BY ALLEN WILEN CPA, CFA, CIRA
DIRECTOR, INSOLVENCY AND ASSET RECOVERY SERVICES

As a specialist in troubled companies, I spend a great deal of time working with family run businesses in their times of greatest challenge. Many of the problems I see occur during periods of transition from one generation to the next — problems that, with the right planning, can often be avoided.

These difficulties vary from generation to generation. In the first generation, Mom and Dad struggle for the survival and growth of the organization. When their children join the business, issues of succession arise and, if left unaddressed, can have an adverse impact on the health of the business. For me, one of the most difficult parts of working with troubled family businesses is seeing family relationships suffer because of misunderstandings about the company.

Family Feuds There are as many different stories of family business problems as there are family businesses: A grown child returns to the family business following an unsuccessful attempt at another career. The family members who have been working in the business all along feel resentment toward the returning son or daughter.

A child joins the business straight out of college and is immediately critical of its operating methods. While this fresh perspective might prove useful, it is more likely unwelcome by the "old guard."

A few years ago, we worked with a second-generation distributor who had grown the family business from a few million dollars in sales to around $150 million. When we met him, the company had just (barely) survived an unsuccessful attempt at entering the manufacturing arena and was facing declining margins. A third generation son, the ink on his MBA not quite dry and with an overly-simplistic view of the company's operations, thought he had all the answers and freely shared them. The first generation, happily retired and hoping to stay that way from the business' business' profits, was worried. Should the first generation founder get involved? Would he be able to accept the decision of his children and grandchildren? Would "assistance" be seen as "interference?"

Family Values?
Disputes between shareholders who are active in the business and those who choose to remain "uninvolved" are perhaps some of the worst. When times are good and distributions plentiful, all is well. When the distributions decrease, the uninvolved shareholders may blame the active shareholders for the downturn, even to the point of demanding that the business be sold. They may even garner enough support among the non active shareholders to vote as a bloc to thwart forward movement by the active shareholders. As a result, the business ends up paralyzed — unable to make major decisions and further deteriorating. Even if the decision to sell was a correct one, by the time the sale occurs, the value of the business may have been significantly decreased by the behavior of the feuding factions.

The "Doctor" is In
The scenarios I have described are not unusual in family owned businesses. All organizations, when in a state of transition, experience growing pains. Like a medical condition left untreated, these pains can progress to something much more serious and, in some cases, terminal. Addressed early by a professional trained to diagnose and treat, the business can not only live, but flourish.

A troubled company professional can be invaluable to management in providing an objective assessment of the issues. This professional acts as a facilitator, keeping the focus on what's best for the organization. Seeing help early however, is the key to success in turning around troubled situations and in keeping family businesses vital and growing.

BY DIANE M. JAY
SENIOR MANAGER, ACCOUNTING & AUDIT DEPARTMENT

Revenue is the electricity that drives business. Revenue has been the starting point on every income statement generated, every sales meeting conducted, on every entrepreneur's wish list.

So why all the fuss lately about revenue? In the business headlines, many companies are not reaching their targeted projections, and one giant in particular publicly announced that it had made an accounting "mistake," overstating revenues by $125 million in its fourth quarter, due to "sales that were incorrectly recorded." An outsider would think that accounting rules would have been in place regarding how companies are to recognize revenue.

Evolving technology and aggressive sales practices have caused the accounting profession and the Securities and Exchange Commission (SEC) to address this matter, by issuing a series of statements and bulletins, supported by their interpretation of the accounting pronouncements that are currently in place.

There are four criteria that must be met to recognize revenue:

• Persuasive evidence that an agreement exists
• Delivery has occurred or services have been rendered
• The seller's price is fixed and determinable
• Collectability is reasonably assured

The key factors generating SEC discussion have surrounded the "delivery has occurred or services have been rendered," coupled with the contractual aspects of client acceptance in the sales agreement itself.

The discussions have been directed to multiple element revenue arrangements, addressing the segregation on each contract into identifiable elements, such as the product itself, the installation, the training and the ultimate finality — customer acceptance of the product. The advent of many "side agreements" to large contracts is also tainting the revenue recognition process, often allowing the customer an an "escape clause" from accepting the product, which defers the revenue recognition process until complete customer acceptance has occurred, either by written acceptance or by passage of a defined time. The guidance provided is applicable to all companies.

Delivery and Performance On "multiple element" contracts, if the undelivered elements are essential to the functionality of the delivered element, then the customer does not have full use of the delivered element. If the customer can't use the product yet because something is incomplete, then generally it is not a sale yet, with the following exceptions:

If the seller meets the criteria for recognizing revenue, except for one undelivered element of the contract, revenue can be recognized on the completed parts only if the remaining obligation is inconsequential, the failure to complete the undelivered element would not result in the customer requesting a refund or reject the sale altogether, the costs to complete are minimal and the remaining element can be performed by any other vendor readily available elsewhere.

