Agency and revenue

~ C.O.R.E. Beliefs ~ Leave a comment

One of the more interesting challenges we had in the past twelve months was convincing a client that they didn’t really have revenues and expenses but instead commissions.  It actually held up the issuance of the review of their financial statement until we had agreement.

The issue in question had the following fact pattern:

  • OpCo (the client we were reviewing) had a contract with a larger business (GenCo) to provide a specific set of services at a price established by GenCo.
  • OpCo would sign up customers who would receive GenCo services
  • OpCo did not purchase GenCo goods or services for resale
  • GenCo provided all the technical expertise and it was included in the price customer paid

When OpCo submitted their financial statements, it reflected $2.0 Million in revenues and $1.5 Million in “cost of sales”.  OpCo, anticipating the issue, engaged another firm to address the ASC 605-45 “Principal versus Agent” issue.  This firm’s research concluded that the revenue met the criteria for reporting as a Principal.

We disagreed.

Our starting point was at the 50,000 foot level.  Why does it matter if revenues are reported net or gross?  The client was insistent it had to be gross.  In any type of attest engagement, the big red warning flags start coming out when a client is insisting on a specific treatment.  By asking a few questions about their motivation we discovered that they were trying to woo a prospective buyer who was only interested in a target with a certain level of turnover.

Knowing this, we applied the key points of ASC 605-45.   The first issue is, “Who fulfills the contracted services?”  Our reading of the contract clearly indicated that GenCo had the technical team which would provide the services. OpCo had sales agents who went out and signed up customers but those customers were ultimately engaging GenCo.

The next key point was, “Who set the price?”  The contract stated that the base price for GenCo’s service was $15,000 and their suggested customer price was $20,000.  OpCo earned 50% of the spread between the final negotiated price and the $15,000.  While this was a little tricky, the substance is that GenCo set the floor and ceiling prices.  As a matter of fact, no customer agreement had a price above $20,000 and the only time it was lower was when a customer had multiple sites and therefore earned a volume discount.

Another major point, but related to the first one, was “Was the service modified in anyway by OpCo?”  Since the service was provided by GenCo and, other than having an OpCo sales agent complete the paperwork, there was no ongoing involvement by OpCo EXCEPT for sales follow-up, it appears that OpCo did not modify the service.

We ended up in a meeting with the client’s senior management and the other firm.  We pointed out the flaws in the logic and, ultimately, the risk to both the Company and us as the reviewing firm, if we allowed the statements to be issued on a gross basis.  The net effect was the same: The problem is that there was going to be reliance upon the statement which could have been considered misleading.  The client agreed to restate the financial statements to report only the “commissions” earned.

If you are unsure if your accounting treatment is correct and would like to discuss the impact of how you are reporting, feel free to contact me.  We will look at the big picture and work our way down to the appropriate level of detail so you can feel comfortable that your position is accurate.  Remember, your business is issuing a financial statement that someone plans to rely upon so using an inappropriate accounting model could cause you problems down the road. And if you would like more information on how our audit and review services could be helpful to your business or non-profit, find out more about us here.

Have a great Tuesday.

 

Financial Statement Compliance

~ C.O.R.E. Beliefs ~ Leave a comment

Doug and I were primarily responsible for audits and reviews and Currie & McLain CPA’s and this has rolled over to our new venture C.O.R.E. Services, LLC .  While we focus our efforts almost exclusively on audits of condo and homeowner associations, we also provide review services for clients of smaller CPA firms in Oregon and Washington who prefer to focus on income taxes. We think it can be a great partnership all the way around.

We conducted many financial statement reviews during 2017.  And, as odd as it sounds, each of them was facing a going concern problem.  While this is not a rehash of the new accounting standards for going concern, we did want to point out what we look for and what management needs to consider.  This can be very important with your year-end possibly approaching and you want the review to be completed early.

For the clients whose financial statements we reviewed this year, the number one driver of the going concern evaluation was non-compliance with bank covenants. For instance, your loan agreement may state that your business must maintain a current ratio of 1.25:1.00.  This means that you must have $1.25 in current assets – cash, a/r, inventory to every dollar of current liabilities – a/p, accrued payroll, current maturities of debt.

Another covenant we typically see is some sort of debt coverage ratio.  This is typically calculated as the current debt obligation divided by earnings before interest, taxes, depreciation and amortization (EBITDA).  if it says you must have a coverage ratio of 1:1, then if you have $1.0 Million of current debt obligations you need to earn $1.0 Million in EBITDA.

The problems arise when one or both of these are missed and missed by a lot or for multiple years.  Most of the financial statements we reviewed reported a second or third year where the current ratio and/or the debt coverage ratio were well below the requirement.  The problem is that, technically, the bank can call the debt, forcing the owners into very painful decisions.

What can management do?  Well, the first step is to admit the problem.  Non-compliance with bank covenants should not be a surprise to management, the owners or the bank.  Typically, the bank will require some sort of plan to address the covenant violation.  This may be as simple as a cash flow projection to a complex plan to sell assets and lease them back to generate cash to pay down a line of credit.  Whatever you do, don’t bury your head in the sand.

