2022 findings

The PCAOB recently inspected portions of financial statement audits for public companies. The findings were published in a new PCAOB Spotlight report, Staff Update and Preview of 2022 Inspection Observations.

Many of the deficiencies found in 2022 are in inherently complex areas that have greater risks of material misstatement. The top seven financial statement deficiency areas were:

1. Revenue and related accounts,
2. Inventory,
3. Information technology,
4. Business combinations,
5. Long-lived assets,
6. Goodwill and intangible assets, and
7. Allowances for loan and lease losses.

Auditors may find this information useful as they plan and perform their audits. Likewise, managers and in-house accounting personnel may benefit from a review of these findings to help improve financial reporting, minimize audit adjustments and use as a reference point when engaging with external auditors.

Spotlight on cryptocurrency transactions

The PCAOB report also highlights an emerging area of concern: cryptocurrency transactions. Examples of these transactions include:

• Earning a fee, or “reward,” for mining crypto,
• Purchasing or selling goods or services in exchange for crypto assets,
• Exchanging one crypto asset for another,
• Purchasing or selling crypto assets in exchange for U.S. dollars, and
• Investing in crypto assets.

The PCAOB notes that companies with material digital asset holdings and/or that engage in significant activity related to digital assets present unique audit risks. This was evidenced by the recent, high-profile collapse of crypto asset trading platform FTX. The risks associated with crypto assets may be elevated due to high levels of volatility, lack of transparency regarding the parties engaging in the transactions and the purpose of such transactions, market manipulation, fraud, theft, and significant legal uncertainties. The PCAOB recommends using specialists and technology-based tools to help audit these transactions in certain situations.

Bottom line

Regardless of whether they’re public or private, companies should take proactive measures to ensure their financial reporting is accurate and transparent. These measures may include providing accounting personnel with additional training and assistance, increasing management review and staff supervision, and beefing up internal audit procedures in relevant high-risk areas.

Also, expect external auditors to focus on these high-risk areas. As audit season approaches, prepare to provide additional documentation to back up your accounting estimates, reporting procedures and account balances for high-risk items.

What are deferred taxes?

Companies pay income tax on IRS-defined taxable income. On their Generally Accepted Accounting Principles (GAAP) financial statements, however, companies record income tax expense based on accounting “pretax net income.” In a given year, taxable income (for federal income tax purposes) and pretax income (as reported on your GAAP income statement) may substantially differ. A common reason for this temporary difference is depreciation expense.

For income taxes, the IRS allows companies to use accelerated depreciation methods to lower the taxes paid in the early years of an asset’s useful life. Some companies also may elect to claim Section 179 deductions and bonus depreciation in the year an asset is placed in service. Alternatively, for GAAP reporting purposes, companies frequently use straight-line depreciation. Early in an asset’s useful life, this divergent treatment usually causes taxable income to be significantly lower than GAAP pretax income. However, as the asset ages, the temporary difference in depreciation expense reverses itself.

The use of different depreciation methods for book and tax purposes causes a company to report deferred tax liabilities. That is, by claiming higher depreciation expense for tax purposes than for accounting purposes, the company has temporarily lowered its tax bill — but it will make up the difference in future tax years. Deferred tax assets may come from other sources, such as capital loss carryforwards, operating loss carryforwards and tax credit carryforwards.

How are deferred taxes reported on the financials?

If a company’s pretax income and its taxable income differ, it must record deferred taxes on its balance sheet. The company records a deferred tax asset for the future benefit it will receive if it pays the IRS more tax than an income statement reflects. If the opposite is true, the company records a deferred tax liability for the additional future amount it will owe.

Like other assets and liabilities, deferred taxes are classified as either current or long-term. Regardless of their classification, deferred taxes are recorded at their cash value (that is, no consideration of the time value of money). Deferred taxes are also based on current income tax rates. If tax rates change, the company may revise its balance sheet and the change flows through to the income statement.

While deferred tax liabilities are recorded at their full amount, deferred tax assets are offset by a valuation allowance that reflects the possibility the asset will expire before the company can use it. Deciding how much deferred tax valuation allowance to book is highly subjective and left to management’s discretion. Any changes to the allowance flow through to the company’s income statement.

Now or later?

Financial statement users can’t afford to lose sight of deferred taxes. All else being equal, a company with significant deferred tax assets may be able to lower its future tax bill and preserve its cash on hand by claiming deferred tax breaks. Conversely, a company with significant deferred tax liabilities has already tapped into tax breaks and may need additional cash on hand to pay Uncle Sam in future tax years. Contact us for more information.

Reimagine data presentation

In business, the use of so-called “infographics” started with product marketing. By combining images with written text, these data visualizations can draw readers in and evoke emotion. They can breathe life into content that could otherwise be considered boring or dry.