For any non-standard product or service customized to buyer specifications, evidence of client acceptance is critical, and usually contractually driven in determining revenue recognition. Your accountant should be involved in this discussion, particularly if your financial statements are being issued to third parties.

Another standard criterion for recognizing revenue was based on title passing during delivery. Enticing "side agreements" are also tainting the delivery and title process, creating a consignment situation by offering to the buyer, who has accepted title on delivery risk free, interest free financing or repurchase clauses at essentially the same price. In these cases, revenue should not be recognized until there is a third party sale, despite title passing.

Other revenues, such as an activation fee or a set-up fee, cannot be recognized as revenue separately and must be amortized over the time period of the service provided. A customer does not go to a service provider and sign up for the set-up without getting the regular service. They are not separate events.

Fixed and Determinable Sales Price Revenues that are refundable, such as "100% satisfaction or a complete refund," cannot be recognized as revenue until the expiration date for refund has occurred. If fees are refundable on a pro-rata basis over time, the revenue can be recognized accordingly. The SEC has made an exception for certain homogeneous fees from a standard group of customers to recognize the revenue, offset by an allowance for refunds, based on reliable estimates calculated on a specific historical basis.

The SEC staff suggests a minimum of two years of experience be considered in determining sales allowances and that there are no wide swings in the calculation from year to year. If the rate of return is volatile from year to year, then it's impossible to reasonably calculate a dependable estimate. In these cases, revenue cannot be recognized until the expiration date for a refund has occurred. For a start up company, this is a critical issue, because a "management estimate" for a sales allowance is unacceptable for any period less than two years of existence. Once you have established the historical, reliable rate of return, then you can change your accounting policy accordingly.

Time to examine your current revenue recognition policy? There is no doubt that revenue recognition is this year's "hot button" for professionals in financial reporting. Any company that has a formalized client product acceptance policy or highly complex contractual arrangements should revisit how they are recognizing revenues, and decide, in the light of new public scrutiny, whether they should be accounting for revenues differently.

It doesn't matter if your company has $50 million or $5 billion in sales annually, is public or private — generally accepted accounting policies are the same. Take a moment and weigh the consequences of addressing your revenue recognition policies now, rather than taking the risk of an embarrassing restatement of financial results due to misinterpretation of the rules. Be aware that financial statement treatment of revenues may not necessarily be the acceptable for tax purposes. There is more guidance today than in the past, and your accountant should be able to assist you in applying this new guidance to your particular situation.

SECTION 529 PLAN

BY DANIEL J. GIBSON CPA
SENIOR MANAGER, TAX DEPARTMENT

If you have a child (or if you'd like to help someone else's child) who is going to attend college in the future, you may be interested to know that the 2001 tax law has provided some enhancements for Qualified Tuition Plans (a/k/a Section 529 plan) and Education IRAs. Both of these savings vehicles accumulate funds towards the qualified education expenses of a designated beneficiary.

Contributions to Section 529 plans are not deductible for federal income tax purposes. However, starting in 2002, the earnings on state sponsored Section 529 plan accounts can be distributed tax-free when made towards qualified higher education expenses. For private institutions, the distributions are tax-free starting in 2004.

One of the nice features of Section 529 plans is to allow the account owner to change the designated beneficiary at any time and to direct when and in what amounts distributions are made.

There are actually two types of Section 529 plans — tuition credit programs and savings account programs.

In a tuition credit program, a purchaser buys tuition credits from a Section 529 plan on behalf of a designated beneficiary. These credits entitle the designated beneficiary to waive payment for credits used by the designated beneficiary in the future.

In a savings account program, a contributor funds an account that is designated as a Section 529 plan account for the purpose of meeting qualified higher education expenses incurred by the designated beneficiary in the future.

Traditionally, savings account programs generally allow distributions to colleges located in any state, not just the state administering the program. For example, you can contribute funds to a 529 Plan in Maine and then use these funds, along with their tax-free earnings, to pay for tuition costs in Florida. Tuition credit programs tend to have more complicated "conversion formulas" that must be used if the designated beneficiary attends a college located outside of the administering state. Federal law does not limit who may participate in a Section 529 plan as a contributor, account owner, or designated beneficiary. There are no income limitations, and the participants are not required to have any relationship or even to know each other. The only restriction is that the designated beneficiary must be an individual.

