Auditing: What It Is & Why It’s Done

The Importance of Auditing

Auditing typically refers to an objective review of a company's financial statements, which consist of the cash flow statement, the income statement, and the balance sheet. Audits are evaluations that analyze the level of accuracy that the business has characterized in its financial records. The process looks at how a business documents investing, financing, and operating ventures.

Depending on the type of audit and what it aims to accomplish, it can be conducted by internal employees or independent, third-party examiners, like a Certified Public Accountant (CPA) firm or a government agency such as the Internal Revenue Service. When it comes to the United States, the Generally Accepted Accounting Principles (GAAP) are what auditors look to when analyzing financial statement preparation. External audits are guided by the American Institute of Certified Public Accountants' (AICPA) Auditing Standards Board (ASB). The AICPA requires that the generally accepted auditing standards (GAAS) are followed by external auditors to ensure proper protocol is followed.

When it comes to regulations, the Sarbanes-Oxley Act of 2002 requires publicly traded companies to have their internal controls’ impacts reviewed. It also states that companies that do not implement and enforce their internal controls may be subject to criminal charges.

Defining Internal Controls

Internal controls can be thought of as how businesses manage operations by regulating permissions, documentation, congruency, protection/safety, and partitioning of responsibilities for business processes. These are broken into preventative and detective activities.

Sometimes referred to as protective activities, responsibilities are compartmentalized and distributed among different individuals to dissuade mistakes or deceit from occurring.

It also integrates highly detailed written procedures and validation procedures for further cautionary measures. It's meant to verify that no sole person is able to approve, document, or be responsible for monetary transactions and final products. Permitting invoices and validation of expenses are examples of internal controls. Only permitting appropriate access to the fewest employees necessary and the fewest required business equipment is one way to implement this type of internal control.

Detective Controls Defined

Detective controsl are redundant systems that are put in place to intercept issues that might have fallen through the initial round of quality control measures. Looking at reconciliation procedures, which match the data in question against known accurate data sets, it's used to fix discrepancies.

Internal Audits

Internal audits are usually conducted by a business’ employees, primarily performed as a way to evaluate internal operations and internal controls. They look to identify any deficiencies or weaknesses in the business' operations, often occurring before an external auditor reviews its financial statements. This type of audit is also meant to review and identify any legal or regulatory compliance issues.

External Audits

An external audit occurs when an independent auditor, such as a third-party CPA firm, assesses a business' internal controls and financial statements. It is performed to provide an objective opinion that an audit conducted by the business itself cannot. With a “clean opinion” or “unqualified opinion” provided by the independent auditor, businesses can provide those looking at financial statements confidence that such financial statements are reliable. It enables the outside entity to focus on the financials, the business's internal controls, etc. by providing a conflict-of-interest-free perspective.

Government Audits

Government audits are done to ensure that businesses have accurately reported their taxable income to respective government agencies. This can include federal agencies such as the Internal Revenue Service (IRS) and Canada Revenue Agency (CRA), which are the U.S. and Canada's respective tax collection agencies.

When an IRS audit has concluded its review, there may be a few different preliminary results and resulting paths. The tax return may see no modification. There may be a modification the taxpayer agrees to, which could result in additional money being owed. The third result occurs when the filer doesn't agree with the change, and it is worked out through an appeal process.

Whether it's an investor for a publicly traded company or a business looking for creditors for help with money, materials, etc., having audited financial statements provide confidence that they'll see a return on their investment or a high likelihood of their debts being satisfied in the future.

Sources

https://www.congress.gov/bill/107th-congress/house-bill/3763

How to Host Awesome Holiday Office Parties

Fall is here and so are many of the holidays we love. Whether it's Halloween, Thanksgiving, or the December holidays, here are some fail-safe things you can do to make sure everyone shows up and has a good time.

Throw a Potluck

One of the easiest ways to lure people away from their desks is – you guessed it – food. Create a sign-up sheet with different categories to make sure you have enough savory and sweet dishes, and provide options for those with dietary restrictions. If you’re the organizer, you might supply the drinks and utensils, maybe even some appetizers or snacks. Depending on the holiday, you might also suggest a theme. If it’s Halloween, you could ask folks to bring their spookiest fare.

