Category: Audit

What Every Corporate Director Should Know About the New Tax Law-Part 1

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George M. Gerachis and David C. Cole

The Tax Cuts and Jobs Act of 2017 (“Tax Act”) has sweeping ramifications. These range from mechanical compliance issues (e.g., revised withholding rates for employees) to strategic concerns that must ultimately be decided in the boardroom. For domestic corporations and foreign corporations with U.S. operations, one strategic imperative is a wholesale re-evaluation of the structure of a company’s operations. In this first of two articles, we identify four significant aspects of the Tax Act with which corporate directors should become familiar.

1. Mandatory “Transition Tax” on Deemed Repatriations of Deferred Foreign Earnings. Many corporations have deferred foreign earnings under Accounting Principles Board Opinion No. 23, recording no associated financial statement U.S. income tax liability based on the position that such earnings are indefinitely reinvested in foreign operations. The Tax Act terminates the deferral and imposes a tax liability on deferred earnings regardless of whether they are actually repatriated. The Transition Tax on this “deemed repatriation” is 15.5 percent on the portion of the earnings represented by cash and cash equivalents and 8 percent on the portion invested in non-cash assets. Although most of the provisions of the Tax Act take effect in 2018, the Transition Tax is due on a corporation’s 2017 tax return and will likely cause a charge to 2017 earnings. There is an election to pay the tax in installments over an eight-year period.

What Directors Should Do. Computing the Transition Tax can be extremely complex and requires data the corporation may not have collected in the ordinary course of its business. This is particularly the case where the corporation has acquired companies that earned foreign profits after 1986. The U.S. Securities and Exchange Commission (SEC) has issued guidance, including Staff Accounting Bulletin 118, to assist corporations in applying generally accepted accounting principles (GAAP) to reflect the impact of the Tax Act where necessary information is not yet available. Directors, and in particular audit committee members, should ensure that the corporation devotes adequate resources to preparing a reasonably accurate computation of the Transition Tax in time to make their disclosures for the fiscal quarter or year ended December 31, 2017. Given the many open issues regarding the Transition Tax that may not be clarified by the filing date of the corporation’s tax return, corporations should enlist expert assistance to interpret the law and refine the company’s computation of the Transition Tax.

The deemed repatriation affords many corporations greater flexibility to utilize previously “trapped” cash (i.e., cash that was held by non-U.S. entities that could not be repatriated without being subject to U.S. tax). This cash might be used to fund acquisitions, capital expenditures, debt repayments, stock buybacks or dividends. Directors should ask management to focus on the corporation’s optimal capital allocation and to report to the board concerning available options.

2. Reduction in Corporate Tax Rate from 35 Percent to 21 Percent. The default rate on corporate taxable income drops from 35 to 21 percent, although there are special lower rates for certain types of foreign earnings discussed below. This 40-percent reduction in the corporate tax rate will affect the value of a corporation’s deferred tax assets and liabilities. For example, all things being equal the value of a net operating loss carry-forward may drop by 40 percent. At the same time, however, the lower tax rate may increase after-tax earnings going forward for many corporations. There are many less obvious implications of the rate reduction, particularly in conjunction with other changes in the Tax Act.

What Directors Should Do. Directors should commission a study by the corporation’s tax department of potential changes in the corporation’s legal entity and operational structures to take full advantage of the rate reductions in combination with other relevant provisions of the Tax Act. Such a study will also be useful in completing the corporation’s tax accounting analysis of the impact of the Tax Act under GAAP and related disclosures in the corporation’s SEC filings.

3. Reform of Taxation of International Operations. The Tax Act radically changes the taxation of profits earned outside the United States.

  • First, it eliminates the deferral of U.S. tax on foreign earnings. Thus, U.S. income tax now will be imposed on most current earnings of foreign subsidiaries rather than being postponed until earnings are repatriated.
  • Second, as a limited exception, foreign profits amounting to a 10 percent return on certain investments in tangible assets are permanently exempt from U.S. tax.
  • Third, profits from intangible assets earned outside the U.S. can be taxed at a special rate of 10.5 percent to the extent those profits result from certain types of revenues. Profits earned by domestic corporations from certain foreign sales of property or services are eligible for a special tax rate of 13.125 percent. Both of these special rates are scheduled to increase after 2025, but to levels well below the general 21 percent corporate rate.

