In tax based financial statements, consolidation is based on requirements within the Internal Revenue Code. Therefore, the consolidation requirements of FIN 46R would not be applicable to financial statements prepared using the tax basis of accounting. However, pursuant to the provisions of SAS No. 62/Interpretation No. 14, there are disclosure “issues” that need to be addressed in OCBOA financial statements. Using this interpretive guidance, if OCBOA financial statements contain elements, accounts, or items where GAAP would require disclosure, the statements should either provide the relevant disclosure that would be required for those items in a GAAP presentation or provide information that communicates the substance of that disclosure. Practice Note: A VIE that is not consolidated using the income tax basis of accounting is analogous to a 60% owned subsidiary that would be consolidated in GAAP-based financial statements but that is not consolidated using the tax basis of accounting because the threshold for consolidation under the Internal Revenue Code is 80% ownership. The primary beneficiary of the VIE should perform the same analysis in determining which disclosures are appropriate as would the parent of the 60% owned subsidiary. Examples of matters that might require disclosure are related-party transactions, guarantees, and commitments. IMPORTANT REMINDER ABOUT THE “SAME OR SIMILAR” DISCLOSURES: Pursuant to the provisions of SAS No. 62/Interpration No. 14, if cash, modified-cash, or income tax basis financial statements contain elements,
  17. 17. accounts, or items for which GAAP would require disclosure, the OCBOA financial statements either should provide the relevant disclosure that would be required for those items in a GAAP presentation or provide information that communicates the substance of that disclosure. The end- result of this requirement may be that reporting entities will choose to substitute qualitative information for some of the quantitative information required for GAAP presentations. An example of disclosing the substance of GAAP-basis requirements rather than following the literal form of those requirements in OCBOA financial statements might be the disclosure of repayment terms of significant long-term borrowings and information about future principal reduction without providing the “listing” of principal maturities for each of the next five years [that would be required for a GAAP presentation]. The following approach may be utilized in developing the “note payable note” in OCBOA financial statements rather than the approach typically utilized in GAAP-basis financial statements: A note with a balance of $485,000 at the end of 2007 and $509,000 at the end of 2006 is payable to National Bank in monthly installments of $2,000 plus interest at an annual rate of prime plus 1% through December 2009, when the remaining principal balance is due. The note is secured by the rental property, is guaranteed by the partners, and limits the amount of distributions to the partners. The remaining note payable to National Bank has a balance of $15,000 at the end of 2007, is secured by equipment purchased during the year, and is payable in monthly installments of $750, which includes interest at an annual rate of 6.5%. Practice Note: GAAP disclosures that are not relevant to measurements included in OCBOA statements may be omitted from these statements. For example, the fair value disclosures in SFAS No. 115, entitled Accounting for Certain Investments in Debt and Equity Securities, need not be made in OCBOA financial statements when the basis of presentation for debt/equity securities does not include an adjustment of the cost of these securities to fair value. END NOTE RELATED TO DISCLOSURES: In those circumstances where a GAAP-basis presentation would require disclosure of other matters, reporting entities should consider the need for that same disclosure or a disclosure that communicates the substance of those disclosure requirements. Some examples that might fall into this category of disclosures relate to contingent liabilities, going-concern considerations, and significant risks/uncertainties. However, as mentioned in the practice note above, the disclosures need not include information that is not
  18. 18. relevant to the basis of accounting. For example, general information about the use of estimates that is required to be disclosed in GAAP-basis presentations by Statement of Position [SOP] 94-6, entitled Disclosure of Certain Significant Risks and Uncertainties, would not be relevant in a presentation that has no estimates [e.g., a cash receipts and disbursements basis]; however, when the OCBOA financial statements include estimates, the disclosure requirements in SOP 94-6 [or the substance of those requirements] should be followed. Changes in The Basis of Accounting Note that a change from GAAP-basis to OCBOA statements [or vice versa] does not represent a change in accounting principles as described in SFAS No. 154. If prior-year financial statements are presented for comparative purposes, they should be restated and presented using the “new” basis of accounting. Essentially, GAAP-basis financial statements are not comparable to OCBOA financial statements. Changing bases of accounting [in either direction] should be disclosed in the notes to the financial statements. When only current year OCBOA statements are presented, two [appropriate] ways exist to present the effect of the change to an OCBOA: • Reflecting beginning retained earnings as