Have a Raffle

This is yet another way to get people out of their offices. Everyone who shows up gets a ticket and on the back, they'll sign their name. At different times during the party, have a drawing. Maybe leave the big prize to the end. You could even stipulate that people must be present to win. Some of the prizes you could offer are gift cards, smart watches, paid time off (PTO), or tickets to an event (a sporting event, a concert, etc.). A weekend at a local hotel (think staycation) or airline tickets are also attractive options. If resources allow, the sky’s the limit.

Designate Secret Santas

During December, this is always a big hit. Employees draw random names and get paired up with someone. The Secret Santa is given a wish list to choose from to give to their giftee. A smart idea is to set a monetary limit, such as gifts for under $25. After opening the present, the giftee has to guess who gave them the gift.

Set Up Games

Think giant Jenga. Pin the carrot nose on the snowman. Cornhole. These can be scheduled or ongoing. And best of all, it’s easy and uncomplicated. Employees can come and go as they wish. A little competition while everyone is noshing is a surefire way to foster employee bonding.

Host a White Elephant Gift Exchange

This is another classic. Everyone brings a wrapped gift and then you draw numbers. People sit in a circle with the presents in the middle, select their gifts in numerical order and unwrap them for all to see. But here’s the fun part: You can steal a gift that someone before you has unwrapped, which causes that person to either select a gift from the pile or steal from someone else. After three steals, the gift is frozen with whoever has it.

Volunteer Together

Working side by side with your colleagues for a purpose greater than yourself always cultivates a sense of community. For example, you could print off blank cards with your company logo on them, then ask employees to send a note of thanks to deployed military members. Another thing you could do with the cards is send a word of encouragement to those who live in places like The Salvation Army. The holidays can bring up lots of emotions, and sending positive messages to others is always a reward in and of itself. After all, when you give, you receive.

Whether you try one or all of these ideas, taking a break from the grind and enjoying a little non-work fun is not just necessary, it's critical. When employees can cut loose, as well as feel appreciated and cared for, you'll likely have a happier, healthier workplace.

Sources

https://www.indeed.com/career-advice/career-development/office-holiday-party

Should You Upgrade Your Homeowners Insurance?

During the first year of the pandemic, many homeowners spent their downtime upgrading their homes. 2020 alone saw a three percent uptick in spending on home improvements – to the tune of nearly $420 billion nationwide. This included modifications for remote work, online schooling, and leisure activities at home.

Between remodeling, high inflation, and today's elevated real estate prices, it's important to review your homeowner's insurance policy to ensure it is up to date. Does it include enough coverage for recent upgrades to your home? Does it carry an inflation factor to ensure coverage is on par with more expensive building material costs and labor increases? Do you have coverage for ancillary factors, such as the cost of meeting local building ordinances or flood insurance for today’s extreme weather events?

Replacement vs. Actual Value

One term to check on your policy's declaration page is whether your coverage is determined by replacement cost or actual cash value. Replacement costs will pay for repairs to your home or replace your personal property (e.g., laptop, television) up to coverage limits, regardless of its current value. In other words, the policy will pay for a new computer even if your old one was three years old.

Actual cash value refers to a cash payout equal to the current value of your property. In other words, if your computer was three years old, you will receive the cash value of a three-year-old computer – which will not likely cover the cost of a new replacement.

Guaranteed Replacement

In lieu of upgrading your home's cost coverage each year, you might have the option to pay for a guaranteed replacement, which is an extra fee that ensures the policy will cover the entire cost to rebuild your home. Extended replacement cost coverage pays out a certain percentage above your policy's stated dwelling coverage limit if the cost to rebuild is higher than the face amount. For example, a policy with $200,000 coverage and 25 percent extended replacement coverage will pay up to $250,000 to rebuild your home.

Ordinance Coverage

Homeowners who live in older homes should consider adding ordinance coverage if it is not standard under their policy. Ordinance coverage pays for the cost to meet current building codes should you need to rebuild. These fees can be substantial and would have to be paid out-of-pocket if you don’t have this form of coverage. Note, too, that although guaranteed replacement cost coverage might offer a higher payout, that is only for the material and labor costs to rebuild – not local ordinance fees, licenses, or inspections.

