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accounting-fair-value-faqs

Accounting Fair Value FAQs
Accounting Fair Value FAQs 1600 941 smolinlupinco

Over the past decade, the accounting industry has seen many rule changes that affect reporting of certain items on balance sheets. One such change is the guidance that certain items be reported at “fair value.” Read on to learn more about this new reporting standard and how to measure it accurately.

What is fair value?

The U.S. Generally Accepted Accounting Principles (GAAP) defines fair value as a “price that would be received to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date.” Buyers and sellers within the principal market of the item are “market participants,” but the market itself can vary according to the specific entity being measured.  

The purpose of estimating fair value is to report assets, including:

  • Nonpublic entity securities
  • Derivatives
  • Acquired goodwill
  • Specific long-lived assets
  • Other intangibles not listed here

However, entity-specific considerations such as transaction costs are specifically excluded from these estimates.

Fair value vs. fair market value

While fair value and fair market value are similar, they are not interchangeable. The IRS Revenue Ruling 59-60 provides the most widely accepted definition of market value: “[T]he price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

The Financial Accounting Standards Board (FASB) chose the term “fair value” to deter businesses from using IRS regulations and precedents from the U.S. Tax Court when determining their assets and liabilities for required financial reporting.  You should also avoid confusing the term with some of its uses in a legal context,  such as conducting a business valuation for a shareholder buyout or divorce. When used in a statutory context, definitions by the GAAP for fair value are different.

Measuring fair value

There are three different valuation methods that the FASB recognizes:  cost, income, and market. The FASB has also put in place a hierarchy for valuation inputs, starting at the highest priority and descending to the lowest: 

  1. Quoted pricing for liabilities and assets which are identical in active markets
  2. Observable inputs including active market pricing for similar items in quoted markets, quoted prices for identical or similar items in active markets, and related market data
  3. Unobservable inputs involving projections of cash flow or related internal metrics

It’s not uncommon to hire a valuation specialist to estimate fair value. Still, those in management roles can’t delegate their personal responsibility for these estimates. Leadership is obligated to understand a valuator’s assumptions, models, and methods, including implementation of adequate internal controls over the measurement process, impairment charges, and disclosures.

How auditors assess fair value

It’s part of an external auditor’s standard audit procedure to evaluate accounting estimates. This could entail inquiring about any underlying assumptions used to determine an input’s estimated completeness, accuracy, and relevance. 

Auditors will try to recreate these estimated assumptions by management whenever possible. If their determination comes to a substantially different conclusion than reported financial statement data, management will have to explain this discrepancy. Requests for additional supporting documentation of your estimations or questions related to your processes aren’t unusual and are a normal part of today’s uncertain marketplace. 

Find out more  

Contact us with any additional questions you may have about fair value measurements. We can help ensure that you’re meeting your financial reporting responsibilities.

© 2022

cash-basis-accrual-accounting-methods-guide-for-small-businesses

Cash-Basis and Accrual Accounting Methods: A Quick Guide for Small Businesses
Cash-Basis and Accrual Accounting Methods: A Quick Guide for Small Businesses 1600 941 smolinlupinco

When they first start out, many small businesses use the cash-basis method of accounting. However, many eventually switch to accrual-basis reporting in order to conform with U.S. Generally Accepted Accounting Principles (GAAP). 

This quick guide can help you decide which method is right for your business.

The cash-basis method of accounting

Businesses using the cash-basis method recognize revenue as their customers pay invoices and expenses as they pay their bills. Because of this, cash-basis entities often report fluctuations in profits from period to period, particularly when they’re engaged in long-term projects. These fluctuations can make it difficult to benchmark a company’s performance from year to year or against other businesses that use the accrual method.

The cash method of accounting can allow eligible businesses to fine-tune their annual taxable income by timing the year in which they recognize taxable income and claim deductions.

The most common strategy is to postpone revenue recognition and accelerate expense payments at the end of the year. Although this can allow businesses to temporarily defer their tax liability, it also causes the company to appear less profitable to investors and lenders.

