Industries

By Barry M. Pelagatti

With the Federal Reserve committed to a slow but steady rate hike program in 2017, lenders face a net interest margin (NIM) squeeze that may exacerbate recent years’ long thinning of the margin and increase funding challenges for many middle-market and regional banking institutions.

Though the Fed elected to hold rates steady at its February 2017 meeting, it reconfirmed its intention to institute three rate hikes this year, after having raised rates only twice in the last decade. Any additional demand-side pressure—for example the new administration’s proposed $1 trillion-plus infrastructure spending plan—could potentially drive up inflation and trigger additional rate hikes.

Taken together, these moving pieces are putting banks’ asset liability management (ALM) programs under scrutiny by senior banking executives and regulatory bodies to ensure banks are able to navigate this transition and to adjust to the new environment with minimal impact on profitability.

At the heart of the issue for banks is the potential for an asset liability mismatch to emerge that could force them to take deliberate steps to protect margins.

This is likely to disproportionately impact banks outside of the top 50 in the U.S., and those that have assets of between $1 billion and $3 billion, according to research done by the Corporate Division of CenterState Bank.

The origin of this risk is that banks in this segment of the market have slowly been increasing loan durations, and many hold over 50 percent of their loan portfolio in durations that are three years or longer, according to CenterState.

At the same time, non-maturity account deposits have ballooned since the 2008 downturn, leaving banks exposed to short-term interest rate moves. These could be further exacerbated by consumers moving money out of non-maturity accounts or to competing accounts in pursuit of higher yield in a rising rates environment.

By contrast, the top 50 banks have allocated more than half of their loan portfolio to terms that are less than three months, according to CenterState Bank. This affords them much greater flexibility to pivot and adjust NIM levels as rates steadily rise.

So what can banking institutions that are heavy on longer term loan durations do to prepare for the road ahead?

Running repricing scenarios is something that banks typically do on a quarterly basis but, in the current environment, banks with high risk exposure should consider more frequent and in-depth ALM stress testing.

These tests should address a number of issues, including repricing, maturities, yield curve, basis and optionality risk exposures. Where assets and liabilities are mismatched, the bank is exposed to risks, which are heightened by the dynamics of the current environment.

Banks should consider expanding their use of derivatives to manage financial risk in a shifting rates environment. While there was a large pullback on the use of derivatives after the 2008 downturn, when used responsibly, derivatives are a powerful tool for managing risk exposure.

Senior banking executives and business line leaders should be aware of what appetite their institution, board members, creditors and other key stakeholders have for the use of derivatives strategies to manage financial risk. Any expanded use of interest rate derivatives should trigger a full review and update to firm policies surrounding their use.

Firms looking to expand derivatives usage will need to put programs in place to educate board members and management teams on the institution’s goals in making that move. They will also need to prepare and maintain the appropriate documentation to comply with applicable accounting and regulatory requirements. Finally, banks will need to ensure that the appropriate compliance and accounting policies and procedures are in place as well as implement a system to ensure appropriate levels of internal oversight.

Years of increased competition and slimming NIMs among banks have organically chipped away at profitability, forcing many institutions to pursue revenues by extending their loan durations.

This has set the stage for a challenging 2017. It has also helped ensure issues surrounding ALM will be on the minds of the executive suite on a weekly, if not daily, basis.

While there should be a sense of urgency for banks with a high exposure to interest rate risk, they should be able to manage that risk by taking the appropriate steps now.

Barry M. Pelagatti is an assurance partner and the national practice leader of BDO’s Financial Institutions & Specialty Finance practice. He can be reached at bpelagatti@bdo.com.

This article originally appeared in BDO USA, LLP’s “Financial Institutions” newsletter (Winter 2017). Copyright © 2017 BDO USA, LLP. All rights reserved.www.bdo.com

By Henry Rinder, CPA, ABV, CFE, CFF, CGMA

Entrepreneurship is the American way. Our country thrives on capitalism, and historically, small businesses create most new jobs. However, business enterprises are not without risk.

For example, statistics show that approximately 50% of all new businesses fail within the first 5 years. There are many reasons businesses fail. Here are my top five in reverse order of magnitude:

1. Lack of Adequate Management Controls

You cannot be in control of a business if you don’t know what is going on. With poor accounting, a company is flying blind. A lot of start-up businesses leave the number crunching until tax time, and that is not the right track to take.

An outside accounting firm can help keep you up to speed on a current basis and provide additional accounting and business advice. Proper division of duties among employees is key to providing the internal controls necessary to prevent employee theft.

Your outside accounting firm can assist you in setting up and maintaining a proper set of internal controls. Cybercrime is on the rapid rise. It’s not just big companies like Target and Sony that cyber criminals go after.

Many small firms get victimized—and it can be deadly to them. Educating your staff about these risks and having technological countermeasures is critical to survival. Every business needs defensive systems in place to prevent cyber crimes.

2. Divisions and Dissension

“The ultimate throttle on growth for any great company is not markets, or technology, or competition, or products. It is… the ability to get and keep enough of the right people.” If the employees who serve your customers aren’t enthused about coming to work, it’s going to show in their performance and hurt your business.