Inflation Impact

As you review your current policy, note that the section labeled “Coverage A” represents the amount available to rebuild your home. It generally rises by two to three percent each year for basic cost-of-living increases. However, it is worth noting that building materials, such as lumber and steel, increased by 19 percent in 2021, and in June the general inflation rate increased to 9.1 percent, its highest level in more than 40 years.

Because rising home building costs, high inflation, and the increasing number of weather events have plagued the home insurance industry, policy premiums are starting to increase at a higher rate each year than in the past. In addition to higher costs due to supply chain disruptions and inflation, the home building industry is hampered by a lack of qualified workers – and experienced workers are demanding higher pay. This is yet another component that is factored into calculating insurance premiums. Basically, anything that would lead to a higher cost to repair your home will result in higher rates.

Insurance companies calculate your policy premiums by multiplying your home's replacement rate with your home's current value. Therefore, a combination of higher building costs and higher real estate values have contributed to higher insurance premiums. Some states have set an annual percentage cap on how much insurance companies can raise homeowner rates each year. However, given the increasing number of extreme weather events (e.g., storm surges, wildfires) in recent years, state legislators also have increased those rate caps so that insurers have the latitude to cover excess payouts. Note that rate increases vary by geographical area and are based on local weather activity, labor costs, and building supplies.

Some insurance policies offer an inflation guard, which automatically increases coverage limits to match inflation rates when the policy is renewed.

Flood Damage

Be aware that homeowners insurance does not cover flood damage. Mortgage lenders require homes located in government-designated Special Flood Hazard Areas (SFHA) to purchase a separate flood insurance policy. However, we have seen inland and even metropolitan areas that are not located in flood zones devastated by the effects of storm surges following hurricanes. Homeowners who live in these higher-risk areas should consider purchasing a separate flood insurance policy as well. 

Tax Break for Commercial Real Estate Investors

COVID-19 impacted the economy dramatically, and commercial real estate was no exception in terms of decreased values. Often, the real property could no longer service the debt used to finance it. This debt restructuring and resulting debt forgiveness can result in taxable income.

Taxable Income and Debt Cancellation

If you have an $80,000 loan and the bank reduces the amount you owe down to $50,000, then you have an economic benefit of $30,000, which should be treated as taxable income. This is indeed how the cancellation of debt is treated, but there are exceptions, such as in the case of bankruptcy or insolvency. There is another unique scenario that applies only to commercial real estate.

Assuming that the taxpayer is not a C-corporation, debt cancellation is excludable from taxable income if it results from qualified real property business indebtedness (QRPBI). QRPBI is debt taken on to buy real property used for commercial purposes. Starting in 1993, debt used for building or improving a property also qualifies.

As we all know, there is no such thing as a free lunch. For debt cancellation to not be considered current taxable income, the taxpayer must reduce their basis in the real property by this same amount. This does not cancel the income; instead, it defers its recognition and helps cash flow as a result. Below, we look at an example of how this works.

Illustrative Example

Assume David bought a property in 2017 and he uses it for business purposes. In 2022, the property has a first mortgage of $200,000 and a second mortgage of $100,000 (both with the same bank), with a fair market value (FMV) of $240,000. He negotiates with the bank to reduce the second mortgage down to $20,000, resulting in income from the cancellation of debt of $80,000.

The amount of debt cancellation that can be deferred is equal to the amount of the second mortgage before the debt cancellation, less the FMV minus the first mortgage. In David’s case, before debt cancellation, the FMV ($240k) minus the first mortgage ($200k) was $40,000. The balance of the second mortgage ($100k) exceeded this by $60,000. Out of the total debt cancellation of $80,000, this $60,000 is subject to deferral, with only the remaining $20,000 reported as immediate taxable income.

The $60,000 is not considered as taxable income only to the extent that David has sufficient adjusted tax basis in the depreciable real property to absorb this as a reduction in basis. Assuming this is the case, the basis reduction applies the first day of the tax year after the debt cancellation (unless the property is sold before year-end — then it applies immediately).

