Private Companies: Beware of SEC Scrutiny

The Securities and Exchange Commission (SEC) doesn’t monitor just publicly traded companies. It also looks at the dealings of some private companies, often to the surprise of their owners and executives.

Reasons for SEC scrutiny

The SEC’s mission is to protect the public as well as the integrity of the financial markets. That mission extends to not only public companies but also private ones that may be acquired by a public company or that are large enough to consider an initial public offering (IPO).

Ultimately, whether a private company attracts regulatory scrutiny depends on its disclosures regarding current and projected financial performance. Therefore, private companies must walk a fine line between 1) enticing would-be investors with attractive financial projections, and 2) painting an overly optimistic picture that’s unhinged from reality.

Interest in private company activities

Increasingly, the SEC has unleashed enforcement actions and investors have filed lawsuits related to allegedly misleading or erroneous statements made by private (or formerly private) companies. So, companies contemplating an IPO or a merger with a public company should begin developing their approach to SEC compliance as soon as possible.

The risk of attracting the attention of the SEC is particularly concerning if there’s a secondary market for your company’s pre-IPO shares. These are known as “security-based swaps” for purposes of SEC regulation. If the swaps are available to retail investors who don’t meet the criteria of an “eligible contract participant” under the Dodd-Frank Act, the securities must follow specific rules, including the existence of a registration statement and the ability to trade on a national securities exchange.

Additionally, the Financial Accounting Standards Board (FASB) recently proposed Accounting Standards Update No. 2019-600, Disclosure Improvements — Codification Amendments in Response to the SEC’s Disclosure Update and Simplification Initiative. The updated FASB guidance — which would apply to both public and private entities — would better sync U.S. Generally Accepted Accounting Principles (GAAP) with the SEC’s updated disclosure requirements.

Proactive compliance

It takes time to create and deploy an effective corporate governance program that complies with the SEC rules. Start the process by determining whether retail investors participate in trading that raises your company’s compliance risk. Pay close attention to every financial disclosure and the publicly available information that may affect trading. This effort should also include keeping track of material, nonpublic information available to insiders who may sell shares in the secondary market.

Next, create and deploy policies regarding how your company compiles its financial reports. Implement tools and procedures designed to prevent financial crime — such as internal fraud, bribery and corruption — and ensure compliance with SEC regulations. For example, you might consider setting up an anonymous whistleblower hotline for employees to report concerns regarding the company’s activities.

We can help

Companies on their way to becoming public represent a small, but growing, segment of the SEC’s enforcement activity. Protect your company against unwanted scrutiny by learning and complying with the SEC’s financial reporting rules and regulations.

Contact us to get a comprehensive assessment of your private company’s corporate governance practices. Now’s the time to shore them up, rather than waiting for an IPO or a merger with a public company.

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Bartering: A Taxable Transaction Even If Your Business Exchanges No Cash

Small businesses may find it beneficial to barter for goods and services instead of paying cash for them. If your business engages in bartering, be aware that the fair market value of goods that you receive in bartering is taxable income. And if you exchange services with another business, the transaction results in taxable income for both parties.

Income is also realized if services are exchanged for property. For example, if a construction firm does work for a retail business in exchange for unsold inventory, it will have income equal to the fair market value of the inventory.

Barter clubs

Many business owners join barter clubs that facilitate barter exchanges. In general, these clubs use a system of “credit units” that are awarded to members who provide goods and services. The credits can be redeemed for goods and services from other members.

Bartering is generally taxable in the year it occurs. But if you participate in a barter club, you may be taxed on the value of credit units at the time they’re added to your account, even if you don’t redeem them for actual goods and services until a later year. For example, let’s say that you earn 2,000 credit units one year, and that each unit is redeemable for $1 in goods and services. In that year, you’ll have $2,000 of income. You won’t pay additional tax if you redeem the units the next year, since you’ve already been taxed once on that income.

If you join a barter club, you’ll be asked to provide your Social Security number or employer identification number. You’ll also be asked to certify that you aren’t subject to backup withholding. Unless you make this certification, the club will withhold tax from your bartering income at a 24% rate.

Required forms

By January 31 of each year, the barter club will send you a Form 1099-B, “Proceeds from Broker and Barter Exchange Transactions,” which shows the value of cash, property, services, and credits that you received from exchanges during the previous year. This information will also be reported to the IRS.

