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Simplifying the Accounting Rules for Convertible Debt and Equity

Distinguishing between liabilities and equity on a company’s balance sheet may seem straightforward. But difficulties arise when it comes to the terms of complex securities and financial contracts like redeemable equity instruments, equity-linked or indexed instruments, and convertible instruments.

The good news is that the Financial Accounting Standards Board (FASB) is currently working on a project to improve how to determine the difference between liabilities and equity.

Need for change

Work on this project dates as far back as 1986, when distinguishing liabilities from equity was added to the FASB’s technical agenda. Since then, the board has issued various pieces of guidance to help resolve issues that have been raised. But the outcry for revisions to the liabilities vs. equity topic hasn’t waned.

In 2017, accounting professionals told the FASB that current guidance is “overly complex, internally inconsistent, path dependent, form based and is a cause for frequent financial statement restatements.”

Once again, the project is a top priority for the FASB. In 2019, deliberations will initially focus on two areas:

  1. Accounting for convertible instruments with embedded conversion features, and
  2. Determining whether instruments are indexed to an entity’s own stock.

A convertible instrument, typically a bond or a preferred stock, is an instrument that can be converted into a different security — often shares of the company’s common stock. For example, emerging and growing companies often use convertible debt as an alternative financing solution. It’s basically a loan obtained by a company from venture capital or angel investors whereby both parties agree to convert the debt into equity at a specific date.

Tentative plans

Convertible instruments create complex accounting issues and have become a major source of confusion and restatements. In February 2019, the FASB tentatively voted to:

  • Revise certain disclosures for convertible instruments, including adding disclosure objectives for convertible debt and for convertible preferred shares,
  • Centralize the guidance on convertible preferred shares in Accounting Standards Codification (ASC) Topic 505, Equity, and convertible debt in ASC Subtopic 470-20, Debt — Debt with Conversion and other Options, and
  • Improve the diluted earnings-per-share calculation and derivative scope exception.

Under the existing rules, there are currently five models to account for convertible debt, which the board plans to narrow down to one or two models. As a result, convertible debt would be recognized in the balance sheet as a single liability, measured at amortized cost. There would no longer be bifurcation, or separation, of the conversion feature and the debt host. Similarly, convertible preferred shares would be recognized in the balance sheet as a single equity element.

Stay tuned

Many start-ups and midsize businesses use convertible instruments to raise cash. But it’s easy for management to miss an aspect of an arrangement and then follow the wrong accounting model under today’s complex, inconsistent principles. And the complex accounting rules even may cause some businesses to avoid tapping into these financing alternatives.

Fortunately, the FASB is taking steps to simplify the financial reporting requirements — and we’re atop the latest developments. Contact us for more information.   

© 2019

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2019 Q2 Tax Calendar: Key Deadlines or Businesses and Other Employers

Here are some of the key tax-related deadlines that apply to businesses and other employers during the second 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.

April 1

  • File with the IRS if you’re an employer that will electronically file 2018 Form 1097, Form 1098, Form 1099 (other than those with an earlier deadline) and/or Form W-2G.
  • If your employees receive tips and you file electronically, file Form 8027.
  • If you’re an Applicable Large Employer and filing electronically, file Forms 1094-C and 1095-C with the IRS. For all other providers of minimum essential coverage filing electronically, file Forms 1094-B and 1095-B with the IRS.

April 15

  • If you’re a calendar-year corporation, file a 2018 income tax return (Form 1120) or file for an automatic six-month extension (Form 7004) and pay any tax due.
  • Corporations pay the first installment of 2019 estimated income taxes.

April 30

  • Employers report income tax withholding and FICA taxes for the first quarter of 2019 (Form 941) and pay any tax due.

May 10

  • Employers report income tax withholding and FICA taxes for the first quarter of 2019 (Form 941), if you deposited on time and fully paid all of the associated taxes due.

June 17

  • Corporations pay the second installment of 2019 estimated income taxes.

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Transparency is Key with Related Party Transactions

In recent years, external auditors have focused more attention on related party transactions. Although related party transactions aren’t necessarily bad, they do raise some concerns about the risk of misstatement or omission in financial reporting.

3 focal points

Issues with related parties played a prominent role in the scandals that surfaced nearly two decades ago at Enron, Tyco International and Refco. Public outrage about these scandals led Congress to pass the Sarbanes-Oxley Act of 2002 and establish the Public Company Accounting Oversight Board (PCAOB). Similar problems have arisen in more recent financial reporting fraud cases, prompting the PCAOB to enact tougher standards on related-party transactions and financial relationships.

