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A warning on pro-forma numbers; plus, the problems with credit rating triggers; simplified tax accounting for smaller businesses; and more.
CFO Staff, CFO Magazine
February 1, 2002
In December, the Securities and Exchange Commission sent a shot across the bow of Corporate America when it issued a formal warning regarding the release of misleading pro forma numbers. "Expect enforcement action to follow in short order," says Christian Bartholomew, a former senior trial counsel for the SEC and a partner in the Miami office of national law firm Morgan Lewis & Bockius. Bartholomew says the SEC will likely bring legal action against several companies at one time, all focused on pro forma accounting practices that allegedly hide material information about the financial health of a company from investors. The time frame: the next 3 to 10 months.
Bartholomew wouldn't speculate about which companies are likely SEC targets, but he notes that the cases will serve as platforms to work out more detailed pro forma guidelines. "The SEC doesn't think pro forma accounting is inherently bad or good; the commission just wants companies to be clear on why and how they use it," he adds.
The SEC's warning follows the accounting-related meltdown at Houston-based Enron Corp., the biggest corporate failure in history. -- Marie Leone
Pull That Trigger
Stung by their indirect responsibility for such spectacular meltdowns as Enron Corp. and Pacific Gas & Electric Co., credit-rating firms are taking a closer look at how corporate credit agreements employ rating triggers. Most vocal has been Moody's Investors Service. It warns that such triggers--particularly those setting off accelerated debt repayment, or "puts" in backup credit lines when there's a downgrade--can rapidly push already shaky borrowers into bankruptcy. "The result is mutual assured destruction" for borrower and creditor, says Moody's senior vice president Pamela Stumpp.
At PG&E, "rating triggers created a tangled web of cross defaults," she notes. A downgrade allowed banks to stop funding the utility's commercial paper, which, when unpaid, triggered defaults on floating-rate notes, unsecured senior notes, pollution-control bonds, and medium-term notes. The California Power Exchange also demanded collateral for all power trades. The utility filed for bankruptcy, turning commercial-paper holders into unsecured claim holders.
From now on, says a report written by Stumpp, "we will incorporate the serious negative consequences of those triggers in our ratings and in our research"--meaning that Moody's will evaluate whether a company can survive a downgrade. "We are going to assume the triggers are triggered. The issuer has to have the wherewithal to repay the resulting debt obligations to survive the consequences of the trigger and meet debt-service obligations without relying on the backup line," she explains.
Standard & Poor's Corp.'s Solomon B. Samson agrees with Moody's assessment of the dangers, but says his agency is taking a more cautious approach. For example, if a company with a long-standing BBB- rating (the lowest investment grade) decides to adopt financing that includes triggers, a downgrade would instantly set the triggers off. "Then we're not providing information about the risk, we're just blowing it away," says Samson, calling that result "a paradox."
S&P is surveying all investment-grade corporate clients about the use of triggers, and will issue its findings as soon as possible. In the meantime, says Samson, "people might start taking triggers out."
Indeed, Houston-based El Paso Corp. has already responded to Moody's stepped-up scrutiny, announcing that it plans to "eliminate or renegotiate the ratings triggers" in certain financings. --Tim Reason
Fewer Eggs In Basket
A bill backed by California senator Barbara Boxer would prevent employees from investing more than 20% of their 401(k) funds in a single stock.
18% of U.S. companies plan to hire in-house attorneys in 2002, down from 47% in 2000, says the American Corporate Counsel Assn.
Small Business Accounting
One Less Tax Obstacle
In an effort to simplify tax accounting for many smaller businesses, the Internal Revenue Service has extended the use of cash-based accounting to certain companies with annual gross revenue of up to $10 million, replacing the previous $1 million ceiling. The change, applying to tax years ending on or after last December 31, reduces both the time and money being spent by an estimated 500,000 companies that have had to use accrual-based accounting in the past.
Accrual accounting requires taxes to be paid based on revenue incurred, while cash accounting requires tax payments only on collected revenue. So, says John Gillespie, co-president of CFOutsource LLC, a provider of financial and accounting services to small businesses, the benefits of allowing cash accounting will be especially significant for growing companies. He points out that a $3 million company with 60 days' worth of sales in receivables and a 35 percent tax rate would save more than $14,500 for the year. "This is a great savings, especially for someone who is self-financed, since those companies are almost prepaying taxes under the accrual method," he says.
The IRS also won't challenge the use of the cash method, or the failure to account for inventory in audits of earlier years, if taxpayers met the current safe harbors, according to Ken Silverberg, a tax specialist and partner in the Washington, D.C., law firm of Nixon Peabody LLP. Essentially, that makes the new rule retroactive. But the change won't apply to companies in industries that rely heavily on inventory for income--including retailers, wholesalers, manufacturers, mining, farming, and publishing--which have business models in which the accrual basis would be more appropriate.
What other tax simplification changes are expected? "The new commissioner [Charles O. Rossotti] understands the need," says Silverberg, but "the IRS hasn't given too many clues as to where it will try to simplify."--Alix Nyberg
A new Internal Revenue Service pilot program aims to cut the time it takes to resolve disputes between the tax agency and large and midsize businesses.
Of Beans and Carrots
As part of its ongoing effort to crack down on tax shelters, the Internal Revenue Service has agreed to waive penalties for companies that voluntarily disclose questionable items in their returns before April 23.