Some businesses may also find it advantageous to take the opposite approach if tax rates are expected to increase substantially in the coming year. Accelerating revenue recognition and deferring expenses at year-end can maximize a company’s tax liability in the current year to take advantage of the lower tax rates.

The accrual-basis method of accounting

The accrual method is more complex and conforms to the matching principle under U.S. GAAP. Companies using the accrual method recognize revenue and expenses in the periods that revenue is earned and expenses are incurred. This method facilitates better financial benchmarking by reducing fluctuations in profits from period to period.

Accrual-basis entities also report several asset and liability accounts that aren’t usually included on a cash-basis entity’s balance sheet: prepaid expenses, work in progress, accrued expenses, accounts receivable, accounts payable, and deferred taxes are all common examples. 

Although small companies have several options, including the cash-basis method, public companies are required to use the accrual method.

Changes under the TCJA

With the passage of the Tax Cuts and Jobs Act (TCJA), more companies are now eligible to use the cash-basis method for federal tax purposes. This has caused many small companies to reconsider which method of accounting is right for them.

Under the TCJA, the small business definition was expanded to include businesses with no more than $25 million of average annual gross receipts, based on the last three tax years (previously, this gross-receipts threshold was only $5 million). This $25 million limit is adjusted annually for inflation, and the inflation-adjusted limit is $26 million for tax years beginning in 2021. For 2022, the limit is $27 million.

The TCJA also modifies Section 451 of the Internal Revenue Code. For tax years beginning after 2017, the Code has been changed so that businesses recognize revenue for tax purposes no later than they recognize revenue for financial reporting purposes. This means that you must use the accrual method for federal income tax purposes if you choose to use it for financial reporting purposes.

Have further questions? We can help

Switching to the accrual method of accounting can help small businesses reduce variability in financial reporting and more easily attract financing from investors and lenders who prefer GAAP financials. However, the cash method offers more simplicity and flexibility in tax planning. 

If you need help choosing the best method for your situation, contact us to discuss your options.

© 2022

audits-related-party-transactions

Audits and Related-Party Transactions
Audits and Related-Party Transactions 1600 941 smolinlupinco

Business transactions involving related parties—including parent companies, subsidiaries, affiliated entities, relatives, and friends—sometimes occur at above- or below-market rates. This can cause your company’s financial statements to become misleading to the people who rely on them, since undisclosed related-party transactions can skew their understanding of the company’s true financial results.

Auditors and related parties

Because there’s a strong possibility of double-dealing with related parties, auditors place significant focus on hunting for undisclosed related-party transactions.

To uncover these transactions, auditors may use all of the following documents and data sources:

  • Lists of a company’s current related parties and associated transactions
  • Disclosures from board members and senior executives regarding their previous employment history, ownership of other entities, or participation on additional boards
  • Press releases announcing significant business transactions with related parties
  • Minutes from board of directors’ meetings, especially any discussion of significant business transactions
  • Bank statements, particularly for transactions that involve intercompany wires, check payments, and automated clearing house (ACH) transfers

In assessing these documents, auditors will pay particular attention to contracts for goods or services that are priced at higher (or lower) rates than goods and services purchased or sold in similar transactions between unrelated third parties.

For example, in order to reduce its taxable income in the United States, a manufacturer might buy goods from its subsidiary at artificially high prices in a low-tax country. Similarly, an auto dealership might pay the child of the owner an above-market salary with benefits that aren’t available to unrelated employees. Or a spinoff business might lease office space at below-market rates from its parent company. 

Targeting related-party transactions

Auditors use all of the following procedures to target undisclosed related-party transactions:

  • Interviewing the accounting personnel who report related-party transactions in the company’s financial statements
  • Looking at the company’s enterprise resource planning (ERP) system and testing how related-party transactions are identified and coded
  • Analyzing how related-party transactions are presented in the company’s financial statements

Robust internal controls are needed to ensure accurate, complete reporting of these transactions. Your company’s vendor approval process should include clear guidelines to help accounting personnel identify related parties and mark them in the ERP system accordingly. Companies that don’t have these measures in place may inadvertently fail to disclose related-party transactions.

