Category: Accounting News

According to the Harvard Business Review, mark-to-market accounting was what some attributed to the Great Financial Crisis of 2008. Economists such as Brian Wesbury and Steve Forbes attacked the so-called “fair value accounting” because it created further instability, leading to the eventual crash of the markets that prompted the Federal Reserve to implement the “Fed Put.” Understanding how mark-to-market asset valuation works is an essential piece of information for businesses to make the most of their accounting.

Mark-To-Market Accounting vs. Historical Cost Accounting

Mark-to-market, also known as fair value accounting, measures the current market value of an asset. Historical cost accounting values assets according to their original purchase price.

Mark-to-market is a method to assess the fair value of assets if they were sold at current market conditions with liabilities removed from the business’ obligations. It’s generally a fair assessment in times of normal market functions; but during times of volatility, it can provide a skewed assessment of value.

When businesses prepare their financial statements for a particular fiscal year and assess fair value for assets, the business would update its balance sheet with the value they would receive selling assets at current market conditions. This is opposed to what the business bought the assets for, or the asset’s historical or original purchase price.

This is especially true when it comes to trading in the markets, such as futures contracts. Futures contracts are marked to market on a daily basis at the end of the trading day. Depending on how the commodity traded intraday, short and long contract values are added to or subtracted from their starting basis, respectively.   

Traded Assets and Bad Debts

When it comes to “traded assets,” HBR gives an example of when an asset is to be marked to market every quarter. If a traded asset’s fair market value falls, it lowers the equity on its balance sheet and migrates via its income statement as a loss. For example, if a bank buys a bond for $2 million, then it falls to $1.8 million when the subsequent quarter closes (assuming the bond is still held), the business’ balance sheet will need to be adjusted (excluding any potential tax impacts). The balance sheet should reflect a $200,000 decrease in assets on the left side and a $200,000 decrease in equity. It will also be included on the bank’s income statement, reflecting a $200,000 pretax quarterly loss.

Institutions that provide loans will inevitably see a certain percentage go bad within a fiscal year. After accounting for the actual percentage of so-called uncollectable loans, they will have to re-evaluate such assets through the use of a contra account. This also can apply when companies offer pre-payment discounts to clients to encourage fast collection of accounts receivables (AR). Similarly, such assets will have to be marked down to lower values via a contra account.  

Conclusion

When it comes to valuing assets, businesses that understand the nuances of how accounting standards treat different types of assets will be better prepared to navigate their own tax and accounting needs.

By 2021, there were 20,000 warehouses in the United States and growing, according to the United States Bureau of Labor Statistics (BLS). With more warehouses expected to pop up in 2022 and beyond, one important consideration for businesses of all sizes is to keep track of their inventories. With different tracking and valuation methods, it’s important to understand how they work and what they can tell business owners.

Before inventory can be valued, it’s imperative to understand how it can be expressed mathematically:

Ending Inventory = Starting Inventory + Net Acquisitions – Cost of Goods Sold (COGS)

Now that inventory is better defined, understanding different approaches to inventory valuation is essential to keeping track. The first type of inventory valuation is referred to as FIFO or First In, First Out. This means that businesses sell their earliest produced inventory first and new inventory last.

Assume a company produces 500 widgets on day 1, costing $2 per widget. The same company then produces 500 widgets on day 2, costing $2.50 per widget. This method says that if 500 widgets are sold over the next week, the cost of goods sold (COGS), derived from the Income Statement, is $2 per widget because that’s how much the first 500 widgets cost to produce for inventory. The remaining widgets, 500 widgets at a cost of $2.50 per unit, would be accounted for under the ending inventory on the balance sheet.

One consideration, especially in an inflationary environment, for remaining inventory on the balance sheet is that a business might see a higher tax obligation. This is likely to occur because of higher net income due to a lower cost basis from the older inventory when assessing the COGS. Newer, more expensive inventory will naturally lead to a lower tax basis, especially if inflation falls and the retail cost is mitigated from decreased demand.