If you don’t contract with a barter exchange but you do trade services, you don’t file Form 1099-B. But you may have to file a form 1099-MISC.

Many benefits

By bartering, you can trade away excess inventory or provide services during slow times, all while hanging onto your cash. You may also find yourself bartering when a customer doesn’t have the money on hand to complete a transaction. As long as you’re aware of the federal and state tax consequences, these transactions can benefit all parties. Contact us for more information.

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The Pros and Cons of Interim Reporting

The Securities and Exchange Commission (SEC) requires certain public companies to publish quarterly financial statements to give investors insight into midyear performance. Though interim reporting generally isn’t required for private companies, stakeholders in smaller entities can benefit even more than those of public companies from this type of information. But it’s also important to understand the potential shortcomings.

Upsides

Interim financial statements cover periods of less than a year. They show how a company is doing each month or quarter.

If you think of annual financial statements as report cards for a business, interim reports would be like progress reports that may forewarn of troubles ahead — or reassure you that everything is going well. A lender or investor might request interim financial statements if a company:

  • Has implemented a turnaround plan to avert bankruptcy,
  • Has previously reported a major impairment loss,
  • Is in an industry that is experiencing a downturn, or
  • Is seeking new investors or applying for a loan.

These reports may provide peace of mind. Or they might signal impending financial turmoil due to, say, the loss of a major customer, significant uncollectible accounts receivable or pilfered inventory.

Early detection of such problems is critical for smaller businesses. While large public companies can often recover from a bad quarter or year, waiting until year end to discover these issues can be disastrous to a smaller business.

Downsides

Interim reports also have certain drawbacks and limitations. Unlike annual financial statements, interim financial statements are usually unaudited and condensed. So, when reviewing interim reports, revisiting last year’s complete annual financial statements may be helpful. Also check that accounting practices are consistent between the interim and year-end financial statements.

Specifically, interim numbers may omit estimates for bad-debt write-offs, accrued expenses, prepaid items, management bonuses or income taxes. And sometimes tedious bookkeeping procedures, such as physical inventory counts, updating depreciation schedules and composing detailed footnote disclosures, aren’t completed until year end. Instead, interim account balances often reflect last year’s amounts or may be based on historic gross margins.

For seasonal businesses, there are operating peaks and troughs. So you can’t multiply quarterly profits by four to reliably predict year end performance. Instead, you may need to benchmark current year-to-date numbers against last year’s monthly (or quarterly) results.

For more information

If interim statements reveal irregularities, you should consider digging deeper to find out what’s happening. Our accounting and auditing pros can help you address unresolved issues and determine an appropriate course of action.

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In Pursuit of Global Tax Transparency

In today’s global economy, multinational corporations engage in numerous cross-border transactions. But how they report those transactions is often vague. To help minimize stakeholders’ exposure to potential hidden risks, the Financial Accountability & Corporate Transparency (FACT) Coalition wants multinationals to disclose more information about corporate taxes.

A global movement

The FACT Coalition is a nonpartisan group of more than 100 state, national and international organizations working toward a fair global tax system and curbing corrupt financial practices. Its website reports that, until the passage of the Tax Cuts and Jobs Act (TCJA), the 500 largest U.S. companies had $2.6 trillion stashed offshore, costing taxpayers over $750 billion in unpaid taxes. But tax reform didn’t completely stop the problem. Under the TCJA, offshore tax avoidance is expected to cost an additional $14 billion in lost tax revenue over the next decade.

As of March 2019, the United States and 77 countries require multinationals to file country-by-country reports privately to tax authorities, according to a standard set by the Organisation for Economic Co-operation and Development (OECD). But few countries require public disclosures of such information, except by certain banks and oil, gas and mining companies.

What inquiring minds want to know

The FACT Coalition recently issued a report titled Trending Toward Transparency: The Rise of Public Country-by-Country Reporting. It urges Congress, the U.S. Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) to up the ante.

