Akron Financial Advisors

Click here to view Part 1 of our series and learn more about the stock option landscape or Part 2 to learn more about the accounting and tax ramifications of issuing stock options.

What To Do?

As discussed above, there are significant risks that a company brings upon itself if it decides to issue stock options without properly valuing the options and the equity of the company. Rather than issuing stock options, if a company wants to offer an employee the opportunity to obtain an ownership interest, the most efficient and “clean” method may be to allow the employee to purchase shares from the company or from existing owners. There is no valuation requirement in this case (unless a party wants to hire an expert to ensure that they the transaction price is fair and reasonable) which also eliminates the out-of-pocket cost for the employer. In fact, a business actually recognizes a cash inflow when an employee purchases shares directly from the company. 

I am a valuation expert and I directly benefit from work associated with the valuation of stock options, so why am I telling you to consider alternative routes of compensation? Too often, the companies that issue stock options without having them professionally valued are the same companies that will fight against having their options valued at all due to the cost associated with the valuation. I simply want to spread awareness that there are other avenues of compensating employees and giving them opportunities for equity ownership that may be more cost efficient for companies that are under the illusion that issuing stock options does not require a cash outlay.

If you take anything away from this article, remember that issuing stock options is not a “cashless” expense. Consider that there are other alternatives for compensating employees other than using stock options. Remember that there are transaction costs associated with issuing stock options, specifically, hiring a valuation expert, that will create real out-of-pocket cost for any company. Unless you are ready to comply with the valuation requirements associated with issuing stock options, you may be better off simply not using them and compensating employees in another manner. Finally, just like selling a home, if you are going to issue stock options make sure that you bring in an expert to ensure that the value of the company and options are determined and documented appropriately – and be prepared to pay the “commission” for these services.

The information in this article is not meant to represent legal or tax advice. Please consult with a Skoda Minotti business valuation professional or your tax/legal advisor regarding the applicability of these issues to your particular situation.

Visit our web site for more information on our business valuation services. Skoda Minotti is a CPA, business and financial advisory firm with offices in Cleveland and Akron.

Accounting and Tax Ramifications of Issuing Stock Options

 Click here to view Part 1 of our series and learn more about the stock option landscape.

To give you more perspective, first let us review the accounting treatment for the issuance of stock options (rest easy - this will not be too painful). When stock options are issued, an expense must be recorded based on the value of the option. A stock option’s value is derived from a variety of factors, two of which are the value of the stock as of the date of the option grant and the exercise price of the option (the price at which the option holder can purchase a share of stock). Determining the value of a company’s stock is not difficult when it is publicly traded, but privately-held companies do not have readily available market prices, which necessitates the services of a valuation expert. Unless the option is properly valued, a company cannot correctly record the associated compensation expense. If a company is unable to correctly record the results of its operations, it may find obtaining a clean audit opinion to be a difficult, if not impossible, task.

Now that I have warned you about the headaches that you may encounter on the “accounting” side of issuing stock options, let me further alarm you with the tax ramifications. If a company sets the stock option exercise price lower than the fair market value of its stock on the grant date, the stock option could be deemed to be deferred compensation according to Internal Revenue Code 409A. Under 409A, such deferred compensation would be immediately taxable to the employees receiving the grant and subject to regular income tax rates plus 1%. Perhaps even more distressing, a 20% penalty plus interest would also be triggered. In addition, employers would be responsible for withholding income taxes for employees on these types of option grants, which if not done, could result in additional tax penalties. The immediate taxability, penalty and withholding requirements do not apply when the stock option exercise price is equal to or greater than the fair market value of the company’s stock on the grant date. It is impossible to compare the exercise price of a stock option to the fair market value of a company’s stock unless a valuation of the company’s stock has been performed. In addition, when a valuation has been performed to establish the fair market value of a company’s stock, the burden of proof shifts to the IRS to disprove the appraised value. Therefore, unless there is documentation to support the fair market value of a company’s stock near the option grant date, there could be significant tax issues in addition to the accounting issues alluded to earlier.

