Preparing for an Audit and Important Accounting Issues to Discuss with Your Auditors

Looking for another New Year’s resolution that doesn’t have anything to do with losing weight? Being prepared for your annual financial statement audit is a great New Year’s resolution and will definitely make your life easier.

Planning

To be completely prepared for the upcoming audit, you should meet with your auditors ahead of time. During this meeting you should establish the timing of the audit and inform them of the deadlines you require them to meet for final issuance of your financial statements. You should ask the auditors for a listing of the information that you are required to provide to them and when it needs to be ready. Internally, you should inform your staff when the auditors will be coming and your expectations of them prior to and during the audit.

Preparation

The information that your auditors typically ask you to prepare will be schedules supporting the more signifi-cant balance sheet accounts (i.e., cash, investments, fixed assets, accounts receivable, accounts payable, accrued liabilities, debt). Additionally, the audit process includes performing analytical procedures on the revenue and expense accounts. You should be prepared to answer questions regarding any significant fluctuations within these accounts as compared to prior years and any industry trends.

Preparation of confirmations will typically be requested as well. You should make the auditors aware of any changes in your banking structure that may have taken place during the year. Your role in the confirmation process is to prepare the actual confirmations; the mailing and receiving of the confirmations is controlled by your auditor.

Completion

Upon completion of the audit, your auditors should review with you all of the following:

• Adjusting and reclassifying journal entries that the auditors have made and their support for the entries
• Journal entries that the auditors proposed making but concluded not to make as a result of materiality thresholds (these are referred to as passed adjustments)
• Draft financial statements (double check all footnote disclosures to ensure information is updated with current information)
• Draft management letter

In addition to the areas identified above, ongoing communication with your auditors on a year-round basis is one of the most important aspects in making the audit process a smooth one.

Accounting Issues to Discuss with Your Auditors

FIN 46R — In December 2003, the Financial Accounting Standards Board issued FIN 46R — Financial Interpretation No. 46(revised), Consolidation of Variable Interest Entities. FIN 46R was issued as an interpretation to consolidation standards with its intent being to get more companies to consolidate. The primary target of the interpretation was all the special-purpose entities (SPEs) that Enron made famous, but virtually every large company uses. These structures are typically set up as business trusts with no substantive owner with any risk of loss or potential for residual reward. They are a financing scheme designed to meet the requirements for non-consolidation resulting in millions of dollars in off-balance-sheet-financing.

The interpretation caught many by surprise because its scope is much broader than the sinister arrangements that prompted the project. Despite the fact that FIN 46R was written with SPEs of public companies in mind, the scope of FIN 46 is not limited to public companies or SPEs. It also includes many arrangements that are common to small and midsize nonpublic entities that have valid business purposes. As a result, we expect to see many situations in our closely-held clients where related entities not previously consolidated may now have to be consolidated under FIN 46R, including:

• Leasing entities
• Employee leasing entities
• Brother-Sister entities with related operations
• Joint Ventures

The mechanics for determining consolidation are extraordinarily complex, and you should consult with your auditors to determine if FIN 46R applies to your company.

Interest Rate Swap Agreements — The single most common derivative we see in our client base is the interest rate swap. A swap contract, generally, is a forward-based contract (meaning a contract negotiated between two par-ties to purchase and sell a specific quantity of a financial instrument at a specific price at a specified future date).In an interest rate swap agreement, two parties agree to “swap” streams of payments over a specified period. These payment streams are based on an agreed-upon rate applied to a “notional” principal amount. This agreed-upon principal amount is called notional because the swap contract does not involve the actual exchange of principal at either the inception or maturity of the contract.

It is essential to remember that the accounting for the original debt remain in accordance with the loan terms. The swap agreement is separate and frequently with a party other than the debt source. The resulting cash flow between the borrower and the other party involved in the swap is a net payment reflecting the difference between the two rates (fixed vs. floating) and is charged to interest expense. Finally, another entry occurs periodically to record, as an asset or liability, the fair value of the swap agreement. The other side of the fair value adjustment is a gain or loss on the derivative contract. If you are a for-profit entity, the gain or loss will be record-ed as a component of stockholders’ equity. If you are a not-for-profit organization, the gain or loss will be record-ed in the income statement. Typically, the fair value of the swap can be obtained from the financial institution that holds the swap agreement, or you can also contact your auditors to assist you with the fair value calculation.

Waiver Funds — For MRDD I/O Waiver providers the treatment of waiver funds received from residents that move from a developmental center has significant accounting issues. Residents from the two closing develop-ment centers are receiving funding from the Ohio Department of MRDD to be used for housing. Frequently this funding is pooled with others receiving similar funding to purchase new housing. This funding contains a requirement that the housing exist for individuals with MRDD for a period of at least 15 years or the pro rata portion of the funding needs to be refunded to the state of Ohio. As a result, the provider or owner of the real estate will need to recognize a liability upon receiving the funding and reduce the liability via income over a 15-year period.