In recent months the focus of discussions related to adoption of the International Financial Reporting Standards have centered on differences with US GAAP (such as LIFO inventory), timing and implementation. I don’t want to debate the necessity of adopting a world standard given our weakening influence over the world economy, or the esoteric benefits or detriments. My concerns are much more basic. Without tort reform in the United States, IFRS is a time bomb with a very short fuse resulting in a cataclysmic disaster waiting to happen.
Currently, US GAAP is a rules based set of standards. While the end result of their application frequently results in worthless unsupportable financial reporting, the issuer and their auditor have but to point to the ‘rules’ in defense. On the other hand, IFRS is principles based, and simpler to apply. But it can and frequently does require the issuer and his auditor to exercise judgment. Judgment that can be questioned, criticized and litigated.
Please don’t misunderstand. Professionally in my opinion the quality of financial reporting will be significantly improved by the application of sound principles. IFRS is long overdue. Without liability reform, however, I fear financial reporting and assurance services will quickly follow the health care industry in terms of cost to the providers.
Maybe I’m just paranoid in my advancing years.
S Corporations are a popular business entity – they allow for limitation of liability, may reduce self-employment taxes, and income is passed through to the owners, resulting in only one level of taxation, while providing a “corporate veil” for liability protection. There are a number of possible pitfalls for the unwary, particularly if the company operated as a C Corporation prior to electing S Corporation status. This series on S Corporation pitfalls will discuss some of the more common issues, and some of the more serious… pitfalls that can have costly results without proper planning…
First, as a rule of thumb, do not hold appreciable assets, such as real estate or passive investments in an S Corporation. Why not? You probably know that there is generally no resulting tax when cash is distributed from S Corporation earnings. What many people fail to realize is that the distribution of appreciated property will result in a taxable transaction. When property is distributed from any type of Corporation (S Corporation or C Corporation) the distribution is made at the property’s Fair Market Value. This means that there is a realized taxable gain on the difference between the Fair Market Value at the date of distribution and the tax basis. You will pay tax on the transaction, and your resulting tax basis in the asset after distribution will be its Fair Market Value at the date of distribution.
This problem is most commonly avoided by distributing cash from the S Corporation to the owners, who then use the funds to purchase real estate, or other passive investments. These assets are frequently purchased through a limited liability company (LLC) to preserve pass through treatment of the income. If the real property is used by the S Corporation in its business, the property is then rented back to the S Corporation. The difference is that distributions from LLC’s (and partnerships) are made at the asset’s tax basis, with no gain or loss recognized on the distribution (resulting in a deferral of tax until the property is actually disposed of). Your basis in the distributed asset will be the same as it was in the hands of the LLC.
Placing appreciable assets into LLC’s instead of S Corporations will provide greater flexibility for future tax planning, and possibly defer the payment of income tax.
The Office of the Chief Accountant through Corp Fin recently published Staff Accounting Bulletin 113. There are four main areas of focus within this SAB which will likely affect everyone to some degree: valuation methodology of oil and gas reserves; clarification of methodology related to write-offs of excess capitalized costs under the full cost method; extending appliability of guidance to include unconventional methods of extracting oil and gas from sand and shale; and removing information from the guidance which is no longer necessary.
For the most part SAB 113 is pretty straight forward, however, as is the case with many of the SABs, hidden in the minutiae are land mines for the unwary or uninformed. Correspondingly you would be well served to skim through it for any matters that might affect your company, and then discuss them with your audit firm.
Additionally, on October 26, 2009 additional Oil and Gas Rules were released. These compliance and disclosure interpretations (C & DIs) relate to Regs S-X and S-K. There is some important information here which is very relevant and brief!
Recently, the House Financial Services Committee passed H.R. 3817, the Investor Protection Act. The bill includes an amendment, which would permanently exempt small public companies from complying with Section 404(b) of the Sarbanes-Oxley Act of 2002. The bill must still be voted on by the entire House of Representatives, but it is nice to know that there is hope.
