Cherry Bekaert

Economy, Business Combinations and Impact on Financial Institution Acquisitions (ASU 2012-06)

2013-01-18T18:41:23Z

The financial crisis of 2008 led to a chain of events which included unprecedented provisions for loan losses, charge-offs of loan balances, and foreclosures of real estate by many national, super-regional, regional and community banks. The significant decline in operating performance of financial institutions led to the erosion of many financial institution’s capital positions (basically shareholder’s equity). The impact of the financial crisis increased regulatory scrutiny to the point that there have been historical highs in the number of financial institutions taken under receivership by the FDIC as it was deemed the financial institutions were unable to manage themselves out of their myriad of problem loans and foreclosed asset positions. The number of banks closed by the FDIC increased from approximately 30 in 2008 to a high of over 160 in 2010. From 2008 to 2011, there have been over 425 financial institution failures. We have only seen a recent decline in failed banks during 2012 as there have been only approximately 50 in 2012.

In a free market society, we will always have the “haves” and the “have-nots”. The deterioration in the operating performance of many regional and community banks in the U.S. created acquisition opportunities for healthy financial institutions that had the capital base to absorb not only their own decline in operating performance but also the opportunity to take advantage of acquisition targets in the marketplace. The FDIC is traditionally not in the practice of operating financial institutions on a daily basis and doesn’t have the operational structure to operate troubled financial institutions efficiently; accordingly, well capitalized financial institutions had a willing seller of closed financial institutions in the FDIC. However, the FDIC’s portfolio of financial institutions consisted solely of financial institutions that comprised of a significant amount of toxic assets (problem loans and foreclosed properties). As a result, FDIC needed to entice a healthy financial institution to acquire, not only the coveted deposits, but also the failing financial institution’s loan portfolio and foreclosed assets. The enticement was in the form of credit enhancement to the failed bank acquisition deals. This instrument utilized to accommodate the healthy financial institution to acquire the toxic assets is referred to as a FDIC Loss Sharing Arrangement. Pursuant to the loss sharing agreement, the FDIC agrees to share in the losses that may be incurred by the acquirer healthy financial institution related to the toxic assets acquired from the failed financial institution. Although the FDIC loss share agreements have evolved over time in the percentage of losses that the FDIC will assume, the typical arrangement over the past several years is an arrangement in that the FDIC will reimburse the acquiring bank for up to 80% of the losses incurred related to the toxic assets acquired. For example, healthy bank acquires a failed bank with $120,000 in outstanding loans and, subsequent to the acquisition, the healthy bank eventually charges-off $100,000 as the loans became ultimately uncollectible. If the acquisition transaction with the FDIC included a loss-share arrangement, the healthy bank would submit reimbursement for 80% of the losses incurred or $80,000. As a result, the net loss to the bank on uncollectible loan portfolio would be only $20,000. This is a nice “insurance” policy. When a bank acquires a failed bank that has come under receivership of the FDIC, the typical terminology to refer to this acquisition is an FDIC-assisted acquisition transaction.

How does one account for the initial transaction of entering into an acquisition transaction with a FDIC that includes a loss-share agreement related to a failed bank? In addition, after initial recognition, how does one subsequently account for the loss-sharing arrangement with the FDIC?

Acquisition Accounting Implications (Day 1 Accounting)

The underlying transaction principle of a healthy bank acquiring a failed bank under receivership by the FDIC is that a business combination has resulted from this transaction. As such, the acquirer bank will apply ASC 805, Business Combinations, in accounting for the transaction. Under ASC 805, the fundamental accounting concept is that, on the acquisition date, an entity should recognize the assets acquired and the liabilities assumed of the failed bank. This may include certain intangible assets of the failed bank that were not reported by the failed bank prior to acquisition. ASC 805 also states that assets acquired and liabilities assumed be initially measured at fair value with some exceptions to fair value measurement outlined in the ASC 805. The initial measurement date is commonly referred to as Day 1 accounting. As part of the negotiations to consummate a business combination, the seller in a business combination may contractually indemnify the acquirer for the outcome of a contingency or uncertainty related to all or part of a specific asset or liability. There is a future economic benefit to a healthy bank acquirer when FDIC enters into an agreement to indemnify the healthy bank for future losses associated with loans receivable and foreclosed assets. As a result, business combination accounting requires the healthy bank to recognize an indemnification asset as part of the Day 1 accounting. Per ASC 805, an indemnification asset is measured based upon the same basis as the indemnified item. Loans receivable and foreclosed assets are typically reported at fair value with minor adjustments for foreclosed assets in that estimated costs to sale are factored into the initial measurement amount. The methodology typically utilized for measuring FDIC loss share indemnification assets is based upon a discounted cash-flow approach. The expected loss estimates and cash flows used for the determining the fair value of the loans receivable and foreclosed assets should also be used to determine the expected cash flows from the FDIC. As a result, the day 1 measurement of an FDIC indemnification asset is typically based upon a discounted cash flow approach. Now that you have initially recorded the FDIC indemnification, how does one report the asset subsequent to the acquisition? This cliffhanger is outlined below in the Day 2 Accounting section.

