Embracing Ethics And Morality

An Analytic Essay for the Accounting Profession

CEOs, CFOs, and Fraud Valuing Private Company Stock What Investors Want from Audit Reports

Plus

C O N T E N T S january 2012

22 Accounting & Auditing

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Auditing

What Do Investors Want from the Standard Audit Report?: Results of a Survey of Investors Conducted by the PCAOBs Investor Advisory Group By Joseph V. Carcello
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Accounting

The Continuing Evolution of Accounting for Goodwill By David A. Rees and Troy D. Janes
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International Accounting

Loss Contingencies Face Controversy in Convergence: Amendments to SFAS 5 and IAS 37 Are Rethought Amid Criticism By Anthony D. Holder and Khondkar E. Karim

22

ESSENTIALS
56 Management
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40 Taxation
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Tax Policy

CPA Consultant

Prospects for U.S. Corporate Tax Reform: Deferral Clouds the Picture By Andrew D. Gross and Michael S. Schadewald

What CPAs Need to Know About Quality Control Assurance Systems By Jacqueline A. Burke and Ralph S. Polimeni

46 Finance
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Business Valuation

62 Responsibilities & Leadership

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Sale of Private Company Stock to Employees and Other Parties By Robert F. Reilly

Fraud

CEOs, CFOs, and Accounting Fraud: Implications of Recent Research By Douglas M. Boyle, Brian W. Carpenter, and Dana R. Hermanson

66 Technology
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The CPA & the Computer

Auditing in the Cloud: Challenges and Opportunities By Christina A. Nicolaou, Andreas I. Nicolaou, and George D. Nicolaou

What to Bookmark

Website of the Month: Nonprofit Finance Fund By Susan B. Anders

vol. LXXXII/no. 1

PERSPECTIVES
6 Perspectives
Taming the Too-Big-to-Fails: Will Dodd-Frank Be the Ticket? Publishers Column: A Fresh Look at Our Business Climate

16

IN FOCUS

16 Embracing Ethics and Morality: An Analytic Essay for the Accounting Profession
By William Stephens, Carol A. Vance, and Loyd S. Pettegrew In the wake of recent financial and accounting failures, the discussion concerning the root causes of these failures has turned to the accounting profession. In this article, the authors posit that the underlying explanation for these accounting failures was a moral and ethical problem throughout society. To fix the problem, the profession must reestablish moral and ethical practices and follow them because of the moral principlea desire to do the right thing for its own sake rather than out of a sense of legal obligation or fear.

PCAOB Proposal for Greater Disclosure from Auditors Public Accounting: Why Its Stressful and What We Can Do About It

74 Classied Ads 79 Economic & Market Data 80 Editorial

Tax Reform: Reflecting Our Values

The CPA Journal is a technical-refereed publication aimed at practitioners, educators, regulators, and other nancial professionals. Our goal is to provide insight and analysis on developments in the areas of accounting, auditing, taxation, nance, management, technology, and professional ethics.
Permission to reprint The CPA Journal articles is granted with few exceptions. Written requests indicating title, author, publication date, and intended use of the reprint should be made prior to each use by writing to the Associate Editor. The views expressed in articles published in The CPA Journal are those of the authors and not necessarily those of The CPA Journal, unless otherwise indicated. Articles contain information believed by the authors to be accurate as of original publication. The reader should not construe the content included in The CPA Journal as accounting, legal, or other professional advice. If specic professional advice or assistance is required, the services of a competent professional should be sought.

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Participating in one or more of the Societys 60 statewide committees is one of the most effective ways for you to practice and perfect your skills and knowledge while contributing to your profession.

Committee service allows you to:

I Build leadership skills I Network with peers and use your affiliation as an invaluable referral source I Gain recognition for you and your organization I Stay up to date on current issues I Enhance your technical proficiency and career potential I Serve your profession and community at large

THE CPA JOURNAL EDITORIAL BOARD

Susan B. Anders C. Richard Baker William Bregman Thomas Buckhoff Douglas R. Carmichael Robert H. Colson Robert A. Dyson Andrew Fair Julie Lynn Floch Dan L. Goldwasser Kenneth J. Gralak Neville Grusd Elliot L. Hendler Neal B. Hitzig Ronald J. Huefner Peter A. Karl III Laurence Keiser Stuart Kessler Michael Kraten Joel Lanz Mark H. Levin Michele Mark Levine Martin Lieberman David A. Lifson Steve Lilien Steve Loeb Vincent J. Love Nicholas J. Mastracchio, Jr. Edwin B. Morris Bruce Nearon Raymond M. Nowicki Paul A. Pacter Lawrence A. Pollack Arthur J. Radin Stephen F. Ryan III Stephen Scarpati Rona L. Shor Arthur Siegel Lynn Turner Elizabeth K. Venuti George I. Victor Paul D. Warner Robert N. Waxman

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THE CPA JOURNAL (ISSN 0732-8435, USPS 049-970) is published monthly by The New York State Society of Certified Public Accountants, 3 Park Avenue, New York, NY 10016-5991. Copyright 2012 by The New York State Society of Certified Public Accountants. Subscription rates: NYSSCPA Members (Basic Rate): $15.00. Non-members, United States possessions, Canada, one year $42.00; Students (Undergraduate and Graduate) $21.00; Foreign $54.00; Single copy $5.00. All subscriptions and remittances may be sent in United States funds to The CPA Journal, The New York State Society of Certified Public Accountants, P.O. Box 10489, Uniondale, NY 11555-0489. Periodicals postage paid at New York, NY and additional mailing offices. The matters contained in this publication, unless otherwise stated, are the statements and opinions of their authors and are not promulgations by the Society. Publishers Copy Protection Clause: Advertisers and advertising agencies assume liability for all content (including text, representation, and illustrations) herefrom made against the publisher. POSTMASTER: Please send address changes to: The CPA Journal, 3 Park Avenue, New York, NY 10016-5991, Attn: Subscription Department. The CPA Journal is a registered trademark of The New York State Society of CPAs.

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E R S P E C T I V E S

viewpoint

Taming the Too-Big-to-Fails: Will Dodd-Frank Be the Ticket?

By Richard W. Fisher

he following is an edited transcript of Richard W. Fishers remarks before Columbia Universitys Politics and Business Club on November 15, 2011. The views expressed are his own. Today, I will speak to the issue of depository institutions considered too big to fail and systemically important. I will argue that, just as health authorities in the United States are waging a campaign against the plague of obesity, banking regulators must do the same with regard to oversized banks that undermine the nations financial health and are a potential threat to economic stability. I shall speak of the difficulty of treating this pernicious problem in a culture held hostage by concerns for contagion, systemic risk, and unique solutions. I will posit that preoccupation with these concerns leads to an ethic that coddles survival of the fattest rather than promoting survival of the fittest, to the detriment of social welfare and economic efficiency (Andrew G. Haldane and Robert M. May, Systemic Rise in Banking Ecosystems, Nature, pp. 351355, January 20, 2011). I will express my hope that, properly implemented, the capstone of financial oversightthe Dodd-Frank Wall Street Reform and Consumer Protection Act might assist in reining in the pernicious threat to financial stability that megabanks or systemically important financial institutions (SIFI) have become. But I will also express concern about the difficulty of doing so, concluding with a suggestion that perhaps the financial equivalent of irreversible lap-band or gastric bypass surgery is the only way to treat the pathology of financial obesity, contain the relentless expansion of

these banks, and downsize them to manageable proportions.

The Problem with SIFIs

Aspiring politicians in this audience do not have to be part of the Occupy Wall Street movement, or be advocates for the Tea Party, to recognize that government-assisted bailouts of reckless financial institutions are sociologically and politically offensive; they stand the concept of American social justice on its head. Business school students here will understand that bailouts of errant banks are questionable from the standpoint of the efficient workings of capitalism, for they run the risk of institutionalizing a practice that distorts the discipline of the marketplace and interferes with the transmission of monetary policy. To this last point, my colleague and director of research at the Dallas Federal Reserve Bank, Harvey Rosenblum, and I have written about how too-big-to-fail [TBTF] banks disrupt the transmission of policy initiatives (The Blob That Ate Monetary Policy, Wall Street Journal, September 28, 2009). Our thesis was that as their losses mounted, the toobig-to-fails were forced to cut back their lending and gummed up the nations capital markets in general. Thus, before the Dodd-Frank Act was even proposed, we wrote that guarding against a resurgence of the omnivorous TBTF Blob [must] be among the goals of financial reform. In previous speeches, I have taken note of another dimension to the prob(Continues on page 8)
JANUARY 2012 / THE CPA JOURNAL

p u b l i s h e r s c o l u m n

A Fresh Look at Our Business Climate

s we head into what promises to be a lively election season, business friendly has become a popular phrasemeaning that New York State government fosters an environment that helps business owners, and, by extension, their employees, which, in turn, benefits the entire state. The phrase, however, is used so much we often dont stop to consider the details of what it means to be business friendly. What does a good business environment involve, especially for New York? Consider an October jobs report from the U.S. Department of Labor: Thirty-nine states saw an increase in nonfarm payroll employment in October, but New York was not among them. New York had the second-highest number of jobs lost, behind only Wisconsin. However, in the bigger picture, New York had 61,500 more jobs in October 2011 than it had in October 2010. This is a positive trend, but new businesses wont come to New York and the ones here wont stick around if neighboring states offer a more hospitable business climate than New York does. How can Governor Cuomo and our state legislature ensure that it does? For one, legislators would do well to listen to their constituencies, who are knowledgeable about the issues they are considering. For business and finance, that often means CPAs. Think of the resource available through the NYSSCPA: nearly 29,000 business and finance experts. Now consider how crucial the CPA perspective is in Albany. Earlier this year, we faced an expansion of New Yorks venerable and powerful Martin Act, which would have given large institutional plaintiffs essentially the same powers as the attorney general when it comes to prosecuting fraud. The NYSSCPA supports a strong stance against fraud, but such a wideranging expansion would not have reined in malefactors. Instead it would have put legitimate companies under a constant threat of baseless litigation by allowing institutional investors to bring a suit against an issuers independent auditor under the Martin Act, even if the auditor had no knowledge of the alleged fraud. The bill never made it out of
JANUARY 2012 / THE CPA JOURNAL

committee, but the Societys leadership continues to monitor any developments. This is a perfect example of what happens when legislators try to write laws without considering the effects theyll have on specific businesses or professions, or the obligations and duties already imposed on those professions. Tax preparer registration is another example. New York is one of the last states to adopt cross-border practice mobility, which allows CPAs to provide services outside their home state of licensure as long as they meet a certain set of standards and are in good standing in their home states. The law benefits New York CPA firms because some of New Yorks neighboring states that had already adopted this law were not allowing New York CPAs to provide client services in their states. Mobility resolved that issue, allowing our CPAs to meet their clients needs in whatever state they were doing business. But another possible piece of legislation, passed by the very same legislature, could negate this law by requiring CPAs who are paid to file tax returns in New York to register with the state. The rule already applies to non-licensed tax preparers, but currently, CPAs, attorneys, and enrolled agents are exempt from it. That could change with the release of a September 2011 report issued by a state task force on tax preparer regulations, which recommends that the legislature consider whether it should end the exemption in order to serve the overall purposes of the program (www.tax.ny. gov/pdf/documents/task_force_report_reg_ preparers.pdf).

The Value of Input from CPAs

CPAs already have stringent testing and continuing education requirements. Additional registration requirements will not make CPAs better tax preparers; instead, they will only burden CPAs, negate the recently passed mobility law, and harm the already tenuous relationship between government and businesses in New York State. Sound and logical regulation provides a balance between the private and government sectors. Most CPAs understand thatsound financial perspective

and logic is what CPAs are hired to provide but when the unintended consequences of what seem like easy revenue raisers come back to haunt New York, everyonegovernment, citizens, businessessuffers. Some have praised notoriously inefficient Albany for passing Cuomos recent compromise deal that features tax cuts for the middle class and tax increases for the wealthiest New Yorkers. However, more public debate would have given CPAs, who have their collective finger on the pulse of business finances, an opportunity to provide input on potential unintended consequences before the bill was pushed throughnot after. Will the long-term budget needs of the state be met by the new revenue plan, or will we find ourselves in even worse shape a year from now? Will the new tax rates prove good for businesses in the state, or has Albany not gone far enough? It isnt clear what were left with: For all the cheering about something getting done in Albany, will the state still have a sizable deficit when all is said and done? Time will tell whether this deal was sufficient, while many in the state, including even some in the legislature, say there should have been more time for input. We join them in wishing the governor had spent more time seeking insight from the public, where tax professionals like CPAs, for example, could have weighed in. With thousands of tax expert membersindeed, an entire committee devoted to state tax issuesthe Societys informed input could have made for a more inclusive result. These wont be the last issues affecting not only CPAs, but also the entire business community in the state. CPAs are uniquely qualified to provide significant input into decisions affecting the states business environment. It is our job to make sure we K are part of that dialogue. Joanne S. Barry Publisher, The CPA Journal Executive Director, NYSSCPA jbarry@nysscpa.org

(Continued from page 6) lem of sustaining behemoth financial institutions, and that is the cost of doing so. Andrew Haldane, executive director for financial stability and a member of the Financial Policy Committee at the Bank of England, provides some rough estimates of the subsidy that flows to banks from governments following a too-big-to-fail policy. With markets working under the assumption that they will invariably be protected by government, the cost of funds is measurably less, according to Haldanes work, giving them preferential access to investment capital. He estimates the global subsidies enjoyed by the too-big-to-fails in 2009 ranged up to a staggering $2.3 trillion (Control Rights [And Wrongs], speech given on October 24, 2011). Thus, I argue that sustaining toobig-to-fail-ism and maintaining the cocoon of protection of SIFIs is counterproductive, expensive, and socially questionable. As students, you should know that financial booms and busts are a recurring theme throughout history, and that bankers and their regulators suffer from recurring amnesia. They periodically forget the past and all the lessons of history, tuck into some new financial, quick-profit fantasylike the slicing-and-dicing and packaging of mortgage financingand underestimate the risk of growing into unmanageable and unsustainable size, scale, and complexity as they overindulge in that new financial fantasy. Invariably, these behemoth institutions use their size, scale, and complexity to cow politicians and regulators into believing the world will be placed in peril should they attempt to discipline them. They argue that disciplining them will be a trip wire for financial contagion, market disruption, and economic disorder. Yet failing to discipline them only delays the inevitablea bursting of a bubble and a financial panic that places the economy in peril. This phenomenon most recently manifested itself in the panic of 20082009. Paul Volcker states the problem thusly: The greatest structural challenge facing the financial system is how to deal with the widespread impressionmany would say convictionthat important institutions are deemed too large or too interconnected to fail (Three Years Later: Unfinished Business in Financial Reform, the William

