Audit & Tax Fee Accounting Treatment - Accrued Or Expensed?

Margaret Hsia's Profile

Accrued Audit FeesMy understanding is that audit/tax fees no longer need to be accrued for a monthly basis but expensed in the period incurred.  Do you have a guidance reference that supports this?

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Would think you still need to expense as incurred, not paid, if material. Presumably a lot of firms expense on a cash basis since they have monthly payments that do not differ much from the expense amount.

I think you should theoretically accrue under FAS 5 (or whatever the reference is now under the FASB Codification).

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Margaret - I think because we sign contracts with the CPA firms we accrue in the period incurred via contract versus when the work is performed. Here is the cite - It's Concepts 6:

.05 Accrual of Audit Fee

According to FASB Concepts Statement No. 6, Elements of Financial Statements, paragraph 145 , "The goal of accrual accounting is to account in the periods in which they occur for the effects on an entity of transactions and other events and circumstances, to the extent that those financial effects are recognizable and measurable." The audit fee expense was incurred in the period subsequent to year end. Therefore, it is properly recorded as an expense in the subsequent period. However, fees incurred in connection with planning the audit, together with preliminary procedures (e.g., confirmation work) would be accruable for the year under audit.

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I am impressed that you were able to find this citation, not many folks know about it. It is in fact an AICPA Technical Q&A which is not an authoritative source of US GAAP. However some firms have adopted it as if it were in fact US GAAP when it is not. US GAAP in this area is not fully defined. I beleive it is acceptable to adopt a policy consistent with the Q&A or accrue in full under a FAS 5 theory.

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Dan,
That is certainly a novel concept and one that I have not heard from PwC or E&Y in past audits. I do not see how potential audit fees would fit the notion of a "loss contingency". Here are some examples identified in FAS5:
a. Collectibility of receivables.
b. Obligations related to product warranties and
product defects.
c. Risk of loss or damage of enterprise property by
fire, explosion, or other hazards.
d. Threat of expropriation of assets.
e. Pending or threatened litigation.
f. Actual or possible claims and assessments.
g. Risk of loss from catastrophes assumed by property
and casualty insurance companies including
reinsurance companies.
h. Guarantees of indebtedness of others.
i. Obligations of commercial banks under “standby
letters of credit.”2
j. Agreements to repurchase receivables (or to
repurchase the related property) that have
been sold.

Not sure where one would draw the accrual line for all kinds of other expenses if you apply FAS5 to audit fees to be incurred in following periods.

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Larry,

Your correct FAS 5 does not mention audit fees or similar types of accruals- however it does apply when analyzing lets say legal fees to be incurred in connection with a lawsuit. However when trying to describe a siutation where you beleive matching an origination of an event in a fiscal year (ie the audit requirment)with the ulitmate outcome (ie the audit and resultant fees- many times which are incurred far after year-end) the FAS 5 model seems to be a nice theoretical descriptor. Perhap I should have referenced the matching principle. I was formerly with a Global firm and consulted on this issue with the national office. I think the best way to approach this issue is to consult with your particular audit firm on what policy you would like to establish and get their concurrence as there is no clearly delineated GAAP on this issue.

Member's Profile

GAAP changed a couple of years ago. My understanding is that you may accrue at year end ONLY for audit related services actually rendered in the current year. Audit related services rendered in the following year are expensed as incurred (even though they are auditing prior year(s) activity). If you think about it, this makes sense and is more in line with how other service related accruals are booked.

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Guidance is provided for under FAS5, however I can summarize the rationale for not accruing tax and audit fees.

Since the basis for recorded service provider expenses is if and only if the service has been performed, the accrual of a service related expense prior to execution of the serice is not reasonable.

You cannot accrue what has not taken place. Would you accrue revenue that has not shipped? Would you accue inventory that has not been received?

John

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Retried intermediate accounting professor here.

The matching principle attempts to record the costs incurred to produce revenue. Audit fees and taxes paid after year end are part of the previous year's operations and therefore SHOULD be accrued. If these amounts do not fluctuate significantly from year to year then the amount accrued is materially equal the amount paid. This may be why differences in practice have been observed. If every year expenses are estimated to be $10K and in a subsequent year $10K is paid, recording the expense when paid is cash basis accounting, and not GAAP. But using accrual accounting would have given the same result. To switch to accrual would be treated as a change in method and applied retroactively to avoid double counting the expense in one year. If your organization has been using the cash basis to report audit fees and taxes and the ultimate bill is significantly different than the amounts shown on the income statement, then adjust the income statement expenses accordingly. While the mechanics are different, the approach is similar to accounting for bad debts. Here an entity may record a percent of sales monthly and then make a year end adjusting entry to reflect the net realizable value of the net accounts receivable. SFAS 5 requires accrual if the expense is probable and can be estimated.

Someone is probably going to say “isn’t that a change in estimate?” “Changes in estimates are supposed to be treated prospectively.” You could try arguing that with your auditors. But wouldn’t any competent CFO/controller know early in the fiscal year if their taxes and/or audit fees were going up significantly? If you answer yes to that question, then estimating and accruing those expenses during the fiscal year is the obvious course to follow.

