(First of two parts)

By J. Carlitos G. Cruz

No one can truly predict the future. With enough information, however, it can be anticipated — which is why companies need to look forward with one eye on risks and the other one on opportunities. This is the new business paradigm discussed in the recently released Ernst & Young global report Business Pulse: Exploring dual perspectives on the top 10 risks and opportunities for 2013 and beyond.

The report shows that more and more executives are realizing the need to optimize their existing business by cutting costs and increasing efficiency while, at the same time, finding ways to be profitable in shrunken markets and/or expanding into emerging markets. They cannot afford to just wait for mature markets to recover from the global financial crisis. In fact, the succession of fiscal issues from the
Eurozone to the United States demonstrates that global economic recovery is likely to take a while.

The report is based on a survey of companies in 21 countries across various industry sectors, with relevant insights from executives and Ernst & Young specialists. It focuses on the top 10 risks and opportunities, clustered into four primary categories: cost competitiveness, stakeholder confidence, customer reach and operational agility. While not all risks and opportunities may apply to our local market, the report provides much introspection, particularly for domestic companies that are expanding internationally.

Cost competitiveness
The survey shows that businesses are putting significant effort into cutting both costs and prices in order to compete in shrunken mature markets and competitive rapid-growth markets. Based on the Ernst & Young risks and opportunities radar, this first risk cluster only shows risks associated with cost competitiveness. This is perhaps something that strategic business leaders should note: opportunities for growth may not lie in the direction of simply reducing costs and prices, but in other less quantifiable areas.

Risk: Pricing pressure
Competition is at an unprecedented level: more companies are competing in rapid-growth economies; low-cost online shopping is becoming more popular; and consumer behavior is shifting. Pricing pressure is generally higher in mature, near-saturation markets where companies are more entrenched; companies therefore need to look towards innovation and creating cost savings from supply chains and operations to mitigate pricing pressure.

Conditions are perhaps slightly different in emerging markets. In countries like ours, where the concepts of “unli,” “budget” and “buy one, take one” are still powerful motivators, pricing pressure can be a tool for building market share or sales generation. Ultimately, pricing must be measured against quality, value, and of course, volume-handling capacity if companies want to gain and retain customers.

Risk: Cutting cost and profit pressure
For many companies, the obvious cost-cutting measures have already been taken. What else needs to be done? How can companies make deeper cuts and improve profits, without sacrificing performance?
Perhaps the key lies in knowing the difference between eliminating waste and simply cutting costs. Companies should examine their current capital investments and ask how they fit into the overall business strategy, rather than simply doing short-term cost-cutting. They should study whether process improvements can improve efficiency, like testing supply chains against customs duties and fuel price sensitivities, and developing far-shore, near-shore and onshore facilities.

Risk: Market risks
Cost cutting and profit pressure are greatly affected by market risks such as commodity price volatility, interest and exchange rates, currency prices and equity risk. High prices of commodities, e.g. oil, metals, gas, and others, significantly affect price pressure and location and distribution decisions, necessitating careful risk management. Scenario planning becomes even more important for companies that are heavily dependent on market conditions.

Risk: Macroeconomic risks
The macroeconomic outlook is grim: larger industrialized European economies have been damaged by falling export growth and weakening domestic demand. Companies must accept that the “current downturn” is likely “the new normal” for business, and need to develop governance structures that align their risk profile and exposures more closely with its strategy.

Risk: Sovereign debt
In Europe, debt crises are raging in a number of countries, forcing governments to focus on access to funding. The narrowly averted US fiscal cliff still has many unresolved issues and some economists are concerned about a slowdown in China’s economy.

Closer to home, however, there may be some good news. Japan’s economy, which has been sluggish for two years, may be due for a revival, thanks to the appointment of Haruhiko Kuroda as the new Governor of the Bank of Japan. Here at home, our own economy has been steadily growing and getting stronger, as evidenced by our second investment grade rating, this time from Standard & Poor’s Rating Services, following the upgrade from Fitch last March.

