AUDIT & ACCOUNTING INSIDER

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1 AUDIT & ACCOUNTING INSIDER Fall 2016 FASB ISSUES ASU ON LEASES IF A PRODUCT OR SERVICE IS DELIVERED VIA THE INTERNET, IT S NOT SUBJECT TO SALES TAX 11 RISKS HIDDEN IN YOUR FORM 990

2 Audit & Accounting Insider FASB ISSUES ASU ON LEASES MAIN PROVISIONS The new standard applies a right-ofuse (ROU) model that requires a lessee to record, for all leases with a lease term of more than 12 months, an asset representing its right to use the underlying asset for the lease term and a liability to make lease payments. The lease term is the noncancellable period of the lease, and includes both periods covered by an option to extend the lease, if the lessee is reasonably certain to exercise that option, and periods covered by an option to terminate the lease, if the lessee is reasonably certain not to exercise that termination option. Reasonably certain has the same meaning as reasonably assured under existing U.S. GAAP, and includes an assessment of economic incentives. For leases with a lease term of 12 months or less, a practical expedient is available whereby a lessee may elect, by class of underlying asset, not to recognize an ROU asset or lease liability. A lessee making this accounting policy election would recognize lease expense over the term of the lease, generally in a straight-line pattern. At inception, lessees must classify all leases as either finance or operating. Balance sheet recognition of finance and operating leases is similar, but the pattern of expense recognition in the income statement will differ depending on the lease classification. A finance lease is a lease The following table compares lessee accounting for finance and operating leases: FINANCIAL STATEMENT FINANCIAL LEASE OPERATING LEASE Balance Sheet Recognize ROU asset and lease liability, initially measured at the present value of the lease payments. Include initial direct costs in the initial measurement of the ROU asset. Recognize ROU asset and lease liability, initially measured at the present value of the lease payments. Include initial direct costs in the initial measurement of the ROU asset. Income Statement Recognize interest on the lease liability separately from amortization of the ROU asset. Recognize a single lease cost, calculated so that the cost of the lease is allocated over the lease term, generally on a straight-line basis. Cash Flows Classify repayments of the principal portion of the lease liability within financing activities and payments of interest on the lease liability and variable lease payments within operating activities. Classify all cash payments for leases within operating activities. 1

3 arrangement in which the lessee effectively obtains control of the underlying asset. In an operating lease, the lessee does not effectively obtain control of the underlying asset. If any of the following criteria is met at commencement, a lessee effectively obtains control of an underlying asset and will account for the lease as a finance lease: Finance leases will result in a front-loaded expense effect due to straight-line amortization and frontloaded interest, while operating leases will result in straight-line expense recognition over the lease term, similar to today s operating lease treatment. 1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term. 2. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise. 3. The lease term is for the major part of the remaining economic life of the underlying asset. 4. The sum of the present value of the lease payments and the present value of any residual value guaranteed by the lessee amounts to substantially all of the fair value of the underlying asset. 5. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. After inception, the lessee s right-ofuse asset will be assessed for impairment under Topic 360. LESSOR ACCOUNTING MODEL The new standard requires a lessor to classify leases as either sales-type, direct financing or operating, similar to existing U.S. GAAP. Classification depends on the same five criteria used by lessees plus certain additional factors. Based on that evaluation: 1. A lease will be treated as a sale if it transfers all of the risks and rewards, as well as control of the underlying asset, to the lessee. 2. If risks and rewards are conveyed without the transfer of control, the lease is treated as a direct financing. 3. If the lessor doesn t convey risks and rewards or control, an operating lease results. The subsequent accounting treatment for all three lease types is substantially equivalent to existing U.S. GAAP for sales-type leases, direct financing leases, and operating leases. However, the new standard updates certain aspects of the lessor accounting model to align it with the new lessee accounting model. For instance, glossary terms have been standardized such that a lessee applying the guidance as a sublessor would apply the same terms as a lessor. Further, guidance for lessors has been aligned with the revenue recognition guidance in ASU

