Mike: Welcome to GAAP Chats, the podcast dedicated to all things accounting, brought to you by GAAP Dynamics. I’m your host, Mike Walworth. Chris is on PTO this week, so joining me today is Bob Laffler. We hope you’ll join us on our journey today as we share our passion for accounting and help change the way you train. Well, Bob, welcome. How are you?
Bob: I'm doing all right, Mike. How about yourself?
Mike: I’m good! Thank you for being with us today. So anyway, today, Bob, I wanted to talk about Donald Trump and Clarence Thomas. Specifically, what's going on in the news lately.
Bob: It sounds a little dangerous, Mike. Knowing you, these things can get contentious. I'm a little concerned that this might get a little inappropriate for an accounting podcast.
Mike: Well, luckily, we have two two guardrails. One, you're going to keep me on my toes, right? So, you're not going to let me delve into an area where we shouldn't go. And two, we you know, if something were to be really wildly inappropriate, we can always edit it thanks to Clark and his and his good editing skills. But I assure you, you don't need to worry about me because I'm not going to really delve into politics. What's interesting is this topic stems from a discussion that we had last week. We started to talk about the Donald Trump hush money payments and the accounting implications. At the time, I actually didn't understand myself kind of why it was illegal.Then, I also wanted to talk about Clarence Thomas a bit and really the concept of independence and what that is. I do think that they can teach us a thing or two and give a helpful review.
Bob: Sounds exciting! Let’s find out.
Mike: Okay, so let’s get everyone up to speed. During the 2016 election cycle, it was alleged that Donald Trump made hush money payments to Stormy Daniels totaling $130,000. The National Enquirer, on his behalf, made another $150,000 payment to the ex-Playboy model. Really what it was is it was sort of “hush money” and a non-disclosure agreement. Hush money so that they would not come out during the 2016 election cycle. Now, Michael Cohen went to jail for these payments. But “individual number one”, or Donald Trump did not. Now, part of the reason why they didn't charge him then was he couldn't be charged because there was a Department of Justice issue. But, Bob, do you know why the payments are illegal? Is it illegal to pay someone in this way?
Bob: I mean, no. I think you pay what you pay and you take it to accounting. I mean, it's all debits and credits, right? You know, credit, cash, debit, whatever. So, I mean, it doesn't seem like there's any illegal aspect at this point.
Mike: So, I looked into it and what's interesting is, Alvin Bragg, the Manhattan district attorney, basically says that it's misclassifying expenses and falsifying business records. That's the underlying charge. That's normally a misdemeanor. The felony charge comes because they're saying it violated campaign finance reform. That's the leap. Who knows whether or not he's going to get him or not? I don't know. When it comes to falsifying business records,I thought, well, wait a second. The Trump Organization is paying these expenses, this hush money payment. How does that benefit the company versus Donald Trump? So, I thought it was initially kind of a personal expense being charged for through the business, and that's where the misdemeanor charge came. But in reading some of the news articles, it's actually a tax thing. It's the fact that, Cohen paid $130,000 and then Trump reimbursed him. Cohen paid the National Enquirer $150,000, then Trump reimbursed him. Then Cohen basically said, well, screw that. If you pay me back, that's going to be income to me and I'm going to get taxed federally and taxed from the state. They're in New York so there are city taxes too. So the Trump Organization grossed up those payments and then therefore called it all a legal expense. It was all really misclassified, because it was not a legal expense.
It’s got me thinking about the time Bob and I taught in Russia. It was back in 1999 or 2000. We taught a U.S. GAAP course to a firm in Russia. Bob, when I bring up that Russia trip, I wanted to kind of go down memory lane here. That was 22, 23 years ago. Now, what's one thing that stands out to you about that Russia trip? Because I remember it was wild. It still resonates in my mind.
