Trends – Roth&Co

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If you’ve been an investor in 2022, you don’t need us to tell you how tough things are. In order to tamp down inflation, the Federal Reserve is deliberately trying to make stock prices go down, crash the housing market, and slow down the overall economy.

For the most part, it’s worked. The stock market is officially in a bear market. The housing market has dried up, and it is almost certain that we are either in, or entering, a recession.

Here are the returns for the stated indices through September 30^th:

Index	Return
S&P 500	-25.25%
AGG Bond Index	-13.79%
60/40 Portfolio	-20.67%

As you can see, it isn’t only the stock market that has taken it on the chin. The “conservative” bond investments have also been taken to the woodshed.

By the Fed raising the Fed-Funds rate under their control, the other interest rates on government and corporate bonds have followed their rise, pushing down prices of existing bond holders. This has caused an extremely unusual reaction in the bond market – a double-digit percent correction. If the year would be over today, it would be the third worst calendar year for the observed 60/40 portfolio.

Charted below is a list of the worst years for a 60/40 portfolio. (Constituting 60% S&P 500 and 40% 10-year treasuries):

Year	Portfolio Return
1931	-27.3%
1937	-20.7%
1974	-14.7%
2008	-13.9%
1930	-13.3%
1941	-8.5%
2002	-7.1%
1973	-7.1%
1969	-6.9%
2001	-4.9%

These returns may surprise you. How are we down so much more now than we were in 2008, during a real financial crisis? Or in 2001 when the dot-com bust cut the S&P 500 in half?

The answer is the diversification aspect that we expected from bonds, or the lack thereof. For example, in 2008, equities were down -36.6%, quite a chunk lower than what equities are down now. Conversely, bonds were up 20.10%. Since 1928, there have been only four points in time where stocks and bonds have been down in the same year. And when that did happen, most were in the low single digits.

So, where is the good news?

The good news is that, if history is any guide, things will be looking quite positive from here on in.

First, on the fixed income side of things: A year ago, the yield we were getting from a ten-year bond was .74%. A two-year bond was yielding .49%. With that backdrop we were at a starting point of almost no yield, making it very hard to diversify portfolios. Now, these same bonds are yielding in the 4% range. So, the bond portion of the account will earn a yield, providing investors with a fixed income and a benefit from diversification.

As for equities, there is also a historical precedent for a comeback. Look below at what happens when the S&P 500 falls by 25% or more:

Source: A Wealth Of Common Sense

This isn’t to say the low for the year is in, or that there won’t be any gut-wrenching volatility until year end. But for those courageous enough to hold on, history proves that they will be paid back nicely.

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Earlier this year, I wrote about the term ”The Great Resignation” describing the record number of employees who have left their jobs since the start of the pandemic. Although the number of employees who are quitting remain at record levels, economists have begun using a different term to describe the recent employment phenomenon – ”The Great Renegotiation.”

”The Great Resignation” seems to imply that employees are simply resigning and finding new jobs or leaving the workforce altogether. The truth is much more complicated. There is a growing belief that the worker-employer relationship has changed both fundamentally and permanently. According to a report by McKinsey, 65% of workers who took a new job in the last 2 years did so in a different industry than the one in which they were previously employed. The pandemic has made employees adjust their priorities and rethink their work expectations.

Put a little differently, employee expectations have gone up, so organizations need to examine how they recruit talent. According to McKinsey, employees have different priorities and want more than just higher compensation, and it is up to employers to adjust. ”The Great Renegotiation” has begun, and companies who are committed to making the necessary work and cultural changes can leverage this workforce reshuffling into a powerful opportunity.

Traditional tools such as compensation, titles, and promotion are still important, but shouldn’t be the only levers that companies can use to attract employees. Katy George, a senior partner at McKinsey & Company, wrote a paper highlighting five changes that companies should consider making if they want to succeed in the emerging talent market:

From Pedigree to Potential

Job descriptions typically list specific education and experience requirements, but this can discourage candidates from applying who may be able to do the job despite lacking a certain credential. To broaden an employment search, companies can shift the focus from degrees to skills – simply changing the entry barriers, not lowering them.

From Preset Career Paths to Self-Authorship

In years gone by, employees would follow a pre-determined career track up a corporate ladder. Given the rapidly changing nature of today’s work and how quickly skills can become obsolete, employees are now taking charge of their own professional development. Companies should provide more professional development, apprenticeship, and personal growth opportunities. Self-directed learning can support both individual ambitions and company priorities.