4 due to the revenue-generating nature of leasing activities for lessors. Specifically, determining whether a lease is a sale is based on the notion of transfer of control, which is the same principle underlying the new revenue guidance; a lessor is precluded from recognizing selling profit or sales revenue at lease commencement for a lease that does not transfer control of the underlying asset to the lessee. Also consistent with the new revenue guidance, the updated lessor accounting model does not differentiate between leases of real estate and leases of other assets. With respect to impairment, Topic 310 applies to a lessor s net investment in the lease. Topic 360 continues to apply to long-lived assets of lessors. The previous accounting model for leveraged leases will continue to apply only for those leveraged leases that commenced before the effective date, but will not be available for leases that commence after the effective date. Determining whether a contract contains a lease at inception is critical under the new guidance because of the requirement to recognize ROU assets and lease liabilities on the balance sheet. While this assessment will be straight-forward in most cases, it may require judgment in some situations, such as contracts that include services. ADDITIONAL CONSIDERATIONS Identification of a Lease The new standard defines a lease as a contract that conveys the right to use an underlying asset for a period of time in exchange for consideration. Components Lessees and lessors are required to separate the lease components from the nonlease components (for example, maintenance services or other activities that transfer a good or service to the customer) in a contract, and account for the nonlease components according to other applicable guidance. However, a practical expedient is available whereby lessees may elect, by class of underlying asset, not to separate lease components from nonlease components, and to account for all components as a single lease component. 3

5 Sale and Leaseback Transactions - For a sale to occur in the context of a sale and leaseback transaction, the transfer of the asset must meet the requirements for a sale in ASU If there is no sale for the sellerlessee, the buyer-lessor also does not account for a purchase. Modifications The new standard provides guidance for determining whether lease modifications should be accounted for as separate leases. It also specifies the modification accounting for both lessees and lessors. Disclosures Lessees and lessors are required to provide certain qualitative and quantitative disclosures to enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. SEC registrants are also required to disclose the impact that recently issued accounting standards will have on the financial statements when adopted in a future period. Refer to BDO s recent SEC flash report for details. Other The new standard provides guidance on combining contracts, purchase options, reassessment of the lease term, and remeasurement of lease payments. It also contains comprehensive implementation guidance with practical examples. EFFECTIVE DATE AND TRANSITION The amendments are effective for public business entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The amendments are effective for all other entities for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, Early adoption is permitted. In transition, a lessee and a lessor will recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. The modified retrospective approach includes a number of optional practical expedients. These practical expedients relate to identifying and classifying leases that commenced before the effective date, initial direct costs for leases that commenced before the effective date, and the ability to use hindsight in evaluating lessee options to extend or terminate a lease or to purchase the underlying asset. An entity that elects to apply the practical expedients would, in effect, continue to account for leases that commenced prior to the effective date in accordance with previous guidance unless the lease is modified, except that lessees would recognize an ROU asset and a lease liability for all Audit & Accounting Insider operating leases at each reporting date based on the present value of the minimum rental payments that were determined under previous guidance. The new standard also provides transition guidance specific to sale and leaseback transactions, build-to-suit leases, leveraged leases, and leases recognized as a result of a business combination. INTERNATIONAL CONVERGENCE The lease project began as a joint project with the IASB. The IASB released its final standard, IFRS 16 Leases, in January Although many aspects of the two standards are converged, there are significant differences, the most notable of which is the lessee accounting model. IFRS 16 does not differentiate between finance and operating leases, but rather treats all leases of assets with values greater than $5,000 as finance leases. This means leases classified as operating leases under U.S. GAAP will be accounted for differently than under IFRS, resulting in different patterns in the income statement and cash flow statement. 4