previously-reported on the GAAP-basis, with an adjustment to convert to an OCBOA. • Reflecting beginning retained earnings on the adjusted OCBOA basis. Practice Note: Historically, some reporting entities have shown these changes in financial statements as cumulative-effect-type changes. Historically [and technically], cumulative-effect accounting has been utilized to reflect changes in accounting principle. Currently, using the provisions of SFAS No. 154, “elected” changes in principle no longer are reflected in financial statements by using a cumulative-effect methodology [i.e., the new principle must be applied retrospectively in the financial statements]. However, and importantly, the type changes discussed above are changes in accounting basis [not changes in accounting principle within a particular basis of accounting]; as such, the two alternatives shown above probably should be utilized to reflect the change in basis of accounting. Very importantly, a change in accounting basis does not constitute a change in accounting principle that requires an inconsistency reference in the report on the financial statements. However, practitioners are allowed to include an explanatory paragraph in audit, review, and compilation reports to emphasize a matter regarding the financial statements. An
  19. 19. example of an explanatory paragraph that may be used in the year of the change to an OCBOA is as follows: As disclosed in Note 1 to the financial statements, in 2006 the Company adopted a policy of preparing its financial statements on the accrual method of accounting used for federal income tax purposes, which is a comprehensive basis of accounting other than generally accepted accounting principles. Accordingly, the accompanying financial statements are not intended to present financial position and results of operations in conformity with generally accepted accounting principles. The financial statements for 2005 have been restated to reflect the income tax basis of accrual accounting adopted in 2006. Some Peer Review Issues Related to OCBOA Financial Statements It is not uncommon for peer reviewers to note some “findings” related to OCBOA financial statements that have been audited, reviewed, or compiled. Some of the more frequently-encountered peer review deficiencies related to OCBOA financial statements include the following [although this is not intended to be an all-inclusive listing]: • The financial statement titles are not appropriate [i.e., they are not modified to reflect non-GAAP financial statements]. • The financial statement titles do not match the titles in the audit, review, or compilation report [i.e., either the financial statements titles or the report titles or both sets of titles would be in error]. • There is inadequate [or no] disclosure related to using an OCBOA, including the fact that OCBOA financial statements are not intended to be GAAP financial statements. • Compilation report paragraphs indicating that substantially all disclosures have been omitted from the financial statements contain [inappropriately] references to GAAP when the references should be to OCBOA disclosures being omitted. Practice Note: These type peer review findings [in the great majority of cases] just relate to the fact that practitioners “make mistakes” when reporting on financial statements that are not GAAP-based statements. Reporting Issues Related to OCBOA Financial Statements OCBOA financial statements may be audited, reviewed, or compiled. In November 1995, the Auditing Standards Board issued SAS No. 77, entitled Amendments to Statements on Auditing Standards No. 22, Planning and Supervision, No. 59, The Auditor’s Consideration of an Entity’s Ability to
  20. 20. Continue as a Going Concern, and No. 62, Special Reports. With the issuance of SAS No. 77, audited financial statements that are presented using a basis indicated in a prescribed form must include a restriction on the distribution of the audit report solely to those within the entity and to those associated with the applicable regulatory agency. There is no requirement to restrict the distribution of audit reports prepared on the other OCBOA bases. Audit, review, and compilation reports generally “look pretty much the same” as reports related on GAAP-based financial statements except that the “look is different” in certain circumstances, including: • Financial statement titles must be modified for OCBOA titles. • Reports refer to the OCBOA [as opposed to GAAP] used in the “development” of the financial statements. Practice Note: Essentially, an audit is an audit, a review is a review, and a compilation is a compilation, so that the “modifications” to reports have nothing to do with the “scope” of the engagement but [rather] have to do with the basis of accounting used in the financial statements. Examples of typical reports associated with audits, reviews, and compilations of financial statements “presented” on an OCBOA are “presented” at the end [the last three pages] of these materials. Paralleling the guidelines for reporting on GAAP-basis financial statements, “things sometimes happen” where there is a need to [or at least you can] modify standard audit, review, and compilation reports on these financial statements. Some of the more common areas where reports may need to be modified are discussed below. Departures from an OCBOA. Like GAAP departures, departures from an OCBOA can result in qualification of an audit report. When the OCBOA departures are considered to be material to the financial statements, the audit report should be modified. Known OCBOA departures also should be “spelled out” in review and compilation reports. Inconsistencies. When there is a change in an accounting principle [or the method of applying an accounting principle], practitioners should add an “inconsistency” paragraph to audit reports on OCBOA financial statements paralleling the paragraph that would be added to audit reports on GAAP- basis financial statements. There is no requirement to modify review and compilation reports for inconsistencies in either GAAP or OCBOA financial statements. Going Concern Uncertainties. When an assessment has been made that there is a substantial doubt about the ability of the entity to continue as a