From One-Way to Two-Way Apprenticeship

Traditional apprenticeship was about a younger person learning directly from an older one. Today, learning and teaching should flow both ways. For example, an apprenticeship that brings together a senior finance manager and a lower-ranking IT engineer would be an excellent way to share knowledge. A two-way learning dynamic gives employees opportunity for continual growth and can lead to greater loyalty and productivity.

From Time Served to Impact Delivered

An employee staying with a singular company for their whole career is pretty much unheard of nowadays. The stigma in leaving a job has never been weaker and the relationship between tenure and performance is nonexistent. Employees are looking for meaningful work where they feel they are making an impact. Employees expect their jobs to bring a significant sense of purpose to their lives and employers need to help meet this need. A paycheck is great, but a paycheck coupled with the feeling that you’ve positively contributed to society is even better.

From Culture Fit to Inclusive Culture

Capturing the full benefits of diversity is not about hiring people who can fit into the existing corporate culture. It’s about creating a company culture that is supportive and adaptable enough to embrace all kinds of talent. If a company does not work to embrace diverse talent, they will miss out on adding creativity and innovation to their team. Whether it is encouraging empathetic managers, or conducting fair performance reviews, there are many different ways to improve a company’s culture to be more inclusive.

Given the stress in many labor markets and the increasingly global hunt for talent, “The Great Renegotiation” is expected to intensify – but it is a process, not an end result. Adopting the changes above will be no small undertaking, but they are important steps to meeting both the present and the future needs of the labor market.

This material has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for, legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.

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There’s a strong sense of relief when outside experts announce that their audit of your not-for-profit is complete. But even if auditors have left your premises and returned the documents they’ve reviewed, the work isn’t really over. Not only do your executive director and board need to review the audit report, but it may be necessary to address auditor concerns by making changes to your organization.

Review the draft

Once outside auditors complete their work, they typically present a draft report to an organization’s audit committee, executive director and senior financial staffers. Those individuals should take the time to review the draft before it’s presented to the board of directors.

Your audit committee and management also need to meet with the auditors before the board presentation. Often auditors will provide a management letter (also called “communication with those charged with governance”) highlighting operational areas and controls that need improvement. Your nonprofit’s team can respond to these comments, indicating ways they plan to improve operations and controls, to be included in the final letter. The audit committee also can use the meeting to ensure the audit is properly comprehensive.

Assess internal controls

The final audit report will state whether your nonprofit’s financial statements present its financial position in accordance with U.S. Generally Accepted Accounting Principles. The statements must be presented without any inaccuracies or “material” — meaning significant — misrepresentation.

The auditors also will identify, in a separate letter, specific concerns about material internal control issues. Adequate internal controls are critical for preventing, catching and remedying misstatements that could compromise the integrity of financial statements. If the auditors have found your internal controls to be weak, promptly shore them up.

Gather feedback

One important audit committee task is to obtain your executive director’s impression of the auditors and audit process. Were the auditors efficient, or did they perform or require redundant work? Did they demonstrate the requisite expertise, skills and understanding? Were they disruptive to operations? Consider this input when deciding whether to retain the same firm for the next audit.

The committee also might want to seek feedback from employees who worked most closely with the auditors. In addition to feedback on the auditors, they may have suggestions on how to streamline the process for the next audit.

Fiscal responsibility

Your donors, grantmakers and other supporters expect your organization to do everything in its power to ensure funds are used appropriately and responsibly. If you fail to act on issues identified in an audit, it could lead to asset misappropriation and seriously damage your nonprofit’s reputation and viability. Contact us if you have questions, require an audit or need help improving internal controls.

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If you’re interested in investing in tax-free municipal bonds, you may wonder if they’re really free of taxes. While the investment generally provides tax-free interest on the federal (and possibly state) level, there may be tax consequences. Here’s how the rules work:

Purchasing a bond

If you buy a tax-exempt bond for its face amount, either on the initial offering or in the market, there are no immediate tax consequences. If you buy such a bond between interest payment dates, you’ll have to pay the seller any interest accrued since the last interest payment date. This amount is treated as a capital investment and is deducted from the next interest payment as a return of capital.

Interest excluded from income

In general, interest received on a tax-free municipal bond isn’t included in gross income although it may be includible for alternative minimum tax (AMT) purposes. While tax-free interest is attractive, keep in mind that a municipal bond may pay a lower interest rate than an otherwise equivalent taxable investment. The after-tax yield is what counts.