As noted in the October 19th blog post by Mark Bailey, the 404(b) requirement for small business issuers is not beneficial in most cases and thus the passing of this act by the House Financial Services Committee is welcome news.
For many companies the transition to IFRS will not result in a major change… the big exception is in the manufacturing and retail industries, as IFRS does not allow the use of LIFO (the Last In First Out method of accounting for inventory). Because LIFO treats the last item to be purchased as the first item to be sold, the use of LIFO generally increases the cost of goods sold during periods of inflation. This reduces a company’s assets and earnings, but can result in large tax savings. It is because of this dichotomy that the IRS requires businesses to use LIFO for their book accounting records and financial statements if they wish to use it for tax purposes. Additionally, use of LIFO is generally restricted to mid-to-large sized companies, as it requires additional administrative work to track multiple LIFO layers for each type of inventory, and to prepare tax Uniform Capitalization adjustments on each layer.
Enter IFRS (from 2014 to 2016 for publicly traded companies – transition dates for privately held businesses have not yet been announced). Exit LIFO. If companies can no longer use LIFO for book accounting purposes, they will not be able to use it for tax accounting. This will give rise to a flood of paperwork to the IRS, as each company requests permission to change accounting method (which must be formally requested, even though the change is required and unwanted). More importantly, it will result in a huge income tax liability for nearly all companies required to make the transition.
So far the IRS has not offered any hint of resolution on this matter… and it looks like our manufacturers and retailers may pay the price.
In an effort to help improve my client’s filings, and of course avoid SEC Comment Letters, I am constantly reminding them that the disclosures required by SEC Rules Release 33-8098, contained in the MD&A, are considerably different than the significant accounting policies disclosed in the footnotes. Too frequently issuers simply cut and paste their summary of significant accounting policies into this section, which I believe will result in comments from the SEC if selected for a full review by Corp Fin.
I believe the intent of the critical accounting policies disclosures is for issuers to identify and disclose only those accounting policies that require significant judgment and estimation with a degree of uncertainty. Further, simply narrating the assumptions used in a Black-Scholes model for valuing stock options does not provide the appropriate information contained in the rules release. Disclosures related an issuers critical accounting policies (estimates) should include the methodology used in developing assumptions and the corresponding estimates, how the estimates impact the financial statements, and the effect of a change in the estimates and / or underlying assumptions.
The SEC provides two questions issuers need ask in making the “critical” determination:
- Did the estimate require making assumptions about matters that are highly uncertain?
- Would reasonably developed, different estimates / assumptions, at the time or in future periods, have a material impact on our financial statements?
When both questions are answered yes, it should be included in this section of the MD&A.
The included disclosures should not simply be boilerplate (like significant accounting policies tend to be) or be overly accounting technical (as “plain English” as possible). Further, the SEC expects varying numbers of critical accounting policies amongst issuers, but they have indicated three to five as a reasonable range.
The rules release provides several examples of disclosures that can help issuers develop the approach and content for appropriate inclusion in future filings.
As a youngster the Song of the South stories penned by Joel Chandler Harris at the beginning of the 20th century and brought to life by Disney were some of my favorites. In one, Bre’r Fox and Bre’r Bear make a tar baby to catch Bre’r Rabbit. Bre’r Rabbit becomes offended when the inanimate tar baby doesn’t respond, strikes it and becomes stuck to it. The more he struggles the more inextricably attached he becomes. It certainly seems that the SEC has found a tar baby in SOX 404(b) as it pertains to non-accelerated filers.
Recently the SEC deferred the compliance date – once again. This time for 9 months. The reason for further deferral was explained as being necessary as the results of an on-line survey conducted by the SEC which was not completed in time. A survey, I venture, that was essentially unknown to virtually everyone it might have affected, so not having it available was irrelevant.
As you may recall the original rationalization for 404 included the premise it would reduce fraud while increasing investor confidence in the issuer’s reporting. Those interviewed for the survey above indicated they did not believe there had been any increase in investor confidence as a result of 404 applied by large filers. Yet in his public comment, Commissioner Aguilar stated ” I join Chairman Shapiro in assuring investors that there will be no further extensions of the compliance deadline.” What am I missing? By the SEC’s own survey, investors don’t care! So why is it mandated? Certainly there can and have been benefits enjoyed by larger issuers. For them it is good governance in many cases, and worthwhile. But not for small companies.
