Peter H Burgher                                                                                                                  December 2011

 
Lease Me No More

They are at it again!  Now the FASB is fiddling with the rules regarding how capitalized Leases are accounted for.  Remember years ago much to the anguish of small businesses and mountains of protest, the predecessor to FASB determined that many Leases are really purchases and should be “capitalized” (i.e. assets and liabilities recorded in the balance sheet).  Amortization of the asset and liability would then follow to charge income for the “depreciation” of the asset and reduce the liability as payments are made.

Well, all of this is now up in the air as the FASB has created a proposal that would require asset amortization to essentially be two components:  one for the asset life and one for the interest implicit in the Lease payment.  This would have the effect of front-ending the expense so early years would show higher “costs” than later years.  Lessees like Walgreen and Wal-Mart are up in arms because of their relatively heavy reliance on Leased properties for their hundreds of properties that may have 20 to 25 year Lease terms.  The Wall St. Journal references Walgreen regulatory filings that say the proposed changes would have a material effect on its financial statements.

While many businesses are resigned to the negative asset and income statement effects of capitalizing Leases (a theory that has been around a long time), the people clamoring for a separate set of accounting principles for small non-public entities have not caught on to this latest assault on financial statement simplicity.  Meanwhile the FASB has apparently turned the other cheek to the European accounting regulators who seem to regard the newest Lease accounting proposals as a bad idea.  Retailers, airlines, multiple location Lessees, small businesses all will be affected if the FASB and IAFS agree.

Peter H. Burgher                                                                                                                      November 2011

 
Watch out for “Marks”

            Marking assets to current market prices is one of accounting’s recent imprimaturs – much to the dismay of small businesses and those who have to deal in or utilize volatile assets.  The requirement to write-up or write-down asset values in balance sheets emerged several years ago as the U.S.’s failed FASB moved to equal Europe’s far out accounting in fear of what inflation, if not recognized in balance sheets, could do to the recognition of income.

            Now there’s a new phenomenon.  The FASB has allowed selective “marking” of liabilities under the view that if assets go up and down, liabilities must have real value changes as well.  This permissiveness has invaded banking as one after another large institution has created income by reducing the payment values of debt.  According to Wall Street Journal articles Bank of American marked to market nearly 15% of its long-term debt in the third quarter of 2011.  Earlier J>P. Morgan swung to a profit for the quarter by the same means.

            This is pure insanity. The debt issuers are going to have to repay their debts dollar for dollar on what they borrowed notwithstanding they may be able to do so with deflated dollars.  Investors are warned to be aware of earnings temporarily improved by liability adjustments.  What comes around goes around as the saying sort of says – the worst case is basing investment decisions on some earning multiple applied to earnings based on “smoke and mirrors”.

            Unfortunately, all this shows the ineptitude of the U.S. FASB in blindly following the European model they so avidly desire.  Worse yet the ensuring complexity absolutely guts any hope of reality in the financial statements of our country’s non-public and small businesses who still must follow the same GAAP the big boys have crafted.  Watch out for “marks”!

Peter H. Burgher                                                                                                                      October 2011

 “OCT” – Other (not so) Comprehensive Income

            A long time ago the Financial Accounting Standards Board (FASB) ruled that some types of income are not really income so they had to be added directly to stockholder’s equity.  Forget what they are, it makes little difference  Suffice to say, splitting out some types of change merely added to bankers and analysts confusion over how t o evaluate a business’s operations.

            Recently, the FASB, in an effort to achieve better “convergence” of American GAAP with European IFRS issued an Accounting Standards Update (ASU) that eliminates the earlier pronouncement to put OCI into stockholder’s equity.  This incomprehensible move merely confounds an already murky situation.  Not only that the International Accounting Standards Board (IASB) immediately stated that the change merely complicate convergence and does not comply with IFRS.

            The new ASU requires any items of OCI to be reported in either of two ways – everything in one total income number or two separate statements one for income and another for OCI.  The ASU doesn’t change definitions of what goes into OCI, it merely confounds the reporting of what was previously required.  More fun comes up in the ASU where items can be reported gross or net of tax.

            Needles to say, the leaders of the IASB are non-plussed by all this.  The new head of IASB in on record as saying the U.S. had better get on board or lose its effectiveness in the race for one world wide standard.  Thing is, that battle was lost a long time ago.