Employees who aren’t happy about their work aren’t likely to put in extra effort or stay up late to help your company. Gallup research had shown that 70 percent of American workers are either not engaged at work, or are actively disengaged to the point of trying to subvert the work of colleagues.

Most personnel issues start at the point of hire. If your business continuously hires the wrong people and experience personnel problems that means that your hiring process is not fine-tuned.

Learn from Sun Tzu and Attila the Hun, terminate people that don’t belong in your business and replace them with people who display appropriate attitude, values and work ethic.

3. Over-Expansion

This one might be the saddest of all reasons for failure — a successful business that is ruined by over-expansion. Over-expansion includes moving too fast into new market segments or borrowing too much money in an attempt to keep growth at a particular rate.

It includes rapid introduction of new and unproven products or services to the detriment of the core business. Even well-established and successful commercial franchises fall victim to over-expansion. The key to successful growth and expansion—and avoiding business failure—is planning.

Solid business vision and strategic thinking are necessary to adequately take into account the risks associated with expansion. Business growth and expansion require careful planning. First, make sure your business is stable and liquid before expanding.

Thorough research and analysis ensure the time is right. Consider local and regional demographics and spending trends, future development plans for the area and pertinent threats before moving forward.

4. Technological Obsolescence

Technology plays a big role in operational solutions that allow businesses to deliver better products and services, faster and cheaper. Robots and artificial intelligence permit us to automate redundant processes that do not require human manipulation.

Entrepreneurs need to leverage off new technologies. Businesses that do not embrace technological advances are being disrupted and rendered obsolete. If you are in business today, you need a website and a social media presence.

In the U.S. alone, the number of internet users (approximately 88.5 percent of the population) and e-commerce sales ($394.9 billion in 2016 according to the US Census Bureau) continue to rise and are expected to increase with each passing year.

At the very least, every business should have a professional looking and well-designed website that enables users to easily find the business and avail them of your products and services.

An added benefit is your ability to take orders and sell products online. Online customer and employee ratings are also extremely important. Take them seriously or you will be out of business.

5. Poor leadership

All successful businesses are leader-driven. From vision to entrepreneurial spirit, financial management and engaging employees, vendors and customers, business leaders affect every aspect of the business. The tone of the business is set at the top.

The most successful entrepreneurs are visionaries and mentors who are absolutely committed to the success of the business above all else. Great leadership drives success. Lack of leadership comes in many forms: a leader who is never there, an indecisive leader, a leader with poor understanding of human nature, a leader who lacks vision and planning skills, etc.

If you are reluctant to take charge and resolve the issues, your business will slip toward failure. Start-up entrepreneurs who go down hard might not have their names splashed across the headlines, but their reason for failure is the same: self-sabotage through poor decisions and toxic tenor, creating the perfect recipe for failure.

Do you understand human nature? Do you have the ability to relate to other people? Do you struggle with anger issues? Are alcohol and other drugs interfering with your life? Entrepreneurs who succeed spend time on their own personal development and the personal development of the leadership team.

Successful leaders are other people’s mentors and heroes. On the other hand, dysfunction at the top kills a business. Effective management and leadership skills are essential to business-building, and a lack of either leads to confusion and conflict within the ranks. Dysfunctional leadership causes business to fail.

In Summary:

When it comes to the success of any new business, you — the business owner — are ultimately in control of your own destiny. With the goal of succeeding in mind, work hard to make it happen.

Contact our professionals for help with your business concerns. We would love to assist you in your quest to succeed.

A FEATURE EXAMINING THE ROLE OF PRIVATE EQUITY IN THE MANUFACTURING SECTOR.

The new administration’s pro-economic growth agenda has spurred optimism among the investment community, and most agree the coming year is primed for a healthy cadence of deals.

In fact, in a poll BDO conducted in January, 71 percent of fund managers characterized the investment environment as favorable. That represented a 15 percentage point jump from managers who said the same prior to the November election results (56 percent).

While the industry continues to barrel toward innovation, traditional manufacturers of components and parts for a variety of applications—including industrial application and consumer products—continue to garner interest from private equity and strategic buyers.

With trade policy front and center and, if proposals aimed at fortifying domestic manufacturing come to fruition, companies in the sector could be poised to see a much bigger influx in private equity investment.

Given the private nature of most transactions, it is difficult to say whether the following proved to generate good returns for the sellers or smart investments for the buyers, but here are a few transactions that characterize the pace and breadth of activity in recent weeks:

In a deal announced Jan. 4, Graham Partners sold blow molder Western Industries to Michigan-based Speyside Equity Fund. Terms of the deal were not disclosed, reports Plastics News. Speyside, a 12-year-old fund, targets manufacturing businesses in specialty chemicals, food and metal-forming, among others.

Western Industries’ plastics unit, which the company says is home to one of North America’s biggest collections of plastic presses, specializes in large and complex plastics products and components for industrial and consumer end-markets. They also offer assembly, packaging and logistics services.