Risk: Political shocks
With more companies making forays into new markets, the risk of being affected by political upheavals increases commensurately. Some examples include the turmoil in the Middle East, the nationalization of oil company YPF in Argentina, and reviews of mining codes in western Africa. Globally, there seems to be a move towards protectionism, with further restrictive measures likely to happen.
In a way, this benefits us. The Philippines’ political and economic stability in recent years has significantly increased our attractiveness as an investment destination and companies are reaping the rewards of more investor confidence.

Stakeholder confidence
Many companies, particularly financial organizations, are now forced to operate under the general feeling of uncertainty and mistrust engendered by the crisis. It is now necessary for companies to listen and engage with a wider field of stakeholders and not just their shareholders.

Risk: Expansion of government’s role
More and more, the public is questioning the role of corporations in society, while governments are asking how they can prevent the crisis from repeating. This has resulted in greater scrutiny and tighter regulation for companies across numerous industries, such as financial services, energy, pharmaceuticals, and others.

Surveys have shown that people (77% in China, 54% in Brazil, 51% in the USA) now want government to have more oversight and regulatory control over companies. The risk of this stance is that strong government intervention may discourage investment, particularly if issues such as expropriation risk and resource nationalism come into play.

Risk: Regulation and compliance
State intervention usually takes the form of new or tighter regulations, which can mean more prohibitive compliance costs for most companies. Usually, companies will increase manpower or hire outside specialists in the area of risk management and mitigation, because even incremental changes can have significant impact. For multinationals, it is important to remember that risk management frameworks across multiple jurisdictions, perhaps even continents, can be interrelated. It is also important to build good working relationships with regulators, ensuring open channels of dialogue and communication.

Opportunity: Excellence in investor relations
With the move towards greater transparency, companies can take this opportunity to show investors their intentions, practices and strategic direction. For example, companies that are transparent about social and environmental issues may find that their investors are more willing to commit to big, long-term investments. With the current atmosphere of uncertainty, full disclosure can greatly reassure investors of a company’s risk management capabilities.

Opportunity: Leveraging CSR and public confidence
Visionary companies are seeing an opportunity to increase public confidence, especially in markets where government funding is stretched too thinly, by promoting meaningful corporate social responsibility (CSR) actions. Corporate philanthropy, which has been increasing in recent years, is an excellent way for companies to enhance their image, although it is equally essential that these efforts be communicated well and carefully, especially in the area of social media.

Opportunity: Investing in cleantech
Clean technology, while very important and necessary in order to deal with climate change, becomes less of a driver in challenging economic conditions. Nonetheless, companies should not lose sight of the opportunities to be gained since “good environmental behavior” can translate into more business, better reputation and potential savings, e.g. avoiding rising carbon emission costs and increased energy efficiency. Locally, the use of cleantech is still in its infancy, though more companies are including sustainability and the use of renewable resources as part of their long-term agendas.

In next week’s article, we will look at the risks and opportunities to be found in terms of customer reach and operational agility.

J. Carlitos G. Cruz is the Deputy Managing Partner and Assurance Head of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.

The search for the 2013 Entrepreneur Of The Year (EOY) Philippines hits the road with Cebu City as its first stop.

Members of the Cebu business community and media attended a presentation on the program at the SGV Cebu office on 26 April. SGV Cebu partner-in-charge Wash Roqueza welcomed the participants while EOY program manager Marlu Balmaceda gave a brief overview of the global awards program and its nomination and selection process. A lively open forum followed the presentation.