Subsequent Accounting Implications of the FDIC Indemnification Asset (Day 2 Accounting)

Prior to the issuance of ASU 2012-06, there was diversity in practice in Day 2 accounting for a loss-share indemnification asset. The diversity in practiced primarily stemmed from the how one interprets “measurement on the same basis as assets indemnified” and “contractual limitations”. In order to address the adversity in practice, the FASB issue ASU 2012-06 in October 2012. This ASU requires that an acquirer (healthy bank in our example) measure an indemnification asset on the same basis as the underlying asset or liability that was being indemnified. For an FDIC-assisted transaction, this would be translated as the indemnification asset would be measured on the same basis as the underlying loans receivable and/or foreclosed assets acquired in a business combination subject to any contractual limitations on the amount. This seems very similar to the Day 1 measurement principle; however, there are few wrinkles that follow. There are some subtle differences in application of ASU 2012-06 depending upon whether a valuation allowance had initially been established on the indemnified assets.

If the expected cash flows of the underlying assets being indemnified (loans receivable and foreclosed assets) increase, one would expect that the underlying cash flows related to the indemnification asset would decrease as we are now predicting that we will not have to seek as much reimbursement from the FDIC. In this case, with the added consideration that we did not have a previously established valuation allowance recorded attributable to the loans receivable and foreclosed assets, the expected decrease in the loss-share indemnified asset should be amortized over the lesser of the contractual term of the loss-share indemnification asset and the remaining life of the indemnified asset (loans receivable or foreclosed assets). However, if there was a previously established valuation allowance attributed to the loans receivable and foreclosed assets that is reversed as the expected cash flows for these assets have improved, the acquirer bank shall account for the associated decrease in the loss-share indemnification asset immediately in earnings up to the amount of the valuation allowance reversed. Any remaining decrease in the indemnification asset shall be amortized as discussed above.

ASU 2012-06 is effective for both public and nonpublic entities for fiscal years, and any interim periods within those years, beginning on or after December 15, 2012.

For more information on what you have read, please contact Todd Batchelor at tbatchelor@cbh.com.

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IRS Issues Final Regulations Implementing Medical Device Excise Tax

2013-01-18T15:16:55Z

On December 5, 2012, the Internal Revenue Service (“IRS”) published final regulations regarding the implementation of the excise tax on the sale of certain medical devices. This excise tax was enacted by the Patient Protection and Affordable Care Act of 2010, as amended by the Health Care Education Reconciliation Act of 2010 (collectively, “the ACA”), and codified under section 4191 of the Internal Revenue Code (“Code”).

Medical Device Excise Tax

Effective January 1, 2013, the IRS will administer an excise tax on the sale of certain medical devices by the manufacturer, producer, or importer of the device in an amount equal to 2.3% of the sale price. The tax includes a retail exemption and safe harbor for items purchased at retail by the general public.

The medical device excise tax is reported on Form 720 (Quarterly Federal Excise Tax Return) on a quarterly basis. Most taxpayers subject to the tax will be required to make semi-monthly deposits to the IRS, the first of which will cover the first 15 days of January 2013, and will be due January 29, 2013. The IRS has stated that it will not impose penalties for the first three calendar quarters of 2013 on taxpayers who make good faith efforts to comply with the tax filing requirements.

Definition of “Taxable Medical Device”

Section 4191(b)(1) of the Code defines “taxable medical device” as a device defined in section 201(h) of the federal Food, Drug and Cosmetic Act (“FDCA”) that is intended for humans. The device must also be listed under section 510(j) of the FDCA. According to section 201(h) of the FDCA, a device is:

“an instrument, apparatus, implement, machine, contrivance, implant, in vitro reagent, or other similar or related article, including a component part or accessory which is:

Recognized in the official National Formulary, or the United States Pharmacopoeia, or any supplement to them,
Intended for use in the diagnosis of disease or other condition, or in the cure, mitigation, treatment, or prevention of disease, in man or other animals, or
Intended to affect the structure or any function of the body of man or other animals, and which does not achieve any of its primary intended purposes through chemical action within or on the body of man or other animals and which is not dependent upon being metabolized for the achievement of any of its primary intended purposes.”

The definition provides a clear distinction between a medical device and other FDA regulated products such as drugs. If the primary intended use of the product is achieved through chemical action or by being metabolized by the body, the product is usually a drug and thus, not subject to the medical device excise tax.

If a device is subsequently added to the list by the FDA, the device is deemed to have been listed as of the date the FDA notifies the manufacturer or importer. Combination products (therapeutic or diagnostic products that combine devices with drugs and /or biological products) that meet FDA listing requirements are taxable medical devices unless they are otherwise exempt. Devices that are sold for further manufacture or for export are excluded from the medical excise tax.