Gladstone Investment Corporation, a publicly traded business development firm that makes debt and equity investments, has announced plans to sell its equity interest and the prepayment of its debt investment in Behrens Manufacturing to Mill City Capital, a producer of branded metal containers. Gladstone, which acquired Behrens in 2013, has seen its shares rally six percent since that announcement on Dec. 19.

Bain Capital Private Equity, meanwhile, has announced it will buy Innocor Inc. from Sun Capital Partners Inc. in a deal set to close in the first quarter of this year, according to The Middle Market. Innocor, a New Jersey-based manufacturer of polyurethane foam products and home furnishings, owns 22 plants and distribution centers across the U.S.

The Middle Market reports that home furnishings manufacturers are the beneficiaries of increased demand tied to an uptick in new home sales. Z Capital Partners’ investment in Twin-Star International and Mattress Firm Holding Corp.’s deal with Sleepy’s are two examples of buyer interest driving deals in this space.

In the food sector, PE Hub reports Charlesbank Capital Partners announced in January the sale of food manufacturer and packaging and supply chain management provider Peacock Foods to Greencore Group plc, an Ireland-based convenience foods producer. Illinois-based Charlesbank focuses on companies in the automation, packaging and processing subsector. The firm operates seven manufacturing facilities.

In December, Platinum Equity completed the acquisition of two Asia-based manufacturing enterprises: Foam Plastics Solutions, a leading maker of protective packaging; and Flow Control Devices, a manufacturer of valves, fittings, sensors and other components, reports PE Hub. The Trump administration’s focus on reshoring American manufacturing, however, could dampen interest in foreign manufacturers in the coming months. This will be a trend for domestic manufacturers to watch as it could add to buy-side demand and drive up valuations for U.S. manufacturing firms.

Future PErspectives: What’s Up Next for Manufacturing Investors

In light of uncertainty around U.S. global trade policy under the new administration, we could see technology companies in particular begin expanding U.S. manufacturing operations, according to Business Insider.

For example, Nikkei reports that Japanese manufacturer Sharp, owned by Foxconn—Apple’s top manufacturing partner—is mulling a screen factory in the U.S. Foxconn is an investor in Softbank’s Vision Fund, which insiders report could be leveraged to purchase technology assets or make a private equity deal.

U.S.-based factories may be subject to increased costs due to higher labor costs and reliance on Asian parts suppliers. If tech darling Apple begins increasing its manufacturing footprint in the U.S., other companies could follow suit. This trend would likely lead to more private equity dollars investing in the domestic technology sector.

Sources: PE Hub, Benchmark Monitor, Plastics News, Pittsburgh Business Times, The Middle Market, Business Insider, Nikkei

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Winter 2017). Copyright © 2017 BDO USA, LLP. All rights reserved.www.bdo.com

By Rick Schreiber, Chai Hoang and Chris Bard

Last year, over 6,000 manufacturers claimed more than an estimated $10 billion in research tax credits (RTCs), with each manufacturer’s average benefit exceeding $1 million.

Generated in part by manufacturers’ efforts to develop new and improved products and processes, these benefits were also generated by their continued investment to develop or improve software to manage or automate production processes and business intelligence, among other things.

This year, thanks to new regulations that broaden the range of software development activities eligible for the credit, more manufacturers may be able to take even greater advantage of these dollar-for-dollar offsets against tax liability, enabling them to invest more in new technologies, expand their labor force and finance other business objectives.

RTC Explained

Often also called the “R&D credit,” the research tax credit is an activities-based credit. Federal and state RTCs are available, in general, to businesses that attempt to develop or improve the functionality or performance of a product, process, software or other component using engineering, physics, biology or the computer sciences to evaluate alternatives and eliminate uncertainty regarding the business’ capability or method to develop or improve the component or the component’s appropriate design (Qualified Research).

RTCs equal to up to an average of 10 percent of qualified spending, which generally includes taxable wage, supply, contractor and cloud-computing expenses related to these attempts. More than 6,000 manufacturers reported performing qualified activities last year, and a recent BDO/MPI Survey shows that this number could be double that.

More than a majority (57 percent) of survey respondents said they weren’t planning to claim tax incentives like the RTC, even though they were planning to do development work to leverage the Internet of Things to capture and communicate more data more accurately and reliably.

This type of work likely qualifies for the RTC, but many respondents said they weren’t going to claim it because they thought they lacked sufficient documentation or weren’t performing qualified activities. 

Happily, these aren’t good reasons not to claim the RTC: several court cases have affirmed that oral testimony can be used to claim and support RTCs; and any manufacturer trying to make something better, faster, cheaper or greener is likely to be performing qualified activities, whether the activities succeed or not.

To that point, manufacturers in the following sub-sectors reported RTCs in 2013, the latest year for which IRS statistics are available:

And although many of these credits related to attempts to design and develop new products and processes, many also related to efforts to develop new or improved software.

Software Development RTC Opportunity Expanded

New final Treasury Regulations issued in October will increase the RTCs manufacturers claim for software development.