All contributions to Section 529 plans must be in cash. Contributions to a savings account program or purchases made from a tuition credit program are completed gifts. Contributions qualify for the annual $10,000 gift exclusion. If the gift exceeds the applicable annual exclusion, the contributor may treat the gift as if it were being made over a period of five years, pro rata. In other words, if you contribute $50,000 in year one, you can treat the contribution in year 1 as a contribution made evenly from years one to five. This can allow you to fund the 529 plan up to $50,000 in year one without any gift consequences. If this election is made, the length of the spread period is not optional (i.e., the contributor cannot spread the gift over less than five years).

UTILIZING STOCK OPTIONS DURING A MARKET DOWNTURN

BY LAWRENCE GRAY CPA
DIRECTOR, QUALITY ASSURANCE

When the clock struck 12:00 a.m. on January 1, 2000 and the Y2K issue never materialized, a downturn in the global economy was starting to brew. A few months later (April 2000), the NASDAQ market reached its all time highest level and then began its steep collapse during 2000 and early 2001. The stock prices in the other exchanges fell at alarming rates but not as severe as NASDAQ. The U.S. employment rate fell to a generation low of 3.9% in early 2000 and is currently over 5%. However, as the economy appears in a downward trend and the "R" word is becomingly increasingly used, stock prices are beginning to increase slightly (as of beginning of November 2001).

Historically, stock prices have risen prior to an economic recovery. If you believe that stock prices are near or at their lowest levels, it would be an excellent time for companies to provide stock options to motivate, retain and compensate employees in a market downturn. Rather than providing salary increases, companies can grant stock options as another means of compensation.

Companies that utilize APB 25 for accounting for stock options do not recognize compensation expense or any charge to operations for fixed award plans. In order to qualify for fixed plan treatment, both the number of shares granted under the option plan and the exercise price are known at date of grant. Therefore, if a company grants 100,000 options at an exercise price, which equals market price at the date of grant, then no compensation expense is recorded. The company is still required to disclose the proforma effect net income and earnings per share of granting these stock options as required by SFAS 123.

As an example, an employee receives $100,000 annual salary and has been receiving both a year-end bonus and a 5% annual salary increase.

Case 1 — Rather than increasing the employee annual salary to $105,000 for the next year and not paying a bonus, the company grants stock options at today’s market price to vest over a period of time (i.e. 5 years). In this way, the employee can realize significant gains if the stock price appreciates, which should be directly related with his/her hard work and continued employment. The company’s cash flow increases by not paying the bonus and the 5% increase in the next year.

Case 2 — Establish that the employee salary will be reduced to $90,000 per year and instead will be granted stock options at today’s market price which will vest over a period of time (i.e., 3 years). The number of stock options granted in this case should be significantly more than in case 1 since the company is saving $10,000 in salary in addition to both the bonus and the 5% salary increase as in case 1. The company’s cash flow increases.

In both cases if the fixed stock option plan award is utilized, then the company does not have to record compensation expense and there is no effect on cash flow.

Another means of motivating and retaining employees is to cancel existing stock options, which were granted previously and are now "out of the money" (exercise price of options are in excess of current market price). However, to avoid variable accounting treatment (the measurement for compensation is not determinable until a later date and can cause significant compensation expense if the market price increases) for newly granted stock options, then the company can cancel these existing stock option plans but must wait six months and one day to issue new stock options. There cannot be any transaction or correlations between the cancellation and the reissuance. Therefore, employees will forfeit stock options that are out of the money for possible stock options that may be in the money. There is always the possibility that within the six month one day period, market prices will spiral upwards and the employees will be unable to capitalize when the market prices are lower but must wait until the time period elapses. Thus, the cancelled options may now be in the money and the new options will become less valuable to the employee.

Any other modification to existing stock option plans such as renewing or increasing the life of an award, a modification that reduces the exercise price or a modification that increase the number of shares to be issued, results in variable accounting treatment which may result in significant compensation costs to the income statement.

There are other vehicles to compensate employees, which I will discuss in future articles.

RETIREMENT PLANS — "Playing Catch Up"

For any owner or employee over the age of 50, you may or may not know that, subject to an amendment filing, you may now put aside an additional $1000 this year above the maximum allowable limits due to a recent change in the tax law. This amount will increase to $2,000 in 2003, $3,000 in 2004, $4,000 in 2005, and $5,000 in 2006 and thereafter. This should allow participants to significantly increase there deductible savings over the years. It is important to note that current plans need to be amended to include this benefit in your plan.

If you would like to discuss this further or would like to explore other ways to maximize under the new law in your plan, please contact Mark Scudillo at 732.287.1000 ext. 341.