Accounting – Excelsis Accounting Group

Why You Shouldn’t Kill Your Rich Uncle Just Yet: Things You May Not Know About the Estate Tax Repeal

The day is finally here. After hearing about it for the past nine years, the estate tax is repealed as of January 1, 2010. Yet, many questions remain. For example, one may wonder what will happen next year when the estate tax (presumably) returns and one is puzzled why U.S. Congress did not address the “estate tax issue” during the 2009 tax year.

The one-year repeal of the “death tax” was a typical congressional compromise. It involved the gradual decrease in marginal tax rates and increase in tax free amount (unified credit) through 2009 and the repeal of the tax for just one year in 2010. The current law reads that in 2011 the rates from 2001 will apply again (P.L. 107-16, 115 Stat 38 (June 7, 2001)).

What does this mean for taxpayers? Let’s assume Uncle Joseph’s taxable estate is valued at $5 million. If he died in 2001, $675,000 of the estate would have been tax free and the rest would have been taxed with a top marginal rate of 55%. Tax liability would have been about 2.17 million and effective tax rate about 43%. Had Uncle Joseph died in 2009, his tax due would have been $675,000 and his effective tax rate around 14% while a 2010 death would mean zero liability (see Table).

Year	Top Marginal Tax Rate	Unified Credit (Exemption Equivalent)	Tax due after credit on $5 million estate	Effective Tax Rate
2001	55%	$220,550 ($675,000)	$ 2,170,250	43%
2002	50%	$345,800 ($1,000,000)	$ 1,930,000	39%
2003	49%	$345,800 ($1,000,000)	$ 1,905,000	38%
2004	48%	$555,800 ($1,500,000)	$ 1,665,000	33%
2005	47%	$555,800 ($1,500,000)	$ 1,635,000	33%
2006	46%	$780,800 ($2,000,000)	$ 1,380,000	28%
2007	45%	$780,800 ($2,000,000)	$ 1,350,000	27%
2008	45%	$780,800 ($2,000,000)	$ 1,350,000	27%
2009	45%	$1,455,800 ($3.5 million)	$ 675,000	14%
2010	NA	NA	No tax	N/A
2011	55%	$220,550 ($675,000)	$ 2,170,250	43%

Questionable Policy Incentives

The stated policy reason for estate taxes has been that too much concentration of wealth is not good for a society. Aside from the fact that the estate tax has not done much in terms of reducing income and wealth inequality, the fact that Congress did not change the one-year repeal before January 1 of 2010, is an example of implementing quite questionable incentives. As the situation above shows, all else equal, the best year for Joseph to die is 2010. His heirs will receive the entire $5 million instead of only $4.3 million if he died in 2009 or $2.8 million if he dies in 2011. Of course, death of natural causes cannot be timed. What happens though if Joseph was in a serious accident in late 2009 without a DNR order in place? Would his heirs insist that he’d be kept alive until January 1 and then taken off life support? What if Joseph has an accident in December of 2010?

In order to prevent anybody of literally making life or death decisions in order to save taxes, Congress should have addressed the estate tax in 2009 before the repeal-year started. There were several proposals on the table. Considering the current budget shortfall and the Democratic majorities in both the House and the Senate it is not unlikely that the legislators will pass a law retroactively changing the 2010 repeal. Since tax returns are not due until nine months after the decedent’s death, a retroactive change is possible. For example, it may be possible that a “patch” (i.e., keeping rates and credit like it was in 2009) will pass for 2010. Thus, contemplating death in light of a possible tax free year would be unwise considering the irreversibility of such action.

Other Negative Consequences

During 2001–2011 inflation was relatively low (around 2.3% on average). Using consumer price index measures, the value of a dollar in 2001 is about 1.25 more than in 2011. Given that in 2001, over 108,000 estate tax returns were filed, compared to only 38,000 in 2008 , we can assume that reverting back to 2001 law would mean that at least 130,000 returns will be due in 2011. This is good news to tax accountants but bad news for many individuals who did not expect to be subject to estate taxes.