There is essentially no benefit to most non-accelerated filers either actual or perceived in most cases, and the cost is proportionately greater than for larger companies. Both the SEC and the PCAOB have exercised common sense in promoting ‘scalability’ in other areas. They need to do so here as well by eliminating the requirement – one with no or negligible benefit and grossly disproportionate cost – for small non-accelerated issuers.
Will it reduce fraud in small companies? I seriously doubt it and I believe most public company audit partners would agree. The SEC has the weapon it needs to fight fraud in the 302 certifications.
Send this tar baby back to Congress and let the money be redirected for innovation and growth.
Last Friday, the AICPA released a discussion draft of the audit and accounting guide for Entities with Oil and Gas Producing Activities. While not authoritative it is anticipated to reflect the current standards being revised by both the Financial Accounting Standards Board which sets US GAAP, and the International Accounting Standards Board, all of which is being done in response to SEC Release 33-8995.
While the changes are too voluminous and complex to even summarize here, I’ve included links and welcome questions,comments to this post or phone calls to discuss the implications.
The definitions in Rule 4-10 have been significantly changed. The pricing mechanism for reserves has been defined as a twelve month average. The definition of what is and is not considered ‘oil and gas’ has been clarified to include bitumen and other saleable hydrocarbon resources (geothermal has been excluded); the definitions of ‘proved’ ‘unproved’, ‘developed’ and ‘undeveloped’ reserves has been amended and clarified; and the disclosure requirements under Regulation S-K has been expanded.
Additionally, the disclosure requirements within the financials and for the K’s and Q’s have been expanded and clarified including the disclosure requirements for MD & A. The SEC continues to coordinate with the FASB and the IASB who continue to develop their standards for the oil and gas entities. Given the SEC has come to the party first, it’s hard to imagine the other standard setting bodies will do anything but comply.
Foreign filers using Form 20-F will be subject to the same disclosure as opposed to the previous disclosure requirements summarized under Appendix A. Canadian filers, however, will not be subject to the new disclosure rules given that the requirements under the Multi-Jurisdictional Disclosure System (MJDS) using form 40-F are already consistent.
Now some good news. The implementation date for registrations filed and for annual reports on Forms 10-K and 20-F is for fiscal years ending on or after January 1, 2010. While the implementation is mandatory, “a company may not apply the new rules to disclosures in quarterly reports prior to the first annual report in which the revised disclosures are required”. Implementation may be deferred as discussions between the SEC, FASB and IASB go forward.
A number of countries don’t allow foreign people (including foreign business entities) to own land in certain areas. The most well known of these countries is Mexico, but I have recently come across a similar situation in Canada, and know of cases in Great Britain. As a work-around, the land is usually held in trust for the foreign owner. This may not seem as though it creates any tax issues, but it does. Unfortunately foreign trusts have at times been used to try to shelter income off-shore in foreign tax havens, so the IRS has strict reporting requirements for foreign trusts… and the penalties for not filing the related forms are huge! (In some cases 35% of the trust assets per year). Even if you don’t think of the trust as a “real trust” – the IRS probably will (they are commonly referred to as “Land Trusts” or “Mexican Land Trusts”). We recently enlisted the services of tax attorney, Jean Ryan at Sideman Bancroft, LLP, to analyze a Canadian land trust. Although the client “never thought of it as being a real trust,” her answer was that it the IRS may treat it as trust, because of the language in the document. So if you own beachfront property in Mexico – lucky you, but in all seriousness, talk to your tax advisor to make sure that you don’t lose it all in penalties.
Today, October 2, 2009, the SEC announced that independent audits of internal control over financial reporting has been extended for smaller reporting companies. The press release indicates small companies will now need to be compliant beginning with annual reports for fiscal years ending on or after June 15, 2010.