Under current and former rules, software development activities fall into two categories, depending on whether the software being developed is intended primarily for the taxpayer’s internal use or not. What category the software falls into is important because “internal use software” (IUS) development activities must meet a higher standard to qualify than activities to develop non-IUS software.

The Final Regulations narrow the definition of IUS considerably. This means that considerably more software development activities are eligible for the credit, which means that more manufacturers may claim more RTCs going forward.

IUS is software developed for use in general and administrative (G&A) back-office functions that facilitate or support the conduct of the company’s trade or business. G&A functions are defined as financial management functions, human resource management functions and support services functions.

Whether software is IUS depends upon whether the taxpayer, at the beginning of development, intended the software to be used primarily for G&A purposes. Software is not IUS if it is developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system.

IUS development may also qualify. The regulations also provide that Qualified Research to develop IUS qualifies if it:

1. Is intended to develop software that would be innovative, i.e., result in a reduction in cost, improvement in speed or other measurable improvement that is substantial and economically significant;
2. Involves significant economic risk, as where the taxpayer commits substantial resources to the development and there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period. The focus should be on the level of uncertainty and not the type of uncertainty; and
3. Is intended to develop software that isn’t commercially available for use by the taxpayer without modifications that would satisfy the first two requirements.

Manufacturers and the RTC Tax Credit

The new regulations apply to a vast array of manufacturers’ activities, and businesses in this space should consider whether they’re missing out on opportunities to benefit from the RTC. Manufacturers have undertaken an effort to digitalize their operations, supply chains and markets.

Companies are increasingly engaged in the development and improvement of business-intelligence software systems and enterprise-resource-management tools. The development, optimization and integration of the Internet of Things to enhance manufacturing and related processes also often qualify for RTCs.

Additionally, sales and operations planning require data from all aspects of a business, from production throughput and distribution and warehousing to financial metrics.

The development and implementation of software to monitor and manage back-office functions could qualify for the RTC, e.g. activities to develop software related to:

• Supply chain functionality;
• Forecasting based on historical baselines, promotions and sales;
• Pricing optimization, of both sales to consumers and procurement of supplies;
• Inventory management;
• Order management;
• Revenue management;
• Routing engineering/software development; and
• Security against cyber-attacks.

Because the final regulations exclude from the definition of IUS software that is developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system, manufacturers should review their software against the new definition and standards.

For example, software developed to manage supply orders, sales or production data with third parties, or to enable customers or third parties to track delivery of goods, search inventory, or receive services over the internet, may qualify under the new regulations, without having to meet the higher standards for IUS.

Conclusion

Manufacturers of all sizes have been benefitting from the RTC since its inception in 1981. Now, with the new regulations on software development, many more should be able to benefit more than ever before, thus reducing their taxes, freeing up capital and gaining a competitive advantage.

In addition, smaller manufacturers may be able to use the RTC against up to $250,000 of their payroll taxes or even their Alternative Minimum Tax.

Rick Schreiber is an Assurance & Advisory managing partner and the national leader of BDO’s Manufacturing & Distribution practice. He may be reached at rschreiber@bdo.com.

Chai Hoang is a manager in BDO’s Research and Development (R&D) Tax Services practice, and may be reached at choang@bdo.com.

Chris Bard is the practice leader for BDO’s Research and Development (R&D) Tax Services practice and chairman of BDO International’s Global R&D Center of Excellence. He may be reached at cbard@bdo.com.

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Winter 2017). Copyright © 2017 BDO USA, LLP. All rights reserved.www.bdo.com

By Eskander Yavar

The arrival of Industry 4.0, or the fourth industrial revolution, signifies the next era in manufacturing, in which plants, processes, products and people come together in an entirely new way, enabling decentralized, autonomous decision-making on factory floors.

Sometimes used interchangeably with the “Industrial Internet of Things”—a term coined by GE CEO Jeff Immelt—Industry 4.0 refers to digitally connected manufacturing, characterized by “smart” factories and smart supply networks.

Born out of a confluence of technology advancements—from the Internet of Things to artificial intelligence to 3-D printing—Industry 4.0 ultimately hinges on the ability to integrate data with physical processes across the entire value chain.

That’s where Enterprise Resource Planning (ERP) and Material Requirements Planning (MRP) come in. ERP is a system for integrating a company’s data from all core business components into a single place to automate decisions and streamline operations.

The question for manufacturers isn’t whether they have an ERP system in place, but whether their ERP system is compatible with the way they use information now and the way they want to use information in the future.

Can your ERP software capture information from third-party systems? Can it process and contextualize data in real time? Can you easily add new features when you add new applications or business processes?

The answers to these questions aren’t one-size- fits-all. Most manufacturing companies can orient themselves within a process continuum. One end corresponds to the repetitive and discrete and the other to the highly sophisticated and engineered-to- order.

ERP software strategy should align with where the company falls along that spectrum and where it wants to go, informing the level of technological sophistication required in the software and the level of discipline in planning.