The information in this article is not meant to represent legal or tax advice. Please consult with a Skoda Minotti business valuation professional or your tax/legal advisor regarding the applicability of these issues to your particular situation.

Visit us tomorrow for Part 3: What to Do?

In the meantime, visit our web site for more information on our business valuation services. Skoda Minotti is a CPA, business and financial advisory firm with offices in Cleveland and Akron.
 

When selling your home, it is common to use an agent to list, promote and show the property. In exchange, you pay a portion of the sales price as a commission to the agent. The benefits of using an agent include: 1) the listing of your home in a database so that homebuyers can access information about it; 2) the agent acting as your middleman during the negotiation process; and 3) the incentive it gives the agent to sell your home quickly (so that her or she can earn their commission). 

Some people choose to sell their home by owner and forego using an agent. These are typically the homes that have “For Sale” signs in their yards for many months, sometimes even years (you know the ones), before they are actually sold. These people often believe that the benefit of not having to pay an agent commission on the sale of their home is worth the prolonged period it will likely take to sell the property. 

What does the choice of hiring a real estate agent or selling your home by owner have in common with private companies issuing stock options? The strange answer is: Much more than many of us realize. 

The Stock Option Landscape

More and more private companies are issuing stock options as part of their key employees’ compensation plans. This may be driven by the ideas that: 1) stock options don’t “cost” anything to the company; 2) stock options will positively influence employees’ performance; or 3) since public companies issue stock options, it must be a good idea and private companies should follow suit. Regardless of the motivation, what most private company owners and executives do not realize is that accounting for stock options, for both tax and financial reporting purposes, may actually have an out-of pocket cost that is greater than the value of the options themselves.

In order to value stock options issued by private companies, there are two major steps that must be undertaken:

1. Determining the value of the company’s equity (which is a key input to valuing a stock option)

2. Determining the value of the stock option

There are not many privately-held companies with the in-house resources or expertise necessary to perform either of the requirements above, both of which are essential in accounting for the issuance of stock options. This often puts accountants in the awkward position of trying to explain to business owners the “unseen” costs and accounting ramifications associated with issuing stock options.

Back to our analogy, hiring a valuation expert to determine the value of stock options is much like hiring a real estate agent to sell your home. A valuation expert is able to perform both of the tasks identified above that are necessary to value the stock options issued by a private company, much like a real estate agent takes care of the necessary steps to sell your home. This work is not free, however, and depending on the complexity of the company and the options issued, the cost to value a private company’s stock options can range in cost from thousands to tens of thousands of dollars. When private companies issue stock options, they often do not consider the “commission” that they will have to pay to a valuation expert to ensure that the options are properly valued. Unlike real estate agent commissions, however, which are based on the sale price of the home, valuation fees are relatively fixed. 

Just like selling a home “by owner,” some companies will issue stock options and try to determine the value themselves (or even worse, not value them at all). By not using a real estate agent, homeowners often find themselves making no headway in the sale of their home. Similarly, by not hiring a valuation expert to value the stock options that they have issued, private companies create the risk that their auditors will not sign off on their financial statements. Maybe even more importantly for business owners and employees, unsubstantiated option values leave both companies and their employees in danger of stiff tax consequences.

The information in this article is not meant to represent legal or tax advice. Please consult with a Skoda Minotti business valuation professional or your tax/legal advisor regarding the applicability of these issues to your particular situation.

Visit us tomorrow for Part 2: The Accounting and Tax Ramification of Issuing Stock Options

In the meantime, visit our web site for more information on our business valuation services. Skoda Minotti is a CPA, business and financial advisory firm with offices in Cleveland and Akron.

With the crash of the real estate market some are looking to capitalize and purchase larger homes for a bargain price. In doing so, they face the problem of selling their current residence to make the move up. With the lack of buyer interest and with some people not willing to take such a large loss people are holding out for the market to rebound. This creates the problem of carrying two mortgages, which the monthly payments on two mortgages can create cash flow problems for many taxpayers in this situation. 

To help with this burden, a taxpayer may decide to rent out their prior residence to help bring in cash and cover the monthly costs on that property. If the tax payer decides to go this route there are a number of rules/guidelines that one has to be aware of. 

