Audit Adjustments. Two little words that can produce the same feeling to accountants as walking into the break room and realizing the coffee carafe is empty and no one has started a new batch. Management dreads the proposed journal entry conversation with the auditors, and heck, the audit team would prefer to never have a need to propose them. As we enter into “audit season” and anticipate the arrival of audit teams on site and Controllers and CFO’s feverishly closing the books on fiscal year 2014, I want to share some tips and tricks to avoid these two dreaded little words. Here are some common audit adjustments that can be easily avoided with a little time spent reviewing the respective guidance:
In accordance with Accounting Standard 840- 20-25, “Rent shall be charged to expense by lessees (reported as income by the lessors) over the lease term as it becomes payable (receivable). If rental payments are not made on a straight-line basis, rental expense nevertheless shall be recognized on a straight-line basis unless another systematic and rational basis is more representative over the time pattern in which use benefit is derived from the leased property, in which case that basis shall be used.” Here’s the breakdown: Many times, leases include escalating rent payments. A simple schedule should be prepared to determine the total lease payments made over the life of the lease divided by total payments to be made to calculate rent expense.
An example is you enter a 5-year lease, $1,000 monthly payments, with increases in monthly rent payments of $500 annually. In total, $120,000 cash payments will be made over 60 months. $120,000 divided by 60 is $2,000 - the amount of rent expensed to be recorded each month over the life of the lease. For the first two years, when monthly payments will be $1,000 and $1,500, respectively, the difference between the cash payment and rent expense recorded will result in a credit to a deferred rent liability account. In year 3, the cash payment will equal the rent expense recorded. In years 4 and 5, the cash payment made will be more than rent expense recorded and the resulting debit will reduce the deferred rent liability account and eventually zero out that account, coinciding with the maturity of the lease.
Similarly, lease incentives provided by the lessor to the leasee, such as tenant allowances, should be recognized over the lease term on a straight-line basis. A tenant allowance should be recorded as a liability, typically in an account called deferred tenant allowance, and amortized over the life of the respective lease. The life used should be the lease term, and if there are available extensions within the lease, these would be used in the life determination only if it was reasonably certain the lease would be renewed.
Capitalizable Costs: Expenses incurred to open a new restaurant or retail space can accumulate quickly and may be incurred over a multi-year period. Financing for new construction may have come from new credit lines or term loans. Legal counsel most likely was involved to purchase the land, obtain building permits, or close on the new debt. Architects were possibly involved to design the new space and provide a great layout. Significant time was incurred by management to make decisions. So what costs immediately hit the income statement and which costs can be capitalized?
- Start-up or preopening costs are costs incurred prior to the commencement of a new operation. Costs of hiring new personnel, costs of operating personnel who initiate the new operations, operational losses in the beginning periods, preopening advertising costs, etc. are considered start-up costs, which should be expended as incurred and not capitalized.
- Legal costs or loan costs charged by the lender are able to be capitalized and amortized over the life of the loan.
- Costs of designing facilities and equipment shall be capitalized as part of the costs of such items. Pre-acquisition costs related to the acquisition of a property, which are incurred prior to the property is acquired (surveys, appraisals, zoning fees, etc.), may also be capitalized if the acquisition of property is probable. These capitalized costs would then be depreciated over the life of the respective asset(s).
Reserves: Estimates made by management are closely reviewed by audit teams. Such estimates may include a reserve for spoiled or unsaleable inventory, warranty reserves for products sold, or reserves against customer accounts receivable. We, as auditors, believe that our clients know their businesses better than we ever will, as they are involved in each and every detail on a daily basis. The audit team will be asking questions surrounding the how and why you arrived at the reserve amount. Did you use historical trends? Are there known facts about the current inventory/sold products/accounts receivable that were factored into your decision? Have there been events subsequent to year-end that would change your estimate (customer filed for bankruptcy, product had a recall, huge sales resulting in full inventory turnover)? As you determine your respective reserves, remember to document these considerations made to support your estimates and provide them to your auditors ahead of time. Getting your auditors to understand how you determined your estimates will benefit all parties and make any conversations challenging the estimates smoother in the long-run.
For questions regarding audit adjustments, please contact Maggie Wise at firstname.lastname@example.org.