Retail Exemption

Section 4191(b)(2) of the Code provides that the term “taxable medical device” does not include eyeglasses, contact lenses, hearing aids and any other medical device determined by the Secretary of the Treasury to be of a type that is purchased by the general public for individual use. The final regulations prescribe a facts and circumstances test for the retail exemption, beginning with a two prong analysis.

Under the test, a device will be considered of a type generally purchased by the general public at retail for individual use if: (1) it is regularly available for purchase and use by the individual consumers who are not medical professionals, and (2) the design of the device demonstrates that it is not primarily intended for use in a medical institution or office or by a medical professional. The final regulations also set forth a list of nonexclusive factors, any one of which is not determinative, which tend to indicate that a device is designed for individual use by the general public, or that a device is primarily intended for use by a medical institution or professional.

The retail exemption also contains a safe harbor, whereby certain items are exempt regardless of the facts and circumstances test. Examples of items that fall within the safe harbor are: over the counter devices and tests, prosthetic and orthotic devices that do not require implantation or insertion by a medical professional and therapeutic shoes.

Refurbished or Remanufactured Devices & Replacement Parts

If a manufacturer refurbishes or remanufacturers a medical device into a new and different taxable articles, then that article can be considered a taxable medical device if it meets the FDA listing requirements and it not otherwise exempt. Furthermore, if a manufacturer provides a customer with a replacement device or part, the tax liability is assess on the actual amount, if any, paid for the replacement item, regardless of whether a warranty exists or not.

Computation of Tax on “Constructive Sales Price”

The final regulations clarify that, in determining the sale price for which a device is sold, the amount of tax imposed should be excluded. This is the case regardless of whether the tax imposed is separately stated. A rebate may be taken into account in determining the sales price, but only to the extent the rebate is made prior to the close of the quarter during with the associated sale was made.

Therefore, the computation of the tax assumes an arm’s length sale to a wholesale distributor, and imposes the 2.3 percent tax on the wholesale sales price of the device, excluding: the excise tax itself, the actual cost of transportation, delivery, insurance, installation or other expenses incurred in placing the article in the hands of the purchaser.

In addition, any payments made pursuant to contracts for installment sales and leases entered into prior to March 30, 2010 (the date that the ACA was enacted) are not subject to liability under the medical device excise tax unless the contract is materially modified on or after that date.

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FAR Changes Coming for Employment of SCA Employees

2013-01-18T14:34:08Z

Effective January 18, 2013, successor contractors must now offer a first right of refusal for employment to employees on the predecessor contract when such contract falls under the Service Contract Act (SCA) and the contract is for performance of the same or similar services.

On December 21, 2012, the Federal Acquisition Regulatory Council issued a final rule to implement Executive Order 13495, Nondisplacement of Qualified Workers Under Service Contracts, dated January 30, 2009. In implementing this Order, the Federal Acquisition Regulation (FAR) is hereby amended to add subpart 22.12 and a new clause at FAR 52.222-17.

When a contract is subject to SCA, the new FAR language will now require a successor contractor (a contractor that wins an award for work that was previously being completed by another contractor) to offer employment to workers subject to SCA qualification, that otherwise would be terminated by the change in contractor. As is often the case with the Government, the new requirement is full of clarifications and exceptions. For example, the requirement applies when the successor contract is for same or similar services at the same location as the predecessor contract. 29 CFR 9.2 defines “same or similar service” to mean “a service that is either identical to or has one or more characteristics that are alike in substance to a service performed at the same location on a contract that is being replaced by the Federal Government or a contractor on a Federal service contract.”

There will be some exceptions from the requirement to provide the right of first refusal, such as if the successor’s current employees, who would otherwise face termination themselves, are qualified for this contract and subject to SCA. Another exception is for predecessor employees with documented past unsuitable performance. If the successor will be working with a smaller workforce than the predecessor due to efficiency, the successor is only required to offer employment to those eligible employees who would be qualified to fill the positions that will exist on the contract.

If a successor wins a contract award due to termination for performance on the predecessor, the successor contractor is not to assume it was the fault of the service employees; the assumption to be made is that the employees were performing suitable work in support of the contract and the fault lay with management. If the Government determines that the poor performance of the predecessor contract was due to the entire predecessor workforce, then FAR 22.12 may be waived.

As a result of this ruling, the successor contractor is going to have to jump through some additional hoops to make their required offers of employment, including trying to obtain the necessary contact information of the eligible employees. FAR 52.222-41(n), Service Contract Act of 1965, already requires the predecessor contractor to provide to the contracting officer a certified list not less than 10 days prior to completion of an existing contract of the names of all service employees on the contractor’s or subcontractor’s payroll during the last month of the contract performance. This list must contain the anniversary dates of employment on the contract. Under the new rule, this list will be required no less than 30 days prior to completion instead of 10. If the list is not provided, the Government will have the right to suspend contract payments until it is provided. But it is interesting to note that since DOL does not require contact information (or even what labor categories these employees held), the FAR will not require this information either. Successor contractors will have to reach out to these employees by any means possible, such as holding job fairs in the area of the performance location or asking the contracting officer to schedule a meeting at the performance site to meet with the employees.