Peter H. Burgher                                                                                                                       August 2011

Peter H. Burgher

2624 Indian Pass Road

Port St. Joe,  FL  32456

                                                                                                                        August 8, 2011

Board of Trustees

Financial Accounting Foundation

401 Merritt 7, Box 5116

Norwalk,  CT  06586

Dear Sirs:

Re: Private Company Accounting

            As a retired partner of a former “big 8” public accounting firm, I have worked as an expert witness in financial litigation for over 30 years.  Further, I have investments in a number of privately held businesses, including both growing and mature institutions.  Therefore, I have personal and financial interest in the now fully emerged problem of FASB  GAAP no longer meeting the business needs of owners, managers, bankers and investors in America’s privately held businesses.

            The surrender of US GAAP to inapplicable European accounting principles is an accomplished fact but applying such tortured methods to American privately held businesses is costly to management’s understanding of its operating results and frustrates both financer’s and banker’s ability to provide money and good service.  Cost is another matter as impractical and often useless exercises are required to comply with IFRS and our vastly revised FASB directed principles.

            While my experience with “cookbook accounting” leads me to believe a principle based system, like our old APB, is to be preferred, it is clear that IFRS is meandering down the same dangerous path as our long despised FASB.  I believe a principles based private company set of standards is required.

            The AICPA and its committees have been clear – the U.S. needs a separate private company principles making body as recommended by the “Blue Ribbon Panel”.  Standards released by such a body should recognize that the users and preparers of private company financial statements have different needs than international public companies.  All such standards should be compiled in a separate codification by the FASB.  Among other things, such matters as OCBOA, FIFO-LIFO, lease hold capitalization, single number net income and shareholders/owners retained income, etc. should be returned to historical methodology.

            Since the 1970s practitioners like myself have been concerned about and struggling with the deterioration of financial reporting under the FASB.  It is time to recognize the needs of American business.  Please implement the ”Blue Ribbon Panel” recommendations.

                                                                                                                        Sincerely,

                                                                                                                        __________________

                                                                                                                        Peter H. Burgher

                                                                                                                        CPA

phb:ed

Peter H. Burgher                                                                                                                            June 2011

 Private Company Accounting is Up in the Air

            For many years as the failure of the Financial Accounting Standards Board (FASB) to recognize the needs of non-public companies for simple principles based accounting guidance the thousands of private businesses in the U.S. have suffered from increased professional fees and reporting requirements that go beyond reality.  Finally, the crescendo against the excessive rules created by the FASB’s move to European accounting cook-book rule making become so loud and pronounced the Financial Accounting Foundation (FAF) appointed a committee to study the issues.

            The committee studied the needs of U.S.’s private companies and the complaints about the excesses of the FASB’s approach to Generally Accepted Accounting Principles (GAAP).  It took a long time. Among the complications created by evolving GAAP for international publicly held companies are the multiple income numbers reported in financial statements.  Community bankers have been completely at a loss as to how to understand annual and quarterly reports.  With three or more “net” income numbers how do you know what a company earned during the reporting period.  Basing credit decisions on earnings before interest, depreciation and taxes (EBITDA) fails to account for major fixed costs for example.  The impending loss of Last-in-First-Out accounting for inventories (LIFO), which measures income best for commodities based businesses, for example, confounds boards and management.  Capitalization of virtually all lease contracts is another.  Mark-to-market accounting is yet another.

            The “Blue Ribbon Panel” reported clearly that accounting principles had gone haywire for the U.S.’s privately held businesses.  A separate set of governing principles would be required.  Furthermore, the Committee said a separate board to set and modify standards for privately held companies was needed.  This approach struck at the heart of the FAS system.  The failure of the FASB to enact realistic and practical standards was apparent and became a non-starter for the governing body.  They “accepted” the report and concluded a separate rules making body would not be created.

            The American Institute of CPA’s (AICPA), caught in the middle, balked for awhile.  Then, a year later realizing that the majority of its membership served the very heart of American industry, private companies, the AICPA went nuts and publicly initiated a letter writing campaign to the FAS to urge creation of a separate set of standards and a separate body to create and administer them.  It is too soon to know whether common sense will prevail.  The first deadline coming up and will be in September 2011 when the results of AICPA’s stand will be known.  Will the FAS cave in?  We shall learn soon enough.

Peter H. Burgher                                                                                                                              May 2011

 The Last Word

This will be the last of some 20 or more years of monthly “audit alerts” and commentaries on financial standards, tax issues and economic matters.  Obviously, the objective of this effort has been practice development.  It has not worked.  In all this time only one bonafide expert witness engagement has evolved as an identifiable result and in that case the client failed to pay its fees.  So why spin our wheels to no avail.

