Why Face-to-Face Meetings With Your Auditor Are Important
September 29, 2020 | BY Joseph Hoffman
Remote audit procedures can help streamline the audit process and protect the parties from health risks during the COVID-19 crisis. However, seeing people can be essential when it comes to identifying and assessing fraud risks during a financial statement audit. Virtual face-to-face meetings can be the solution.
Asking questions
Auditing standards require auditors to identify and assess the risks of material misstatement due to fraud and to determine overall and specific responses to those risks. Specific areas of inquiry under Clarified Statement on Auditing Standards (AU-C) Section 240, Consideration of Fraud in a Financial Statement Audit include:
- Whether management has knowledge of any actual, suspected or alleged fraud,
- Management’s process for identifying, responding to and monitoring the fraud risks in the entity,
- The nature, extent and frequency of management’s assessment of fraud risks and the results of those assessments,
- Any specific fraud risks that management has identified or that have been brought to its attention, and
- The classes of transactions, account balances or disclosures for which a fraud risk is likely to exist.
In addition, auditors will inquire about management’s communications, if any, to those charged with governance about the management team’s process for identifying and responding to fraud risks, and to employees on its views on appropriate business practices and ethical behavior.
Seeing is believing
Traditionally, auditors require in-person meetings with managers and others to discuss fraud risks. That’s because a large part of uncovering fraud involves picking up on nonverbal cues of dishonesty. In a face-to-face interview, the auditor can, for example, observe signs of stress on the part of the interviewee in responding to the question.
However, during the COVID-19 pandemic, in-person meetings may give rise to safety concerns, especially if either party is an older adult or has underlying medical conditions that increase the risk for severe illness from COVID-19 (or lives with a person who’s at high risk). In-person meetings with face masks also aren’t ideal from an audit perspective, because they can muffle speech and limit the interviewer’s ability to observe facial expressions.
A videoconference can help address both of these issues. Though some people may prefer the simplicity of telephone or audioconferences, the use of up-to-date videoconferencing technology can help retain the visual benefits of in-person interviews. For example, high-definition videoconferencing equipment can allow auditors to detect slight physical changes, such as smirks, eyerolls, wrinkled brows and even beads of sweat. These nonverbal cues may be critical to assessing an interviewee’s honesty and reliability.
Risky business
Evaluating fraud risks is a critical part of your auditor’s responsibilities. You can facilitate this process by anticipating the types of questions your auditor will ask and ensuring your managers and accounting personnel are all familiar with how videoconferencing technology works. Contact us for more information.
Don’t Predict. Prepare.
September 29, 2020 | BY Our Partners at Equinum Wealth Management
If you’re still around at this point of 2020, you’re probably expecting something crazy to happen. Will there be a release of a new and improved COVID-20? Will there be a civil war when half the country doesn’t like the election outcome? Are we in for a zombie apocalypse, perhaps?
While we do know that crazy stuff can happen, we can never predict it.
Financial media on the other hand, lives on predictors and prognosticators.
Every day, talking heads come onto CNBC and Bloomberg to gab about and predict the future of the economy, the stock markets and more. (In all honesty, they know nothing. But hey, something’s gotta fill their programming.)
We don’t like predictions because we know they don’t actually represent the truth. And even if they did, that information might not be as helpful as you’d think. Just imagine having a time machine where you could see future news, but not its financial outcome. All you’d need to do to know how the economy and stock market would look, is interpret the news.
So, it’s January of 2020, and you check into your magical machine. Alas, you see that a pandemic will be unleashed into the world, where air-travel would come to a halt, live sports would take a total sabbatical and the entire globe would be on an obligatory home confinement for months. You see that the virus will leave forty million Americans jobless, millions of people infected, and hundreds of thousands – dead.
Okay, now what would you do with your portfolio? Probably go to all-cash. Maybe you would buy some gold?
With the benefit of hindsight, cash was probably the worst asset class to be in. Gold did perform very well, but regarding the bulk of your decision, you would have been dead wrong. You would have never predicted that although thousands would die each day from the virus, the stock market would make a new all-time high just a couple of months afterwards.
Just think: If we can’t even predict the financial future knowing the news in advance, we definitely don’t stand a chance without that advantage.
Our take at Equinum is: stop predicting what the future holds. Instead, prepare and be ready for many diverse outcomes, including the crazy stuff.