In addition, the repeal of the estate tax for 2010 means that assets transferred at death during this year do not get a stepped-up basis. Thus, beneficiaries will have to pay larger amounts in income taxes when they sell the inheritance.

Last, the one-year repeal is also bad news for estates below the exemption equivalent. For these estates, the tax savings are zero while the elimination of the step-up in basis increases beneficiaries’ income tax when they sell the assets received. One can make the argument that this is a rule against the middle class and upper middle class since presumably most of these individuals would have never paid estate tax anyway but their heirs would benefit from the step-up in basis. If the law reverts back to 2001 law in 2011, the step-up will be back next year. Thus, while individuals with large estates have an incentive to die in 2010, others (most middle and upper middle class taxpayers) who have an estate below the exemption equivalent should not die in 2010.

Oil and Gas Accounting – SEC Issues SAB 113

Oil & Gas Industry 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!

Taking the Life out of LIFO

Taking the Life out of Lifo 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.

IFRS – No Big Deal!

Judging by the material that is coming out from the Big 4 accounting firms, it seems that accounting as we know it is about to disappear and a new behemoth called IFRSs are about to invade the US accounting scene. Recently the office managing partner of one of those firms admitted to me that they viewed the issue as a consulting opportunity rather than a threat. I agree.

IFRS are already here and have been for quite some time. Most of the standards that have been issued since in the past four years have been designed to bring US GAAP standards and international GAAP standards (IFRS) closer and closer together. This is commonly referred to as ‘convergence’. FASB 141 (R) for business combination’s and FASB 160 on minority interests are typical examples. FASB has issued standards that are consistent with the international standards. The International Accounting Standards Board (IASB) is doing the same thing as the FASB. They are issuing standards to bring them closer to US GAAP alternative over time where US GAAP is deemed preferable to IFRS. This convergence process has been going on for years and is nothing new.

What is new is the “road map” that has been put in place by the SEC, and it changed again recently. Foreign listers on the US exchanges are already allowed by the SEC to use IFRS. A limited group of about 100 US companies will experiment with early adoption of IFRS in the US in 2009. Most of these companies are already using IFRS for significant parts of their international operations anyway so they don’t need much outside help. For the rest of us, the SEC will make a decision in 2011 on whether to move to require all US listed companies to follow IFRS by 2014. Unless we get some xenophobic idiots appointed to the SEC this is a done deal. Although the new SEC Chairperson, Mary Shapiro, has announced that she is considering slowing down the process, it probably won’t change the FASBs agenda.

Is this a major issue? I don’t think so. By 2014, all of the major differences between US GAAP and IFRS will almost certainly have been eliminated. There are some problem issues to be resolved. Some are straightforward like the use of LIFO for inventory accounting. The problem here is that tax accounting in the US is impinging on real accounting. We will have to find some tax solution to unbundle the inbuilt tax problem that LIFO has created for many companies.

Other issues are more difficult and highly technical. The ugly issue of derivatives is always at the forefront here. Almost nobody understands the US standard FASB 133 and the same is true that almost nobody understands its international equivalent. All we know is that they have some differences and the financial institutions don’t like either of the standards anyway.

Some issues appear more frightening. For example, with IFRS we will lose those “bright line” guidelines that US accountants love so much. For example, the four tests for a capital lease that lawyers love to circumvent will be no more. Greater judgment will be required. This is an issue because you may have to get up in a court of law to defend your judgment. Looking on the bright side, at least you wont get tripped up by some smart trial lawyer because you did not follow some little known paragraph of one of the 14 FASs, 6 INTs, 10TBs, 2FASBSPs and about 25 EITFs that currently relate to leases in US GAAP. They will be gone as authoritative documents.

For non-listed companies, there are some proposals on the table on how to apply IFRS to smaller entities. Personally I don’t like the proposals because I don’t like having two-tier GAAP for large and small enterprises. Again, whatever changes occur will drift in over time largely unnoticed by most. If you have any experience with IFRS please comment.