Specifically, the FACT Coalition wants multinational corporations to publicly disclose, on an annual, country-by-country basis:

  • The number of entities,
  • The names of principal entities,
  • Primary activities of these entities,
  • The number of employees,
  • Total revenues broken out by third-party sales and intragroup transactions of the tax jurisdiction and other tax jurisdictions,
  • Profit/loss before tax,
  • Tangible assets other than cash and cash equivalents,
  • Corporate tax paid on a cash basis,
  • Corporate tax accrued on the profit or loss (including reasons for any discrepancies), and
  • Significant tax incentives.

The FACT Coalition believes that “these enhanced disclosures are essential for investors to effectively value and assess the risks related to the public companies in which they have invested.”

Transparent reporting

Some multinationals, such as Vodafone and Unilever, voluntarily provide country-by-country tax disclosures. Should your company report similar information? Companies that are upfront about their tax strategies may engender trust and goodwill with stakeholders.

Contact us to discuss whether the benefits of expanded global tax disclosures outweigh the costs. We can help you collect this information and report it to your investors to a user friendly format.

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2019 Q3 Tax Calendar: Key Deadlines for Business and Other Employers

Here are some of the key tax-related deadlines affecting businesses and other employers during the third quarter of 2019. Keep in mind that this list isn’t all-inclusive, so there may be additional deadlines that apply to you. Contact us to ensure you’re meeting all applicable deadlines and to learn more about the filing requirements.

July 31

  • Report income tax withholding and FICA taxes for the second quarter of 2019 (Form 941) and pay any tax due. (See the exception below, under “August 12.”)
  • File a 2018 calendar-year retirement plan report (Form 5500 or Form 5500-EZ) or request an extension.

August 12

  • Report income tax withholding and FICA taxes for the second quarter of 2019 (Form 941), if you deposited on time and in full all of the associated taxes due.

September 16

  • If a calendar-year C corporation, pay the third installment of 2019 estimated income taxes.
  • If a calendar-year S corporation or partnership that filed an automatic six-month extension:
    • File a 2018 income tax return (Form 1120S, Form 1065 or Form 1065-B) and pay any tax, interest and penalties due.
    • Make contributions for 2018 to certain employer-sponsored retirement plans.

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How Auditors Use Nonfinancial Information

Every financial transaction your company records generates nonfinancial data that doesn’t have a dollar value assigned to it. Though auditors may spend most of their time analyzing financial records, nonfinancial data can also help them analyze your business from multiple angles.

Gathering audit evidence

The purpose of an audit is to determine whether your financial statements are “fairly presented in all material respects, compliant with Generally Accepted Accounting Principles (GAAP) and free from material misstatement.” To thoroughly assess these issues, auditors need to expand their procedures beyond the line items recorded in your company’s financial statements.

Nonfinancial information helps auditors understand your business and how it operates. During planning, inquiry, analytics and testing procedures, auditors will be on the lookout for inconsistencies between financial and nonfinancial measures. This information also helps auditors test the accuracy and reasonableness of the amounts recorded on your financial statements.

Looking beyond the numbers

A good starting point is a tour of your facilities to observe how and where the company spends its money. The number of machines operating, the amount of inventory in the warehouse, the number of employees and even the overall morale of your staff can help bring to life the amounts shown in your company’s financial statements.

Auditors also may ask questions during fieldwork to help determine the reasonableness of financial measures. For instance, they may ask you for detailed information about a key vendor when analyzing accounts payable. This might include the vendor’s ownership structure, its location, copies of email communications between company personnel and vendor reps, and the name of the person who selected the vendor. Such information can give the auditor insight into the size of the relationship and whether the timing and magnitude of vendor payments appear accurate and appropriate.

Your auditor may even look outside your company for nonfinancial data. Many websites allow customers and employees to submit reviews of the company. These reviews can provide valuable insight regarding the company’s inner workings. If the reviews uncover consistent themes — such as an unwillingness to honor product guarantees or allegations of illegal business practices — it may signal deep-seated problems that require further analysis.

Facilitating the audit process

Auditors typically ask lots of questions and request specific documentation to test the accuracy and integrity of a company’s financial records. While these procedures may seem probing or superfluous, analyzing nonfinancial data is critical to issuing a nonqualified audit opinion. Let’s work together to get it right!

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AUP Engagements: A Middle Ground Between Audits and Consulting Services

Your CPA offers a wide menu of services. An audit is a familiar type of attestation service that provides a formal opinion about whether the company’s financial statements conform to U.S. Generally Accepted Accounting Principles (GAAP).