Nominations end on 31 May. For nomination forms and other information, please contact the EOYP secretariat at 891-0307 local 7766 or e-mail at eoy.info@ph.ey.com

SGV recently conducted a lecture on transfer pricing for members of the Australian-New Zealand Chamber of Commerce in partnership with the Chamber’s Business Investment, Issues and Trade Committee. Transfer Pricing Group Head Atty. Rommie Danao briefed the participants on the salient features of the newly issued Philippine transfer pricing regulations, followed by an open forum. The briefing was part of the Committee’s bimonthly lecture series, which features discussions on key business issues, market trends and government regulations for the benefit of its members. MG7 Leader Jimmy del Rosario and senior director Katrina Francisco also participated in the briefing.

SGV Cebu recently welcomed participants from the Aboitiz Group of Companies at the Parklane International Hotel for a transfer pricing seminar. More than 60 financial and accounting executives were present. The next day, participants from different companies all over Cebu attended the Seminar on Transfer Pricing and Recent Developments in Taxation held at the SGV Cebu Office.

Transfer Pricing Group Head Atty. Rommie Danao and managers Emmylou Limwan and Nilo Mendoza facilitated the discussions, with the assistance of Marygrace Cebu and Ethel Grengia.

By Lucy L. Chan and Arnel F. de Jesus

In July 2010, the International Accounting Standards Board (IASB) issued an Exposure Draft (ED) on Phase 2 of International Financial Reporting Standard (IFRS) 4, Insurance Contracts, which detailed several significant changes to the way insurers measure insurance contracts. The ED required them to apply current market assessment when they measure their liabilities. The comment period for the ED ended on 20 November 2010 and the IASB has since conducted re-deliberations and has reached tentative conclusions on key topics.

Given the expected requirements under the proposed Phase 2 of IFRS 4 and the current state of the Philippine insurance industry, a Financial Reporting upheaval may just be brewing and we pose these questions: How large are the changes? What will be required of the local insurance industry to be prepared for them?

The impact
As prescribed in the Insurance Code, insurance companies in the Philippines are currently using a maximum of 6% discount rate for statutory reserves. Since the Insurance Code was issued way back in 1974, many industry players view the 6% maximum discount rate as outdated and believe that they should not confine themselves to the 6% maximum rate. Further, only mortality rate, premiums and benefits are considered in the cash flows for actuarial liability.

Under the ED, insurers should set their reserves composed of the discounted current estimate of future cash flows, plus a risk adjustment, and residual margin. This is known as the “building block approach.” Current estimate of future cash flows will not just comprise benefits and premiums, but will also include expenses and acquisition costs. These cash flows are then probability-weighted, incorporating not only mortality but also other factors such as lapsation and disability. These cash flows are discounted at the risk-free discount rate, adjusted for a liquidity margin.

The risk adjustment is the compensation the insurer requires for bearing the uncertainty inherent in the cash flows that arise as the insurer fulfills the insurance contract. This component reflects management’s level of risk aversion and their willingness to accept the risk of favorable or unfavorable cash flow outcomes compared to expectations. The residual margin, which is the difference between the discounted expected cash inflows, outflows and the risk adjustment, will be determined at inception and adjusted each period for changes in expected cash flows.

As described above, the building block approach requires detailed data analysis and management judgment to arrive at a reasonable and understandable value for the insurance contract liabilities. Developing an industry consensus on the calculation of a risk-free discount rate plus liquidity margin, capturing new data to support cash flow projections, and developing a company policy and approach to calculate the risk adjustment and residual margin will prove to be challenging new areas.

The new standard will have a significant impact not only on financial reporting but also on other areas of the insurance business, such as changes in the systems, data storage, policies, processes and controls, and governance. These obviously require significant investments in infrastructure, mostly to be incurred for systems and data. Some insurance companies may even have to replace their current systems, including the actuarial software, so that they can handle the demands of the proposed standards in terms of data manipulation and analysis. Regardless of the underlying systems, significant investment in actuarial modeling and analytical capability is likely to be required.