What Directors Should Do. Directors should request a thorough review of the corporation’s international footprint as part of the study described above. This review should consider the optimal location not only of the corporation’s operations, but its personnel, tangible assets and intangible assets. Unlike GAAP consolidation, tax reporting must generally be made on an entity-by-entity basis (although consolidation of affiliates within a single country is often allowed). As a result, the corporation’s legal entity structure and inter-company contracts must be carefully aligned with its commercial arrangements. Given evolving changes in the tax laws of other member countries in the Organization for Economic Co-operation and Development (OECD), and particularly under the OECD’s Base Erosion and Profit Shifting (BEPS) initiative, structuring operations to accommodate both foreign tax laws and the new U.S. tax regime may be challenging. Finally, in evaluating any structure, directors should consider the prospects for future tax changes in reaction to the Tax Act in jurisdictions where the corporation operates.

4. Changes to Interest and Depreciation Deductions. The Tax Act gives with one proverbial hand—allowing immediate deduction of 100 percent of the acquisition cost for certain depreciable assets—and takes away with the other by limiting deductibility of net interest expense for many corporations. The “immediate expensing” provision applies only to tangible assets like plant and equipment and is phased down beginning in 2023. This new provision is more generous than prior “bonus depreciation” rules because it also applies to used assets, as well as new assets.
The interest expense rule limits certain corporations’ ability to currently deduct net business interest expense amounts exceeding 30 percent of certain thresholds. These thresholds are based on Earnings Before Income and Tax (EBIT) in years through 2021 and—less favorably—on Earnings Before Income, Tax, and Depreciation (EBITDA) after 2021. Disallowed interest deductions generally may be carried forward indefinitely. Interest expense on existing indebtedness is not grandfathered. Regulated public utilities are automatically exempt from these rules. Corporations in a broad spectrum of real property related businesses, farming businesses, and certain other agricultural businesses may elect to have these rules not apply.

What Directors Should Do. Directors should evaluate the impact of these two provisions on their corporation’s capital structure and its investment decisions. They should understand the implications of immediate deductibility of depreciable assets on acquisition structures. For example, acquiring stock may result in a lower internal rate of return than acquiring assets. Regarding the business interest limitations, directors should encourage management to determine whether the corporation is eligible to elect out of these rules and, if not, to explore alternatives to debt repayment, such as preferred equity instruments or other structures, that might mitigate the impact of these limitations.

Visit the NACD Board Leaders’ Blog again for the second installment in this series. 

George M. Gerachis serves as head of Vinson & Elkins’ Tax and Executive Compensation and Benefits department. He represents corporate and individual clients in a wide range of tax planning and tax controversy matters. David C. Cole is a tax partner at Vinson & Elkins and represents corporations, partnerships, and high net worth individuals in a wide range of domestic and international tax matters. Thoughts expressed here are their own. 

The Auditor’s Report: Reading Between New Lines

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Alexandra R. Lajoux

Now that the U.S. Securities and Exchange Commission (SEC) has released an order approving the Public Company Accounting Oversight Board’s (PCAOB) new rules on the auditor’s report, what items should the audit committee and shareholders look for there?

The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards, released by the PCAOB June 1 and approved by the SEC October 23, contains five main changes, including one that requires careful reading between the lines.

