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Don’t Let Your Client Miss the Domestic Production Activities Deduction

Author: Robert Wood, CPA, Principal

Make Your Clients’ Aware of DPAD – An Often Overlooked Tax Deduction

ABLThe end of the year is a great time to revisit certain tax-saving opportunities, especially Internal Revenue Code Section 199, involving the Domestic Production Activities Deduction (DPAD). If you are an asset based lender with clients who aren’t aware of the DPAD, or are simply intimidated by its perceived complexity, you can do a great service for them by raising awareness of the possibility that they might be leaving money on the table.

Production activities that qualify

Do you have clients in any of the following lines of business? They may qualify for the DPAD:

  • U.S.-based construction services, including renovation and building of commercial and residential properties,
  • U.S.-based manufacturing,
  • Architectural and engineering services relating to a U.S.-based construction project,
  • Leasing, selling or licensing items manufactured in the United States,
  • Leasing, selling or licensing motion pictures or recordings that are produced in the United States, and
  • Software, including all video game development in the United States.

In addition to the above list, mining, oil extraction and farming also qualify as domestic production activities. Moreover, businesses qualify even if their products are partially produced in the United States. Safe harbor rules allow businesses to take the DPAD if at least 20% of total costs result from direct labor and overhead costs incurred domestically.

Mind the limitations

The lines of business that are specifically excluded from claiming the DPAD include leasing or licensing activities to a related party, cosmetic construction services (such as decorating or painting ), and selling food or beverages prepared at a retail establishment.

The DPAD is generally equal to 9% of the lesser of a borrower’s qualified production activities income (known as QPAI) or its taxable income (or adjusted gross income for estates, individuals, and trusts). The DPAD generally can’t exceed 50% of W-2 wages paid to employees.

Understand the mechanics

If a client engages in only qualified domestic production activities, the QPAI will typically equal its taxable income. Companies that manufacture or produce partially outside the United States must implement cost accounting mechanisms to make sure their tax deduction is calculated accurately.

To show how the deduction works, suppose ABC manufactures widgets in the United States. The revenue from domestic widget manufacturing is $4 million, with $2 million of domestic manufacturing costs. ABC also reports $500,000 of income derived from repairing software, which doesn’t qualify as a domestic production activity. Total W-2 wages were $600,000, including $400,000 to provide needed repair services.

The QPAI thus equals $2 million ($4 million of software revenues - $2 million of manufacturing costs). ABC can deduct $180,000 under IRC Section 199 (9% × $2 million of QPAI), assuming ABC has at least $180,000 of taxable income. Moreover, the deduction would be limited to W-2 wages attributable to software production ($600,000 - $400,000 = $200,000).

This is a simplified example. S corporations and other pass-through entities also qualify for the DPAD, which reduces their owners’ personal tax obligations. Eligible borrowers should revisit their calculations and consult a tax professional to ensure full compliance and adequate documentation.

Freed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. We can assist you in helping you show your clients ways to minimize their taxes.

For more information about our business advisory, audit, and other accounting services contact us here, or call us at 716-847-2651.

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Smart ABL Lenders Use Cash Conversion Cycles to See Borrowers’ Liquidity Problems

Author: Robert Wood, CPA, Principal

Guidance on Factoring Timing into the Liquidity Equation

how asset based lenders reduce risk of lendingAs you know, many loan covenants include a minimum liquidity threshold based on static metrics, such as the quick ratio or current ratio. Asset based lenders have learned the hard way that a large decline in liquidity can foreshadow bankruptcy. But few banks consider (or even know about) the cash conversion cycle (CCC), which factors timing into the liquidity equation.


Understanding liquidity

The term “liquidity” refers to an asset’s nearness to cash. For instance, current assets (those that will be consumed or converted to cash within the next 12 months) determine a company’s liquidity. Marketable securities are generally more liquid than trade receivables, which in turn are typically more liquid than inventories.

Common liquidity metrics

Static liquidity measures tell whether a company’s current assets are sufficient to cover its current liabilities. A loan agreement, for example, may require a borrower to maintain a current ratio of 1.75. What this means is that, for every $1 of current liabilities, the client should have at least $1.75 of current assets.

The quick ratio (also known as the acid-test) is a more conservative static liquidity measure. It compares the most liquid current assets, such as cash, trade receivables and marketable securities, to current liabilities.

Pretend you’re comparing two borrowers. Borrower A has a current ratio of 2.5 and a quick ratio of 1.8. Borrower B, on the other hand, has a current ratio of 1.5 and a quick ratio of 1.0. Both borrowers have sufficient current assets to cover their current liabilities, but Borrower A seems to be more liquid and, thus, healthier. But, if you compute the CCC, you may very well come to a different conclusion.

The CCC difference                           

Current ratios assume that cash, inventories and receivables are all immediately available to pay off any debt. The CCC accounts for the timing of converting all current assets to cash and then paying off current liabilities. It’s really a function of three other ratios: CCC = Days in Inventory + Days in Receivables - Days in Payables.

As you can see, the CCC gauges how efficiently a client manages working capital. A positive CCC shows the number of days a company must borrow or tie up capital while waiting for payment from customers. A negative CCC, however, represents the number of days a business has received cash from customers before it has to pay its suppliers. A strong borrower will have a low or even negative CCC.

Who is more efficient now?