Data governance will become more important than ever. Insurers will need to adopt additional processes and controls to improve quality of both internal- and market-sourced data. With reliable base data, the modeling and analysis will require not only actuarial expertise, but also management judgment on future expectations. For many products, companies will need to run literally thousands of scenarios to determine the probability-weighted cash flows and test the sensitivity of assumptions. These assumptions, together with the additional processes and controls, should be documented to provide clarity and transparency on the insurance company’s approach to their adoption of the new standard.

Lastly, considering all the factors discussed earlier, implementation of IFRS 4 Phase 2 would affect the overall operations of an insurance company, and changes in governance will be necessary. Management should expect dramatic revisions in their procedures and policies, and some products will potentially no longer be commercially attractive.

Moving forward
Even though the IFRS 4 is still pending, many international companies are already performing high-level impact assessments given the significance of the changes. Insurance companies are encouraged to identify the areas where significant changes are expected, evaluate the cost and benefit of investing to cope with the changes, such as data management, actuarial modeling and reporting systems, assessing the resources needed and developing training programs. In particular, the potential profit impact and volatility under the proposed standard are key concerns of many boards and management teams. The preparation can be done in conjunction with the other significant players in the industry, including the actuarial community and accounting firms.

With sufficient preparation, insurers will be more equipped to weather the coming changes. They will be in a better position to make an initial assessment on how the new standard will impact their financial position and results of operations, including changes that can affect their business operations, and reducing the risk of being overwhelmed by the additional complexity.

Lucy L. Chan and Arnel F. de Jesus are Partners of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.

By Ken Meissner

(Third of three parts)

Over the past two weeks, we have written about how the US Congress prevented the so-called “Fiscal Cliff” and introduced significant changes in US tax laws. These changes have brought some stability to previously uncertain tax provisions, or extended the lifespan of some taxpayer-friendly provisions. We will now conclude the discussion with other changes that will affect US taxpayers in 2013 and beyond.

Gift and Estate Tax Relief. For the first time in 12 years, there is some degree of stability and certainty in tax planning for estates and the transmission of wealth within a family. Congress has made the US$5 million gift and estate exemption permanent. (Actually, the exemption is US$5,250,000 for 2013, as indexed for inflation). However, the marginal estate tax rate rises to 40% from 35%. The new Act also makes permanent the ability of a deceased spouse to transfer his or her unused exemption amount to the surviving spouse. Thus, in the case of decedents who transfer all of their assets to a surviving spouse at death, a surviving spouse will be able to take advantage of up to US$10.5 million of exemption, as indexed for inflation. In addition, the annual exclusion for gifts increased to US$14,000 per donee as of January 1, 2013.

Quick write-offs for certain business investments. Rules that allow a quick write-off for certain capital investments are extended retroactively for 2012 and going forward for 2013. These include:
• 15-year write-offs for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements. (These would normally have to be written off over 39 years.)
• Seven-year recovery period for motorsports entertainment complexes;
• Accelerated depreciation for business property on an Indian reservation;
• Increased limits on the portion of capital investments that smaller businesses can deduct in full in the year an asset is place in service under Section 179 of the Internal Revenue Code;
• Extending Section 179 to cover certain types of real estate investments;
• Quick write-offs for some production expenses of movies and TV programs, and
• Quick write-offs for mine safety equipment.

Tax credits for businesses. A wide array of expired business tax credits are brought back to life for 2012 and 2013. These include:
• The research credit
• The “work opportunity” credit
• Credits that benefit low income housing
• Credits to encourage hiring of Native Americans
• The “New Markets” credit for certain investments in low-income communities
• Credits for expenses involving railroad track maintenance and mine safety team training

Tax-favored employee education assistance benefits are now permanent (they were to expire at the end of 2012). An employee may exclude up to US$5,250 of company-funded education assistance from his or her gross income each year. This benefit is available for both undergraduate and graduate education. However, this exclusion does not provide an automatic inflation adjustment.