Taylor Memorial Lecture, Washington, D.C., p. 8, September 23, 2011). On previous occasions, I have referred to Volcker as the Moses of central bankers. He is an iconic figure who led us out of the desert of inflation and economic stagnation in the 1980s. Volcker is a man of principle and probity, is selfless and indifferent to financial gain, and is wise to the political shenanigans of powerful lobbies that perpetuate structural distortions that interfere with the public good. (In short, he is the perfect stuff of a central banker.) Most importantly, he understands the necessity of allowing for failure as a part of the process of creative destruction, especially so in the world of finance. Having referred to Moses, I trust that in this academic setting I might be forgiven if I draw upon one of my favorite literary references to failure, albeit one that is otherworldly. In Paradise Lost, John Milton has God telling us why he created men and angels, both of whom could betray Him: I made [mankind] just and right, Sufficient to have stood, though free to fall. Such I created all th ethereal Powers And Spirits, both them who stood and them who failed; Freely they stood who stood, and fell who fell. Milton considered the issue of failure on a much higher plane than the realm of bank regulatory policy. But the principle, expressed in that stanza of his paean to Gods creation of the ethereal Powers, applies equally to banking. Banks are created and given powers as mechanisms of credit intermediation, in order to allow an economy to grow and become prosperous. Yet, if regulatorswho oversee the creation of banks and monitor their businesscant secure capital structures at our largest financial institutions that are just and right, and do not allow for institutions that betray their creators to be free to fall, it is unlikely those financial institutions will fulfill their proper intermediary role and be agents of economic prosperity. Thus far, regulators have failed in their mission of warding off betrayal.

Perpetuating Obesity
With each passing year, the banking industry has become more concentrated.

Half of the entire banking industrys assets are now on the books of five institutions. Their combined assets presently equate to roughly 58% of the nations gross domestic product (GDP). The combined assets of the 10 largest depository institutions equate to 65% of the banking industrys assets and 75% of our GDP. Some of this ongoing consolidation is the result of a dynamic set by Congresss passage of interstate branching legislation in 1994 and repeal of GlassSteagall provisions in 1999. But some of it also reflects the result of the recent financial crisis. When difficulties began to appear at large financial institutions, resolution policies often entailed their merger or acquisition with other large institutions. Add to this the regulatory forbearance and financial backstops that tend to be granted to the largest banks in exigent circumstances, and the end result is a few financial behemoths, each with well over a trillion dollars in assets and a heavy concentration of power. In fact, the top three U.S. bank holding companies each presently have assets of roughly $2 trillion or more. Of course, problems in the banking sector have not been exclusively confined to large financial institutions. Regional and community banks have faced their own problems, especially connected to construction lending. But heres the rub: When smaller banks get in trouble, regulators step in and resolve them. The term resolve in the context of smaller banks is a fancy way of saying their demise was quickly and nondisruptively arranged they were disposed of. We might have expected equal treatment of big banks, but of course, that did not happen. To be sure, some very large financial firms have ceased to exist or have been through a corporate reorganization with some of the characteristics of a Chapter 11 bankruptcy. But these institutions deemed too big to fail, and deemed systemically important due to their size and complexity, were given preferential treatment. Many were absorbed by still larger financial institutions, thus perpetuating and exacerbating the phenomenon of too big to fail. This problem of supersized and hypercomplex banks is not unique to the United States. Europe is struggling today
JANUARY 2012 / THE CPA JOURNAL

with how to cushion its megabanks from excessive exposure to intra-European sovereign debt. And Japan is still feeling the negative impacts of not successfully resolving the financial difficulties at its megabanks two decades ago.

A Perverse Lake Wobegon

Why are too-big-to-fail institutions treated differently than smaller banks? In a system of large or interconnected banks, difficulties at one institution can easily spill over and take down other banks, or even the entire industry. Fear of systemic risk conditions the treatment of financial behemoths. In todays interconnected, globalized financial system, systemic risk is more pronounced than ever. And we know that when a systemic crisis occursas it did in the panic of 20082009the results can be catastrophic to the economy. Small wonder that in commenting on the problems currently besetting Europe, the U.S. Treasury secretary recently stated, The threat of cascading default, bank runs, and catastrophic risk must be taken off the table (Timothy F. Geithner, statement at the 24th Meeting of the International Monetary and Financial Committee, U.S. Department of the Treasury, Press Center, September 24, 2011). This has become dogma among banking regulators and their minders. Thus, in the recently announced Greek bond deal, the Euro Summit Statement tells us that Greece requires an exceptional and unique solution (Euro Summit Statement, Brussels, October 26, 2011, p. 5). Such a solution is certainly in the interest of American bankers. In Saturdays New York Times, it was reported that the Congressional Research Service has estimated that the exposure of U.S. banks to Portugal, Italy, Ireland, Greece, and Spain amounted to $641 billion; American banks exposure to German and French banks was in excess of an additional $1.2 trillion. According to the Bank for International Settlements, U.S. banks have $757 billion in derivative contracts and $650 billion in credit commitments from European banks. Thus, the Congressional Research Service concluded that a collapse of a major European bank could produce similar problems in U.S. institutions (Annie Lowrey, European Turmoil Could Slow U.S. Recovery, New York Times, November 12, 2011).
JANUARY 2012 / THE CPA JOURNAL

In the land of the too-big-to-fails, we find ourselves in something akin to a perverse financial Lake Wobegon: All crises are exceptional, and all require unique solutions. Yet, it seems to me that in our desire to avoid cascading default and catastrophic risk, and in our search for exceptional and unique solutions, we may well be compounding systemic risk rather than solving it. By seeking to postpone the comeuppance of investors, lenders, and bank managers who made imprudent decisions, we incur the wrath of ordinary citizens and smaller entities that resent this favorable treatment, and we plant the seeds of social unrest. We also impede the ability of the market to clear or, to paraphrase Milton, allow the marketplace to distinguish freely those who should stand and those who should fall.

big-to-fail-ism. It creates a Financial Stability Oversight Council (FSOC), composed of the major financial-sector regulators charged with overseeing the entire financial system. The FSOC can recommend that important nonbank firms be brought under the regulatory umbrella. Those who will be brought under that umbrella will be subjected to periodic stress tests to make sure they can withstand reversals in the economy and other adverse developments. Dodd-Frank calls for enhanced capital requirements for SIFIs. And it provides for a new authority for resolving bank holding companies and other financial institutions that wasnt available to authorities during the recent crisis.

Implementing Dodd-Frank
Will it work? Will Dodd-Frank achieve the desired goals declared in its preamble? The devil, as always, is in the details of how the legislation is implemented. At the most basic level, the legislation leaves many of the details to rulemakings by various regulatory agencies; more than one year after enactment, there is still much work to be done in actually implementing the act. On November 1, 2011, the law firm of Davis Polk & Wardwell released its monthly progress report on Dodd-Frank implementation. According to that report, of the 400 rulings required by the legislation, 173, or roughly 43%, have not yet been proposed by regulators. Of the 141 rulemakings required of bank regulators the Federal Reserve, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency58, or about 41%, have not yet been proposed (DoddFrank Progress Report, November 2011,www.davispolk.com/files/Publication/ e3379fb6-ab9d-4ed8-b873-0877696a8005/ Presentation/PublicationAttachment/690130 be-02e6-4037-88e8-01648c94664f/ November2011_Dodd.Frank.Progress. Report.pdf).

Enter Dodd-Frank
I said earlier that financial crises are nothing new. Nor is the response to them: a flurry of legislation that ends up giving more power to regulators in the hope of preventing the next crisis. The GlassSteagall Act was enacted during the Great Depression, the FDIC Improvement Act after the banking and savings-and-loan troubles in the late 1980s. And now, in response to the panic of 20082009, we are implementing the Dodd-Frank Act. Dodd-Frankwhich is over 2,000 pages long, containing 16 titles, 38 subtitles, and a total of 541 sectionsis the most complex document ever written in the history of efforts to change the financial regulatory landscape. A cheeky historian might recall French Prime Minister Georges Clemenceaus reaction to Woodrow Wilsons 14 points, proposed as a safeguard for world peace after World War I: Clemenceau is reported to have thought that God did a pretty good job with only 10. Whether it is through 10 commandments or 14 points, or over 2,000 pages, the question is: Does Dodd-Frank appropriately confront systemic risk and the associated problem of too big to fail? Its preamble certainly states a desire to do so, declaring boldly that its purpose is to end too big to fail and protect the American taxpayer by ending bailouts. Dodd-Frank does, in fact, contain a number of measures that attempt to address too-

Capital Requirements and an Atomic Reaction

While acknowledging that the specific regulations spawned by Dodd-Frank have yet to be perfected, one of the harshest criticisms of its treatment of SIFIs has come from my former colleague and president of the Kansas

City Federal Reserve Bank, Tom Hoenig, who is now the nominee to be vice chair of the FDIC [Federal Deposit Insurance Corporation]. He has argued that the very existence of SIFIs is fundamentally inconsistent with capitalism and inherently destabilizing to global markets and detrimental to world growth (Do SIFIs Have a Future? speech on July 27, 2011). Moreover, according to Hoenigwho had unquestionably the greatest depth of regulatory experience of all the Federal Reserve presidents and governorseven with the completion of DoddFrank, the existence of too-big-to-fail institutions will likely remain and poses the greatest risk to the U.S. economy (Financial Reform: Post Crisis?, speech on February 23, 2011). One might counter that the enhanced capital requirements envisioned by DoddFrankbeing negotiated presently by the Federal Reserve and other regulators nationally and internationallywill be a fitting treatment for too-big-to-fail-ism. In theory, it certainly sounds good. But as Paul Volcker has pointed out, Thats an old story. Weve had a system of international risk-based capital requirements in place for some time under the auspices of the Bank for International Settlements, beginning with Basel I in the early 1990s. That morphed into Basel II in the early 2000s, and now we are introducing Basel III. In fact, in the United States, we can go all the way back to the National Bank Act of 1864 to find a system of capital requirements on banks. Capital requirements are indeed important. A strong capital base protects a business when times get tough, giving it reserves to draw upon so that it can wait out a storm. Applied to banks, it also should mitigate risk-taking incentives that are an inevitable by-product of our too-bigto-fail system: If you put meaningful shareholder money directly at risk, managers of banks beholden to those shareholders will be less tempted to take pie-eyed risks. (Given the opacity of bank balance sheets and the arcane accounting practices whereby very similar assets can be valued differently in many circumstances, the discipline imposed on bank managers by shareholders has been limited, in both megabanks and smaller banks.)

The operative word in the previous sentence is meaningful. The existing regulatory measures were found wanting on measures of meaningful capital. For example, at the height of the crisis in mid2008, two of the largest, most troubled institutionsCitigroup and Bank of Americawere considered adequately capitalized (or even higher), according to the then-prevailing regulatory criteria. The Belgian bank Dexia is another case in point. In a press release issued last May, it highlighted its regulatory capital ratio of 13.4% as confirming our Groups high level of solvency (Net Profit of EUR 69 Million 1Q2011. Strong Operational Performance by the Commercial Business Lines. Transformation Plan Ahead of Schedule, May 11, 2011). Winston Churchill used the phrase terminological inexactitude to suggest a certain lack of directness; one might easily conclude that there was some inexactitude surrounding the capital structures of Citigroup, Bank of America, and Dexia. I return to Andrew Haldane of the Bank of England. Haldane makes an intriguing parallel between the financial system and epidemiological networks. Conventional capital requirements seek to equalize failure probabilities across institutions to a certain threshold, say 0.1%. But using a systemwide approach would result in a different calibration, if the objective were to set a firms capital requirements equal to the marginal cost of its failure to the system as a whole. Regulatory capital requirements would then be higher for banks posing the greatest risk to the system, which is what Dodd-Frank proposes, and what the current Basel III requirements are also considering. To Haldane, this is a new approach in banking, but not in epidemiology where focusing preventive action on superspreaders within the network to limit the potential for systemwide spread is the norm. As Haldane emphasizes, If anything, this same logic applies with even greater force in banking. To me, treating too-big-to-fail institutions as potential super-spreaders of financial germs has a great deal of appeal. The latest round of international capital standards is seeking to correct for terminological inexactitude and tighten up the

definition of what banks can count as capital, so as to prevent super-spreading. Thats good news. Yet, this effort is being met with fierce resistance from the SIFIs. Hoenig once suggested that when regulators begin the process of tightening up the latitude granted the megabanks, they will find themselves facing an atomic force of resistance (Its Not Over Til Its Over: Leadership and Financial Regulation, speech on October 10, 2010). He appears to have been spot on. The head of one of the major U.S. financial institutions has called these new proposals anti-American (Tom Braithwaite and Patrick Jenkins, JP Morgan Chief Says Bank Rules Anti-US, Financial Times, September 11, 2011). Last Thursday, the Wall Street Journal wrote of bankers seething over rising capital requirements (Victoria McGrane, Fed Governor Allays Banks, November 10, 2011). Such is the intensity of emotion to resist the work of the Fed and other regulators as they seek to protect the system from the pernicious risk inherent in the existence of megabanks. We cannot let that resistance prevail. And we must insist, as Dodd-Frank does, that SIFIs be required to submit a living will that describes their orderly demise. Credit exposure reports must also be submitted periodically to estimate the extent of SIFI interconnectedness. We must see to it that the FDIC ensure(s) that the shareholders of a covered financial company not receive payment until after all other claims are fully paid (section 206). This is essential to restoring the discipline of the marketplace and is what the Fed expects to achieve when it finalizes its work on section 165 and other aspects of the legislation, as discussed last week by Vice Chair [of the Federal Reserve Board of Governors] Janet Yellen in a speech in Chicago (Pursuing Financial Stability at the Federal Reserve, November 11, 2011, www.federalreserve. gov/newsevents/speech/yellen20111111a.htm).

