Assessing the Effectiveness of Internal Controls

Strong internal controls can help prevent and detect fraud. That’s why Section 404(a) of the Sarbanes-Oxley Act (SOX) requires a public company’s management to annually assess the effectiveness of internal controls over financial reporting. And Sec. 404(b) requires the company’s independent auditors to provide an attestation report on management’s assessment of internal controls. Some smaller entities may be exempt from the latter requirement — but not the former one.

Burdensome for smaller entities

When the SEC published the regulations, smaller public companies told the SEC that the costs of complying with Sec. 404(b) would outweigh the benefits for investors. While the SEC explored ways to ease the compliance burden, the compliance deadline for Sec. 404(b) was repeatedly delayed for nonaccelerated filers — companies with a public float of less than $75 million on the last business day of their most recent second fiscal quarter.

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act instructed the SEC to permanently exempt nonaccelerated filers from SOX Sec. 404(b). Absent this exemption, nonaccelerated filers would have been required to comply with Sec. 404(b) beginning with fiscal years ending on or after June 15, 2010.

New definition provides no new Sec. 404(b) relief

Earlier this year, the SEC expanded its definition of “smaller reporting companies” from companies with a public float of less than $75 million to those with a public float of less than $250 million. This change will allow nearly 1,000 more companies to qualify for a lighter set of disclosure rules available to smaller reporting companies. However, the SEC did not raise the public float thresholds for when a company qualifies as an accelerated filer. This means the $75 million threshold still applies in relation to the Sec. 404(b) exemption.

SEC Commissioners Michael Piwowar and Hester Peirce favored raising the accelerated filer threshold to $250 million to expand the number of companies that would be exempt from Sec. 404(b). But, based on feedback from auditors and investor advocate groups, SEC Chairman Jay Clayton decided to keep the current threshold at $75 million — at least for now.

It’s also important to note that not all companies with a public float of less than $75 million are considered nonaccelerated filers. If a company’s public float drops below $75 million, it continues to be an accelerated filer until it drops below $50 million, and thereby “exits” accelerated status.

Still on the hook

Even if your company is exempt from Sec.404(b), you’re still responsible for assessing the effectiveness of internal controls over financial reporting pursuant to Sec. 404(a). Contact us for any questions about complying with the SOX rules or for information regarding best practices in internal controls.

© 2018

Auditing Royalty Agreements

Companies often grant licenses to others allowing them to use intellectual property — such as a patent or proprietary computer code — in exchange for royalties. Licensors can hire an external audit firm to ensure the licensee pays the correct royalty rate and amount. Here’s how the audit process works.

The agreement

The parties’ attorneys usually create a royalty agreement that governs the use of the intellectual property. This legal contract between the licensor and licensee details the terms of the arrangement. It spells out how the licensee may use the asset, the duration of the license and how much the licensee agrees to pay the licensor in royalties for the right to use the asset.

Unfortunately, royalty payments sometimes fall short of the agreed-upon amount. This may be due to a clerical error, confusion regarding the agreement’s terms — or even fraud. To detect and deter shortfalls, most contracts include a “right-to-audit” clause, meaning that the licensor retains the legal right to hire an outside firm to audit the licensee’s payments to confirm compliance with the terms detailed in the agreement.

The auditor’s role

When auditing royalty agreements, CPAs typically perform the following six steps:

1. Review the agreement to understand its scope, including the asset under license, the duration of the contract, prohibited uses and the royalty rate.

2. Analyze sales data used to derive royalty payments to date. Depending on the type of asset under license, the audit team may request production and inventory records.

3. Perform a detailed walk-through of the process the licensee follows to identify, track and report sales subject to a royalty payment.

4. Conduct random sampling of sales data to ensure the licensee applies the correct rate to generate the royalty payment.

5. Review sales and royalty payment trends to confirm that the licensee’s sales align with the royalty payments.

6. Gather individual invoices from key customers to locate and confirm that sales transactions subject to royalties actually generated a royalty payment.

Usually, the licensor assumes the cost of the royalty audit. However, some agreements include a clause that requires the licensee to assume responsibility for the cost of the audit if the audit uncovers underpayment of royalties by a certain margin.

Keep licensees on their toes

Most licensing arrangements function without a hitch. But a minor error or oversight could result in a significant shortfall in royalty payments. Periodic royalty audits can prevent small, but honest, mistakes from spiraling out of control — and help reduce the temptation for dishonest licensees to commit fraud. Contact us to discuss the benefits of auditing your royalty agreements.