Credit for adoption expenses and exclusion for employer-funded adoption assistance made permanent. The adoption expenses credit allows a dollar-for-dollar offset of certain adoption related expenses against both the regular income tax and AMT. Eligible expenses include adoption fees, court costs, attorney fees, and other expenses involved in adopting a child. For 2013, the maximum amount of the credit is US$12,770. This maximum is reduced when a taxpayer’s modified adjusted gross income (MAGI) rises above US$191,530 and the credit is fully eliminated at MAGI of US$231,530. All these amounts are adjusted annually for inflation.

Taxpayers whose employers help out with adoption expenses can exclude from income up to US$12,970 of employer payments. The maximum exclusion for this fringe benefit phases out as a taxpayer’s AGI rises above US$234,580. Again, these amounts are adjusted annually for inflation.

Dependent Care Credit rules stabilized. The new law permanently extends the dependent care credit at levels that were enhanced back in 2001.

This credit is mostly aimed at low-income taxpayers—single parents and couples who both work and must pay for child or dependent care in order to keep working. The maximum credit will remain where it’s been the past few years: up to US$1,050 for taxpayers with one dependent, up to US$2,100 with two or more dependents. The credit phases down for taxpayers with moderate incomes (anything above US$15,000). For taxpayers with incomes of US$45,000 or more, the credit ranges from US$600 for one dependent to US$1,200 for two dependents.

The credit had been scheduled to fall at the end of 2012 to US$420 for moderate-income taxpayers with one dependent, or US$960 for those with two or more dependents.

Help for taxpayers who manage to restructure debt on “underwater” home mortgages is extended to the end of the current year. As a general rule, any taxpayer who is not totally insolvent and whose creditors forgive some or all of his debts must report the debt forgiveness as taxable income. Under a rule that was to expire at the end of 2012 and has now been extended to Dec. 31, 2013, taxpayers who took on debt to buy, build, or improve their primary home may exclude up to US$2 million worth of such debt-discharge income.

Some education tax breaks temporarily extended. College tax breaks that continue under the new law include a five-year extension of the popular American Opportunity Tax Credit (AOTC) for college tuition. Although rarely used by higher income families due to AGI limits, the return of the Personal Exemption Phaseout means that this credit deserves more attention in 2013.

If a taxpayer’s AGI is over US$250,000 single (US$300,000 on a joint return), he may want to consider not claiming a dependency exemption for his college-enrolled children. If they have income of their own, they may qualify to take the credit against their own income tax instead. (Please note that the refundable part of the AOTC will still not be available as long as a dependent could have been claimed).

For some taxpayers with AGI below US$65,000 if single (US$130,000 filing jointly), the above-the-line deduction for up to US$4,000 of qualified tuition expenses may be a better deal. Congress extended the above-the-line deduction, which decreases to US$2,000 for taxpayers with AGI of up to US$80,000 (US$160,000 joint), through December 31, 2013.

Conclusion
This summary covers many, but not all, of the changes scheduled to take place this year. A number of narrowly focused changes have been omitted. The US Congress is likely to revisit the issue of tax reform again later this year as part of a more comprehensive approach to budget reform and deficit reductions. US taxpayers are advised to keep an eye out for any more changes.

Ken Meissner is a Tax Senior Director of SGV & Co.

To ensure compliance with requirements imposed by the Internal Revenue Service (IRS) of the United States of America (US), we inform you that any US tax advice contained in this communication was not intended or written to be used, and cannot be used, by the recipient, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.

April 15 marked the end of this year’s busy season, the first under SGV’s new Market Group structure. After months of working long hours, partners and staff took the time to thank and congratulate one another for a job well done. In celebration, catered lunches and meriendas were served in the respective MG areas.

Chairman and Managing Partner Vic Noel and Deputy Managing Partner Itos Cruz paid tribute to our people by noting that “Each and every one of you are credits to the Firm, and the integral components of SGV’s unblemished reputation as the country’s foremost professional services firm. Your diligence and hard work have once again sustained our reputation for the best quality services.”

Congratulations to everyone!