  21. 21. going concern for a reasonable period of time [not to exceed one year from the financial statement date], practitioners should add a “going concern” paragraph to audit reports on either GAAP-basis financial statements or financial statements prepared on an OCBOA. There is no parallel requirement to modify review and compilation reports for material uncertainties [including going concern uncertainties]. Emphasis of a Matter. Practitioners always can add a paragraph to any report to emphasize a matter associated with the financial statements. Importantly, the additional report paragraph should not contain “new” information that is not already disclosed in the financial statements. IMPORTANT NOTE RELATED TO COMPILATION ENGAGEMENTS: The fact that financial statements are prepared on an OCBOA must be disclosed in compilation reports related to financial statements that omit substantially all disclosures unless the financial statements clearly indicate the use of an OCBOA. As a practical matter, compilation reports contain the OCBOA reference just to “complete the cycle” related to disclosing the OCBOA. Some Frequently-Asked Questions [and Answers] Related to OCBOAs QUESTION #1: When reporting on OCBOA financial statements, is it acceptable to ignore most of the disclosures that are required in GAAP- basis statements? ANSWER TO QUESTION #1: No! The major advantage of OCBOA financial statements [when compared to GAAP financial statements] relates to measurements included in the OCBOA statements. The disclosure requirements for OCBOA financial statements [essentially] parallel the disclosure requirements in GAAP-basis financial statements so that the same disclosures [or disclosures that communicate the substance of GAAP-basis disclosures] should be included in OCBOA financial statements. QUESTION #2: Is the recording of trade account receivables and payables one of the more common modifications to cash basis financial statements? ANSWER TO QUESTION #2: No! Reporting entities [and practitioners associated with those entities] need to be very careful with modifications made to cash basis financial statements so that the “end-result” is that these statements [essentially] do not constitute GAAP-basis statements with GAAP departures. Accruing trade receivables and payables, recording deferred taxes, and recording assets and liabilities associated with capital lease agreements probably would be “strong indications” that the “line has been crossed” related to modifications that would be acceptable to the cash basis of accounting.
  22. 22. QUESTION #3: Is it acceptable to include nontaxable revenues and nondeductible expenses in tax basis financial statements? ANSWER TO QUESTION #3: Yes! These amounts may be shown as separate line-items within revenues and expenses, additions or deductions to or from net income, or as disclosures in notes to financial statements. QUESTION #4: Tax basis financial statements of an S Corporation generally segregate retained earnings into amounts associated with the accumulated adjustments account, previously-taxed income from pre-1983 years, and accumulated earnings and profits, right? ANSWER TO QUESTION #4: No! While this type information may need to be maintained for tax purposes, these amounts typically are combined into one retained earnings account for financial reporting purposes. QUESTION #5: Is there a requirement to modify GAAP-basis financial statement titles when preparing/reporting on OCBOA financial statements? ANSWER TO QUESTION #5: Yes! These titles should be modified so that folks will “not be confused” related to the fact that the financial statements are not GAAP-basis financial statements [i.e., they are OCBOA statements]. QUESTION #6: When current-year financial statements are prepared using an OCBOA where prior-period financial statements [presented for comparative purposes] were prepared using GAAP requirements, would there be a requirement to “restate” the prior-year financial statements so that those statements also would be prepared using the OCBOA? ANSWER TO QUESTION #6: Yes! GAAP-basis financial statements are not comparable to OCBOA financial statements. A change in the basis of accounting either way [GAAP to OCBOA, or OCBOA to GAAP] would require restatement of prior-year financial statements. Best approach here = Just have single-year financial statements in the current reporting periods and “go back to comparatives” after a one-year reprieve. QUESTION #7: If a statement of cash flows is not included in OCBOA financial statements, are practitioners required to modify reports to indicate an OCBOA departure? ANSWER TO QUESTION #7: No! The statement of cash flows is not required in OCBOA financial statements so that modifying audit, review, and compilation reports for an OCBOA departure would not be appropriate.