© 2018

How to Trim the Fat From Your Inventory

Inventory is expensive. So, it needs to be as lean as possible. Here are some smart ways to cut back inventory without compromising revenue and customer service.

Objective inventory counts

Effective inventory management starts with a physical inventory count. Accuracy is essential to knowing your cost of goods sold — and to identifying and remedying discrepancies between your physical count and perpetual inventory records. A CPA can introduce an element of objectivity to the counting process and help minimize errors.

Inventory ratios

The next step is to compare your inventory costs to those of other companies in your industry. Trade associations often publish benchmarks for:

  • Gross margin [(revenue – cost of sales) / revenue],
  • Net profit margin (net income / revenue), and
  • Days in inventory (annual revenue / average inventory × 365 days).

Your company should strive to meet — or beat — industry standards. For a retailer or wholesaler, inventory is simply purchased from the manufacturer. But the inventory account is more complicated for manufacturers and construction firms; it’s a function of raw materials, labor and overhead costs.

The composition of your company’s cost of goods will guide you on where to cut. In a tight labor market, it’s hard to reduce labor costs. But it may be possible to renegotiate prices with suppliers.

And don’t forget the carrying costs of inventory, such as storage, insurance, obsolescence and pilferage. You can also improve margins by negotiating a net lease for your warehouse, installing antitheft devices or opting for less expensive insurance coverage.

Product mix

To cut your days-in-inventory ratio, compute product-by-product margins. Stock more products with high margins and high demand — and less of everything else. Whenever possible, return excessive supplies of slow moving materials or products to your suppliers.

Product mix can be a delicate balance, however. It should be sufficiently broad and in tune with consumer needs. Before cutting back on inventory, you might need to negotiate speedier delivery from suppliers or give suppliers access to your perpetual inventory system. These precautionary measures can help prevent lost sales due to lean inventory.

Reorder point

Another important metric that’s not available from benchmarking studies is reorder point. That’s the quantity level that triggers a new order. Reorder point is a function of your volume and the purchase order lead time. If your suppliers have access to your inventory system, they can automatically ship additional stock once inventory levels reach the reorder point.

Take inventory of your inventory

Often management is so focused on sales, HR issues and product innovation that they lose control over inventory. Contact us for a reality check. We can provide industry benchmarks and calculate ratios to help minimize the guesswork in managing your inventory.

© 2018

Use Pay-Ratio Disclosures with Caution

Starting in 2018, certain public companies must disclose the ratio of their CEO’s annual compensation to that of its “median employee.” The rule allows for significant flexibility in calculating these ratios, leading to widely divergent ratios within the same industry. Therefore, public companies and their investors should tread carefully before they rely on these metrics.

Complying with the rule

The pay-ratio disclosure rule applies to all U.S. public companies required to provide Summary Compensation Table disclosures. With limited exceptions, covered companies must disclose pay ratios in annual reports, on Form 10-K, in proxy and information statements, and in registration statements — if these filings require executive compensation disclosures.

The rule doesn’t apply to the following companies:

Smaller reporting companies (SRCs). The Securities and Exchange Commission (SEC) voted unanimously in June 2018 to increase the public float threshold for SRCs to $250 million.

Emerging growth companies (EGCs). This term generally refers to new public companies with gross revenues under $1 billion in the most recent fiscal year. (The SEC allows a transition period for newly public companies.)

The rule also exempts registered investment companies, foreign private issuers and Canadian companies filing in the United States pursuant to the Multijurisdictional Disclosure System.

Calculating pay ratios

The SEC allows significant leeway in calculating pay ratios to ease the burden of complying with the rule. Companies may choose a process that fits their structure and compensation programs. But they must disclose the methodology used to determine the median employee pay and the estimates used in calculating the pay ratio.

For example, a company could use a statistically representative sample of its workforce rather than the entire population. Or they could compare only base salary or W-2 wages, excluding from their computations bonuses, overtime, stock options and other forms of compensation.

Companies also aren’t required to calculate the exact compensation when identifying the median. Rather, the SEC lets them use “reasonable estimates.” In addition, the rule allows companies to exclude up to 5% of their non-U.S. workers and to adjust foreign pay to account for differences in the cost of living between regions.

As a result, the initial round of pay-ratio disclosures published in early 2018 vary widely. For example, a recent study found that ratios disclosed by companies in the financial services industry ranged from 1:1 to 1:429.