PCAOB Auditing Standard No. 2410 (AS 2410), Related Parties, requires auditors of public companies to beef up their efforts in financial statement matters that pose increased risk of fraud. Specifically, auditors must focus on three critical areas:

1. Related-party transactions, such as those involving directors, executives and their family members,
2. Significant unusual transactions (SUTs) that are outside the company’s normal course of business or that otherwise appear to be unusual due to their timing, size or nature, and
3. Other financial relationships with the company’s executive officers and directors.

Subjecting these transactions and financial relationships to enhanced auditor scrutiny may help avert corporate failures. The PCAOB also hopes that enhanced auditor scrutiny will lead to improvements in accounting transparency and disclosures, which will help investors to more clearly gauge financial performance and fraud risks.

From start to finish

AS 2410 requires auditors to obtain a more in-depth understanding of every related-party financial relationship and transaction, including their nature, terms and business purpose (or lack thereof). Tougher related-party audit procedures must be performed in conjunction with the auditor’s risk assessment procedures, which occur in the planning phase of an audit.

In addition, auditors are expected to communicate with the audit committee throughout the audit process regarding the auditor’s evaluation of the company’s identification of, accounting for and disclosure of its related-party relationships and transactions. They can’t wait until the end of the engagement to communicate on these matters.

During fieldwork, expect auditors to be on the hunt for undisclosed related parties and unusual transactions. Examples of information that may be gathered during the audit that could reveal undisclosed related parties include information contained on the company’s website, tax filings, corporate life insurance policies, contracts and organizational charts.

Certain types of questionable transactions — such as contracts for below-market goods or services, bill-and-hold arrangements, uncollateralized loans and subsequent repurchase of goods sold — also might signal that a company is engaged in unusual or undisclosed related-party transactions.

To facilitate the audit process, management should be up-front with auditors about all related party transactions, even if they’re not required to be disclosed or consolidated on the company’s financial statements.

Let’s be honest

Private companies also engage in numerous related party transactions, and they may experience spillover effects of the tougher PCAOB auditing standard, which applies only to audits of public companies. Regardless of whether you’re publicly traded or privately held, it’s important to identify, evaluate and disclose all related parties. We can help you present related party relationships and transactions, openly and completely.

© 2019

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Could Your Business Benefit from the Tax Credit for Family and Medical Leave?

The Tax Cuts and Jobs Act created a new federal tax credit for employers that provide qualified paid family and medical leave to their employees. It’s subject to numerous rules and restrictions and the credit is only available for two tax years — those beginning between January 1, 2018, and December 31, 2019. However, it may be worthwhile for some businesses.

The value of the credit

An eligible employer can claim a credit equal to 12.5% of wages paid to qualifying employees who are on family and medical leave, if the leave payments are at least 50% of the normal wages paid to them. For each 1% increase over 50%, the credit rate increases by 0.25%, up to a maximum credit rate of 25%.

An eligible employee is one who’s worked for your company for at least one year, with compensation for the preceding year not exceeding 60% of the threshold for highly compensated employees for that year. For 2019, the threshold for highly compensated employees is $125,000 (up from $120,000 for 2018). That means a qualifying employee’s 2019 compensation can’t exceed $72,000 (60% × $120,000).

Employers that claim the family and medical leave credit must reduce their deductions for wages and salaries by the amount of the credit.

Qualifying leave

For purposes of the credit, family and medical leave is defined as time off taken by a qualified employee for these reasons:

• The birth, adoption or fostering of a child (and to care for the child),
• To care for a spouse, child or parent with a serious health condition,
• If the employee has a serious health condition,
• Any qualifying need due to an employee’s spouse, child or parent being on covered active duty in the Armed Forces (or being notified of an impending call or order to covered active duty), and
• To care for a spouse, child, parent or next of kin who’s a covered veteran or member of the Armed Forces.

Employer-provided vacation, personal, medical or sick leave (other than leave defined above) isn’t eligible.

When a policy must be established

The general rule is that, to claim the credit for your company’s first tax year that begins after December 31, 2017, your written family and medical leave policy must be in place before the paid leave for which the credit will be claimed is taken.

However, under a favorable transition rule for the first tax year beginning after December 31, 2017, your company’s written leave policy (or an amendment to an existing policy) is considered to be in place as of the effective date of the policy (or amendment) rather than the later adoption date.

Attractive perk

The new family and medical leave credit could be an attractive perk for your company’s employees. However, it can be expensive because it must be provided to all qualifying full-time employees. Consult with us if you have questions or want more information.

