The Cooperative Accountant - Spring 2022

1

Spring 2022 | The Cooperative Accountant

82 ––––––––––– EXECUTIVE COMMITTEE AND NATIONAL DIRECTORS –––––––––––––

PRESIDENT: *William Miller, CPA Electric Co-op Chapter Bolinger, Segars, Gilbert & Moss, LLP 8215 Nashville Avenue Lubbock, TX 79423

CONTENTS FEATURES 3

From the Editor

4

Utility Cooperative Forum: Should our company “on or lease” our fleet equipment

By Frank M. Messina, DBA, CPA

By Peggy Maranan, CPA, MBA, Ph.D.

10 ACCTFAX Bulletin Board

By Editor Greg Taylor, MBA, CPA, CVA; and Assistant Editor Bill Erlenbush, CPA

19 TAXFAX

By George W. Benson; Ross S. Reiter; Christopher Herman; Brian Watkins

28 Small Business Forum: Are the DOAs the New Coops?

By Barbara A. Wech, Ph.D.; Chris Edmonds, PhD; Jennifer Echols Edmonds, PhD; Ryan Leece, PhD, CPA

32 Best Practices: 5 Steps to Prevent Fraud

(806) 747-3806 bmiller@bsgm.com

VICE PRESIDENT: *Nick Mueting (620) 227-3522 Mid-West Chapter nickm@.lvpf-cpa.com Lindburg, Vogel, Pierce, Faris, Chartered P.O. Box 1512 Dodge City, KS 67801

EXECUTIVE COMMITTEE SECRETARY-TREASURER: *Dave Antoni Capitol Chapter KPMG, LLP 1601 Market St. Philadelphia, PA 19103

President David Antoni, CPA KPMG, LLP

(267) 256-1627 dantoni@kpmg.com

IMMEDIATE PAST PRESIDENT: *Jeff Brandenburg, CPA, CFE (608) 662-8600 Great Lakes Chapter jeff.brandenburg@cliftonlarson ClifftonLarsonAllen LLP 8215 Greenway Boulevard, Suite 600 Middleton, WI 53562

Vice President Eric Krienert, CPA Moss Adams LLP

*Indicates Executive Committee Member

Treasurer NATIONAL OFFICE Erik Gillam, CPA Kim Fantaci, Executive Director Aldrich CPAs +Advisors Jeff Roberts, Association Executive Tina Schneider, Chief Administrative Officer

136 S. Keowee Street Dayton, Ohio 45402 info@nsacoop.org

Krista Saul, Client Accounting Manager Bill Erlenbush, Director of Education

Secretary Kent Erhardt CoBank, ACB

Phil Miller, Assistant Director of Education THE COOPERATIVE ACCOUNTANT

Winter 2018

Immediate Past President Nick Mueting, CPA Lindburg, Vogel, Pierce, Faris, Chartered

At Large April Graves, CPA United Agricultural Cooperative Inc.

For a complete listing of NSAC’s National Board of Directors and Committees, visit

www.nsacoop.org 2

Spring 2022 | The Cooperative Accountant

From the

Editor

Frank M. Messina, DBA, CPA Alumni & Friends Endowed Professor of Accounting UAB Department of Accounting & Finance Collat School of Business CSB 319, 710 13th Street South Birmingham, AL 35294-1460 • (205) 934-8827 fmessina@uab.edu

The Cooperative Accountant (TCA) is beyond pleased and excited that Greg Taylor has accepted the role and will be replacing a legend in Phil Miller in editing the ACCTFAX portion of TCA. Greg has a storied career in public accounting and with NSAC. Greg grew up on a six-hundred acre cattle and cotton farm south of Ralls, Texas. He is a shareholder with D. Williams & Co., P.C. in Lubbock, Texas, and oversees the firm’s assurance, litigation support and valuation services. He has extensive experience with many types of agri-business entities including all facets of the cotton and cottonseed processing industries, grain merchandising, farm supply, fertilizer production, and wholesaleretail operations. His experience also includes banks and financial institutions and not-for-profit and governmental entities. His litigation support and valuation experience includes services to debtors-in-possession and creditor committees in bankruptcy proceedings, and civil and criminal cases. He joined D. Williams & Co., P.C in 1989 after working with Doshier, Pickens & Francis, P.C. in Amarillo, Texas and in the Lubbock office of KPMG Peat Marwick.

Greg received his B.B.A. in finance and accounting from West Texas State University (now West Texas A&M University) in 1983 and his M.B.A. from West Texas State University in 1988.

Greg holds the CVA designation (Certified Valuation Analyst) and is a member of NACVA. He is also a member of the Lubbock Cotton Exchange, the National Association of Bankruptcy Trustees (NABT), the AICPA, TSCPA and the Texas Chapter of the National Society of Accountants for Cooperatives (NSAC). Greg served as the National President of NSAC in 2008-2009. He also served NSAC as the chairman of the Accounting and Auditing Committee (2002 – 2013), in that capacity he consulted with the staff and members of the Financial Accounting Standards Board (FASB) regarding the impact of proposed accounting pronouncements on the cooperative sector. In 2013, NSAC recognized Greg for his efforts on behalf of NSAC and cooperatives with the Silver Bowl award.

An Eagle Scout and active Boy Scout volunteer, he currently serves the South Plains Council BSA as Treasurer and was Council President in 2013 and 2014.

Greg has three children, Nicole 30 (a graduate of UC Berkeley and Princeton and a research scientist with BristolMeyers Squibb), Jackson 18 (a freshman at the University of Oregon studying architecture), and Mason 15 (a sophomore at Lubbock High School). His wife, Jill, a native of Lamesa, Texas is also a CPA and works as a corporate controller in private industry.

Welcome Greg, our new ACCTFAX forum editor.

Remember, we too are always looking for you to share your knowledge since you may have some extra time on your hands (like others continue to do) with us through articles in The Cooperative Accountant. Feel free to contact me (fmessina@uab.edu) if you have any ideas or thoughts on a potential article contribution. Sharing knowledge is a wonderful thing for all!!! Knowledge can change our world!

That is why we must remember – “The Past is history; the Future is a mystery, but this Moment is a Gift – that’s why it’s called the Present.”

Positively Yours, Frank M. Messina, DBA, CPA Articles and other information which appear in The Cooperative Accountant do not necessarily reflect the official position of the NATIONAL SOCIETY OF ACCOUNTANTS FOR COOPERATIVES and the publication does not constitute an endorsement of views or information which may be expressed.

The Cooperative Accountant (ISSN 0010-83910) is published quarterly by the National Society of Accountants for Cooperatives at Centerville, Ohio 45459 digitally. The Cooperative Accountant is published as a direct benefit/ service to the members of the Society and is only available to those that are eligible for membership. Subscriptions are available to university libraries, government agencies and other libraries. Land Grant colleges may receive a digital copy. Send requests and contact changes to: The National Society of Accountants for Cooperatives, 7946 Clyo Road, Suite A, Centerville, Ohio 45459.

3

Spring 2022 | The Cooperative Accountant

The decision whether to “own or lease” company fleet equipment has been seen by many historically as a financial decision. But there may be other good reasons to consider one option over the other. Some of the non-financial reasons to choose leasing may include the constant influx of new equipment technologies and an ever-growing shortage of qualified automotive technicians. In the past, leasing had been favored by sizable fleets that run standard equipment on shorter trade cycles. But, increasingly, more companies of all sizes are looking at all options which could include outright ownership, finance leasing, full-service leasing, or some combination of these options. Full-service leasing includes the use of the vehicle for a set number of years, repairs and maintenance not caused by accident or abuse, and potential other services bundled into the monthly lease payments. Financing leases are generally done through a financial institution, and the lessee maintains control over how the equipment is managed and maintained. A purchase can be either with cash or through financing, and all responsibility and expenses related to the vehicle remain with the 4

Editor & Guest Writer Peggy Maranan, Ph.D. DEMCO Director, Finance 16262 Wax Road Greenwell Springs, LA 70739 Phone 225.262.3026 Cell: 239.887.0131 peggym@DEMCO.ORG

purchaser. A fleet could vary depending on the needs of your company and might encompass a range of vehicles and machinery, including commercial motor vehicles, mobile construction machinery, trucks, trailers, vans, and specialty-use vehicles.

Leasing could offer the opportunity to operate newer equipment more frequently.

This could lead to benefits such as reduced emissions, safety improvements, and better driver retention and recruitment since drivers prefer to operate newer equipment. By contrast, when fleet assets are purchased, the company has full control and ownership over what happens throughout their entire service life. If leasing, the leasing company may limit use during the lease period so they can be re-sold or re-leased at the end of the leasing period. In contrast, if owned, vehicles can be used until they can’t be used anymore.

The decision depends on the organization, how much fleet equipment is needed, and what resources the organization can devote to owning and maintaining them. Some organizations see fleet management as a core Spring 2022 | The Cooperative Accountant

UTILITY COOPERATIVE FORUM

competency, can do it well, and keep owning their fleet as a result.

An unbiased analysis should be prepared to compare owning versus leasing as it relates to your organization’s circumstances in order to decide on the options that are right for your company. Factors such as the type of operation, fleet requirements, organizational preferences, miles driven and driving conditions, and financial considerations can influence the decision.

There are pros and cons to each option. The analysis should be completed periodically, depending on when it makes sense to update the last analysis. It is important to consider the timing and goals of any analysis, for instance “why now”, what has or hasn’t changed since the last analysis, and who is requesting the analysis. The decision to “own or lease” is not the sole responsibility of the fleet manager, but instead is one that is completed in conjunction with finance and operations personnel. The fleet manager’s role is to serve as the subject matter expert regarding fleet management and fleet operating activities. The financial person’s role is to build the financial model. The role of the operations staff is to provide guidance and direction in evaluating the analysis results, directing the decision to the one that is right for the organization. Final decisions are typically made at senior levels 5

of management. If a fleet manager learns that the option that is determined to be the most cost effective is not the one currently in use, and the company decides to make a change, the impacts could be dramatic to the fleet management area. This could result in requiring new processes, new suppliers, and a different way to manage fleet activities.

For instance, budgeting, warranty tracking, and administrative duties (i.e. tag renewals, insurance renewals, etc.) would change. A fleet manager’s participation in the decision making process is critical because that person will have to live with the consequences resulting from the decision.

The own versus lease financial calculation continues to be a straightforward one. But the bigger challenges have been around the increasing cost of equipment, the growing complexity and more frequent deployment of new vehicle technology, and the maintenance costs associated with it all. With ownership or finance leasing options, a company will be required to recruit and retain qualified, trained technicians to ensure proper vehicle upkeep and repair. Equipment today is becoming more obsolete faster, and qualified technicians can be increasingly more difficult to come by, which is causing the full-service lease option to become more popular. By relying on a full-service lease arrangement, a company is depending upon a third party provider to maintain the fleet. Advantages of a full-service lease could include decreased fleet downtime and eliminating the challenges that come with maintaining inhouse fleet maintenance operations.

When preparing an analysis as to available options, basing the decision on functional obsolescence for how many years the fleet can be operated is an outdated decision model. Instead, Cullen (2018) cites Holland, president and CFO of Fleet Advantage, as noting that a company “should look at economic obsolescence, which uses data and analytics to determine how many years each individual truck should be operated” (Cullen, The Reasons Why section, para. 4).

