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Financial Reporting

OCBOA Financial Statements

Here’s some practical guidance on a popular accounting option.

By Thomas A. Ratcliffe
October 2003
EXECUTIVE SUMMARY
IN CERTAIN INSTANCES CPAs SHOULD CONSIDER preparing and reporting on financial statements using an “other comprehensive basis of accounting” (OCBOA). Tax-basis and cash-basis, including modified-cash-basis, financial statements are the most widely used OCBOA statements.

A MAJOR ADVANTAGE OF OCBOA STATEMENTS is that many clients and external users understand them better than GAAP-basis statements. In addition, OCBOA statements may cost less to prepare compared with GAAP-basis ones: It’s not uncommon to save clients up to 20% to 30% in time and cost.

ONE OF THE ISSUES CPAs FACE WITH OCBOA STATEMENTS is the adequacy of disclosures within them. A statement of cash flows is not required, but statement titles should clearly indicate the basis of accounting the practitioner used. The notes to the statements should include disclosures related to contingent liabilities, going-concern considerations and risks and uncertainties.

SAS NO. 62 CONTAINS REPORTING GUIDANCE FOR WHEN a client engages a practitioner to audit OCBOA financial statements. CPAs typically will need to make certain modifications to the standard audit report when using it to report on OCBOA statements.

WITH THE GROWING COMPLEXITY OF PREPARING GAAP -based financial statements, the use of an OCBOA may be a logical alternative that meets the needs of both the client and the external statement users. Recent regulatory changes also may lead to an increase in the growing popularity of OCBOA statements.

THOMAS A. RATCLIFFE, CPA, PhD, is dean of the Sorrell College of Business and Eminent Scholar in Accounting and Finance at Troy State University in Troy, Alabama. He is a member of the AICPA accounting and review services committee. His e-mail address is tratclif@troyst.edu .

ne of your small business tax clients asks you to prepare and report on a set of financial statements. Because you’re familiar with the company, you know it has entered into an interest rate swap to lock in a low rate. The company also has a significant amount of goodwill and other intangible assets that may be subject to impairment as well as considerable fixed assets still subject to depreciation. It wants financial statements the company’s owners and executives can easily understand. You wonder whether there is a way to comply with the client’s request that is both cost-effective and less complicated than GAAP-based financial statements. Before you turn down the engagement, you might want to consider preparing and reporting on the financial statements using an “other comprehensive basis of accounting” (OCBOA). In situations where GAAP-basis statements aren’t necessary because of loan covenants, regulatory requirements or similar circumstances, an OCBOA may just be the answer.

In this article, CPAs will find guidance on preparing and reporting on OCBOA statements, their advantages and some caveats related to their use. Practitioners also will find advice that should be useful in preparing and reporting on modified-cash-basis and tax-basis financial statements—the most widely used forms of OCBOA.

WHAT IS AN OCBOA?
Under SAS no. 62, Special Reports, an OCBOA is any one of

A statutory basis of accounting (for example, a basis of accounting insurance companies use under the rules of a state insurance commission).

Income-tax-basis financial statements.

Cash-basis and modified-cash-basis financial statements.

Financial statements prepared using definitive criteria having substantial support in accounting literature that the preparer applies to all material items appearing in the statements (such as the price level basis of accounting).

Because tax-basis and cash-basis—including modified-cash-basis—financial statements are the most widely used OCBOA statements, the guidance in this article will focus on them. Exhibit 1 , below, lists some reminders CPAs should find useful in preparing and reporting on any type of OCBOA.

Exhibit 1 : Practical Reminders on OCBOAs
CPAs may audit, review and compile OCBOA financial statements.

OCBOA financial statements are simpler and more cost-effective to prepare, and easier for clients to understand when compared with GAAP-basis ones.

Disclosures in OCBOA financial statements should parallel those in GAAP-basis statements or communicate the same information.

The same disclosure requirements apply in compiled and reviewed OCBOAs that apply in audited OCBOAs.

Modifications to the “pure” cash basis of accounting are acceptable if they are equivalent to the accrual basis and the modifications are logical.

CPAs should not go too far in modifying cash-basis statements so the essential result is GAAP-basis statements with GAAP departures.

