Taxpayer Beware

The IRS goes where the money is; more grim projections for the federal budget deficit; the SEC bulks up; the bottom line of giveaways; FASB's ambitious agenda; and more.


The tax man is knocking on doors. In June, the Internal Revenue Service informed Motorola that the global communications giant owed an estimated $500 million in back taxes due to transfer-pricing errors. The IRS is also taking a hard look at pharmaceuticals giant GlaxoSmithKline for alleged transfer-pricing problems. The agency says the London-based company owes the United States an estimated $5.2 billion (yes, with a "b") in back taxes and interest on profits its U.S. unit earned between 1989 and 1996.

Is this a sign that the IRS is trying to make up for its own resource constraints by enforcing existing tax law more aggressively? Attorney Louis Marett thinks so. "They are looking for the low-hanging fruit," says the chairman of the tax-practice group at Testa, Hurwitz & Thibeault LLP, in Boston. He expects the IRS to go where the money is, conducting fewer audits of individuals and smaller companies and more audits of larger companies.

In particular, says Marett, the agency will focus on tax shelters and transfer pricing. The IRS is making good on a May 2003 directive aimed at curbing transfer-pricing abuses. The practice, which involves the sale of goods from one business unit to another in a different country, is a notoriously gray area that has often confounded regulators. The agency has tried to address the issue at the pre-audit stage with its advance pricing agreement program, in which companies can agree with the IRS on appropriate pricing levels prior to filing their tax returns. Marett says "dozens and dozens" of companies are participating in the program.

In Motorola's case, the IRS claim arose from a field audit of the company's operations from 1996 to 2000. The agency argues that the company didn't record enough of its profits in the United States during the period, and thus underpaid taxes on those proceeds. Motorola CFO David Devonshire calls the dispute routine. "Like all companies doing business internationally, we are audited each year covering many issues, including transfer pricing," he says. He adds that the company resolved a disagreement arising from the same audit in the second quarter, which resulted in a $197 million addition to net income from reserves that had been set aside for tax adjustments. Motorola has said it intends to "vigorously dispute" the latest charge. (The IRS declined to comment.)

GlaxoSmithKline plans to contest the IRS's claim, and says it expects a trial sometime in 2005 or 2006. —Kate O'Sullivan

Deficit Bending

Last month, the Congressional Budget Office announced it expects a record federal budget deficit of $422 billion for fiscal 2004. While the CBO projects the deficit will shrink to $348 billion in 2005, its outlook for the next 10 years is grim. If current laws and policies remain in place, the deficit could reach a cumulative $2.3 trillion for the years 2005 to 2014. And if the Bush tax cuts do not expire as scheduled, the 10-year hole will deepen to $3.6 trillion.

Economist Ken Goldstein of The Conference Board says the news is both good and bad. As a percentage of gross domestic product, the current budget deficit (about 3.5 percent of GDP) is smaller than the deficits of the late 1980s and early 1990s (which fell in the range of 5 to 6 percent). However, Goldstein says the current deficit could be big enough to have an impact on the capital markets.

"It's going to be a lot more expensive for businesses to raise capital in a year's time," he predicts. Furthermore, state and local governments are in much worse shape than they were 20 years ago. With the baby boomers set to retire soon, "the worst is still to come" in terms of stress on the fiscal sector, says Goldstein. —Joseph McCafferty

A Trademark Move

In the late 1990s, business-method patents came into vogue as Internet pioneers staked out intellectual property. patented its "reverse auction" sales method in 1998, for example, and patented its "one-click" ordering system a year later.

Now financial-services firms are getting into the act. In July, Goldman Sachs & Co. received a patent for a hedging strategy. "We've locked down for our shareholders our best thinking on a tough problem," says John A. Squires, chief patent counsel for Goldman Sachs.

