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Chief Value Officer

October 19, 2017

This book review appeared in the August 2017 issue of The CPA Journal (www.cpajournal.com). It is reprinted with permission and is subject to their copyright. I believe the book addresses an emerging topic and would like to make as many people as possible aware of it.

Chief Value Officer / Accountants Can Save the Planet
by Mervyn King with Jill Atkins
Reviewed by Edward Mendlowitz, CPA

This short book is direct in its focus and is a fitting way to discuss the importance and practicality of sustainability actions and responsibility in conserving natural resources. The book addresses the very important topic of how to save the planet and presents ways progress can be reported that can lead companies to act in ways that can also create value for themselves.

The book goes further. It brings up the concept of the importance of companies issuing financial reports not as financial statements but as a method of reporting their value measurement and creation using an integrated approach to include all six capitals, not just financial capital. Judge King also proffers that the most appropriate people to lead the charge are the accountants, specifically Chief Financial Officers who should be renamed and reconfigured as Chief Value Officers.

This is a quick read but it is on an extremely serious topic and as such needs careful consideration. The book begins by introducing as its foundation why conventional financial reporting should be transformed. Hard to defy logic is used to present the authors’ points using the history of the corporation and how the “ownerless company” emerged. The belief that shareholders are the primary “owners” of a corporation is overturned in favor of all of a company’s direct stakeholders collectively being the true “owners.” It is these stakeholders a company’s board needs to address.

Four major premises
The six capitals are categorized as financial, manufactured, social, human, intellectual and natural. The book sets forth how each is important in its own right. Whether one is more important than the others is not the issue – they are all important. It is similar to asking a person with six children which one they love best.

Integrated reporting (IR) is a way that companies can disclose information relating to the six capitals, sustainable development goals and other targets that can lead to value creation over the long term. IR is a relatively new concept that is taking hold in some countries and larger companies. As a new concept it needs to be introduced, thought about and considered, tried, refined and built upon. I believe there is much merit to IR as a concept and needs to be considered by everyone responsible for a company’s reporting and governance. I am not suggesting that it be adopted universally, as the book does, but I am imploring responsible officers to consider what the book suggests with an open and inquiring mind. Use this book as an introduction and a spring board to further study. Integrated reporting can and will lead to integrated thinking as a strategic business plan with concomitant results.

Stakeholders are any party who affects or is affected by a company and includes shareholders, employees, suppliers, lenders, creditors, service providers, the local community where it does business, the government and the natural environment that is impacted by the companies’ actions. Of the group the one most able to diversify its involvement are the shareholders that can spread their investments among multiple companies. The least able might be the employees who spend all their work time with the company. The one with the least advocates is likely the environment which cannot speak for itself.

Accountants’ are the primary measurers, auditors and designers of financial reports and they can be a vital influence to change the reporting vehicles. There is no doubt of the centrality of the accountant’s role. However, I think the book limits itself by using the accountant as the central or driving force. This book is too important of an introduction and thesis statement to be so limited. It should reach a much wider audience and with little changes in that regard (and in the title) it should be directed at all corporate directors, CEOs and CFOs of the major stakeholders and professionals engaged and consulted with by these organizations, and our legislators in all areas of government. As much as I appreciate accountants’ importance the subject is too big and too important to be limited to the accountants’ roles.

Sustainability
The six capitals and IR are tied into the “Sustainability” movement. However you feel about sustainability, clean air, toxic wastes and species extinction there should be no deniability that these are issues that must be responsibly considered. Six capitals are six separate issues and IR is another issue on how reporting should adapted to wider issues involving all the stakeholders. Each needs to be focused in separately and then on their totality. This is not a single do-good issue, but something much bigger and more important.

New concept
New concepts that address not only the way companies issue reports but account for waste, sustainable actions, human resource management, natural resource conservation and replenishment among others and how companies can establish a mindset and culture to assume responsibility toward this and how this needs to be established, organized and implemented are important and should be carefully looked at. Good citizenship requires awareness and actions promoting positive sustainability behavior. This book presents a way to start.

Mervyn King is the Godfather and founder of the IR movement and has garnered worldwide recognition of the importance of IR and the six capitals in corporate reporting and better value creation which sound reports lead to, so long as people pay attention to the reports, so anything he writes, as far as I am concerned, is a must read; and this book certainly is.

Given the issues the authors develop, this is a must read for all accountants as well as the heads of each stakeholder group. Get it and read it…and think about the consequences of ignoring what is suggested.

Deferred taxes explained

October 17, 2017

My last blog illustrated the effect of a lower corporate tax rate on the deferred taxes payable or receivable accounts. I received a few emails asking me to explain what a deferred tax actually is and how it comes about. Good questions, so here are explanations with examples.