© 2019

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ESG Issues: To Report or Not to Report?

Securities and Exchange Commission (SEC) Chairman Jay Clayton recently said that public companies shouldn’t be required to disclose information concerning environmental, social and governance (ESG) matters in their financial statements using a standardized format. Right now, these disclosures are voluntary and unstandardized.

ESG issues

The SEC is a long-standing member of the International Organization of Securities Commissions (IOSCO). But, in January, the SEC refused to sign a statement issued by IOSCO that urged companies to disclose nonfinancial ESG matters that may affect a company’s financial condition and performance. Examples include:

• The size of the company’s carbon footprint,
• Efforts to replace fossil fuels with renewable energy sources,
• Workplace, health and safety issues, and
• Consumer product safety risks.

Media attention on these external threats has increased public awareness and prompted concerns about how ESG issues could impact value or increase a company’s risk of litigation. Some investor groups and regulators are calling for formal rules that would mandate the use of a standardized framework.

SEC position

SEC Commissioner Hester Peirce and Chairman Clayton recognize that voluntary ESG disclosures provide insight into company operations when used in conjunction with traditional financial metrics. But they oppose a one-size-fits-all reporting format. They contend that some ESG information isn’t relevant to a reasonable investor and thus takes time away from focusing on more pressing matters.

They also point out that companies that follow U.S. Generally Accepted Accounting Principles (GAAP) already must disclose material ESG matters in the following sections of their financial statements:

Description of business. This disclosure describes the business and that of its subsidiaries, including information about its form of organization, principal products and services, major customers, competitive conditions and costs of complying with environmental laws.

Legal proceedings. This disclosure briefly explains any material pending legal proceedings in which the company, any of its subsidiaries and any of its property are involved.

Risk factors. These disclosures highlight the most significant factors that make an investment in the company speculative or risky.

Management’s discussion and analysis (MD&A). Public companies must identify known trends, events, demands, commitments and uncertainties that are reasonably likely to have a material effect on financial condition or operating performance.

In addition, some companies voluntarily issue separate standalone “sustainability” reports that cover a broad range of nonfinancial issues. However, these nonfinancial figures aren’t audited, and, unfortunately, some companies use ESG data to present a stronger financial picture than the ones that appear in their audited financial statements.

A custom approach

Voluntary ESG reporting can provide valuable insight to investors and lenders. We can help your company create customized financial statement disclosures and standalone sustainability reports that reflect its most pressing ESG concerns. Contact us for more information.

© 2019

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There’s Still Time for Small Business Owners to Set Up a SEP Retirement Plan for Last Year

If you own a business and don’t have a tax-advantaged retirement plan, it’s not too late to establish one and reduce your 2018 tax bill. A Simplified Employee Pension (SEP) can still be set up for 2018, and you can make contributions to it that you can deduct on your 2018 income tax return.

Contribution deadlines

A SEP can be set up as late as the due date (including extensions) of your income tax return for the tax year for which the SEP is to first apply. That means you can establish a SEP for 2018 in 2019 as long as you do it before your 2018 return filing deadline. You have until the same deadline to make 2018 contributions and still claim a potentially substantial deduction on your 2018 return.

Generally, other types of retirement plans would have to have been established by December 31, 2018, in order for 2018 contributions to be made (though many of these plans do allow 2018 contributions to be made in 2019).

Discretionary contributions

With a SEP, you can decide how much to contribute each year. You aren’t obligated to make any certain minimum contributions annually.

But, if your business has employees other than you:

1. Contributions must be made for all eligible employees using the same percentage of compensation as for yourself, and
2. Employee accounts must be immediately 100% vested.

The contributions go into SEP-IRAs established for each eligible employee.

For 2018, the maximum contribution that can be made to a SEP-IRA is 25% of compensation (or 20% of self-employed income net of the self-employment tax deduction), subject to a contribution cap of $55,000. (The 2019 cap is $56,000.)

Next steps

To set up a SEP, you just need to complete and sign the very simple Form 5305-SEP (“Simplified Employee Pension — Individual Retirement Accounts Contribution Agreement”). You don’t need to file Form 5305-SEP with the IRS, but you should keep it as part of your permanent tax records. A copy of Form 5305-SEP must be given to each employee covered by the SEP, along with a disclosure statement.

Although there are rules and limits that apply to SEPs beyond what we’ve discussed here, SEPs generally are much simpler to administer than other retirement plans. Contact us with any questions you have about SEPs and to discuss whether it makes sense for you to set one up for 2018 (or 2019).