If you watch financial media, your head should be spinning from all the current predictions coming from all the pundits sitting in their living rooms. (Although their bookshelves of borrowed books do make them look intelligent.)
Will we have hyper-inflation due to all the helicopter money being dropped in the form of stimulus and unemployment benefits, or deflation due to the millions of people out of work?
Will the market retest the March lows, or will the amazing ascent we are currently on, continue?
Will New York real estate have a Humpty Dumpty fall, or is this a once-in-a-life-time opportunity where the king’s horses and men come through?
Again, we don’t predict. But we do need to prepare.
And how do we do that?
Well first and foremost, we want to have an all-weather portfolio. That is, a properly diversified portfolio where you have a mix of asset classes and proper asset allocation.
At Equinum, we have made some changes to our clients’ accounts. We have swapped some of the government bonds in our portfolios to TIPS, which are inflation protected. So, if inflation gets out of control, clients won’t lose purchasing power.
We added some real assets to portfolios, like precious metals and real estate. These tend to do well in cases of inflation.
Income producing companies can also be a good hedge as well.
One more thing to the renters out there: It might be a prudent idea to consider purchasing a home. If we do have a pickup in real inflation, your rent can double over the next decade or so. But if you lock in a mortgage, your price is locked. To sweeten the deal, mortgage rates are the lowest ever recorded by Freddie Mac in a series that goes back to 1971.
If you have personal questions or concerns, please reach out to us at info@equinum.com to set up a call.
Can Investors Who Manage Their Own Portfolios Deduct Related Expenses?
September 22, 2020 | BY Joseph Hoffman
In some cases, investors have significant related expenses, such as the cost of subscriptions to financial periodicals and clerical expenses. Are they tax deductible? Under the Tax Cut and Jobs Act, these expenses aren’t deductible through 2025 if they’re considered expenses for the production of income. But they are deductible if they’re considered trade or business expenses. (For tax years before 2018, production-of-income expenses were deductible, but were included in miscellaneous itemized deductions, which were subject to a 2%-of-adjusted-gross-income floor.)
In order to deduct investment-related expenses as business expenses, you must figure out if you’re an investor or a trader — and be aware that it’s more advantageous (and difficult) to qualify for trader status.
To qualify, you must be engaged in a trade or business. The U.S. Supreme Court held many years ago that an individual taxpayer isn’t engaged in a trade or business merely because the individual manages his or her own securities investments, regardless of the amount of the investments or the extent of the work required.
However, if you can show that your investment activities rise to the level of carrying on a trade or business, you may be considered a trader engaged in a trade or business, rather than an investor. As a trader, you’re entitled to deduct your investment-related expenses as business expenses. A trader is also entitled to deduct home-office expenses if the home office is used exclusively on a regular basis as the trader’s principal place of business. An investor, on the other hand, isn’t entitled to home-office deductions since the investment activities aren’t a trade or business.
Since the Supreme Court’s decision, there has been extensive litigation on the issue of whether a taxpayer is a trader or investor. The U.S. Tax Court has developed a two-part test that must be satisfied in order for a taxpayer to be a trader. Under this two-part test, a taxpayer’s investment activities are considered a trade or business only if both of the following are true:
- The taxpayer’s trading is substantial (in other words, sporadic trading isn’t a trade or business), and
- The taxpayer seeks to profit from short-term market swings, rather than from long-term holding of investments.
So, the fact that a taxpayer’s investment activities are regular, extensive and continuous isn’t in itself sufficient for determining that a taxpayer is a trader. In order to be considered a trader, you must show that you buy and sell securities with reasonable frequency in an effort to profit on a short-term basis. In one case, even a taxpayer who made more than 1,000 trades a year with trading activities averaging about $16 million annually was held to be an investor because the holding periods for stocks sold averaged about one year.
Contact us if you have questions about whether your investment-related expenses are deductible. We can also help explain how to help keep capital gains taxes low when you sell investments.
How to Report COVID-19-Related Debt Restructuring
September 21, 2020 | BY Joseph Hoffman
Today, many banks are working with struggling borrowers on loan modifications. Recent guidance from the Financial Accounting Standards Board (FASB) confirms that short-term modifications due to the COVID-19 pandemic won’t be subject to the complex accounting rules for troubled debt restructurings (TDRs). Here are the details.
Accounting for TDRs
Under Accounting Standards Codification (ASC) Topic 310-40, Receivables — Troubled Debt Restructurings by Creditors, a debt restructuring is considered a TDR if:
- The borrower is troubled, and
- The creditor, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession it wouldn’t otherwise consider.