Spring 2022 | The Cooperative Accountant

UTILITY COOPERATIVE FORUM Cullen refers to this as the “tipping point” or that point where it costs more to maintain and fuel an existing vehicle than it does to replace it with a new one.

Merchants Fleet (n.d.) offers a quick look at the advantages and disadvantages of fleet leasing versus owning, which are presented in Table 1 below.

Merchants Fleet also offers a decision tree on the lease versus buy decision, as shown on the next page in Table 2.

Some of the components or pieces of information that need to be gathered to create the financial model include cost of the vehicle, discounts or rebates offered, sales tax, balance subject to lease charges, term of

lease, security deposits, monthly payments, interest rates paid, residual value or loan balance at maturity date, any tax savings.

The goal is to measure total cost of ownership over the life of each vehicle for each own versus lease scenario for comparison purposes. Costs to capture include financing, maintenance, administration, and licensing.

Cost comparability should include areas of financing costs, asset depreciation and operating expenses, maintenance costs, vehicle mileage, Table 1. Fleet leasing vs. owning analysis Table 1. Fleet leasing vs. owning analysis and administrative Leasing Owning costs. Total cost of ownership analysis Only pay for the portion of the vehicle you use Pay for the entire cost of the vehicle by helps to determine financing or in cash the direct and indirect Lower vehicle acquisition costs Requires significant capital to acquire vehicles costs of each scenario Lower monthly payments Higher monthly payments and provides the cost Monthly payment is matched to vehicle’s Monthly payment is not typically tied to basis for determining market depreciation market depreciation the total economic Flexible leasing terms Inflexible purchasing terms value of each decision choice.

Short-term leasing allows temporary scaling to Under-utilized vehicles are retained for longer meet peak/seasonal demands periods and can be difficult to dispose The ability to get expected resale Save on fuel and maintenance costs Establish equity values at the end More cash flow flexibility More budgeting and forecasting costs of a vehicle’s life is More control over vehicle cycling for lower Longer lifecycles, which can increase nonan important factor non-preventative maintenance expenses preventative maintenance costs in the own versus Cost-effective, simple way to upgrade to Vehicles are cycled less often because of high lease decision. newer models investment costs With increasing Lessor takes care of vehicle disposal Owner must arrange for vehicle disposal technological advances, the leasing More control over vehicle selection and Allows for more vehicle variety standardization option had been gaining popularity Less age-related maintenance problems Owner is responsible for all maintenance and as companies want repairs to avoid the risk of (para. 2) 6

Spring 2022 | The Cooperative Accountant

UTILITY COOPERATIVE FORUM Merchants Fleet also offers a decision tree on the lease versus buy decision, as shown below in Another important concept to build into Table 2. Should you buy or lease your fleet Table 2. the financial model includes net present vehicle?

Table 2. Should you buy or lease your fleet vehicle? value calculations. A dollar spent today is worth more than a dollar spent in the future.

The cost of a fleet vehicle produces a flow of funds from the first day the vehicle is purchased or leased until the day the vehicle is sold. These cash flows occur over a period of time, and when the financial model is constructed it should incorporate the costs being analyzed on the net present value of the after-tax, if applicable, funds flow.

Tax incentives and financial goals of owning versus leasing will depend upon the type of legal entity structure. For example, many cooperatives are non-profit and taxexempt. Other cooperatives are taxable, or own taxable subsidiaries that operate fleet equipment. The Financial Accounting Standards Board had issued a new standard, FASB 13 (ASC 842 under FASB’s new coding structure) (2019), which requires lessees to recognize most leases on their balance sheets as leased liabilities with corresponding rightof-use assets. Equipment leased for more than 12 months must be reported on the balance sheet and can no longer be carried off the balance sheet as had been prior (Finances section, para. 6) practice. Although companies will record declining vehicle values due to obsolescence. an operating lease liability on the balance But the flip side of that risk is that in times of sheet, it will not be classified as debt, so supply chain disruption, as we are currently debt metrics remained unaffected. To further experiencing, there is a shortage of used note, if a full-service lease is entered into, the vehicles causing companies to either hang maintenance charges versus the financing onto equipment longer or obtain higher portion of the lease need to be unbundled. resale values. Given the current lack of The financing portion is recorded to the supply of new vehicles, used vehicles have balance sheet and the maintenance portion seen their values increase. The supply of expensed as a period expense. new and used fleet equipment are both There is more to the own versus lease historically low, and that is a constraint decision than just the financial considerations. for both companies wishing to buy their A major consideration is the availability vehicles and for leasing companies. Most of fleet management services. The fleet fleets have extended the service lives of manager has a broad range of responsibilities vehicles that were scheduled for replacement. besides controlling costs and contributing The consequence of this has been higher to decisions regarding the method of maintenance costs. These new market and procurement. Automotive Fleet (2014) resale market risks should be evaluated in any describes these duties to include: overall “own or lease” decision.

• Ensuring that vehicles are as safe as

7

Spring 2022 | The Cooperative Accountant

UTILITY COOPERATIVE FORUM possible and that company drivers perform quality, maintenance predictability, and their jobs as safely as possible. financing options (Immordino, et al., n.d.).

• Providing for, and managing, the regular Here is an analysis tool that you might find preventive maintenance of those vehicles. useful in evaluating your own versus lease • Managing the purchase of tires and decisions. other repairs, both predictable and • Fleet procurement analysis tool and user unpredictable. guide – published by Atlas Public Policy, • Overseeing the processes for drivers to L.L.C. (2021): report accidents, obtaining replacement m User guide available at https:// transportation, managing and authorizing atlaspolicy.com/fleet-procurementthe repair, and authorizing subrogation analysis-tool/ recovery possible. analysis tool available of the lease needwhere to be unbundled.

The financing portion is recorded to m the Excel balance spreadsheet sheet and the •maintenance Arranging forexpensed the means by expense. which drivers at https://www.atlasevhub.com/ portion as a period can buy fuel, and managing the resulting resource/fleet-procurement-analysisThere is more to the own versus lease decision than just the financial considerations. A major costs of that fuel, all the while tracking the tool/ consideration is the availability of fleet management services. The fleet manager has a broad fuel efficiency of the controlling vehicles costs theyanddrive. range of responsibilities besides contributing to decisions regarding the Summary •method Having a process in place for(2014) vehicle of procurement.

Automotive Fleet describes these duties to include: For cooperatives, owning and operating a administrative needs, such as license • Ensuring that vehicles are as safe as possible and that company drivers their jobs fleet of perform equipment is not typically the core renewals the payment of parking as safely and as possible. business of the organization. It is, though, tickets.

• Providing for, and managing, the regular preventive maintenance of those vehicles. an integral function that is necessary in order (Continued responsibilities section, para. 3) to transport employees and perform work • Managing the purchase of tires and other repairs, both predictable and unpredictable.

The fleet manager is integral in evaluating related to the company’s mission. For this • Overseeing the processes for drivers to report accidents, obtaining replacement the impacts of any own and versus leasethedecision reason, more and more cooperatives are transportation, managing authorizing repair, and authorizing subrogation recovery on these activities. Decisions looking to possibly diversify from ownership wheremanagement possible. to “own or lease” can also hinge on these to a leasing option as ever-changing • Arranging for the means by which drivers can buy fuel, and managing the resulting costs factors, regardless financial outcomes technological of that fuel, all the of while tracking the fuel efficiency of the vehicles they drive. and regulatory environments of model calculations. Robinson (2017) present on-going challenges. The “own or • Having a process in place for vehicle administrative needs, such as license renewals and offersthe guidance additional lease” question is not necessarily an either/ payment ofon parking tickets. non-financial considerations as follows in Table 3. or choice, there is no one option that is better (Continued responsibilities section, para. 3) Final own versus lease decisions should be than the other. It really comes down to what The fleet upon managerthe is integral in evaluating the impacts of any own versus lease decision on these based following drivers: customer is the best fit for your company’s financial management activities. Decisions to “own or lease” can also hinge on these factors, regardless service, purchase cost, tax benefits, fleet circumstances and overall operational needs of financial outcomes of model calculations. Robinson (2017) offers guidance on additional flexibility, maintenance expense, maintenance at the time. There could be times when non-financial considerations as follows in Table 3. your fleet may have Table Lease or buy your fleet vehicles?

Table 3. 3.

Lease or buy your fleet vehicles? a mix of all three, Consider LEASING if your fleet: Consider BUYING if your fleet: depending upon (1) Has high vehicle turnover rate (1) Has low vehicle turnover rate the circumstances of your organization. If (2) Requires maintenance in distributed (2) Has lots of wear and tear locations an in-house analysis is not possible, consider Few additional tips: (3) Has infrequently used or specialty-use vehicles hiring a qualified • Look out for potential hidden fees! consultant that (4) Doesn’t prioritize vehicle replacement flexibility specializes in this area • Consider the total cost of leasing and of expertise to assist. operating vehicles

8

Spring 2022 | The Cooperative Accountant

Final own versus lease decisions should be based upon the following drivers: customer service, purchase cost, tax benefits, fleet flexibility, maintenance expense, maintenance quality,

UTILITY COOPERATIVE FORUM

References Automotive Fleet. (November 10, 2014). How to produce a lease vs. buy analysis.

Retrieved February 20, 2022 from the following website: https://www.automotive-fleet. com/155745/how-to-produce-a-lease-vs-buy-analysis Cullen, D. (April 5, 2018). Should fleets own or lease trucks? Retrieved February 20, 2022 from the following website: https://www.truckinginfo.com/279778/should-fleetsown-or-lease-trucks Immordino, J., Singh, S., Stella, D. (n.d.). Own or lease: are you making the right choice for your truck fleet? Retrieved February 20, 2022 from the following website: https://www.donahuetrucks.net/fckimages/Own-or-lease.pdf Merchants Fleet. (n.d.). Fleet vehicles: lease vs. buy, 13-point comparison chart.

Retrieved February 20, 2022 from the following website: https://www.merchantsfleet. com/industry-insights/lease-vs-buy/ Robinson, J. (May 16, 2017). Should you lease or buy your fleet vehicles? Retrieved February 20, 2022 from the following website: https://www.fleetio.com/blog/lease-orbuy-your-fleet-vehicles Articles of Interest: Antich, M. (November 20, 2021). 15 Predictions that will impact the fleet market in CY-2022. Retrieved February 20, 2022 from the following website: https://www. globalfleetmanagement.com/10156480/15-predictions-for-the-fleet-market-in-cy-2022 Antich, M. (July 23, 2021). Strong buying inclinations for fleet vehicles in 2022. https:// www.globalfleetmanagement.com/10147944/strong-buying-inclinations-for-fleetvehicles-in-2022 Birren, J. (n.d.). Should contractors purchase or lease trucks for business? [cost example]. Retrieved February 20, 2022 from the following website: https://www. merchantsfleet.com/articles/contractor-lease-work-truck-business/ Corporate Fleet Services, Inc. (December 5, 2019). Commercial truck leasing vs. owing: which one is the best? Retrieved February 20, 2022 from the following website: https:// corporate-fleet.com/commercial-truck-leasing-vs-owning-which-one-is-the-best/ Penske Truck Leasing. Understanding lease accounting changes. Retrieved February 20, 2022 from the following website: https://www.pensketruckleasing.com/pdfs/ Accounting_TFN_7-23.pdf Vicha, D. (December 15, 2021). The great disruption of 2021 and what it means for 2022. Retrieved February 20, 2022 from the following website: https://hktruck.com/11top-tips-to-winterize-your-fleet-3/ 9

Spring 2022 | The Cooperative Accountant

UTILITY COOPERATIVE FORUM

GENERAL EDITOR Greg Taylor, Shareholder, D. Williams & Co., Inc. 1500 Broadway, Suite 400 Lubbock, TX 79401 (806) 785-5982 gregt@dwilliams.net

By Greg Taylor FASB AMENDS THE LEASE STANDARD TO ALLOW LESSEES THAT ARE NOT PUBLIC BUSINESSES GREATER FLEXIBILITY IN APPLYING INTEREST RATE SELECTION On November 11, 2021, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU 2021-09) that modifies an existing provision of Topic 842 which allows non-public business entities to elect to use a risk-free rate as the discount rate for all leases. The amendments in this Update allow those lessees to make the riskfree rate election by class of underlying asset, rather than at the entity-wide level. The ASU states: “An entity that makes the risk-free rate election is required to disclose which asset classes it has elected to apply a risk-free rate.