The foregoing relates to expense recognition.

John, ideally revenue is recognized when earned. If the company hasn’t performed the services or shipped the goods, the revenue hasn’t been earned and therefore, not recorded.

Assets, like inventory, are typically recorded when title has transferred (inventory) or there has been constructive receipt of the asset (a capitalized leased asset.)

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Karen,

Many other comments provide what is now GAAP. The only accrual to be made at year-end is for services rendered not yet billed. This is similar to any other accrual. You only accrue for what has been used. Technically, a firm often prepays the anticipated fee in equal installments. Again this should be treated as a prepaid expense and charged against income only when the service has been rendered.

Where there is no material variance year over year, the impact is negligible between years.

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I respectfully disagree with the academic argument as in practice, you would accrue Audit and Tax Fees throughout the year just because you expect to have an audit of that year's financials. While some companies do accrue throughout the year, it is often allowed for private companies as it is generally not material and by year end, is materially correct. However, authoritative guidance would prevent this as well as what was FAS5. If the work hasn't been performed, there is in fact no liability. If the company decided to shut it's doors before any work is ever performed, there would be no obligation to pay.

I have worked with several of the Big 4 firms who concur that it is not appropriate to accrue the expenses unless and to the extent work has been performed.

Member's Profile

In my past Controller and CFO positions, I've seen this handled both ways. In discussing with our external auditors, the feedback I got was about 2/3's of their clients accrued the fees at the year end date (typically building a periodic accrual throughout the year), for audits taking place after the year end being reported.

About 1/3 of clients expensed as incurred.

My point of reference goes up to fye 2002. I believe this expense should be expensed as incurred.

In most instances, the fees being accrued in advance were tied to how the companies budgeted, not really a GAAP compliant rationale.

What we would do is as the work was being done, given the audit firms were not necessarily the most timely in billing, we would make monthly accruals as the actual work progressed.

It's always been another pet peeve of mine with the audit firms, and the lack of detail/transparency provided with their billings vs. their original engagement estimates to complete the audit work. Even law firms are much better at accounting for the time and costs being billed. If the audit firms saw a client billing the way they did, I believe you would be subject to considerable criticism, they would want proof of percentage of completion calculations for how you billed vs. the revenue recognized.

Randy

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My comany's auditors required us to book an audit adjustment to reverse the audit fees we accrued at year-end. We now expense on billings. I was very surprised but decided not to make an issue of it.

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Generally you know approximately what the annual audit fee will be. I have always accrued it monthly as a standard journal entry. Any adjustment to the total amount charged for the year under audit should be made in the last month of the year.

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I have also seen this handled both ways, but I must admit that I come down on the side of expensing the audit fees during the time period of audit performance, and not accruing them in the prior year (the period being audited).

The costs of an audit is obviously not a COGS for the prior period and I would argue is not an Expense for the prior period either. The revenues and expenses of last year have nothing to do with the company's choice to have an audit performed early in the following year. In fact, I believe a stronger argument could be made that an audit of 2009 performed in early 2010 would have much more to do with 2010's operations than 2009's operations. My rationale is this: the audit is performed to give investors, lenders, and others confidence in the accuracy of the financial reports for the prior year. That information is then used in the CURRENT year to attract new investors, maintain lending or attract new lending, etc. The outcome of the audit (that is, confidence-building for external parties and continued lending/investor relationships, or on the flipside a tightening of credit and worsening of relationships, insurers/bonders backing away, etc.) has much more of an impact on the current year and even future years, and not really any impact on last year.

I think the confusion comes in because the audit is being done on information from the prior year, and so we automatically think "accrue, accrue!" But the fact of the matter is that the audit this year on the prior year's statements is a period expense this year that helps (or hurts) the company's operations this year, depending on the specific outcome of the audit.

For this reason, I believe audit costs should be expensed as incurred, which will be for the most part in the period following the period under audit.

Member's Profile

If you come down on the side of accruing the expense in X0 for an event that will occur in X1, what do you do when it is decided that no audit will be necessary? Do you reverse and restate X0? Or, do you simply flush the reversal through the current year?

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David:

I think your hypothetical scenario is a perfect example of the difficulties that arise with the accrual method, which is exactly why I took the position on the issue that I did.

The year is over -- no audit performed in the following year will benefit that period. If, in the current period, you determine an audit on the prior period is required or even just helpful, then the expense is relevant to the current period-- the period it is benefiting, not the period the audit is "about".

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We were corrected on this several years ago by our audit firm and now expense as the service is delivered. Looking back, there was no valid reason to do it the other way other than that was common practice for years... now that we've "seen the light" I have trouble justifying any other way of expensing it.

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While I hear the arguement that it "doesn't benefit" the period being audited, I think it does, or at least should. Without the audit and the requisite opinion, the financials for that period are not accepted as being valid and accurate.

Besides that, why would you WANT to defer this expense? I see it as a benefit to reduce tax liability, improving cash flow. What everyone seems to be ignoring is if you defer the expense to a subsequent year, it is a one-time benefit and only in the first period of (non)recording.