Bob: Well, yeah. So there were a couple of famous quotes and the two that I think I remember most were questions that we received from the participants in the class. When we were going through U.S. GAAP and impairment standards and so forth, then all of a sudden you get the hand raise. One of the famous questions was,” how do you account for a contract killing? I mean, is that an expense?”
Mike: I totally forgot about that. Dude said basically his audit client was under investigation or charged with the contract killing of the CEO of another company. Bob and I looked at each other like, where the hell are we?
Bob: I don't think my training has really prepared me for accounting for contract killings. Then the second crazy question was how to account for bribes or bribery.
Mike: Yeah, so going back to Trump, the NDA, paying someone for a non-disclosure is not illegal. However, if the payment itself is illegal, such as bribes or blackmail, that is a matter of criminal law. Specifically payments of bribes by companies, especially those that are in the United States under the SEC domain, would be a violation of the Foreign Corrupt Practices Act, the FCPA.
But, I remember I think I had the best answer to that bribery question: Dump it in "other expenses". I was like, you're gonna bury that.
Bob: But you need to account for it because if, it truly is a company expense, it needs to be accounted for. So, it needs to go somewhere. I guess that's where the GAAP accounting and the tax accounting kind of come into play. GAAP says cash out the door needs to be accounted for. It's an expense. But for tax purposes, bribery is not deductible. So, somehow then it shows up if you don't have, you know, equal expenses on both GAAP and tax books, well, then what do you do with it?
Mike: Back when we did this in 1999, I don't think the rule for uncertain tax positions had been released. But, this would be a perfect example of what would fall into uncertain tax positions under U.S.GAAP. And so the question is, my credit is cash, my debit is "other, other expense" and it was for a bribe. It's illegal and we got a whole host of FCPA violations. But as Bob said, I probably don't want that difference between book and tax.
Bob: That would be a permanent difference.
Mike: A permanent difference that would stick out like a sore thumb that I did pay this. So, if I'm going to bury it in "other, other", I'm going to bury it deep into taxes too. I'm probably going to take a deduction on it for tax purposes. But we know that bribes and illegal payments are not tax deductible. So, what do I have to do under GAAP, Bob? GAAP says you've got to look at these sort of uncertain tax positions. After we identify the position and we determine the appropriate unit of account, the next step is we have to determine if the tax position meets the recognition threshold criteria. Basically what we're saying is that if the tax authorities knew about this payment, would they give me a deduction, yes or no? If the answer is no then you cannot deduct it (but you already did on your tax return). So you're going to have to set up a tax liability. Now, it is not deferred it is a current tax liability. I'm going to have to set up a current tax liability and debit either current or non-current current tax expense depending on when I think the taxing authority is going to find it. Now, I have a question for you, Bob. Detection risk? Does that sort of rear its ugly head in this scenario? In other words, I buried it so deep that there's no way the tax authorities would ever find it.
Bob: We'd like to think that that was something we consider. But, that's part of, you know, ASC 740. You need to look at these positions without any consideration of detection risk as if the authorities were aware.
Mike: So basically, what you're saying is the tax authorities see the check, however much the bribe is, signed by whoever, payable to whoever. In the memo line, they see “bribe”. And the question is, would they give you a tax deduction for that? And the answer to that is no, forget it.
Bob: So, you better put up this tax liability.
Mike: Now, sometimes it isn't yes or no. It's not black and white like a bribe. So, give me an example of when a tax position could be questionable. In other words, it's not that we're not questioning whether or not it's deductible. It's more or less the amount, because that can happen, too.
Bob: Yeah, I mean, the example that we use a lot of times in our training is sometimes you have kind of intercompany licensing and stuff like that where basically, the company has the rights to the or the trademark or whatever. They essentially will do some, you know, transfer type of cost for the license of that right. Therefore, how much can you really charge for an intercompany license of your trademark or your IP. Sometimes tax rules have some gray area as far as what is a reasonable amount to be able to charge because you're really charging between jurisdictions. Right? You might be going from one tax jurisdiction to another where you're trying to hit the expenses of the high tax rates, and get the revenue on the low tax rate. So, there's a lot of those kinds of shenanigans that go on. That's a gray area. It's not illegal. We're not we're not talking about bribery, that's obviously illegal. It's a legal arrangement. It's just a question of what is the amount that you can actually get.