An Achilles Heel
For all that it specifies to treat the unhealthy obesity and complexity of too-bigto-fails, Dodd-Frank has an Achilles heel. It states that in the disposition of assets, the FDIC shall to the greatest extent practicaJANUARY 2012 / THE CPA JOURNAL

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ble, conduct its operations in a manner that mitigates the potential for serious adverse effects to the financial system (section 210). This is entirely desirable; nobody wants to initiate serious financial disruption. But directing the FDIC to mitigate the potential for serious adverse effects leaves plenty of wiggle room for fears of cascading defaults and catastrophic risk to perpetuate exceptional and unique treatments, should push again come to shove. I may be excessively skeptical on this front. Vigilantes of the bond and stock market, of which I was once a part, have been demanding greater transparency in reporting the exposures of the megabanks, including a more fulsome account of both gross and net exposures of credit default swaps. And Moodys has recently downgraded the long-term debt of major U.S. and U.K. banks. This is oddly reassuring. Moodys said that actions already taken by U.K. authorities have significantly reduced the predictability of support over the medium to long term (Rating Action: Moodys Downgrades 12 UK Financial Institutions, Concluding Review of Systemic Support, October 7, 2011), whereas in the United States, it found a decrease in the probability that the U.S. government would support [major banks] (Rating Action: Moodys Downgrades Wells Fargo & Company

Rating, September 21, 2011 [similar releases appeared on the same date for Citigroup and Bank of America]). Of course, the ratings agencies did not exactly cover themselves in glory during the crisis. Lets hope their assessment of at least somewhat more limited government support for the megabanks proves more accurate than the triple-A ratings they gave to so many mortgagebacked securities.

The Alternative: Radical Surgery

In short, progress is being made in the direction of treating the pathology of SIFIs and the detailing of enhanced prudential standards governing their behavior. Yet, in my view, there is only one fail-safe way to deal with too-big-to-fail. I believe that too-big-to-fail banks are too-dangerousto-permit. As Mervyn King, head of the Bank of England, once said, If some banks are thought to be too big to fail, then they are too big. I favor an international accord that would break up these institutions into more manageable size. More manageable not only for regulators, but also for the executives of these institutions. For there is scant chance that managers of $1 trillion or $2 trillion banking enterprises can possibly know their customer, follow time-honored principles of banking and fashion reliable risk

management models for organizations as complex as these megabanks have become. Am I too radical? I think not. I find myself in good companyPaul Volcker, for example, advocates reducing their size, curtailing their interconnectedness, or limiting their activities. In my view, downsizing the behemoths over time into institutions that can be prudently managed and regulated across borders is the appropriate policy response. Then, creative destruction can work its wonders in the financial sector, just as it does elsewhere in our economy. We shouldnt just pay lip service to letting the discipline of the market work. Ideally, we should rely on market forces to work not only in good times, but also in times of difficulties. Ultimately, we should move to end too big to fail and the apparatus of bailouts and do so well before bankers lose their memory of the recent crisis and embark on another round of excessive risk taking. Only then will we have a financial system fit and proper for servicing an economy as dynamic as that K of the United States. Richard W. Fisher is president and CEO of the Federal Reserve Bank of Dallas, Tex.

viewpoint

PCAOB Proposal for Greater Disclosure from Auditors

By Arthur J. Radin
n June 21, 2011, the Public Company Accounting Oversight Board (PCAOB) issued a concept release, Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements. This concept release presents a number of alternative ways by which the information issued by auditors could be expanded, and it also asks for comments. The basic issue is that the standard auditors report, which has existed for more
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than 75 years, is normally a pass/fail report with no qualitative information. The concept release asks whether the auditor should include various types of subjective information. Because the PCAOB regulates only auditors who report on public companies and are registered with the PCAOB, this article only relates to auditors of public companies. The various disclosures referred to in this article as being made in the filings include all disclosures in an SEC 10-K or Registration. The issue of including subjective information in the audit report has come up periodically; however, to the best of my knowledge, this is the first discussion by an important governing authority. Prior to issuing the concept release, the PCAOB

had its Investor Advisory Group (IAG) survey its members about their views on the standard audit report. The results of this survey are reported this month in an article on page 22 of this months CPA Journal, What Do Investors Want from the Standard Audit Report? by Joseph V. Carcello. My comments are based on this article, which contains the survey results and supplementary information not in the formal survey results. The survey summary was appropriately neutral; however, the majority of respondents favored increased auditor reporting, although the requested areas of additional information were not consistent. I interpret the survey and the concept release as leaning heavily toward the inclusion of more

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subjective, qualitative auditor disclosure. The concept release raises the following areas where auditors could make subjective disclosures and possible changes to the standard audit opinion: I An auditors discussion and analysis (AD&A) describing auditors judgments; auditors evaluation of accounting policies and practices; audit details, such as materiality limits, independence, and procedures; and other audit issues. There is a suggestion that the key issues in the audit partners memorandum be published. I Required emphasis paragraphs on estimates in financial statements, judgments, audit procedures, or the same information indicated for the AD&A. I Auditors assurance on managements discussion and analysis required in SEC filings, non-GAAP disclosures, earnings release information, and other information in the SEC filings. I Expansion of the standard auditors report to further inform readers of the auditors responsibility for fraud detection, financial disclosures and other information in the filings, managements responsibilities, a definition of reasonable assurance, and auditor independence. I am strongly opposed to these alternatives. I believe that acceptance of these proposals would be expensive, useless to investors, and potentially damaging to auditor-client relations. A major issue of our public security markets is the excessive expense incurred by being a public company. Over the past few years, there has been a substantial expansion of the disclosure requirements of public companies and an increase in the cost of such disclosures, without a demonstrated value of the disclosures. To conduct its survey, the IAG contacted investors and their representatives and asked them questions relating to proposed changes. Not surprisingly, these individuals consistently asked for more information from the audit report, although the type of information requested was not consistent. When users are asked whether they want more disclosure, the answer is invariably, Give me more. I have not seen a discussion as to whether any of the information is actually helpful to readers. My article in the November 2007 CPA Journal, Have We Created Financial Statement Disclosure

Overload? discussed the huge increase in disclosure requirements, the equally huge increase in annual reports and proxies, and the lack of evidence that anyone is actually using the information. I believe that before any new standard requiring additional disclosure is enacted, all of the following criteria should be met: I The information is believed to be useful based on criteria other than whether someone would like to see it. I The information is not available or reported elsewhere. I The cost of preparing and reviewing the information justifies the requirement. I The information is likely to be used by users of financial statements. I do not believe that the suggested disclosures in the concept release meet these criteria. I will discuss each of the alternative suggestions from the concept release.

Auditors Discussion & Analysis

The concept release states: The intent of an AD&A would be to provide the auditor with the ability to discuss in a narrative format his or her views regarding significant matters. The AD&A could include information about the audit, such as audit risk identified in the audit, audit procedures and results, and auditor independence. Other suggestions in the concept release include the auditors views on managements judgments and estimates, accounting policies and practices, difficult or contentious issues, and close calls. Responses to the IAG survey indicated that auditors should disclose materiality limits, includingaccording to one respondent qualitative materiality standards. A proposed approach is publication of the lead auditors summary audit memorandum. In evaluating this proposal, it is important to understand that documents written for an audit firms internal use would be written entirely differently if their intended distribution was to the entire investment community. For example, what if the lead partners summary memorandum was to be included in the AD&A? This document, which may have originally taken an hour or two to produce, would require review by various levelsfirst at the accounting firm, then by client management, and of course by the clients counselbefore it could be released

to the public. A memorandum that was once useful would become a watered-down, committee-produced document with the primary goal of not raising unwanted questions. Anyone suggesting that this document would not undergo such an evolution has not been in the loop of drafting a document for public distribution. Much of the additional disclosure is already required in managements discussion and analysis, or elsewhere in a filing. Managements estimates, accounting policies and procedures, and business risk factors are currently required to be disclosed; the rest is of questionable value. Information regarding independence would invariably result in a statement that the auditor had followed all independence requirements. I believe that comments on difficult, contentious issues and close calls would be disclosed by the auditor by reference to the footnotes. Quantitative materiality would be disclosed by presentation of an amount. I do not believe that this information would be helpful to readers of financial statements. Other suggestions for the AD&A include, but are not limited to, the following: I Evaluation of the quality of the accounting principles used. For example, are they high quality or minimally acceptable? The problem is a lack of definition of a high-quality accounting principle, as opposed to those other, lowquality ones. While the SEC has always said that it wants high-quality accounting principles, I have never seen a definition. Would an auditor ever admit that its client was using one of those low-quality accounting principles, whatever they are? I A valuation as to whether the financial statements are aggressive or conservative on a 1-to-10 scale. Here again, the problem is one of definition. Is accelerated depreciation or last-in, first-out aggressive or conservative? Are high loss allowances aggressive or conservative? Is the use of current values aggressive or conservative? And what about the use of International Financial Reporting Standards? I A sensitivity analysis as to areas of significant judgment. Sensitivity analyses are useful, but are the province of management. Any analyses used by management and included in a filing are subject to auditor review, as indicated above. The
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proposal appears to be a request for a separate, different analysis by auditors, which I believe would be redundant. I A requirement for the auditor to opine on whether, in addition to being in conformance with GAAP, the financial statements are true and fair. These code words imply that there should be two standards: GAAP and truthwith truth, like beauty, defined by the reader. For the past 75 years, standards setters and the SEC have been working to write rules so that financial statements properly reflect underlying economic principles and are useful for readers. Believers in true-and-fair seem to claim that if auditors also had to say that the financial statements were true-and-fair, all of the failings of GAAP would drop away. I do not expect that auditors will readily adopt this concept. I Disclosure of unusual transactions. If such transactions occur and are material, they would be disclosed elsewhere in the filings. I doubt that there is a benefit to separate disclosure in AD&A.

has been that auditors will challenge factual errors, such as wrong numbers, but will tend not to challenge managements judgments about why a trend or change has occurred. This proposal would require positive assurance. This suggestion is not new; it was previously rejected by the SEC because it believed that its adoption would limit the information presented. Auditors prefer opining on specific information and facts rather than on subjective judgments. For example, if management wished to state that the downward trend is a result of competition, auditors would appear to be required to challenge the response with questions, such as whether the clients projects are approaching obsolescence, whether the client is not advertising enough or appropriately, or whether the market is shrinking. I believe that the result would be a less informative tabulation of statistics.

Expansion of the Standard Auditors Report

This issue has been around since our profession began; 75 years ago, the audit report was standardized so that all of us use the same language. While great thought has gone into the exact words of the report, which have changed over the years, the basic concept of one-size-fits-all has continued. There are basically two approaches to what should be in a standard auditors report: 1) a concise, cogent description of the audit process and its weaknesses, auditors and managements responsibilities, and the auditors opinion on the financial statements; or 2) a short document saying the auditor followed the rules and believes that the financial statements are in accordance with GAAP. The proposals in the concept release suggest the following possible changes: I A definition of reasonable assurance; I Auditors responsibility for fraud; I Auditors responsibility for financial statement disclosures; I Managements responsibility for the preparation of financial statements; I Auditors responsibility for information outside of the financial statements; and I Auditors independence. These are all educational suggestions for the readers of auditors reportsand the

more education, the better. The question is whether this is the place to educate readers and whether they will read the information. In the survey, 91% of respondents indicated they do not read audit reports in their entirety. Since the reports are all the same, why would anyone read them, other than to scan for something different or unusual? I believe that expanded opinions would not be read either. All the proposal would do is to drive up costs for paper and printing with no benefit. I believe that each of the items would require two to three sentences. Aside from the cost of drafting, it is not a productive enterprise to disclose, in every report, information that will not be read. I would propose for the audit report to be one sentence: Based on our audit, which was performed in accordance with U.S. auditing standards, in our opinion the financial statements on pages __ to __ are presented in accordance with generally accepted accounting principles in the United States.

Boilerplate Issues
The major problem with all of these disclosures is that they will quickly become boilerplatecarefully produced at great expense and providing no additional information to readers of financial statements. We have seen this with additional disclosures added over the years to financial statements and other areas of SEC filings. Below are some examples: I SEC filings require disclosure of future accounting changes in both the financial statements and the MD&A. Almost all say that there will be no effect or the company is studying them. I Every financial statement now has the same language regarding to the use of estimates. This requirement has accomplished nothing. I The compensation disclosures are masterpieces in saying nothing with a lot of words. The disclosures were heralded as bringing down excessive executive compensation. All studies say that such compensation is growing. I Audit committee disclosures, especially audit committee charters, are meaningless to anyone not on that particular committee. The concept release states that these alternatives are focused primarily on

Required Emphasis Paragraphs

This alternative differs little from the suggestions made relating to the AD&A. Rather than a separate section, the auditor would add to its standard report paragraphs highlighting certain financial statement matters. All of the objections previously raised would apply to this proposal as well. The concept release gives four examples of commonly used explanatory paragraphs: The entity is a component of a larger business enterprise, significant transactions with related parties, unusually important subsequent events, and matters affecting the comparability of the financial statements with those of the prior periods and going concern modifications. The information that is suggested is generally required to be disclosed in the notes to the financial statements. It is unclear why these topics require or suggest disclosure in the auditors report.

Auditors Assurance on MD&A

Auditors are now required to read the entire filing, including the managements discussion and analysis (MD&A), and take action if it is believed that such information is either inconsistent with the financial statements or incorrect. My experience
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enhancing communication to investors. I sincerely doubt it. Public company annual reports now frequently run over 200 pages. The concept release proposes to add additional pages, substantially all of which will repeat information already presented, or will quickly become boilerplate. Another theory that runs through the concept release is that such disclosures will provide auditors with the necessary leverage to effect appropriate change in the companys financial statement. There is no evidence that auditors do not already have such leverage, or that additional disclosures will provide it. Although the concept release looks forward to an AD&A indicating positions different from management, I doubt it. For example, there is an SEC requirement that dismissed auditors have management indicate in Form 8-K whether there have been disagreements and if the auditor disagrees with the opinion of management. One of the reasons for this change was to allow some subjective disclosure by auditors of why they were dismissed. I have

reviewed many such disclosures; none appear to fulfill a real informative role.