Meanwhile, the FASB has recognized that private companies (in the millions) have little concern for International Financial Standards, manage by cash flow and, yet, still need some kind of financial statements for stakeholders, bankers and (hiccup) regulators.  Belatedly, the Financial Accounting Foundation (the FASB’s parent) has agreed to the creation of a one-time panel to formulate recommendations for a set of “private” company accounting standards.  The mission of the new panel will be “to establish exceptions and modifications to U.S. GAAP for private companies”, not to issue new standards.  The FASB has said it would “consider” input from all entities and identify potential exceptions.  A sunset period for the panel is proposed.

This is patently absurd.  Our country’s closely held “private industry” needs a cohesive and pragmatic set of standards to employ in reporting to stakeholders, lenders and authorities. Temporary exceptions will not work.  This is a last gasp effort by the ill-founded and poorly managed FASB to retain some semblance of control before it surrenders under SEC pressure to the European IASB in a full and confolusive abdication of U.S. authority over financial standards.  If they can’t beat the French, Germans and English they will still beat up on American business owners.  This series of developments are deplorable, but American entrepreneurs will focus on cash flow, tax reduction and asset preservation.

See my website for future commentary from time to time.

Peter H. Burgher                                                                                                                        April 2011

            As part of its initiative to “improve the professionalism of tax return preparers the IRS has imposed a program of fees ($64.50), tests and a number (PTIN) on every person who prepares a tax return for some one other than themselves.

            This means the legions of farmer’s wives, unemployed bookkeepers and others (in addition to CPA’s) who pay for lessons in August in order to prepare returns in January have to comply with the new rules.  Competency tests, continuing education courses and, yes, the fees have instilled pandemonium among the unlettered.  This may leave the H&R Blocks, Jackson-Hewitt’s (now advertising returns done for free, with limitations) and innumerable around-the-corner preparers short of workers. The result may be more people preparing returns and not signing them.  Absolutely the opposite of what IRS wants.  Even non-signing employees of registered CPA’s are covered by the new rules and the IRS threatens penalties on the preparer and “whoop-e-doo!” denial of  refunds, among other things, for clients.  A problem exists with people who don’t have or refuse (for religious reasons) to get a Social Security Number, required to get a PTIN.

            Further, any one preparing 100 returns or more must e-file them now. This will drive away filers, like myself, who believe that the harder you make it for the IRS to access your return (by paper filing) the less likely will be scrutiny thereof. The IRS has threatened non e-filing preparers with competency challenges, including refund and status denials.  The AICPA is fighting this battle, somewhat belatedly, it seems.

            In many cases, substantiation of facts claimed in a particular return is not capable of being reduced to e-filing or other electronic reproduction.  Letters acknowledging gifts, for example, will simply not reproduce electronically and they scan illegibly.  The IRS is out in left field on this one.

            Not only that, the IRS plans to visit preparers, how they are selected we don’t know. To date, the problem seems to be IRS visits don’t correlate with the types of returns they say will be targeted, like filers with schedule “C”.  One Mr.Fartis Fink is in charge and says this will be better targeted than in the past.

            More and more, it appears we are encountering “1984” with well-intended (we hope) government extending its claws into a once free-based society with expected consequences of deteriorating compliance, freedom and trust.  The enemy is us, unfortunately.

Peter H. Burgher                                                                                                                  March 2011

 Tax Alert – Uncertain Tax Position Disclosure

            In an unbelievable intrusion into taxpayer’s affairs, the IRS early in 2010 announced a plan (with proposed forms) to require all business taxpayers include a list of “uncertain tax positions” with their federal returns.  In September, after suffering a barrage of unfavorable comments and publicity, the IRS backed down somewhat. What the Treasury ends up with a phased-in shopping list of tax audit adjustments.  Principal provisions of the administrative action include:

• A five-year phase in for corporations with assets under $100 million for 2010, $50 million for 2012, $10 million for 2014 and beyond.  Businesses over the thresholds must file new “Schedule UTP” with their 1120s.
• Businesses must rank their disclosed “positions” including calculated interest and penalties and disclose positions exceeding 10% of all tax reserves reported in the UTP form.
• Rationale and degree of uncertainty (initially required disclosures) don’t have to be reported….yet.  Concise description is required.
• Positions for which no tax reserve has been recorded do not have to be disclosed….yet.  But where a position is expected to be litigated it must be disclosed even if no reserve was recorded.
• Audited financial statements are the key to which matters are required to be disclosed – compilations and reviews are exempted.
• Either recording a reserve for a tax position or taking a position in a return (regardless of which first occurs) generates an item for the UTP form.
• Positions or reserves set up before 2010 need not be reported.
• Enforcement action will be taken if there appears to be a failure to prepare the form.