Mike: So, let's go back. We do a lot of training in the Cayman Islands, 0% corporate tax rate. If I'm a company and I have all these jurisdictions, it would benefit me to have my revenue in a lower tax jurisdiction and have all my expenses in Germany, which is a higher tax rate, right?
Bob: You put your head office in the low tax rate jurisdiction where they have the rights to the IP and property and then they charge the crap out of the higher districts where you actually are selling your product. Therefore reducing the revenue there and increasing the revenue in these home countries.
Mike: So, what you're saying is the tax authorities could say, listen, I understand that you got a charge some of this IP, but you charge through X and I think it should probably be X minus something, not as much. So, you have a question about the amount. Now, in that case, what does GAAP say? If for book purposes and for tax purposes, I tried to go for the full Monty, right. 100% of this stuff is in the higher tax jurisdiction. But what does GAAP say then about sort of figuring out the amount for uncertain tax positions?
Bob: Well. So, the threshold is: you've got to get the amount that's more likely than not to get accepted by the tax authorities. You need to take the highest amount that is more likely than not to be allowed by those tax authorities. It does require you looking at all the different scenarios, and then what's the highest amount that I can justify that is more than 50% likely to be accepted.
Mike: I think uncertain tax positions is one of those areas in GAAP, whether it's U.S. GAAP or IFRS, that does give people some trouble. I thought that was a good sort of tee up. Then there's, you know, you've got to calculate interest and penalties and then all these disclosures. But just remember that if you're making these payments or if you're doing these sort of charges to intercompany… or even or even I was thinking even a simpler one, right? Even like meals and entertainment. A perfect example is our annual meeting for GAAP Dynamics. That's an internal meeting that's 100% deductible. But if I'm doing entertainment, that's 50%. And so the tax authorities could question that, too. That's another sort of simpler example than sort of intercompany IP.
Mike: Now let's sort of segue into Clarence Thomas. Basically, the story here is that for years he's friends with a high powered Republican donor. This donor took him and his wife, Jenny, on trips. These trips were luxurious. Literally, these were $250,000 trips, right. Flying on private jets or whatever. He didn't disclose it and now that’s coming up.
Bob: This takes me back, Mike, to remember the days when we were working for the Big Four? Our clients used to take us out on those big trips. I remember going on those private jets and going on those vacations with our clients. That was right before the audit sign off where they would say, you know, you guys have been working hard. Let me take you out to a fancy dinner and show you a good time before that audit report needs to get signed.
Mike: Well, you and I grew up at the same firm. I don't know what the hell you were talking about. First of all, if there was any wining and dining, it was probably us wining and dining the clients. Because we had an expense sort of thing. We would take them out on golf trips or whatever. But that was still pre-PCAOB.
Bob: Yeah, there were limitations on what we could do, right? We still couldn't kind of, you know, be taking advantage of the private jets and the golf memberships of our clients and so forth.
Mike: Yeah. No, I am not alleging that Clarence Thomas did anything wrong. I think what the issue was he maybe didn't disclose it. And maybe there should be independence rules for Supreme Court justices just as there are for accountants. There are independence rules for the AICPA, U.S. GAAS, PCAOB, and the SEC. Then each firm has their own independence rules. One of the main things is when you think about independence and CPAs, you need to have an independence of mind and an independence in appearance.
So basically, the PCAOB rule states auditors must be independent of their audit clients throughout the audit and professional engagement period. It also states that auditors have an obligation to satisfy all other independence criteria to the engagement, including the independence criteria set out in the rules and regulations of the SEC. And so when we look at some of the main things, right, an auditor cannot function in the role of management. An auditor cannot audit his or her own work. An auditor cannot serve in an advocacy role for the client, and the auditor cannot have a mutual or conflicting role with the client. An auditor is not independent of the client if the auditor maintains or prepares the client's audit accounting records, prepares the client's financial statements that are filed with the SEC, or prepares or originates source data underlying the client's financial statements.