For middle-market manufacturers, investing in an ERP and/or MRP system can help manage resources, drive efficiencies and position them to more effectively compete with larger players with more resources. ERP may not be as “sexy” as artificial intelligence or robotics—but it’s a necessary precursor to embarking on any Industry 4.0 journey.

Here are four things manufacturers should do to maximize their investment in an ERP system:

Balance Risk and Reward Along the Complexity Continuum

The more complex the manufacturing process, the more rewarding it can be for operations and the bottom line to build and implement strategies for ERP systems to eliminate redundant systems and processes.

And conversely, manufacturers with complex operations can also experience more painful financial and operational consequences if they don’t do that well.

Understand What Functionalities You Need

ERP software can afford companies many benefits, including:

• Managing compliance and regulatory requirements
• Increasing inventory accuracy and materials planning
• Increasing on-time deliveries
• Enabling more efficient and meaningful reporting
• Improving management decision-making
• Improving customer service
• Consolidating databases
• Enabling a paperless factory

While even the smallest manufacturer can achieve all these benefits, it’s important to consider how ERP needs to work for your business and which vendor’s software will best position you to achieve your goals.

Across the board, though, ERP can empower manufacturers to understand how they’ve historically sourced, made and distributed a product, as well as how they can repeat cost-effective processes and drive efficiencies across the entire enterprise.

Master the Basics

The flashier and more sophisticated ERP software gets, the more companies will need to be mindful of how the tool can help them solve a specific organizational problem, or their investment could risk going to waste. Before investing in an advanced supply chain planning tool, for example, they need to master the basic modules.

Mastery of the basics will be more critical than ever as we look toward the next technological advances—things like Industry 4.0 and widespread adoption of the Internet of Things and more data-driven business intelligence.

Clean up Your Data

Successful adoption of Industry 4.0 technologies is predicated on a disciplined process, clean data and organized teams. And at the core of ERP strategy and implementation is the integrity of an organization’s data. There are more opportunities for errors when machines cooperate autonomously with one another based on flawed data.

Because Industry 4.0 fundamentally changes the role of the operator, building systems that maintain the integrity of certain production processes without the same level of human oversight remains one of the main challenges to implementation. If the underlying data or data analysis has errors, the automated decision-making based on that data will be riddled with errors too.

This means it’s critical to ensure data is clean, accurate and accessible as part of an overall information governance strategy. Just as a contractor wouldn’t build over a cracked foundation, embracing technological advancements without the right fundamentals of information governance, IT strategy and analytics capabilities could result in a flawed execution.

With these fundamentals in place, ERP can be a useful tool for middle market manufacturers looking to save on time and material costs and drive efficiencies enterprise-wide. And as Industry 4.0 becomes a reality for more manufacturers, smart, strategic use of ERP software can help middle market manufacturers leverage those benefits to maintain their competitive edge.

For more information, contact Eskander Yavar, national leader of BDO’s Management Advisory Services, at eyavar@bdo.com.

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Winter 2017). Copyright © 2017 BDO USA, LLP. All rights reserved.www.bdo.com

By Jerry Dentinger & Ryan McCaslin

Dealmaking in the manufacturing industry is poised to accelerate in 2017, buoyed by investor optimism around proposed pro-growth economic policies. Despite the modest slowdown in volume last year, multiples and valuations stayed high going into 2017.

Therefore, buyers remain laser-focused on understanding a target’s profitability model to justify the expensive prices they are paying. The due diligence process continues to be critical to making informed investment decisions and capturing value after closing.

As part of the due diligence process, buyers typically seek out a detailed analysis of a target’s Quality of Earnings (QofE). QofE analyses aren’t new, but attention continues to grow around Big Data and how to navigate the exponential increase in volume and variety of structured and unstructured data in a due diligence process.

This development has added a new layer of complexity—demanding a near-forensic level of detail, further increasing the burden on sellers and raising buyers’ appetite for information. For small and mid-sized manufacturers, where QofE processes often start immediately after receiving a Letter of Intent (LOI), introducing another layer of unexpected complexity can add serious anxiety to the sale process.

The proliferation of data, however, is also a major opportunity for both buyers and sellers to analyze and glean meaningful insights and thus gain important leverage during negotiations.

For sellers, QofE analysis proactively identifies new areas to create value. For buyers, it helps confirm or challenge value to justify the investment or re-trade the deal.

Increasingly, manufacturers are proactively using data analytics tools to identify new areas where value can be created and proven. No longer viewed as a burden, the QofE process is enabling sellers to take more objective looks at their business and operations prior to sale.

It’s crucial to understand where your business generates value well before bringing a buyer into the picture. Data analytics has proven to be an extremely important means to identify, create and hold value for companies going through a sale.

How is Big Data changing the QofE process?

QofE is not simply an accounting function—it also helps a buyer understand how and where a business makes its profits. Buyers request QofE analysis to be performed on targets to help them confirm value and identify areas where they can begin to drive returns post-close.

The process requires sellers to disclose a significant amount of company data to allow buyers to drill into profitability by customer, product, SKU, geography, distribution channel and a variety of other metrics to understand where value is generated.