No one knows how the IRS will utilize this new intrusion into business affairs in

 examinations in future years.  The burden on small audited taxpayers will be tremendous. The IRS states it will follow a “policy of restraint”.  Suddenly, it is 1984 again.

Peter H. Burgher                                                                                                             February 2011

            According to the Wall Street Journal about 30% of property and casualty firms’ investments consist of municipal bonds. Some well-known firms have as much a half of their portfolios in muni’s.  We’re talking billions here.

            There is a sell off going on in municipal bonds and to add to insurers’ woes imagine what will happen when today’s super low interest rates begin to rise to historical norms. The sell-off is said to be a result of massive new issue sales as governments and businesses supported by governments’ revenue bonds take advantage of the rate environment.  Concerns also exist about structural deterioration led by massive deficits in key well-watched heavily populated states.

            Now, to the accounting implications of this situation.  First, when portfolios decline today’s market-to-market accounting environment requires paper losses to be booked.  This hits reported income and can theoretically wipe out stockholder’s equity. Some have muni portfolios amounting to or exceeding stockholder’s equity so the risk is large enough to be worrisome.  A ten or twenty percent decline in portfolio values simply cannot be offset by operating earnings.

            Just as you were warned about investments in big banks a year ago and big operating companies a year before that (all of which came to pass) now it is insurance companies turn.  With big borrowers flirting with insolvency or possible even bankruptcy bad things can happen to the markets. Follow up with interest rate increases and you have a recipe for trouble.

            Some holders of large amounts of muni’s have divided their portfolios and are trying to trade their way out of this dilemma, keeping local issues and letting others hold the troubled states’ bonds.  But they cannot avoid the interest rate environment which has to change.  Buyer beware.

Peter H. Burgher                                                                                                                          January 2011

 The Slowed Down Speed Up

In April, the U.S. Securities and Exchange Commission (SEC) decided to require U.S. securities issuers to use IFRS (International Financial Reporting Standards) but not before 2015.  Short of a definitive vote the SEC said it “supports” the move away from U.S. Generally Accepted Accounting Principles (GAAP) and will vote again in 2011 to make it final. What this really does is it puts U.S. publicly held companies in a position where major accounting changes must be readied but not used in such areas as:

-         Fixed Asset accounting; composite asset accounting must be replaced by separate components and asset values may be reduced

-         Inventory accounting; LIFO goes away and new cost assumptions appear

-         R&D accounting; early capitalization, product life cycle and other changes

-         Compensation accounting: share grants separated into groups and amortized

There’s more but the issue is how do U.S. companies get ready for a moving target. Since I have been writing about the absurdities of IFRS it has migrated further into the mysteries of the east.  Meanwhile the U.S. Financial Accounting Standards Board (FASB) has struggled to keep up as it tries to move GAAP to IFRS.  Some flip flops have provided embarrassment.

Some large companies are complaining about the cost of waiting.  Surprisingly few are complaining about the basic objective.  The feeling among large issuers seems to be not to worry about what system as long as everyone is measured by the same system.

Meanwhile a fierce debate has emerged as the groups representing U.S. non-public companies are complaining bitterly about being forced into an arbitrary, high cost European system.  Some in the FASB take the position that every business, large or small, must use the same rules while others see the need for a simpler way for private businesses.  This debate is not over yet.

Against this background another migration has taken place.  IFRS was once advertized as a principle based system (a good idea) but recently it has started to move to a rules based system.  This is what has generated major criticism of U.S. GAAP.  The more rules there are the more gaps there are to wiggle through (Lehman Bros., Merrill Lynch, AIG, Enron, et al).  The SEC appears not to have caught on to this and our ineffective FASB seems to have embraced it. There will be more to this in the next few years.

Peter H. Burgher                                                                                                             December 2010

Fraud is not out of Style

            It sometimes amazes me how often I am asked to evaluate a case where fraud has been perpetrated on a business. Happens regularly unfortunately.  Recently the Wall Street Journal published a well done article by a writer named Rob Johnson.  Below are summarized Mr. Johnson’s recommendations and some of my own.

1. Separate accounts receivable (collections) and disbursement responsibilities even if it means hiring an extra person.
2. Have an outside auditor do at least a review annually or more often if possible.  A full audit is a good idea because it involves independent confirmation of balances and will get into inventory and cost questions.
3. Make sure employees involved in finance take vacations and someone else fills in for them.
4. Watch for upward changes in employee’s life style, cars, vacations, girls, gambling or booze.
5. Be alert to opportunities for vendor kickbacks, watch for unusually close relationship.  Look for mysterious increases in purchase prices or quantities.
6. Open and review bank statements before anyone else sees them – just showing your involvement is a useful preventative.  Investigate items you don’t find familiar.
7. If your bank will let you, examine cancelled checks from time to time for unusual or spurious payees or endorsements.
8. Make sure you see the receipts for federal, state and payroll taxes, often a source of cash for miscreants.  You want to be sure taxes are paid.
9. Include provisions for encouraging “open door” reporting in your employee manual and mean it. Anyone suspicious of misappropriations should feel comfortable in reporting with confidentiality.