The next option is referred to as LIFO – or Last In, First Out. This means that businesses sell what they’ve produced first, then move on to the older inventory. If any inventory is left at the end of the accounting time-frame, it’s accounted for accordingly. Assuming the same 500 widgets were sold in the particular accounting period, the time-frame’s COGS would be $2.50 per widget, with the 500 widgets left over in inventory valued at the $2 per widget cost.  

One important caveat to this type of valuation is with regard to inventory that’s perishable or becomes obsolete quickly (cell phones, televisions, etc.). It is not an effective method because the product will either spoil or become worth next to nothing due to highly competitive industries. For this approach, using the most recently produced goods first would lend their COGS basis to be higher. In one respect, the higher COGS basis can lower profits, but can also offset taxes due to the same effect. The third type of inventory valuation is referred to as Average Cost. This method is a way to blend LIFO and FIFO, which takes the average of inventory across all production and storage timelines. This approach averages costs in proportion to the amount of widgets produced in each run, then calculates the mean cost to determine the ending inventory and COGS figures.

[(500 x $2) + (500 x $2.50)]/1,000 = ($1,000 + $1,250)/1,000 = $2,250/1,000 = $2.25

Therefore, the average cost for inventory using this method would be $2.25 per widget.

With different types of inventory valuation explained, there are considerations that businesses should be mindful for each approach. This can make a difference to those running the company and for potential investors and lenders contemplating investing in or loaning the company money.

Some businesses, especially publicly traded ones, may choose accrual accounting to reduce volatility in earnings, while start-ups or small businesses may choose to go with a cash basis accounting option. A poll conducted by the Journal of Accountancy on Topic 606 discovered that one in five respondents reported that one of the most common audit perils for their clients was the risk of evaluating “material misstatement” when it comes to recognizing revenue under Topic 606.

According to the Association of International Certified Professional Accountants (AICPA) and the Financial Accounting Standards Board’s (FASB) Accounting Standards Topic 606, proper revenue recognition involves following five steps. While each step requires exercising judgment, the following is a brief overview.

Step 1

When all the following criteria is satisfied in the first step to establish a contract with their client, an organization should follow the revenue recognition standard mandates when an agreement falls within such criteria.  

All contract parties have agreed to the terms of the contract and are engaged in fulfilling their agreed-to commitments. All party’s rights are easily identifiable when it comes to goods/services to be exchanged. Payment is clearly described for the goods/services to be delivered. The recipient’s cash flows are expected to change based upon the contract’s deliverables. The organization that provides the product or service should have “a reasonable expectation” of receiving consideration from the customer and they have a reasonable expectation the customer is able and willing to provide such payment.

Step 2

The second step is to determine what each party of the contract must fulfill to satisfy their respective contractual obligations. This is what businesses pledge to customers and clients while delivering their unique product or service. This step is where each performance obligation should be identified as unique. If each performance obligation does not qualify as unique, based upon this standard, it must be packaged with other goods or services until it meets such criteria.

The FASB AICPA ASC 606 standards explains if both of the following apply, a good or service is considered “distinct:”

If the receiving party can receive a useful product or professional assistance by itself or in conjunction with related materials the client had pre-existing to the contract in question;

AND

The business’ contractual pledge to deliver the service or finished materials is individually distinguishable from additional pledges from the contract.

Step 3

The third step is to calculate the financial terms of the deal. This entails how much money the business anticipates receiving in return for delivering the goods or services, minus portions related to that of external organizations. This can include taxes businesses must collect for local, state or federal government agencies. Other examples of this include “variable consideration” – or how much consideration a company will receive, bearing in mind financial adjustments in conjunction with delivering their product or service. Businesses should estimate the impact of such variable costs and what they might be allowed while fulfilling their contractual obligations. Examples can include financial enticements, fines, reimbursements, price cuts, etc.