Communicating with auditors

Communication is key when it comes to related-party transactions. You should always tell your auditors if you have any known related-party transactions—and don’t be afraid to ask for assistance disclosing and reporting these transactions in accordance with U.S. Generally Accepted Accounting Principles.

Beneficiary Designations and Joint Titles: Careful Planning Avoid Overriding Will

Beneficiary Designations and Joint Titles: Careful Planning Is Needed to Avoid Overriding Your Will
Beneficiary Designations and Joint Titles: Careful Planning Is Needed to Avoid Overriding Your Will 850 500 smolinlupinco

A careless approach to beneficiary designations and jointly titled assets can easily undermine your estate plan. 

For example, you may specify in your will that all of your property should be divided equally among your children. But say that your IRA accounts for half of your estate and names your oldest child as the beneficiary. In this case, your oldest child will inherit half of your estate in addition to a third of the remaining assets. It’s hardly an equal division of your assets, and probably far from what you intended.

Jointly owned property requires similarly careful treatment. Regardless of the terms of your will, the surviving owner takes title to the property after your death. What many people fail to realize is that their wills exert no control over disposition of nonprobate assets. 

Understanding nonprobate assets

Nonprobate assets include life insurance policies, IRAs and retirement plans, joint bank or brokerage accounts, and even savings bonds. When you pass away, nonprobate assets are generally transferred automatically according to a beneficiary designation or contract. Because of this, they override your will. 

To ensure your estate plan remains in line with your wishes, it’s important to regularly review beneficiary designations and property titles, especially after significant life events such as a marriage or divorce, the death of a loved one, or the birth of a child. 

Planning to use POD and TOD designations

Payable-on-death (POD) and transfer-on-death (TOD) designations allow you to transfer assets outside of probate in a simple and cost-effective way. While POD designations are used for bank accounts and certificates of deposit, TOD designations can be used to transfer stocks, bonds, or brokerage accounts. In many states, you may even be able to use TOD designations to transfer real estate.

All you need to do to set up these designations is provide a signed POD or TOD beneficiary designation form. To claim the money or securities after you pass away, your beneficiaries will simply need to present their identification to the bank or brokerage, along with a certified copy of the death certificate.

Although they are useful and convenient, POD and TOD designations must be carefully coordinated with the rest of your estate plan. Without careful planning, your POD or TOD may conflict with your will, trusts, or other estate planning documents.

You should also take care not to use POD and TOD designations for too high a proportion of your assets. If you use these designations for the majority of your assets, there may not be sufficient assets left in your estate to settle your debts, taxes, or other expenses. In this case, your executor will need to initiate a proceeding to bring assets back into the estate.

If you hold joint accounts, use POD or TOD designations, or have large retirement accounts or life insurance policies, proper planning is essential to avoid overriding your will. We can help you identify potential conflicts in your estate plan.

Startup Businesses Research Tax Credit Payroll Taxes

Startup Businesses May Be Able to Apply the Research Tax Credit Against Payroll Taxes
Startup Businesses May Be Able to Apply the Research Tax Credit Against Payroll Taxes 850 500 smolinlupinco

If your business has increased research activities, you may be eligible to claim a valuable tax credit often referred to as the research and development (R&D) credit. Although claiming the R&D tax credit requires complex calculations, we can help take care of these calculations for you.

In addition to the tax credit itself, you should also be aware of two features that are especially advantageous to small businesses:

  1. Small businesses with $50 million or less in gross receipts are eligible to claim the R&D credit against alternative minimum tax (AMT) liability
  2. Certain startup businesses may claim the credit against the employer’s Social Security payroll tax liability

It’s worth taking a closer look at this second feature.

If your business is eligible, your business can elect to apply some or all of the research tax credit you earn against your payroll taxes, rather than your income tax. With this payroll tax election in mind, some small startup businesses may wish to undertake or increase their research activities. And if your business is already engaged in or is planning to undertake research activities, you should be aware that some tax relief may be available to you.

Benefits of the election

Many new businesses pay no income tax and won’t pay tax for some time, even if they have a net positive cash flow and/or a book profit. 

Because of this, new businesses typically have no amount to apply business credits, including the research credit, against. However, even a new wage-paying business will have payroll tax liabilities. 