            No one is immune – I have seen law firms, title companies, manufacturers, distributors, engineers, contractors, employee leasing companies and more hit by employee misappropriation.  If you are not proactive about it you may be next.

Peter H. Burgher                                                                                                                     November 2010

 How Many Angels?  

My friend and client, Harvey Sarles, President of Narragansett Capital used to ask when discussing accounting principles “How many angels dance on the head of a pin?”, echoing the fierce debates among medieval monks, concerning the principles of emerging Christian philosophy.

Undeterred by the race to embrace European accounting the (U.S.) FASB has uttered another meaningless principle change effective June 15, 2010.  This time it’s about recording revenues when there are multiple deliverables for one price.  Examples are cell phone contracts, autos with free maintenance, some machine tool sales, and even mattresses with replacement guarantees.  This is distinguished from sales with extended warranty.

ASU 2009-13 was released in 2009.  Basically it reverses previous methods which measured and allocated revenues for deliverables over a period of time based upon available objective and reliable fair value of the elements to be delivered.  FASB missed the fact that International Accounting Standards No. 18 indicates the old approach.

The new rules require a relative selling price method to be used.  Vendor specific objective evidence (VSOE) and third-party objective evidence (TPOE) are the terms employed.  GAAP now replaces the term “relative fair value” with “relative selling price” for which accountants must now refer to VSOE and TPOE.  If they are not available, the fall back procedure is to calculate what each deliverable would sell for if sold alone.

Along with this purely hypothetical reversal is a mandate for greatly expanded disclosures regarding how revenues are allocated to multiple periods.  For many companies disclosure of multiple element revenue recognition will occur for the first time.  It would be helpful to clients to tip them off to this iceberg early on.

            If you are a bank executive the answer to this question is decidedly negative.  The FASB is at it again, rather than its quest to emulate European accounting principles the FASB is making new “law” solely for U.S. banks on two levels.

            First, the FASB makes it harder to level bank earnings by proposing that every outstanding loan receivable be marked to market value in financial statements.  So, in addition to collection risk reflected in loan loss reserves, banks would also have to adjust loan values for interest rate fluctuations and, by implication, economic and ecological risks.  Banks don’t normally write down loans that are performing well but now they will have to if the proposed rules prevail.  In the spring I warned about investing in bank stocks.

            Next, the FASB has proposed a reallocation of charges in bank’s income statements.  The proposed would require interest income to be charged directly for loan loss provisions relating thereto.   Previously loan loss provisions were recorded separately in the income statement.  The idea is to reduce net interest margin by loan loss provisions.  The FASB hopes this change will make it more difficult to front load net interest margin (which I question as a procedural matter).  Investors will have a hard time finding numbers they are accustomed to or comparable.

            As if banks don’t have a hard enough time these days, the FASB is assiduously striving to make bank investments less attractive.

Peter H. Burgher                                                                                                                   September 2010

 New Taxes on Health Care (plans)

Everybody (almost) breathed a sigh of relief when Congress finally passed “something” related to insurance on health care – some because the wait and uncertainty was finally over and some, in confusion, thought they got what they wanted.  What almost everybody missed is the tax consequences of Congress’ action.  Behold the list below:

TAX IMPLEMENTATION SCHEDULE OF “HEALTH” LAWS*

2010                                Small business tax credit

Adoption credit increase

Adoption assistance program increase

Tanning excise tax

2011                                Prescription drug coverage deduction eliminated

W-2 reporting

SIMPLE cafeteria plans

Restrictions on use of HAS and FSA funds for over-the-counter drugs

Tax on HAS distributions increases

2012                                1099s required for payments to corporations

Adoption credit sunset

Adoption-assistance programs sunset         

2013                                Increase in medical deduction threshold for taxpayers under age 65

Additional hospital insurance tax on high-income taxpayers

Medicare tax on investment income

Fees on health plans (after Oct. 1  2012)

Medical device excise tax

Flexible spending arrangement maximum imposed

2014                                Premium assistance credit

Excise tax on uninsured individuals

Excise tax on applicable large employers

Insurer reporting requirements

Eligible premiums included in cafeteria plans

2017                                Increase in medical deduction threshold for taxpayers age 65 and over

2018                                Excise tax on high-cost employer plans

 No wonder no one can project whether the legislation can be priced out.  Will it pay for

itself?   Or will it cost billions?  No one knows, but we do know it’s going to cost us more than it used to.