Deferred taxes payable
The deferred tax payable arises when the income tax expense on the financial statement using GAAP rules is higher than the income taxes actually paid based on the profits reported on the tax return. In effect taxes were underpaid for GAAP and this will have to be made up in a later year (i.e. it is deferred); therefore they “owe” the taxes.

An example is when the company uses straight line depreciation on the financial statement and accelerated depreciation on the tax return. The straight line method results in equal deductions for every year of the asset’s useful life while the accelerated depreciation creates larger deductions in early years and lower deductions in later years. This strategy defers taxes to later years. At the end of the designated useful life of the asset [which must be the same for GAAP and tax] being depreciated, the same amounts would have been deducted.

Note that most companies want to report as high a profit as possible since it supports the stock price and creates greater book value for borrowing purposes; while no company wants to pay more taxes than necessary so they use permissible strategies that allow lower profits even if it is a temporary reduction.

Deferred taxes receivable
When the taxes on the tax return are higher than the GAAP taxes the company “overpaid” their current taxes and will get these back via paying lower taxes in the future, hence an asset.

An example is charitable contributions that are limited for tax purposes but not limited for GAAP. In that case the company will eventually get the deduction for the unused charitable contributions which can be carried forward on the tax return. Therefore the future tax deductions create an asset for the taxes that will be saved.

Another example creating a deferred asset could be a tax loss that can be carried forward to offset future years’ profits. To the extent this can be deducted in full on the financial statement, but not on the tax return, it becomes an asset for tax purposes that will reduce taxes in a later year, i.e. a deferred asset.

Timing differences
All deferred taxes are the result of timing differences. There are other differences that are not timing differences but inherent in the differences between the two systems, and those do not factor into the deferred taxes.

Hopefully the above sheds some light on this confusing area.

Berkshire Hathaway’s Deferred Taxes

October 12, 2017

Whatever tax bill is enacted, it appears that there will be some reduction in the top corporate tax rate. I would like to explain the effect of this and will do it using Warren Buffett’s Berkshire Hathaway (“BRK”).

Some information: Last year BRK earned $24 billion in profits. Its deferred tax liability was $78 billion. The stock is priced at about 19 times earnings.

BRK’s deferred taxes was based on a tax rate of 35%. If the rate drops to 20% that will cause a reduction in the deferred tax liability of $33 billion. That is about a third more than all of last year’s profits. This will create a one-time swelling of the profits and presumably would have an effect on the P/E and price of the stock.

I do not know what effect this would have on the BRK stock price but would be surprised there was no reaction to the increased earnings. This is an exaggerated illustration but I believe shows how the reduced corporate tax rates would affect companies.

Another comment relates to companies that have a deferred tax asset. Any decrease in tax rates would reduce the value of this asset resulting in a loss of expected tax refunds, an operating loss and a reduction of book value. Not good! Note to the extent the deferred asset is for unused tax credits, then there would be no loss of benefits.

Tax reform, tax policy or tax reductions directly affect the federal government’s revenues, but they also have other effects and sometimes unintended consequences – good and bad. The immediate adjustment of corporate earnings is one of them.

Just another thing to be concerned about or to observe as a point of interest.

Language of Accounting

October 10, 2017

Here are definitions of some of the jargon used in accounting or by accountants.

A = L + C: This is our basic equation. Assets equal the liabilities and capital. For a corporation capital is shareholders’ equity; for a partnership it is partners’ capital; for an LLC it is members’ capital; and for a not-for-profit it is fund balance, or similar wording. Generically it is referred to as capital.

Debits and credits: A debit is an increase in an asset or decrease in a liability or capital. A credit is an increase in a liability or capital and a decrease in an asset. Do not try to make logic out of the two words; they are simply names and should be accepted as such. The debits always equal the credits. Using A = L + C we have the debits (A) equaling the credits (L+C).

Current assets and current liabilities: A current asset is either cash or other assets that will be converted into cash within the next year in the normal course of business. A current liability is a debt that will be paid within the next year also in the normal course of business. These are indicated as such on the balance sheet.

Working capital: Working capital refers to the amounts used to fund daily operations. It is the excess of current assets over current liabilities. If it is a negative amount, the company or entity is said to have no or negative working capital and is considered to be insolvent. An insolvent entity is one that cannot pay its bills when due in the normal course of business.

Book value: The stockholders’ equity is often referred to as book value. Book value is becoming less meaningful since for many companies a company’s market value, referred to sometimes as market capitalization or market cap, is becoming significantly greater than the book value. Part of the difference is attributed to undervalued long held assets such as land and buildings, fully amortized intangibles such as acquired companies’ goodwill, software, patents and film libraries, and the balance for a capitalization of current and expected earnings, market assigned price earnings ratios and other factors making the stock appear attractive.