Cherry Bekaert has worked with many clients regarding various SCA issues. Please contact us if you have specific matters that you would like to discuss.

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Are you squandering money on inefficient energy use?

2013-01-11T21:28:13Z

The latest report from Siemens Financial Services demonstrates the enormous potential energy cost savings of implementing variable speed drives on motors in industrial production environments

Alone, German industry could save upwards of £5,913m

The incorporation of variable speed drives (VSDs) has the potential of saving the UK industry up to £2,512 million in energy costs, according to Siemens Financial Services’ (SFS) new report; which predicts Germany, Europe’s industrial colossus, could save upwards of £5,913 million.

Traditionally, to change a motors speed of operations, the accepted method was ‘chocking’ the constant speed; consuming significant amounts of electricity. In comparison, VSDs optimise the voltage and frequency supply to an industrial motor in order to change the speed, greatly reducing that consumption.

SFS estimates that, in Europe, around 70 percent of the total industrial electricity consumption is derived from electric motor-driven systems. Bearing in mind that 95 percent of the lifetime expense of an industrial motor is the cost of electricity, and the argument for implementing VSDs begins to stack up.

The latest edition of Manufacturing Digital is available now

Head of Energy Efficiency Financing for SFS UK, Darren Riva commented:

“In light of the steady upward trajectory of electricity prices, greater energy efficiency is becoming an urgent concern for industrial organisations as escalating energy costs will erode profit margins and damage competitiveness.”

“The magnitude of the estimated potential savings enabled by VSDs presents an extremely compelling business case for industrial companies to invest in this power-saving technology. More importantly, keeping in mind that VSD is just one of the many possible energy efficiency initiatives that industrial companies can adopt; the true potential for energy and cost savings in industry is very large indeed.”

Riva continued:

“The uncertain economic situation in Europe and the restricted access to traditional finance have prompted many companies to defer their investment intentions. However, companies can easily overcome this financial barrier by using alternative methods to fund energy-efficient equipment upgrades.”

“Asset financing techniques such as leasing and renting aim to offset the monthly cost of the new equipment against the energy savings it delivers across the financing term, effectively making the investment zero net cost or even cash positive.”

“Even when a project cannot completely offset the equipment upgrade with energy-efficient cost savings, the financing arrangement can nevertheless subsidise the larger part of the upgrade cost. As up-to-date equipment may not only reduce energy costs but also boost productivity and extend manufacturing capability, leading to improved revenues and margin, manufacturers should leverage such alternative financing solutions to capture the significant potential cost savings hidden in the industrial processes.”

Though VSDs can’t be applied to all motors, over half of those currently being used could benefit from the technology, especially pumps, fans and centrifugal compressors, and to a lesser extent mixers, centrifuges, reciprocating compressors and extruders. Yet, the current penetration rate of VSD as a proportion of installed motors is still low.

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Are You Ready for a Study Abroad Program? International Tax Implications You Need to Consider

2013-01-11T17:00:04Z

International study abroad programs are gaining in popularity and are fast becoming a fundamental part of college and university initiatives. Such programs assist in increasing enrollment while enhancing studies by providing students with an opportunity to experience another culture firsthand and improve foreign language skills. However, the overall investment involved with global initiatives can be quite significant and the risks of operating in foreign jurisdictions can be substantial as well, given the complex regulatory and cultural environments. Thus, international activities often trigger significant legal, tax, and reporting requirements – both domestic and foreign.

One of the core issues encountered with international expansion is that the notion of a “tax-exempt” entity is not recognized in all countries. Thus, an educational institution, although exempt from income taxation in the United States, may very well be treated as a taxable enterprise in a foreign jurisdiction. Therefore, educational institutions have to re-consider how their activities are conducted and structured from an international perspective.

Organizational Structure of the Program

Typically, colleges and universities venture into global expansion by structuring the program based on one of the following models:

Students participate in study abroad programs with U.S. faculty from the U.S. school;
The educational institution and a foreign institution enter into an agreement whereby the U.S. students take courses in the foreign country; or
The school owns or leases real property and establishes its own campus in the foreign jurisdiction which engages either U.S. or foreign professors and other employees.

The school will need to conduct varying levels of due diligence depending upon which of the above models is pursued. For instance, the school’s establishment of its own foreign campus will require significantly more due diligence compared to the other models.

International Tax Implications

Regardless of how the program is ultimately structured, the school faces a number of various international tax matters. Questions that should be considered are summarized below.

Taxable and Legal Presence

Does the activity create a “taxable presence” in a foreign country?

A foreign country may reserve the right to tax the income that the school generates in the foreign jurisdiction. However, the United States has entered into income tax treaties with many countries. These treaties will need to be analyzed to determine the overall tax consequences. In the absence of a treaty, the local tax laws of the country will need to be considered.

Is a formal legal presence required in the country?