Peter H. Burgher                                                                                                                   August 2010

 Limited Liability does not mean Limited Deductions

            In a victory for taxpayers the Federal Tax Court has recently held that an LC member does not lose the ability to deduct operating losses due to “passive activity”.  In Newell v. Commissioner the tax court looked beyond the fact that an LLC member has limitations on liability.  The IRS had taken the position that being a member of an LLC per se meant that passive activity limitations applied.  The taxpayer incurred losses while participating both as an investor and as a part-time manager of several business projects for a number of years.  In general, IRC Section 469 disallows recognition of losses or related credits from trade or business activities in which taxpayers do not materially participate.  Temporary Treasury Regulation ¶1.469-5T(c) (3) has several provisions that, among other things, has an exception to limited partnership interests for general managers.  Otherwise, partners having fixed liabilities may be deemed to be passive.  In the instant case, the Tax Court found that while the taxpayer did have limited liability his managerial activities functioning as a general partner overcame the passive activity presumption.  Passive activity losses can only be used against passive activity income, hence the potential for limitations on deductibility.  We note the taxpayer here was only part-time in each of his business interests which fortunately for him did not undermine his managerial status.  The IRS has not acquiesced gracefully in this arena.  Recently, it issued a memo on another decision that held an LLC is not a limited partnership, but it has so far not given in on Newell.  So beware, keep records, maintain proofs and be prepared for a fight unless you have plenty of passive income!

Peter H. Burgher  
                                                                                                                          July 2010

            Lest you may have thought there were enough outfits messing around with accounting principles along come The Private Company Financial Reporting Committee (PCFRC) which put itself together to advise regarding principles and pronouncements relating to non-public companies and non-profits.  To make matters more interesting, the FASB has come up with a new way to communicate its conclusions – The Accounting Standards Update (ASU).

            There are now six ASU’s and one of the more interesting ones has to do with accounting for income tax uncertainties.  The PCFRC admonished the FASB to obliterate Financial Interpretation (FIN) 48 to private companies.  It is a hodge-podge of rules about what’s likely and not likely to happen regarding tax accounting decisions.  The FASB declined to do so.  But what they did do is delay application of FIN 48 for non-public entities from its original 2009 implementation.  The FASB modified FIN 48 by revising an Accounting Standards Codification (ASC) to eliminate disclosure requirements in paragraphs 740-10-50-15 (a)   through b) for non-public, non-profit and pass-through entities.  You might be comforted by the knowledge that ASU 2009-6 modifies ASC topic 740 which previously was FIN 48.

            Truly, the accounting standards scene has become a bag of mush.  With pronouncements contradicting announcements and advisory opinions modifying positions, the accounting

establishment has become a zoo for businesses the world over.  The competition between GAAP and IFRS has almost ended with the U.S. on the short end of the stick.

            A little statistic shows how bad it as become for the accounting profession.  Recently one of the major CPA firm’s annual report statistics revealed that 20% of the firm’s head count is comprised of non-client handling personnel. Now, there have to be some people in HR and administration, but the task of keeping up, training the troops and quality control has eaten deeply into their profitability and performance.  It’s not likely to get better soon.

Peter H. Burgher 
                                                                                                                             June 2010

            Creditors are faced with an enormous set of problems these days, not the least of which is the possibility of “phantom” taxable income created by an exchange of old debt for new.

            Unless a debt exchange qualifies as a full recapitalization even modifications which the Treasury deems as significant can result if taxable income.  A material change in yield, for instance, or receipt of consideration for a change in terms could be treated as an exchange of old debt for new.  Then comes the problem of measurement.

            Taxable gain or loss generally is the difference between the creditor’s tax basis of the “old” debt and the issue price of the “new” debt plus any money or property received in the exchange.  Issue price is the stated principal of the new debt if not publicly traded (beware of pumped up paperwork).  Publicly traded debt is priced at fair market value (sometimes hard to obtain).  A big risk is debt purchased at a discount and later exchanged at a new higher arbitrary value.

            A non-taxable recapitalization can occur if both the old and new debt are deemed to be a “security” (generally debt with a term of 10 years or more).  Five years or less is definitely not a security. Also, exchange of a security debt for equity qualifies as non-taxable.  But even recapitalizations that start out looking as non-taxable can become taxable gain (but not loss) if the principal of the security surrendered is exceeded by that of the security received or if there is cash or other property added and it all adds up  to more  than the tax basis of what was turned in.