Tax-basis OCBOAs may include nontaxable revenue and nondeductible expenses.

CPAs must modify titles to OCBOA financial statements to show the basis of accounting.

GAAP-basis captions may be used within OCBOA financial statements.

There is no requirement for a statement of cash flows in OCBOA financial statements.

A policy note to the financial statements should describe the OCBOA.

CPAs face no requirement to quantify the differences between GAAP and an OCBOA in describing the basis of accounting.

Audit, review and compilation reports should indicate the financial statements were prepared using an OCBOA.

Audit reports on OCBOA financial statements must be modified for OCBOA departures, inconsistencies and going-concern issues. Review and compilation reports should be modified for OCBOA departures, but there is no requirement to modify these reports for inconsistencies and going-concern issues.

Changing the basis of accounting in the financial statements from GAAP to an OCBOA (or vice versa) necessitates the restatement of financial statements presented for comparative purposes.

ADVANTAGES OF OCBOA STATEMENTS
When clients ask about why they should let their CPA prepare financial statements using an OCBOA, practitioners should point out that one of the major benefits is that some clients can understand OCBOA statements better than GAAP-basis statements. For example, it isn’t uncommon for the owner/manager of a private company to fully understand the measurement issues represented in tax returns while having little grasp of the measurement and disclosure complexities in GAAP-basis financial statements.

Another major advantage: When compared with GAAP-basis statements, OCBOA financial statements generally cost less for CPAs to prepare. In cash- and modified-cash-basis statements, many of the measurement principles associated with GAAP simply don’t exist; in tax-basis financial statements, the CPA already has addressed the measurement issues in tax returns he or she prepared for the client. Thus practitioners could save clients up to 20% to 30% and even more in certain cases because of reduced time and cost in preparing and reporting on OCBOA financial statements. A final advantage is that many external financial statement users such as banks and insurance companies are now willing to accept OCBOA statements. CPAs can use all of these reasons to persuade clients that OCBOA statements are a good idea for their business.

Since disclosure requirements for OCBOA statements generally parallel those for GAAP-basis statements, CPAs will find only limited benefits, including minimal cost savings, when it comes to this aspect of preparing OCBOA statements. Interpretation no. 14 of SAS no. 62, Evaluating the Adequacy of Disclosure in Financial Statements Prepared on the Cash, Modified Cash, or Income Tax Basis of Accounting, gives practitioners expanded guidance on disclosure requirements. It says disclosures in these types of statements should parallel those for GAAP-basis statements or should communicate the substance of the GAAP disclosures.

 
Exhibit 2 : Sample Audit Report/OCBOAs

MUNTER & RATCLIFFE
CERTIFIED PUBLIC ACCOUNTANTS
123 Bibb Graves Street
Miami, Florida 33124
(305) 670-3137

Independent Auditors’ Report

Sue Beasley, President
Ann Wholesale Inc.
Petrey, Alabama

We have audited the accompanying statements of assets, liabilities and stockholders’ equity—income tax basis of Ann Wholesale Inc. as of December 31, 2002 and 2001, the related statements of revenues and expenses—income tax basis for the years then ended. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe our audits provide a reasonable basis for our opinion.

As described in Note 1, these financial statements were prepared on the basis of accounting the company uses for federal income tax purposes, which is a comprehensive basis of accounting other than generally accepted accounting principles.

In our opinion, the financial statements referred to above present fairly, in all material respects, the assets, liabilities and stockholders’ equity of Ann Wholesale Inc. as of December 31, 2002 and 2001, and its revenues and expenses for the years then ended, on the basis of accounting described in Note 1.

Munter & Ratcliffe, CPAs

March 15, 2003

CPAs will find disclosure to be simpler when OCBOA statements do not include some of the items, events and transactions typically part of GAAP-basis statements. For example, since tax-basis statements don’t show deferred taxes, CPAs don’t have to prepare the deferred tax disclosures GAAP-basis statements require. Practitioners should remember there is no disclosure “advantage” when they have compiled or reviewed OCBOA financial statements vs. auditing them. The advantage results from using another basis of accounting to prepare the financial statements and not from the level of service (audit, review or compilation) the CPA provides. Of course, the statements on standards for accounting and review services (SSARSs) allow CPAs to compile financial statements when management elects to omit substantially all of the disclosures. This applies both to GAAP-basis and OCBOA statements.