Conceived by managing director David J. Marshall, the hedging strategy addresses the risks faced by companies offering deferred-compensation plans. Typically, companies hedge these plans either through corporate-owned life insurance (COLI) or by buying the same mutual funds selected by participating employees. Neither approach is bulletproof: COLI plans have some tax effects, and some carriers permit only limited investment options; mutual funds generate taxable income if the plan sponsor adjusts its holdings to mirror changes employees make in their allocations.

In Goldman Sachs's hedging strategy, a plan sponsor enters into a "total return swap" with a third-party swap provider. The plan sponsor pays a LIBOR-based rate, and the swap provider pays the rate of return of the deferred-compensation liability. The swap is periodically reset to reflect changes in the size or aggregate allocations of the deferred-comp liability. The firm has developed software for this periodic calculation, and patent 6,766,303 covers both the hedging strategy and the software.

Other financial-services firms are seeking protection for their intellectual property. As of August, Goldman Sachs had a total of 4 patents (including 3 for software and hardware), making it a mere piker compared with Citigroup (39) and Merrill Lynch (26). —Ilan Mochari

The SEC Flexes Its New Muscle

Two years after Congress voted to boost its budget, the Securities and Exchange Commission has nearly completed a monumental hiring binge, adding 932 employees between December 2002 and July 2004, which boosted staff to 3,520 after attrition. Now that the agency has beefed up, how will its approach change?

So far, the answer seems clear. "It has become far more aggressive," says Michael Caccese, a partner with Kirkpatrick & Lockhart LLP. "This is definitely not your father's SEC." In fiscal year 2003, the SEC launched a record 679 enforcement actions.

And to ward off criticism that it is always responding to last year's crisis, the SEC has initiated a new approach to investigation, which it calls wildcatting. When the agency spots something amiss at one company, it can initiate a broad sweep of an entire industry, as it has on such issues as oil-reserve accounting and accounting for pharmaceutical sales. "It makes sense," says Alan Bromberg, a professor at Southern Methodist University's Dedman School of Law. "If there's something going on in an industry, it may be more widespread than you can tell from the first look."

Justified or not, such tactics are making life difficult for companies. Complying with SEC requests for information can be expensive and disruptive. The situation is even more burdensome for investment firms, which must contend with routine examinations as well as nationwide sweeps on such issues as investment performance and revenue sharing for 401(k)s.

To be fair, the SEC's staff is catching up after years of being undersized and underpaid. And the agency has uncovered some notable scams. The question now is whether it can keep up with the bigger workload that wildcatting generates. Says Greg Bruch, a partner with Foley & Lardner LLP and a former SEC attorney: "It raises the question of how realistic it is that the SEC can follow up on all the leads they generate." —Don Durfee

A Loan and a Helping Hand

General Electric Commercial Finance (GECF) wants to lend you money. And if that's not enough, it'll throw in a few finance experts to help out around the shop.

Through a program called "At the Customer, For the Customer" (ACFC), GECF says it will help clients solve their nagging business problems for free (the exception is health-care clients, which by law must be charged). The idea is that GE can draw on its background in process improvement and Six Sigma (a quality-improvement method) to help clients become better borrowers. GE will even dispatch consultants on-site to assist with a problem.

For example, when Blue Ridge Paper Products, of Canton, N.C., a GECF client since 1999, enrolled in the ACFC program in 2002, it asked the lender to help out with problems that had plagued the company for years — including improving invoice accuracy. GE responded by conducting a two-day introduction to Six Sigma for Blue Ridge managers and inviting four employees to GE's Greenville, S.C., gas-turbine plant, where they saw the principles of Six Sigma in action. "In three or four months, we were up to about 98 percent perfect on our receivables," says CEO Rich Lozyniak. "More important, our customers were satisfied with our performance." He says the improvements have saved the company $100,000 a year.

GE says the program makes good business sense. "GECF grows its business when its customers succeed," says Sharon Garavel, the firm's Six Sigma practice leader. "We are taking our best practices, best processes, and best people, and sharing them directly with our clients." She says the company can help clients with change management, acquisition integration, and process mapping, among other things. GE hopes the program will not only inspire borrower loyalty, but also make clients stronger financially and increase their need for capital.