Sellers are not always comfortable sharing such sensitive information with potential buyers. This friction has increased with the introduction of data analytics.

Historically, sellers have responded to QofE requests by providing as little information as possible. Today, they provide significant confidential information, most of which is delivered in electronic form with multiple large data extracts from their operating systems.

QofE teams analyze these data sets manually through sophisticated spreadsheet modeling. All of this is done under tight time frames and often requires significant effort to reconcile and ensure completeness of the information.

Most sellers have never provided or analyzed this volume of data—much less in an electronic form—until entering a sale. This can result in a slow start to the QofE process, delays and sometimes cost overruns if sellers are not prepared.

In the manufacturing industry, embedded sensor technology, wireless connectivity and mobile technologies have given companies access to unprecedented levels of data, enabling more sophisticated reporting and metrics.

However, combing through these disparate data sets to create actionable information poses a significant challenge for mid-sized manufacturers unless they use data analytics software that links to their ERP systems.

Even then, companies may still struggle to design management reporting that combines operating data with the financial information to meet the rigors of a QofE analysis. Today, few manufacturing companies are able to implement a comprehensive, cost-effective data analytics approach.

But that is changing.

With a variety of Big Data tools available, companies can now obtain greater visibility into key financial variables and their relationships, identify gaps and evaluate business opportunities in significantly less time.

For both buyers and sellers, leveraging data analytics in conjunction with a QofE process provides valuable insights into where value is created or exposes whether value is sustainable or if it truly exists.

Manufacturers face unique QofE challenges

QofE analyses can be more challenging for manufacturers than other industries. Why?

• Production volume: Many manufacturers, particularly in sectors like fabricated metals, plastics and components, operate in high-production-volume environments with thin product margins. Analytics and reporting are both critical and challenging because of product costing, hundreds of bills of materials and the sheer number of SKUs. However, this level of complexity presents a significant opportunity to pinpoint value drivers across product lines, channels, geographies and individual customers.
• Difficulty understanding costs: Manufacturers are proficient at tracking direct costs of production and distribution for specific products, but complications arise when accounting for indirect costs, overhead and allocations of variances, particularly if there is strong seasonality to revenues or volatility in the supply chain or marketplace. Errors can occur in standard costing and overhead allocation methods that affect fully absorbed product costs and thus raise questions about whether a SKU, product family or entire customer relationship is actually profitable. Further challenges arise when companies operate with multiple business lines. Successfully implementing data analytics here generates visibility and adds significant value.
• Inventory and working capital: Manufacturers typically operate with high inventory levels and overall working capital. In a deal, buyers and sellers negotiate a working capital target or “peg” that will be delivered at closing based on an agreed-upon methodology and historical performance. Data analytics is starting to play a critical role in setting pegs by, for instance, proactively identifying inventory obsolescence issues down to the SKU level. These tools are facilitating stronger negotiating positions for their users.

A proactive approach to QofE adds value

Regardless of whether you’re considering an immediate sale or looking to increase value through process improvements, these three proactive practices will improve your readiness for the eventual, extremely thorough QofE process.

• Mind the GAAP gap. Keeping your books on Generally Accepted Accounting Principles (GAAP) and as current as possible is prudent if you are considering a sale. Many companies update their ledgers quarterly or even once a year, whether audited or not, and many keep certain accounts on a cash basis. In QofE, you need the historical bookend of a trailing 12-month period on accrual basis, and scopes are usually no less than two full years, often three. Monthly GAAP-based financials and corresponding monthly metrics are key.
• Be proactive and understand the QofE process. Get ahead of the curve and anticipate the demands you will face in the sale process. A QofE is industry standard, and most third-party debt and equity providers require it. Too often sellers aren’t aware of QofE requirements until they have an LOI, and regardless of whether it is a proprietary sale process or a broad auction, due diligence is extremely detail-oriented, with no topic left off the table. Technology-enabled tools are making the exercise more complex, not less—but they’re also necessary to the process. Thus, QofE preparedness should start no later than 90 days before hiring an advisor.
• Look in the mirror. The sooner QofE disciplines are introduced, the sooner value creation can begin for selling shareholders. Sellers should consider “reverse due diligence” one or two years before starting a sale process so they can identify and capitalize on process improvement opportunities to increase long-term value, identify lower versus higher profit operations, and generate a higher purchase price. Today, however, sell-side QofE typically begins when the seller hires an advisor, who shortly thereafter assists the company in the selection of an accounting firm. Better late than never, a seller-initiated QofE at the time of sale will be instrumental to holding value during the sale process. Holding value and certainty to close are the two biggest reasons why sell-side QofE has become a necessary part of a seller’s process in the U.S. market—despite being part of the European M&A landscape for decades. Sell-side QofE pays for itself many times over, whether started at the time of sale or years earlier.

Understanding the methodologies behind a QofE analysis, and then approaching it as a best practice—rather than as an accounting function or “check the box” requirement for due diligence—can help sellers maximize value upon exit.

Incorporating data analytics solidifies the understanding where value is created and where to drive the business after sale. Sophisticated buyers are already looking to the future on how to drive value in their targets long before they submit an LOI.

