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Audit & Accounting Alert Newsletter

Issue 4 | April 2015

At-A-Glance

Gerry Herter

This issue continues our series on technology related accounting trends that began with Big Data in February and Cyber-security in March. During modern times, financial transactions typically have been reported on the basis of a local currency. The recent emergence of virtual currencies like Bitcoin portends to transform the way business is conducted. Our first article explores the prospects for this new way of exchanging money.

The level of quality in financial statement audits is also an ongoing topic for the Audit & Accounting Alert. The latest survey results from the International Forum of Independent Audit Regulators reveal a disturbing pattern of recurring shortcomings, as described in our second article.

The groundbreaking new revenue accounting standard will command regular attention going forward, as well. The scheduled rollout is in the midst of fielding application and interpretation queries. Our third article considers insights from recent tentative decisions by the FASB and IASB.

Editor Gerald E. Herter, CPA

In This Issue 

Bitcoin: A Fad or the Future for Business?

Virtual currencies seek to transform the conduct of financial transactions

The jury is still out on the prospects for bitcoin. Will perceived flaws lead to its ultimate demise, or will the world of commerce be upended in a way not seen in hundreds of years? Three aspects of this phenomenon that accountants will want to consider are: transacting business in bitcoin, accounting treatment, and audit implications.

But first, some background may be helpful. Long ago, the single entry system of accounting developed, at one time with clay tokens representing various commodities. These were eventually replaced with coins that could be added together, but still as one single entry list. About 800 years ago, double entry accounting appeared on the scene, enabling commerce to expand more readily with the built-in check and balance of the dual entries. This system was codified in the fifteenth century by the Italian Friar, Pacioli, who as a result became known as the Father of Accounting.

Bitcoin is a much more recent occurrence, first introduced in an October 2008 paper, written under the name Satoshi Nakamoto. Drawing upon concepts from the field of cryptography, bitcoin is basically a peer to peer virtual monetary system. Compared to a bank, which keeps a centralized ledger recording each transaction, the bitcoin “ledger” resides on the internet. Just as the internet is spread around computers all over the world, bitcoin exists in a similar fashion, and thus is decentralized and not controlled by anyone, but collectively by the users.

In January 2009, the first bitcoin came into existence when the initial open-source network was established online. Each transaction created has a public key and a private key. The public key is like an email address and can be seen by everyone, but the private key is like an email password and can only be seen by the party to the transaction. When a transaction is created by a user, it is in effect date stamped by being added chronologically to an ongoing chain of all transactions. Independent users employ specialized software to verify that transactions are correctly entered into the system. The system compensates these users by awarding bitcoins to them. The continuous nature of the transaction chain and the volume of entries help to deter tampering. The Nakamoto paper describes the structures as “…a public history of transactions that quickly becomes computationally impractical for an attacker to change if honest nodes control a majority of CPU power.”

The internet chain of transactions provides a triple entry form of accounting, which will be expanded upon later, when auditing implications are discussed.

As for transacting business in bitcoin, Habif, Arogeti & Wynne, LLP (HA&W), an Inside Public Accounting Best of the Best CPA firm in Atlanta, has already responded positively, recently announcing that the firm is accepting bitcoin payments for its services. One of the first US accounting firms to accept bitcoin, HA&W (quoting Forrester Research) stated in a press release that “25 percent of consumers across all generations plan to try using bitcoin for payment. The digital currency has an estimated market value of $3 billion, with millions of dollars traded in bitcoin each day.” The fact that Bitpay, the “world’s leading bitcoin payment processor,” is a HA&W client, provides the firm with a helpful resource.

Clear anxiety still surrounds the use of bitcoin, considering the alarming reports of theft and losses in cyber space. The worry appears to be not so much with bitcoin itself, but with the companies that hold bitcoin for customers. Just as a bank can be robbed, a bitcoin company can be hacked. When a business is merely receiving or paying in bitcoin, that concern is apparently mitigated, by using a third party such as Bitpay. The process can be set up such that the bitcoin goes directly to or from Bitpay, who converts the payment to the appropriate local currency, which then is remitted to the business.

When bitcoin is held by the business, then the question of proper accounting arises. Don’t look to the FASB or IASB for guidance, since standards have not been developed. Informally members of the FASB indicated that bitcoins fall under an other comprehensive basis of accounting (OCBOA); in other words not GAAP.