Accrual or cash basis: Accrual basis is where the transactions and financial statements and tax returns are reported based on when income is earned and an expense incurred, regardless of when it will be collected or paid. The cash basis is where income is considered earned when collected and an expense incurred when paid. For accounting purposes the accrual basis is the only acceptable method. For tax purposes, there are rules who can and cannot be on the cash basis while any business can be on the accrual basis. It is possible for a company to be on the cash basis for tax purposes while on the accrual basis for financial statement purposes.

Generally accepted accounting principles or “GAAP:” These are the accounting rules or “laws” that determine how a financial statement should be prepared and what disclosures are necessary. These are usually qualified as being in the United States since different countries have their own rules. Many foreign countries use International Financial Reporting Standards or “IFRS” and for which U.S. companies do not follow.

Public Company Accounting Oversight Board or “PCAOB:” This is a Congress mandated board that sets the standards for financial statement preparation, presentation and disclosure that independent accountants must follow when auditing statements of publicly held companies.

Registered Accounting firm: Only accounting firms registered with the PCAOB can perform audits of publicly owned company. Unregistered PCAOB certified public accountants can audit nonpublic companies and other entities. However, both groups of accounting firms have to have their quality control practices reviewed either by PCAOB or a state oversight qualified peer reviewer, as the case may be. The auditor’s report for non-publicly owned companies is substantially similar to those of public companies.

Independence: All auditors must be independent. There are strict rules to assure this and violations are treated seriously either by the PCAOB or the state licensing board. Independent means the firm, its partners and certain family members can have no investment, creditor, management, control or other involvement in the company being audited.

Disclosures: The disclosures are reported in the notes to financial statements which contain descriptions of the accounting principles adopted by the Company; additional back up, expansion, descriptions and explanations of many of the amounts; and coverage of items not necessarily reflected in the numbers on the financial statement.

Goodwill: This is the amount paid when a business is acquired for more than the aggregate value of the business’ individually identifiable assets such as accounts receivable, inventory, equipment and real estate less the liabilities that are assumed.

Depreciation and amortization: This is the accounting terminology for the process that periodically deducts the cost of major asset expenditures supposedly over their estimated useful life. When the property is a tangible asset, such as a machine or building the deduction is called “depreciation.” When the periodic deduction is for an intangible asset such as a patent, copyright or goodwill, it is called amortization. Do not relate the name “depreciation” with any actual wear and tear of an asset – it is not relevant.

Deferred income taxes: Most companies “keep two sets of books.” One for the IRS and one for financial statement purposes. The difference between the income tax expense for GAAP and tax purposes is reflected as deferred taxes. If the difference is an underpayment of tax there is a deferred tax liability. If the difference is an overpayment, there is a deferred tax asset. If Congress reduces the corporate tax rate you will start hearing a lot more about deferred taxes and their effect on net income because of the changes in the deferred tax asset or liability. Actually some companies also have additional sets of books such as for regulatory purposes, contractual obligations, investment banking purposes or employee benefit plan calculations.

Commitments and contingencies: Most balance sheets include these words after the liabilities and immediately before the stockholders’ equity without any amounts. This is to indicate that not all liabilities are reflected on the balance sheet. These refer to liabilities that might have arisen from past transactions that are probable but not definite or quantifiable in any manner. An example is a new car, equipment or software warranty by a manufacturer or developer. They know there will be some claims but have no idea how many and or their scope. A note to financial statement would describe this contingency alerting of the possibility letting a reader apply their own judgment as to the scope. If the amount was able to be reasonably estimated, it would appear in the income statement and balance sheet using that estimated amount. Without that reasonable estimate it is include as a commitment or contingency.

Year End Tax Planning

October 5, 2017

Since tax changes are in the air, let me inject some reality with suggestion for year tax planning based on existing law and with the probability of no substantive changes occurring that will affect 2017 taxes.