The amendments require that when the rate implicit in the lease is readily determinable for any individual lease, the lessee use that rate (rather than a risk-free rate or an incremental borrowing rate), regardless of whether it has made the risk-free rate election.”

The ASU continues: “Under the current guidance, a lessee that is not a public business entity that makes the risk-free rate election is required to use a risk-free rate for all leases.

The amendments in this Update provide more flexibility for those lessees by allowing them to make the election by class of underlying asset, rather than at the entity wide level.

Stakeholders also noted that the interaction between the risk-free rate election and a 10

ASSISTANT EDITOR Bill Erlenbush, CPA NSAC Education Director (309) 530-7500 nsacdired@gmail.com

lessee’s use of the rate implicit in the lease is unclear under current GAAP. The amendments in this Update require that a lessee use the rate implicit in the lease when it is readily determinable, instead of a risk-free rate or incremental borrowing rate.”

Topic 842 becomes effective for private companies for fiscal years beginning after December 15, 2021 (calendar 2022). Early adoption of Topic 842 was allowed. For those companies that have already adopted Topic 842 as of November 11, 2021, the amendments in this update are effective for fiscal years beginning after December 15, 2021 (earlier application is permitted). Entities are required to apply the amendments on a modified retrospective basis to leases that exist at the beginning of the fiscal year of adoption of a final update.

For entities that will adopt Topic 842 as of its effective date and period, the transition provisions of paragraph 842-10-65-1 should be applied. Those provisions require: “that an entity use either of the following transition methods: (1) apply the guidance to existing leases retrospectively with the cumulativeeffect adjustment from transition recognized at the beginning of the earliest period presented or (2) apply the guidance to existing leases on a modified retrospective basis with the cumulative-effect adjustment from transition recognized in the opening balance of retained earnings at the beginning of the period of Spring 2022 | The Cooperative Accountant

ACCTFAX adoption.”

The ASU, including effective date information, is available at www.fasb.org NEW FASB STANDARD ADDRESSES DISCLOSURES BY BUSINESS ENTITIES ABOUT GOVERNMENT ASSISTANCE On November 17, 2021, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU 2021-10) that addresses disclosures by business entities that receive government assistance.

The ASU summary states: “The FASB is issuing this Update to increase the transparency of government assistance including the disclosure of (1) the types of assistance, (2) an entity’s accounting for the assistance, and (3) the effect of the assistance on an entity’s financial statements.

Diversity currently exists in the recognition, measurement, presentation, and disclosure of government assistance received by business entities because of the lack of specific authoritative guidance in generally accepted accounting principles (GAAP). Requiring disclosures about government assistance in the notes to financial statements will provide comparable and transparent information to investors and other financial statement users to enable them to understand an entity’s financial results and prospects for future cash flows.”

The update is intended to apply to business entities that account for a transaction with a government by applying a grant contribution accounting model by analogy to other accounting guidance (for example, (a grant model with IAS 20, Accounting for Government Grants and Disclosure of Government Assistance, or subtopic 958-605, Not-For-Profit Entities – Revenue Recognition).

In further explaining its reasoning for the need for the standard, the FASB states: “Current GAAP has no specific authoritative guidance on the accounting for, or the disclosure of, government assistance received by business entities. The amendments in this Update improve financial reporting by requiring disclosures that increase the 11

transparency of transactions with a government accounted for by applying a grant or contribution accounting model by analogy, including (1) the types of transactions, (2) the accounting for those transactions, and (3) the effect of those transactions on an entity’s financial statements.”

The main provisions are thus: “The amendments in this Update require the following annual disclosures about transactions with a government that are accounted for by applying a grant or contribution accounting model by analogy: 1. Information about the nature of the transactions and the related accounting policy used to account for the transactions 2. The line items on the balance sheet and income statement that are affected by the transactions, and the amounts applicable to each financial statement line item 3. Significant terms and conditions of the transactions, including commitments and contingencies.”

The amendments in the update are effective for all fiscal years beginning after December 15, 2021; early application is permitted.

“Application should be made either (1) prospectively to all transactions within the scope of the amendments that are reflected in financial statements at the date of initial application and new transactions that are entered into after the date of initial application or (2) retrospectively to those transactions.”

The ASU, including effective date information, is available at www.fasb.org.

PROPOSED ASU CONCERNS TROUBLED DEBT RESTRUCTURING AND DISCLOSURES UNDER THE CREDIT LOSSES TOPIC (TOPIC 326) On November 23, 2021, the FASB issued an exposure draft of a proposed ASU encompassing changes to the treatment of loans modified as troubled debt restructurings (TDRs) The comment deadline was December 23, 2021. Quoting extensively from the exposure draft: “Since the issuance of Accounting Standards Update No. 2016-13, Spring 2022 | The Cooperative Accountant

ACCTFAX Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, the Board has provided resources to monitor and assist stakeholders with the implementation of Topic 326. PostImplementation Review (PIR) activities have included forming a Credit Losses Transition Resource Group (TRG), conducting outreach with stakeholders of all types, developing educational materials and staff question-andanswer guidance, conducting educational workshops, and performing archival review of financial reports. The amendments in this proposed Update respond to feedback received during the PIR process.

Issue 1: Troubled Debt Restructurings

by Creditors The amendments in Update 2016-13 require that an entity measure and record the lifetime expected credit losses on an asset that is within the scope of the Update upon origination or acquisition, and, as a result, credit losses from loans modified as troubled debt restructurings (TDRs) have been incorporated into the allowance for credit losses. Investors and preparers observed that the additional designation of a loan modification as a TDR and the related accounting and disclosure are unnecessarily complex and no longer provides decisionuseful information.

Issue 2: Vintage Disclosures—Gross Writeoffs Stakeholders noted that there is an inconsistency in the requirement for a public business entity to disclose gross write-offs and gross recoveries by class of financing receivable and major security type in the vintage disclosures referenced in paragraph 326-20-50-6 and Example 15 in paragraph 326-20-55-79. Investors and other financial statement users observed that disclosure of gross write-offs by year of origination provides important information that allows them to better understand changes in the credit quality of an entity’s loan portfolio and underwriting performance.”

The most important revision concerns issue 1, thus the following extensive quotation from the proposed ASU explains how the main provisions would differ from current GAAP: 12

“Issue 1: Troubled Debt Restructurings by Creditors Current GAAP provides an exception to the general recognition and measurement guidance for loan restructurings and refinancings that an entity determines meets specific criteria to be considered a TDR. Modifications are TDRs, and thus are subject to different accounting guidance, if they are made to borrowers 3 experiencing financial difficulty and if the creditor has granted a concession.

If a modification is a TDR, an incremental expected loss, if any, is recorded in the allowance for credit losses upon modification.

Certain concessions can be captured only through a discounted cash flow or reconcilable model, and, therefore, discounted cash flow models are required for measurement of some TDRs. Additionally, specific disclosures are required for TDRs. The amendments in this proposed Update would eliminate the TDR recognition and measurement guidance and, instead, require that an entity evaluate (consistent with the accounting for other loan modifications) whether the modification represents a new loan or a continuation of an existing loan. The proposed amendments would enhance existing disclosure requirements and introduce new requirements related to modifications of receivables made to borrowers experiencing financial difficulty.”

The main provisions of the proposed ASU are: Issue 1: Troubled Debt Restructurings by Creditors The amendments in this proposed Update would eliminate the accounting guidance for TDRs by creditors in Subtopic 310-40, Receivables—Troubled Debt Restructurings

by Creditors, while enhancing disclosure requirements for certain loan refinancings and restructurings by creditors when a borrower is experiencing financial difficulty. Specifically, rather than applying the recognition and measurement guidance for TDRs, an entity would apply the loan refinancing and restructuring guidance in paragraphs 31020-35-9 through 35-11 to determine whether a modification results in a new loan or a continuation of an existing loan.

Spring 2022 | The Cooperative Accountant

ACCTFAX Issue 2: Vintage Disclosures—Gross Writeoffs For public business entities, the amendments in this proposed Update would require that an entity disclose current-period gross write-offs by year of origination for financing receivables and net investments in leases within the scope of Subtopic 32620, Financial Instruments—Credit Losses— Measured at Amortized Cost.”

The proposed ASU, specific queries the board had for respondents, and the proposed effective date information, is available at www. fasb.org PROPOSED ASU CONCERNS LIABILITIES AND SUPPLIER FINANCE PROGRAMS On December 20, 2021, the FASB issued an exposure draft of a proposed ASU encompassing disclosures concerning supplier finance program obligations. The comment deadline is March 21, 2022. In its summary and questions for respondents, the FASB offered this rationale for the proposed ASU: “The Board is issuing this proposed update to enhance the transparency of supplier finance programs. Stakeholders have observed that there is a lack of transparency about supplier finance programs because (1) there are no explicit disclosure requirements in generally accepted accounting principles (GAAP) for those programs and (2) a buyer party (described below) may present obligations covered by those programs in the same balance sheet line item as accounts payable or in another balance sheet line item depending on the facts and circumstances of the arrangement. The amendments in this proposed Update address investor and other financial statement user requests for additional information about the use of supplier finance programs (the programs) by the buyer party to understand the effect of those programs on an entity’s working capital, liquidity, and cash flows.”

There seem to be a fairly large group of businesses that are using a supplier finance program as a form of credit for their business and a way to pay their vendors sooner than 13

would be required under normal terms of trade credit. The FASB offers this description of an arrangement: “Typically, a buyer in a program (1) enters into an agreement with a finance provider or an intermediary to establish the program, (2) purchases goods and services from suppliers with a promise to pay at a later date, and (3) notifies the finance provider or intermediary of the supplier invoices that it has confirmed as valid. Suppliers may then request early payment from the finance provider or intermediary for those confirmed invoices.”

The main provisions are: “The amendments in this proposed Update would require that a buyer in a supplier finance program disclose sufficient information about the program to allow a user of financial statements to understand the program’s nature, activity during the period, changes from period to period, and potential magnitude. To achieve that objective, the buyer would disclose the following information about a program: 1. The key terms of the program 2. For the obligation amount that the buyer has confirmed as valid to the finance provider or intermediary: a. The amount outstanding (that is, the amount that remains unpaid by the buyer) as of the end of the period (the outstanding confirmed amount) b. A description of where that amount is presented in the balance sheet c. Changes in that amount during the period, including the amount of obligations confirmed and the amount subsequently paid.”