Companies that spill the beans about a tax shelter--and about the person who promoted or recommended it--can avoid the 20 percent penalty on any resulting understatement of tax. "In a big corporate tax shelter, that can be a very large sum of money," says Herbert N. Beller, an attorney with Sutherland Asbill & Brennan LLP, in Washington, D.C. Beller is chair-elect of the American Bar Association's Section of Taxation, which applauded the IRS's move.
Existing regulations that require companies to disclose tax shelters "may not provide enough teeth," says Beller. In fact, advocates of new legislation to curb abuse cite recent IRS court defeats, including the recent Compaq Computer Corp. case, as evidence that the laws need to be rewritten.
Under the waiver program, companies that disclose a shelter or questionable tax practice do not lose their right to defend the tax strategy in question if it is challenged in an audit, explains Beller, although "it does shine a spotlight on the transaction." He adds that since most large companies face a regular audit cycle, the disclosure provides protection against the IRS's somewhat inconsistent application of penalties if the item is disallowed. "Sooner or later," he says, "these taxpayers will likely do battle with the IRS over these types of transactions. The benefit of disclosing is that they don't have to worry about a penalty."
With the new carrot, however, comes a reinforced stick. When the disclosure initiative was announced, Larry Langdon, commissioner of the IRS's Large and Midsized Business Division, also sent out an internal memo to agency personnel, noting that failure to disclose tax shelters under existing regulations could make it more difficult for a company to claim that it acted with reasonable cause and good faith to avoid the 20 percent penalty--a traditional and widely used exception to existing tax-shelter regulations. -- T.R.
Reports of a questionable tax shelter to the IRS must include:
Source: Internal Revenue Service
Table Talk: Starting in Q2, the SEC will require companies to detail equity compensation plans in new 10-K and 10-KSB tables.
Tax Relief Runs Out of Gas
Pining for tax relief from Congress? Don't get your hopes up. Granted, with Congress back in session optimists still have their fingers crossed, even though such juicy tax provisions as the repeal of the alternative minimum tax (AMT) were scuttled when the economic stimulus package went down in December.
"The tax provisions that were in the close-to-consensus [stimulus bill] will be a starting point, but how soon legislation will emerge and whether it will be retroactive remains a very open question," notes Timothy McCormall, executive director of the Tax Executives Institute Inc.
So what's to become of the orphaned tax provisions? A popular theory is that they will be wrapped into a larger tax bill. Then again, the near-term outlook on the recession, the budget deficit, and the war on terrorism could do more to sideline provisions than any political maneuvers.
One of the package's top provisions for businesses was the repeal of the AMT, which requires taxes even from companies with a net loss. While critics say the AMT overtaxes companies, outright repeal isn't likely, because "right now [the repeal] is surrounded by bad politics," says Clint Stretch, director of tax policy for Deloitte & Touche. He expects relief will come through smaller, incremental measures like adjustments to the depreciation allowances and time limits on carrybacks and carryforwards.
Also on the chopping block was an accelerated depreciation incentive for IT investments that would last through 2003. Backed by the likes of IBM, AOL Time Warner, Intel, and Dell, the bill could pass in a modified form, says Stretch, especially since it simply shifts corporate tax liabilities to the future, rather than extinguishing them altogether. A proposed five-year carryback on net operating losses could survive for similar reasons. By early January, a new proposal from Sen. Tom Daschle emerged, offering up payroll tax refunds for workers hired in 2002 and depreciation allowances of up to 40 percent of investments for the first six months of 2002.
As a leading gear-and-machinery producer, Rochester, N.Y.-based Gleason Corp. could see an increase in sales from the passage of the accelerated depreciation proposal. However, CFO John Perrotti is sanguine about the impact. "It's likely that some portions of the package will occur," he says, "but from a planning perspective, we're not counting on it." What's more, "if a company doesn't have the capital available, [tax relief] won't stimulate new investments." --A.N.
An Online Standard at Last?
Padded paychecks are under fire. The number of shareholder resolutions on executive pay doubled to 42 in 2001, says Institutional Shareholder Services.
Raising debt and equity online will become easier if software developed by quasi-newcomer i-Deal LLC is successful. The software provides a broker-neutral platform that can link the disparate backroom systems of corporate issuers and investment banks. Although the New York-based company is less than a year old, its pedigree is impressive: Merrill Lynch, Citigroup's Salomon Smith Barney, Microsoft, and Thomson Financial are its founders and equity investors.
Most large investment houses, and some issuers, currently use proprietary Web-based systems to aid the book-building process, the practice syndicates use to help arrive at a consensus when pricing new issues. But as raising capital becomes more complex--increasingly, issues are global, multitranche, multicurrency, and jointly led--it becomes more attractive to use a standard platform, says i-Deal chief technology officer Frank LaQuinta.
The software, which is usually sold to investment banks, allows bankers to manage book building in real time, granting different levels of access to investors and issuers. Banks and issuers can then gauge investor appetite for a particular security, and arrive at an optimum price, using the Internet's whizbang efficiency rather than a combination of old-fashioned phone, fax, and E-mail systems.
Freddie Mac, a giant issuer of corporate bonds, will be the first issuer to test-drive the software. Jerome Lienhard, Freddie Mac's senior vice president of investment funding, expects to move the company's long-term debt syndication process--it will issue more than $175 billion this year--from in-house spreadsheets to the i-Deal platform later this year. But he still isn't sure which bank will lead the cybersyndication.
The benefits for issuers are greater transparency, accuracy, and efficiency, though how much of the cost savings banks pass along remains to be seen. --M.L.
Sinking Salaries: 20% of U.S. employers are adjusting their 2002 base pay budgets downward, according to William M. Mercer.