6 Audit & Accounting Insider IF A PRODUCT OR SERVICE IS DELIVERED VIA THE INTERNET, IT S NOT SUBJECT TO SALES TAX, RIGHT? By Jeffrey Saltzberg, J.D. As organizations try to meet the growing needs of members and non-members by selling products and services delivered via the Internet, they may not realize that such products and services are subject to sales and use tax in a number of states. If the organization has nexus in one or more of these states, it is required to collect sales tax on sales of these products and services. These taxable products and services include information services, software as a service and digital goods. Many organizations provide access to a database of information or documents that can be accessed by all subscribers. This service may be treated as a taxable information service in some states. For example, in a 2015 New York Technical Service Bulletin, TSB-A-15(5)S, the New York State Department of Taxation and Finance (the Department) determined that an organization s provision of a healthcare registry that provided healthcare providers and suppliers with access to a database that contained common standards to locate 5 products and potential trading partners was an information service subject to New York state sales tax. The Department explained that the collecting, compiling and analyzing of information and reporting the information to others constituted a taxable information service under New York sales tax law. Furthermore, the Department stated that the service did not meet the statutory exclusion from the provision of information services because the information was not personal or individual in nature and could be substantially incorporated into reports furnished to others. In addition to being subject to sales tax in New York, information services are taxable in a number of other states including, but not limited to, Ohio and Texas. There is also a trend among organizations to provide cloud-based software that allows subscribers to analyze their own data. A growing number of states impose sales tax on such service as software as a service. The following describes the typical software as a service situation. 1. The seller owns and operates the software application. 2. The seller operates and maintains the server that hosts the software. 3. Subscribers access the software application through the Internet. The software is not transferred to the subscriber, and the subscriber does not have the right to download, copy or modify the software. 4. The seller bills subscribers for the use of the software. The major factor in determining whether a service is software as a service or some other service for sales tax purposes is the amount of control that the subscriber has over the software s features. The more control the user has over the software, the more likely the service will be characterized as software as a service. Some of the states that impose sales tax on software as a service include Massachusetts, New York, Pennsylvania, Ohio and Texas. Finally, providing information digitally rather than on paper or CD

7 does not exempt the sale from sales tax in a number of states. These states impose sales tax on specified digital products. These products include digital audio works, digital audiovisual works and digital books that are transferred electronically to a customer. Some of the states that impose sales tax on sales of digital goods include New Jersey, North Carolina, Ohio, Tennessee and Texas. In order to avoid potential sales tax exposure, in addition to focusing on where they have sales tax nexus and are selling tangible items such as CDs and periodicals, organizations need to also examine where they are providing products and services delivered via the Internet to determine if those products and services are taxable in the various states in which the organization conducts activities. 6

8 Audit & Accounting Insider 11 RISKS HIDDEN IN YOUR FORM 990 By Rebekuh Eley, CPA, MST A s watchdog groups and other stakeholders continue to expect increased transparency from nonprofits, it s become all the more important for organizations to prepare Form 990 as accurately and completely as possible. These publicly available forms can expose organizations to public scrutiny, but they can also leave the door open for preventable penalties from the IRS and state and local taxing authorities. Read the list below to learn about some of the hidden pitfalls in your Form 990 that you may never have noticed, but need to address. 1. You have a history of reporting gross income and net losses from activities that are not substantially related to your mission (Part I, Questions 7 and 7b) You will need to ensure that the activities you ve reported as unrelated business income meet the criteria and methods for allocating costs between related and unrelated activities. The IRS is paying close attention to this, and is focused on monitoring nonprofits methods of allocating costs and determining whether their activities would qualify as businesses with a profit motive. If organizations don t 7 take care, an audit could mean they face significant retroactive tax burdens. 2. Your organization has a financial interest over a foreign account (Part V, Question 4) If you re engaged in foreign activity or have signature authority over a foreign bank account or other type of foreign financial account (exceeding certain thresholds), then you may need to file Form 114, Report of Foreign Bank and Financial Accounts (FBAR). The rules relating to this filing are very complex, and the penalties for noncompliance are steep $10,000 for each non-willful violation and $100,000 (or 50 percent of the account s highest balance, whichever is greater) for failure to file an FBAR. 3. Your organization has a significant amount invested with alternative investments (Part X, Question 12 and Schedule D, Part VII) If you have investments such as managed futures, hedge funds, commodities or derivatives contracts, you may be exposed to unrelated business income, foreign filing and state filing obligations. The rules in each of these areas are very complex and can lead to steep penalties for noncompliance. You should also ensure you are compliant with the U.S. Foreign Investment Disclosure Rules (USFID) and the U.S. Foreign Account Tax Compliance Act (FATCA), as those penalties are more severe than the penalties for failure to file a Form 990 or 990-T. 4. Some of your employees receive compensation packages greater than $150,000 (Schedule J) Your organization could face potential unreported compensation issues or compliance risks if employees with salaries greater than $150,000 receive fringe benefits and expense reimbursements without a written policy, or participate in a nonqualified retirement plan. To reduce your risk, you may consider establishing an accountable reimbursement plan and using an independent compensation consultant or commissioning a compensation survey or study to support your organization s compensation decisions. 5. Your organization has a significant amount of inventory sales (Part VIII, Question 10) If this is true, or if you store inventory in a warehouse in a different state, you may be exposed to sales tax and