Comparing apples to oranges

Before relying on pay-ratio disclosures to evaluate compensation practices or cost efficiency, it’s important to compare a company’s process for calculating pay ratios to others used in the same industry. Contact us for more information about pay-ratio disclosures and how a company’s compensation practices measure up.

© 2018

Auditing the Use of Estimates and Specialists

Complex accounting estimates — such as allowances for doubtful accounts, impairments of long-lived assets, and valuations of financial and nonfinancial assets — have been blamed for many high-profile accounting scams and financial restatements. Estimates generally involve some level of measurement uncertainty, and some may even require the use of outside specialists, such as appraisers or engineers.

As a result, examining estimates is a critical part of an audit. Companies that understand the audit process are better equipped to facilitate audit fieldwork and can communicate more effectively with their auditors. Here’s what you need to know about auditing the use of estimates as we head into next audit season.

Audit techniques

Some estimates may be easily determinable, but many are inherently complex. Auditing standards generally provide the following three approaches for substantively testing accounting estimates and fair value measurements:

1. Testing management’s process. Auditors evaluate the reasonableness and consistency of management’s assumptions, as well as test whether the underlying data is complete, accurate and relevant.
2. Developing an independent estimate. Using management’s assumptions (or alternate assumptions), auditors come up with an estimate to compare to what’s reported on the internally prepared financial statements.
3. Reviewing subsequent events or transactions. The reasonableness of estimates can be gauged by looking at events or transactions that happen after the balance sheet date but before the date of the auditor’s report.

When performing an audit, all three approaches might not necessarily be appropriate for every estimate. For each estimate, the auditor typically selects one or a combination of these approaches.

Regulatory oversight

Accounting estimates have been on the agenda of the Public Company Accounting Oversight Board (PCAOB) since it was established by Congress under the Sarbanes-Oxley Act of 2002. Although the leadership of PCAOB changed hands in early 2018, proposals to enhance the auditing standards for the use of accounting estimates and the work of specialists remain top priorities.

Earlier this summer, Chairman William Duhnke told the PCAOB’s Standard Advisory Group (SAG) that he hopes to complete these projects in the coming months. The updated auditing standards would help reduce diversity in practice, provide more-specific direction and be better aligned with the risk assessment standards.

Prepare for next audit season

Improvements on the audit standards for the use of estimates and the work of specialists could be coming soon. As companies plan for next year’s audit, they should contact their audit partners for the latest developments on the standards for auditing the use of estimates and specialists to determine what (if anything) has changed.

We can help you understand how estimates and specialists are used in the preparation of your company’s financial statements and minimize the risk of financial misstatement.

© 2018

Consider These Financial Reporting Issues Before Going Private

Issuing stock on the public markets isn’t right for every business. Some public companies decide to delist — or “go private” — often due to the high costs of complying with the requirements of the Securities and Exchange Commission (SEC). But going private can be nearly as complex as going public, so it’s important to dot your i’s and cross your t’s.

SEC requirements

The SEC scrutinizes going-private transactions to ensure that unaffiliated shareholders are treated fairly. A company that’s going private — together with its controlling shareholders and other affiliates — must, among other requirements, file detailed disclosures pursuant to SEC Rule 13e-3.

The SEC allows a public company to deregister its equity securities when they’re held by fewer than 300 shareholders of record, or fewer than 500 shareholders of record if the company doesn’t have significant assets. Depending on the facts and circumstances, a company may no longer be required to file periodic reports with the SEC once the number of shareholders of record drops below the above thresholds.

Detailed disclosures

To comply with SEC Rule 13e-3 and Schedule 13E-3, companies executing a going-private transaction must disclose:

  • The purposes of the transaction, including any alternatives considered and the reasons they were rejected,
  • The fairness of the transaction, both substantive (price) and procedural, and
  • Any reports, opinions and appraisals “materially related” to the transaction.

The SEC’s rules are intended to protect shareholders, and some states even have takeover statutes to provide shareholders with dissenters’ rights. Such a transition results in a limited trading market to be able to sell the stock.

Failure to act with the utmost fairness and transparency can bring harsh consequences. SEC scrutiny can lead to costly damages awards and penalties if your company is guilty of treating minority shareholders unfairly or making misleading disclosures.

Handle with care

Companies that pursue going-private transactions should exercise extreme caution. To withstand SEC scrutiny and avoid lawsuits, it’s critical to structure these transactions in a manner that ensures transparency, procedural fairness and a fair price.

