December 23, 2013

Breaking Bad: A Case Study in Accounting Fraud

If you are familiar with AMC’s hit series Breaking Bad, you may think the show could be a case study in a number of societal issues, but accounting fraud is probably not one of them. It’s true though. Through all five seasons of this show, accounting fraud has been prevalent in one form or another: financial statement misrepresentation, tax fraud, and money laundering. We will examine each throughout this article.

For a bit of background, the show centers on the life of Walter White, Sr. (portrayed by Bryan Cranston), a brilliant high school chemistry teacher with terminal lung cancer, who begins manufacturing very potent, illicit drugs to provide for his family’s financial well-being after his death. His wife, Skyler White (portrayed by Anna Gunn), is pregnant with and later gives birth to their second child; their first child is a teenager with a mild case of cerebral palsy. Five seasons depict how Walt’s decisions affect his life, and the lives of those he loves and loathes.

Skyler takes a job as a bookkeeper with an old employer, Beneke Fabricators, to help make ends meet when Walt begins cancer treatments that are not covered by his health insurance. The company’s owner, Ted Beneke (portrayed by Christopher Cousins), has been committing financial statement fraud since before Skyler’s arrival, by not recording certain customer invoices, or recording less revenue than what was actually received, in order to make revenues appear worse than they actually were. Skyler quickly catches on to his scheme and when confronted, Ted insists that he must continue doing this for the time being and enlists Skyler’s help. She objects at first, but later agrees to be a willing participant in the scheme.

The scheme continues on for almost another year, when Ted receives a letter from the IRS’s Criminal Investigation Division notifying him that Beneke Fabricators is being investigated for tax fraud for claiming less revenue on tax returns than was actually earned, as a way to lessen the company’s tax liability. Skyler helps him deflect the CI agent by playing the part of an incompetent, under-qualified bookkeeper who assumed all of her entries of customer revenue were correct because, “the Quicken didn’t flash red.” As a result, the agent believes the whole situation came about because of negligence, rather than fraud and backs off pursuing any criminal action.

There was ample opportunity for Ted and Skyler to commit this fraud because both had unlimited access to the company’s books. In Ted’s case, he felt pressure to keep his family’s business running by keeping the IRS off his back and not paying his huge tax bill. In Skyler’s case, she needed her job’s income because she believes it is helping her family’s financial situation while Walt undergoes expensive cancer treatments. It is also hinted that Skyler and Ted may have had a past romantic relationship, which may also contribute to the pressure she feels to help Ted commit the fraud. They both rationalize the wrongdoing by believing that this will all stop and unwind itself at some point in the future.

However noble their intentions, what they did could have landed them in prison. While the storyline is fictional, the IRS’s Criminal Investigation unit is very real. According to the IRS’s website, CI is responsible for, “investigating potential criminal violations of the Internal Revenue Code and related financial crimes…” At many points in the show, Skyler warned Ted that he could go to prison for this scheme, and she was right. In Fiscal Year 2013, CI initiated 4,119 investigations, recommended prosecution for 3,250 cases, and obtained convictions on 2,336 cases. The average criminal served 44 months in prison for crimes investigated by this division.

This fraud played a major role is Ted’s downfall and eventual paralysis, but Skyler also willingly participated in her husband’s money laundering scheme to protect her family and the huge, illegal fortune her husband has amassed. It is revealed in season 5 that over the course of about a year, Walter White has accumulated about $80 million in cash from manufacturing illegal drugs. If that amount seems outrageous to you, as it certainly did to me, click here to read an article analyzing its plausibility.
If Walt were to attempt to deposit all of that cash into a bank account, it would likely raise a number of red flags. First, the bank would be required to file a currency transaction report (“CTR”), which is a report filed by a financial institution when a customer makes any transactions at or above $10,000 in cash either all at once, or that total to $10,000 in one business day. These reports are filed with the Financial Crimes Enforcement Network of the U.S. Department of the Treasury. If the bank feels the cash came from or is used in suspicious activities, a suspicious activity report (“SAR”) can be filed. These are just the reports Walter White doesn’t want filed, considering the sources of his cash.

In season 2, Walt’s lawyer, Saul Goodman (portrayed by Bob Odenkirk) suggests to Walt that he buy a business with his cash so that he has a means to launder his illegally obtained drug money. Eventually Skyler and Walt buy a local car wash business, using said illegally obtained drug money, because it is a business that has a high number of customers paying in cash. It would be an easy way to deposit, or launder, the illegally obtained cash into the financial system and use it for operational expenses, Walt and Skyler’s salaries, distributions, and, most importantly, to pay taxes. Thus, the dirty money going into the system would come out seemingly clean in the end. Skyler willingly created fake car wash tickets and added the cash from the fake sales to the cash register and deposited the money at the end of the day. Sounds simple right? Well, money laundering is an incredibly complex scheme to pull off, and unfortunately, other events in the show do not allow the viewers to see any conclusion to the laundering of Walt’s drug money other than the seizure of all of his and his family’s assets once it is discovered that he is the elusive drug manufacturer, “Heisenberg.”

Who would have known a show that focuses on the morality of manufacturing and distributing drugs could have so much focus on accounting fraud? The truth is accounting fraud could also be considered a study in morality. Whether witnessing it through a fictional TV show or reading a real article in the newspaper or online, accounting fraud boils down to the methods and rationale used when seemingly good people decide to “break bad” and commit financial malfeasance.