Sellers who understand that perspective and prepare for diligence accordingly will facilitate greater success for themselves and all parties in the transaction.

Jerry Dentinger is a partner and leader of the Central Region Transaction Advisory Services practice, and may be reached at jdentinger@bdo.com.

Ryan McCaslin is a managing director in BDO’s Transaction Advisory Services practice, and may be reached at rmccaslin@bdo.com.

This article originally appeared in BDO USA, LLP’s “Manufacturing Output” newsletter (Winter 2017). Copyright © 2015 BDO USA, LLP. All rights reserved.www.bdo.com

SUMMARY

On March 1, 2017, the American Institute of Certified Public Accountants (AICPA) issued a working draft aimed at helping broker-dealers apply the new revenue recognition standard when accounting for the costs associated with underwriting services on either a gross (principal) or net (agent) basis.

The new working draft, Issue #3-3: Principal vs. Agent: Costs Associated with Underwriting, is part of a series of revenue recognition implementation issues identified by the AICPA Brokers and Dealers in Securities Revenue Recognition Task Force.

The task force was convened to assist the industry with implementing the Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. The new revenue standard is effective for calendar-year public companies in 2018.

The Principal vs. Agent working draft is open for public comment until May 1, 2017. Once finalized, the draft will be implemented in the ongoing revenue recognition guide developed by the task force.

This guidance from the AICPA is anticipated to have a limited impact on the brokerage industry’s accounting standards.

Key Takeaways from Issue #3‑3: Principal vs. Agent: Costs Associated with Underwriting Guidance

Underwriting syndicate members should evaluate whether they are principal or agent in providing underwriting services to the issuer in accordance with guidance in FASB ASC 606-10- 55-36 through ASC 606-10- 55-40.

The lead underwriter and participating underwriters in an underwriting syndicate should conduct this analysis by assessing whether they have promised the issuer that they would provide the specified goods or services themselves (acting as principal) or arrange for them to be provided by the other party (acting as agent).

This would include an assessment of whether they control the specified goods or services to be provided to the customer before these goods or services are transferred to the customer.

FASB ASC 606-10- 55-37A indicates that when another party is involved in providing goods or services to a customer, an entity is defined as a principal if it obtains control of any one of the following:

i) a good or asset from the other party that it then transfers to the customer; ii) a right to direct that party to provide one of its services to the customer on the entity’s behalf; or iii) the opportunity to combine the other party’s goods or services with other goods or services to the customer.

FASB ASC 606-10- 55-39 provides indicators that an entity controls the specified good or service. A lead underwriter could evaluate these as follows:

• Primary responsibility for fulfilling the contract: Each underwriting syndicate member is legally responsible to perform services for the issuer and is liable under the terms of the contracts. The lead underwriter, however, plays more of an agent role as it negotiates with the issuer on behalf of the entire syndicate.
• Inventory risk before or after the goods have been ordered, during shipping, or upon return: Each underwriting syndicate member is obligated to pay the service providers even if they do not perform as promised. The lead underwriter doesn’t have inventory risk because it doesn’t purchase the participating underwriters’ services at any time, and so is indicative of an agent relationship.
• Discretion in establishing the price for the specified good or service: While the lead underwriter negotiates the agreements between the issuer and syndicate members, it doesn’t necessarily have greater influence on pricing than the other syndicate members. Underwriting syndicate members also have limited discretion on pricing. Thus, lead underwriters and syndicate members can have either a principal or agent relationship in this case, depending on the scenario.

AICPA’s Financial Reporting Executive Committee (FinREC) generally believes that the role of the underwriting syndicate members, including the lead and participating underwriters, is that of a principal because the underwriter obtains control of the services and combines them with other services when fulfilling its performance obligation.

Thus, each underwriter should reflect their proportionate share of the underwriting costs on a gross basis in the statement of earnings in accordance with ASC 606‑10‑55-37B.

FinREC generally believes that the role of the lead underwriter with regard to services provided by the participating underwriters is that of an agent because the underwriter does not obtain control over the other syndicate members’ services.

Thus, the lead underwriter should record underwriting revenues net of revenues allocated to the participating members and expenses incurred net of the expenses that are allocated to the participating members in accordance with ASC 606-10- 55-38.

FASB ASC 940-340- 25-3 states that underwriting expenses incurred before the actual issuance of the securities shall be deferred.

FASB ASC 940-340- 35-3 states that underwriting expenses deferred shall be recognized at the time the related revenues are recorded. In the event that a securities transaction is not completed, the entities involved shall write those costs off to expense.

Registered broker-dealers should be prepared to identify which role they are playing (lead or participating underwriter, or syndicate member) when working with issuers. They should also understand how each role will affect their financial reporting.

The AICPA has also issued for comment working draft Issue # 3-3a: Costs Associated with Investment Banking Advisory Services. Comments on this working draft are also due May 1, 2017.

This article originally appeared in BDO USA, LLP’s “Brokerage Insights” (March 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com.