SFAS 157 – How 'Fair is Fair' Value?

No matter if you believe that “fair value” drives unnecessary market instability or that it provides enhanced transparency of financial information, the question remains unchanged.

No matter if you believe that “fair value” drives unnecessary market instability or that it provides enhanced transparency of financial information, the question remains unchanged. What is a supportable fair market value that reflects an orderly transaction between two or more willing market participants?

The SEC’s recently issued “Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting” concludes, amongst other things, that “..additional measures should be taken to improve the application and practice related to existing fair value requirements – particularly as they relate to both Level 2 and Level 3 estimates”. In the report, the SEC’s Committee on Improvements to Financial Reporting (CIFiR) further recommended the SEC issue a statement of policy articulating how it evaluates the reasonableness of accounting judgments and include factors that it considers when making this evaluation, as well as that the PCAOB should also adopt a similar approach with respect to auditing judgments.

In light of these conclusions, and unlikely forthcoming judgment “guidance” for valuing financial instruments with primarily Level 2 and 3 inputs, it is important to gather all pertinent information and variables potentially used in building a valuation model. There are several keys to doing this including:

Monitor your investments and those similar throughout the reporting period, not just at the reporting date.
Stay in touch with general economic indicators.
Consider your true plans of instrument liquidation and whether the Company has the ability to wait out the market.
Get your non-accounting finance and analyst types involved as they are generally more comfortable with assumptions and judgment than most accounting types.
Provide your assumption documentation to your auditor as soon as possible – it is generally not difficult to audit the fair value model itself, however, getting reasonable documentation related to assumptions is where the time is spent, particularly when there is a difference in opinion as to what constitutes reasonable.
Try to keep it simple concise and as straightforward as possible. Tying certain assumptions to the lining up of the planets will likely not pass your auditor’s smell test.

By the way, the SEC’s Report concluded that the fair value accounting standards did not cause the bank failures of 2008.

Proactively Controlling Your Audit Fee

For many firms it is that time of year. The annual invasion of that group of mind numbing, routine interrupting, standards spouting unwelcome invaders – your independent auditors! And they are expensive! Reflectively they can make you want to trade their presence for an unannounced three month visit from your cantankerous incontinent father-in-law who never speaks directly to you and who for fifteen years has referred to you only as “him / her”. An article published in cfo.com, Auditor Angst, has some great points to not only help you survive, but to reduce the expense at the same time. While the article primarily focuses on what the company can/should do there is obviously a lot the auditors can do as well. Continue reading “Proactively Controlling Your Audit Fee”

How to create profits out of thin air

In my last posting I tried to make assets out of liabilities. Now I want to make some profits out of my liabilities. This is a piece of cake under current GAAP but my current favorite again relates to the issue of the convertible debt that seems to be so popular with companies with a bit of a going concern problem. Continue reading “How to create profits out of thin air”

Now to make silk purses (assets) out of sows’ ears (liabilities)

I have noticed a few companies using some ingenious accounting to create assets by issuing liabilities.

I have noticed a few companies using some ingenious accounting to create assets by issuing liabilities. One would have thought that debit cash credit liabilities would be a fairly simple transaction when you issue debt. Not so when that debt is convertible debt issued with a warrant.

The way the scheme runs is a follows. The text books and the ancient APB 14 tell us that when you issue debt with detachable warrants you have to separate the warrants out from the debt and take the value assigned to the warrants to paid in capital. Continue reading “Now to make silk purses (assets) out of sows’ ears (liabilities)”

Does anybody know what an accounting policy is?

Until FAS 154 came along I thought I understood what an accounting policy was. They were the things that went into note 1 to the financial statements for situations where there was an accounting choice between two alternatives. Rather curiously whatever choice you made ended up providing a fair presentation as long as you were consistent and disclosed it in Note 1.