In addition to helping you comply with the SEC rules, we can evaluate whether going private can help your company reduce its compliance costs or allow it to focus on long-term goals rather than satisfying Wall Street’s demand for short-term profits.

© 2018

Spotlight on Auditor Independence and Hosting Arrangements

With Independence Day coming up, it’s a good time to check up on auditor independence issues. This is especially important in 2018. Why? New rules go into effect this fall that may warrant changes to the services provided by your audit firm. If you discover potential issues now, there’s still plenty of time to take corrective action before next year’s audit begins.

What’s independence?

Independence is one of the most important requirements for audit firms. It’s why investors and lenders trust CPAs to provide unbiased opinions about the presentation of a company’s financial results. The AICPA and the Securities and Exchange Commission (SEC) have rules regarding auditor independence. Even the U.S. Department of Labor has issued independence guidance for auditors of employee benefit plans.

The AICPA specifically goes to great lengths to explain how auditing firms can maintain their independence from the companies they audit. In short, auditors can’t provide any services for an audit client that would normally fall to management to complete. Auditors also can’t engage in any relationships with their clients that would compromise their objectivity, require them to audit their own work, or result in self-dealing, a conflict of interest, or advocacy.

Independence is a matter of professional judgment, but it’s something that accountants take seriously. A firm that violates the independence rules calls into question the accuracy and integrity of its client’s financial statement.

What’s changing?

Today, some businesses have chosen to host their company’s data with their audit firm. In response, the AICPA’s Professional Ethics Executive Committee announced a change to the profession’s independence rules. As of September 1, 2018, to maintain independence, auditors can’t perform any of the following services for their audit clients:

  • Serve as the sole host of a client’s financial or nonfinancial records.
  • Function as the primary custodian of a client’s data, meaning that a company must access the data in the CPA’s possession to possess a complete set of records.
  • Provide business continuity and disaster recovery support services.

Not all custody or control of a client’s records results in hosting services, however. The new rule narrowly interprets hosting services to mean the audit firm has accepted responsibility for maintaining internal control over data an audit client uses to run the business. Accepting responsibility to perform a management function explicitly compromises auditor independence.

Finding a host with the most

Is your audit firm responsible for managing your company’s data? If so, it may be time for a change. Data migration isn’t necessarily time consuming, but it may take time to find a new hosting company with the right balance of security and services to meet your data storage and access needs. Contact us to evaluate your hosting arrangement and, if necessary, identify an alternate provider to stay in compliance with the AICPA independence rules.

© 2018

An FLP Can Save Tax in a Family Business Succession

One of the biggest concerns for family business owners is succession planning — transferring ownership and control of the company to the next generation. Often, the best time tax-wise to start transferring ownership is long before the owner is ready to give up control of the business.
A family limited partnership (FLP) can help owners enjoy the tax benefits of gradually transferring ownership yet allow them to retain control of the business.

How it works

To establish an FLP, you transfer your ownership interests to a partnership in exchange for both general and limited partnership interests. You then transfer limited partnership interests to your children.

You retain the general partnership interest, which may be as little as 1% of the assets. But as general partner, you can still run day-to-day operations and make business decisions.

Tax benefits

As you transfer the FLP interests, their value is removed from your taxable estate. What’s more, the future business income and asset appreciation associated with those interests move to the next generation.

Because your children hold limited partnership interests, they have no control over the FLP, and thus no control over the business. They also can’t sell their interests without your consent or force the FLP’s liquidation.

The lack of control and lack of an outside market for the FLP interests generally mean the interests can be valued at a discount — so greater portions of the business can be transferred before triggering gift tax. For example, if the discount is 25%, in 2018 you could gift an FLP interest equal to as much as $20,000 tax-free because the discounted value wouldn’t exceed the $15,000 annual gift tax exclusion.

To transfer interests in excess of the annual exclusion, you can apply your lifetime gift tax exemption. And 2018 may be a particularly good year to do so, because the Tax Cuts and Jobs Act raised it to a record-high $11.18 million. The exemption is scheduled to be indexed for inflation through 2025 and then drop back down to an inflation-adjusted $5 million in 2026. While Congress could extend the higher exemption, using as much of it as possible now may be tax-smart.

There also may be income tax benefits. The FLP’s income will flow through to the partners for income tax purposes. Your children may be in a lower tax bracket, potentially reducing the amount of income tax paid overall by the family.

FLP risks

Perhaps the biggest downside is that the IRS scrutinizes FLPs. If it determines that discounts were excessive or that your FLP had no valid business purpose beyond minimizing taxes, it could assess additional taxes, interest and penalties.