CASH- AND MODIFIED-CASH-BASIS STATEMENTS
Under the cash basis of accounting, CPAs record transactions according to an entity’s cash receipts and disbursements. The entity recognizes certain revenue when it receives cash rather than when it earns the income, and recognizes certain expenses when it pays them rather than when it incurs the obligation. CPAs rarely use the “pure” cash basis of accounting in practice; they use it almost exclusively for clients such as estates and trusts and civic ventures. Typically, both for-profit and not-for-profit entities use the modified cash basis in cash-basis OCBOAs.

The modified cash basis of accounting is a hybrid approach that combines elements of the cash- and accrual-basis methods. Modifications CPAs make to the cash basis should have substantial support in the accounting literature. SAS no. 62 cites as examples two modifications that meet these criteria: depreciation on fixed assets and accruing income taxes. However, CPAs can use other modifications as long as they are logical and have substantial support in the accounting literature. For this to be true, accountants should report on interrelated accounts on the same basis. For example, when a CPA records a fixed asset, he or she should record depreciation on those assets.

While it is common for CPAs to “modify” cash-basis statements to include fixed assets and the related depreciation, and to record liabilities for short-term and long-term borrowings and the related interest cost, practitioners should not go so far in modifying cash-basis statements so in the end they have prepared GAAP-basis statements. For example, a company shouldn’t accrue trade receivables and payables in modified-cash-basis statements; it also shouldn’t record deferred taxes and capital leases. To do so means the CPA has prepared GAAP-basis statements, losing the advantages of the OCBOA.

 
Exhibit 3 : Sample Review Report/OCBOAs

MUNTER & RATCLIFFE
CERTIFIED PUBLIC ACCOUNTANTS
123 Bibb Graves Street
Miami, Florida 33124
(305) 670-3137

Independent Auditors’ Report

Sue Beasley, President
Ann Wholesale Inc.
Petrey, Alabama

We have reviewed the accompanying statements of assets, liabilities and stockholders’ equity—income tax basis of Ann Wholesale Inc. as of December 31, 2002 and 2001, and the related statements of revenues and expenses—income tax basis for the years then ended, in accordance with Statements on Standards for Accounting and Review Services issued by the American Institute of CPAs. All information included in these financial statements is the representation of the owners of Ann Wholesale Inc.

A review consists principally of inquiries of company personnel and analytical procedures applied to financial data. It is substantially less in scope than an audit of financial statements in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in conformity with the income tax basis of accounting, as described in Note 1.

Munter & Ratcliffe, CPAs

March 15, 2003

TAX-BASIS STATEMENTS
The income tax basis of accounting follows the provisions of the federal income tax law. It covers a range of reporting alternatives, from cash to full accrual, depending on the nature of the taxpayer and, in some circumstances, the taxpayer’s elections.

Here are some of the practical issues CPAs will encounter when preparing and reporting on tax-basis statements:

The statements may include both nontaxable revenue and nondeductible expenses.

The statements should treat changes in accounting principle in the same manner as on the tax return.

S corporations should combine the accumulated-adjustments account, previously taxed income from pre-1983 years and accumulated earnings and profit into one retained earnings account for financial statement presentation purposes.

DISCLOSURE GUIDELINES
Perhaps the most difficult issue practitioners need to address in preparing and reporting on OCBOA financial statements—whether cash basis or tax basis—relates to the adequacy of disclosure within those statements. As previously mentioned SAS no. 62 and Interpretation no. 14 give CPAs valuable guidance on these concerns. Following are some of the unique disclosure issues associated with OCBOA financial statements:

Statement titles should clearly identify the basis of accounting used.

The inclusion of a statement of cash flows is not required.

Disclosures should include policy notes paralleling those in GAAP-basis statements and a basis of accounting policy note that clearly identifies the primary differences between GAAP and the OCBOA.

The notes to the statements should include disclosures related to contingent liabilities, going-concern considerations and risks and uncertainties.