© 2019

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Will Leasing Equipment or Buying It Be More Tax Efficient for Your Business?

Recent changes to federal tax law and accounting rules could affect whether you decide to lease or buy equipment or other fixed assets. Although there’s no universal “right” choice, many businesses that formerly leased assets are now deciding to buy them.

Pros and cons of leasing

From a cash flow perspective, leasing can be more attractive than buying. And leasing does provide some tax benefits: Lease payments generally are tax deductible as “ordinary and necessary” business expenses. (Annual deduction limits may apply.)

Leasing used to be advantageous from a financial reporting standpoint. But new accounting rules that bring leases to the lessee’s balance sheet go into effect in 2020 for calendar-year private companies. So, lease obligations will show up as liabilities, similar to purchased assets that are financed with traditional bank loans.

Leasing also has some potential drawbacks. Over the long run, leasing an asset may cost you more than buying it, and leasing doesn’t provide any buildup of equity. What’s more, you’re generally locked in for the entire lease term. So, you’re obligated to keep making lease payments even if you stop using the equipment. If the lease allows you to opt out before the term expires, you may have to pay an early-termination fee.

Pros and cons of buying

Historically, the primary advantage of buying over leasing has been that you’re free to use the assets as you see fit. But an advantage that has now come to the forefront is that Section 179 expensing and first-year bonus depreciation can provide big tax savings in the first year an asset is placed in service.

These two tax breaks were dramatically enhanced by the Tax Cuts and Jobs Act (TCJA) — enough so that you may be convinced to buy assets that your business might have leased in the past. Many businesses will be able to write off the full cost of most equipment in the year it’s purchased. Any remainder is eligible for regular depreciation deductions over IRS-prescribed schedules.

The primary downside of buying fixed assets is that you’re generally required to pay the full cost upfront or in installments, although the Sec. 179 and bonus depreciation tax benefits are still available for property that’s financed. If you finance a purchase through a bank, a down payment of at least 20% of the cost is usually required. This could tie up funds and affect your credit rating. If you decide to finance fixed asset purchases, be aware that the TCJA limits interest expense deductions (for businesses with more than $25 million in average annual gross receipts) to 30% of adjusted taxable income.

Decision time

When deciding whether to lease or buy a fixed asset, there are a multitude of factors to consider, including tax implications. We can help you determine the approach that best suits your circumstances.

© 2019

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Beware the Ides of March – If You Own a Pass-Through Entity

Shakespeare’s words don’t apply just to Julius Caesar; they also apply to calendar-year partnerships, S corporations and limited liability companies (LLCs) treated as partnerships or S corporations for tax purposes. Why? The Ides of March, more commonly known as March 15, is the federal income tax filing deadline for these “pass-through” entities.

Not-so-ancient history

Until the 2016 tax year, the filing deadline for partnerships was the same as that for individual taxpayers: April 15 (or shortly thereafter if April 15 fell on a weekend or holiday). One of the primary reasons for moving up the partnership filing deadline was to make it easier for owners to file their personal returns by the April filing deadline. After all, partnership (and S corporation) income passes through to the owners. The earlier date allows owners to use the information contained in the pass-through entity forms to file their personal returns.

For partnerships with fiscal year ends, tax returns are now due the 15th day of the third month after the close of the tax year. The same deadline applies to fiscal-year S corporations. Under prior law, returns for fiscal-year partnerships were due the 15th day of the fourth month after the close of the fiscal tax year.

Avoiding a tragedy

If you haven’t filed your calendar-year partnership or S corporation return yet and are worried about having sufficient time to complete it, you can avoid the tragedy of a late return by filing for an extension. Under the current law, the maximum extension for calendar-year partnerships is six months (until September 16, 2019, for 2018 returns). This is up from five months under the old law. So the extension deadline is the same — only the length of the extension has changed. The extension deadline for calendar-year S corporations also is September 16, 2019, for 2018 returns.

Whether you’ll be filing a partnership or an S corporation return, you must file for the extension by March 15 if it’s a calendar-year entity.

Extending the drama

Filing for an extension can be tax-smart if you’re missing critical documents or you face unexpected life events that prevent you from devoting sufficient time to your return right now.

But to avoid potential interest and penalties, you still must (with a few exceptions) pay any tax due by the unextended deadline. There probably won’t be any tax liability from the partnership or S corporation return. But, if filing for an extension for the entity return causes you to also have to file an extension for your personal return, it could cause you to owe interest and penalties in relation to your personal return.