In the example above, David would include the $10,000 of cancellation of debt income on his 2022 tax return and adjust his basis in the real property by $60,000 as of Jan. 1, 2023.

Filing Mechanics

For real estate held via partnerships instead of by individuals, determining if a debt is QRPBI qualified happens at the entity level, although reductions of basis are done at the individual level for each partner, allowing individual planning. The election to defer the cancellation of debt income is recorded on Form 982.

Conclusion

The COVID pandemic caused many real estate investors to restructure their debts. The option to defer debt income cancellation offers a great tax planning opportunity by delaying taxable income and improving cash flows.

How to Increase After-Tax Returns on Investments

Earnings is all about how much you keep after taxes – not what you bring in from your job, a business, or investments. While it is always great to see fabulous investment gains, the only financial metric that really matters is what is in your bank account at the end of the day. One of the ways you can influence this is by minimizing the taxes you pay on your investments.

Unfortunately, many people do not think about how taxes impact their investment returns until near the end of the year; however, you should act all year round. Taking part in investment tax planning throughout the year will give you opportunities to keep more of what you earn. Here are some rules and strategies to keep in mind.

Know When to Take Your Losses

Psychologically, many investors are averse to taking losses, holding out to “make their money back.” Instead of emotion, logic and investment acumen needs to be applied here. If an investment does not have a fundamental reason to turn around, then you are better off selling it and taking a tax loss.

Losses reduce taxes on either your capital gains for the year or, when losses exceed gains, up to $3,000 on other income. Excess losses can be carried forward to future years. Plus, you will have the proceeds to reinvest in something more likely to produce a return.

Let Winners Run

Unlike long-term capital gains, short-term capital gains are taxed as ordinary income. This means your marginal income tax rate (the highest rate applied to you) can impact your investment gains.

While you should not let the tax tail wag the investment dog, ideally you want to hold a winning investment for at least a year and a day to benefit from long-term capital gains tax treatment. This means you will pay only a 20 percent maximum tax versus whatever your marginal rate is.

As with losses, the fundamentals of the investment are key. Therefore you should not sell a holding if you think the gains are at risk just to save on taxes. If you believe in the investment for the long term, then holding out for preferred capital gains treatment can be a clever idea.

Give the Gift of Appreciation

Making charitable donations you would not otherwise give is generally not a viable tax strategy. However, if you are already charitably inclined, then consider donating stock or mutual funds instead of cash.

When you donate property such as stocks, your charitable deduction is based on the fair market value of the asset on the date of the gift. It is much better to do this than donate cash.

For example, if you have a stock you purchased for $35 and it is now worth $135 when you donate it you will receive a charitable deduction of $135. If you were to sell the stock first, you would have to pay tax on the $100 gains and then have only $103 to donate in cash – assuming you are in the 32 percent tax bracket. The only winner in this situation is the IRS; both you and the charity lose. This is because the charity is excluded from paying capital gains taxes on the appreciation that occurred while you owned the asset.

Hold Until You Die

This strategy does not benefit you directly, but rather your heirs. When someone inherits an asset such as real estate, stocks, bonds, mutual funds, etc., the cost basis of the asset is reset to the fair market value at the date of death.

This means that if you have stock in company XYZ that you bought for $50 and now it is worth $500, you would pay tax on the gain of $450 per share. However, your heir would pay $0 if he sold it on the day you died. If your beneficiary continues to hold the stock, the benefit still applies as his cost basis in the stock of XYZ would reset to $500, so he will pay taxes only on gains over that amount.

Conclusion

While you should never cheat on your taxes or do anything unethical, it is foolish to pay any more than is legally necessary to the IRS. Engage in investment tax planning year-round and you may see better after-tax returns and more money in your bank account.

Financial Accounting Overview

Released once a month, every quarter, or once per year, an income statement reports revenue, expenses, and net earnings or losses of a company for a given period. A company's net revenue is calculated by subtracting allowances for uncollectable accounts, discounts, etc. from the business's gross sales or revenue. From there, subtract the cost of sales, or how much the lot of products or services cost to make for the accounting period, from the net revenues figure. This results in gross profit or gross margin. Depreciation, along with amortization—or the cost of machinery and equipment losing life over time—is subtracted from the gross profit figure.