The second step is to prepare a disclosure for your financial statement.  Now, I know that typically you expect your accountant to write up the notes but this is one where you may want to be involved.  Your company is on the line and the reader, i.e. the credit officer at the bank, may well decide that your plan can’t deal with the problem and start creating solutions for you.

If you would like some ideas of how to disclose the going concern issue and your plan, let us know  by writing to info@core-acct.com and we will be happy to send you an outline of the disclosure we have clients complete.  The vital thing though is to provide enough detail that the reader can see the issue and understand your plan without investing so many hours that it distracts you from the issue of running the business.

The third step is to get the bank to issue a waiver or forbearance on compliance.  Stay in control here because this can become a circular problem since the bank will want the reviewed financial statement to know where your business is and the accountant will not want to issue the reviewed financial statement without the forbearance.  It requires a good deal of communication to make this work and it is very helpful if you can get them together for a conversation.

A going concern issue is possibly the single biggest financial statement headache you are likely to ever have to address.  Get in front of it early and work closely with your bank on getting approvals in place and with your accountant to draft the plan for inclusion in the notes and it is very likely that you can still meet a respectable turnaround time for producing the financial statements.

Have a great Monday.

Understanding trusts

~ C.O.R.E. Beliefs ~ Leave a comment

We have been involved with a very interesting project related to a trust.  I obviously won’t go into the project details but think the over-arching issues are worth trying to understand so hopefully others won’t run into this particular problem.

Hal and Wilma set up a living trust in 2005.  They have 2 biological children together and Hal has 2 children from a previous marriage and Wilma has one.  The kids are named Adam, Bob, Claire, Denise and Ed.  All are over the age of 21.

There are 3 primary assets in the living trust: The home worth $500,000, a joint investment account worth $500,00 and a business worth $5,000,000.  The business was started by Hal in 1984, prior to his marriage to Wilma.  The shares always remained in his name.  And, the business was treated as a Subchapter S Corporation.

Obviously H&W want to ensure that all the kids are taken care of.  To do this, Hal and Wilma set up a trust where, should Hal die first, Wilma would receive “income for life” from the business and upon her passing, the shares would be distributed to the kids.

Hal passes away in 2014.

The trouble begins almost immediately.

The two children from Hal’s first marriage immediately demand the shares be distributed to the final beneficiaries.  Their argument is that Wilma was entitled to only the income, not the actual ownership of the shares.  Naturally, Wilma didn’t agree but to ensure that the kids would feel like they in fact had “control”, Wilma had an LLC set up.  This LLC was set up with the kids owning a Class A interest and Wilma owning a Class B interest.  The Class B interest paid a Guaranteed return of 8% and did not allow for participation in any increase in value.

Sounds great right?  Wilma gets her $400,000 a year and the kids get control of the growth in value and any cash which may result from a sale of the business.

Bzzzz.  Thanks for playing.

Technically, the transfer of the shares in the business invalidated the S election since the trust was not a Qualified Subchaper S Trust (QSST).  We could probably get around that little headache but it is compounded by the subsequent transfer of the shares to an LLC.

An LLC is not a qualified owner of S Corporation interests.  So even if we could convince the IRS to ignore the QSST issue, the LLC issue killed everything.  And now we have to address 2014, 2015, 2016 and part of 2017 where the business issued distributions to Wilma but where the owner was the LLC.  Like I said, an interesting problem.

What should we take away from this?

  • Do not try to do tax and estate planning on your own.  It is easy to set up and then think you can update your documentation without talking with an expert.  Spend the money and time.  Especially if you own and operate businesses.
  • S Corporations are simple, except for their ownership structure.  Side deals with S Corporations can lead to trouble as it is easy to have nonqualified ownership or two classes of stock – all without meaning to.
  • If you are not going to gift S Corporation stock directly to your kids, then you need to plan and set up the proper trusts to protect the ownership.  To have one person receive the distributions while another gets the vote really requires the correct trust type.  This little detail gets overlooked sometimes and it can cause big problems.
  • If you own an operating business, it may be wiser to avoid titling it to a living trust.  And, if you own in jointly with a spouse, it may be better to issue a separate ownership interest to the spouse to avoid shares going in the wrong direction.
  • An LLC treated as a partnership is a great tool for planning and wealth transfer in many instances.  It can take the place of the Family Limited Partnership.  But somethings can’t be owned by an LLC.  And somethings don’t work well inside one, especially if there are guaranteed returns with insufficient cash being generated.

Thank you for the opportunity to share this little exercise.  If you have questions or thoughts, feel free to comment.  Have a great day.

 

My two cents on taxes

~ C.O.R.E. Beliefs ~ Leave a comment

Many of you know I have practiced accounting and taxes for many years, even after taking a break to work with a start-up.  I work mostly with small business owners who have incredibly high hopes and dreams and who have never met an opportunity for zero taxes they haven’t liked.  I am also incredibly honored to be working with Doug McLain on our new start-up C.O.R.E. Services which focuses on condominium and homeowner association audits and reviews.