An Additional Proposal
There are several other areas discussed in the survey that I have not covered in this article, such as disclosure of proposed adjustments, hours spent in high-risk areas, determination of qualitative materiality, and reliance on other firms or specialists. All of these areas have the same issues as the ones discussed above. The concept release hopes that such disclosures would increase transparency. But transparency has become a buzzword for improved disclosure; although I have never seen it formally defined, I believe it has come to mean that the reader has a better chance of understanding the economics that the financial statements are attempting to summarize. There is no support in the concept release for why these additional disclosures would promote transparency, or even what transparency is and why it would be good to have more of it.

I believe that the disclosures in the concept release would be expensive, uninformative, and eventually unread by investors. I believe that these efforts would be better spent determining what information investors actually use from the 200 pages of disclosures now being produced as a result of the SEC requirements. It would be wonderful to have an evaluation of what information users actually use; a survey to determine what is used would be excellent. Anecdotal evidence would indicate that very little is used. In my previous article, I called for an evaluation of what is useful in the report and how to separate it from the noise of the irrelevant. In three-and-a-half years, there has been no progress in determining how to make disclosures useful to readers, although FASB K has looked into the issue. Arthur J. Radin, CPA, is the managing partner of Radin Glass & Company, LLP, New York, N.Y. He is also a member of The CPA Journal Editorial Board.

practice management

Public Accounting: Why Its Stressful and What We Can Do About It

By Penelope Bagley and Tracy Reed

ccountabilitythat is, the notion that employees have responsibilities and must report (i.e., be accountable) to superiorsis an aspect of almost every job. It is often a good thing because it induces effort that, in turn, can help improve job performance. Yet there are certain aspects of accountability that can impair both effort and performance. For instance, when employees know the views or expectations of those they are accountable to prior to completing a task or making a decision, they are more likely to adopt or conform to their superiors preferences instead of fully evaluating alterna-

tive positions (Jennifer S. Lerner and Philip E. Tetlock, Accounting for the Effects of Accountability, Psychological Bulletin, vol. 125, no. 2, pp. 225275, 1999). Accountability for a position or viewpoint can also cause defensive bolstering, which can amplify commitment to a prior course of action, regardless of subsequent information, and may lead one to hold extreme positions on a given decision. Accountability for the outcome alone, as opposed to the process one follows, can decrease the amount of effort exerted and result in less consideration of alternatives and less attention to information presented (Lerner & Tetlock 1999; Tracy N. Reed, The Effect of Process Accountability on the Evaluation of Audit Evidence: An Examination of the Audit Review Process, dissertation, Virginia Polytechnic and State University, 2010). In addition, the perception of an authority figure as illegitimate can negate any positive effects of accountability and may even have negative effects such as attitude polar-

ization, decline in intrinsic motivation, and excessive stress (Michael E. Enzle and Sharon C. Anderson, Surveillant Intentions and Intrinsic Motivation, Journal of Personality and Social Psychology, vol. 64, no. 2, pp. 257266, 1993). Lastly, accountability to multiple audiences, especially when those audiences have competing agendas, can cause negative emotions and impact performance (Penelope L. Bagley, Negative Affect: A consequence of multiple accountabilities in auditing, Auditing: A Journal of Practice & Theory, vol. 29, no. 2, pp. 141 157, 2010). A career in public accounting involves accountabilityin fact, public accountants are a great example of professionals who are accountable to multiple audiences, often with competing or conflicting agendas, such as superiors, clients, regulators, investors, and in some instances the public at large. Superiors will be interested in the public accountants work quality, but at the same time efficiency is also a concern. Superiors
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are also concerned with compliance with all applicable standards and regulatory bodies. Clients might be most concerned with how efficiently and unobtrusively the work can be performed. Clients also have incentives for certain results related to the final presentation of their financial statements or their tax returns. Regulators, investors, and the public at large are most concerned with quality. Not surprisingly, recent academic research finds that accountantsauditors in particularexperience negative emotions as a result of the multiple accountabilities they face, and these negative emotions can, in turn, harm performance (Bagley 2010).

Strategies for Superiors

What can be done? The accountability structure of public accounting is not likely to change; therefore, the only recourse is to try to decrease the negative emotions that accountants have as a result of these multiple accountabilities. Below are several simple yet effective ways to decrease negative feelings around the office and curb their detrimental side effects. Communicate. Clearly define your employees roles and responsibilities for each assigned job and their roles within the firm itself. Similarly, keep your employees in the loop. Be sure to share any information that is important to the job at hand. Even if the information may not seem relevant, keeping them in the loop will help them feel important and necessary to the job as a whole. In addition, be sure to share any information that will help lessen employees uncertainties about their career or future with the firm (Jeanne Segal, Laura Horwitz, Ellen Jaffe-Gill, Melinda Smith, and Robert Segal, Stress at Work: How to Reduce and Manage Job and Workplace Stress, HelpGuide.org). Let employees participate. Ask your employees for their input and participation during important meetings about their clients. In addition, increase your employees control over their own careers. For example, be sure to consult them about scheduling issues. Ask them which clients and seniors or managers they would prefer to work with. Allowing your employees to participate and exercise some control over their own careers will help them to feel valued. In addition, their input may also help avoid uncomJANUARY 2012 / THE CPA JOURNAL

fortable working relationships and thus avoid any additional negative feelings (Janet Cahill, Paul A. Landsbergis, and Peter L. Schnall, Reducing Occupational Stress, presentation at the Work Stress and Health 95 Conference, Washington, D.C., September 1995; Segal et al. 2010). Help them build skills. Make sure you are aiding your employees in developing new skills and providing them with opportunities to apply these abilities. During down time, experiment with job rotation so that your employees can learn new skills and expand their knowledge. Also, provide your employees with ample training and practice with new pronouncements, technology, and work procedures so that when things do get busy, your employees will have the necessary tools to complete their jobs successfully (Cahill et al. 1995). Keep job demands reasonable. This can be especially difficult in public accounting given the tight filing deadlines; however, there are things that you can do to help lessen job demands. One possibility is to limit out-of-town travel. Similarly, if an employee is working on an especially difficult engagement, schedule a simpler engagement next. Interchanging employees schedules will hopefully keep them from experiencing excess stress and burnout. Also, be observantif an employee seems to be experiencing an excessive amount of stress, anxiety, or just overall negative emotions, an afternoon or night off might do wonders (Cahill et al. 1995). Allow flextime and alternative work week schedules. Employees know what time of day is the most productive for them. If employees are more productive early in the morning, allow them the opportunity to come in and leave early; likewise, if late afternoon is better for them, allow them to come in and leave late. While there is a limit to the amount of flexibility you can provide (when with a client, there may not be much opportunity for flextime), give them what you can. Not only will your employees appreciate having this as an option, it will allow them to perform at their best (Cahill et al. 1995). Reward and appreciate your employees. Let your employees know that all of the hard work and stress is worth it and they are appreciated. Here are some fun

and easy things you can do to help them feel appreciated: I Feed them. Dont underestimate the power of a good meal. If your employees come into the office on Saturdays to help with the busy season, give them lunch. Let them know you care about their well-being by keeping their stomachs full (Dan Reynolds, Accounting Firms try to Lessen Employee Stress as April 15 Approaches, Pittsburgh Business Times, April 2005). I Play games. If you have to be at work, make it fun. One firm incorporates an ongoing competition during its busy season that involves dance contests, a bean bag toss, and other challenges that lead up to a final showdown. Employees participate voluntarily, and those who do appreciate the stress relief as well as the camaraderie (Reynolds 2005). I Give rewards. Do something to reward your employees and show how much you appreciate their hard work. Many firms have a postbusy season celebration, but providing your employees with a fun reward need not happen only once a year. For example, one company provided their employees with periodic movie days, during which they rented out the local theater. While it is not necessary to be this extravagant, rewarding employees periodically with fun and laughter will help alleviate stress and keep them motivated (Gary Vikesland, Employee Burnout, Employer-Employee.com).

Practical Realities
Accountants will always be held accountable to multiple parties due to the nature of the services they provide. Therefore, the only way to help decrease the effect of negative emotions is to increase the positive experiences accountants have related to work and to foster positive feelings toward work (Peter Cotton and Peter Hart, Occupational Wellbeing and Performance: A Review of Organisational Health Research, Australian Psychologist, vol. 38, no. 2, pp. 118127, 2003), using the K above solutions. Penelope Bagley, PhD, CPA, Reznick Group Research Fellow, and Tracy Reed, PhD, CPA, Dixon Hughes Goodman Research Fellow, are assistant professors at the college of business at Appalachian State University, Boone, N.C.

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In Focus

Embracing Ethics And

An Analytic Essay for the Accounting Profession
By William Stephens, Carol A. Vance, and Loyd S. Pettegrew

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Morality
JANUARY 2012 / THE CPA JOURNAL

n this era after the financial and accounting failures of Enron, WorldCom, AOL, Global Crossing, Tyco, Lehman Brothers, Washington Mutual, and AIG, the discusion concerning the root causes of such failures must be redoubledand the accounting profession stands at the center of this discourse. Were the failures due to incompetent accounting and auditing practices? Did the profession provide inadequate accounting and auditing rules for a complex business environment? Was there too much emphasis on short-term results and performance rewards at the expense of sound accounting principles? Could the failures have resulted from the professions reluctance to take responsibility for detecting fraud? Or was it simply what baseball philosopher Yogi Berra once said when asked to explain his teams lack of success, We made too many wrong mistakes (YogiIt Aint Over, McGraw-Hill, 1989)? In this article, the authors join analysts like Paul F. Williams and submit that the underlying explanation for these accounting failures was a moral and ethical problem and that to ignore this underlying issue is to seriously miss the point (You Reap What You Sow: The Ethical Discourse of Professional Accounting, Critical Perspectives on Accounting, vol. 5, no. 1, pp. 9951001, 2004). If the accounting profession is willing to settle for a rules-based approach of legislative fixes, without looking at a failed moral and ethical underpinning, any efforts to regain a preeminent professional status will fail. The authors offer a prescription that the accounting profession can use to regain its moral foundation and reestablish ethical practices.

Reasons for Decline

The etiology of the professions problems is more systemic than the factors that many analysts have citedsuch as the growing pains from the expansion of consulting over auditing, the emerging demands of revenue growth (Patrick T. Kelly and Christine E. Earley, Leadership and Organizational

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Culture: Lessons Learned from Arthur Andersen, Accounting in the Public Interest, vol. 9, no. 1, pp. 129147, 2009; Stephen A. Zeff, How the U.S. Accounting Profession Got Where It Is Today: Part I, Accounting Horizons, vol. 17, pp. 189205, September 2003; Stephen A. Zeff, How the U.S. Accounting Profession Got Where It Is Today: Part II, Accounting Horizons, vol. 17, pp. 267286, December 2003), the cognitive development and socialization of new accountants into the profession (Lawrence A. Ponemon, Ethical Judgments in Accounting: A Cognitive-Developmental Perspective, Critical Perspectives on Accounting, vol. 1, pp. 191215, 1990; Lawrence A. Ponemon, Ethical Reasoning and Selection Socialization in Accounting, Accounting Organization and Society, vol. 17, pp. 239258, 2006), and the change in the educational foundation of accounting from principles-based to rules-based standards (Terri L. Heron and David L. Gilbertson, Ethical Principles vs. Ethical Rules: The Moderating Effect of Moral Development on Audit Independence Judgments, Business Ethics Quarterly, vol. 14, no. 3, pp. 499523, 2004; David Satava, Cam Caldwell, and Linda Richards, Ethics and the Auditing Culture: Rethinking the Foundation of Accounting and Auditing, Journal of Business Ethics, vol. 64, pp. 271284, 2006; Paul F. Williams, Accounting and the Moral Order: Justice, Accounting, and Legitimate Moral Order, Accounting in the Public Interest, vol. 2, no. 1, pp. 121, 2002). The authors argue that the decline in ethics is largely cultural and appears to be as closely associated with a failing system of morality as it is with the professions ethical rules. The discussion below is divided into two sections that contend that 1) the attitudes and behaviors of todays youth toward ethics and morality are an important detriment to the profession doing the right thing both now and the future, and 2) in the profession should adopt a morality-based approach to the development of its ethical codes and standards. The authors analysis and recommendations are abetted by Lawrence Kohlbergs moral stage theory (The Psychology of Moral Development: The Nature and Validity of Moral Stages, Harper & Row, 1984).