The laws of the foreign jurisdiction may require that a separate legal entity be created (i.e., corporation, disregarded entity, partnership, etc.) to conduct the activities abroad. Thus, the school should gain an understanding of the legal and tax ramifications of the various types of entities in order to make an informed decision.

Staffing Considerations

Will U.S. employees work in the foreign jurisdiction?

If so, the school may wish to consider a tax equalization process to assist the employees with the increased cost-of-living expenses. However, keep in mind that such benefits may result in additional taxable income to the employee.

Will the school hire citizens of the local country to perform services?

If so, it may be necessary for the institution to register in the country as an employer which may trigger payroll tax reporting, the payment of the equivalent to social security taxes, as well as potential local taxes.

Will the school engage citizens of the local country as independent contractors?

If so, an understanding of the country’s laws regarding worker classification (i.e., independent contractor versus employee status) is essential to determine tax and reporting consequences.

Other Considerations

Will the school be required to register and pay a Value Added Tax (VAT)?

Many countries impose a VAT, which is not an income tax, but instead is applicable to most transactions involving a purchase of goods and/or services. In general, a VAT is not covered by any treaty and will need to be addressed by a local tax specialist.

Will the university maintain any foreign bank accounts?

If the school maintains foreign bank accounts and/or individuals working for the university have signature authority over a foreign bank account, then in the United States, the filing of a Report of Foreign Bank and Financial Accounts (TD F 90-22.1) may be required.

Does the local jurisdiction impose any non-income taxes or fees such as real estate taxes, etc.?

The rules of the local jurisdiction should be reviewed in order to determine the additional taxes and/or fees to which the school may be subject.

The Need for an Assessment

As you can see based on this list of considerations, domestic and foreign regulations and compliance are complex when venturing into other countries. Regardless of whether your organization is planning an activity overseas or is already conducting a foreign program, an overall assessment of the institution’s international activities is essential. This assessment can help identify potential risks of noncompliance and develop a plan to correct or mitigate such risks. A consultation with a tax advisor who specializes in international tax matters can assist your institution throughout the process.

James Dawson –As the Firm’s Director of International Tax, Jim directs the specialized services and worldwide resources of the Firm to meet the international tax needs of our clients. He provides a full range of international tax and accounting services, including global structuring and tax burden minimization, intellectual property migration strategies, international mergers and acquisitions, transfer pricing, inbound U.S. investment strategies, and import/export strategies. He can be reached at 404.209.0954 or jdawson@cbh.com.

Janice Ratica – As the Firm’s Director of Nonprofit Tax Service, Janice oversees all tax compliance and consulting matters that impact the Firm’s tax-exempt clients. She provides advice regarding obtaining and maintaining tax-exempt status, minimizing unrelated taxable income, structuring joint ventures and preventing excess benefit transactions. In addition, she also assists organizations during IRS audits, including full and limited scope examinations. Further, Janice counsels clients regarding various employment tax matters, including executive compensation, worker classification, and the taxation of fringe benefits. She can be reached at 704.377.1678 or jratica@cbh.com.

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An Introduction to Big Data

2013-01-11T21:35:07Z

Think about all the tweets, texts, emails, pins, likes, posts, photos, documents, and videos that are created and shared in a single day. And that’s just on the social side of things. Now think about the data sets and files created and stored by large corporations (especially IT companies) in a single day. Each piece of data builds on top of others to form a massive system of data points, which ultimately becomes so complex that basic management tools simply won’t do. Big Data refers to the collection and analysis of these data sets, which require new tools to make sense of and draw conclusions from this information.

Plenty of definitions for the term exist, but at its simplest, Big Data involves pulling information from various sources to ultimately identify and analyze trends. And we’re talking terabyte- and petabyte-sized data sets here. It takes sophisticated technology to perform the storage and analysis needed for BigData to truly uncover insights or predict trends.

While we may not all be experts in how multiple data sources combine to provide insight into a variety of industries, we can certainly appreciate what Big Data teaches us, as well as how it is helping to transform the IT environment.

Analytics abound with the various ways we can look at data. When information is collected from multiple sources and multiple points of view, we gain insight about a certain industry, product, demographic group, or phenomena. Leveraging those insights allow business owners and markers to understand their target audience better, thus resulting in an improved product, service or process. What’s more, Big Data can identify issues in areas such as law enforcement, healthcare, billing, and operations management.

Big Data is a rapidly changing segment that requires real-time analysis. It’s therefore vital to stay abreast of its changes and trends.

Stay tuned for the second installment in the Big Data blog series, which will discuss the factors driving Big Data.

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Fighting Government Fraud

2013-01-11T21:18:52Z

How much fraud actually occurs is debatable, but the benefits of eliminating it are clear. And many governments are taking steps to stop schemes, scams and public-sector swindles.

We’re not convinced that there’s as much fraud in government as a whole host of observers and politicians seem to believe. One of our frequent correspondents, Tom Sadowski, a former auditor of Missouri, wrote us a while back, “While there may be frauds that go undetected, many of the ones reported are relatively not that numerous or that large. It is like crime. If you hear too many reports of crime, you tend to overestimate their frequency and severity. What you rarely, if ever, get is an overall sense of how good or bad things really are.”