Rental vs. Vacation Property

The first of these rules (which would only apply to the first year of renting) is determining if the property being rented qualifies as a “rental property” or a “vacation property.” The general rule is if the home was personally used for more than the greater of 14 days or 10% of the days the dwelling is rented for the year it is classified as a vacation home and subject to the rules under code section 280A. The main difference between a rental and vacation property is the expenses that can be deducted. If it is classified as a vacation property the only rental expenses that are deductible is the portion of the year that the property was rented. If it is deemed to be a rental property all expenses are considered business related and possibly deductible. For the sake of this conversation we are assuming that this rule is met and the home qualifies as a rental property.

Depreciable Basis of a Property

After determining the home is a rental property the first step is determining the depreciable basis of the property. When a personal home is converted to business use, the total basis is calculated by taking the lower of the adjusted basis or the fair market value of the property on the date of conversion. If the property was a personal residence and no depreciation was taken for business use of home you should go back to the purchase documents of the home to determine original cost which would also be the adjusted basis. Once the total basis is calculated the land portion is broken out and the remaining portion is considered the depreciable basis. Once the depreciable basis is calculated it must be depreciated using the method and recovery period set by the IRS at the time of conversion (at this time the method to be used is straight line and recovery period is 27.5 years for residential property).

Along with depreciation expense the taxpayer must start keeping records of the income earned and expenses incurred in renting the home. The list of expenses that are deductible for rental properties is longer than that for a personal residence. Many of the costs of renting a home (mortgage interest, real estate taxes, insurance, advertising, repairs and maintenance, supplies, etc.) are deductible.

First Time Home Buyer Credit

If the home was purchased within 2008 or 2009 and the first time home buyer credit was taken on the purchase there may be additional tax consequences to consider. If the home for which the first time home buyer credit is taken is converted to a rental property within 36 months of purchase a portion of the credit will be required to be repaid. This portion will depend on how long the home was used as a personal residence. 

Selling the Property

Finally, after a taxpayer converts their former personal residence to rental property and gets to the point that they want to sell it there are more rules to be aware of. First the gain or loss must be calculated, and to do this the basis of the property must again be calculated. The basis can differ depending on if the property is being sold at a gain or a loss. If the property is sold at a gain, the basis of the property is the original cost basis to the taxpayer, plus any amounts paid for capital improvements (capitalized and not previously deducted), less any depreciation taken. If the property is sold at a loss, the basis is the lower of the original cost basis or the fair market value at the date of conversion, plus any capital improvements, less any depreciation taken. Rental property, when sold, is treated as a capital gain/loss but just because it was rented for a short period of time does not completely preclude the taxpayer from taking advantage of the gain exclusion rules for a personal residence. If the property is rented for less than 3 years before being sold, the taxpayer may still be eligible to take a portion of the personal home gain exclusion. This gain exclusion cannot be used against gain from recapture of depreciation though.

Summary

With the current state of the real estate market, renting a prior personal residence may be beneficial for a taxpayer to help wait out the recession and see some of the buyer interest and value come back. If one decides to go this route these are the rules/guidelines that should be considered at each stage of the process.

Contact our CPAs, business and financial advisors in Cleveland or Akron at 440-449-6800 or www.skodaminotti.com.

Many of us probably remember Harvey Dent, aka “Two-Face,” from our childhoods as one of Batman’s arch enemies. He looked like a normal guy from one perspective, but from the other side, he was a bizarre-looking villain. While normalizing adjustments in business valuation may not be quite as exciting as watching Batman battle Two-Face, they bear a similarity to this comic book character.

The results of many companies as reported in financial statements or tax returns do not always reflect economic reality. Therefore, normalizing adjustments are required when business valuations are performed to present a company’s income statements and balance sheets at their true economic levels, without distortion from accounting rules or the owners’ operational preferences. A company’s value can look completely different after normalizing adjustments have been made – it is almost like spinning Two-Face around to look at one side as opposed to the other. 