A Report Card on the Next Generation

If the accounting profession is to set a standard of ethical behavior for others to follow, then its leadership must be dedi-

cated to achieving that goal. To acquire people with this quality, the profession must attract a core of individuals with a passion for becoming leaders who are honest, trustworthy, and of high personal integrity. But looking to the professions long-term prospects, there is little reason to be encouraged by the generation of leaders that will come from the youth of today. Unfortunately, there exists little evidence that todays youth have values about ethical behavior that are consistent with the professions needs. In 2008, the Josephson Institute surveyed 30,000 American high-school students on their attitudes toward ethics and morality and released its Report Card on the Ethics of American Youth with the following headline: Survey of Teens Reveals Entrenched Habits of DishonestyStealing, Lying and Cheating Rates Climb to Alarming Rates. The survey reported that I 64% of high-school students have cheated on a test in school one or more times, I 82% have copied someone elses homework for school, I 82% have lied to a parent about something significant, I 30% have stolen something from a store, I 65% have lied to a teacher, and I 26% said they werent perfectly honest in answering the questions on the survey. Given that more than one in four highschool students admitted to not answering some of the survey questions truthfully presumably, because of social expectations the authors expect the evidence of dishonesty to be understated by at least this amount. Furthermore, over 92% of those surveyed said they were satisfied with their personal ethics and character, which strongly suggests that todays youth has a view of ethics that is far different from what the accounting profession needs to turn the ethical corner. Another study forecasts an even bleaker future for a profession that must depend on todays generation. In 1999, Marianne M. Jennings published a study of young people between the ages of 18 and 34 who were asked the following question: Are there absolute standards for morals and ethics or does everything depend on the situation? Jennings reported that Seventy-nine percent in the 1834 age group said the standard did not exist and that the situation should always dictate behavior. Three percent said they were not sure. Jennings concluded that If this poll is correct, 82

percent of all students believe that right and wrong are relative terms and that morality is a ridiculous concept. This is the den of lions into which I walk every day. It is called the modern American classroom (The Real Generation Gap: Attitudes and Education of Generation X, Executive Speeches, vol. 13, no. 4, pp. 2026). In a more recent article, Carol A. Vance and William Stephens analyzed the strengths and weaknesses of this new generation of accounting majors and pointed to this deficiency in ethics as a significant threat to the future of the accounting profession (How Does the New Generation of Accounting Majors Measure Up: Observations from the Ivory Tower, The CPA Journal, pp. 613, November 2010). In a USA Today article, Advice from the Top: Words of Wisdom for Graduates, Deloitte & Touche CEO Jim Quigley commented, Nearly half of all teens say they would act unethically to get ahead or make more money if they knew for sure they would not get caught. I find this troubling and would advise any graduate to make ethical behavior the cornerstone of their career (May 21, 2007). A 2009 study by Deloitte & Touche indicated that a large number of teens possess a troubling contradiction in their ethical readiness for the workforce: While 80% boasted of their confidence in being prepared to make ethical decisions in the future, many freely admitted to unethical behavior in the present. Only 25% said they would be very likely to reveal knowledge of unethical behavior in the workplace. Unfortunately, these are not isolated cases. Students realize that they will not be held accountable for their misdeeds. Parents will rarely accept the possibility that their children did something wrong. Even when their children fully admit to an unethical act, parents typically fail to see it as deserving any meaningful punishment. School administrators and school boards too often bow to the pressure and strong-armed tactics of parents, undermining a teachers authority, credibility, and ability to dole out punishment for classroom misdeeds. This often leads to many wonderful teachers deciding to simply look the other way or leave the profession altogether. With no accountability for unethical actions, students realize that they can cheat with impunity and, thus, come to believe that cheating is an acceptable activity.
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As a result, students later enter the professions such as accounting having developed their personal integrity within an ethical vacuum, thinking that if they cheat, it is unlikely they will be caught. If they are caught, they believe that the punishment if anywill be minor. And if sharper punishment is imposed, it will most likely be reversed. Consider such an individual 20 years later, in a high-level accounting position, having to make a decision about an accounting standard that could ruin careers and impact millions of dollars on the bottom line. Add to that the fact that management is almost always evaluated, financially rewarded, and promoted based on short-term profits and not on upholding ethical standards. One might argue that young people will eventually mature into responsible adults who realize the importance of being ethical and understand that ethical people and organizations usually achieve longterm success in the world. By the time they finish college and have been exposed to the importance of ethical behavior, one might suppose that their attitudes will have changed. But there is no evidence of this, and most ethicists agree that an individuals value system has been fully developed by the time he reaches college and that further education can do little to change that. As evidence that such negative attitudes do not change after college, a study of 5,331 graduate students found that 56% of graduate business students admitted to cheating in the past year. Many said they cheated because they believed it was an accepted practice in business. The report stated: Many graduate business students have work experience where they have been exposed to the Get it done at all costs culture (a situational ethic) still found in many corporate workplaces (Katherine Mangan, Study Finds Widespread Cheating in MBA Programs, Chronicle of Higher Education, September 19, 2006). A Wall Street Journal editorial reported on the unethical behavior of students in the Fuqua School of Business MBA program at Duke University, where 34 firstyear MBA students cheated on a takehome exam, and the university either suspended or failed all of them. Reaction from the cheaters came from two directions. Some felt that its a dog-eat-dog world, and is no different from the professional world they will enter. Others argued that
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cheating is simply the postmodern leadership style an inventive person who gets things done (Their Cheatin Hearts, May 11, 2007, p. W11).

Can Teaching Ethics in Accounting Help?

While ethicists say that an individuals value system has been fully developed by the time she reaches college, and further education can do little to bring about change, most accounting programs include accounting and auditing ethics in their curricula, whether in stand-alone courses or integrated into a number of other courses. Recent data suggest that ethics training at school or work may not be the panacea some would have hoped. In a comprehensive review of modern education, Charles Murray points to a moral void in educational curricula and values (including college) where the prevailing orthodoxy emphasizes being nice rather than being good (Real Education: Four Simple Truths for Bringing Americas Schools Back to Reality, Three Rivers Press, 2008). Murray stated: Instead, if they have gone to a typical college, they have imbibed the reigning ethical doctrine of contemporary academia: nonjudgmentalism. They have been taught not just that they should be tolerant of different ways of living, but that it is wrong to make judgments about the relative merit of different ways of living. But education needs to teach a renewed sense of professional ethics in accounting if it is to somehow overcome this distorted view of nonjudgmentalism.

Analyzing the Professions Low Standard

People perform unethical acts for a variety of reasons. Kohlberg classified cognitive frameworks giving rise to ethical behavior into six categories, which are described as the six stages (or levels) of moral reasoning (The Claim to Moral Adequacy of a Highest Stage of Moral Judgment, Journal of Philosophy, vol. 70, pp. 630646, 1973; The Philosophy of Moral Development: Essays on Moral Development, Harper & Row, 1981; and Kohlberg 1984). Kohlbergs system derived from his passionate belief that moral reasoning involved both an individual and communal sense of what constitutes the right behavior (Susan Ellen Henry, What Happens When We Use Kohlberg? His Trouble Functionalism and the Potential of Pragmatism, Educational Theory, vol. 51, pp. 259269, 2001). As one moves from

stage one to stage six, the explanations for ethical behavior progress from the quite practical and selfish to a concern for others and a decision to do the right thing simply because its the right thing to do. Kohlbergs six stages of moral reasoning are as follows: I Stage one: being ethical for fear of being caught or punished I Stage two: being ethical out of concern for ones self-interest I Stage three: being ethical because of peer pressure to do so I Stage four: being ethical because its the rule, regulation, law, or standard I Stage five: being ethical out of concern for the good of others, because of a sense of social responsibility I Stage six: being ethical out of a concern for the moral principle involved and knowing that its simply the right thing to do. Kohlbergs research later concluded that stage four is the highest level achieved by a majority of the young people in his study when they took an ethical action. This supported the position that many people do the right thing for no better reason than a law, rule, or requirement tells them to do so. Kohlberg contended that most people do not typically rise to levels in which they consider the welfare of others, in stage five, or the moral principle, in stage six (Kohlberg 1984). What happens when CPAs face an ethical dilemma and there is little risk of punishment (stage one); long hours, familial sacrifices, and inadequate rewards given (stage two); a lack of peer pressure, given the crush to get the job done (stage three); or a gray area concerning the proper application of an accounting or auditing principle (stage four)? Such situations offer little justification for acting ethically when stages five and six are not part of ones prior socialization. When the authors discussed these six stages of ethical reasoning in an accounting classroom, the vast majority of accounting students in upper-level classes conformed to Kohlbergs conclusion. Although some students felt that the highest level achieved by most people was lower than stage four, very few demonstrated the moral reasoning of stages five or six. If stage four is indeed the highest level considered by most accountants making ethical decisions, then this helps explain why codes of ethics are often ineffective for organizations and professional groups.

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Most large companies and professional groups, such as the AICPA and the American Bar Association, have codes of ethics. Most of these codes rely on a set of rules for achieving ethical behavior. And yet, violations of these codes seem to have been an integral part of many business failures. One example is the AICPAs failure to issue a public objection to Timothy Geithners nomination to Treasury Secretary for failed timely tax compliance. The AICPA defaulted to a situational ethic that was politically expedient but morally the wrong thing to do when it gave Geithner a pass, rather than holding him to a higher standard as a financial expert. When a culture becomes dysfunctional (i.e., permissive of lawlessness), leadership is needed to direct individuals back to a more ethical position (Kelly and Earley 2009, pp. 143144). The authors believe that we, as a profession, have forgotten that we must adhere to the moral principle of the rules and not just to the letter of the rules. The line exists not for us to stand on but, rather, to stand far behind. In the aforementioned USA Today article, Quigley admonished, The question is not Will I get caught? or even Is it legal? To be successful in business and life, we must follow the higher standard of, Is it right? In my view, the people who follow this standard live richer, fuller lives and achieve success that lasts. In essence, Quigley is saying that the fifth and sixth levels of ethical reasoning are what we should all be following. Admittedly, everyone, no matter how noble or honorable, at times might only do the right thing because of fear, selfishness, peer pressure, or some standard or law. To think that most people never rise above stage four, however, is to sadly realize that these same people probably have little desire, courage, or instinct to strive to reach stages five or six. How can any profession ever be ethical, if many or most of its members do not strive to do the right thing for the right reasons?

Ethics and Morality in Accounting

The term ethics, although defined in several different ways, is almost always closely linked with moralityand moral is the one word common to all the following definitions: I The study of morals in human behavior (Oxford English Reference Dictionary, 2002);

I The study of standards of conduct and moral judgments (Webster, 2002); I A set of moral principles: a theory or system of moral values (MerriamWebster, 2003); I The philosophy of morals (American Heritage Dictionary, 1969); I The science of morals (Oxford College Dictionary, 2007). In his address as the new AICPA chair, S. Scott Voynich did his best to lay down what was expected to be the new moral imperative for accounting: When I speak about our core values, I always put competence in the middleintegrity, competence, and objectivity. I do this because I believe integrity and objectivity are the strengths that hold up and give life to our competence. Integrity, by definition, is key to our profession. Integrity: a rigid adherence to a code of behavior. We are expected to live by a code of ethics which serves as the North Star for all of our activities (Integrity in Action: AICPA Inaugural Speech to AICPA Convention, October 21, 2003, see www.journalof accountancy.com/Issues/2004/Jan/ IntegrityInAction.htm). Despite his admonition, some of the biggest and most prestigious accounting firms in the world continue to behave badly, turning a blind eye to the moral bases of the profession (Michael Rapoport, Role of Auditors in Crisis Gets Look, Wall Street Journal, December 23, 2010). The AICPA must do more than hint at morality as an underlying foundation for accounting ethics. Evidence that the AICPA originally intended to stress morality comes from the prologue to the AICPAs Code of Professional Conduct, originally published in 1973; in that version, it quoted Marcus Aurelius: A man should be upright, not kept upright. The AICPA seemed to be saying that it is more important to be a moral person than to appear moral. As a natural instinct, an upright person does the right thing because of the moral principle, rather than because he is kept upright by a set of rules or laws, or by another person. At least in 1973, the AICPA embraced a similar moral compass. In 1999, however, the AICPA deleted this quote from the code. While we dont know the reasons for this change, the AICPA may have no longer thought that the quote was still applicable, necessary, or even relevant. There is reason to believe

that the AICPA was not directly implying that ethics are no longer morality-based, because the current code still includes the concept of morality in its discussion of the responsibilities of members: In carrying out their responsibilities as professionals, members should exercise sensitive professional and moral judgments in all their activities (AICPA Code of Professional Conduct, 1999, p. 4291). In addition, the concept of morality is closely linked to integrity, the first of the AICPAs five broad concepts of professional conduct. Websters dictionary defines ethics as the firm adherence to a code of especially moral or artistic values. Not only is morality an integral part of the definition of this ethical standard, but the definition even seems to stress its importance, with the adjective especially (AICPA 1999, p. 4311).

Disassociating Ethics and Morality

Despite the fact that the concepts of morals and morality have always been a part of the AICPAs Code of Professional Conduct, there never seems to have been much emphasis placed on this value in the discussion of developing ethical standards. There is even less reference to morality in the codes of ethics for other accounting professional groupssuch as the IMA (Institute of Management Accountants), the NTA (National Tax Association), and the IIA (Institute of Internal Auditors)where no mention is made at all. On an even broader scale, the discussion of morality in public forums does not receive the attention it deserves, and it is often replaced with other terms like integrity, as used by Voynich above. The authors believe that by ignoring the essential link between ethics and morality, any treatment of professional codes of ethics for the accounting profession will be seriously flawed. The authors strongly encourage the AICPA and academia to make it quite clear that accounting professionals must be people of high moral principles who, as a natural result of these principles, conduct their activities in a highly ethical manner not because of the rule of law, but because it is the right thing to do. Following the current ethical standards-as-practiced for the profession will yield only minimum and mandatorybut not conclusiveethical behavior. Rather than encouraging members to strive for the highest levels of ethical behavior (stages five and six), the profession seems to be content with
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its members peaking at level fourdoing what is required in order to maintain a license to practice.

