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May 2005
Analyzing behavior can help make rational financial decisions 
Anyone who has observed human behavior knows we aren't very rational, especially when it comes to financial decisions. Yet, economists have traditionally based their theories on the dubious assumption that we're consistently rational and self-interested when it comes to money.
Traditional economics is unable to explain why we make certain financial decisions. For example, how do you explain why stock investors sell their "winners" just before the price takes off and hold their "losers?" Why do most individual investors buy high and sell low? Why do most consumers pay more than they need to purchase insurance policies with low deductibles?
About 30 years ago, pioneering researchers began to explore the apparent disconnect between traditional economic assumptions and normal, sometimes irrational, human behavior. The result of this research was the development of a new field of study: behavioral finance. In other words, the study of how emotions and mental errors affect the pricing of securities and capital markets.
While investment strategies that exploit emotions and investor sentiment have been around a long time, behavioral finance is relatively new. It focuses on identifying mental mistakes regularly made by individual investors, and incorporates scientific knowledge of how the brain solves problems.
Few financial decisions can be explained by only one behavioral quirk. However, there are three that help explain many: Overconfidence, ignoring the odds and regret avoidance.
Overconfidence
Psychologists have observed that most people are overconfident; they tend to overestimate the precision of their knowledge and the level of their abilities.
In the realm of investing, overconfidence leads to trading too much. A University of California at Berkeley professor analyzed the trading characteristics of more that 66,000 households. He ranked the subject households based on turnover in their common stock portfolios, from highest to lowest, then divided them into five groups. The results of his study indicate the 20 percent of investors who traded the most earned an average net annual return 5.5 percent lower than that of the least active investors. Bottom line: The more actively an investor traded, the poorer his performance.
Ignoring the odds
It's a well-documented phenomenon that the number of lottery tickets sold increases when the jackpot increases. Yet, as the number of tickets sold increases, the odds of winning go down. This tendency to disregard or discount the odds is what early behavioral finance researchers called "ignoring the base rate."
Behavioral finance focuses on identifying mental mistakes regularly made by individual investors, and incorporates scientific knowledge of how the brain solves problems.
Ignoring the odds shows up in the stock market regularly. For example, there is a wealth of evidence to suggest most actively managed mutual funds fail to match the performance of a simple market index. In fact, the odds are 3-in-4 that any given actively managed mutual fund will under-perform the market in any given year. Despite these odds, most individual investors insist on selecting actively managed mutual funds.
Regret avoidance
People hate to sell at a loss. After all, selling at a loss is evidence that your decision to buy wasn't a good one. And if, by chance, the stock you sell later bounces back, then you regret selling, and buying, the stock. So, in a cognitive sense, selling is a no-win game. As a result, investors tend to hold their losers too long and sell their winners too early.
Academics have developed a theory to explain the behavior: prospect theory. On one side, "loss aversion" - the tendency of psychologically weighing losses more heavily than gains. On the other side, "status quo bias" - the tendency to fall in love with what we own. Together, these two tendencies explain why we hate to sell our losers, but unload our winners.
What's this got to do with you?
Analyzing you own behavior can help you avoid making some very poor financial decisions. The first step in using behavioral finance to make better financial decisions is to identify the signs that you're behaving irrationally. Ask yourself some of these simple questions:
- Do you trade frequently? You may be overconfident in your skill at picking stocks and timing the market. The market isn't an adversary you need to beat - in fact, few have beaten it. Get real and trade less. You're more likely to save on transaction costs and taxes and less likely to under-perform the market.
- Do you avoid selling at a loss but regularly sell your gainers? Consider regularly "harvesting" capital losses to offset gains and remember: Up to $3,000 in losses can be used to shelter higher-taxed ordinary income.
- Do you pick mutual funds on the basis of past performance? Do you buy insurance policies with low deductibles? Then you're probably ignoring the odds. Consider purchasing index funds that have low expenses and track the market. There are many index funds and exchange-traded index funds to choose from, making it easy to diversify your portfolio across large cap, small cap and foreign stocks. Also, ask your insurance agent to quote the premium on your home and auto policies with a higher deductible ($500 or $1,000).
Published in: RSM McGladrey, Wealth Wisdom, First Quarter 2005
For more information on the above topics, please contact Beason & Nalley, Inc. at 256-533-1720 or email at info@beasonnalley.com. AJCA puts a choke hold on deferred compensation
Written by: Mark Sullivan, Manager, RSM McGladrey Consulting
For a piece of legislation that met with little fanfare, the American Jobs Creation Act (AJCA) of 2004 has cause for some concern. The legislation will have some major tax repercussions for manufacturers including a significant change for organizations that provide income deferral arrangements for their executives.