  • All planning starts with a projection. Prepare one now to see where you stand
  • If you are eligible for traditional or Roth IRA contributions, consider making the contribution sooner rather than later to start the tax-deferred or tax-free income stream
  • If you have a business or receive income subject to self-employment tax, consider opening a 401k or Keogh account on or before December 31, 2017. Note you can delay opening a SEP as late as the due date (including extensions) for your 2017 tax return. Contributions to all three plans do not have to be made until sometime in 2018 (check with your tax advisor for the dates)
  • Accelerate as many deductions as possible to get the benefit this year rather than next year. One effective way is to donate appreciated stock to a donor-advised fund (DAF). You will get a deduction for the full value of the stock and not have to recognize the income. You can then time the payment to your favorite charities by recommending that the DAF make the contributions in 2018 or later
  • If you own stock with losses, you can sell them to realize the loss. If you buy them back within 30 days (before or after the sale), you will have a “wash sale” and cannot deduct the loss. A suggestion is to sell and then immediately buy an ETF that is similar to the stocks you sold. This will provide a comparable market risk. After the 30-day period, you can reverse the transactions. An example is to sell individual healthcare stocks, and buy a healthcare ETF
  • If you have realized short-term gains, try to sell stocks with losses to shelter them. The best is to sell stock with long term losses. This will net out and these losses won’t offset long term gains in a later year
  • If you own mutual funds that will declare year-end capital gain dividends in December without making an offsetting distribution, consider selling them now!
  • If you will be subject to the Alternative Minimum Tax don’t pay any more state income or real estate taxes which will not give you a benefit; instead make the payment the beginning of January if possible. If you cannot avoid the AMT, consider accelerating income that will be taxed at the lower AMT bracket such as cashing in long held U.S. Savings Bonds, accelerating the receipt of income you normally would receive in January, taking a distribution from your IRA or converting all or part of your IRA to a Roth IRA
  • If you want to pass some wealth to others that will be subject someday to estate taxes if retained by you, tax-free gifts of $14,000 per person can be made up until December 31. The $14,000 is doubled if you have a consenting spouse. There is no income tax benefit to this, but it will remove this money and any future earnings and appreciation from your eventual estate
  • If you were required to make estimated tax payments and did not, you should consider taking an IRA distribution and having the funds applied to withholding tax. If you do not want to treat this as a taxable distribution, repay the gross amount to the IRA within 60 days designating it as a tax-free rollover. Note that such distributions can only be done once in a 365 day period
  • If you suffered a large business loss in 2017 consider accelerating income that would be sheltered by the loss such as a distribution from an IRA, 401k or pension account

The above are suggestions you can consider. Note that none of the proposed tax changes would cause a change in any of the above moves. However, before you do anything, meet with your tax advisor to make sure the planning is effective for your situation.

Tax Reform Proposal “What-If” Game

October 3, 2017

Last week President Trump released his framework for tax reform.

One of the favorite games being played by the financial media and tax experts is the effect of the proposals on our clients and how to protect them from the bad parts and how to get a bigger share out of the good parts. This is a game I do not wish to play. I will if CNBC, CNN or any of the major NY stations ask me to appear and give my opinion, which they have in the past, but otherwise, I am sitting it out.

The tax laws as constituted are unbelievably complicated with intricate clauses, myriad deadlines and penalties and loopholes just waiting to be uncovered. Assuming we have limited time and energy it seems it would best be spent working on what we already have in place to help clients as much as anyone can. Diverting that attention to play a what-if game makes no sense to me and will not make any of my clients richer. Instead of our clients asking how they will make out with “tax reform” they should be asking how they can save taxes right now using the existing laws.

We are near the close of the year and there are many creative year end moves we can suggest. Passing them up to prepare a what if model seems to me to be a waste of time and energy. I also discovered a long time ago that clients don’t mind paying fees for positive results and even for diligent attempts to get positive results; while they question why they are being charged for what-if scenarios for something that is not law, might not become law, and might have no prayer of ever saving them a single cent.

When the law is written and the potential for enactment is there, serious actions will be discussed since I will be jumping on it. Right now the only thing I could see that makes any sense is to suggest that clients accelerate as many deductions into 2017 as they can – but that is pretty much what I am suggesting anyway – with or without the threat or glimmer of tax reform. I’ve been through this before. The best way to proceed is to keep alert for our clients in their present situation with the present tax laws and the probable progression from that – not a what-if game that produces an ethereal result.

Stock Tip of the Day

September 28, 2017

One of the investment programs I occasionally watch provides a “stock tip of the day.” This brought up some questions.

What are the people that bought that stock “today” going to do tomorrow when the tip is for a different stock? Should they sell that stock and buy the new tip? Or hold on to it and forgo the stock touted in the more recent tip? If yesterday’s tip was still good, shouldn’t it also be today’s tip too? If the show airs 200 days a year, does it mean that there will be 200 separate tips? Does the prognosticator with the daily tip expect his viewers to actually follow his advice, or is he just acting in a reality show believing his job is to simply provide entertainment?

Moving on, almost every investment program and publication offers the “top 10 investments for the next year” at some point during the year. Some publications have multiple authors with their top 10 lists and where most stocks recommended only appear on one list. Anyone can give a stock tip with what looks like credible backup, but very few tell when to sell. I reckon that they mean to provide the tip and then let you figure out when to bail out. Further, if the tip is for a short term bump up, aren’t they are encouraging their fans to become active traders or market timers causing them serious time managing the portfolio, watching the program or continuing to read the publication while continuously maintaining an adroit hand on their keyboard?

Back to reality: Set up your long term goals, develop your investment plan to achieve those goals, make your investments creating a well-diversified portfolio and then sit on what you did with periodic reviews to assure your portfolio hasn’t deviated too much from your original plan, or that your plan or circumstances haven’t changed drastically. If you feel you need professional help for this, then get it, but stay away from the tips!