Practical Suggestions
The authors believe that any organizations code of ethics would be significantly more valuable if it would embrace the moral principle as an integral part of its development of ethical standards. This moral principle would move beyond simply espousing values to behaving consistently in a moral waynot just appearing to be moral, but acting morally because it is the right thing to do. While Enron espoused such values in its last annual report, including honesty and truthfulness, Williams has drawn a line in the sand, noting that Enrons behavior and that of Arthur Andersen are truly moral problems (2004, p. 996). It would be impossible for professional organizations and public CPA firms to develop codes of ethics that consist entirely of subjective moral principles; there must always be objective rules that provide direction, so that people can understand their intended meaning. But that does not preclude the use of basic moral principles within these codes in addition to the elaboration of rules. The former should serve as the foundation for the latter. Accounting professionals must know what the right thing to do is and then consistently behave that way because, in any situation, it is right. As former Deloitte & Touche CEO James E. Copeland, Jr., has stated, emphasis must be given to the importance of accountants clearly demonstrating moral behavior in their lives, rather than simply avoiding unethical actions. Accounting professionals should actively strive to behave as moral individuals, even when it means taking a stand against situations, actions, ideas, organizations, or powerful people who would sully the professions reputation. Then, the AICPAs Code of Professional Conduct might once again begin with the quote by Marcus Aurelius. As Kohlbergs sixth moral stage of development demands, accountants must be ethical out of a concern for the moral principles involved and the notion that its simply the right thing to do. Unlike some other professions intent on living by the 11th Commandment of Dont get caught, the accounting profession must draw a line in the sand by proscribing the moral principles of honesty,
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character, uprightness, honor, and fairnessnot just in appearance, but in action. The AICPA Professional Standards: Code of Professional Conduct and Bylaws could then define each of these moral principles and prescribe how each impacts professional accounting behavior. The code might define honesty as the quality of telling the truth, being upright and sincere and follow that definition with this professional standard: Accountants are expected to demonstrate honesty in all they do in their professional conduct (both in action and intent). They must be upright and sincere in their attempt to never deviate from the truth. They must never be associated with the actuality or appearance of deceit or fraud. Failure to comply with the letter and spirit of this principle is considered a violation of professional ethics. Naturally, it is also important that each firm, corporation, and professional organizationincluding the AICPA, the IMA, the Public Company Accounting Oversight Board (PCAOB), and the SEChas its own code of ethics that is based upon moral principles. This code would need to be promoted widely throughout that entity, as well as in the public arena, so that both inside and outside stakeholders would be aware of the entitys willingness to be held accountable for the actions of its constituents. It would also be necessary for top managers (CEOs, managing partners, and directors) to personally and publicly make it clear to all stakeholders, employees, clients, vendors, or investors that they will commit to being personally responsible and held accountable; in essence, they must commit to being role models of the highest ethical practices. There is evidence indicating that where organizations have codes of ethics and top management serves as appropriate role models for stakeholders, the likelihood of ethical behavior throughout the organization is greatly enhanced. In an unpublished 1988 report by Touche Ross & Co., Ethics in American Business, 39% of respondents agreed that the existence of codes of ethical behavior within organizations is extremely effective in promoting ethical behavior. It addition, the report pointed out that 73% of respondents (managing partners, CFOs, and university deans) also strongly agreed that top management plays a significant role in promoting ethical behavior. The study quoted Russell Palmer: The inescapable fact is that leaders set the moral and ethical tone for the orga-

nizations they run. Leaders of companies and organizations should express the expectation that all members and employees must be people of high morals whose behaviors match their words. They must follow up that directive with behavior that matches their words. An action will be evaluated based on what is right or wrong, not whether the rule has simply been followed exactly or the behavior is not illegal. If the two are considered together alongside a well-developed code of ethics and top management that not only promotes but lives strictly by that code, the likelihood of success will be even greater. But this approach can only work if top management demonstrates that the ethical behavior must, first and foremost, be based on moral principles, and that the reason for acting ethically should exceed Kohlbergs stage four, rather than end at that point.

A Society-Wide Problem
While many factors have contributed to the accounting professions reputational decline, much of what is wrong in the accounting world can be traced to the ethical morass in all areas of our society. The whole of society, the accounting profession, and every individual must address these problems in terms of the moral failures that have occurred, rather than the rule of law that has been violated. We must continually stress the need to make ethical decisions on the basis of the moral principle, rather than basing it entirely on ambiguously following the rule of law. We then need to be willing to hold people accountable for not doing the right thing. The reputation of the accounting profession continues to be tarnished by the scandals preceding and continuing into the new millennium. To regain our status as one of the most highly respected professions, we must take the extra step to show both the public and ourselves that we are indeed ethicaland that our ethics are based upon a strict set of moral principles rather than just a long list of rules to which we only adhere K in certain situations. William Stephens, DBA, is a professor emeritus and Carol A. Vance, CPA, is an instructor, both in the school of accountancy at the University of South Florida, Tampa, Fla. Loyd S. Pettegrew, PhD, is a professor of organizational communication, also at the University of South Florida.

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C C O U N T I N G

& A auditing

U D I T I N G

What Do Investors Want from the Standard Audit Report?

By Joseph V. Carcello
udit engagements performed by registered public accounting firms can cost tens of millions of dollars, and in some cases, the audit fee can approach $100 million. For example, Bank of Americas 2010 audit fee was $96 million (according to Bank of Americas 2011 proxy statement). The only outcome of the audit process that is observable to investors is the auditors reportand in most cases an unmodified, or clean, report is issued (hereafter referred to as the standard audit report [SAR]).

Results of a Survey of Investors Conducted by the PCAOBs Investor Advisory Group

A
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The SAR contains an introductory paragraph (which identifies the company audited, the years and financial statements audited, and the responsibilities of management and the auditors); a scope paragraph (which confirms that the audit was performed in accordance with standards of the Public Company Accounting Oversight Board [PCAOB], and which briefly explains the nature and limitations of an audit and states that the auditor believes that he has a sufficient basis for expressing an opinion); and an opinion paragraph
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(which states that the auditor believes that the financial statements are fairly presented in accordance with U.S. GAAP). Other than the opinion paragraph, the SAR is essentially devoid of informational content. The SEC does not permit issuers to file qualified audit opinions, and consequently the overwhelming majority of audit reports issued are clean. This serves to further limit the informational content of the audit report. The limited informational content of the SAR has been a concern to investors for many years. The Cohen Commission (1978) recommended that the audit report contain standardized alternative phrases or paragraphs, rather than a single standard report form. The Chartered Financial Analyst (CFA) Institute (2008) recommended that the SAR include more specific information about how the auditor reached his opinion, as well as identify key risk areas, significant changes in risk exposures, and amounts requiring judgment and involving uncertainty. Finally, the U.S. Treasury Advisory Committee on the Auditing Profession (2008) recommended changes to the SAR to make the audit report more descriptive, including clarifying the auditors role and limitations in detecting fraud. Notwithstanding these and other calls from blue-ribbon groups and investor advocates for modifying the SAR, its form and content have remained largely unchanged for more than 20 years. The last substantive change to the SAR occurred in April 1988, when Statement on Auditing Standards (SAS) 58, Reports on Audited Financial Statements, was issued. For example, the only notable changes to the SAR over the past two decades was to indicate that audits are performed in accordance with PCAOB standards and to indicate the auditors opinion on the effectiveness of internal control over financial reporting. Both of these changes were a direct result of the passage of the Sarbanes-Oxley Act. More recently, changing the SAR has again attracted attention from regulators and standards setters. The PCAOBs Standing Advisory Group discussed the auditors report at its July 15, 2010, meeting (pcaobus.org/News/Events/Pages/ 07152010_SAGMeeting.aspx), and the PCAOBs Office of the Chief Auditor (OCA) has conducted a series of focus
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groups with auditors, audit committee members, investors, and preparers about potential changes to the SAR. The OCAs work was presented to and discussed by the board at its March 22, 2011, open meeting (pcaobus.org/News/ Webcasts/Pages/03222011_OpenBoard Meeting.aspx). Moreover, international standards setters are considering whether changes to the SAR are needed. Most notably, the International Auditing and Assurance Standards Board (IAASB) has a project on its agenda to consider the needs of users with respect to the SAR, with an eye toward potentially changing the form and nature of the audit report (www.ifac.org/IAASB/Projects.php# InProgress). Finally, the European Commission is considering changes that would increase the level of assurance provided by auditors, as well as provide more information in the SAR (e.g., more information about risks) (ec.europa.eu/ internal_market/consultations/docs/2010/ audit/green_paper_audit_en.pdf). In addition to these initiatives, a task force of the PCAOBs Investor Advisory Group (IAG) has completed a survey of investors as to their views of the SAR, as well as desired changes to the audit report. The results from this survey of investors were presented at the March 16, 2011, IAG meeting (pcaobus.org/News/Events/Pages/ 03162011_IAGMeeting.aspx). The rest of this article discusses the scope and findings of the IAG task force survey.

bers are not necessarily the views of their employers.)

Development and Administration of the Questionnaire

The IAG task force, assisted by senior officials from BlackRock and Capital Group, developed a survey to solicit investor views regarding the standard audit report. (The author is a member of the PCAOBs IAG and was actively involved in developing and administering the survey and analyzing the responses received.) Survey questions were developed by reviewing previous investor surveys and academic studies on the auditors report

The limited informational content of the SAR has been a concern to investors for many years.

Origins of the PCAOBs IAG

The PCAOB established the IAG to advise the PCAOB on issues affecting investor protection. Its members are individuals with a demonstrated commitment to investor protection (pcaobus.org/ Information/Pages/Investors.aspx). The IAG is chaired by Steve Harris, one of PCAOBs five board members. An IAG task force was assigned to examine the SAR and make recommendations for possible changes. A number of the individuals on the IAG task force either currently, or previously, work for or represent large institutional investors (e.g., TIAACREF, Breeden Capital Management, Legg Mason, Vanguard, CalPERS, Ospraie Management, and the Council of Institutional Investors [CII]). (It should be noted, however, that views of IAG mem(e.g., the CFA Institute and the CII), and were also based on the personal knowledge and experiences of task force members. In developing the questionnaire, the focus was on potential changes to both the information the auditor communicates (i.e., the substance of the audit report) and the manner in which the auditor communicates information (i.e., the form of the audit report). The survey purposely did not ask about proposed changes to the scope of the auditors responsibilities, nor did it ask investors why they wanted more or different information or how they planned to use any additional information received. Although changing the scope of the auditors responsibilities, including the scope of the auditors work, may be worth con-

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sidering, the authors sought to make recommendations to the PCAOB that would not entail fundamental changes to the scope of the auditors work. If the nature of the auditors report changes, however, the relationships between the auditor, audit committee, and management are likely to change as well. In addition, changing the nature of the audit report will lead to new, and possibly different, responsibilities for auditors. The survey provided project background and instructions, asked respondents to evaluate the current usefulness of the SAR and to indicate how they use the audit report, and then asked a series of questions relating to potential changes to the substance of the information in the audit report and to the form of the audit report. Limited demographic data (i.e., position and employer) on respondents was also gathered. Task force members solicited individuals within their organizations to complete the survey and, in addition, developed a database of more than 300 leaders from investment banks, hedge funds, private equity funds, mutual funds, pension funds, and endowments. The survey was sent to these individuals by mail. Seventythree responses were received from a wide range of participants, including CEOs, presidents, managing directors, CFOs, controllers, CIOs, equity analysts, portfolio managers, and credit analysts. The following are investor organizations from which multiple responses were received (the number of respondents from each organization and approximate assets under management are in parentheses): Black Rock (7, $3.6 trillion), Vanguard (6, $1.4 trillion), Capital Group (4, $1.3 tril-

lion), TIAA-CREF (4, $450 billion), Legg Mason (3, $672 billion), and Breeden Capital Management (3, $1 billion). Other responding organizations included the Association of British Insurers, CalPERS, the Florida State Board of Administration, Highbridge Capital Management, Pershing Square Capital Management, Ospraie Management, and the Virginia Retirement System, among others.

Current Views of the Utility of the Standard Audit Report

To establish whether investors are satisfied with the current SAR, the first section of the survey asked if the current format of the report provides valuable information and is integral to understanding the financial statements. It also asked respondents how they use the SAR. Forty-five percent of respondents believe the current audit report does not provide valuable information that is integral to understanding the financial statements (23% of respondents believe the SAR currently provides valuable information). (Most questions on the survey were evaluated using a 5-point Likert scale, from strongly disagree [1] to strongly agree [5] with the proposed change. For purposes of determining the percentage of respondents in favor of [opposed to] a proposed change, the percentage totals in the agree and strongly agree [disagree and strongly disagree] categories were aggregated.) Moreover, fully 91% of respondents acknowledged that they dont even read the SAR73% of respondents simply skim the report looking for departures from the standard unqualified report, and 18% of respondents believe the report is of no use to them at

all. The following are representative examples of the comments received relating to the usefulness of the SAR: I The audit report is largely boilerplate, and only provides meaningful information in extreme circumstances, usually around going-concern issues.chief investment officer, mutual fund I The statement feels very binary. Either a qualified opinion or not. Not a lot of incremental information once a company gets an unqualified opinion.chief executive officer, hedge fund Some respondents found the SAR useful in its current form. The following comment summarizes the perspective of those who find the SAR useful in its current form: I I read the auditors reports on financial statements and controls and in conjunction with other disclosures in the financial statements, MD&A and managements (CEO and CFO) statements regarding controls and the audit committee report they represent a package and should be thought of as a connected triangle.audit committee member, mutual fund

More Information About What the Auditor Did

The second section of the survey asked respondents if they wanted more information about the auditors process (i.e., what the auditor did during the audit). Questions in this area addressed greater disclosure by the auditor of 1) financial statement and audit risk, changes in risk from the prior year, and work performed in high-risk areas; 2) hours incurred in auditing high-risk areas; 3) the auditors determination of materialityboth quantitative and qualitative; 4) the nature and extent to which the auditor relies on other audit firms and specialists, and the names of these firms and specialists; and 5) proposed adjustments discussed with management, including whether the adjustment was recorded and the rationale for not recording a proposed adjustment. Financial statement and audit risk. Seventy-seven percent of respondents believe the auditor should disclose the areas that pose the greatest financial statement and audit risk, and describe the audit work performed in those areas. (Only 17% disagree with requiring this disclosure.) Requiring greater disclosure about risk was the second most popular potential change to the audit report expressed by survey
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EXHIBIT 1 Survey of Investor Organizations: Most Desired Changes to the Standard Audit Report
1. Auditor should discuss its assessment of estimates and judgments made by management, and how the auditor arrived at that assessment. 2. Auditor should disclose more information related to areas of high financial statement and audit risk and how the auditor addressed these risk areas. 3. Auditor should discuss unusual transactions, restatements, and other significant changes. 4. Auditor should discuss the quality of the issuers accounting policies and practices.