OTHER REPORTING ISSUES
SAS no. 62 contains audit guidance for when a client engages the practitioner to audit OCBOA financial statements. Exhibit 2 illustrates the modifications to the audit report that are necessary for CPAs to use the standard audit report on OCBOA financial statements. Interpretation no. 12 of SSARS no. 1, Reporting on a Comprehensive Basis of Accounting Other Than Generally Accepted Accounting Principles, provides important guidance for CPAs engaged to review or compile OCBOA financial statements. Exhibit 3 and exhibit 4 illustrate the modifications to the review and compilation reports that are necessary for CPAs to use the standard reports with OCBOA financial statements.

Paralleling the guidelines for reporting on GAAP-basis statements, the rules for OCBOA statements may result in CPAs’ needing to modify standard audit, review and compilation reports on these statements. The following is a list of some of the more common areas where accountants may need to modify reports.

OCBOA departures could result in the need for an auditor to qualify the opinion expressed in audit reports and CPAs might need to spell out these departures in review and compilation reports.

Changes in accounting principles within an OCBOA could result in CPA’s needing to add an inconsistency paragraph in audit reports; there is no parallel requirement for accountants to modify review and compilation reports for inconsistencies in the application of accounting principles, although they may do so.

 
Exhibit 4 : Sample Compilation Report/OCBOAs

MUNTER & RATCLIFFE
CERTIFIED PUBLIC ACCOUNTANTS
123 Bibb Graves Street
Miami, Florida 33124
(305) 670-3137

Independent Auditors’ Report

Sue Beasley, President
Ann Wholesale Inc.
Petrey, Alabama

We have compiled the accompanying statements of assets, liabilities and stockholders’ equity—income tax basis of Ann Wholesale Inc. as of December 31, 2002 and 2001, and the related statements of revenues and expenses—income tax basis for the years then ended, in accordance with Statements on Standards for Accounting and Review Services issued by the American Institute of CPAs. These financial statements have been prepared on the income tax basis of accounting, which is a comprehensive basis of accounting other than generally accepted accounting principles.

A compilation is limited to presenting in the form of financial statements information that is the representation of management (the owners). We have not audited or reviewed the accompanying financial statements and, accordingly, do not express an opinion or any other form of assurance on them.

Management has elected to omit substantially all of the disclosures ordinarily included in the financial statements prepared on the income tax basis of accounting. If the omitted disclosures were included in the financial statements, they might influence the user’s conclusions about the company’s assets, liabilities, equity, revenues and expenses. Accordingly, these financial statements are not designed for those who are not informed about such matters.

Munter & Ratcliffe, CPAs

March 15, 2003

Note: Obviously, if the compiled financial statements are full-disclosure financial statements, CPAs would delete the third paragraph in this compilation report. Further, since full-disclosure financial statements would include a policy note describing the basis of accounting utilized in the financial statements, the last sentence in the first paragraph of this report would be unnecessary. Essentially, in full-disclosure financial statements, the “standard report” associated with GAAP-basis statements can be used when reporting on OCBOA financial statements (although the financial statement titles will be modified).

When a CPA concludes the entity is not a going concern in an audit engagement, he or she should modify the audit report on OCBOA statements in the same way the practitioner would modify the report when auditing GAAP-basis statements; an accountant faces no parallel requirement to modify review and compilation reports for going-concern issues, although he or she may do so.

A change in the basis of accounting from GAAP to OCBOA (or vice versa) results in the requirement for clients to restate financial statements presented for comparative purposes; in these circumstances, CPAs might decide they should modify audit, review and compilation reports to emphasize this change.

A POPULAR ALTERNATIVE
Since the ASB issued SAS no. 62 in April 1989, CPAs have increased their use of OCBOA financial statements. With the growing complexity of accounting guidance associated with GAAP-basis statements, practitioners may be looking for a logical alternative to preparing and reporting on financial statements that result in more understandable and cost-beneficial statements for clients. Such an alternative may be to prepare and report on OCBOA financial statements. With the recent changes in the regulatory landscape including enhancements to GAAP reporting requirements, there is little question OCBOA statements will continue to gain in popularity with both preparers and users of financial statements.

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