As NACD summarized in a recent brief to its members, the new PCAOB standard will require auditors to:

  • Standardize the format of the auditor’s report, placing the auditor’s opinion in the first section of the auditor’s report, followed by the basis for the opinion. This change makes the auditor’s opinion easier to find in the auditor’s report.
  • Disclose the auditor’s tenure, stating when the audit firm began its current service to the company. This new requirement comes in lieu of limiting audit firm tenure through mandatory audit firm rotation, a concept NACD and others have rejected in the past.
  • State that the auditor is required to be “independent.” This requirement is intended to strengthen shareholder confidence in the auditor’s report, possibly as an offset to the tenure disclosure, if it reveals that the auditor has been serving the client for more than a quarter century, for example.
  • State that the financial statements are free from material misstatements “whether due to error or fraud.” This change aligns with other recent or pending regulations on error vs. fraud, such as the proposed executive pay clawbacks rule still pending under Dodd-Frank, which mandated disgorgement of performance-based pay after financial restatements even if restatements were due to error rather than to fraud.

Report on critical audit matters (CAMs), defined as “matters communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements; and (2) involved especially challenging, subjective, or complex auditor judgment.” A number of commenters said that the CAMs mandate is “redundant” with existing reports, which already reveal the required information. See for example NACD’s comment to the PCAOB or State Street’s comment.

The key letter in CAM is M, for material. For those who may wonder what may be “material” to the financial statements, join the club. The SEC has still never defined this term, leaving this job to the courts as they interpret federal securities laws.

The going definition of “material” is more than 40 years old. The SEC release cites TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976), in which the U.S. Supreme Court states that a fact is material if there is “a substantial likelihood that the . . . fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” In that same case, the Supreme Court said that determining materiality requires “delicate assessments of the inferences a ‘reasonable shareholder’ would draw from a given set of facts and the significance of those inferences to him . . .”

Such wisdom is not lost on the PCAOB and SEC. In its June 1 release, the PCAOB cites as CAMs the auditor’s evaluation of the company’s “goodwill impairment assessment” and, more broadly, the auditor’s assessment of the company’s “ability to continue as a going concern.” These two examples are material to financial statements. By contrast, the following two examples are not material to the financial statement: a loss contingency already discussed with the audit committee and “determined to be remote;” and a “potential illegal act.”

Audit committees need to ensure that their auditors are in a position to recognize critical audit matters, and to learn from those matters.  But this does not mean looking for problems where there are none.

Significantly, SEC Chair Jay Clayton had this to say about the new standard:

“I would be disappointed if the new audit reporting standard, which has the potential to provide investors with meaningful incremental information, instead resulted in frivolous litigation costs, defensive, lawyer-driven auditor communications, or antagonistic auditor-audit committee relationships — with Main Street investors ending up in a worse position than they were before.

I therefore urge all involved in the implementation of the revised auditing standards, including the Commission and the PCAOB, to pay close attention to these issues going forward, including carefully reading the guidance provided in the approval order and the PCAOB’s adopting release.”

To Chairman Clayton’s point, the SEC makes this point in its approval order:

“As the [PCAOB] notes, in order to succeed, any claim based on these new statements would have to establish all of the elements of the relevant cause of action (e.g., when applicable, scienter, loss causation, and reliance). Moreover, as discussed above, CAMs could be used to defend as well as initiate litigation. …However, because of these risks and other concerns expressed by commenters, we expect the Board to monitor the Proposed Rules after implementation for any unintended consequences.“  (SEC approval order , pp. 32–33)

Shareholders and others should read between the lines of auditor’s report (appreciating the regulations behind it), but they should not expect auditors to “look under rocks” to find problems. That is the job of management, internal control, and the audit committee. The auditor’s job is to focus on the audit of the financial statements to ensure that they conform to generally accepted accounting principles (GAAP). Given the complexity of GAAP, that is a big enough job as it is.

The CAM standard can’t be mastered overnight and won’t be required any time soon. Auditors of large accelerated filers will not be required to adopt CAM changes until audits of fiscal years ending on or after June 30, 2019—with audits of all remaining filers to adopt CAM changes for fiscal years ending on or after December 15, 2020.

By contrast, all the other changes will apply to audits of fiscal years ending on or after December 15, 2017.  That mean, essentially that auditors must work on this immediately, since most companies they are working with right now have fiscal years ending December 31, 2017. (According to Audit Analytics, 71 percent of public companies have a fiscal year ending December 31.)