These provisions differ from current GAAP as follows: “Currently, there are no explicit GAAP disclosure requirements that provide transparency to an investor or other user about a buyer’s use of the programs over time. The amendments in this proposed Update would improve financial reporting by requiring new disclosures about the programs, thereby allowing financial statement users to better consider the effect of the programs on an entity’s working capital, liquidity, and cash flows.

The amendments in this proposed Update would not affect the recognition, measurement, Spring 2022 | The Cooperative Accountant

ACCTFAX or financial statement presentation of obligations covered by supplier finance programs.”

The proposed ASU, specific queries the board had for respondents, and the proposed effective date information, is available at www. fasb.org RECENT ACTIVITIES OF THE PRIVATE COMPANY COUNCIL The Private Company Council (PCC) met on Friday, December 17, 2021. Below is a brief summary of topics addressed by the PCC at the meeting:

• Profits Interests and Their Interrelationship with Partnership Accounting: FASB staff updated the PCC on the comprehensive research (including outreach) conducted by the staff and Working Group on the issue of determining the appropriate scope of guidance for profits interest awards (such as Topic 710, Compensation—General, or Topic 718, Compensation—Stock Compensation). PCC members discussed the research findings, observations on current diversity in practice, and the scope and objective of a potential project. PCC members also discussed what form potential solutions might take if a project were added to the PCC’s technical agenda. FASB staff will provide an analysis of the FASB agenda criteria for discussion at future PCC technical agenda consultation group and PCC meetings. FASB staff also will present a summary of the research and outreach performed on other issues (implied performance conditions, classification as liabilities or equity, and measurement) at a future meeting.

• FASB Agenda Consultation Research Project: FASB staff updated the PCC on private-company-specific feedback received in response to the June 2021 FASB Invitation to Comment, Agenda Consultation, which had a comment deadline of September 22, 2021. PCC members discussed specific topics, 14

including disaggregation of financial reporting information, presentation of the statement of cash flows, reduction of unnecessary complexity in certain areas of GAAP, such as debt modifications, distinguishing liabilities from equity, and consolidation, and accounting for certain emerging transactions, such as environmental, social, and governance related transactions, digital assets, intangibles, software costs, and financial key performance indicators. Throughout the various topical discussions, PCC members encouraged the Board to continue to simplify language in the Financial Accounting Standards Codification® and continue to consider the Private Company Decision-Making Framework and attributes specific to private companies when considering potential changes to the FASB’s technical agenda.

• Share-Based Payment Disclosures: The PCC discussed the disclosures required

by Topic 718, Compensation—Stock Compensation. PCC members shared their views on areas of potential private company relief from the stock compensation disclosure requirements and the decisionusefulness of the required disclosures for private company financial statement users. The PCC Chair noted that the PCC will consider its discussion and determine whether it wants to move forward on further evaluating stock compensation disclosures, including conducting user outreach.

• Joint Venture Formations: FASB staff updated the PCC on recent project activity including the measurement and recognition alternatives considered by the Board to account for joint venture formations in their separate financial statements. FASB staff summarized significant tentative Board decisions, including that a joint venture would adopt a new basis of accounting upon formation, which would generally result in the joint venture recognizing and initially measuring its assets and liabilities Spring 2022 | The Cooperative Accountant

ACCTFAX at fair value. FASB staff also provided details on the application of a new basis of accounting by a newly formed joint venture and noted that the next steps of the project include distributing a draft of a proposed Accounting Standards Update for external review, summarizing external review comments, addressing remaining sweep issues, and asking the Board for permission to ballot a proposed Update. A PCC member indicated support for the Board’s tentative decisions.

• Leases: FASB staff updated the PCC on a recent Board decision related to the private company effective date of Topic 842, Leases. Since issuing Accounting Standards Update No. 2016-02, Leases (Topic 842), in February 2016, the FASB has issued two effective date deferrals for certain entities: one in June 2020 and one in November 2019. In November 2021, the Board decided not to provide a third effective date deferral of Topic 842 for entities within the scope of paragraph 842-10-65-1(b) (generally private companies and certain not-for-profit organizations). FASB staff also reminded stakeholders that the staff is available for implementation questions through the technical inquiry system on the FASB website. PCC members encouraged private companies to begin their leases implementation and suggested that the FASB hold a webcast in 2022 focused on leases implementation targeted to private companies.

• Current Issues in Financial Reporting: The PCC Chair noted that while no new financial reporting issues are currently being raised

by PCC members resulting from the current business environment under the COVID-19 pandemic, stakeholders are encouraged to communicate new issues to the PCC. The next PCC meeting is scheduled for Thursday, April 21 and Friday, April 22, 2022.

15

THE FOLLOWING ARE SELECTED TOPICS FROM THE DAILY ACCOUNTING HIGHLIGHTS PUBLISHED BY THOMSON REUTERS – FULL ATTRIBUTION TO DENISE LUGO, WHO WRITES THESE SUMMARIES FOR THOMSON REUTERS February 11, 2022 – Efforts to Revise the Income Statement Slated for FASB debate next week: The FASB on February 16, 2022, will rekindle discussions to revise the income statement, efforts focused on more effectively capturing a company’s performance. The topic ranks first on the list of financial reporting issues investors have said they would like the board to address in the near-term. The FASB on February 16, 2022 will rekindle discussions to revise the income statement, efforts focused on more effectively capturing a company’s performance.

The project is called “disaggregation of performance information” and outranks – as a priority issue for investors – hot button topics like cryptocurrencies, and environmental, social, and governance (ESG), according to prior board discussions.

Investors want to see more detailed income statement line items to better assess future operating results and cash flows of a company as those are items that reveal the health of a business. They also want to know from which nations and localities a company works to glean a sense of risks in relation to earnings, legislation, income taxes, foreign currencies, and reputation.

Next week’s discussions will consider comment letter feedback on June 2021 Invitation-to-Comment (ITC) No. 2021-004, Agenda Consultation, a February 10 board alert says. The meeting will decide the fate of the project, including a path forward.

February 10, 2022 – FASB to Issue Flexible Hedge Accounting Technique MidApril: U.S. accounting rulemakers plan to issue a flexible hedge accounting rule called the portfolio-layer-method mid-April, according to a source. The guidance will allow more than one hedge against a closed portfolio Spring 2022 | The Cooperative Accountant

ACCTFAX of assets. It takes effect next year. The rules will finalize a revised version of Proposed Accounting Standards Update (ASU) No. 2021002, Derivatives and Hedging (Topic 815): Fair Value Hedging—Portfolio Layer Method, which was issued last year for public comment.

February 7, 2022 – Certain Asset Acquisitions under Credit Loss Accounting Rules Moving to One Model, FASB says: The FASB on February 2, 2022, said it would expand the model for credit losses that meet the definition of purchased credit-deteriorated (PCD) assets so that it applies to assets acquired in both business combinations and asset acquisitions with some exceptions.

The decision would change what is required today as credit loss rules make the distinction between PCD and non-PCD assets, though both business combinations and acquired assets result in most financial assets being recognized at fair value upon acquisition and investors do not differentiate between them.

The PCD model, though not perfect, is more intuitive, according to the discussions.

January 27, 2022 – Level at Which Goodwill is Tested for Impairment Won’t Change, FASB Signals: The FASB on January 26, 2022, tentatively voted 4 to 3 against changing the unit level at which goodwill should be tested for whether its value has dwindled – a win for the investor voices on the board.

If the board were to change from testing for goodwill impairment at the reporting level to the more aggregated operating segment level, it could cause fewer impairments to be recognized which investors do not favor.

“Investors lose hundreds of billions of dollars of market cap as a result of loan acquisitions either through paying too much or poor execution,” FASB member Fred Cannon said. “And I believe that while we move to an amortization model to reflect the cost of the acquisition, if we move completely to that we still miss out on a true economic event and that is measuring actual impairments especially in the early years of acquisitions,” he said.

16

“So I think it’s critically important to maintain as robust an impairment model as possible, if indeed we continue to move toward amortization.”

Goodwill is an accounting term for the figure that is recorded on the balance sheet after subtracting the book value of a business from the higher price that was paid for it.

Goodwill becomes impaired when its fair value declines below its carrying value.

The narrow discussion aimed to give board leanings on whether the impairment testing for the goodwill figure should stay at the reporting unit level, or be changed to the operating segment level in the context of an earlier decision to amortize goodwill.

January 6, 2022 – Companies Want Simpler Accounting Rules That Deal With Raising Capital: Some companies have recently suggested to the FASB that it focuses efforts this year on improving accounting rules surrounding capital raising activities.

Accounting rules for warrants and simple agreements for future equity (SAFEs) are among the most tough to navigate, accounting professionals said.

Some companies have recently suggested to the FASB that it focuses efforts this year on improving accounting rules surrounding capital raising activities.

“A lot of companies are consistently and regularly going to the capital markets, whether it’s for debt or equity and any sort of iteration in between - it can be warrants, preferred stock and other things,” Adam Brown, BDO’s National Managing Partner–Accounting, said on January 4, 2022. “So simplifying that area, hopefully reducing restatements in that area - there’s a whole laundry list of potential narrow issues that would make life a little more straight forward for the folks who are raising capital – the ones who are borrowing, issuing preferred stock or common or whatever,” he said.

A warrant is an option to purchase a certain number of a company’s shares at a pre-determined price, within a defined time Spring 2022 | The Cooperative Accountant

ACCTFAX period, according to a published definition by Accounting Tools, Inc. Companies find accounting for warrants to be tough because it involves navigating through multiple accounting guidelines like FASB ASC 480, Distinguishing Liabilities from Equity, ASC 815, Derivatives and Hedging, and ASC 815-40, Derivatives and Hedging: Contracts in Entity’s Own Equity.

January 3, 2022 – Top 5 Issues to Master to Adopt FASB Lease Accounting Rules This Year: Private companies, the largest business demographic in the U.S., have to adopt the FASB’s new lease accounting standard starting this month, but many are still lagging in those efforts.

Early adopters caution that the rules can bulk up balance sheet liabilities which could have debt covenant implications.

“We have a huge increase in finance leases as a result of 842,” said Douglas Uhl, principal team leader, corporate accounting policy at Chick-fil-A, Inc., during the FASB’s advisory meeting in December. “That was something we had to work with our debt holders internally - now we’re going to have all these debtlike liabilities on our balance sheet,” he said.

“Nothing has changed economically with our leases, it’s simply a nuance of the classification guidance that changed.”

Topic 842, Leases, also referenced as Accounting Standards Update (ASU) No. 2016-02, Leases, requires companies to report the full magnitude of their long-term lease obligations on the balance sheet - a historic first in the U.S. The rules took effect in 2019 for public companies, but were deferred twice for private companies and will take effect after December 15, 2021, i.e. January 1, 2022 for calendar year-end filers. Earlier adoption is permitted.

Companies generally use accounting software vendors when applying new standards, but should not wait too late to get on their radar, FASB discussions indicated.

Some CFOs are having problems accessing software vendors, Holly Nelson, chief 17

executive officer at Key Advisory Services, said.