Proponents may prefer the same accounting as for traditional currencies. But as a virtual decentralized currency not tied to any legal jurisdiction, and subject to extreme volatility, bitcoin needs to develop a more stable track record before receiving general acceptance alongside conventional currencies.

Others would characterize bitcoin as a commodity used in a manner akin to bartering. That treatment would require analysis for revenue recognition purposes.

The US Internal Revenue Service (IRS) has weighed in and treats virtual currencies, including bitcoin, as property, to be recorded at fair market value in US dollars as determined by a market based exchange. The IRS issued Notice 2014-21 that explains how to report sales or exchanges of virtual currencies:

The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer. A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer. For example, stocks, bonds, and other investment property are generally capital assets. A taxpayer generally realizes ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer. Inventory and other property held mainly for sale to customers in a trade or business are examples of property that is not a capital asset.

Auditing presents challenges other than just testing the valuation determined above. Virtual currencies, of which bitcoin is one of many, are considered by some as offering a transparent form of security, made possible by what is characterized as a triple entry system.

Virtual currencies, such as bitcoin, offer a triple entry approach, signified by an underlying technology known as the “blockchain.” The blockchain is described by Ryan Lazanis of Xen Accounting in a recent Techvibes article:

The blockchain is a public, decentralized, distributed ledger that is capable of storing and confirming the transactions that pass through it. This means that the ledger is not owned nor controlled by any one party. Instead the control of the network, or protocol, is distributed among the network’s users. As transactions hit the blockchain, they are confirmed as true and accurate by the network’s users, called miners. If you see a transaction on the blockchain, the transaction has been confirmed and it cannot be reversed.

When two parties enter into a virtual currency transaction, the blockchain becomes the third party, independently holding a copy of the entry, thus completing the triple entry. Lazanis sees the role of the auditor diminishing in the future, since anyone can verify the blockchain content at anytime from anywhere. Even if not reduced as Lazanis predicts, auditor procedures could undergo substantial changes if virtual currencies prevail.

When computers first took over accounting functions in the twentieth century, auditors realized that their traditional audit techniques were inadequate. Computer experts were engaged to help navigate through the new technology to assure the reliability of the numbers. Similarly, with the complex new world of virtual currency, those experts will again be vital for the audit function.

At this point, there are still more questions than answers as to how to gain adequate audit assurance, or whether such assurance is attainable, with regard to virtual currency. Controls will need to be developed to protect the bitcoins from theft, loss, or improper use. Password security and encryption will also need to be evaluated. In addition, since the blockchain is public, means of privacy will need to be devised.

Nevertheless, Reuters reported last month that IBM is considering using the blockchain technology to create a digital currency that would consist of virtual dollars, as opposed to bitcoins, under the purview of a central bank like the U.S. Federal Reserve. That approach would resolve some of the current concerns that limit widespread appeal of virtual currencies.

With the benefits of speed, versatility and transparency, virtual currencies could well become the commercial form of choice in the future. The unknown is how long before that reality arrives.

For further information, see How Technology Behind Bitcoin Could Transform Accounting As We Know It and Habif, Arogeti & Wynne, LLP Now Accepting Bitcoin as Payment for Accounting Services  and What You Should Know about Bitcoin.


Improved Audit Quality Slow in Coming

Third annual international survey plays like a broken record of recurrent deficiencies

The International Forum of Independent Audit Regulators (IFIAR) was established in 2006 to foster a closer working relationship with audit regulators around the world. With representatives from 51 jurisdictions, the IFIAR has a threefold focus:

  • Sharing knowledge of the audit market environment and practical experience of independent audit regulatory activity with a focus on inspections of auditors and audit firms;
  •  Promoting collaboration and consistency in regulatory activity;
  •  Providing a platform for dialogue with other international organizations that have an interest in audit quality.

The annual global survey of audit inspection findings was initiated in 2012 to share results from across jurisdictions. The third annual survey for 2014 was released on March 3, 2015.

For the third year in a row, internal control testing and fair value measurement were the areas with the highest number of audit inspection deficiencies. Revenue recognition was new this year as the third highest area, possibly drawing closer scrutiny from publicity of the upcoming new revenue standard.

Financial institutions were again singled out for special attention. In all three years the results were the same, with the most deficiencies in the auditing of allowance for loan losses and loan impairments, internal control testing, and auditing the valuation of investments and securities.