Step 4

The fourth step is to figure out how much it will cost parties to fulfill their responsibilities spelled out in the legal agreement. When attempting to recognize revenue according to Topic 606, if there’s multiple distinct responsibilities, the business is required to break down the price based on “each separate performance obligation in an amount” that is commensurate to an amount the business is expected to receive for each “separate performance obligation.” This means looking at each piece of the contract as a unique “performance obligation.”

When the transaction is subject to a discount or “variable consideration,” businesses may or may not assign the price concession or “variable consideration” to one or more performance obligations versus across the agreement’s full list of “performance obligations.” If the business offers markdowns of the goods or services, in addition to adjusting the “transaction prices,” there should be proportional and estimated calculations when it comes to recognizing revenue.

Step 5

The fifth step says that once a business has satisfied its “performance obligation” set out in the contract, revenue can be recognized. This occurs when the customer receives their contracted goods or services, which is when they have complete command of the property. This can be illustrated when the customer can increase their cash flow, use it as an asset to obtain financing, leverage pre-existing equipment or service delivery, etc.

When it comes to recognizing revenue under Topic 606, this is just the beginning of how businesses can analyze and interpret the many nuances of this accounting topic.

According to the Internal Revenue Service, the 2019 tax year saw more than 25 million partners comprising nearly four million tax returns filed by partnerships in 2019. With many concerns necessary for navigating the U.S. tax code, including filing annual returns, one important consideration for partnerships and their partners is how to calculate a tax liability. In order to determine how much they profit or lose on their investment, there must be an accurate calculation of adjusted cost basis via outside cost and inside cost basis.

According to the Internal Revenue Code (IRC), one aspect of Section 754 details how the tax basis of partnership assets are handled. When partnerships change or when there are changes in partnership interest, it helps to rebalance the basis of the business entity’s property. This entails defining and calculating both outside cost basis and inside cost basis.  

Understanding Outside Cost Basis

Outside cost basis refers to what percentage of interest each partner owns in a partnership. For example, if three partners own a partnership and each partner contributes $200,000, this establishes their outside cost basis. Recording what each initial partner contributes to the partnership is essential to determine their tax basis, including whether they’ve established a loss or gain and therefore their tax obligations.

Understanding Inside Cost Basis

As the Internal Revenue explains it, “Inside basis refers to a partnership’s basis in its assets.” One way to look at it is if three partners bought an asset for $600,000, each contributing $200,000 (symbolizing their inside cost basis), their respective inside basis in that particular asset would be $200,000.

When to Consider a Section 754 Election

It’s important to distinguish that partnerships adding or selling partnership interests must consider how such changes impact owners’ tax basis. By making a Section 754 election, partnerships can adjust the cost basis for new partners to provide an accurate accounting of profits (or losses). Assume five partners contributed $200,000 to a partnership and bought an asset for $1 million. A year later, the asset appreciated to $1.3 million. The outside basis is $200,000 (per partner) and the inside basis is $1 million.

Assume the asset appreciates to $1.3 million and one of the original five partners wants to cash out and sell it to a new, independent partner for $260,000. The original partner must pay taxes on the appreciation of $60,000 when exiting the partnership. Assume three months later, the asset is sold at the same price of $1.3 million with no Section 754 election. The four original partners are faced with a taxable gain of $60,000 ($1.3 million selling price – $1 million inside basis) / 5 partners = $300,000 profit / 5 partners). However, despite the new partner’s outside basis of $260,000, they would face the same $60,000 tax liability.

However, if a partnership chose to elect their partnership to Section 754, the new partner’s tax basis is “stepped up” to $260,000 instead of the original partner’s basis of $200,000. The new partner’s inside cost basis will remain at $200,000, requiring no adjustment. However, the new partner now has an outside basis of $260,000 – the amount the partnership interest was sold for from the original partner to the new partner.

While each business arrangement is unique, for partnerships that see their assets regularly increase in value and experience frequent changes in partners, it could make sense to go with a Section 754 election.