The IRS pays close attention to how FLPs are administered. Lack of attention to partnership formalities, for example, can indicate that an FLP was set up solely as a tax-reduction strategy.

Right for you?

An FLP can be an effective succession and estate planning tool, but it isn’t risk free. Please contact us for help determining whether an FLP is right for you.

© 2018

Don’t Let Collaborative Arrangements Cause Financial Reporting Headaches

Businesses often enter into so-called “collaborative arrangements” when they partner with another entity on a major project. Unfortunately, the current guidance for these types of arrangements under U.S. Generally Accepted Accounting Principles (GAAP) is somewhat vague.

Here are some questions that may arise as participants report shared costs and revenue on their income statements, along with details about a recent proposal that would clarify how to report collaborative arrangements.

What is a collaborative arrangement?

Accounting Standards Codification (ASC) Topic 808, Collaborative Arrangements, provides guidance for income statement presentation, classification and disclosures related to collaborative arrangements. It lists three requirements for collaborative arrangements:

1. They must involve at least two parties (or participants).
2. The parties involved must all be active participants in the activity.
3. All participants must be exposed to significant risks and rewards dependent on the commercial success of the activity.

Collaborative arrangements are a particularly common type of joint venture for film production and life science companies. For example, two pharmaceutical companies might agree to share research and development expenses to produce a new drug. Then, if the drug succeeds, the companies also would share the revenue from sales of the drug.

What qualifies as revenue?

Today’s guidance on collaborative agreements has led to inconsistent accounting practices. Why? Topic 808 doesn’t include guidance for determining what the appropriate unit of accounting is or when recognition criteria are met. Rather, it says to look to other areas of GAAP to account for a transaction. If there’s no formal guidance available, businesses typically apply an accounting policy or another accounting method by analogy. As a result, companies may label items as “revenue” when they belong elsewhere on the income statement.

To further complicate matters, the landmark revenue recognition standard goes into effect in 2018 for public companies and in 2019 for private ones. Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606), limits application of the revenue standard to arrangements that involve a customer as one of the parties to a contract.

In April, the Financial Accounting Standards Board (FASB) proposed an update to clarify the scope of its standards for revenue and collaborative arrangements. If finalized, the proposal will help partners in a collaborative arrangement determine when a transaction should be treated as revenue. Public comments on the proposed changes are due in June.

Got more questions?

We’re atop the latest developments on reporting collaborative arrangements. Contact us with questions about the interaction of the standards for collaborative arrangements and revenue recognition. We can help you concurrently implement the latest rules and minimize the risk of restatement.

© 2018

Hire Your Children to Save Taxes for Your Business and Your Family

It can be difficult in the current job market for students and recent graduates to find summer or full-time jobs. If you’re a business owner with children in this situation, you may be able to provide them with valuable experience and income while generating tax savings for both your business and your family overall.

Shifting income

By shifting some of your business earnings to a child as wages for services performed by him or her, you can turn some of your high-taxed income into tax-free or low-taxed income. For your business to deduct the wages as a business expense, the work done by the child must be legitimate and the child’s wages must be reasonable.

Here’s an example of how this works: A business owner operating as a sole proprietor is in the 39.6% tax bracket. He hires his 17-year-old son to help with office work full-time during the summer and part-time into the fall. The son earns $6,100 during the year and doesn’t have any other earnings.

The business owner saves $2,415.60 (39.6% of $6,100) in income taxes at no tax cost to his son, who can use his $6,350 standard deduction (for 2017) to completely shelter his earnings. The business owner can save an additional $2,178 in taxes if he keeps his son on the payroll longer and pays him an additional $5,500. The son can shelter the additional income from tax by making a tax-deductible contribution to his own IRA.

Family taxes will be cut even if the employee-child’s earnings exceed his or her standard deduction and IRA deduction. That’s because the unsheltered earnings will be taxed to the child beginning at a rate of 10% instead of being taxed at the parent’s higher rate.

Saving employment taxes

If your business isn’t incorporated or a partnership that includes nonparent partners, you might also save some employment tax dollars. Services performed by a child under age 18 while employed by a parent aren’t considered employment for FICA tax purposes. And a similar exemption applies for federal unemployment tax (FUTA) purposes. It exempts earnings paid to a child under age 21 while employed by his or her parent.

If you have questions about how these rules apply in your particular situation or would like to learn about other family-related tax-saving strategies, contact us.

© 2017