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respondents. The opinion of those in favor of expanded risk disclosures is captured in the following quote: I There needs to be an expanded discussion of risks, processes related to the identification of risks, risk management, governance oversight, and auditor review; this goes beyond auditor assessment of risks related to financial statements. audit committee member, mutual fund Hours incurred in auditing high-risk areas. Fifty-one percent of respondents indicated that they would not find it useful for auditors to disclose how many hours were spent on individual financial statement accounts. (Twenty-one percent of respondents wanted information on audit hours.) This was the only item on the survey in which respondents were strongly opposed to the change. The opinion of those opposed to disclosing audit hours is captured in the quote below: I Time is not necessarily a sufficient indication of quality.anonymous respondent Auditors determination of materiality. Fifty-six percent of respondents believe the auditor should disclose the specific quantitative and qualitative materiality thresholds and considerations applied in conducting the audit. (Seventeen percent oppose an auditors disclosure of materiality.) The opinion of those in favor of auditor disclosure of materiality is captured in the following quote: I I think disclosing qualitative materiality is more important than disclosing the number.controller, money management firm Reliance on other audit firms and specialists. Forty-seven percent of respondents believe the auditor should disclose the names and the nature and extent of work performed by other audit firms and specialists, including non-U.S. affiliates of the principal auditor (20% oppose the disclosure of other audit firms and specialists). The opinions of those in favor ofand opposed todisclosure of these matters are captured in the following narrative comments: I Especially important in light of the fact that non-U.S. affiliates may not have been subjected to PCAOB audit.state government official I It is the auditors responsibility to get happy with the audits by other firms. Disclosure would add confusion since readers would have little ability to evaluate
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the information.chief compliance officer, hedge fund Proposed audit adjustments. Respondents were almost evenly split as to whether the auditor should disclose proposed audit adjustments discussed with management. Thirtynine percent of respondents wanted the disclosure of proposed audit adjustments, 36% of respondents were opposed to this disclosure, and the remaining 25% of respondents were neutral. In summary, with respect to the audit process, respondents were most interested in receiving more information about the

A discussion by the auditor of managements estimates and judgments was the prospective change to the SAR most favored by respondents.
auditors perception of financial statement risk and the manner in which the audit plan addressed those risks (77%). To a lesser extent, respondents expressed interest in receiving more information about materiality (56%), and the nature, extent, and identity of other audit firms and specialists who participated in the audit (47%). Respondents did not express an interest in the disclosure of audit hours.

More Information About What the Auditor Found

The third section of the survey asked respondents if receiving more information about what the auditor found during the audit would be valuable to their investment process. Questions in this area addressed the desirability of greater disclosure by the auditor of 1) the companys significant estimates and judgments; 2) the quality, and not just the acceptability, of the companys accounting policies and practices; 3) a

grade relating to the aggressiveness or conservatism of the companys accounting practices; 4) sensitivity analyses performed by the engagement team; 5) unusual transactions, restatements, and other significant changes; and 6) key issues included in the summary audit memorandum prepared by the engagement partner at the end of the audit. Significant estimates and judgments. Seventy-nine percent of respondents believe the auditor should discuss significant estimates and judgments made by management, the auditors assessment of their accuracy, and how the auditor arrived at that assessment. (Only 14% of respondents opposed additional discussion by the auditor of estimates and judgments made by management.) A discussion by the auditor of managements estimates and judgments was the prospective change to the SAR most favored by respondents. The opinion of those in favor of requiring the auditor to discuss managements estimates and judgments is captured in the following comment: I There are many judgments that ultimately determine the data on the financial statements. Its critical to understand how estimates were made and how much margin of error there might be in the estimates.chief investment officer, mutual fund Quality, not just the acceptability, of the companys accounting policies and practices. Sixty-five percent of respondents believe the auditor should discuss the quality, not just the acceptability, of the accounting policies and practices employed by the company, as well as the consistency of their application. (Only 15% of respondents did not want the auditor to discuss the quality of the companys accounting practices.) An auditor discussion of the quality of the companys accounting policies and practices was the fourth most favored change among respondents. Grade the relative aggressiveness or conservatism of the companys accounting practices. Respondents were split as to whether the auditor should assign a grade (using a 110 scale) as to the relative aggressiveness or conservatism of the companys accounting practices. Forty-two percent of respondents were in favor of assigning such a grade, 44% of respondents were opposed, and the balance of the respondents were neutral.

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Sensitivity analyses performed by the engagement team. In some instances, the company or the auditor will perform sensitivity analyses in areas of significant judgment. For example, an auditor might test how sensitive the fair value of a debt instrument is to changes in the credit standing of the issuer of the instrument. Sixty-five percent of respondents would find it beneficial for the auditor to disclose the results of sensitivity analyses in significant areas of judgment. (Eighteen percent of respondents do not want this disclosure.) Unusual transactions, restatements, and other significant changes. Sixty-seven percent of respondents want the auditor to separately disclose unusual transactions, restatements, and significant changes in segment reporting or the entities consolidated. (Only 14% of respondents are opposed to this auditor disclosure.) Auditor disclosure of unusual transactions, restatements, and other significant changes was the third most desired change by respondents. The opinion of those in favor of this auditor disclosure is captured in the following quote:

I An unbiased and objective discussion of these issues by the auditor may provide the investor with information necessary to make an informed investment decision.state government official Key issues included in the summary audit memorandum prepared at the end of the audit. Near the completion of the audit engagement, it is customary for the lead engagement partner to prepare a summary audit memorandum. The memorandum typically discusses, among other things, the major issues encountered on the engagement, the audit procedures employed and evidence gathered, and how the issues were resolved by the engagement team. Fifty-four percent of respondents believe the auditor should disclose the key issues discussed in the summary audit memorandum and how those issues were resolved by the auditor. (Eighteen percent of respondents were not in favor of this disclosure.) The opinions of those in favor ofand opposed tothis disclosure are captured in the following comments: I Critical, investors should know. equity analyst, mutual fund

I Only if issues were not resolved; this is internal, confidential information and investors should respect that.principal, mutual fund In summary, survey respondents expressed most interest in requiring the auditor to share more information about what the auditor found during the audit with users of the audit report. Of the four most strongly desired changes in auditor reporting expressed by our respondents, three involved options presented in this section of our survey. Respondents most uniformly expressed a desire for more information from the auditor about the companys estimates and judgments (79%). Respondents also want the auditor to 1) discuss unusual transactions, restatements, and other changes (67%); 2) assess the companys accounting policies and practices (65%); and 3) discuss sensitivity analyses performed in significant judgmental areas (65%). To a lesser extent, respondents were interested in the auditors discussion of key issues included in the summary audit memorandum, including how these key issues were resolved. Respondents were less supportive of requiring the auditor to disclose additional information about all proposed

EXHIBIT 2 Notable Differences When Analyses Are Limited Only to Investment Professionals (Average Values Reported)
Nature of Issue Materiality disclosure Risk disclosure Unusual transactions, restatements, and other changes Audit adjustments Grade: aggressiveness vs. conservatism Replace binary report with multiple levels Significant estimates and judgments Sensitivity analyses Audit report currently provides valuable information Quality of accounting policies and practices Discuss issues in summary audit memorandum Disclose audit hours Fraud roles and responsibilities Communicate to investors information communicated to audit committee Audit partner signature All Respondents 3.50 3.96 3.80 2.92 2.94 3.04 3.96 3.56 2.60 3.71 3.46 2.51 3.20 3.47 3.28 Investors Only 3.87 4.32 4.14 3.24 3.26 3.36 4.26 3.85 2.32 3.98 3.70 2.72 3.41 3.66 3.46 Difference 0.37 0.36 0.34 0.32 0.32 0.32 0.30 0.29 0.28 0.27 0.24 0.21 0.21 0.19 0.18

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audit adjustments discussed with management (39% favored, 36% opposed), and were slightly opposed to having the auditor grade the relative aggressiveness/conservatism of the companys accounting policies and practices (42% favored, 44% opposed). Notwithstanding the desires of investors, one risk of requiring auditor reporting on more subjective issues is that the credibility of the audit report could be diluted, which would adversely affect investors.

Form of the Audit Report

The last section of the survey asked respondents to evaluate potential changes to the form of the auditors report. The survey explored the desirability of the following potential changes: 1) more explicitly stating the auditors responsibility for detecting fraud; 2) stating managements responsibility for preventing and detecting fraud, as well as describing the auditors procedures aimed at detecting fraud; 3) requiring the engagement partner to sign the audit report; 4) replacing the current pass/fail audit report model with a model that includes more than two reporting options; 5) requiring the auditor to state whether the financial statements present a true and fair view of the companys financial condition and results of operations, regardless of whether the financial statements are prepared in accordance with U.S. GAAP; 6) including any additional disclosures by the auditor in an auditor discussion and analysis (AD&A) narrative rather than in the SAR; and 7) requiring the auditor to include, either in the SAR or in an AD&A, a summary of the information communicated to the audit committee. Auditor responsibility for detecting fraud. Forty-three percent of respondents believe the audit report should state that the auditor has obtained reasonable assurance as to whether the financial statements contain a material misstatement, whether caused by error or fraud. (Fifteen percent disagree with requiring this disclosure). The opinions of those in favor ofand opposed tomore explicitly stating the auditors responsibility for detecting fraud are captured in the following comments: I Auditors should state that they looked for material fraud.equity analyst, mutual fund I Seems to just provide potential legal protection to the auditor, no extra insight
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or protection to shareholders/investors. principal, mutual fund Management responsibility for preventing and detecting fraud, and auditor procedures aimed at detecting fraud. The survey asked respondents if the audit report should indicate managements responsibility for preventing and detecting fraud, as well as describing the auditors procedures aimed at detecting fraud. Forty-two percent of respondents wanted this additional disclosure, but 30% of respondents were opposed to providing this type of disclosure; 27% of respondents were indifferent. Engagement partner signature. Forty-four percent of respondents supported a change to the SAR that would require the lead engagement partner to personally sign the audit opinion, in addition to including the firms name. (Twenty-six percent of respondents were not in favor of a partner signature requirement, and 30% of respondents were neutral). The opinions of those in favor ofand opposed torequiring the engagement partner to personally sign the opinion were captured in the following quotes: I Accountability tends to focus the mind.chief investment officer, mutual fund I Liability limitations should be part of this requirement so as not to drive up costs.anonymous respondent Replacing the pass/fail model with an audit report with multiple reporting options. The current audit opinion is dichotomousthe auditor concludes that the financial statements are either fairly presented in accordance with U.S. GAAP or they are not. Since there is likely to be variability in the quality of financial statements that are fairly presented, the survey asked respondents if they would find it beneficial for the auditor to opine on the quality of the issuers financial statements using multiple levels of measurement. Forty-five percent of respondents favored replacing the dichotomous audit opinion choice with a reporting model with multiple levels, but 40% of respondents expressed little or no interest in this change. True and fair view reporting. In the United States, the auditor issues an opinion on whether the financial statements are fairly presented in accordance with U.S. GAAP. However, to the extent that a transaction is not contemplated by U.S. GAAP or is structured to meet the letter but not the spirit of U.S. GAAP, the finan-

cial statements may not present an accurate picture of the economic condition of the entity. The survey asked respondents whether they would derive any benefit from a statement by the auditor that the companys financial statements present a true and fair view of the companys economic condition and results of operations, regardless of compliance with U.S. GAAP. Forty-one percent of respondents favored a move to this broader scope of opinion, 26% of respondents opposed this option, and 33% of respondents were neutral. Inclusion of an AD&A. Any additional auditor reporting requirements (relating, for example, to risks, estimates, and judgments) could be communicated either in the SAR or in another format. Fifty-two percent of respondents preferred that any additional auditor reporting be communicated in a new AD&A narrative. (Eighteen percent of respondents opposed an AD&A.) Disclose communications with audit committees in the SAR or AD&A. Existing auditing standards already require the auditor to communicate to the issuers audit committee much of the information that our survey indicates is desired by investors. One possibility for providing this information to investors would be to require the auditor to communicate to external users of the audit report some or all of the information it reported to the audit committee. Fifty-six percent of survey respondents believe the SAR (or AD&A) should include a narrative summary of the issues communicated to the issuers audit committee. (Twenty percent disagree with requiring this disclosure.) The opinions of those in favor ofand opposed toa reporting requirement of this sort are captured in the following quotes: I Any insight into the disconnect between the companys and the auditors assumptions gives a better sense of management, and managements willingness to engage in aggressive accounting.credit analyst, mutual fund I The zeal for more specific information to be made public will constrain quality dialogue among auditors and audit committees.audit committee member, mutual fund In summary, with respect to the form of the audit report, none of the proposed changes ranked among the top five changes desired by survey respondents. Notwith-

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standing this fact, respondents generally favored changes to the auditors reporting model that would provide 1) a narrative summary of the information communicated by the auditor to the audit committee (56%); 2) any additional information the auditor is required to communicate in an AD&A and not in the SAR (52%); 3) the engagement partner signature on the audit report (44%); 4) a statement in the report that the financial statements are free of material misstatement, whether caused by error or fraud (43%); and 5) a statement by the auditor that the financial statements present a true and fair view of the companys financial condition and results of operations, regardless of the companys compliance with GAAP (41%). Respondents were about evenly split with respect to replacing the dichotomous audit report with a report that includes multiple levels of comfort about the extent to which the financial statements present fairly, in all material respects, the issuers financial condition and results of operations (45% favored, 40% opposed).

Most Desired Changes

The four changes to the SAR most desired by respondents are listed in Exhibit 1. The most desired change is for the auditor to discuss its assessment of estimates and judgments made by management and how the auditor arrived at that assessment. For example, assume that a hypothetical financial institution believes that a reasonable estimate for the loan loss reserve is between $90 million and $110 million, and that a reserve of $100 million is the best estimate within this range. The auditor may believe that any number within a range of $100 million to $120 million is acceptable, but the auditor believes that $110 million is the best estimate. The companys recorded loan loss reserve of $100 million would clearly be acceptable to the auditor, but if changes to the SAR are adopted as suggested by respondents, the auditor would be required to indicate in its report that while the companys loan loss reserve is acceptable, it has the effect of increasing income in the current period over the amount that would be reported if the loan loss reserve that would be selected by the auditor had been applied. The auditor might indicate that it arrived at its assessment of the loan

loss reserve by independently computing its own estimate, by evaluating the clients estimate by considering developments subsequent to the balance sheet date, or by reviewing and evaluating the companys process for developing the loan loss reserve. The second most desired change to the SAR revealed in this survey is for the auditor to disclose more information regarding significant financial statement and audit risks and how the auditor addressed these risk areas. For example, assume that the high-risk areas for a hypothetical hightech company are revenue recognition and inventory obsolescence. The auditor would disclose these high-risk areas in the SAR or in the AD&A. In addition, the auditor would disclose its approach to auditing these high-risk areas. For example, the auditor might disclose that it confirmed an expanded number of open accounts receivable at year-end, and specifically confirmed the absence of written or oral side agreements with a responsible corporate officer from each customer. Inventory obsolescence might be assessed by a combination of procedures, including calculating days sales in inventory; examining the last sale date and dollar amount for potentially obsolete items; and calculating the runoff rate for potentially obsolete items, given the ending inventory balance in units and the annual sales rate in units. The third most desired change is for the auditor to discuss unusual transactions, restatements, and other significant changes to the reporting entity. Although these items should already be disclosed by the company in its financial statements, the auditor would highlight the existence of these items and refer the financial statement reader to the applicable note where the item is discussed. The fourth most desired change is for the auditor to discuss the quality of the issuers accounting policies and practices. A company may have adopted acceptable, but not preferable, accounting policies or applied its adopted accounting policies in an acceptable, but less-than-preferable, manner. For example, first-in, firstout (FIFO) is an acceptable method of inventory costing, but the auditor may believe that last-in, first-out (LIFO) is a more appropriate method for a subsidiary

located in a country experiencing elevated inflation. Furthermore, the straight-line depreciation method may be preferable, but in applying the straight-line method, the company may tend to overstate the useful lives and salvage values of fixed assets.