The payroll tax election thus offers new businesses a chance to more quickly use the research credits they earn. Since every dollar of credit-eligible expenditure can result in as much as a 10-cent tax credit, this election can serve as a major boon to businesses during the start-up phase when help is most needed.

What businesses are eligible?

In order to be eligible for the election, a taxpayer must:

  • Have gross receipts for the election year that are less than $5 million
  • Be no more than five years past the startup period (the period for which it had no receipts)

Only the gross receipts from the taxpayer’s business are taken into account in making these determinations. Other income such as an individual’s salary or investment income aren’t taken into consideration. 

You should also note that an entity or individual can’t choose to make the election for more than six straight years.

Limitations

If an individual chooses to make the payroll tax election, the research credit for which the election is made may only be applied against the Social Security portion of FICA taxes. The credit can’t be applied against the “Medicare” portion of FICA taxes or any FICA taxes that are withheld and remitted to the government on behalf of employees.

In addition, the election can’t be made on research credit amounts in excess of $250,000 annually. For C corporations and individual taxpayers, the election can only be taken for research credits that would have to be carried forward in the absence of an election. This means that C corporations can’t make the election for amounts that the taxpayer could use to reduce their own income tax liabilities.

Identifying and substantiating expenses eligible for the research credit is a complex undertaking, and these are only the basics of the payroll tax election. If you have further questions or believe you may benefit from the payroll tax election, contact us.

IRA Contribution Reduce Tax Bill

IRA Contributions: You May Still Be Able to Reduce Your Tax Bill
IRA Contributions: You May Still Be Able to Reduce Your Tax Bill 850 500 smolinlupinco

If you haven’t filed your 2021 tax return yet, you may still be able to lower your tax bill by making a contribution to an IRA.

Eligible taxpayers can make deductible contributions to a traditional IRA at any time before the filing date on April 18, 2022. Making a deductible contribution now could allow you to save on your 2021 return.

Eligibility requirements

Generally speaking, taxpayers are eligible to make a deductible contribution to a traditional IRA as long as:

  1. They (or their spouse) aren’t an active participant in an employer-sponsored retirement plan, OR
  2. They (or their spouse) are an active participant in an employer plan, but their modified adjusted gross income (AGI) is below specific levels that change from year-to-year by filing status.

For 2021, deductible IRA contribution phases out over $105,000 to $125,000 of modified AGI for joint tax return filers who are covered by an employer plan. This phaseout range is:

  • $66,000 to $76,000 for taxpayers who are single or a head of household
  • $0 to $10,000 for those who are married and filing separately
  • $198,000 to $208,000 for taxpayers aren’t active participants in an employer-sponsored retirement plan but have spouses who are

Although a deductible contribution to a standard IRA will reduce your tax bill for 2021 and earnings within the IRA will be tax deferred, every dollar you take out will be taxed in full. In addition, any amount taken out is subject to a 10% penalty for taxpayers under the age of 59½, unless certain exceptions apply to you.

Even if you don’t work, you may still be able to lessen your tax bill by making a deductible IRA contribution. Generally speaking, taxpayers must have wages or other earned income in order to make deductible contributions to an IRA. However, an exception may apply if your spouse is the primary earner of the home. In this case, you may be able to make a deduction to a spousal IRA.

It’s worth noting that most IRAs are called “traditional IRAs” to differentiate them from Roth IRAs. 

Although you can still contribute to a Roth IRA before April 18, contributions to a Roth IRA aren’t deductible. However, you can make tax-free withdrawals from a Roth IRA as long as you’re age 59½ or older and the account has been open at least five years. (To contribute to a Roth IRA, you will also need to be under certain income limits.)

Contribution Limits

For 2021, eligible taxpayers may make a deductible contribution of up to $6,000 to a traditional IRA (if you’re age 50 or older, this limit is $7,000).

Small business owners may also set up and make contributions to a Simplified Employee Pension (SEP) until the date their return is due, including extensions. The maximum contribution for SEPs is $58,000 for 2021.

If you have questions or need more information about IRAs or SEPs, contact us. We can guide you through your savings options as you consider your tax bill.

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