Consulting services, in contrast, provide advice or technical assistance that’s only for internal purposes. That is, lenders and other third parties can’t rely on the findings, conclusions and recommendations presented during a consulting project.

If you need a report that falls somewhere between these alternatives, consider an agreed upon procedures (AUP) engagement.

Scope

An AUP engagement uses procedures similar to an audit, but on a limited scale. It can be used to identify specific problems that require immediate action. When performing an AUP engagement, your CPA makes no formal opinion; he or she simply acts as a fact finder. The report lists:

  • The procedures performed, and
  • The CPA’s findings.

It’s the user’s responsibility to draw conclusions based on those findings. AUP engagements may target specific financial data (such as accounts payable, accounts receivable or related party transactions), nonfinancial information (such as a review of internal controls or compliance with royalty agreements), a specific financial statement (such as the income statement or balance sheet) or even a complete set of financial statements.

Advantages

AUP engagements boast several advantages. They can be performed at any time during the year, and they can be relied on by third parties. Plus, you have the flexibility to choose only those procedures you feel are necessary, so AUP engagements can be cost-effective.

Specifically, AUP engagements can be useful:

  • In M&A due diligence,
  • When a business owner suspects an employee of misrepresenting financial results, and
  • To determine compliance with specific regulatory requirements, such as the Health Insurance Portability and Accountability Act (HIPAA) or the Federal Information Security Management Act (FISMA).

In addition, lenders or franchisors may request an AUP engagement if they have doubts or questions about a company’s financials or the effectiveness of its internal controls — or if they want to check on the progress of a distressed company’s turnaround plan.

Contact us

AUP engagements can be performed to supplement audits and consulting engagements — or as a standalone service. We can help you customize an AUP engagement that fits the needs of your business and its stakeholders.

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Employers: Be Aware (or Beware) of a Harsh Payroll Tax Penalty

If federal income tax and employment taxes (including Social Security) are withheld from employees’ paychecks and not handed over to the IRS, a harsh penalty can be imposed. To make matters worse, the penalty can be assessed personally against a “responsible individual.”

If a business makes payroll tax payments late, there are escalating penalties. And if an employer fails to make them, the IRS will crack down hard. With the “Trust Fund Recovery Penalty,” also known as the “100% Penalty,” the IRS can assess the entire unpaid amount against a responsible person who willfully fails to comply with the law.

Some business owners and executives facing a cash flow crunch may be tempted to dip into the payroll taxes withheld from employees. They may think, “I’ll send the money in later when it comes in from another source.” Bad idea!

No corporate protection

The corporate veil won’t shield corporate officers in these cases. Unlike some other liability protections that a corporation or limited liability company may have, business owners and executives can’t escape personal liability for payroll tax debts.

Once the IRS asserts the penalty, it can file a lien or take levy or seizure action against a responsible individual’s personal assets.

Who’s responsible?

The penalty can be assessed against a shareholder, owner, director, officer, or employee. In some cases, it can be assessed against a third party. The IRS can also go after more than one person. To be liable, an individual or party must:

  • Be responsible for collecting, accounting for, and paying over withheld federal taxes, and
  • Willfully fail to pay over those taxes. That means intentionally, deliberately, voluntarily and knowingly disregarding the requirements of the law.

The easiest way out of a delinquent payroll tax mess is to avoid getting into one in the first place. If you’re involved in a small or medium-size business, make sure the federal taxes that have been withheld from employees’ paychecks are paid over to the government on time. Don’t ever allow “borrowing” from withheld amounts.

Consider hiring an outside service to handle payroll duties. A good payroll service provider relieves you of the burden of paying employees, making the deductions, taking care of the tax payments and handling recordkeeping. Contact us for more information.

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Measuring “Fair Value” for Financial Reporting Purposes

The standard for valuing certain assets and liabilities under U.S. Generally Accepted Accounting Principles (GAAP) is “fair value.” This differs from other valuation standards that may apply when valuing a security or business interest in a litigation or mergers and acquisitions (M&A) setting.