“Everybody put it off until the last minute, and were having trouble implementing because they need the software vendor to do things and they’re stacked up with all of the different companies,” she said.

Lease accounting software vendors said surveys they have taken show most private companies have not yet adopted the rules.

They flagged the following as the top five issues to pay attention to:

• Developing a Process to Create the Inventory of Leases. Putting together a cross departmental team from divisions such as real estate, procurement, legal, IT in order to identify all leases. “One of the biggest challenges that companies face with the new lease accounting standard is just identifying where all their leases are,” Joe Fitzgerald, Senior Vice President of Lease Market Strategy at Visual Lease, said on December 28, 2021. “What we find with companies is that their real estate leases tend to be somewhat centralized in the organization – that they kind of have a handle on where they are and who they’re with – while nonreal estate leases – vehicles, IT equipment, etc. – tend to be very decentralized and not always readily available,” he said. “So, you really will need to get a complete population of your leases together, which is one of the first steps and it will be one of the things I can guarantee that your auditors are going to kick the tires on and test you on when they come in to do their audit at the end of the year.”

• Accounting Policies on Adoption. The standard includes three practical expedients that have to be selected as a package, but there are other policies that a company needs to go through and select when determining materiality thresholds. For private companies especially important is determining how they are selecting a discount rate - whether using an incremental borrowing rate, or a risk free rate. The FASB recently provided accommodations Spring 2022 | The Cooperative Accountant

ACCTFAX for private companies that allow them to select a risk free rate by class of assets. “I think it’s going to be important for private companies to think through all of these elections,” Jennifer Booth, accounting vice president of Georgia-based LeaseQuery, said on December 27. “Start documenting those and along with that the impact on your financial statement that this whole lease process has,” she said. If in this process the company identifies that it did not have some of its leases accounted for, it has to go back and consider the implications under Topic 840, Leases, and then start accounting for them under Topic 842. “You can’t just say ‘oops I didn’t do it historically, I’ll forget about those,’” Booth said.

• Company Expertise on ASC 842. Public companies that adopted the rules had staff that sufficiently understood Topic 842 and could manage the whole project, which requires a team effort, the vendors said. Others outsourced the work. Private companies that do not have personnel that are versed on Topic 842 would likely need to hire a consultant to join their team. A major part of the work is extracting data such as a lease commencement date, lease payments, term options, and the discount rate.

• Software. Software should not only handle the initial adoption but also go-forward entries on a monthly basis and required disclosures. “A good software will allow you to say ‘I have a modification, these are my changes’ and it will process the accounting for you,” said Booth. “What we’ve seen some public companies get pigeon holed on is they set up their software to be the old process, the way they used to do it, instead of ‘how can the software function into the company’s new control environment and new controls and new processes,’” she said.

• The Day Two Implications. Leases are very dynamic so while there is an initial asset and liability that needs to be booked on the balance sheet it is not a “set it and forget it” because leases are going to change literally day two. “This is not a one and done, said Fitzgerald. “So if you book it at effective January 1, as early as the next day a company may have new leases are coming on, old leases going off, there’re amendments to the leases, particularly in the real estate arena - very dynamic,” he said.

“So those changes and those modifications could result in what we call in accounting ‘subsequent measurement’.”

Note to our members and readers. Phil Miller, who wrote and edited this section of The Cooperative Accountant for thirty-five years completed his last ACCT-FAX column with the Winter edition. No one can really fill the role that Phil occupied for so long and so well. I have known Phil for almost thirty years now and have come to rely on his wise insight and measured, capable assessments. I count his friendship and collegial efforts among the highlights of my career in working with cooperatives. I agreed to take on the role as I believe it’s an important part of this publication and important information for our membership. While the sources of information concerning developments in the accounting standards process have certainly increased over time, and the speed with which information can be disseminated and feedback obtained have made quantum leaps, The Cooperative Accountant remains the source of record for our membership. My goal in editing this section of the publication is to continue to provide timely information that is needful for our members.

As we go forward I will probably have less material on SEC developments and IASB developments and more material concerning developments at the AICPA’s auditing standards board. I will also aim to highlight issues that are of particular concern to those of us working with Agricultural and Rural Electric Cooperatives. Any feedback from the reading membership is greatly appreciated. – Greg Taylor 18

Spring 2022 | The Cooperative Accountant

TAXFAX EDITOR George W. Benson Counsel McDermott Will & Emery LLP 444 West Lake Street, Suite 4000 Chicago, Illinois 60606-0029 tel: (312) 984-7529 fax: (312) 984-7700 e-mail: gbenson@mwe.com

Research Credit Update

By Ross S. Reiter; Christopher Herman; & Brian Watkins The federal Section 41 Credit for Increasing Research Activities (“R&D Credit”) is an intriguing opportunity for cooperatives to claim a dollar-for-dollar tax credit against their tax liability for the year based on their qualified research expenses and a 20year carryforward of any unused credit to offset tax liabilities in future tax years.

However, the IRS and U.S. Tax Court have recently indicated heightened requirements for taxpayers to provide supporting information to substantiate their R&D Credit claims. On October 15, 2021, the IRS released IR-2021-203 (October 15, 2021) and Chief Counsel Memorandum 20214101F (September 17, 2021) (the “Memorandum”), providing detail regarding what information taxpayers must provide to the IRS to substantiate a refund claim for the R&D Credit, how the information must be formatted, and specified the statute of limitations period for such a refund claim. Subsequently, the IRS has issued interim guidance in LB&I-04-0122-0001 and released a set of FAQs describing the new requirements and how R&D Credit claims will be processed by the IRS in the future. The FAQs are available at: https://www.irs.gov/ businesses/corporations/research-credit-claims-section-41-onamended-returns-frequently-asked-questions.

This Memorandum comes after two important memorandum opinions were issued by the U.S. Tax Court on the issue, Siemer Milling Company v. Commissioner, T.C. Memo 201937, in 2019 and Little Sandy Coal Company v. Commissioner, T.C. Memo 2021-15, in 2021.

19

GUEST WRITERS Ross S. Reiter Managing Director, Accounting Methods and Credit Services KPMG LLP 1601 Market Street Philadelphia, PA 19103 rsreiter@kpmg.com 267-256-2681 Christopher Herman Senior Associate, Accounting Methods and Credit Services KPMG LLP 1601 Market Street Philadelphia PA 19103 cherman@kpmg.com 267-256-1943 Brian Watkins Washington National Tax, Accounting Methods and Credit Services KPMG LLP 1601 Market Street Philadelphia, PA 19103 brianwatkins@kpmg.com 267-256-7000

Spring 2022 | The Cooperative Accountant

TAXFAX What is the Research Credit?

The federal R&D Credit, as set forth in IRC section 41, is a credit available to taxpayers for increasing their qualified research expenses (“QREs”) during the applicable tax year. QREs include wages paid for performing qualified research activities, expenses for supplies used in conducting qualified research activities, and contract research expenses for qualified research activities performed on behalf of the taxpayer by a non-employee of the taxpayer. Qualified research activities include engaging in qualified research as well as engaging in the direct supervision or direct support of qualified research. Generally, the R&D Credit equals a percentage of the taxpayer’s QREs that exceed a base period calculation based upon the taxpayer’s prior year gross receipts or research expenses.

Qualified research must satisfy a “fourpart test” – 1) the research is related to a new or improved business component’s function, performance, reliability, quality, or composition; 2) the research fundamentally relies on principles of physical sciences, biological sciences, computer science, or engineering; 3) the research is intended to discover information to eliminate uncertainty concerning the capability or method for developing or improving a product or process; and 4) substantially all of the activities of the research must constitute the process of experimentation involving simulation, evaluation of alternatives, confirmation of hypotheses through trial and error, testing or modeling, or refining or discarding of hypotheses.

The R&D Credit was first established in 1981 as an incentive for taxpayers to invest in research and development to drive long-term technical change and innovation. Although the R&D Credit has gone through some iterations since its inception, the R&D Credit still provides a valuable benefit to taxpayers.

Cooperatives may claim the R&D Credit, but in order to receive a current year benefit the cooperative must have sufficient taxable income during the year to apply all or a 20

portion of the R&D Credit against. Without sufficient taxable income, the cooperative may carry any unused R&D Credit forward up to 20 taxable years. Note, however, that the portion of R&D Credits exceeding taxable income cannot be transferred to members of the cooperative generating sufficient income.

The Siemer Milling Company Case On April 15, 2019, the U.S. Tax Court issued its memorandum opinion in Siemer Milling Company.

Siemer Milling Company (“Siemer”) was a wheat milling company that operated two mills in the United States. It consulted with an accounting firm to file an R&D Credit for tax years 2011 and 2012, based on its various research projects during those years. The projects included a flour heat-treatment project, a project involving a Pulsewave machine that reduces the particle size of materials, a wheat hybrids project, an ozone project, a toasting production project, and a whole wheat flour project.

After Siemer filed its tax returns claiming R&D Credit for 2011 and 2012, the IRS audited the returns and issued a notice of deficiency disallowing the R&D Credits claimed for both years. The Commissioner raised a number of arguments as to why Siemer’s projects did not meet one or more prong of the four-part test to substantiate its notice of deficiency, many of which were rejected by the Tax Court, but one of which was accepted.

The Tax Court rejected the following arguments: • First, the Commissioner unsuccessfully argued that Siemer’s projects did not face uncertainty because the projects spanned several years, and the same uncertainty could not exist for more than one year. The court held that there is no requirement that the taxpayer face different uncertainties each year.

• Second, the Commissioner unsuccessfully argued that Siemer’s activities did not rely on principles of engineering, computer science, or physical and biological sciences because Spring 2022 | The Cooperative Accountant

TAXFAX Siemer did not employ anyone with the title of engineer or anyone with an engineering degree. The court held that the taxpayer does not need to employee or contract with someone with a specialized degree to prove a reliance on sciences.

• Third, the Commissioner unsuccessfully argued that Siemer did not establish what business components the projects related to because Siemer was inconsistent in describing the business components of each project, at alternate points stating the projects were to improve processes or to improve products, or a combination of the two. The court held that ultimately the different phrasing in Siemer’s statements was inconsequential and not at odds with one another.

• Finally, the Commissioner argued that a business component must be a new issue during the tax year for research related to that business component to qualify. As was also the case with technical uncertainties, the court ruled there was no requirement business components could not span more than one year.

While these arguments were unsuccessful, the Tax Court did rule on several projects that Siemer failed to establish the technical uncertainty, business component, and technological information qualifications on a basis of a lack of evidence provided by Siemer.

After presenting those failed arguments, the Commissioner successfully argued that Siemer had not shown that it engaged in a process of experimentation with respect to its projects, thereby failing the four-part test. The Court held that Siemer failed to prove that its various projects had “a methodical plan involving a series of trials to test a hypothesis, analyze the data, refine the hypothesis, and retest the hypothesis so that it constitutes experimentation in the scientific sense.” Siemer raised various arguments against the Commissioner’s assertion. It argued summarily for all projects that it engaged in a process of experimentation, 21

that it engaged in a process designed to evaluate alternatives, and that it “ran tests.”

However, for each project, the court stated that it required the description of a scientific process where a hypothesis was formed, tested, and retested. In one instance, Siemer presented the steps in a project’s process but did not demonstrate that it engaged in the testing of a hypothesis.