So now is the time to prepare for the changes! In its above-cited report on the new rule, NACD prepared questions for directors to ask, along with related resources.

Questions for Boards

  • For which fiscal year will our auditor first be required to report on CAMs?
  • What areas during the audit do we anticipate our auditor will find challenging, subjective, or complex—and how can we preemptively address those concerns?
  • How will the auditor’s insights in the newly expanded report affect our ongoing work as we prepare the audit committee report for the proxy and review risk disclosures in the annual report on Form 10-K?
  • How will it shape our meeting with auditors, who themselves have extensive standards for their communications with audit committees?
  • How might our company need to adjust our year-end reporting calendar in order to file the 10-K on time?

NACD Resources: See NACD’s commentary on this topic to the PCAOB in the Corporate Governance Standards Resource Center, and visit NACD’s Audit Committee Resource Center for a repository of content related to leading practices for the audit committee. Register for the KPMG webinar “What You Need to Know About the New Auditor Reporting Model” on Thursday, November 9, and review the Center for Audit Quality’s recent alert “The Auditor’s Report—New Requirements for 2017.”

Boardroom Implications for the New Revenue Recognition Standard

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It’s all a matter of time—at least when it comes to recognizing revenue at public companies. The Financial Accounting Standards Boards (FASB) and the International Accounting Standards Board (IASB) in 2014 developed an accounting rule that is set to change how companies approach revenue recognition. The rules, available here, go into effect for public companies with fiscal years beginning after December 15, 2017, and will have major consequences for financial reporting in many industries.

To address the executive-compensation implications of the revenue recognition standard, NACD, executive compensation advisory firm Farient Advisors, and law firm Katten Muchin Rosenman cohosted a meeting of the Compensation Committee Chair Advisory Council on April 4, 2017. During that meeting and its related teleconference, Fortune 500 companies’ compensation committee chairs came together to discuss leading practices and key considerations related to the impact of the new revenue recognition standard. Jose R. Rodriguez, partner in charge and executive director of KPMG’s Audit Committee Institute, joined council delegates for the discussion. The meeting was held using a modified version of the Chatham House Rule, under which participants’ quotes (italicized below) are not attributed to those individuals or their organizations, with the exception of cohosts. A list of attendees’ names are available here.

About the New Standard

A 2014 press release from FASB explained the rationale behind the new standard, noting that revenue is an important metric that investors use when trying to understand how a company has performed and its potential for future performance. Previous accounting standards from the International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (GAAP), however, were somewhat at odds, according to the press release. Those inconsistencies between IFRS and GAAP meant that different industries that had very similar types of transactions were accounting for revenue in sometimes very different ways. The revenue recognition standard aims to bring more consistency to accounting done for similar types of transactions.

A key part of the new standard is that revenue can only be recognized—among other requirements—once customers actually benefit from the services or goods that the company has already provided them, as noted in the Journal of Accountancy. The Journal continues that if a company provides a customer with goods or services over time, such as a yearlong service contract, the company can recognize revenue as the customer receives benefits in the contract period. For more information on the standard, see this four-page overview and in-depth guide from KPMG.

Key Questions Directors Should Ask
While the level of disruption that the revenue recognition standard will cause varies by industry and company, four questions important for all boards emerged from the Advisory Council meeting:

  1. How will the new revenue recognition standard affect our company specifically?
  2. Does the board understand the key milestones for the revenue recognition standard and how the company is progressing in light of those milestones?
  3. How will compensation plans be affected?
  4. How will our disclosures need to change?

How will the new revenue recognition standard affect our company specifically?

Impact of the new standard will vary widely for a few reasons.  First, sales and service contracts can differ significantly depending on industry—consumer products, health care, manufacturing, IT, and so on. Additionally, the types of sales contracts—and, therefore, the way revenue is recognized—can differ even within a single company, depending on the types of products and services sold. The company’s suppliers and vendors are a third factor influencing change: “Even if the standard doesn’t affect our core business, we could be working with partners and vendors that are affected,” said one director. “One of my companies has hundreds of millions of dollars in service contracts,” another delegate commented. “Our whole income statement is going to change.”