Banks generally must account for TDRs as impaired loans. Impairment is typically measured using the discounted cash flow method. Under this method, the bank calculates impairment as the decline in the present value of future cash flows resulting from the modification, discounted at the original loan’s contractual interest rate. This calculation may be further complicated if the contractual rate is variable.
Under U.S. Generally Accepted Accounting Principles (GAAP), examples of loan modifications that may be classified as a TDR include:
- A reduction of the stated interest rate for the remaining original life of the debt,
- An extension of the maturity date or dates at a stated interest rate lower than the current market rate for new debt with similar risk,
- A reduction of the face amount or maturity amount of the debt as stated in the instrument or other agreement, and
- A reduction of accrued interest.
The concession to a troubled borrower may include a restructuring of the loan terms to alleviate the burden of the borrower’s near-term cash requirements, such as a modification of terms to reduce or defer cash payments to help the borrower attempt to improve its financial condition.
Recent guidance
Earlier this year, the FASB confirmed that short-term modifications made in good faith to borrowers experiencing short-term operational or financial problems as a result of COVID-19 won’t automatically be considered TDRs if the borrower was current on making payments before the relief. Borrowers are considered current if they’re less than 30 days past due on their contractual payments at the time a modification program is implemented.
The relief applies to short-term modifications from:
- Payment deferrals,
- Extensions of repayment terms,
- Fee waivers, and
- Other payment delays that are insignificant compared to the amount due from the borrower or to the original maturity/duration of the debt.
In addition, loan modifications or deferral programs mandated by a federal or state government in response to COVID-19, such as financial institutions being required to suspend mortgage payments for a period of time, won’t be within the scope of ASC Topic 310-40.
For more information
The COVID-19 pandemic is an unprecedented situation that continues to present challenges to creditors and borrowers alike. Contact your CPA for help accounting for loan modifications and measuring impairment, if necessary.
Weighing the Risks vs. Rewards of a Mezzanine Loan
September 17, 2020 | BY Joseph Hoffman
To say that most small to midsize businesses have at least considered taking out a loan this year would probably be an understatement. The economic impact of the COVID-19 pandemic has lowered many companies’ revenue but may have also opened opportunities for others to expand or pivot into more profitable areas.
If your company needs working capital to grow, rather than simply survive, you might want to consider a mezzanine loan. These arrangements offer relatively quick access to substantial funding but with risks that you should fully understand before signing on the dotted line.
Equity on the table
Mezzanine financing works by layering a junior loan on top of a senior (or primary) loan. It combines aspects of senior secured debt from a bank and equity-based financing obtained from direct investors. Sources of mezzanine financing can include private equity groups, mutual funds, insurance companies and buyout firms.
Unlike bank loans, mezzanine debt typically is unsecured by the borrower’s assets or has liens subordinate to other lenders. So, the cost of obtaining financing is higher than that of a senior loan.
However, the cost generally is lower than what’s required to acquire funding purely from equity investment. Yet most mezzanine instruments do enable the lender to participate in the borrowing company’s success — or failure. Generally, the lower your interest rate, the more equity you must offer.
Flexibility at a price
The primary advantage of mezzanine financing is that it can provide capital when you can’t obtain it elsewhere or can’t qualify for the amount you’re looking for. That’s why it’s often referred to as a “bridge” to undertaking ambitious objectives such as a business acquisition or desirable piece of commercial property. But mezzanine loans aren’t necessarily an option of last resort; many companies prefer their flexibility when it comes to negotiating terms.
Naturally, there are drawbacks to consider. In addition to having higher interest rates, mezzanine financing carries with it several other potential disadvantages. Loan covenants can be restrictive. And though some lenders are relatively hands-off, they may retain the right to a significant say in company operations — particularly if you don’t repay the loan in a timely manner.
If you default on the loan, the lender may either sell its stake in your company or transfer that equity to another entity. This means you could suddenly find yourself with a co-owner who you’ve never met or intended to work with.
Mezzanine financing can also make an M&A deal more complicated. It introduces an extra interested party to the negotiation table and can make an already tricky deal that much harder.
Explore all options
Generally, mezzanine loans are best suited for businesses with clear and even aggressive growth plans. Our firm can help you fully explore the tax, financial and strategic implications of any lending arrangement, so you can make the right decision.