  23. 23. QUESTION #8: Should audit reports on OCBOA financial statements be modified to reflect the fact that the financial statements are not prepared using the requirements associated with GAAP financial statements? ANSWER TO QUESTION #8: Yes! The titles to the financial statements [first paragraph] should be modified, a new third paragraph referring to a note to the financial statements describing the OCBOA should be added, and a reference to this note should be included in the opinion paragraph of the report. QUESTION #9: Should review and compilation reports be modified to reflect the fact that the financial statements are not prepared using the requirements associated with GAAP financial statements? ANSWER TO QUESTION #9: Yes! Review reports should be modified [first paragraph] for different financial statement titles, and the third paragraph in the review reports should contain a specific reference to the OCBOA. The first paragraph in compilation reports should be modified to reflect different financial statement titles and, when substantially all disclosures are omitted from the financial statements, a statement that the financial statements are prepared using an OCBOA typically will be necessary because it would be difficult for financial statement users to ascertain that the statements are prepared on a basis that is not GAAP. QUESTION #10: When auditing financial statements that are prepared using an OCBOA, when there is a substantial doubt about the ability of the reporting entity to continue as a going concern, would there be a requirement to modify audit reports for the going concern issue in a manner similar to how audit reports would be modified if the financial statements were prepared as GAAP-basis statements? ANSWER TO QUESTION #10: Yes! Auditing is auditing! Practitioners have the same obligation related to the going concern issue without regard to whether the financial statements are GAAP-based or on an OCBOA. Tom R. January 10, 2007 This publication does not represent an official position of any organization, and it is distributed with the understanding that the author and the publisher are not rendering legal, accounting, or other professional services in this publication. If legal advice or other expert assistance is required, the services of a competent professional should be sought.
  24. 24. Model Audit Report/OCBOA Financial Statements MUNTER & RATCLIFFE Certified Public Accountants 123 Bibb Graves Street Miami, Florida 33124 (305) 670-3137 INDEPENDENT AUDITORS’ REPORT Susanne Richards, President Richards Company Marbury, Alabama We have audited the accompanying statements of assets, liabilities, and stockholders' equity--income tax basis of Richards Company as of December 31, 2006 and 2005, and the related statements of revenues and expenses-- income tax basis, and statements of cash flows--income tax basis for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1, these financial statements were prepared on the basis of accounting the Company uses for income tax purposes, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, the financial statements referred to above present fairly, in all material respects, the assets, liabilities, and stockholders' equity of Richards Company as of December 31, 2006 and 2005, and its revenues and expenses and its cash flows for the years then ended, on the basis of accounting described in Note 1. Munter & Ratcliffe, CPAs Miami, Florida March 15, 2007
  25. 25. Model Review Report/OCBOA Financial Statements MUNTER & RATCLIFFE Certified Public Accountants 123 Bibb Graves Street Miami, Florida 33124 (305) 670-3137 Susanne Richards, President Richards Company Marbury, Alabama We have reviewed the accompanying statements of assets, liabilities and stockholders' equity--income tax basis of Richards Company as of December 31, 2006 and 2005, and the related statements of revenues and expenses-- income tax basis and statements of cash flows--income tax basis for the years then ended, in accordance with Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accountants. All information included in these financial statements is the representation of the owners of Richards Company. A review consists principally of inquiries of company personnel and analytical procedures applied to financial data. It is substantially less in scope than an audit of financial statements in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in conformity with the income tax basis of accounting, as described in Note 1. Munter & Ratcliffe, CPAs Miami, Florida March 15, 2007
  26. 26. Model Compilation Report/OCBOA Financial Statements MUNTER & RATCLIFFE Certified Public Accountants 123 Bibb Graves Street Miami, Florida 33124 (305) 670-3137 Susanne Richards, President Richards Company Marbury, Alabama We have compiled the accompanying statements of assets, liabilities and stockholders' equity--income tax basis of Richards Company as of December 31, 2006 and 2005, and the related statements of revenues and expenses--income tax basis and statements of cash flows--income tax basis for the years then ended, in accordance with Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accountants. The financial statements have been prepared on the accounting basis used by the Company for Federal income tax purposes, which is a comprehensive basis of accounting other than generally accepted accounting principles. A compilation is limited to presenting in the form of financial statements information that is the representation of management. We have not audited or reviewed the accompanying financial statements and, accordingly, do not express an opinion or any other form of assurance on them. Munter & Ratcliffe, CPAs Miami, Florida March 15, 2007 Practice Note: If substantially all disclosures are omitted from the financial statements, a third paragraph should be added to the report as follows: Management has elected to omit substantially all of the disclosures ordinarily included in financial statements prepared on the income tax basis of accounting. If the omitted disclosures were included in the financial statements, they might influence the user’s conclusions about the Company’s assets, liabilities, equity, revenue, and expenses. Accordingly, these financial statements are not designed for those who are not informed about such matters.

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