We can help you file your tax returns on a timely basis or determine whether filing for an extension is appropriate. Contact us today.

© 2019

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The Home Office Deduction: Actual Expenses vs. the Simplified Method

If you run your business from your home or perform certain functions at home that are related to your business, you might be able to claim a home office deduction against your business income on your 2018 income tax return. Thanks to a tax law change back in 2013, there are now two methods for claiming this deduction: the actual expenses method and the simplified method.

Basics of the deduction

In general, you’ll qualify for a home office deduction if part of your home is used “regularly and exclusively” as your principal place of business.

If your home isn’t your principal place of business, you may still be able to deduct home office expenses if 1) you physically meet with patients, clients or customers on your premises, or 2) you use a storage area in your home (or a separate free-standing structure, such as a garage) exclusively and regularly for your business.

Actual expenses

Traditionally, taxpayers have deducted actual expenses when they claim a home office deduction. Deductible home office expenses may include:

  • Direct expenses, such as the cost of painting and carpeting a room used exclusively for business,
  • A proportionate share of indirect expenses, such as mortgage interest, property taxes, utilities, repairs and insurance, and
  • A depreciation allowance.

But keeping track of actual expenses can be time consuming.

The simplified method

Fortunately, there’s a simplified method that’s been available since 2013: You can deduct $5 for each square foot of home office space, up to a maximum total of $1,500.

For example, if you’ve converted a 300-square-foot bedroom to an office you use exclusively and regularly for business, you can write off $1,500 under the simplified method (300 square feet x $5). However, if your business is located in a 600-square-foot finished basement, the deduction will still be only $1,500 because of the cap on the deduction under this method.

As you can see, the cap can make the simplified method less beneficial for larger home office spaces. But even for spaces of 300 square feet or less, taxpayers may qualify for a bigger deduction using the actual expense method. So, tracking your actual expenses can be worth the extra hassle.

Flexibility in filing

When claiming the home office deduction, you’re not locked into a particular method. For instance, you might choose the actual expense method on your 2018 return, use the simplified method when you file your 2019 return next year and then switch back to the actual expense method thereafter. The choice is yours.

Unsure whether you qualify for the home office deduction? Or wondering whether you should deduct actual expenses or use the simplified method? Contact us. We can help you determine what’s right for your specific situation.

© 2019

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Auditing Cashless Transactions

Like most businesses, you’ve probably experienced a significant increase in the number of customers who prefer to make cashless payments. And you may be wondering: How does the acceptance of these types of transactions affect the auditing of your financial statements?

Cashless transactions require the exchange of digital information to facilitate payments. Instead of focusing on the collection and recording of physical cash, your auditors will spend significant time analyzing your company’s electronic sales records. This requires four specific procedures.

1. Identifying accepted payment methods

Auditors will ask for a list of the types of payments your company accepts and the process maps for each payment vehicle. Examples of cashless payment methods include:

  • Credit and debit cards,
  • Mobile wallets (such as Venmo),
  • Digital currencies (such as Bitcoin),
  • Automated Clearing House (ACH) payments,
  • Wire transfers, and
  • Payments via intermediaries (such as PayPal).

Be prepared to provide documents detailing how the receipt of cashless payments works and how the funds end up in your company’s bank account.

2. Evaluating roles and responsibilities

Your auditors will request a list of employees involved in the receipt, recording, reporting and analysis of cashless transactions. They will also want to see how your company manages and monitors employee access to every technology platform connected to cashless payments.

Evaluating who handles each aspect of the cashless payment cycle helps auditors confirm whether you have the appropriate level of security and segregation of duties to prevent fraud and misstatement.

3. Testing the reconciliation process

Auditors will review prior sales reconciliations to test their accuracy and ensure appropriate recognition of revenue. This may be especially challenging as companies implement the new accounting rules on revenue recognition for long-term contracts. Auditors also will test accounting entries related to such accounts as inventory, deferred revenue and accounts receivable.

4. Analyzing trends

Cashless transactions create an electronic audit trail. So, there’s ample data for auditors to analyze. To uncover anomalies, auditors may, for example, analyze sales by payment vehicle, over different time periods and according to each employee’s sales activity.

If your company has experienced payment fraud, it’s important to share that information with your audit team. Also tell them about steps you took to remediate the problem and recover losses.

Preparing for a cashless future

Before we arrive to conduct fieldwork, let’s discuss the types of cashless payments you now accept — or plan to accept in the future. Depending on the number of cashless methods, we’ll amend our audit program to review them in detail.

© 2019