GE isn't the only lender to offer this kind of assistance, though. David Lentini, CEO of The Connecticut Bank and Trust Co., says GECF is simply doing what smaller banks have done for years. "This is done at community banks all over the country every day," he says. "We go into businesses, sit down with the people who run them, and give them all kinds of financial guidance." —Clare Adrian

Give It Away Now

Each month, Quill Corp., a $1 billion office-supply company owned by Staples Inc., ships thousands of free Mrs. Fields cookies to its customers, along with their orders of pencils and pens.

The company has also given away weekend trips, digital cameras, and George Foreman grills. To cost-conscious finance executives, this is the stuff of nightmares.

But to Mike Patriarca, Quill's vice president of finance and operations, the millions of dollars spent annually on freebies is well worth it. "It's part of the cost of doing business," he says. The program was launched three years ago as part of a push to differentiate the company from its competitors. The giveaways are often tied to low-margin products that sell much better with an extra incentive, says Patriarca. And since the freebies are linked to order size, people tend to add products to hit the giveaway threshold.

At Dancing Deer Baking Co., a Boston-based maker of cookies and cakes that also offers regular giveaways, management calculates the impact of each promotion in advance, says vice president and director of marketing Geoffrey Klapisch. Dancing Deer gave out free cookies as part of a promotion during the Democratic National Convention in Boston. And its "Break the Curse" cookie, created for Boston Red Sox fans pining for a World Series crown, received mention on NBC's "Today Show" — exposure that the company, with about $5 million in revenues, "would never have been able to buy," says Klapisch. To determine more-tangible returns from the DNC promotion, he's tracking purchases by customers who received coded coupons with the free cookies to use in the company's online store.

Such measurements are crucial to the success of promotional programs, says Sridhar Balasubramanian, associate professor of marketing at the University of North Carolina's Kenan-Flagler Business School. "Good marketers should be able to capture the financial consequences of their programs," he says. —K.O'S.

The FASB Express

Once upon a time, you could grow a mighty oak from a seed during the time it took the Financial Accounting Standards Board to make a ruling. But during a CFO conference at the Massachusetts Institute of Technology last November, FASB chairman Robert Herz ticked off the steps he had taken to streamline the board since taking the reins in July 2002, then asked the assembled finance chiefs, "How many of you still think we're moving too slowly?" No hands went up.

Speed Bump

Even those who aren't happy about particular FASB projects concede that Herz has presided over one of the most ambitious and productive periods in the board's history. This quarter alone, FASB is scheduled to release five final accounting standards and propose eight more. Moreover, as 2004 draws to a close, Herz's accomplishments will almost certainly include issuing a final statement on stock-option expensing, despite opposition from members of Congress and a broad swath of Silicon Valley firms. Indeed, once a threat to FASB's very existence, stock-option expensing is now more of a speed bump.

Among the proposals, or exposure drafts, due out this quarter is a broad-based revenue-recognition statement. A Grant Thornton survey released in late August showed that three out of four senior financial executives agreed on the need for a comprehensive statement on revenue recognition.

But there's always a risk they won't like what they get. Any revamping of revenue recognition is not likely to be confined to the most common gray areas (think software licenses or professional services). "When FASB opens up an issue, it appropriately takes a broad perspective," says Grant Thornton CEO Edward Nusbaum, a member of FASB's Advisory Council. Nusbaum says some of the early revenue-recognition proposals he has seen could "significantly change the amount of revenue that companies can record."

Less likely to set off immediate battles is FASB's Fair Value Measurement statement, scheduled for final release next quarter. This effort to improve the reliability of fair-value measurements for assets and liabilities is too conceptual for companies to gauge its impact on their own balance sheets, but it lays the foundation for FASB to weave additional fair-value calculations into accounting standards. That, in turn, may increase balance-sheet volatility, and is likely to spark new debate over the right mix of historic-cost and fair-value measurements in financial statements.