From there, operating expenses, which aren’t directly attributable to product or service production but are running day-to-day operations, are deducted from the resulting gross profit figure. This number is now called income from operations or operating profit before interest and income expense. Depending on the number, the interest income or interest expense is either added or subtracted from operating profits to arrive at the operating profit before income tax. Finally, income tax is deducted, resulting in net profit (net income or net earnings) or net losses. For publicly traded companies, it gives investors insight as to how much the company is making per share—so-called “earnings per share” (EPS).

Statement of Cash Flow

Per the SEC, a statement of cash flow features three sections that detail sources and utilization of the business’ operating, financing, and investing cash flows. It paints a picture of inflows and outflows of the business's cash levels. At the end of the day, it helps anyone interested in the company's financials, especially potential and current investors, to see the latest status and trends of cash flow.

One way to calculate cash flow, according to the SEC, is to look at a company’s free cash flow (FCF). This is calculated as follows:

Free Cash Flow = Operating Cash Flow – Capital Expenditures

Free Cash Flow = $50 million – $20 million = $30 million

This information is useful because free cash flow can help determine a company’s financial health, how well (or not) the business model is performing, and its overall likelihood of success moving forward. Additionally, understanding the difference in accounting methods is another helpful piece of financial accounting analysis.

Accrual Method vs. Cash Method

Accrual Method

When it comes to the accrual method, according to the Congressional Research Service, when a business is paid for services or products to be rendered in the future, the payment is permitted to be recognized as revenue only when the product or service has been rendered. When it comes to accounting for expenses that are presumably deductible, under the accrual method, the expense can be recorded when it’s experienced by the business, not when payment has been made to the utility, raw material supplier, etc.

Cash Method

If a consultant gets payment immediately but isn't expected to do said job until the following month, this approach requires revenue to be recognized when the cash has been received. Similarly, when expenses are paid is when expenses are recorded.

Considerations

For any business that handles inventory or sells to customers on credit, accrual accounting is required by the Internal Revenue Service. Similarly, for companies with an average gross receipt of revenues greater than $25 million for the past 36 months, the IRS mandates accrual accounting. For companies with an average gross receipt of revenues of less than $25 million, depending on the exact circumstances of the company's business nature, cash or accrual may be used.

Financial accounting provides investors, business owners, and those providing businesses with legal and accounting services a way to monitor performance and compliance. 

Recent Trends in Long-Term Care Insurance

Long-term care (LTC) is associated with the elderly for good reason. Over the past 50 years, life expectancy has increased significantly and is therefore something all families should be prepared to address. Even though we may live to a ripe old age, that doesn't mean we will be healthy or able to live independently. Most people develop one or more chronic conditions that require living assistance – and many live with that ailment for years. Conditions such as arthritis, joint and muscle deterioration, or back pain often lead to chronic disability, making it difficult to impossible to take care of your own physical and lifestyle needs. Among even healthy seniors, about half of people age 80 and older experience some form of dementia or cognitive impairment.

Most LTC insurance (LTCi) contracts require that a policy owner seeking LTC no longer be able to perform at least two of the basic activities of daily living (ADL), which include dressing, bathing, toileting, feeding, and moving without assistance. However, before getting to that stage, many people may live for years needing help with domestic ADLs, such as preparing meals, paying bills, shopping, attending appointments, etc.

New Criteria for LTC Insurance

An unfortunate influence of the pandemic is that some LTC insurance carriers now require an in-person medical exam as part of the application process. In the past, underwriting generally involved a telephone interview, a completed questionnaire, and a medical records review. These days, in addition to an exam, issuers have increased the number of pre-existing conditions that are excluded from coverage. Furthermore, insurers are declining more applications for medical reasons. There is preliminary data that suggests more LTCi applications are declined, or higher premiums are charged, in geographical areas where populations have persistently higher rates of serious COVID-19 infections. Not surprisingly, these areas are generally correlated with lower vaccine rates.