There are several aspects of the congressional tax debate I am struggling with.  First, does the current approach of taxing income need to be changed?  Second, will rewriting tax law address fundamental issues of fairness, competition and profitability in business?  Third, can reforming how we collect taxes address underlying social issues that will need to be addressed to move this wonderful country into a world where technology, not people, produce goods and services?

I am not an economist or a political type.  I am a practicing accounting and tax theorist.  And I doubt if my missive here will explore all the nuances of the three questions – at least in one post.  But I want to take a stab at it in hopes that my friends and colleagues around the US will weigh in before we take this plunge.

Does the current model of taxing income need to be changed?

I have argued for several years that the model of income taxation is problematic for a net consumption society.  What I mean by this is that the US overall consumes more than it produces domestically.  By taxing production through income taxes, the US continues to exempt internationally produced goods.  Which means that our legislators spend considerable effort trying to find new ways to capture taxes on these non-us produced goods.  It is not successful.

The problem with taxing income is that it relies upon someone defining the term.  Income, profit, is revenues less expenses.  Sounds simple.  But, what is revenue?  What is an expense?  If you think I am being rhetorical, the accounting profession has rewritten the rules of accounting for revenues under ASC 606.  There is no one simple definition of income and when legislators get involved, they try to pick winners and losers to society’s detriment.  Again, look at the current plan of allowing businesses to immediately write-off all business equipment purchased by supercharging section 179.  Small business can already write-off $250,000 of new equipment so who benefits from this?

It is probably time for the US to rethink its approach to the collection of taxes to pay for government spending.  So, reforming the concept of taxes is a good idea and it should address the fundamentals of how to simplify collection and reporting and probably even address what is the most effective way to ensure sufficient tax inflows to cover government’s spending plan.

Will the current attempt at tax reform lead to fairness, competition and profitability in business?

The problems I see in the current approach to tax reform is that there is no attempt at creating a truly level business playing field.  As a case in point, lets look at the claim that creating a new tax system for pass-through entities will enhance fairness, competition and profitability.

First, a basic primer on choosing an entity.  The primary choice for most operating businesses is the corporate structure.  In the US, we have two types of corporations – C corporations and S corporations.  The S Corporation has certain restrictions as to when it can be used and in return offers certain benefits to the owners.  The C corporation has minimal restrictions on its use and has certain costs to its owners.

The C Corporation pays taxes on its profits.  The S Corporation does not and instead passes the taxable profits to its owners who pay the tax as though it was earned by them.   Because the profits are taxed to the C Corporation, if it decides to issue dividends then those dividends are taxed by its owners.  This is the primary dreaded double taxation.  This can, at times, run to a combined tax of over 50%.  Not that any one person sees that though.  The S Corporation, on the other hand, can issue the dividend with no additional tax because the owners already paid tax on the income.  No double taxation.

So, while the two types of businesses operate and issue dividends, the S Corporation is tax advantaged as its earnings are taxed at a maximum 39.6% and C Corporation earnings at about 50%.

Getting to the point.  Today, any business which meets certain basic rules can be an S Corporation.  The current reform effort wants to change that so certain “professionals” such as lawyers, doctors and yes accountants, cannot be.

This is the antithesis of fairness and creating a level competitive playing field.  Again, I work with many small business owners all of whom spend far more hours at their company than I do and whose sole efforts make or break their small business.  How is that widget makers profits any more special than a doctors?

I and other tax professionals have disliked some aspects of the S Corporation tax law forever but this attempt to fix it seems worse than the original problem.  To be a little snarky, I do appreciate the opportunity for continued employment though as small businesses will spend considerable sums of money hiring professionals like me to help them avoid some aspects of any new tax law where certain professions are targeted; likely even more than they pay us now.

Finally, how do we reform tax law so that it puts the US on a path to ensure that our spending priorities are met in the future when production is something that has even less human intervention than it does today?

Obviously, the fly in the wine we should address is the fact that, at the federal level, the US spends $3.0 TRILLION annually and only taxes about $2.0 Trillion.  To be fair to America, tax reform should first address that the spending amounts agreed to by congress should be met with an equal amount of tax inflows.  Yes, I am in favor of some sort of balanced budget requirement – although I think it should be modified so infrastructure spending is not part of a current budget cycle as its benefit spans multiple years and decades.

But the important thing about this is, if legislators want to spend $3.0 TRILLION and we, as the voting public agree, then find a way to bring in tax inflows which equal that amount.  Get rid of the gimmicks and funky multi-year accounting games.

Next, we need to evaluate how wealth is generated in America and it should be taxed to support our social goals.  Sorry, but again the reality of taxing income likely needs to change which leaves us with few options.  The hard truth is, ensuring that lower and middle income citizens have discretionary cash flow benefits the wealthy, not the other way around.  So tax reform should focus less on people earning a wage and receiving wealth transfers and more on those who have the disposable wealth.

The current attempt at tax reform does not really address these issues, sadly.  Yes, tax reform is essential but even more important is eliminating the desire by politicians to spend today and tax tomorrow.  Tax reform must focus on how to ensure that our national goals (spending) are met by appropriate levels of inflows (taxes).  What we are witnessing is simply another way for our legislators to avoid making critical decisions about how to ensure that America is positioned to lead the world for the next 100 years.