The Siemer case is an important barometer for the level of detail the IRS, and ultimately the judicial system, requires for a taxpayer’s R&D Credit claim. It is important to note that the court did not conclude that Siemer had not engaged in qualified research activities, but rather concluded that Siemer had not met the four-part test in demonstrating that it had conducted a scientific process. The Tax Court would continue to provide its input on how R&D Credit claims must be substantiated in the Little Sandy Coal Company case.

The Little Sandy Coal Company Case On February 11, 2021, the U.S. Tax Court issued its memorandum opinion in Little Sandy Coal Company. Little Sandy Coal Company (“Little Sandy”) owned a shipbuilding subsidiary, Corn Island Shipyard, Inc. (“CIS”).

Similarly, to Siemer, the court here was tasked with determining whether CIS’ activities met the four-part test and ultimately concluded that they did not. Specifically, the Court concluded that Little Sandy did not establish that CIS’ research activities constituted elements of a process of experimentation, and separately that Little Sandy did not establish that substantially all of CIS’ research activities constituted elements of a process of experimentation.

CIS conducted research activity on two projects of interest to the case during the tax year in question, ending June 30, 2014: a tanker it was designing, partially based on a previously designed vessel, and a dry dock it was designing. Little Sandy argued that the vast majority of the vessel it was designing, including the hull, was re-engineered from the vessel its design was based on. The court Spring 2022 | The Cooperative Accountant

TAXFAX was not persuaded, instead noting that the “substantially all” test applied to the activities conducted, and not the physical elements of the business component being created or improved. The court also declined to follow the holding of the District Court in Trinity Industries Inc. v. United States, 691 F. Supp.

2d 688 (N.D. Tex. 2010), aff’d , 757 F.3d 400 (5th Cir. 2014), where that court concluded that the substantially all test had been met when 80% of the costs the taxpayer incurred in developing its business component were part of a process of experimentation but did not specify how the court made its calculation. Similarly, the Tax Court declined to use CIS’ supply costs as a means to determine a percentage of time spent working on qualified activities with respect to a business component with a process of experimentation.

Little Sandy further argued that its production employees spent at least 87% of their time working on novel components of the tanker. The court again denied this argument, asserting that CIS’ production employees were not in direct support of experimentation by merely fabricating a physical component of the business model to be tested, especially if there are other means of testing the efficacy of a design besides physical experimentation. The use of the physical component in testing after fabrication of the physical component constituted a process of experimentation; however, the fabrication itself of the physical component did not constitute either a process of experimentation or direct support of such experimentation.

There are elements of the court’s opinion in Little Sandy that have been subject to criticism. Specifically, the court appeared to drastically narrow the meaning of direct support of research activities. The court also did not consider that the regulations allow costs to be used as a barometer for whether substantially all of a taxpayer’s research

activities constitute elements of a process of experimentation1. However, the court’s memorandum opinion here is in line with its opinion in Siemer, further indicating a stricter standard for research activities and supporting documentation in R&D Credit claims.

IRS Office of Chief Counsel Issues Memorandum on Research Credit Claim Requirements As noted above, on October 15, 2021, the IRS released IR-2021-203 (October 15, 2021) and the Memorandum. In these, the IRS announced “the information that taxpayers will be required to include for a research credit claim for refund to be considered valid” for refund claims filed on or after January 10, 2022.

IR-2021-203 and the Memorandum set forth three items of support that must be included in a R&D Credit claim going forward: 1) an identification of all business components to which the R&D Credit claim relates for that year; 2) each identified business component must identify all research activities performed, all individuals who performed each research activity, and all the information each individual sought to discover; and 3) the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year.

Previously, and as noted in the Memorandum, taxpayers merely had to set forth in detail each ground upon which a R&D credit or refund is claimed and provide facts sufficient to apprise the IRS of the exact basis thereof. The Memorandum identifies this language as the “specificity requirement.” The Chief Counsel made sure to note that the greater and more detailed the information provided by R&D Credit claimants is, the more expeditiously the IRS may determine which claims warrant detailed examination and can accelerate the speed

1 See Section 1.41-4(a)(5), noting that the substantially all requirement is satisfied if 80 percent or more of a taxpayer’s research activities, measured on a cost or other consistently applied reasonable basis, constitute elements of a process of experimentation.

22

Spring 2022 | The Cooperative Accountant

TAXFAX of the examination if one is conducted. The Chief Counsel also maintained that the requirements are so that taxpayers do not merely rely on a legal assertion, but rather that they provide sufficient facts in their claims. In the event of an insufficient claim, jurisdiction is not conferred to the federal courts. In other words, taxpayers who file insufficient claims in accordance with the requirements of the Memorandum will not have a further avenue of relief.

The Chief Counsel provides various legal bases for its requirements presented in the Memorandum, and in particular summarized Harper v. United States, 123 AFTR 2d 2019-1660 (D. Ca. 2019), rev’d and rem’d, 127 AFTR 2d 2021-1027 (9th Cir. 2021). In Harper, the taxpayers who fully owned Harper Construction Company claimed an R&D Credit on amended tax forms for the 2008 and 2010 tax years, providing no other support beyond that the amendment was due to a claim for the R&D Credit. The refund claims were selected for examination and denied by the IRS, and Harper filed suit. The district court agreed with the IRS, finding that Harper did not meet the specificity requirement, failing to set forth sufficient facts in their claims in dismissing the case for lack of subject matter jurisdiction. However, on appeal, the Ninth Circuit Court of Appeals agreed with Harper, indicating in its 2021 opinion that the IRS waived its right to enforce the specificity requirement by examining and denying the R&D Credit refund claim on the merits. One cannot help but think that the Chief Counsel issued the Memorandum in response to the Harper case, putting more onerous requirements on the taxpayer to allow the IRS to more expeditiously determine whether the specificity requirement has been met, therefore not transferring jurisdiction of the matter to federal courts2.

The Memorandum represents a significant change in reporting requirements for most

typical R&D Credit claims, which usually did not identify each individual with a specific research activity, business component, and information the individual sought to discover.

The American Institute of CPAs (“AICPA”), in a public letter to IRS officials, requested that the IRS delay the implementation of the new requirements to allow adequate time for public comment and to allow the IRS sufficient time to consider and amend the new requirements in response to such comments.

The IRS has since issued additional guidance on implementation in the form of LB&I-040122-0001 and a set of FAQs. The requirements in the Memorandum went into effect on January 10, 2022, and the IRS has since clarified that the requirements apply only to R&D Credit claims made on amended returns.

The end of being able to currently expense research expenses?

The “Tax Cuts and Jobs Act” (TCJA)—signed into law on December 22, 2017—includes certain research and experimentation (R&E) measures that became effective for tax years beginning after December 31, 2021.

Before the enactment of the TCJA, taxpayers had the option to currently deduct R&E expenses or capitalize and amortize R&E over a specified period of time. The TCJA provides that specified R&E expenditures under section 174 paid or incurred in tax years beginning after December 31, 2021, must be capitalized and amortized ratably over a five-year period for research conducted in the United States, and 15 years for research conducted outside of the United States beginning with the midpoint of the tax year in which the specified R&E expenditures were paid or incurred.

This change in law has many impacts and considerations for taxpayers, including cash and effective tax rate, transfer pricing, state and local tax, international tax provisions, and more.

2 Two recent decisions of the U.S. District Court of Utah reached similar conclusions. See, Premier Tech, Inc. v.

United States, 128 AFTR 2d 2021-5220 (D. Utah 2021) and Intermountain Electronics, Inc. v. United States, 128 AFTR 2d 2021-5240 (D. Utah 2021).

23

Spring 2022 | The Cooperative Accountant

TAXFAX Many taxpayers hope that Congress will act to roll back this change. The Build Back Better Act, which is currently stalled in Congress, would have, among other things, delayed the effective date of the TCJA change for four years. It remains to be seen what Congress will do in the upcoming year.

Conclusion As noted above, the R&D Credit is a great opportunity for cooperatives to claim a valuable tax credit for its qualified research activities. However, it is important to note that the IRS and federal courts have recently indicated heightened requirements for supporting documentation. Taxpayer should be aware of ongoing developments on this issue, especially the new reporting requirements set forth by the IRS and the federal courts’ trend of requiring heightened levels of supporting documentation for R&D Credit claims. Furthermore, because of the recent law change for the treatment of R&E for federal income tax purposes, it is prudent for Taxpayers to identify all sources of R&E within the organization.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information specific situations should be determined through consultation with your tax adviser.

This article represents the views of the authors only and does not necessarily represent the views or professional advice of KPMG LLP. Expiring Federal Tax Provisions

By George W. Benson Most provisions of the Internal Revenue Code are permanent, but some are temporary and rely on periodic extenders’ bills for their continued existence. The Joint Committee on Taxation recently released a list of provisions that expired at the end of 2021 and that are scheduled to expire during the next ten years. “List of Expiring Federal Tax 24

Provisions 2021-2031” prepared by the Staff of the Joint Committee on Taxation, JCX-1-22 (January 13, 2022).

The list contains 40 provisions, many of which are specialized credits, which expired in 2021. Rather surprisingly, after earlier in the year extending the employee retention credit through the end of 2021, as part of the Infrastructure Investment and Jobs Act, P.L. 117-58 (November 15, 2021) Congress ended the credit at the end of September, leaving some taxpayers scrambling. Provisions scheduled to expire at the end of 2021 include, most notably, the enhancements (including refundability) to the child tax credit and the add-back of depreciation, amortization, and depletion for purposes of the Section 163(j) interest deduction limitation.

Also, for fiscal years beginning after December 31, 2021, businesses will no longer be permitted to deduct research and experimental expenses (including software development costs) under Section 174.

Rather, they will be required to capitalize and amortize such expenses, over five years if the research is conducted in the U.S. and over fifteen years if it is foreign. Since the line between Section 174 research expenses and Section 162 ordinary and necessary business expenses has never been particularly well defined, having to capitalize research expenses could be troublesome. Many believe that Congress will do something this year to delay this change (a delay was included in the currently stalled Build Back Better Act), but that remains uncertain.

Public companies are wrestling with the impact of this change on their quarterly reporting. Others are considering the impact on estimated tax payments.

The list of provisions expiring at the end of 2022 is shorter. Most notably for cooperatives and their members, the list includes the credit for biodiesel fuel mixtures.

Additional depreciation begins to phase out in 2023 and will generally be fully phased out by 2026.

For tax years beginning on or after Spring 2022 | The Cooperative Accountant

TAXFAX December 31, 2025, 36 provisions are relief under Section 9100. This year’s version ByofBarbara isA.little Wech scheduled to expire. This is the result changed from prior years, but even using a reconciliation process (like that being a casual review of Rev. Roc. 2022-1 should used for the currently stalled Build Back make it clear that there are a lot of rules Better Act) to pass the Tax Cuts and Jobs governing ruling requests.