For example, an owner may be taking a very large salary in an effort to reduce taxable income and income taxes, effectively eliminating any net income. When employing an earnings-based approach in valuing such a company, a normalizing adjustment would likely be necessary to adjust owner’s compensation downward to an appropriate fair market value, effectively raising net income and the resultant value of the company. 

It is important to note that normalizing adjustments can both increase, or decrease, net income. Another common normalizing adjustment occurs when a related party rents property to the company being valued at a monthly cost lower than the property’s fair market rental value. In this case, the valuation expert would increase the company’s rent expense to fair market value, effectively reducing net income and lowering the company’s value. 

While valuation experts are trained to identify normalizing adjustments through trend analysis and management inquiry, business owners and advisors can make the valuation process run more smoothly by bringing potential adjustments to the attention of their valuation expert. It is ultimately up to the valuation expert’s judgment as to what normalizing adjustments are appropriate for a given company, but when a business owner is prepared to answer questions regarding potential adjustments, it can lead to a more efficient valuation engagement.

Looking for business valuation assistance in Cleveland or Akron? Contact our Business Valuation Group at 440-449-6800 for more information.

While the likely adoption International Financial Reporting Standards (IFRS) is a hot topic for accountants, many privately-held small and medium-sized business owners may not be aware of the potential changes on the horizon for financial reporting. The general consensus is that in the coming years, the U.S. will move to adopt IFRS in place of Generally Accepted Accounting Principles (GAAP) as the governing standards for financial reporting, although no official date for conversion has been set yet. 

As discussed in the September 2009 issues of the Journal of Accountancy, IFRS for Small and Medium-Sized Entities (SME’s) was released in July 2009 after five years of development. SMEs are defined as businesses that publish general-purpose financial statements for external users and do not have public accountability. IFRS for SMEs is much more condensed than the full version of IFRS and does not address many of the areas that do not apply for privately-held companies, such as segment reporting or earnings per share.

What does this new standard mean for small to medium-sized business owners and operators? 

Some of the most significant differences between IFRS for SME’s and U.S. GAAP are:

-          Simplified disclosures for pensions, leases, financial instruments, and other areas.

-          Prohibition of the last-in, first-out (LIFO) method of inventory valuation.

-          Amortization of goodwill and indefinite-lived intangibles over a period of ten years or less.

-          Simplification of the temporary difference approach to income tax accounting.

-          Greater use of historical cost in accounting for financial assets and liabilities.

While the actual transition from U.S. GAAP to IFRS has yet to occur, privately-held small and medium-sized business owners should know that the next set of financial reporting standards that they may have to follow have been tailored to fit their needs and the needs of the users of their financial statements.

Looking for Cleveland or Akron CPAs, business or financial advisors? Contact Skoda Minotti at 440-449-6800.

What did Picasso’s paintings look like when he was only halfway finished? How did Michelangelo’s “David” look like after the first few chisels? How livable is a house after the frame has been erected, but no interior work has been done?

A valid answer to all of the preceding questions is, “Something different than the final product.” However, for financial experts who provide opinions on economic damages and other litigated matters involving calculated figures, current rules sometimes allow for previous non-submitted, and non-final, drafts of an expert’s report to be considered discoverable evidence. 

The review of draft iterations of an expert report is often considered to be a waste of time (and dollars) as such drafts often do not correctly capture all of the relevant information that was synthesized in the final submitted report. Oftentimes, the tactic of reviewing an expert’s draft reports is an attempt by an opposing attorney to discredit the expert or make the expert’s conduct appear improper in some way. Therefore, some attorneys will request that non-final draft iterations of reports be admitted as evidence and scrutinized, distracting the court from the analysis offered in the financial expert’s final, submitted opinion. 

This is akin to asking Phil Collins to stop all work on a song that he is still feeling his way through, releasing that song, and then asking him to defend its quality to the public and his fans. Not only is this unfair to Phil, but it is unfair to the music-listening public, who expect a polished, quality product that Phil would be willing to stand by. 