Convergence Efforts

Several of the final statements due by year-end are "convergence" efforts — projects to eliminate differences between international accounting standards and U.S. generally accepted accounting principles. Among them is a change in the method of calculating year-to-date earnings per share. "The impact will probably be to dilute EPS" for American companies, says Lisa Filomia-Aktas, a practice leader of Ernst & Young's On-Call Advisory Services Group.

Another convergence project would require companies to retrospectively apply changes in accounting principles, eliminating the practice of recording a one-time cumulative effect in the income statement in the year the new accounting principle is adopted. That proposal has drawn protests from many companies for the confusion and potential compliance burden it might cause. "The current public perception of 'restatements' is very negative," Eli Lilly and Co. chief accounting officer Arnold C. Hanish wrote to FASB. "Treating the correction of accounting errors and changes in accounting principles similarly will tend to eliminate [investors'] distinction between the two," echoed PG&E Corp. controller Christopher P. Johns.

There is, of course, much more on FASB's agenda for CFOs to watch, from upcoming exposure drafts on business combinations to a reexamination of "qualifying" special-purpose entities used by financial vehicles. It's all a part of the fast-paced, exciting world of accounting. —Tim Reason

Wal-Mart Wants to Skip This Class

Wal-Mart may be facing the largest class-action lawsuit ever filed against a private employer in the United States. Or it may not. The class action, involving up to 1.6 million women charging sexual discrimination, was certified in June. But a 1998 change to the rules of civil procedure allows defendants to appeal the designation of a lawsuit as a class action before the final outcome of the case.

Judges generally frown upon such "interlocutory" appeals, says Michael Gass, a partner at Palmer & Dodge LLP in Boston. In the past, defendants could challenge the certification of the class only after the case had been decided. But because most large class actions are settled before they go to trial, defendants have had little recourse once the class was certified.

The sheer magnitude of the Wal-Mart case means that the class-action designation could be a critical factor. "It changes the dynamic so dramatically that the class certification itself becomes the centerpiece of the case," says Glenn Dowd, a partner in the New York office of law firm Day, Berry & Howard LLP.

Wal-Mart will argue that each instance should be looked at individually. In a petition to the court, lawyers for the retailer wrote, "It is undisputed that compensation and promotion decisions for hourly employees are made almost exclusively on a case-by-case, discretionary basis, by local store managers." Says Dowd: "They will take issue with the idea of typicality," a key determinant for class actions.

"Based on the size of the Wal-Mart case, it would be shocking if the [certification of the class action] had not been reviewed," notes Samuel Issacharoff, a professor at Columbia Law School. Whatever the outcome, Issacharoff doesn't think the case will set a precedent for mammoth class actions against employers. —J.McC.

A Few Good Suppliers

Cut costs by trimming the number of your suppliers. Heard it before? It's the business equivalent of "diet and exercise." But paring down to just a few suppliers can be too much of a good thing. The Hackett Group, an Atlanta-based business-advisory firm, says that many leading companies are actually adding suppliers. Why? To mitigate risk.

"If you have only one supplier in a key category, that's undue risk," observes Chris Sawchuk, a senior business adviser at Hackett. "If that supplier goes under, you're dead." Instead, Sawchuk advises companies to give favored suppliers 80 percent of their business and backup vendors 20 percent. While the strategy will cost a little on pricing, "you'll remove risk from your equation and feel less at the mercy of your top supplier," he says.

In the wake of the SARS scare and 9/11, some companies learned the lessons of having too few suppliers the hard way. For this reason, leading companies in procurement, as identified by Hackett, slightly increased the number of suppliers they use during the past few years. "Most companies still have too many suppliers," says Richard T. Roth, chief research officer at Hackett. But the companies that were ahead of the curve are coming back a little, he says.