If we return to the example, let’s suppose that Borrower A maintains 60 days in inventory, 80 days in receivables and 30 days in payables, which generates a CCC of 110 days. But, let’s suppose Borrower B has 45 days in inventory, 45 days in receivables and 60 days in payables, which generates a CCC of 30 days. All of a sudden, Borrower B looks a lot more efficient. Why?

Borrower B is carrying less inventory and incurring lower carrying costs. It also collects from customers much faster than Company A is. Plus, it extends its payments to suppliers longer, therefore taking advantage of a form of interest-free financing.

So, based on our expanded liquidity analysis, Company B looks a lot stronger, so long as its inventories can meet customer demand, suppliers aren’t angry with the two-month lead time on payables, and collections are without excessive early bird discounts.

The bottom line

The CCC offers greater insight into a borrower’s liquidity position over time when used in conjunction with traditional static measures of liquidity. But before you make any credit decisions, make sure you evaluate other metrics, such as profitability, leverage and growth, and then compare the borrower to others in its industry.

Freed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. We can assist you in evaluating the integrity of your loan portfolio using CCC and other types of analyses.

For more information about our business advisory, audit, and other accounting services contact us here, or call me at 716-847-2651.

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Asset Based Lenders: FASB Proposals Affect Private Borrowers’ Financial Statements

Author: Robert Wood, CPA, Principal

FASB Eases Rules for Private Businesses

As you might know, the Financial Accounting Standards Board (FASB) has talked about easing its rules for small private firms for years. Fortunately, FASB recently proposed some revisions to Generally Accepted Accounting Principles (GAAP) to accommodate the needs of private businesses and their stakeholders.

These proposals may have an impact on the asset based lending industry.

4 areas targeted:

ABLThe FASB proposals target four specific areas: amortization and impairment of goodwill, intangible asset recognition, variable interest entities, and certain types of interest rate swaps. So, how might these proposals affect your private borrowers’ financial statements? Read on.

1. Intangible asset recognition

The current GAAP requires that companies recognize intangible assets acquired in business combinations at their fair value on the acquisition date. These intangibles need to be reported as separate line items if they meet either the contractual-legal criteria or the separable criteria.

Some examples of contractual-legal intangibles include domain names, trademarks and customer contracts. Some examples of separable intangibles include unpatented technology, customer lists and recipes.

FASB’s proposed change allows private companies to recognize only contractual-legal intangibles on the acquisition date, while other intangible assets would be combined with goodwill. This proposal might cause private companies to recognize more goodwill in business combinations and fewer intangible assets.

2. Goodwill

As you may know, goodwill is the residual intangible asset that’s recognized in a business combination after recognizing all other identifiable assets and liabilities assumed. As of now, GAAP requires businesses to record goodwill at its fair value on the acquisition date. Then it’s tested each year for impairment at the reporting unit level.

The reporting units may be based on product lines or geography. It may be necessary to employ interim impairment testing if a triggering event, such as the loss of a major customer or discontinued product line, takes place. Impairment occurs when the fair value of a reporting unit’s goodwill falls below its book value.

FASB proposes that private businesses amortize goodwill on a straight-line basis over a useful life of no more than 10 years. Private companies would test for goodwill impairment only when a triggering event occurs. The proposal simplifies impairment testing to apply at the entity level, not at the reporting unit level.

Under these proposed changes, private businesses would make fewer and less complicated computations to report goodwill in business combinations. Thus, goodwill would receive similar treatment as other finite-lived intangible assets, such as patents and copyrights.

3. Interest rate swaps

When clients can’t qualify for inexpensive fixed rate debt, they can instead obtain variable rate debt and then enter into an interest rate swap with another entity. This will help reverse their exposure to interest rate risk. Those that enter into an interest rate swap don’t trade debts. Instead, they agree to make each other’s interest payments as if they had swapped debts.

Generally speaking, GAAP requires businesses to use complex hedge accounting techniques to report interest rate swaps at fair value. Or they can measure debt at its amortized cost and make swaps separately at fair value. But, both methods can create income statement volatility over the life of the swap.

FASB has proposed two simpler methods for private businesses that use interest rate swaps: the simplified hedge approach and the combined instrument approach. The simplified hedge approach is quite similar to the current GAAP rules for reporting swaps, except that qualifying interest rate swaps are valued at settlement value, and not fair value.

With the combined instrument approach, qualifying interest rate swaps aren’t reported separately on the balance sheet. There is an exception for periodic accruals from interest rate settlements, however.

4. Variable interest entities

In the aftermath of the Enron scandal, FASB required consolidation of variable interest entities with their parent companies in order to prevent management from using them to disguise lackluster performance or fraud.

Consolidation has, indeed, been burdensome for small business owners who own buildings personally and then lease them to their companies. Under this proposal, private firms wouldn’t need to consolidate results from a lessor entity if they have a formal lease agreement, are under common control and substantially all of their interactions relate to leasing activities. The proposal, however, would require detailed disclosures of the leasing arrangements.

The debate rages on

ABLThis fall, FASB and the Private Company Council are supposed to discuss the comments received on the four proposals mentioned above. Keep your eyes and ears open for news later this year on whether FASB will enact the changes and when they’ll become effective.

Freed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. Contact us for any questions or concerns you may have on wither the FASB or AICPA proposals.

For more information about our business advisory, audit, and other accounting services contact us here, or call me at 716-847-2651.

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