Act of 2017. The scorekeeping rules for The volume of private letter rulings has reconciliation discourages making permanent declined in recent years. During 2021, for changes. The lower rates authorized instance, there were, for the first time in by the TCJA generally expire after ten recent years, no private letter rulings involving years, but many of the offsetting revenue Subchapter T issues. At one time, the IRS raising provision (such as suspension of welcomed private letter ruling requests, miscellaneous itemized deductions and the viewing them as a way to serve the taxpayer limitation on the deduction for state and local community while at the same time keeping taxes) currently are scheduled to expire at the abreast of issues concerning taxpayers, but same time. that has not been the case in recent years Section 199A is one of the provisions (though the IRS would not publicly admit scheduled to expire for taxable years that). beginning after December 31, 2025. This, • There are certain areas where the IRS will not of course, will be an important time for rule. They are described generally in Rev. Proc. cooperatives and their members since the 2022-1 and a number specific examples are continuation of the special cooperative listed in Rev. Procs. 2022-3 and 2022-7. While provision in old Section 199 ended up as the list of “no-rule” areas has not gotten much Section 199A(g). As a consequence, the longer in recent years, there still are many cooperative domestic production activities questions which are off limits for requests. deduction is scheduled to expire when Generally, the IRS will not rule on factual Section 199A expires. questions. In all cases, the IRS retains the right As noted above, additional first-year to decline to issue a ruling “when appropriate depreciation will be fully phased out at the in the interest of sound tax administration, end of 2026. including due to resource constraints, or on At the end of 2026, the special additional other grounds whenever warranted by the facts depreciation rule for certain plans being fruits or circumstances of a particular case.” The IRS and nuts contained in Section 168(k)(5)(A) also can decide not to accept a request if it is scheduled to expire. At the end of 2027, views what is being requested as a “comfort” the special temporary rule for replanting cost ruling. for citrus plants lost by reason of casualty contained in Section 263A(d)(2)(C)(ii) is • The ruling process has always been slow, which scheduled to expire.

Private Letter Rulings Private letter rulings remain an option for taxpayers, including cooperatives, seeking guidance as to the tax results in appropriate situations.

At the beginning of each year, the IRS updates its procedures for requesting private letter rulings. This year’s updated set of procedures is contained in Rev. Proc. 20221. That revenue procedure also contains information about submitting requests for 25

can be a problem when, as is often the case, an issue cannot wait. Currently, rulings appear to take approximately six months from the time of submission, provided there are no special problems.

• The IRS recently announced a pilot program for responding to rulings involving corporate tax issues within 12 weeks. Rev. Proc. 2022-10.

That, of course, does not apply to most ruling requests such as those involving issues peculiar to Subchapter T. Spring 2022 | The Cooperative Accountant

TAXFAX •

The IRS now charges a substantial “user fee” for ordinary ruling requests, namely, $38,000. For the first time in several years, this fee was not increased this year, but the size of the fee discourages casual requests.

Any decision to request a ruling should involve an analysis of what will happen if the IRS does not agree with the taxpayer’s view as to the proper outcome.

There are ways to sound out the IRS National Office before a request is submitted (including having a formal pre-submission conference). Taxpayers have the right to a meeting in the IRS National Office if, after a ruling has been submitted, the IRS indicates that it is tentatively adverse. A taxpayer can always withdraw a request if it cannot convince the IRS National Office to reach the “right” result. When this is done, the IRS will not refund the user fee. In addition, the IRS National Office “generally will notify, by memorandum, the appropriate Service official in the operating division that has examination jurisdiction of the taxpayer’s tax return.”

This may increase the risk of controversy if the taxpayer proceeds after the withdrawal to take the position that it argued for in the ruling request.

Taking Employee/Independent Contractor Disputes to the Tax Court Worker classification issues continue to arise from time to time. Whether a worker is an employee or an independent contractor is ultimately a factual issue. When the IRS asserts that a worker should have been treated as an employee, it can be prevented by making an adjustment if the employer is entitled to so-called Section 530 relief.

Traditionally, taxpayers that disagreed with IRS worker classification determinations and could not convince Appeals to reverse the determination had to look to a U.S. District Court or the U.S. Court of Federal Claims for relief. This typically involved paying tax for one disputed employee for one quarter, filing a refund claim, and proceeding to court after six months or, if earlier, upon denial of the refund claim.

26

As part of the Taxpayer Relief Act of 1997, Congress granted taxpayers the alternative of taking some worker classification disputes to the Tax Court (which means that they can do so without first having to pay the tax).

Congress did so by adding Section 7436 to the Code.

Not long after Section 7436 was enacted, the IRS released Notice 2002-5, 2002-1 C.B. 320, describing procedures for seeking Tax Court review. Among other things, that notice stated that receiving a Notice of Determination of Worker Classification (“NDWC”) from the IRS is a prerequisite to Tax Court jurisdiction: “Because the Notice of Determination constitutes the Service’s determination described in § 7436(a), the Notice of Determination is a jurisdictional prerequisite for seeking Tax Court review of the Service’s determinations regarding worker classification, § 530 treatment, and the proper amount of employment tax under those determinations. Tax Court proceedings seeking review of these determinations may not be commenced prior to the time the Service sends the Notice of Determination by certified or registered mail.”

It was probably only a matter of time before a case arrived in Tax Court involving a situation where, for whatever reason, the IRS did not issue a NDWC to the purported employer, but in fact made what was for all intents and purposes a determination.

When it did, the Tax Court concluded that an NDWC is not a jurisdictional prerequisite if a determination has in fact been made.

See, SECC Corporation v. Commissioner, 142 T.C. 225 (2014), and American Airlines v. Commissioner, 144 T.C. 24 (2015). In footnote 5 in SECC Corporation, the Tax Court stated that it was disregarding Notice 2002-5 because “[w]e owe no deference to what an administrative agency says about our jurisdictional bounds.” In a concurring opinion, Judge Halpern observed: “Were we to adopt respondent’s position, the Commissioner, by refusing Spring 2022 | The Cooperative Accountant

TAXFAX to issue a notice of determination, would be able to deny the taxpayer access to this Court, which he may be tempted to do whenever he feels his chance of success on a worker classification or RA § 78 sec.

530 issue is better in either the District Court or the Court of Federal Claims than in this Court. There is no basis in section 7436 or as a matter of policy for granting the Commissioner this ‘forum shopping’ discretion, and it would thwart the obvious congressional intent embodied in that provision to permit taxpayers, in their discretion, to litigate, in this Court, worker classification and RA § 78 sec. 530 issues that the Commissioner has raised on audit.”

Recently the IRS withdrew Notice 20025 and replaced it with Rev. Proc. 2022-13, 2022-6 I.R.B. 1 (January 19, 2022). The purpose of this new revenue procedure is to explain, in light of the Tax Court decisions, “when and how the Internal Revenue Service (IRS) will issue a Notice of Employment Tax Determination Under IRS § 7436 (§ 7436 Notice) and how taxpayers petition for Tax Court review of certain IRS determinations…”

The revenue procedure notes that the Tax Court has jurisdiction only if four requirements

are satisfied: (1) the IRS conducts an examination in connection with an audit of any person; (2) as part of the audit, the IRS determines that – (a) one or more individuals performing services for the person are employees of the person for purposes of subtitle C (worker reclassification), or (b) the person is not entitled to relief under section 530(a) with respect to such an individual (section 530 relief); (3) there is an ‘actual controversy’ involving the determination as part of an examination; and (4) the person for whom the services at issue were performed files an appropriate pleading in the Tax Court.”

The revenue procedure then goes on to explain in some detail what the IRS believes to be the prerequisites and limitations of actions in Tax Court for Section 7436 relief.

Of course, any suit brought in Tax Court is governed by the Tax Court Rules of Practice including Rules 290, 291, 292, 293 and 294 dealing specifically with actions for redetermination of employment status.

https://nsacoop.org/events/2022-tax-finance-accounting-conference-cooperatives 27

Spring 2022 | The Cooperative Accountant

TAXFAX TAXFAX

EDITOR Barbara A. Wech, Ph.D. Department of Management, Information Systems, and Quantitative Methods University of Alabama at Birmingham COLLAT School of Business 710 13th St. South Department of Management, Information Systems, & Quantitative Methods Birmingham, Alabama 35233 bawech@uab.edu

There has been extensive media coverage surrounding Bitcoin but DAOs (Decentralized Autonomous Organizations) are utilizing the same blockchain technology to revolutionize organizational structure. DAOs have garnered a large amount of capital and attention in the last year. In August 2021, BitDAO raised $365 million, $230 million of which was secured within 20 minutes of going live (Genc 2021). Other interesting DAOs include Krause House DAO formed in November 2021 with the mission of buying an NBA team. It has currently raised $1.7 million dollars. The DAO market is growing rapidly. By 2020, it exceeded $3 billion in capital, and it is expected to reach 37.8 billion by 2025 (Iredale 2020). This amount of growth leads to the question, what is a DAO and how does it relate to a Coop?

What is a DAO A decentralized autonomous organization (DAO)1 is an organization where the rules of the organization are encoded into a computer program called a Smart contract. A Smart contract is analogous to a regular contract, it is simply a set of rules between two parties. The primary difference is a Smart contract is self-executing, requiring no human intervention. This difference may seem trivial but when many Smart contracts are combined it is possible to create a fully autonomous organization.

GUEST WRITERS Chris Edmonds, PhD Associate Professor Department of Accounting and Finance COLLAT School of Business The University of Alabama at Birmingham CSB 325 Birmingham, AL 35294,4460 P: 205.960.2407 cte@uab.edu Jennifer Echols Edmonds, PhD Associate Professor Department of Accounting and Finance COLLAT School of Business The University of Alabama at Birmingham CSB 327 Birmingham, AL 35294,4460 P: 205.937.6498 jee@uab.edu Ryan Leece, PhD, CPA Associate Professor Department of Accounting and Finance COLLAT School of Business The University of Alabama at Birmingham CSB 327 Birmingham, AL 35294,4460 P: 205.934.8862 dleece@uab.edu

1 DAOs are synonymous with Decentralized Autonomous Corporations (DAC).

28

Spring 2022 | The Cooperative Accountant

TCA SMALL BUSINESS FORUM Benefits of the DAO organizational structure DAOs eliminate the hierarchical structure found in most business entities. In a DAO, all employees contribute to an organization’s strategy instead of a select few (e.g., board or directors). Decentralizing the decisionmaking process helps minimize failure points associated with individual biases.

Since DAOs utilize smart contracts that are autonomous, organizational rules and policies are prearranged further limiting the influence of a few individuals. Therefore, stakeholders place their trust in the code that dictates how the organization functions instead of in How decisions are made in a DAO a small group of individuals as in a traditional Membership in a DAO is typically represented organization. DAO stakeholders benefit from by tokens which can be purchased, earned the transparent environment DAOs operate through work, or earned by using the DAO’s in. The organization’s governing code is services. The flexibility of a token-based publicly available and so are its business system allows all stakeholders to participate. activities. DAO business activities are Tokens represent voting rights and voting verifiable and publicly available via a blockrules are defined in Smart contracts. chain. In essence, DAOs offer a solution to The simplest voting system is Token-based the long-standing principal-agent dilemma. quorum voting which requires a certain threshold of voters for a proposal to pass.