Unless your audit fees are huge relative to earnings, it is fairly meaningless, handled either way. Why not pocket the cash flow benefit, and call it a day?

I also doubt many companies that accrue audit fees, get to forgo a year-end audit very frequently. But if it happens, it becomes a "gift from the gods" increasing profit. I've never heard of an accountant that incurred the ire of management for a favorable year-end accounting "surprise".

While all this is fun to debate, isn't it close to being a case of "who cares"?

I know of no publically traded companies that defer recording their year-end audit fees. I doubt the biggies out there would even consider it. Or am I wrong?

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it isn't deductible until economic performance occurs, which would negate your point about tax deductibility. I also don't think the conversation is about deferral. As to your comment about "forgoing" an audit, that's true, but you could switch firms between January X0 and February X1 when the audit begins because you've gotten a lower quote. While my firm isn't a biggie, we follow the FAS and accrue it in the year it is incurred. I think that actual practice is probably more like 50-50 because it isn't material for most businesses.

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Otto,
I believe you are mistaken. You cannot accrue for audit services not yet rendered. If you do not need to keep your books in accordance with US GAAP, no problem. Otherwise, the auditors will almost certainly catch it, and it will be noted as a weakness (severity depending on what else they find) in the management letter.

How you prepare your tax returns is another matter. You may want to seek advice from your tax advisors before you "accelerate" such expenses in order to reduce your current year tax liability. One thing I do know is that you "Don't mess with the IRS".

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Does it make a difference how the fees are billed? I have always accrued the fees into the year under audit, but have also negotiated a fixed fee for the audit. In a recent assignment audit fees were billed on an hours incurred basis. The auditor's position was that this fee structure necessitated expensing the fees in the period when the services were rendered. A key difference is that audit fees were soaring year-to-year due to structural changes at the company that led to additional work. I don't think there is a universal answer to this question, but all the factors listed in the postings need to be considered. Consistency and disclosure of changes in methodology & estimates are the guiding principles.

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I wasn't going to comment, but the "debate" here finally compelled me to -
Due to the nature of my comments, I AM GOING TO COMMENT TWICE... (Sorry)
My first,this one, will include an excerpt from an SEC 10K filing I happened to be involved with (names changed to protect the innocent), my second comment will be more about our collective "EXPERTISE"

During the fourth quarter of YYYY Yr’s, the company’s auditors, (ABC), acting upon literature of the AICPA, requested that the company reverse accrued audit fees of $200,000 for YYYY Yr’s audit services not yet provided by ABC, and that the company not record these expenses until the first quarter of YYYZ. In prior years, the company has always accrued its audit fees in the year in which the audit fee pertains.

On Feb 22, YYYY, the company issued a press release that contained a narrative and quantitative discussion of the preliminary fourth quarter and full year consolidated financial results for the ended Dec 31 YYYY, which included the effect of this audit fee reversal. In the press release, the company reported net income for the YYYY Yr’s Q4 of $1,000,000 and $.10 per diluted share and net income for the full YYYY Yr’s of $2,000,000 and $.20 per diluted share.

=====

While completing its review of the company’s Form 10-K, the company’s auditors, ABC, determined that the company’s method of accruing audit fees was an acceptable method, and did not require the company to reverse the accrued audit fees discussed above. Accordingly, the company will continue its original accounting method and will record the audit fees of $200,000 in Q4 of YYYY so that the financial statements are prepared on a consistent basis with the prior years. As a result, upon filing its Form 10-K, the company will report net income for Q4 of YYYY Yr’s that has been reduced to $800,000 and $.08 per diluted share and full YYYY Yr’s net income that has been reduced to $1,800,000 and $.18 per diluted share. For both the fourth fiscal quarter and the year to date, the impact is a reduction of net income of $.02 per diluted share.

In the aggregate, this action does not impact the overall net income of the company, as the $200,000 audit fees will now be reported as a cost in YYYY Yr’s rather than first quarter of YYYZ.

EVEN THE EXPERTS CHANGE THEIR MINDS...

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OK, Here is my unscientific poll, from my personal experience working with EY, KPMG, PWC, BDO, and locally - Mohler and ISFP:
VOTES: ACCRUE(YEA); EXPENSE (NAY)
YEAs: EY, KPMG, PWC
NAYs: EY, KPMG, PWC
EITHER (be consistent): BDO, Mohler, ISFP

I hope there will be more 'technically challenging" topics for us to debate later... But for now, I am honestly a bit embarrassed that this is even a debatable topic -- just shows how GAAP's technical materials can be interpretted any number of ways by any number of competent experts and long-time practitioners (our collective body here).

I feel like we could all be hired as "expert witnesses" for Defense Attys *AND/OR* Prosecutors, and find technical guidance to support either position...

Keith

Member's Profile

Keith

I was tempted to comment to PART1 but thought that putting this to rest was a good idea. I agree with you that GAAP's technical materials can be interpreted any number of ways... In addition, SFAS 5 is the most principles (theoretically) based pronouncement I’ve ever read. If we can’t decide how to record accounting fees, how are we supposed to apply the set of principles based standards that IFRS purports to be?