Simply described, deferred compensation arrangements are plans that allow the employer or the employee participant to defer income through unfunded (benefits payable from the employer's operating assets) or funded (proceeds paid from assets set aside by either the employer or employee in a trust) mechanisms for payment at a later time. To avoid constructive receipt issues found in Section 83 of the Internal Revenue Code, deferred compensation is subject to a "substantial risk of forfeiture" in case of an organization's insolvency or bankruptcy. Basically, if employees have deferred compensation, they're creditors of an organization.
Since the inception of rabbi (grantor) trusts, deferred compensation arrangements have attempted to protect participants' assets from creditors despite the terms of the trust. Also, elements of deferred compensation plans were established to allow participants access to the deferred amounts, while still purporting to meet the safe harbor rules described by the IRS. Congressional budget staff estimates the tax law change will generate as much as $1.05 billion annually for federal tax coffers.
Deferred compensation redefined
What is deferred compensation as of January 1, 2005? The last has significantly broadened what was once a loose definition: Any plan, agreement or arrangement that provides for the deferral of compensation (pay that can be deferred from individual income taxation) other than tax qualified plans such as 401(k)s, IRAs, SIMPLEs, SEPs and 457(b) plans, among others. It also excludes bona fide vacation, sick, disability, compensatory time and death payments. The "any plan" phrase should concern executives.
This new, more global definition includes both contributory and non-contributory arrangements, severance agreements, some equity-based plans like SARs, discounted non-qualified stock options, stock-option gains and restricted stock deferrals. Even annual bonuses can be classified as deferred compensation if they're not paid within two and a half months of the end of your company's tax year. If there's any good news, it's that AJCA didn't close the deferral window completely.
The four prohibitions
The new law also bans four basic practices as they relate to deferred compensation: late elections; early distributions; deferrals of gains on certain equity-based incentive plans; and assets-protection methodologies to keep creditors at bay.
Employees who generate the salary, bonus or deferred equity gain must make elections prior to the year in which the service is performed. For performance-based bonus plans, the timing is slightly relaxed, allowing employees to elect deferral six months prior to the end of the service period. However, the definition of "performance-based" is likely to become more stringent.
Distributions, too, have been significantly affected. In the past, plan elements were similar to those of an early withdrawal from a 401(k) plan: The amount withdrawn is immediately taxable and there's a 10 percent penalty sometimes called a "haircut" or "barber" provision for early withdrawal.
Under AJCA, distributions are only allowed on separation from service, retirement, death, disability or an unforeseen emergency. An "emergency situation" definition is forthcoming from the IRS, but it's likely to be more stringent than those found in safe harbor 401(k) rules (i.e., illness, significant loss of property). Key employees of public companies will have to wait six months following their separation from service.
If these rules are violated, employees are subject to significant early withdrawal penalties, including immediate taxation of all amounts deferred to the plan, all interest earned to date, an extra interest penalty for not paying taxes at the time of original deferral, and a 20 percent penalty tax.
For all intents and purposes, deferral of gains from stock options and stock grants are prohibited. However, ISOs aren't subject to the rules. A non-qualified stock option must be granted at fair market value on the date of the grant (e.g., no discounts) to qualify as deferred compensation. Stock appreciation and, as such, will be taxable upon vesting, not exercising. Further IRS regulations concerning the treatment of equity gains are expected.
The act prohibits the use of offshore trusts to hold deferred compensation plan assets. In addition, it bans the use of transfers of company assets to a rabbi/grantor trust in response to a (negative) change in an employer's financial health. Material modifications to existing deferred compensation plans after October 2004 are subject to the rules.
There will likely be an IRS-defined transition period for establishing documentation related to the changes that organizations may choose, or be required, to make in their deferred compensation plans. Although the IRS plans to clarify certain rules, the message is clear: Any income deferred after December 31, 2004 is subject to the rules of a new game.
Published in: RSM McGladrey, HR Update, First Quarter 2005
For more information on the above topic, please contact Beason & Nalley, Inc. at 256-533-1720 or email at info@beasonnalley.com. Constructing value in an audit
Written by: Michael Balter, Managing Director with RSM McGladrey
If you were asked to list the most valuable outside services your company receives, would you include a financial audit? Audits are an effective service for contractors and provide worth to your company in numerous ways. Assuring credible financial reporting; detecting and preventing fraud; improving internal controls; and providing best practices advice are among the four major benefits. Assuring credible financial reporting
An audit's primary function is to produce credible financial reporting that offers assurance that your company's financials are in accordance with generally accepted accounting principals (GAAP) as established by the American Institute of Certified Public Accountants (AICPA). Basically, it ensures your organization's financial reporting is a reasonable representation of its financial condition.