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December 12, 2013

Understanding Repair Regulations Elections for Taxpayers

The repair regulations have many complex areas to understand. One of the biggest changes to understand is the new elections that taxpayers can utilize on their tax returns. For the most part, these elections can be made on tax returns with taxable years beginning January 1, 2014.  We are waiting for the IRS to issue transition guidance to help taxpayers understand how to apply some of these elections prior to 2014. The six elections available under the final and proposed repair regulations are as follows: De minimis safe harbor, small taxpayer safe harbor, capitalize and depreciate certain materials and supplies, capitalize amounts paid for employee compensation or overhead, capitalize repair and maintenance costs, and partial disposition elections. These annual elections all need to be filed on an originally filed tax return by the due date including extensions. Below is a brief summary of some of the elections:

  • De minimis safe harbor – this might be the most important election to understand. Our next blog will go into more detail on this particular election. This election will allow a taxpayer to deduct items under certain dollar thresholds. The threshold differs whether the taxpayer has an applicable financial statement or not.  If a taxpayer has an applicable financial statement, the taxpayer may deduct up to $5,000 per item. If a taxpayer does not have an applicable financial statement, the amount is limited to $500 per item to deduct.  In order to make the election, a capitalization policy must be in effect at the beginning of the year.
  • Small taxpayer safe harbor– in order to facilitate some of the administrative burden that the new regulations placed on small taxpayers, the small taxpayer safe harbor election was introduced. Under this election, a qualified small taxpayer is one that has annual average gross receipts over the last three years of $10,000,000, or less and that owns or leases a building with a cost no greater than $1,000,000.  A qualified small taxpayer does not need to capitalize improvements if the total annual costs for repairs, maintenance and improvements do not exceed the lesser of $10,000 or 2% of the unadjusted basis of the building.
  • Partial Disposition – this is a great opportunity for taxpayers and an area that we will discuss in more detail in future blogs. This election allows a taxpayer to recognize a gain or loss on the disposition of a building structural component. The taxpayer makes the election on a timely filed tax return by recognizing the gain or loss of the partial building disposition. A taxpayer can use any reasonable method, some of which are outlined in the proposed repair regulations, to determine the amount of the portion of the building that should be disposed.

As you can see, there are many elections associated with repair regulations that affect all taxpayers and industries.  It is important that taxpayers recognize when they can take advantage of these elections available, and that they incorporate them on their timely filed tax returns. For help with these complicated elections, contact an Anders advisor.

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December 3, 2013

Buying or Selling a Company: Stock or Asset Deal?

Agreeing on a purchase price isn’t the only negotiated outcome of a business transaction.  In fact, it’s usually not the first or last item of agreement.  When a buyer is purchasing 100% of a target company, they can either purchase (1) the assets of the target or (2) the equity of the target.  The deal structure can influence the eventual agreed-upon purchase price.  Both scenarios have their advantages and disadvantages.

The purchase of a company’s equity is usually the most efficient deal structure for both parties.  In these deals, the buyer is assigned the stock of the target in exchange for cash or future payments of cash.  By purchasing the equity of a company, the buyer is purchasing all of the target company’s recorded and unrecorded assets as well as any liabilities, including contingent liabilities.  In essence, the buyer may be buying assets they’re not aware of, or assuming liabilities they didn’t know were in existence.  This is one of the reasons sellers generally desire the structure of a stock deal; they don’t walk away with unwanted assets or liabilities.  Obviously, the legal language within a stock purchase agreement could influence some of these items, but in general these are the advantages and disadvantages.

Buying a company’s assets can be advantageous because they can target only desired assets and assume only certain liabilities of their choosing. These assets could encompass all of the company’s known assets, including the fixed assets and real estate, or they could include only certain intangible assets such as company name, trademarks, trade names, and/or customer lists or contracts.  In essence, the buyer can choose what they want to purchase from the seller. The buyer would need to be sure that any contracts and/or agreements are assignable since it is likely the target company was the one that originally executed them.

Furthermore, the buyer and seller also have to agree on who will “assume” or pay for the company’s liabilities after the deal is final.  By assuming the seller’s liabilities, the buyer is essentially paying the seller additional consideration since they will be paying the future obligations of the loans assumed.  If no liabilities are assumed, the buyer simply pays an agreed-upon price for the desired assets.

As an example, assume the target company has appraised assets worth $3,000,000 (working capital, inventory, real estate and intangible assets) and $2,000,000 in recorded liabilities.  Under this example, the equity of the company would be worth $1,000,000.  A buyer could pay $3,000,000 if they desire to own all of these identified assets, or less if they want to exclude some assets.  If a stock deal is preferred, then the value would be closer to the $1,000,000 figure.  The final agreed-upon price may be somewhere in between depending on the individual motivations and desires of the buyer and the seller.

Bridging the gap between an asset purchase price ($3,000,000) and a stock purchase price ($1,000,000) may sometimes be necessary.  This is especially true if there has been an appraisal of target’s stockholders’ equity, but an asset deal was eventually consummated.  This may not always be a clean exercise.  The eventual deal price may have been influenced by motivations for each party that were not quantified in the valuation of the equity of the target company.  However, if properly done with knowledge of each party’s relevant motivations, this exercise can be accomplished.

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