 

New Policy Options

Even before the pandemic, LTCi sales were on the decline, and many insurers had exited the market. This is because, with longer life expectancies, carriers increased premiums to cover the financial risk. This priced many policies out of range for most households. In recent years, the life insurance industry has found a strong market in sales of hybrid policies, which guarantee benefits one way or another. For example, a contract might include a rider that allows the policy owner to use the future death benefit in the present to pay for LTC expenses while she is still alive. If she doesn't need the money, her beneficiaries will receive the value when she dies. Another benefit of hybrid policies is that they guarantee premiums will not increase. In many cases, a policy can be purchased with a single lump sum.

 

New Focus for LTC: Live at Home

Apart from exploring new ways to pay for long-term care, there is political interest in finding ways to provide LTC more efficiently than in the past. For perspective, consider that the current U.S. system of placing Medicaid recipients in nursing home facilities proved to be one of the most vulnerable components of the pandemic. As of February 2021, more than 170,000 residents in long-term care facilities had died due to the coronavirus.

 

Various public agencies and non-government organizations (NGOs) are looking at new paradigms for caregiving as an alternative to high-volume residencies to minimize the risk of disease contagion. Some recent proposals include the following:

 

  • Enhance current public programs that support independent living [e.g., Original Medicare, Medicare Advantage (MA) plans, and Special Needs Plans (SNPs)] with integrated benefits such as wellness care, behavioral healthcare, case management, home-delivered meals, transportation, and adult daycare services.
  • Allow Medicaid‚Äôs long-term services and supports (LTSS) programs to reimburse long-term care expenses at home and for community-based services.
  • Expand efforts already originated in a handful of states (e.g., Illinois, Michigan, Minnesota, Washington) for state-sponsored, long-term care insurance plans.
  • Consider building on state initiatives such as California‚Äôs Master Plan for Aging, which includes plans to:
    • Create community housing solutions that are age-, disability- and dementia-friendly, as well as climate- and disaster-prepared.
    • Improve the quality of life for the elderly and disabled by presenting opportunities for work, volunteering, engagement, and leadership regardless of age or disability. The purpose of this initiative is to reduce isolation, discrimination, abuse, neglect, and exploitation.
    • Generate up to 1 million highly-qualified, well-paid caregiving jobs.
    • Improve financial security for the elderly population by making long-term care affordable.
  • Reimagine nursing homes using a continuum of care housing model designed for 8 to 10 residents with integrated staffing.

 

The current trend in the caregiving industry is to help seniors be able to live at home for as long as possible. In many cases, this increases the burden on families. Since some people have to leave the workforce to care for family members, this hampers economic growth and tax revenues that could be used to fund better options. While LTC insurance remains expensive, potential buyers must be aware that most policies pay out benefits regardless of where care is bestowed, including nursing homes, assisted living facilities, the insured's home, or even the home of the insured’s family member.

How to Determine Partnership Basis, Inside and Out

According to the Internal Revenue Service, the 2019 tax year saw more than 25 million partners comprising nearly four million tax returns filed by partnerships 2019. With many concerns necessary for navigating the U.S. tax code, including filing annual returns, one important consideration for partnerships and their partners is how to calculate tax liability. To determine how much they profit or lose on their investment, there must be an accurate calculation of adjusted cost basis via outside cost and inside cost basis.

According to the Internal Revenue Code (IRC), one aspect of Section 754 details how the tax basis of partnership assets is handled. When partnerships change, or when there are changes in partnership interest, it helps to rebalance the basis of the business entity's property. This entails defining and calculating both the outside cost basis and the inside cost basis. 

Understanding Outside Cost Basis

Outside cost basis refers to the percentage of interest each partner owns in a partnership. For example, if three partners own a partnership and each partner contributes $200,000, this establishes their outside cost basis. Recording what each initial partner contributes to the partnership is essential to determine their tax basis, including whether they’ve established a loss or gain, and therefore their tax obligations.

Understanding Inside Cost Basis

As the IRC explains it, “Inside basis refers to a partnership's basis in its assets.” One way to look at it is if three partners bought an asset for $600,000, each contributing $200,000 (symbolizing their inside cost basis), their respective inside basis in that particular asset would be $200,000.