Disadvantages of DAOs For example, a 65% quorum requires 65% While decentralizing decision making has of the voting power to pass a proposal. If its benefits, it can lead to issues including the quorum is met, the proposal passes and slow decision making, security risk, and an is autonomously executed. However, if the uncertain legal and regulatory environment. proposal receives less than 65% the proposal Each of these issues must be carefully fails. DAOs using quorum voting include considered before investing in a DAO. Curve, Compound, and Kleros. Quorum First, DAO’s flat organizational structure voting has been around a long time and has (rather than hierarchical) provides a strong been tested extensively in coops. It is easy form of governance but can slow reaction for members to understand and provides a time because it requires an organization strong form of governance. However, the wide vote. New voting systems are being quorum requirement can make it difficult to designed to allow for faster decision making pass proposals thus reducing operational (Aresenault 2020) but with every system efficiency. there is a tradeoff between governance and DAO voting systems continue to evolve. operational efficiency.

Other more sophisticated voting systems Second, the code dictating DAO decisions include holographic consensus, permissioned through smart contracts can be problematic. relative majority, and conviction (Aresenault DAO stakeholders rely on the autonomous 2020). Each of these systems have their nature of smart contracts; however, if flaws advantages and disadvantages. in the algorithms underlying the smart Smart contracts are maintained on a blockchain which is a cryptographically secure public ledger. Smart contracts cannot be modified without approval of DAO members.

Ethereum and Solana are popular blockchains for storing and maintaining smart contracts.

DAOs are decentralized in that they are not controlled by any central authority or system and instead run on a decentralized network of computer nodes. It is not possible to stop Smart contracts from executing by turning off a single node. In fact, a DAO’s code is extremely difficult to alter once the system is setup and running.

29

Spring 2022 | The Cooperative Accountant

can be problema<c. Development updates and bug fix implementa<on requires an organiza<onal vote. Varying degrees of stakeholder understanding related to code fixes further complicate maCers.

TCA SMALL BUSINESS FORUM contract exist, the DAO can be susceptible Other jurisdictions default DAO treatment Finally, the lack of legal framework around DAOs can be aCrac<ve but can also complicate how to attacks or the DAO can behave in an to general partnerships or unincorporated DAOs are treated across jurisdic<ons. In the U.S, certain states (e.g., Wyoming) have developed unintended fashion. Resolving code issues associations leading to personal liability liability protec<ons for DAOs by trea<ng them as limited liability companies (LLC). Other in a decentralized environment can be exposure for the DAO’s actions and jurisdic<ons default DAO treatment general or unincorporated associa<ons problematic.

Development updatestoand bug partnerships obligations. leading to personal requires liability exposure for the DAO’s ac<ons and obliga<ons. fix implementation an organizational vote. Varying degrees of stakeholder How are they similar to Coops?

How are they similar to Coops? understanding related to code fixes further In many ways, DAOs are like coops. DAOs complicate matters. are typically people centered, jointly owned, InFinally, many ways, DAOs likeframework coops. DAOs are typically people centered, jointlyand owned, the lack of are legal democratically controlled, often have a democra<cally controlled, and oien have a flat organiza<onal structure.

However, DAOs are around DAOs can be attractive but can flat organizational structure.

However, DAOs also complicate how rely DAOs treated for governance are different in that they rely on blockchain different in that they onare blockchain and cryptocurrency for monetary across jurisdictions.

In the U.S, ac<vi<es certain within a DAO for governance and cryptocurrency for ac<vi<es.

This has advantages: are more transparent and self-execu<ng states (e.g., Wyoming) have developed monetary activities.

This has advantages: Smart contracts reduce the principal-agent conflict. However, depending on the vo<ng system, liability protections formay DAOs by treating activities within a DAO are more transparent opera<onal efficiency be reduced by having all members par<cipate.

Addi<onally, DAOs are them as limited liability companies (LLC). and self-executing Smart contracts reduce not always legally recognized pukng its members at greater risk than a coop.

Comparing DAOs to Coops DAO

Coop

Governance

Democra<c, no hierarchy

Democra<c, no hierarchy

Transparency

All ac<vity is public

Ac<vity is normally private and limited to certain people

Trust

Cryptography (i.e. Blockchain) Based on experience and rela<onships among members

Vo<ng

Members always vote for any changes to be implemented

Members vote on some changes

Vote count

Counted automa<cally without intermediaries

Counted internally and outcome is handled manually

Opera<onal cost

Low

High

Opera<onal flexibility

Harder to make changes

Easier to make changes

Geographical dispersion

Anywhere

Central headquarters

In 2016, the first DAO (called The DAO)Smart was exploited by hackers for 3.6 million Eth worth $50 million at the <me Management contracts Human handling (Finley 2016).

2

Legal liability

30

Conclusion

Depending on the jurisdic<on, Limited to member 4 DAOs may be considered a investment general partnership or an unincorporated associa<on, thus exposing members to personal liability.

Spring 2022 | The Cooperative Accountant

TCA SMALL BUSINESS FORUM the principal-agent conflict. However, depending on the voting system, operational efficiency may be reduced by having all members participate. Additionally, DAOs are not always legally recognized putting its members at greater risk than a coop.

Conclusion While widespread DAO adoption as an organizational form is likely years away, there are aspects of the DAO that may prove influential in the near future. The transparency inherent with DAOs provides an example for

other organizations to improve inefficiencies associated with hierarchical governance. For example, DAOs could oversee corporate forms instead of a traditional board or directors (Quiroz-Gutierrez 2021). Will Papper, an active DAO entrepreneur, contends that DAOs will prove just as influential for corporations as the internet was for content creators (Allison 2021). Overall, legal and regulatory reforms will likely impact the speed at which DAOs move to domains outside of business activities related to crypto currencies and investments.

References Allison, I. 2021. A16z, Ohanian, Snoop Dogg Back DAO-Builder Syndicate in $20M Series A. CoinDesk, https://www.coindesk.com/business/2021/08/31/a16z-ohanian-snoop-dogg-backdao-builder-syndicate-in-20m-series-a/ Aresenault, E. 2020. Voting options in DAOs. https://medium.com/daostack/voting-optionsin-daos-b86e5c69a3e3 Beingcrypto. 2021. The Merits and Pitfalls of Decentralized Autonomous Organizations. https://beincrypto.com/the-merits-and-pitfalls-of-decentralized-autonomous-organizations/ CoinTelegraph. 2021. What is a decentralized autonomous organization, and how does a DAO work? https://cointelegraph.com/ethereum-for-beginners/what-is-a-decentralizedautonomous-organization-and-how-does-a-dao-work CryptoSwede. 2021. Advantages & Disadvantages of a DAO. https://www.cryptoswede.com/ the-advantages-and-disadvantages-of-a-dao/ Finley, Clint. 2016. A $50 million hack just showed that the DAO was all to human. https:// www.wired.com/2016/06/50-million-hack-just-showed-dao-human/ Genc, Ekin. 2021. BitDAO raises another $365 million after governance token launch. https:// decrypt.co/78719/bitdao-raises-another-365-million-after-governance-token-launch Iredale, Gwyneth. 2020. How blockchain job market is booming. https://101blockchains.com/ blockchain-job-market-is-booming/ Locke, T. 2021. What are DAOs? Here’s what to know about the ‘next big trend’ in crypto.

CNBC, https://www.cnbc.com/2021/10/25/what-are-daos-what-to-know-about-the-next-bigtrend-in-crypto.html Quiroz-Gutierrez, M. 2021. What’s a DAO and could one replace a traditional corporate board?. Fortune, https://fortune.com/2021/11/19/dao-decentralized-autonomousorganization-consitutiondao/ 31

Spring 2022 | The Cooperative Accountant

hotline, anonymous email and an internal fraud website reporting link.

Published November 29, 2021 While no one wants to believe fraud is occurring at their organization or nonprofit, unfortunately, it can and does happen.

Typically, fraud is a crime of opportunity, which means that putting preventative fraud measures in place can help you reduce fraud before it starts.

Here are five steps you can put in place no matter what size your organization is to decrease your risk of fraud. Remember, when you have formal reporting mechanisms in place for fraud, you are setting the foundation of fraud reduction.

1

Whistleblower Policy

2

Create a clear fraud whistleblower policy for your organization and its employees. Make sure this fraud policy is part of employee onboarding, and part of your employee handbook. Conduct background checks during the hiring process. Post the fraud policy in your office as well as on your internal website. Establish different ways any employee can report fraud, including a tip 32

Note: Make sure your whistleblower policy includes a no-retaliation clause, a reporting procedure and confidentiality protection for the whistleblower.

Tips

Encourage employees to submit a tip or concern of fraud at any time and make sure they can do so via email, phone or in an anonymous tip box onsite. Help employees understand that they are part of the fraud protection team.

Note: The latest Report to the Nations from the Association of Certified Fraud Examiners found 43% of occupational fraud was reported through tips.

3

Internal Controls Ensure that you have internal controls to protect the security of your data, assets and any proprietary information in place, and that you update them on a regular schedule.

Spring 2022 | The Cooperative Accountant

BEST PRACTICES One of the most important controls you can implement is the segregation of transactions.

Fraud is more difficult to pull off if you need to get multiple people involved. Typically, fraud is only perpetrated by one person alone, so if you have more people involved, the more you can deter fraud.

Don’t have a single employee handling the entire cash processing cycle. By assigning more than one staff member or employee to handle the processing and accounting for cash from beginning to end, organizations can lessen the opportunity for fraud. These multiple staff processing systems provide a benefit not only in fraud reduction but also in the security of the cash received and proper reconciliation for the donations.

Organizations should also avoid a single employee having sole responsibility over reconciling cash or asset activities.

Putting checks and balances in place for any transactions processed will reduce the opportunity for fraud. Using a fund accounting software solution can help you to have internal controls in place that will flag entries or variances of a budget that would be otherwise undetected.

Keep in mind as well that fraud can be as simple as one employee printing out duplicate checks, or forging signatures on checks, so you want to keep all company checks locked up. Many companies also employ a two-signature check system so any check larger than $500 must be signed by two different people on the financial team.

Make sure you have your organization’s financial tasks segregated when it comes to processing cash and checks or reconciling cash, checks and payments. It is much easier to cover up fraudulent activities if the person committing the fraud is the only person with access to the full accounting system.

Fraud can be committed at any level of the organization so it’s important that all internal controls for fraud apply to every role at your organization.

Note: Internal accounting controls might include user role restrictions, protected access to proprietary asset information or funds, and alerts for budget variances.

4 Audits

Make sure you’re not waiting for a yearly audit to detect any fraud that might be occurring. While fraud is sometimes detected through an audit, don’t depend on or wait for a yearly audit to find fraud.

Note: Financial statement fraud is one kind of fraud that can occur. This includes net worth overstatements or understatements, misstating or overstating assets, false revenues or understated revenues, as well as improper disclosures. These are items an auditor will be looking for throughout an audit.

5

33

Internal Fraud Assessments Build internal fraud assessments into your yearly organizational calendar, and make sure your managers and employees know your company conducts fraud assessments regularly.

Just as you do yearly reporting to your stakeholders, think about conducting yearly fraud awareness training. Research shows that more tips on fraud come through organizations that have standard fraud awareness training in place, in addition to a fraud policy.

If fraud is committed at your organization, once it’s resolved, use the opportunity to discuss how the fraud occurred, what was lost and how it happened as part of your fraud awareness training. When you have fraud awareness training, the more you can use real-world specific fraud events that correlate with your type of organization or nonprofit, the easier it will be for everyone to understand how to detect fraud.

(Source: AccountingToday – Audit & Accounting – November 1, 2021) Spring 2022 | The Cooperative Accountant