Annual reports are traditionally lengthy and heavy with numbers and text. Some organizations are now using visual aids to disclose critical financial information to investors and other stakeholders. In this context, infographics help stakeholders digest complex information and retain key points.

Show, don’t just tell

Examples of formats that might be appropriate in financial reporting include:

Line graphs. These graphics can be used to show financial metrics, such as revenue and expenses over time. They can help identify trends, like seasonality and rates of growth (or decline), which can be used to interpret historical performance and project it into the future.

Bar graphs. Here, data is grouped into rectangular bars in lengths proportionate to the values they represent so data can be compared and contrasted. A company might use this type of graph to show revenue by product line or geographic region to determine what (or who) is selling the most.

Pie charts. These circular models show parts of a whole, dividing data into slices like a pizza. They might be used in financial reporting to show the composition of a company’s operating expenses to use in budgeting or cost-cutting projects.

Tables. This simple format presents key figures in a table with rows and columns. A table can be an effective way to summarize complex time-series data, for example. It can provide a quick reference for information that investors may want to refer to in the future, such as gross margin or EBITDA over the last five years.

Effective visualizations avoid “chart junk.” That is, unnecessary elements — such as excessive use of color, icons or text — that detract from the value of the data presentation. Ideally, each graphic should present one or two ideas, simply and concisely. The information also should be timely and relevant. Too many pictures can become just as overwhelming to a reader as too much text.

Other uses of visual aids

In addition to using infographics in financial statements, management may decide to create data visualizations for other financial purposes. For example, they could be given to lenders when applying for loans or to prospective buyers in M&A discussions. An infographic could also be used in-house to help the management team make strategic decisions.

Additionally, nonprofits often use infographics to create an emotional connection with donors. If effective, this outreach may encourage additional contributions for the nonprofit’s cause.

Bringing the numbers to life

By supplementing text and numeric presentations with visual elements, your organization can communicate more effectively with investors, lenders, donors and other stakeholders. Contact us to decide how visual aids can help you drive home key points and clarify complex matters.

Random data sets

According to Benford’s Law, in sets of random data, numbers beginning with smaller digits occur more frequently. For example, numbers beginning with 1 occur about 30% of the time, numbers beginning with 2 occur about 18% of the time, and so on, down to numbers beginning with 9, which occur less than 5% of the time. The law also makes predictions about the distribution of second digits, third digits and digit combinations.

These patterns become skewed when dishonest workers attempt to manipulate numbers in certain financial documents. In fact, it’s nearly impossible to manually enter data so that it conforms to Benford’s Law. So, auditors may be able to use Benford’s Law to test journal entries made for the following items:

• Inventory records,
• Expense reports,
• Accounts payable or receivable,
• General ledgers, and
• Refund reports.

If anomalies appear when performing this analysis, auditors will perform analytical review procedures to determine whether specific unusual circumstances, business changes, random fluctuations or misstatements may have impacted the data set. And they may need to consider whether alternative audit procedures — such as physically tracing transactions to supporting documentation or comparing the transactions to prior years’ data — can be used to assess the validity of a questionable data set.

Spreadsheet analysis

When applying Benford’s Law, auditors typically run a spreadsheet program on the data set to examine the distribution of digits in random sets of numbers. By doing this, they calculate the frequency with which the digits 1 through 9 occur. The spreadsheet can be converted into a chart that highlights any significant deviations from the patterns the rule predicts.

For example, a chart that shows that 20% of the numbers in a data set begin with 9 and only 10% begin with 1 may indicate financial misstatement. But it doesn’t prove wrongdoing. Often, innocent explanations — such as duplicate entries and other human errors — lie behind suspicious patterns. That’s why it’s essential to dig deeper to understand what’s gone awry.

Limitations

Beware: Benford’s Law sometimes generates false positive and negative results. Examples of confounding variables include:

Small data sets. There must be enough journal entries to be statistically relevant. For instance, if a receivables clerk falsifies just one or two journal entries, the impropriety is unlikely to be caught with Benford’s Law.

Assigned numbers. The data being tested must occur naturally for Benford’s Law to work. Nonrandom numbers that were created by humans — such as invoice numbers — won’t conform to the prescribed pattern.

Artificial limits. If transactions are subjected to a floor or ceiling, some numbers won’t occur in the data set. For instance, if petty cash draws can’t exceed $50, the petty cash ledger won’t conform to Benford’s Law.

Also consider review thresholds. If a second signature is required on all disbursements greater than $5,000, the auditor might detect an unusually high occurrence of “4” in the first-digit position.

For more information

Despite its limitations, Benford’s Law can be a simple, cost-effective tool to test for data manipulation, processing inefficiencies and errors. Contact us to discuss whether this analysis can enhance your financial reporting. We can identify the types of transactions that are best suited for Benford’s Law-based testing.