Not Stratasys, a $51 million company in Eden Prairie, Minn. The maker of plastic prototypes for the aerospace, automotive, and medical industries relies on just one supplier for some of its critical materials. Stratasys CFO Thomas Stenoien says that doing so allows it to have more control over the quality of its products and helps build a long-term relationship with suppliers. Yes, there's risk in relying on one supplier, he concedes, "but if you introduce defects into the products and have failures in the field, that's expensive, too." (In some areas, Stratasys does employ the 80/20 rule.)

Increasing the number of vendors in order to reduce risk pertains only to key suppliers, Hackett points out. When it comes to items like office supplies, reduction is still the way to go.

And reducing suppliers isn't the only way to lower risk. Stratasys, for example, makes sure its vendors have emergency capabilities. —I.M.

Half-baked Accounting?

In August, Interstate Bakeries Corp. announced it would delay filing its 2004 10-K report, citing a glitch in implementing its new accounting system. Mitchell Pinheiro, an analyst at Janney Montgomery Scott LLC, says the maker of Wonder Bread and Twinkies continues to have difficulties with its new SAP system, which went live on June 1.

But Interstate has troubles beyond its software problems. In June, it announced it was launching an audit-committee investigation into the accounting for workers' compensation reserves. The company was forced to take a $40 million charge to pretax income to account for a reserves shortfall. The Securities and Exchange Commission is investigating, too.

Billy Soo, an accounting professor at Boston College, says he doesn't expect workers' compensation reserves to become a major accounting issue at other companies. "It's such a wild card that there is a fair amount of leeway," he says. "Companies are supposed to make estimates to the best of their ability, but other than that, it's a judgment call."

How soon Interstate will be able to file audited financial statements is anyone's guess. A company spokesman says Interstate hopes to file the report by September 24, but it's likely that the uncertainties about the financials have made company officers (including Ronald Huchinson, who was named CFO in July) reluctant to certify them. Indeed, the company noted in the August release, "Filing will occur when the officers who must make the certification required by the Sarbanes-Oxley Act in connection with such filing are in a position to do so."

On top of everything, Interstate is also suffering from lowered demand for its bread and sweets, thanks to the popularity of low-carbohydrate diets. Now, rumors of an impending bankruptcy are circulating. "The outlook for the company is bleak," confirms Pinheiro. —J.McC.

Getting the Prices Right

When costs have been cut to the bone and revenue growth is still shaky, a company naturally turns to thoughts of pricing. Many are thus moving from cost-plus pricing to value pricing or variable pricing. But the new models can be tricky, so more companies are turning to price consultants to get it right.

For example, when Concentra Preferred Systems, a Naperville, Ill.-based provider of health-care cost-management services, was recently renegotiating with one of its top clients, it called in pricing expert Strategic Pricing Group Inc., of Waltham, Mass., to assess what it should be charging. "Our next-biggest competitor prices well below us, so we have to be able to [explain] why our pricing is higher," says Concentra CFO Steven A. Flack. Thanks to the new pricing strategy developed with Strategic Pricing, Concentra should be able to retain more-profitable business, says Flack.

The Professional Pricing Society, a national association of pricing experts, has increased its membership from 600 to 2,000 in the past three years. The services offered by its members are also expanding. Firewhite Consulting Inc., in Burlingame, Calif., for example, conducts large Internet surveys, testing different product offerings at different price levels. Firewhite president and CEO Marcia Kadanoff says the firm uses a "science-driven approach, exposing potential customers to various value propositions." Different features and benefits are tested in different combinations. "From that we can tell the customer how to optimize its pricing to get the most revenue or market share," she says.

Cleveland-based PricePoint Partners Inc. specializes in industrial and business-to-business pricing. Co-founder and senior partner Ralph Zuponcic says the firm finds opportunities to improve revenue by examining areas in which loss may occur, such as excessive discounting, poor negotiation skills, or missed opportunities in transaction fees. "We look in all the cracks in the floor," he says.

But price consulting doesn't come cheap. In addition to a small management fee to cover costs, PricePoint receives a percentage of a company's actual price-improvement gain. Says Zuponcic: "We share the risk with our clients, and they all seem to like that." —C.A.


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