When to Consider a Section 754 Election

It’s important to distinguish that partnerships adding or selling partnership interests must consider how such changes impact owners’ tax basis. By making a Section 754 election, partnerships can adjust the cost basis for new partners to provide an accurate accounting of profits (or losses). Assume five partners contributed $200,000 to a partnership and bought an asset for $1 million. A year later, the asset appreciated to $1.3 million. The outside basis is $200,000 (per partner) and the inside basis is $1 million.

Assume the asset appreciates to $1.3 million and one of the original five partners wants to cash out and sell their portion to a new, independent partner for $260,000. The original partner must pay taxes on the appreciation of $60,000 when exiting the partnership. Assume three months later, the asset is sold at the same price of $1.3 million with no Section 754 election. The four original partners are faced with a taxable gain of $60,000 each ($1.3 million selling price Р$1 million inside basis) / 5 partners = $300,000 profit / 5 partners). However, despite the new partner’s outside basis of $260,000, they would face the same $60,000 tax liability.

However, if a partnership chose to elect its partnership to Section 754, the new partner’s tax basis is “stepped up” to $260,000 instead of remaining at the original partner's basis of $200,000. The new partner’s inside cost basis will remain at $200,000, requiring no adjustment. However, the new partner now has an outside basis of $260,000 – the amount the partnership interest was sold for from the original partner to the new partner.

While each business arrangement is unique, for partnerships that see their assets regularly increase in value and experience frequent changes in partners, it could make sense to go with a Section 754 election.

Understanding Free Cash Flow

Understanding how cash flow is measured and analyzed is an important step for businesses. Business owners should constantly monitor and adjust their operations to increase the chances of becoming and staying cash flow positive.

JP Morgan Chase & Co. (JPM) monitors small business activity and presents some sobering statistics for businesses' cash flow challenges. For a median small business, JPM has found the middle amount of daily cash outflows to be $374 and average daily cash inflows to be $381. The middle statistics for small businesses hold an average daily cash balance of $12,100 and an average of 27 cash buffer days in reserve.

Defining Free Cash Flow to Equity

The Free Cash Flow to Equity (FCFE) calculation measures how much money a company produces that can be dispersed to equity holders. One way to determine this figure is to subtract Capital Expenditures from Cash from Operations and then add Net Debt Issued to the remaining figure.

FCFE = Money from Operations – Capital Expenditures + Net Debt Issued

Interpreting the FCFE's Results

This metric helps businesses, investors, and professional financial experts determine how much money is available for a business' disbursement of dividends and/or share buybacks. The more easily dividends and share buybacks are available via a better FCFE, the better a company is performing financially.

Even though the FCFE can tell how much shareholders may receive, there is no requirement that any of that amount be paid to shareholders. This valuation is preferred for companies that do not pay a dividend. One alternate source of funding buybacks or dividends is through retained earnings from past quarters.

Free Cash Flow to the Firm (FCFF)

Looking at how well a business runs, this calculation examines a company's cash flow health once taxes, investments, depreciation, and working capital are deducted, along with factoring in costs for current and long-term assets. It evaluates how much money the business could disburse to equity and debtholders once the company satisfies its financial obligations.

A company’s FCFF shows how much it has available to issue dividends, buy back shares, or satisfy debt obligations. If the FCFF is negative, there is no consideration for investors, as the business cannot meet existing bills and capital expenditures. When a negative result is found, there is a reason to see if and why there's not enough revenue. Interested parties should consider f it is a short-term need or if the business model needs to be re-tooled.

How FCFF is Calculated

Free cash flow to the firm can be calculated with the following formula:

FCFF = Operating Cash Flow + [Interest Expense √ó (1 – Tax Rate)] – Capital Expenditures

Putting FCFF in Perspective

FCFF must be taken as a part of the holistic analysis, whether it is an investor or the business itself analyzing numbers. If a business is reporting high FCFF figures, an analysis must be taken to ensure long-term investment in business structures, cars/trucks, tooling, and business development are accurately reported. If businesses institute collection protocols sooner than standard, run low inventories or extend satisfying their own financial obligation, it can lower what a business owes and revise its working capital numbers – but that is generally temporary.

With cash flow's impact on a business' operation so integral, understanding how it is calculated is the first step to making smarter operational and investment decisions.