By Mark McDonald
We get it. Sometimes the alphabet soup of leasing-adjacent terms is enough to make your eyes water and brain melt.
That’s nothing, however, compared to the physiological reactions you’d have if your accounting team screwed up something very important to your company’s bottom line. Some things are—dare we say—critical to get right.
What are critical audit matters?
If an auditor finds something material during their audit of a company’s financial statements that is especially challenging, subjective, or complex, the auditor is required to report that matter to the company’s board of directors (the audit committee).
That is called a critical audit matter or a CAM.
The consideration of these began in earnest in 2020. A Deloitte analysis from that year of public filings showed that there was an average of 1.8 critical audit matters in the auditor’s reports for large accelerated filers with fiscal years ending on or after June 30, 2019. The most commonly disclosed critical audit matters related to:
- Goodwill and intangible assets (35%)
- Revenue (19%)
- Income taxes (15%)
Samatha Ross, former special counsel at the Securities and Exchange Commission, states: “Critical audit matters are a valuable communication tool, especially in times of disruption and uncertainty. A good audit report should be the starting point for investors looking to understand the areas of the audit that required the most judgment and what the auditor did to ascertain whether the financial statements as a whole are free of material misstatement.”
Even more importantly, auditors are documenting CAMs related to lease accounting! Before we go any further, let’s clearly define the most relevant aspects.
The lease impact of CAMs
As we look at what makes them so important, let’s define a related term: operating expenses.
This refers to all the expenses associated with a leased property besides rent. These expenses can include taxes, insurance, utilities, repairs, maintenance, and administrative expenses.
Since 2018 or so, auditors have been documenting CAMs related to lease accounting. The primary areas of concern have been asset impairment, fair market value, and incremental borrowing rate.
- Impairment: Companies are required to test asset groups for impairment, and lease right-of-use assets are no exception. One nuance of the ASC 842 standard is that the pattern of depreciation of an operating lease ROU asset changes after an impairment.
- Fair market value (FMV): The FMV is a key variable required for finance versus operating lease testing. It is also relevant for impairment calculations, when determining favorable or unfavorable terms during business combinations, and in other lease accounting business cases.
- Incremental borrowing rate (IBR): This is the interest rate a company would pay to borrow on a collateralized basis over a similar term for an amount equal to the lease payments. This rate is used to discount lease payments and calculate the present value of the lease liability and ROU asset. When the rate implicit in the lease is not readily available, the IBR is the required discount rate for lessees.
This makes it critical to have lease accounting solutions that offer automation for impairment remeasurement events, fair market value determination and support with the industry standard market research data, and IBR matching technology to make sure the correct rate is chosen every time.
Transparency and the audit process
CAMs are a key tool in providing transparency during audits. They provide more insights for investors because they allow auditors to include more information that can affect all key stakeholders. The frequency of CAMs is especially important because if there are too few of them, it is difficult for outside parties to determine if the related audit is a high-quality audit.
Think of it along the lines of getting medical “auditing” from a doctor at a yearly checkup. If the doctor only says that you “seem mostly healthy!” without saying anything else, you would have no idea of the kind of medication or lifestyle changes you need to adopt to stay that way. You wouldn’t even know if you are truly “healthy” by your own standards! Similarly, CAMs are necessary to add the sort of detail that lessees and lessors need to understand the true value of the leases they’re involved with.
The value of CAMs
Last September, the Center for Audit Quality conducted a survey of 100 institutional investors about CAMs. In the results, 92% of those investors responded that they use CAMs when making investment decisions. This is a pretty big indicator of their value to all stakeholders.
- Related article: Investors Rely Heavily on CAMs in Decision Making, Survey Finds
Lease accounting teams must understand that CAMs applied to audits of their material are not a “bad” thing. It’s understandable that having notes or subjective judgments applied to audits of your work can be unnerving. Given the complex nature of lease structures, however, it makes sense for CAMs to deliver added detail and transparency to the audit process.
ABOUT THE AUTHOR:
Mark McDonald is president of CoStar Real Estate Manager (formerly Virtual Premise), a wholly owned subsidiary of CoStar Group. He joined Virtual Premise as a member of the professional services team while the company was still in the start-up phase.
Mark also served as the leader of the field sales team during a multi-year period of hyper growth, worked to established implementation partnerships with the Big Four, and has guided numerous Fortune 500 companies through the digital transformation of their real estate portfolios and lease accounting compliance. He currently leads CoStar Real Estate Manager’s overall strategy development and operations.
Prior to joining Costar Group, Mark served on the professional services team for Manhattan Associates, a supply chain software company, and also spent time at Johnson Controls as a sales engineer in the building automation division. Mark received a Bachelor of Science degree in mechanical engineering from the Georgia Institute of Technology and earned his M.B.A. from MIT’s Sloan School of Management.
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