In a press release, the IFIAR described the specific findings as:

…deficiencies in audit procedures that indicate that the audit firm did not obtain sufficient appropriate audit evidence to support its opinion. Findings identify areas where the auditor’s performance fell below the expected level of diligence to satisfy the public interest role the audit is meant to fulfill, and that the audit failed to provide the level of assurance about the financial statements that it purported to do and that is required by professional standards.

Further disturbing news revealed that of the 948 company audits inspected, 47% had deficiencies, and of the 141 financial institution audits, 41% were deficient. When asked about impressions of overall trends in audit quality, 28% of respondents had observed overall improvement, while 44% observed no significant overall improvement.

These results are surprising and disappointing considering the massive overhauls of the audit process stemming from the Enron-like failures of 2001 and the financial crisis of 2008. The survey covered audits of the six largest audit firms, which include the Big 4 plus BDO and Grant Thornton. These firms could be expected to have the greatest access to resources and capabilities for assuring high quality audits. Even so, inspection findings of their quality control systems revealed the highest number of findings in the areas of engagement performance, independence and ethics requirements, and human resources.

As with any major reform process, though the latest outcomes are disheartening, adequate time must be allowed for the full impact of the changes to take hold throughout the system. In prior issues of the A & A Alert, we have discussed a number of reforms that are in various stages of fruition. The groundbreaking overhaul of the COSO internal control framework, issued in May 2013, is in the midst of implementation at many companies. Fundamental changes to the audit report prescribed or proposed by multiple boards and jurisdictions were outlined in last month’s A & A Alert. The European Parliament has recently enacted auditor rotation and service restrictions, while the AICPA has recommended far-reaching proposals that will revamp peer review and internal practice monitoring for auditors of private entities (September 2014 A & A Alert). Moreover, the Center for Audit Quality is pilot testing the new Audit Quality Indicators described in the June 2014 A & A Alert.

The IFIAR plans to keep audit quality in the spotlight by continuing to monitor developments and engage with audit firm networks and associations, promoting the cause internationally. Audit firms are called upon to “develop a robust root cause analysis to gain a clearer understanding of the factors that underlie these [inspection] findings and take appropriate remedial actions.” Also, firms need to “continue improving their auditing techniques, as well as their oversight policies and procedures.”

With all the attention, improvements in audit quality results should start to appear in the near future. If not, the audit profession may soon face the reality suggested by The Economist (April 5, 2014), when referring to a British Parliament report responding to the 2008 financial crisis:

“The fact that some banks failed soon after receiving unqualified audits does not necessarily mean that these audits were deficient. But the fact that the audit process failed to highlight developing problems in the banking sector does cause us to question exactly how useful audit[ing] currently is.” With or without new rules, the main worry for auditors may be that people wonder whether their reports are worth a bean.” 

 For further information, see IFIAR 2014 Inspection Findings Survey.


Revenue Recognition Standard Advances Judiciously

Implementation and interpretation issues are addressed

Almost a year has passed since FASB and the IASB jointly issued the converged standard, Revenue from Contracts with Customers, in May 2014 (see June and September 2014 A & A Alerts). Recognizing that the monumental pronouncement was bound to raise questions as companies worked to understand and implement the new approach, the boards established the Transition Resource Group (TRG) to help ease the way.

The AICPA also jumped in with assistance, including a roadmap and implementation plan. Additionally, task forces were set up in sixteen industries to coordinate issues as they developed. So far, the AICPA’s website lists over 180 issues submitted for guidance. The insurance industry had a low of four issues, not surprising since the bulk of that industry’s provisions are contained in a separate standard. The high was 26 issues submitted for the construction industry.

Separately, the TRG Submissions log as of January 13, 2014 described 40 issues at various stages of evaluation. After considering staff analyses, the Boards determined that for a number of issues the contents of the new standard were adequate for understanding and application. The staff analysis is available for review on the Boards’ websites. For other issues, the Boards called for further research.

At the Boards’ February 18, 2015 joint meeting, several implementation issues were deliberated with tentative decisions publicized, in the areas of licensing of intellectual property and performance obligations. From the nature of the submissions, the Boards realized that further clarifications were necessary to lessen differences of application. These had been contentious issues during the original standard setting process, with the Boards finally settling on compromise solutions.

However, those agreements may unravel, as the differing outcomes now reached by each Board may strain the goal of ongoing convergence for the new standard. Hopefully, the variations remain minor, so that the thrust of revenue recognition remains consistent between the IASB and FASB.