Regardless of the volume of fraud in the public sector, it’s clear that a good many cities and states are attacking the problem. And we have no quibbles with that. Up to a point. Sometimes, it may cost more to find the fraud than to suffer it. That said, any fraud that can be eliminated is good for taxpayers.

Some of the most helpful antifraud approaches are reasonably straightforward. Among the most common are requiring two people to sign a check rather than one; having bank statements reconciled by someone other than the person who writes the checks; and making sure that people log into their computers via individualized passwords, rather than providing shared access. “That is an inexpensive — probably free – way to prevent fraud,” says David Denby, deputy state auditor of Mississippi.

Then there are purely data-based approaches. One such is derived from something called Benford’s Law. Bear with us for a moment on this, because it may seem complicated at first, but it’s really very cool. Benford’s Law demonstrates that when you’re looking at a long list of numbers from most real-life sources of data, the first digit is going to be 1 about a third of the time, and the frequency of other digits in that position declines as they get higher. A computer run of a department’s books that discovers this law isn’t being followed can lead directly to a potentially worthwhile investigation.

One approach to stomping out fraud that we’ve seen blossoming are fraud hotlines. The Los Angeles Controller’s office has a fraud hotline that is now accessible in more than 150 languages, a change made following a few recent incidents in which city employees were busted for defrauding non-English speakers. In Mississippi, many of the calls that come in on the state’s hotline don’t merit investigation for a variety of reasons. But the ability to register complaints anonymously is still very valuable. “We have calls from people in counties who know that if their name was revealed, it could cost them their job,” Denby says.

One example of a useful hotline — intended for employees only — can be found in Virginia. It’s run by the Division of State Internal Audit and receives more than 700 calls per year. That’s up from about 400 not too long ago, thanks to better promotion.

It accomplishes a lot. About 35 percent of those calls lead to substantiated findings of fraud (following investigations). As Tim Sadler, audit manager for the division, points out, the benefits go beyond simply identifying instances of fraud. The tips also help avoid future problems. For instance, 10 percent of the tips, though they don’t specifically uncover instances of existing fraud, lead to recommendations for actions, such as a change in internal controls.

Moreover, Sadler adds that the existence of the hotline itself is a deterrent: When people think they might be caught, they might be less likely to commit fraud. He recalls a 2004 case when a hotline-originated investigation led to the discovery that three state officials had used state funds to buy supplies for an African safari. The state recovered the funds, but as Sadler notes, this also helped the state improve agency operations to stop similar, if less exotic, abuses from coming up in the future.

The hotline seems to pay for itself. In fiscal 2010, identified savings from substantiated allegations made to the hotline were $1.27 million, about twice the cost of the hotline. As useful as hotlines can be, they’re not a panacea. “The current whack-a-mole approach of waiting for the phone to ring to report a fraud is not a systemic way of reducing fraud losses,” says Chris Swecker, former assistant director of the FBI and a fraud consultant with Chris Swecker Enterprises. “Most government programs have some sort of integrity programs to catch fraudulent activities, but it is a one-fraud-at-a-time approach. The detection is not real time — it is always pay and chase.”

http://www.governing.com/templates/gov_print_article?id=135997548 12/7/2012

A few more thoughts from Swecker:

Go after people who make a living out of defrauding the government first. Then go after the folks who are opportunists. Governments should use data analysis software for real-time detection processes that aren’t siloed by agency, program type or fraud type. This broad approach would “enhance” the antifraud efforts already in place. In using databases to detect fraud, confidentiality and privacy issues can make life difficult. “You have to jump through hoops as with any other data-sharing actions.”

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Employee Tax Audits

2013-01-11T21:35:18Z

The IRS National Research Program’s Employment Tax Audits. It is not uncommon for state and local governments to issue numerous 1099s to employees for work outside of their normal position. For example, police officers working security at events or parks employees working set-up and clean-up at sporting events. Employers also draw scrutiny in how they handle or mishandling the payouts of paid time off. As a result, the IRS National Research Program began conducting Employment Tax Audits. These audits have indicated more noncompliance than anticipated. As such, the IRS will be scrutinizing employers even more heavily moving forward.

The reviews impact state and local government employees as well as private sector businesses. The IRS’ review of Employment Tax could mean substantial penalties imposed on employers if they have miscoding errors. To avoid penalty, employers should review any employee/contractor relationships they may have as well as review contractor relationships to ensure they should not be considered employees.

For more information on this topic, please visit the links provided.

http://focusonpublicbenefits.com/?p=235

http://www.site-kconstructionzone.com/?p=8057

For direct answers to your questions on this topic, contact Mary Grady at mgrady@cbh.com or 706-724-3557.