FASB guidance

The Financial Accounting Standards Board (FASB) issued Accounting Standards Codification (ASC) Topic 820, Fair Value Measurements and Disclosures , in 2006. It defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

The statement unified approximately 60 existing accounting pronouncements that used this term. Among the items currently reported at fair value (rather than historic cost) are asset retirement obligations, derivatives and intangible assets acquired in a business combination.

Valuation hierarchy

The statement also establishes a “fair value hierarchy” that emphasizes market-based valuation methods. In order of decreasing relevance, the following factors should be considered when measuring fair value:

  1. Quoted prices in active markets for identical assets or liabilities,
  2. Quoted prices in active markets for similar assets or liabilities, or other “observable” inputs, and
  3. Unobservable inputs, such as the reporting entity’s own data.

When the recession hit in 2008, the FASB advised companies to use internal assumptions, such as expected cash flows and appropriately risk-adjusted discount rates, to value securities when relevant market data is unavailable. FASB guidance said that, in times of “market dislocation,” market prices may not always be determinative of fair value. Rather, valuations “may require the use of significant judgment about whether individual transactions are forced liquidations or distressed sales.”

Different purposes, different standards

Though it may be tempting to “recycle” valuations prepared for litigation or M&A purposes for use in financial reporting (or vice versa), the values may not be equivalent. That’s because different standards sometimes apply, depending on the purpose of the valuation.

For example, “fair value” in an oppressed shareholder or divorce case may be statutorily defined and based on relevant case law. Likewise, “strategic value,” which is commonly used in M&As, may include buyer-specific synergies and, therefore, warrant a premium above the price others in the marketplace would pay.

In addition, the FASB specifically avoided using the term “fair market value” in ASC 820. This term applies to valuations prepared for federal tax purposes. The rationale was that the FASB wanted to separate its guidance from the extensive body of IRS guidance and Tax Court precedent. The term “fair value” has less baggage tied to it and allowed the FASB to start with a clean slate.

Use valuation experts

Estimating fair value, like any valuation assignment, generally requires the use of specialists who are independent of your audit team. Contact us for more information about fair value measurements.

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Predicting Future Performance

CPAs typically report historical financial performance. But sometimes they’re hired to predict how a company will perform in the future.

Prospective reporting options

There are three types of reports to choose from when predicting future performance:

  1. Forecasts. These prospective statements present an entity’s expected financial position, results of operations and cash flows. They’re based on assumptions about expected conditions and courses of action.
  2. Projections. These statements are based on assumptions about conditions expected to exist and the course of action expected to be taken, given one or more hypothetical assumptions. Financial projections may test investment proposals or demonstrate a best-case scenario.
  3. Budgets. Operating budgets are prepared in-house for internal purposes. They allocate money — usually revenues and expenses — for particular purposes over specified periods.

Though these terms are sometimes used interchangeably, there are important distinctions under the attestation standards set forth by the American Institute of Certified Public Accountants (AICPA).

Factors to consider

Historical financial statements are often used to generate forecasts, projections and budgets. But accurate predictions usually require more work than simply multiplying last year’s operating results by a projected growth rate — especially over the long term.

For example, a high-growth business may be growing 20% annually, but that rate is likely unsustainable over time. Plus, the business’s facilities and fixed assets may lack sufficient capacity to handle growth expectations. If so, management may need to add assets or fixed expenses to take the company to the next level.

Similarly, it may not make sense to assume that annual depreciation expense will reasonably approximate the need for future capital expenditures. Consider a tax-basis entity that aggressively took advantage of the expanded Section 179 and bonus depreciation deductions in 2018, which permitted immediate expensing in the year qualifying fixed assets were purchased. Because depreciation is so boosted by these tax incentives, this assumption may overstate depreciation and capital expenditures going forward.

Various external factors, such as changes in competition, product obsolescence and economic conditions, can affect future operations. So can events within a company. For example, new or divested product lines, recent asset purchases, in-process research and development, and outstanding litigation could all materially affect future financial results.

Objective expertise

Some companies create prospective financial reports as part of their annual planning process. Others use these reports to apply for loans or to value the business for corporate litigation, buying out a retiring owner or a merger or acquisition. Whatever the reason for creating prospective financial statements, it’s important that the underlying assumptions be realistic and well thought out. Contact us for objective insights that are based on industry and market trends, rather than simplistic formulas and gut instinct.

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