Tentative decisions were made on the following topics:

1. Accounting for licenses of intellectual property:

a. Determining the nature of an entity’s promise in granting a license:

This issue arose over whether a license is symbolic, such as a brand, or functional, such as software that can be used today. An argument could be made that a symbolic license should be recognized over time, while a functional license should be recognized at a point in time. While the IASB would simply add clarifying guidance, the FASB proposes a change to the standard to more clearly delineate which type a license is, and therefore which treatment is appropriate.

b. Sales-based and usage-based royalties:

The general rule for royalties is that revenue recognition is prohibited until sales or usage occur. The Boards agreed that this rule should be applied whenever the predominant item to which a royalty relates is a license of intellectual property. Also, there is no need to split a royalty into portions that are subject to the general rule and portions that are not.

c. Other issues:

The FASB proposes amendments to clarify that; 1) certain contractual restrictions are characteristics of the license that do not change the number of items promised, and 2) licenses that are not separate performance obligations may still need to be analyzed to determine their impact on how revenue is recorded for the performance obligation that the license is a part of. The IASB felt that the standard provided adequate guidance without further amendment.

2. Identification of performance obligations:

a. Identifying promised goods or services:

The FASB proposes an amendment to clarify that if some of the goods or services are considered immaterial at the contract level, they do not need to be analyzed further. The IASB did not see this as an issue with its constituents.

b. Distinct within the context of the contract:

The FASB proposes to amend guidance to further define “separately identifiable” promises in the contract and more closely align the factors described in the standard to this definition. The IASB will not amend the standard, but along with the FASB will provide illustrative examples.

c. Shipping and handling services:

The FASB will clarify guidance so that shipping and handling, that occur prior to the transfer of control of goods to the customer, are considered fulfillment activities as opposed to separate performance obligations. Also, an election may be made to treat shipping and handling activities after transfer of control as fulfillment activities as well. The IASB needs to determine if this issue has arisen with its constituents.

Subsequently, at a joint meeting on March 18, 2015, the following narrow issues were addressed:

1. Practical expedients upon transition – contract modifications and completed contracts:

Both Boards will propose a simplified transitional method.

2. Sales tax presentation: Gross versus net:

FASB will propose a practical expedient to allow an election to net sales tax. IASB will not propose a change.

3. Non-cash consideration:

FASB will propose clarifying guidance for determining the measurement date using the contract inception date, and for applying the constraint on variable consideration. IASB will not propose a change.

4. Collectability considerations:

FASB will propose improved guidance. IASB will decide later on this issue.

The general trend for the FASB in the above tentative decisions is to clarify by amending, while the IASB appears to feel that the current standard is adequate as is, or can be satisfied by merely adding some examples. These differing approaches recall the traditional rules-based heritage of the FASB, as compared to the IASB’s principles-based history. Some may see this situation as a shortcoming of IFRS in general. The ambiguities emerging from the new standard, as exemplified by the above issues, may lead to further diversity in application, weakening the goal of global consistency.

Exposure drafts for these proposals are expected in coming months. Also, the Boards are considering whether a delay in the effective date of the revenue standard may be needed to provide more time for preparation, and for dealing with the expected proposed changes. The European Financial Reporting Advisory Group (EFRAG) announced its endorsement of the new revenue accounting standard on March 17, 2015, but did not recommend a deferral of the effective date.

For further information, see FASB Tentative Board Decisions and IASB Tentative Board Decisions.


Additional A&A News 

The following links provide a selection of current articles devoted to highlighting other A&A topics currently making news.

  1. New accounting standards to impact India corporates' fund raising strategy
  2. CPA Australia: Culture and simplicity key for audit committees
  3. IASB sets out practical effects of bringing leases onto the balance sheet
  4. Irish and South African Accountants Ink Deal
  5. IFRS Has Increased Investor Confidence in Nigeria
  6. Iranian Accounting Firms Weather Sanctions

Audit & Accounting Alert is a publication of Integra International intended to highlight emerging issues in the profession. The goal is to give Integra members an awareness of developments impacting the practice of Audit & Accounting, enabling them to stay on the forefront of industry trends.

Editor Gerald E. Herter  •  HMWC CPAs & Business Advisors, 17501 E. 17th Street, Suite 100, Tustin, CA 92780-7924
 •  Tel: 1 714 505-9000  •  Fax: 1 714 505-9200  •  Email: gerry@hmwccpa.com