Bob: The thing with the independence that really resonated with me was, you know, there are all these rules, but at the end of the day, you need to be independent. The biggest thing, and the one that really just kind of captures everything is this idea of being independence in appearance. Because at the end of the day, as an auditor, you are acting independently, verifying financial statements, saying they're okay. If a shareholder or any outsider were to look at you and get the sense that maybe you're not an independent body from the company itself, then the biggest thing that public accounting has going for it, which is trust, is is lost. Therefore, those rules are really strict to maintain that independence in appearance as well as independence in fact.
Mike: Well, it's interesting. All the firms have these independence databases set up so that they don't run amok. Also, the Big Four have gotten in trouble over the years when they start doing some of this consulting work.
That brings me to a story. When I was working at a Big Four firm prior to going to Switzerland, there was an audit client of mine and I had taken over the manager responsibilities. It had been a client of ours for a period of time. As a new manager, you know, I assumed, maybe wrongly, I didn't have to go back and look at their accounting policies to make sure that they were correct. So, long story short, I get a call one day from someone and they said, "Hey, excuse me, is Mike there?" And I'm like, that's me. And she said, "I have a question. I'm the auditor of XYZ company and I see you're the auditor of ABC Company and you account for beneficial interest in securitizations this way. But, I've been told I'm not allowed to account for it that way." This was back in the days, you know, there was some discrepancy in accounting and I guess half the industry was accounting for it at mark to market. Half the industry was accounting for it at LOCOM, like a loan. So, there was some discrepancy in accounting and the first thing she said was like, "oh my God, you're doing it Fair value. My client and the head of the accounting practice for this firm said, you're supposed to be doing it at LOCOM."
Long story short, she came back and it turns out that my client had been doing it wrong. Again, I was like two months into it, but the client had been doing it wrong for 2 or 3 years. And there was a restatement and it was a big “R” restatement. Go back and restate the previous year. I remember during that time, here was discussions between the firm's head accounting department and then my client, the CFO and controller. I looked bad in this. At the end of the day, it turned out that they were wrong and they had a big restatement. But during that time I was sort of on the calls with the firm's head of head of accounting and the client's head of accounting. Long story short, I did all this stuff and I had this big meeting. I had these presentations and I remember when I got back to the audit room, I got a call from the head partner of the firm's professional practice. He's like, "who do you work for?" And I'm like, "I think I still work for you." I mean, I didn't know I was fired or whatever. And he's like, "you're damn right, and don't you ever forget it."
What he was essentially saying was one of the things of independence is you don't serve in an advocacy role for the client. Essentially during that meeting, I was the defense attorney for the client's accounting. I mean, I had all the information lined up like me and the client were working together to prove that this was the right accounting. He pointed to it. He was totally true. That is not our responsibility as auditors. Management is responsible for the financial statements. Management is responsible for the reports and the accounting policies, not me as auditor. So, I always appreciated that guy.
Bob: So to summarize, I guess we figured out that Donald Trump might have a FIN 48 uncertain tax position issue with his GAAP financial reporting if he were to do such a thing. For Clarence Thomas, if he were an accountant, would have an independence issue. But he's not. He's just a Supreme Court justice who apparently has different independent standards.
Mike: And we should be advocating for independence rules for the justices, I think. Bob, why don't you take us out?
Bob: That’s all for this episode of GAAP Chats, your source for all things accounting. Notes and resources from today’s episode are linked in the description and as always you can find us online at GAAPDynamics.com, and @gaapdynamics across social media. It’s never too late to become a GAAPologist! Head over to our website and subscribe to our blog so that you’re the first to know what’s new with GAAP Dynamics.
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