Earlier this month the SEC and FINRA released their respective examination priorities for 2017— please see a brief overview and link to the releases below.

FINRA

Five Areas of Regulatory Focus

FINRA CEO Robert Cook calls this year’s priorities “a focus on core blocking and tackling issues of compliance, supervision and risk management.” Here are the highlights.

1. HIGH-RISK BROKERS

Regulators will review how firms hire and supervise brokers with disciplinary records, including branch office inspection practices, the use of unapproved email addresses for business, and client communications via social media, radio, seminars and podcasts.

2. SENIOR INVESTORS

Broker suitability standards will be under scrutiny as regulators look to ensure sound sales practices targeting senior investors, particularly with penny stocks and complex yield-generating products.

3. FINANCIAL RISKS

Liquidity and financial risk management practices and contingency planning will be reviewed as regulators seek to understand if firms are adequately prepared to endure market stresses.

4. OPERATIONAL RISKS

Cybersecurity remains a priority with regulators focusing on how well firms understand and manage sensitive data, prevent data loss, monitor passwords, ensure physical security and maintain books and records.

5. MARKET INTEGRITY

Regulators will focus on surveillance programs targeting trading activity at the open and close, cross-product layering surveillance, best execution, pre- and post-trade market access controls, as well as expand OATs and TRACE reporting programs.

See the full text of the release here:

http://www.finra.org/industry/2017-regulatory- and-examination- priorities‑letter

SEC

The SEC sets sites on Robo-Advisors and FINRA Supervision

The SEC s Office of Compliance Inspections and Examinations (OCIE) selected its 2017 examination priorities by focusing on five thematic areas: examining matters important to retail investors, risks associated with elderly and retiring investors, market wide-risks, FINRA oversight and cybersecurity. While many of these priorities are not new, the SEC will be focusing more on electronic investment advisors (“Robo-Advisors”) and oversight of FINRA examination.

1. RETAIL INVESTORS

The SEC will be examining investment advisors who provide advisory services through electronic means with a focus on meeting retail investors’ needs, as well as wrap fee programs that provide advisory and brokerage services for a single bundled fee.

2. SENIOR AND RETIREMENT INVESTMENTS

Meeting the needs of senior investors and those preparing to retire is an important expansion of the regulatory examination program. The OCIE will monitor pension advisors and broker-dealers that offer high risk products in the area of variable insurance products to retirement accounts and manage target date funds.

3. MARKET-WIDE RISKS

Regulators will continue their mission of ensuring registrants focus on the integrity of the systems they use by complying with Regulation SCI and anti-money laundering rules. Money-market fund compliance with SEC amended rules, effective October 2016, is a new addition to this initiative.

4. FINRA

Regulatory inspections of FINRA’s operations and regulatory programs will continue Resources will be directed to access the examinations of individual broker-dealers.

5. CYBERSECURITY

The examination staff will continue to examine investment advisors’ and brokers’ cyber compliance, in accordance with previous pronouncements, related to a cyber framework with policies, procedures and controls to protect the integrity of information systems.

See the full text of the release here:

https://www.sec.gov/news/pressrelease/2017-7.html

This article originally appeared in BDO USA, LLP’s “Brokerage Insights” (February 2017). Copyright © 2017 BDO USA, LLP. All rights reserved. www.bdo.com.

In a three to two decision, the Supreme Court in Arkansas has reversed 29 years of decisional law in order to return to the statutes as written in the state. The Court found that three precedent setting cases beginning in 1987 through 2008 did not follow the state’s statutes which were plainly written. In this case, Moore v. Moore, 2016 Ark. 105, the Justices ruled that the statutes specifically excluded the increase in value of non-marital assets from property division due to a divorce.

Beginning with the ruling of Layman v. Layman, 292 Ark. 539, in 1987, a standard of “active appreciation” of non-marital assets came into play in a divorcing couple’s property division. This standard weighed the efforts of the owning and non-owning spouses when determining whether non-marital property should be re-classed as marital property. In formulating such weight, turning the previous non-marital asset into a marital asset, division was then deemed appropriate between the divorcing parties.

With this ruling in Moore v. Moore, the Justices determined that it was “appropriate to return to the statute’s plain language, which states that ‘the increase in the value of property acquired prior to marriage’, is non-marital.”

The Justices also pointed out in their ruling that the normal exceptions to the property division statute, permits the division of non-marital property in a divorce, in certain cases. This statute permits the division of non-marital property if the Court deems it equitable in the case of: length of marriage, age, health, occupations, and sources of income, employability and so forth. But the court must determine its bases for not returning the non-marital property to its owner.

Take away: Each state is governed by its own statutes. However, rulings in one state are noticed by others, with changing tides possibly beginning anew elsewhere. It is also important to note that commingling of assets within a marriage will change the very nature of an asset from non-marital to marital status, thus leaving the asset open to division should a divorce occur.

We are ready to discuss this Arkansas Supreme Court ruling and its implications. Contact your advisor at Smolin. We can help avoid the potential pitfalls awaiting you, and present positive alternatives for your path.