9 other regulation under state taxing authorities. Although nonprofits are exempt from income tax, they are not exempt from sales tax or sales tax collection responsibilities. 6. You have offices, employees and/ or independent contractors in a foreign country (Schedule F) You may have created a taxable presence in a foreign country. A U.S. tax exemption does not mean an organization is exempt from tax elsewhere. You ll need to determine whether foreign income tax or Value Added Tax (VAT) reporting requirements exist and whether your organization is in compliance with those requirements. You ll also need to assess whether further action is necessary to avoid establishing an unintended taxable presence in a country. This type of foreign activity may also trigger employment tax reporting and withholding requirements, not only in the U.S. but also the foreign country. Employees, too, may face individual tax reporting requirements in foreign countries where they are working. You should carefully review these workabroad arrangements for compliance and to ensure your employees are aware of their non-u.s. filing requirements. 7. Your organization has established foreign subsidiaries (Schedule F) Compliance in this area requires knowledge of the tax laws, regulations and other requirements for the countries in which you do business. For any foreign entity, you will also need to ensure that U.S. international tax compliance reporting is included with your Form 990 or 990-T. If you fail to file the additional forms, your organization may face significant penalties typically $10,000 per form missed per year. 8. You have outstanding liabilities associated with tax-exempt bond issues (Schedule K) Your organization could easily become noncompliant if it is not vigilant regarding the rules related to spending bond proceeds and the use of bond-financed property. Good post-issuance compliance is critical in order to maintain the taxexempt status of the bonds. The rules must be met for as long as the bonds are outstanding. 9. You have more 1099s than Forms W-2 (Part V, Questions 1 and 2) If this is true, or if you ve disclosed compensation for your organization s employees under Part VII but did not disclose forms W-2, you could be improperly classifying workers as independent contractors or employees. Failure to classify workers properly can not only lead to penalties; it can also subject your organization to 8

10 audits from Federal and state tax authorities, the Department of Labor and other regulatory agencies, especially if a misclassified worker quits and files for unemployment benefit. 10. You believe or indicate that you ve followed the correct process for determining executive compensation (Part VI, Question 15) The IRS rules for determining whether an executive s compensation is reasonable and not excessive sound simple: approve the arrangement in advance by an authorized body, obtain and rely on comparable data, and document the basis for the determination. While you may believe you re following these rules to the letter, you may need to adapt your policies to establish the Rebuttable Presumption of Reasonableness that shifts the burden to the IRS to prove that compensation is not reasonable. Many organizations check the yes boxes indicating they ve followed the right process, but may not take all the steps to ensure compliance, including: Adding a compensation study to comply with the comparability component; and Documenting compensation committee meeting minutes that satisfy IRS requirements, with adequate detail who participated in the meeting, what was discussed, what competitive data was relied upon and the results of any vote or decisions made. Failure to fully comply leaves the board and those who can influence the organization at risk of potential intermediate sanctions. 11. You have a taxable, related organization in which you do business (Schedule R) There are special tax rules for exempt organizations that have taxable subsidiaries. Income from the taxable subsidiary to the parent exempt organization that would otherwise not be taxable may become taxable. You need to take precautions to maintain separation so the taxable subsidiary does not threaten your tax exemption with significant unrelated business activities through an agency relationship. Your organization should also have a transfer pricing study to substantiate any charges and reduce your exposure to penalties. 1`1

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