            So the moral of the story is beware of swaps and get good sound advice from a tax professional before you agree to anything.

Peter H. Burgher                                                                                                                            May 2010

 What is the Value of a Gift?

            In a rare victory for taxpayers the U.S. Tax Court (Pierre v. Commissioners 133 TC no.2) ruled that a taxpayer who formed an LLC and then gifted a small portion of ownership to a son and granddaughter was not taxable on the remaining underlying assets subsequently sold to them.  This discussion is simplified for clarity.

            At issue was the question whether the check-the-box regulation (as a disregarded entity) merely covered tax form filing or whether the IRS could extend its meaning to addressing valuation of assets.  In this case the taxpayer did everything right in giving enough to her descendants to utilize the unified credit and subsequently selling them the balance of the LLC’s assets.  The IRS chose to expand on its own regulations thus posing a significant tax exposure risk to the careful taxpayer.  They wanted to gift tax the entire asset value of the LLC.

            The tax court held that while check-the-box regulations determine how a single member LLC is taxed for federal income tax purposes they do not govern how a donor should be taxed under federal gift tax provisions on transfer of ownership of an LLC.  For federal gift tax valuation state law rather than federal law determines the nature of a taxpayer’s interest in transferred property.  Here interest in an LLC is considered personal property and a member has no interest in the underlying assets of an LLC.

            As a result, the transactions were left alone and the transfers were properly valued as transfers of interest in the LLC and not of its underlying assets.  A rare taxpayer victory.

Peter H. Burgher                                                                                                                          April 2010

 The Trap in IPR&D

            In Process Research and Development (IPR&D) has undergone major accounting changes under FAS 141(R) about which we have previously reported.  The effects and implications of that bulletin are just now becoming recognized by the investing industry.  As we reported at the time FAS 141 (R) was issued, previously companies acquiring businesses that had in-process research merely recorded the fair value of what was being acquired and immediately expensed it.  This was consistent with the previous accounting theory that R&D had to be expensed as incurred.

            Well, all of that has changed.  Under FAS 141 (R) acquiring companies must first record the “fair value” of IPR&D in their balance sheets.  If projects succeed, a useful life is then assigned and the “asset” is amortized.  If projects fail or are abandoned the “asset” is written-off.  Partially successful projects are later treated as impaired and partially written off (leaving some value presumably).  This whole approach comes from European attitudes that leave enormous judgement calls to the accounting establishment.  Earnings “management” can be troublesome in businesses that have a high level of R&D investment.

            A big change in contingent consideration arises from FAS 141 (R).  Previously, unearned contingent payouts were not recorded until earned for certain.  Now the entire potential earnout must be recorded as acquisition date, only to be written off if ultimately nothing is earned or payable.  Watch out for impairment of other assets recorded at acquisition if earnouts are reversed.

            The increase in requirements for higher level and more frequent subjective judgements may create opportunities for leveling earnings volatility and surely will increase risks for earnings disappointments.  Recently an attorney in northern California opined that FAS 141 (R) has enabled plaintiffs to “transform a routine disclosure claim into one for accounting fraud” a time bomb that may explode in the future.  Litigation risks have increased significantly.

            Heightened attention is warranted on monitoring fair values not just at acquisition date but long thereafter.  Regular appraisals are almost mandatory, meaning continuing higher compliance expenses.  Operating departments must be made aware of their new responsibilities to be alert and communicate changes that relate to recorded “fair” values.  The FASB has created a bucket of worms and the rascals are climbing out all over the place.

Peter H. Burgher                                                                                                                          March 2010

            Under the belief that relaxing independence standards for CPA’s practicing compilation and review engagements will promote greater CPA participation in preparation of financial statements, an AICPA committee has proposed dramatic reductions in independence standards.  First, some explanations.  Compilations are engagements where the CPA basically assembles information given to him by management into financial statement format.  No verification, no disclosure requirements.  Reviews are a step above in that they do not require external verification or inventory observation but they do require consideration of proper disclosure and accounting theory and standards.  If fraud is suspected it must now be investigated, reported and disclosed.  (Note – these are not technically precise explanations.)

            The proposals now put forward include a requirement for an engagement letter – a written understanding with the client concerning the services to be performed.  I had always thought this to be the case but now it’s to be clearly mandated.

            The primary new proposal would allow CPA’s to perform review engagements when independence has been impaired by performing services to prepare “higher quality or more reliable” financial statements.  In the real world this is already the case in many if not all small business engagements what often happens is the CPA puts together a report that management or internal accounting personnel haven’t the ability to accomplish.