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GASB’s New Pension Standards: Setting the Record Straight

2013-01-11T21:35:26Z

The Governmental Accounting Standards Board’s (GASB) recent pension standards substantially improve the accounting and financial reporting of public employee pensions by state and local governments. The new standards are:

 Statement No. 67, Financial Reporting for Pension Plans, which applies to financial reporting by most pension plans.

 Statement No. 68, Accounting and Financial Reporting for Pensions, which applies to financial reporting by most governments that provide their employees with pension benefits.

Below are questions and answers that should help clarify common misperceptions about the new pension Statements.

1. Do the new GASB Statements establish requirements for how governments should fund their pensions?

No. In the past, the accounting and financial reporting standards were closely associated with the approach that many governments take to funding their benefits—that is, toward contributing sufficient resources to a defined benefit pension plan to finance benefit payments when they come due. Consequently, many governments have established funding policies based on the GASB’s standards. However, after reexamining the prior standards for pensions, the GASB concluded that approaches to funding are not necessarily the best approach to accounting for and reporting pension benefits. Therefore, the new Statements mark a definitive separation of accounting and financial reporting from funding.

2. Will governments have to pay more each year for pensions because of the GASB’s new Statements?

As just stated, the new pension Statements relate only to accounting and financial reporting, or how pension costs and obligations are measured and reported in external financial reports. How much governments actually contribute each year to a pension plan is a policy issue. Governments will likely report pension expense more quickly than under the prior standards; however, how or whether this information is used in assessing the amounts that governments will contribute to their pension plans is a public policy decision made by government officials.

3. Do governments have to use a municipal bond rate for discounting as punishment for not fully funding their pensions?

No. The selection of an appropriate interest rate for discounting projected future benefit payments to their present value is based on what resources are projected to be used to make those payments: (1) assets of the plan that have been invested using an investment strategy to achieve the assumed long-term expected rate of return and their earnings; or (2) the general resources of the government employer. As long as the projected plan net position related to current employees and inactive employees exceeds the projected benefit payments for those employees, the long-term expected rate of return on investments will serve as the basis for discounting. This asset-based rate is appropriate because the earnings on the plan’s investments reduce the amount an employer will need to contribute to the plan.

If a government reaches a crossover point—when projected benefit payments for current employees and inactive employees exceed projected plan net position related to those employees—then benefit payments projected to be made from that point forward will be discounted using a high-quality municipal bond interest rate. This liability-based rate is appropriate because the plan would no longer be expected to have sufficient assets related to those employees to produce investment income that will reduce how much an employer will have to contribute. The pension liability would then resemble the employer’s outstanding debt and other typical long-term liabilities.

However, it is true—all other factors being equal— that the less well-funded a pension plan is, the more likely it will reach a crossover point and therefore have to discount some projected benefit payments using the municipal bond index rate. Under current economic conditions, municipal bond rates are lower than long-term expected returns on pension plan investments. Using a lower discount rate increases the present value of projected benefit payments and, thereby, increases the size of the pension liability.

4. Do the GASB’s standards allow governments to make their liabilities look smaller by using a discount rate based on unrealistically high expected rates of investment return?

No. The new Statements require that governments measure their pension liabilities using assumptions that are consistent with the standards of practice of the actuarial profession. If a government assumes a rate of return that is out of line with the actuarial standards, then it is misapplying the accounting standards rather than exploiting a loophole in the standards.

It is important to note that examining a pension plan’s investment return in any short-term period is not appropriate for drawing conclusions about the appropriateness of a government’s assumption about long-term investment earnings. The investment return in any given year or short-term period is likely to be either higher or lower than the assumed long-term return. However, an appropriate long-term investment return assumption will reflect the expected average earnings over a long period, even though it may not be the same as actual earnings in any particular single or short-term period.

Governments will disclose information about their long-term investment return assumptions in the notes to the financial statements to assist in evaluating the reasonableness of those assumptions. The information will include a brief description of how the long-term expected rate of return was determined, significant methods and assumptions used for that purpose, the assumed asset allocation of the pension plan’s portfolio, and the long-term expected real rate of return for each major asset class.

5. Is the discount rate the most important factor in determining the size of a government’s pension liability?

The guidance put forth in the new Statements pertaining to the selection of a discount rate is certainly an important element but it is only one part of the determination. Discounting is one of the basic three steps involved in measuring a government’s total pension liability—projecting, discounting, and attributing. (The measurement process is more fully described in separate fact sheets about accounting and financial reporting by governments that provide pension benefits.)

The amount of a government’s pension liability also depends on a variety of other factors such as:

 The types of benefits a government has promised

 The length of service of employees and their salaries in the final years of their employment

 The life expectancy of retirees, which determines how long they will continue to receive benefits

 The inflation rate, which affects both salaries and rates of return on investments.

6. Can the information reported by governments under the new Statements be compared?

Yes. The comparability of the pension information that will result from the new Statements has been significantly improved. One of the features of the prior standards that many financial statement users have criticized is the variety of choices that employers could make when attributing the present value of projected benefit payments to past, present, and future periods. Governments previously were allowed to select from six different actuarial cost allocation methods, each of which could be applied in two ways—as a level dollar amount each year or as a level percentage of payroll in each year. In the view of many users, these options seriously diminished comparability. The new Statements, however, require that all governments use one type of actuarial cost method—called entry age—and apply it only as a level percentage of payroll.