“Every company’s finance department has been looking at this,” Rodriguez said. “Ask your CFO to brief the board about the major income-statement changes that will occur for the company. What will be affected across all revenue lines? How are key reporting processes changing to accommodate the new standard?”

Does the board understand the key milestones for the revenue recognition standard and how the company is progressing in light of those milestones?

Rodriguez said that a pitfall for many companies is not investing enough time upfront in ensuring compliance with the new standard. “Some companies are finding that this is a bigger lift than they thought [to adopt the standard], so they are having to scramble to coordinate.”

Rodriguez shared several steps that companies can take to prepare:

  • Forming cross-functional task forces that integrate finance, accounting, IT, legal, and HR to ensure activities are coordinated.
  • Designating a revenue group to analyze contracts in different regions and locations to ensure all jurisdictions are covered.
  • Devoting sufficient time and resources to make required changes and upgrades to IT and reporting systems, especially in companies that have multiple legacy systems in place.
  • Developing a communication plan to explain to affected employees (especially on sales teams) how the changes will impact their work. “This is actually a huge change-management process,” one council delegate said. “You have to re-train sales people about how they design contracts and agreements.”

How will compensation plans be affected?

Council delegates agreed that compensation committees need to have a clear understanding of how the new standard will affect the key metrics that drive compensation for all levels of employees, from rank-and-file to the C-suite (For more information on incentives and risk taking, please see NACD’s brief, Incentives and Risk Taking). Changes to the way revenue is reported could have a major impact on the numbers used in annual bonus plans, as well as on long-term incentive plans that are already in place.  “With multi-year incentive plans that are in mid-cycle, the effects could be quite complex,” said Dayna L. Harris, partner at Farient Advisors. “For compensation committees, it will be important to ensure incentives are paid out in a way that’s appropriate to what was originally intended to keep consistent with the compensation philosophy the board has devised.”

Compensation committees can ask the following questions:

  • Is the company adopting the new standard prospectively or retrospectively, and how will that change our revenue numbers?
  • Which compensation plans will be affected beyond the CEO and named executive officers (e.g., sales staff at multiple levels)?
  • What do we anticipate will be the impact on the peer groups we use to benchmark executive compensation?

Rodriguez suggested that compensation committees schedule a briefing session with the external auditor, audit committee chair, CFO, and compensation consultant to discuss these and other questions. Members of the audit committee can also be invited to the briefing.

How will our disclosures need to change?

As noted in the Report of the NACD Blue Ribbon Commission on Board-Shareholder Communications (p. 17), “Directors have a general responsibility to oversee the company’s disclosure programs. They also need to take special care in reviewing certain specific disclosures—notably the company’s regular financial disclosures, such as the proxy statement, 10-Ks, 10-Qs, and 8-Ks, as well as any securities registration statements filed with the [U.S. Securities and Exchange Commission (SEC)].” A director observed, “In addition to the changes to reports, we need a strategy to communicate with our major investors. They will be asking questions about why compensation payouts appear to have ‘changed.’”

The SEC will task review teams with scrutinizing public companies’ financial disclosures, 10-Ks especially, to determine if the statements include information on the revenue recognition standard, Bloomberg BNA reports. Mark Kronforst, chief accountant of the SEC’s Division of Corporation Finance, told Bloomberg BNA, “I don’t think that we will be shy about issuing comments if we don’t see the disclosures.”

“Accounting changes should not interfere with a good business decision, performance outcomes on incentives, and appropriate incentive payouts,” said Harris. “With an accounting change in the middle of a performance period, compensation committees will need to provide full transparency into incentive payout decisions, especially if they appear larger than expected under the new accounting. There’s a whole list of ramifications if that transparency is lacking, from proxy advisors’ criticisms to activist investors’ reproach.”

And there’s no time like the present to understand those ramifications and ensure that management stays on top of key milestones.