In the case of a tax-free bond, the after-tax yield is generally equal to the pre-tax yield. With a taxable bond, the after-tax yield is based on the amount of interest you have after taking into account the increase in your tax liability on account of annual interest payments. This depends on your effective tax bracket. In general, tax-free bonds are likely to be appealing to taxpayers in higher brackets since they receive a greater benefit from excluding interest from income. For lower-bracket taxpayers, the tax benefit from excluding interest from income may not be enough to make up for a lower interest rate.

Even though municipal bond interest isn’t taxable, it’s shown on a tax return. This is because tax-exempt interest is taken into account when determining the amount of Social Security benefits that are taxable as well as other tax breaks.

Another tax advantage

Tax-exempt bond interest is also exempt from the 3.8% net investment income tax (NIIT). The NIIT is imposed on the investment income of individuals whose adjusted gross income exceeds $250,000 for joint filers, $125,000 for married filing separate filers, and $200,000 for other taxpayers.

Tax-deferred retirement accounts

It generally doesn’t make sense to hold municipal bonds in your traditional IRA or 401(k) account. The income in these accounts isn’t taxed currently. But once you start taking distributions, the entire amount withdrawn is likely to be taxed. Thus, if you want to invest retirement funds in fixed income obligations, it’s generally advisable to invest in higher-yielding taxable securities.

We can help

These are only some of the tax consequences of investing in municipal bonds. As mentioned, there may be AMT implications. And if you receive Social Security benefits, investing in municipal bonds could increase the amount of tax you must pay with respect to the benefits. Contact us if you need assistance applying the tax rules to your situation or if you have any questions.

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Whether you’re considering selling your business or acquiring another one, due diligence is a must. In many mergers and acquisitions (M&A), prospective buyers obtain a quality of earnings (QOE) report to evaluate the accuracy and sustainability of the seller’s reported earnings. Sometimes sellers get their own QOE reports to spot potential problems that might derail a transaction and identify ways to preserve or even increase the company’s value. Here’s what you should know about this critical document:

Different from an audit

QOE reports are not the same as audits. An audit yields an opinion on whether the financial statements of a business fairly present its financial position in accordance with Generally Accepted Accounting Principles (GAAP). It’s based on historical results as of the company’s fiscal year end.

In contrast, a QOE report determines whether a business’s earnings are accurate and sustainable, and whether its forecasts of future performance are achievable. It typically evaluates performance over the most recent interim 12-month period.

EBITDA effects

Generally, the starting point for a QOE report is the company’s earnings before interest, taxes, depreciation and amortization (EBITDA). Many buyers and sellers believe this metric provides a better indicator of a business’s ability to generate cash flow than net income does. In addition, EBITDA helps filter out the effects of capital structure, tax status, accounting policies and other strategic decisions that may vary depending on who’s managing the company.

The next step is to “normalize” EBITDA by:

Eliminating certain nonrecurring revenues and expenses,
Adjusting owners’ compensation to market rates, and
Adding back other discretionary expenses.

Additional adjustments are sometimes needed to reflect industry-based accounting conventions. Examples include valuing inventory using the first-in, first-out (FIFO) method rather than the last-in, first-out (LIFO) method, or recognizing revenue based on the percentage-of-completion method rather than the completed-contract method.

Continued viability

A QOE report identifies factors that bear on the business’s continued viability as a going concern, such as operating cash flow, working capital adequacy, related-party transactions, customer concentrations, management quality and supply chain stability. It’s also critical to scrutinize trends to determine whether they reflect improvements in earnings quality or potential red flags.

For example, an upward trend in EBITDA could be caused by a positive indicator of future growth, such as increasing sales, or a sign of fiscally responsible management, such as effective cost-cutting. Alternatively, higher earnings could be the result of deferred spending on plant and equipment, a sign that the company isn’t reinvesting in its future capacity. In some cases, changes in accounting methods can give the appearance of higher earnings when no real financial improvements were made.

A powerful tool

If an M&A transaction is on your agenda, a QOE report can be a powerful tool no matter which side of the table you’re on. When done right, it goes beyond financials to provide insights into the factors that really drive value. Let us help you explore the feasibility of a deal.

Finally, some good news.

Competing for Talent During “The Great Renegotiation”

The audit is over. Now what?

Tax and other financial consequences of tax-free bonds

M&A on the Way? Consider a QOE Report