            In another proposal, the committee recommends that CPA’s have the ability to be non-independent in doing compilations as long as t he reasons for lack of independence is disclosed in the report. This makes the report a “so what”.  The CPA is today required to render a report if he is associated with a financial statement in any way (such as putting the numbers together).  The reason is that it’s better to know what the CPA did or did not do than know nothing.

            There are 31,000 practitioners in the U.S. who are largely the servants of small businesses many of which require outside help in obtaining any type of financial statement (monthly, annual, tax returns, bank reports, etc.)   In some case the CPA is actually a de facto internal control for the business.  Correcting mis-statements in records and financial statements is what CPA’s do.  This should not be considered wrong.

            Reality is, the AICPA is preparing to accept reality, so the proposed changes are not a revolutionary as they might seem a first sight.

Peter H. Burgher                                                                                                                   February 2010

 
What’s Fair is Fair, or is it?

            Well, maybe it’s not.  As accounting rule makers in the U.S. rush to conform U.S. GAAP to European standards by 2011, questions arise as to what is truly fair value.  Suffice to say there are major differences between what has been written by the FASB and others in the U.S. and what seems to be generally the word in Europe.  In the U.S. FAS 157 has been replaced by an obscure new rule system and “Topic 820” covers value determination.

            Specifically, Topic 820 requires considering a “principal market” or the market with the greatest volume or level of activity.  If none exists, FASB says it’s OK to look for any value that is available and could be the most advantageous.  In private equity value measurements it is difficult to value assets that don’t trade or trade only infrequently.  Some have to resort to using appraisers who bring in ratio rationales, not actual trading data.

            Under International Standards one only need look as the most advantageous market.  While this seems a small difference, consider your friendly bank that under FASB has to book all assets at fair value, while under IAS they would merely record loans at amortized cost (new idea to us in the U.S.), moving fair value measurements. Imagine what this means in an environment of declining housing values or rising interest rates.

            And, to the surprise of many the chairman of the FASB recently announced that it was not their intention to put banks in jeopardy and that he will recommend that banks be separated from the rest of us and allowed to use “amortized cost” as the basis for loans and investments instead of market value.  This could put millions back into balance sheets.  Maybe even offset the impact of recording variable interest entities in bank statements.

            New rules are promised for early 2010 and final rules later on.  Whether the leaders of both tribes can merge highly differing philosophies remains to be seen. Meanwhile, U.S. financial statement issuers are going to struggle through preparation of year-end reports in a highly confusing environment as rules seem to change almost every day.  Best advice is to hold off issuing required reports as long as possible in the hope that some codification may occur before deadlines are close to limits.  For public companies March 31 is a critical date for the SEC, but other industry pressures may require earlier issuance.  For private companies, consultation with lenders and interest groups is advised.

Peter H. Burgher                                                                                                                    January 2010

Individuals, limited partners, companies all face a serious consequence when foreclosures, short sales and loan modifications occur.  In today’s financial crisis such occurrences have become ordinary and frequent.  So the best advice is to become informed and wherever possible plan ahead.

The tax consequences of the loss of property through foreclosure are hugely different depending on whether the mortgage is recourse or non-recourse.  Cancellation of debt will create taxable income if the debt is recourse – that is the property owning individual has agreed in writing to pay or support the obligation. With a recourse note the sale price of a foreclosed property is assumed to be its fair market value at the time of foreclosure. With a non-recourse note the sale price is assumed for tax purposes to be the amount of the note. Thus, while the non-recourse note issuer has no taxable income, the recourse note issuer can have considerable “income” even though he may get nothing for his property.

The same principles apply for pass-through entities like LLC’s and limited partnerships.  With debt restructuring or debt buyback income can also occur for tax purposes.  Generally the taxable amount is the difference between the old debt and the new debt.  There is a window of relief, however, for debt restructurings in 2009 or 2010 in which the taxable amount can be deferred and amortized over a five-year period beginning in 2014.

So, to recap – a foreclosure of a non-recourse note is treated as a sale by the owner to the creditor for the greater of the fair market value of the property or the outstanding debt.  No income is recognized for the difference between the tax basis of the property and the “sale”.  If the property owner is on the cash basis of accounting accrued but unpaid interest is ignored.

Cancellation of debt income becomes ordinary income if the debt exceeds the fair market value of the property on a recourse note.  Some rules apply:  for instance, such income is taxed only if the debtor is solvent at the time of foreclosure. Cancellation of debt income is not taxable in bankruptcy. But these exceptions are not applicable at the entity level:  they only apply to individual members.

Bankruptcy is a complicated matter with a whole set of its own special tax rules that must be carefully studied before considering that route.

Consultation and advice are highly recommended.