Some think GAAP adherence is merely an academic exercise with no real impact on the contractor's operations. Not true. Properly recognizing and reporting financial transactions allows contractors to better understand the information presented. Also, many company bankers and sureties are accustomed to reviewing GAAP-compliant financials. Knowing that the contractor's financial reporting meets industry-accepted standards helps confirm the report's credibility.
Detecting and preventing fraud
With the latest legislative and regulatory changes, the AICPA has added several new procedures to the audit process, which have significantly increased the auditor's responsibility to search for material and nonmaterial fraud, as well as identify potential opportunities for it.
They include:
- Brainstorming. Each contractor's operations and work environment are reviewed to help identify possible ways all employees might steal from your company. Although a checklist of likely threats is used, each company's specific operations are evaluated and discussed. Then mitigating controls already in place - that determine areas of concern - are considered. The results are used - prior to conducting the actual audit fieldwork - to adjust the audit procedures and focus on any threat areas identified.
- Interviewing employees at varying authority levels. To help determine if employees are aware of fraudulent activities or opportunities to perpetrate fraud, interviews are held with all employees at various authority levels. As with brainstorming, interview results are used to tailor the audit procedures.
- Using an unpredictable audit approach. Unpredictability can thwart employees who may be considering engaging in fraudulent behavior. This can include auditing transactions that have occurred throughout the year (rather than in specific periods) and varying sampling types and thresholds.
- Identifying employee abuse. Focus attention on common patterns of financial abuse, such as where employees may be spending company funds for personal gain.
The mere fact an audit is being performed, especially by a well-experienced industry auditor, can be a deterrent to fraud in itself.
Improving internal controls
Proper internal controls help assure that financial transactions are reported correctly and that contractor employees operate in an honest and ethical fashion. Audit procedures contain an investigation of few aspects: segregation of duties; administrative control of expenses; and the proper recording of revenues and expenses. Control of revenue is especially important to auditors, since diversion of revenues (theft) is generally the most harmful manifestation of employee fraud. Any weaknesses identified during the audit are reported to your company's management with recommendations on how to tighten controls.
Providing best practices advice
Having an industry expert look at your company's financial statements can be a huge benefit. The expert's ability to spot anomalies in how certain transactions are handled - and funds controlled - and how those transactions are reported adds greatly to the contractor's financial operations. An auditor's key responsibility is to gain an understanding of the client's operations and to comment and make recommendations - and not limited to financial matters - for improvement. Industrywise, experienced audit firms frequently comment on pure operations issues, providing significant insight to management on best practices used throughout the business.
Materiality and industry expertise
A major factor in determining the relative seriousness of financial risk or reporting errors is materiality. Materiality verifies how large an error must be to affect the overall credibility of the financial reporting. In the case of risk, it is how considerable the risk must be to threaten the contractor's financial well being.
Legislation and the resulting AICPA audit requirements have emphasized the importance of focusing on not only quantitatively material issues, but also qualitatively material issues.
Review vs. audit
A review employs "analytical review procedures" that focus on information your company provides that doesn't validate if the underlying transactions represented by your organization's financial statements are correct. Instead, it's more of a "30,000-foot view" of your company's financials, based upon contractor provided data, to assure financial information is presented in accordance with AICPA standards. No source documents testing is performed.
An audit uses detailed, independent testing procedures to verify that the underlying transactions are materially correct and certifies the statements to that effect.
However, for most contractors, the "audit vs. review" question is arguable simply because most contractor bonding requirements or bank convenants require an annual audit performed by an independent professional.
For more information on the above topic, please contact Brett Holt at Beason & Nalley, Inc. at 256-533-1720 or email at bholt@beasonnalley.com. Coffee Talk
Gail Wall was a guest on "Law Line" on Sunday night, April 9th on Channel 31. This was a call in program for people to ask tax questions to a professional.
RSM McGladrey will be honoring Beason & Nalley's 10 year membership in an awards ceremony at the Network Forum.
Scott Butler attended the RSM McGladrey's NetGroup meeting in Norfolk, VA.
Congratulations to Melissa & Alan Anderson on the birth of their son, Andrew, on April 27th.
Scott Butler and Chad Braley will be teaching a FedPubs course in Washington, D.C. May 18-19 on Government Contract Accounting Systems Compliance.
Darryl Walker will be teaching FAR Part 31 Cost Principles in Huntsville, AL on May 5th. Related Information:
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