It should be noted that, although governments are required to measure their pensions within the same parameters set forth in the standards, the resulting amounts will be different because of differences in the terms of the governments’ respective pension plans, differences in the demographics of the plan members, and differences in other relevant factors. In other words, because the governments are in different circumstances, their measurements will employ different assumptions.

It has been suggested that comparability would be greatly improved if all governments were required to use the same assumptions. However, taking a one-size-fits-all approach would ignore significant differences between governments—such as the mix of their investment portfolios and their actual earnings experience—that are relevant to determining the amount that governments are obligated to provide for pensions.

7. Has the GASB determined that state and local government pension plans are underfunded by $3 trillion?

No. The GASB has never conducted research regarding the extent to which pension plans are funded in the aggregate. Funding relates to a public policy issue that is beyond the scope of the GASB’s activities.

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The Potential Impact of Proposed Lease Accounting Rules on Creditor Financial Statements

2013-01-11T21:35:33Z

The Financial Accounting Standards Board (“FASB”) is in the process of deliberating significant changes to the accounting rules regarding leases. If approved, this new lease accounting guidance would require U.S. companies to record in their balance sheets as much as $2 trillion in additional debt by some estimates. The proposed model, which is not yet effective, would have significant implications for any business that leases equipment or real property.

Should the new guidance be approved, it will introduce a right-to-use model. This model will require companies to record in their balance sheets estimated liabilities associated with the obligation to make lease payments and a related intangible asset representing the right to use the specified asset over the lease term. As currently contemplated, the proposed standard would eliminate the opportunity for lease contracts of greater than 12 months to be structured as operating leases. Substantially all leases would be treated in a manner similar to the treatment of capital leases under the current accounting rules.

The proposed standard does not provide for the “grandfathering” of existing leases and would thus require the new guidance to be applied to all existing lease agreements and not just those entered into after an effective date. Although it is believed that the new guidance would not be applicable to leases of 12 months or less, the guidance would be applicable to all company leases including those incidental to a company’s business, such as those related to copy machines, telephone systems, and those related to mailing equipment. The proposed guidance will present a significant administrative burden to companies that are a party to thousands of leases as well as those companies with smaller accounting staffs.

If approved, the new guidance will require companies to estimate lease terms and resulting lease payments under a criteria that carefully considers, in addition to written lease arrangements, the “economic incentives for a company to exercise an option to extend a lease term or for an entity not to exercise an option to terminate a lease”. These payments will then be discounted at a company’s incremental borrowing rate to arrive at the lease obligation with respect to leases that are primarily financing in nature, without discounting for leases that are not primarily financing in nature. This liability will be recorded in a company’s balance sheet with an offsetting intangible asset representing the company’s right to use the specified asset over its lease term. Any direct cost associated with the negotiation of the lease and paid by the company will be added to the recorded amount of the right-to-use asset.

When implemented, the proposed standard will increase a company’s total assets and liabilities without changing a company’s net worth. Nonetheless, these additions may negatively impact certain financial performance measures, including computation of tangible net worth and various metrics related to a company’s total liabilities.

Although total assets added may equal the total liabilities that must be added when the proposed guidance is effective, it is important to note that the right-to-use asset is considered an intangible asset under current U.S. GAAP, and is therefore excludable under proper calculations of tangible net worth. Under the proposed standard, however, the required lease obligation will be treated just like any other liability of the company and as such, will make a company appear to be more highly leveraged.

The proposed standard will not significantly impact a company’s reported net income over the term of a lease arrangement. Lease payments under operating leases, which are currently deducted in arriving at net income, will be replaced by amortization of the right-to-use asset and the portion of the lease obligation being treated as interest expense. Given the declining nature of interest expense, however, the proposed guidance will negatively impact net income in the early years of a lease, when interest expense is highest, and positively impact net income in the later years of a lease, when interest expense is the lowest.

Interestingly, the proposed standard will improve reported measures of both EBITDA and operating cash flows. The improved measures of EBITDA will result from the additive nature of amortization and interest expense in EBITDA calculations when operating lease payments were treated as deductions in those same calculations. Given the proposed treatment of all leases as debt, the operating cash flows of a company will no longer include a reduction for rental payments. Instead, these payments will be reflected as a financing activity.

Although the proposed lease accounting guidance has not yet been adopted, banks and other lenders need to be informed of the changes and prepared to discuss its impact with their customers including the potential impact of the changes on current and future loan covenants. The guidance, as currently drafted, will potentially impact a variety of loan covenant provisions including tangible net worth requirements, debt to equity ratios and various calculations related to cash flow.

Sam Johnson is a partner with Cherry, Bekaert L.L.P. He can be reached at sjohnson@cbh.com.

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Cherry Bekaert

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