In a recent article by Thomas Hilton, MS, CPA/ABV/CFF, ASA, CVA in Financial Valuation and Litigation Expert, a highly-regarded publication in the business valuation and litigation support field, Mr. Hilton discussed that relief for this problem may be on the way. The Committee on Rules of Practice of the Judicial Conference of the United States (Committee) recently proposed amendments to the Federal Rules of Civil Procedure that would shield draft expert reports from discovery. If the proposal makes its way through the necessary channels without any holdups, this relief could come as soon as December 1, 2010. 

As part of the community of financial experts, we hope that relief from the proposals highlighted above (which have been backed by the AICPA) comes swiftly. Primarily, we believe that these proposals will force courts to focus on the merits of an expert’s submitted opinions rather than the potentially unfinished and in-process analysis that is present in draft reports.

Need assistance with a litigation matter? Contact our Litigation Advisory Services Group at 440-449-6800.

Topics: Litigation Advisory Services, Cleveland Business Advisors, Akron Business Advisors, Akron Business Consultants

This week is our final update in our series on the changing rules and regulations and their impact on employee benefit plan audits.

This week’s topic:

2009 Cost of Living Adjustments for Qualified Retirement Plans

The Internal Revenue Service announced cost-of-living adjustments applicable to dollar limitations for pension plans and other items for tax year 2009.

Click here for more of this article.

Looking for assistance with your benefit plan audit? Contact the CPA’s business and financial advisors at Skoda Minotti at 440-449-6800.

One unique service we offer to clients is the ability to compare our client to their industry benchmarks.  Our external benchmarking tools are tailored to our clients and their specific industries.  We can generate benchmarks based on revenue size, geographic region, North American Industry Classification System (NAICS) codes, and also both public and private companies.  The service compares a number of financial metrics, and provides explanations and guidance as to variances your company has versus the industry.

These tools provide us, as business advisors, an ability to consult with our clients year-round and also allow us to prepare both short-term budgets, and long-term projections and forecasts.

This service maintains client data anonymously and confidentially, and has been approved by our business partner, BDO Siedman.

Are you looking for industry benchmarks?  Contact Paul Etzler at 440-449-6800.

Topics: Akron Business Advisors, Akron Business Consultants, Cleveland Business Advisors

“Corporate Vigilance in Desperate Times” was the title of a presentation I made to a group of corporate controllers on behalf of the Ohio Society of Certified Public Accountants.

It’s hard not to pick up a newspaper these days and see dismal economic results. The next article discusses employee layoffs. “Happy Days Are Here Again” will not be heard on your car radio on the way home. And once home, chances are that you don’t want to look at your stock portfolio or 401k statement that came in the mail. 

Many employees are scared. Financial pressures are fierce. A spouse may have been laid off thus crippling the family cash flow. Retirement, carefully planned for years, may now have to be delayed since the market has halved your nest egg. With foreclosures at record numbers not seen since the Great Depression, many must evaluate whether they can provide a house for one’s family?

In troubling times such as this severe economic downturn, the opportunity is ripe for fraudsters to shake cash from unsuspecting companies. Companies must be more vigilant than ever to protect their financial resources.

Unfortunately, we have become aware of some companies cutting jobs within accounting departments and as a result potentially compromising their internal controls – controls vital to not only good financial reporting, but safeguards in general to the overall corporate assets.

Is there a correlation between a downturn in the economy and an increase in fraudulent acts such as embezzlement? Sure there is. In larger corporations there is intense pressure to “make the numbers” thus resulting in tempting financial statement crimes.

Eliminating staff in an accounting department will usually reduce the effectiveness of established internal controls.   Less effective internal controls is an invitation for embezzlement. And don’t think that the thieving opportunist doesn’t recognize the void suddenly created. 

The CPAs, business and financial advisors in Skoda Minotti's Real Estate and Construction Group recently authored an article for Builders Exchange Magazine.

The article summarizes some important accounting and tax provisions that construction professionals need to keep in mind. The article highlights the American Recovery and Reinvestment Act, the Energy Policy Act of 2005, qualified rehabilitation and low income housing tax credits.

To view this helpful article, click here.

Looking for a Cleveland or Akron accounting firm that provides services to the construction industry? Contact the Real Estate and Construction Group at Skoda Minotti at 440-449-6800.