Other Analyses
Although this survey was only sent to investor organizations (e.g., mutual funds, pension funds, and hedge funds), there was no way to determine which professionals in these organizations completed the questionnaire. Some respondents were not primarily engaged in the investing functionfor example, CFOs, controllers, legal counsel, and audit committee members. It is possible that the mandate for changes in the format and content of the SAR would be even stronger if respondents were limited to only those individuals who directly perform an investment function (e.g., CIOs, portfolio managers, managing directors, equity analysts, and credit analysts). In order to test this hypothesis, the survey results were retabulated by limiting the respondents only to those individuals who are primarily engaged in the investing function. Notable differences in the results when the analysis is limited only to responses provided by investment professionals are presented in Exhibit 2. Investors rated every proposed change to the SAR more highly than did the overall pool of respondents. This refined analysis underscores the strong desire of investors for changes to the SAR.

Next Steps
On June 21, 2011, the PCAOB released a concept release on possible revisions to the SAR, with a comment deadline of September 30, 2011. The board plans to issue a proposed standard on a revised SAR early in 2012. Changes to the SAR will have farreaching effects, not only on auditors, but also on financial statement preparers and users. CPAs should monitor the PCAOBs continuing efforts in this area so that they are prepared if the board decides to change the form or content of the standard auditors report. K Joseph V. Carcello, PhD, CPA, CMA, CIA, is the director of research at the Corporate Governance Center, the University of Tennessee, Knoxville, Tenn.
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C C O U N T I N G

& A accounting

U D I T I N G

The Continuing Evolution of Accounting for Goodwill

By David A. Rees and Troy D. Janes
wo recent pronouncements by FASBAccounting Standards Update (ASU) 2010-28 and 201108have altered the accounting for goodwill subsequent to its initial measurement. Conceptually, goodwill is defined as the current value of expected future income in excess of a normal return on the net tangible assets (See Kohlers Dictionary for Accountants, 6th ed., Prentice Hall, 1983). Accordingly, the intangible assets that are collectively called goodwill may be generated either internallythrough methods such as superior management or a successful advertising campaign, for exampleor externally, through a business combination. Because of the difficulties in measuring them, expenditures to create, protect, or enhance goodwill (i.e., internally generated goodwill) have always been expensed as incurred. Since 1944, when the first pronouncement that dealt specifically with goodwill was issued, only goodwill resulting from a business combination has been recorded. In a business combination, goodwill is measured as the difference between the price paid for an acquired company and the sum of the fair value of the identifiable net assets. Thus, goodwill is a residual assetthat is, the amount remaining after fair values have been attached to the identifiable assets and liabilities of the purchased company. The initial measuring and recording of goodwill has remained constant; however, the accounting for goodwill after its initial measurement continues to evolve.

goodwill after its initial measurement. In ARB 24, the Committee on Accounting Procedure (CAP) specified that acquired goodwill was to be carried as an asset at cost. Regarding the subsequent accounting for goodwill, CAP specified that when the useful life of goodwill was relatively

inconsistent treatment of the accounting for goodwill, the Accounting Principles Board (APB) issued Opinion 17, Intangible Assets, in 1970. In Opinion 17, the APB considered the following four methods of accounting for goodwill:

Historical Background
Issued in 1944, Accounting Research Bulletin (ARB) 24 (later codified into ARB 43, chapter 5) was the first guidance dealing with goodwill, including accounting for

short, a company could partially write down goodwill, through a charge to earned surplus, and amortize the rest of the goodwill. Otherwise, goodwill was to remain on the books at cost until it became reasonably evident that the goodwill had a limited life or an event occurred that indicated there was a loss, at which time goodwill was to be amortized or written off if it had become worthless (ARB 43, chapter 5, para. 6, 8, 9). Over time, the guidance in ARB 43 was viewed as a choice between two acceptable methods: 1) systematically amortizing goodwill; or 2) not amortizing goodwill until there was evidence of a loss or limited life, and then amortizing goodwill or recording a loss. Primarily because of this

I Retain goodwill indefinitely as an asset until it is evident that a reduction in value has occurred. I Permit goodwill to be amortized over an arbitrary period. I Require goodwill to be amortized over its estimated life or over an arbitrary period within a specified minimum and maximum. I Deduct the cost of goodwill from stockholders equity at the time of acquisition. After considering the four accounting alternatives, the APB chose to amortize goodwill over an arbitrary period, with a maximum limit of 40 years. The APB argued that few, if any, assets last forever, and because goodwill has an indeterminate life and its value will, at some point,

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become zero, some arbitrary period within a range of time must be selected as the amortization period (APB Opinion 17, para. 1820). The APBs position was not unanimous. One dissenter on the board maintained that goodwill is an expression of investor expectations, and after goodwill is initially measured, it fluctuates frequently and widely. Furthermore, the dissent stated that goodwill does not have a demonstrable useful life; and its expiration, if any, cannot be related on any logical basis to operating income. Others dissented as well, arguing that whether amortization is appropriate depends upon the particular circumstances of each case, and that when amortization is appropriate, it should be based on professional judgment rather than arbitrary rules (APB Opinion 17, Dissent). APB Opinion 17 remained in effect until June 2001, when FASB issued SFAS 142, Goodwill and Other Intangible Assets. At the same time, FASB also issued SFAS 141, Business Combinations, which eliminated the pooling-of-interests method of accounting for a business combination, a method that does not give rise to goodwill. Since the 1930s, this method had been used when affiliated companies combined. APB Opinion 16 (implemented in August 1970), Business Combinations, set 12 conditions that had to be met to establish that the combining companies were affiliated and thus the use of the pooling-of-interests method was appropriate. But although the pooling-of-interests method was always considered appropriate only when affiliated companies combined, some business combinations were inappropriately manipulated to allow the pooling method and thus avoid recording goodwill. By disallowing the pooling-of-interests method, FASB eliminated a perceived loophole for avoiding recording goodwill in a business combination. All entities that had been using the pooling-of-interests method had to retroactively restate their financial statements as if the new acquisition method had been used to account for the business combination. SFAS 142, which contains most of the current guidance on the topic, mandated major changes in the accounting for goodwill. The standard eliminated amortization of goodwill and required carrying goodwill at cost unless it becomes impaired, thus reverting to a position held
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in ARB 24. SFAS 142 also required that companies test goodwill for impairment at least annually. The first step of the impairment test is to compare the carrying amount of a reporting unit, including goodwill, to the fair value of the reporting unit. If the fair value of the reporting unit is greater than the carrying amount, goodwill is not impaired. If the fair value of the reporting unit is less than its carrying amount, then the second step of the impairment test is to compute the implied value of goodwill and compare it to the carrying value of goodwill; any excess of book value over implied value is recorded as an impairment loss. Although the methods of accounting for goodwill in countries around the world have converged somewhat over time, practices have varied widely historically. France treated goodwill as an asset that was only written down when impaired, similar to the current standard in the United States. For many years, standards in the United Kingdom, as well as early standards of the International Accounting Standards Board (IASB), encouraged or required the writeoff of acquired goodwill in the year of acquisition. Most other countries that required or allowed the capitalization and amortization of goodwill did so over periods considerably shorter than the United States. Frequently, goodwill was amortized over periods of just a few years and rarely exceeding 20 years (Seetharaman et al, Accounting Treatment of Goodwill: Yesterday, Today and Tomorrow: Problems and Prospects in the International Perspective, Journal of Intellectual Capital, vol. 5, no. 1).

Recent Changes
When issuing the guidance in SFAS 142, FASB was sensitive to the recurring preparation costs and hours spent on computing the fair value of a reporting unit that were necessary for the first step of the impairment test. FASB believed that most of the costs in computing the fair value of a reporting unit would be incurred in the year of adoption. To relieve companies of some of these costs, FASB allowed a prior years fair value to be carried forward when certain criteria were met and also permitted the fair value of a reporting unit to be computed using several different methods, including a market approach and an income approach.

As practice has evolved, however, many preparers have not used this carryforward option because they either could not meet the criteria or their auditors disagreed with the use of the carryforward provision. In practice, a market approach to computing the fair value of a reporting unit has proven to be very challenging, because the unique characteristics of a reporting unit make it difficult to find a comparable entity. Thus, the costlier income approach is frequentlyand sometimes exclusivelyused to compute the fair value of a reporting unit. In short, FASBs initial attempts to reduce costs for financial statement preparers have not worked to their expectations. In December 2010, ASU 2010-28 amended the accounting for goodwill to correct a shortcoming in the impairment test. Prior to the change, a reporting unit with a zero or negative carrying value (i.e., an equity deficit) would usually pass the first step of the impairment test because the fair value of the reporting unit would generally be greater than zero. The results of the test would therefore indicate a lack of impairment, even though the existence of a deficit indicates the possible presence of impairment. Under ASU 2010-28, companies with reporting units with a zero or less carrying value are required to skip the first step of the impairment test and conduct the second step when qualitative factors indicate that it is more likely than not that the reporting unit has sustained a goodwill impairment loss (ASC 350-20-35-8A). This guidance on reporting entities with zero or negative carrying amounts was effective for public entities whose fiscal years and interim periods began after December 15, 2010 and private entities whose fiscal years and interim periods begin after December 15, 2011 (ASC 350-10-65-2). Early adoption was not permitted. When initially implementing this guidance, any goodwill impairment loss is reported as a cumulative-effect adjustment to the beginning balance of retained earnings. Any goodwill impairments occurring afterward are reported in earnings (ASC 350-10-65-2D). In September 2011, with the stated goal that the benefits of providing information should justify the related costs, FASB considered several proposals for amending the guidance on goodwill impair-

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EXHIBIT 1 Accounting for Goodwill

Qualitative Assessment: Evaluate relevant events and determine if it is more likely than not that the fair value of a reporting unit is less than its carrying value.

Is it more likely than not that the fair value is less than the carrying value?

Yes

Is the fair value greater than or equal to zero?

Yes

Step 1: Compare fair value of the reporting unit to carrying amount.

No

No Step 2: Calculate the implied fair value of goodwill and compare to its carrying amount. Is the fair value of reporting unit less than its carrying amount?

Yes

No Is the implied goodwill less than its carrying value?

No

Yes Recognize impairment loss. Stop.

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ment, including: 1) modifying the guidance on using the carryforward provision; 2) coupling an amortization model with an impairment model that would be triggered when certain qualitative criteria are met; 3) derecognizing existing goodwill and recognizing any new goodwill, either on the income statement or in an equity account; and 4) requiring the goodwill impairment test at some level higher than the reporting unit. In their deliberations, FASB put considerable weight on reducing costs and not further diverging from the guidance under International Financial Reporting Standards (IFRS). Under ASU 2011-08, Testing Goodwill for Impairment, FASB now allows an entity to assess qualitative factors to determine whether goodwill is impaired before performing the two-step impairment test. It is thought that this will reduce the cost and complexity of calculating the fair value of a reporting unit. Preparers also have the option to ignore the qualitative assessment and proceed with the two-step impairment test. After an analysis of qualitative factors, if it is determined that it is more likely than not that the fair value of a reporting unit is greater than its carrying amount, then performing the two-step test is not necessary (ASC 35020-35-3A-B, D). Examples of these qualitative factors include the following: I Macroeconomic conditions, such as a deterioration in general economic conditions, limitations on accessing capital, fluctuations in foreign exchange rates, and market conditions; I Industry and market considerations, such as a deterioration in the environment in which an entity operates, increased competitive environment, a change in the market for an entitys products and services, or a regulatory or political development; I Cost factors, such as increases in raw materials, labor, or other costs; and I Overall financial performance, such as negative or declining cash flows or a decline in actual or planned revenues or earnings. Other examples of qualitative factors are given in ASC 350-20-35-3C, but the standard cautions that the qualitative factors described are just examples and that financial statement preparers should also consider other relevant events and circumstances. In addition to negative factors, an entity should also consider positive
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and mitigating qualitative factors in determining whether it is more likely than not that the fair value of a reporting unit is greater than its carrying amount. In this consideration of whether it is more likely than not that goodwill impairment exists, an entity must weigh the evidence (both positive and negative) and the significance of all identified events and circumstances. The existence of mitigating evidence or events does not constitute a presumption that the first step of the goodwill impairment test need not be conducted. This amended guidance becomes effective for public and private entities whose fiscal years and interim periods begin after December 15, 2011; early adoption is permitted for implementing the qualitative assessment (ASC 350-10-65-2A-B). Following these two recent changes, the accounting for goodwill is as depicted in Exhibit 1.

off and the impairment loss is not absorbed, then the other assets in the CGU are written down pro rata, with some restrictions on the write-downs of the individual assets.

A Continual Transformation
The accounting for goodwill after its initial measurement has evolved from recording it as an asset without amortization until it is impaired or has a limited life (ARB 24), to amortizing it over its life or 40

FASB now allows an entity to assess qualitative factors to determine whether goodwill is impaired before performing the two-step impairment test.
years, whichever is less (APB Opinion 17)and then back to recording it as an asset with a yearly impairment test (SFAS 142). Each of these methods has had shortcomings that have required additional guidance. With its latest pronouncement (ASU 2011-08) in September 2011, FASB now offers the option of not performing the two-step impairment test when qualitative factors indicate that the fair value of a reporting unit is greater than its carrying value. The recent changes by FASB have, by the boards own admission, not aided in the convergence of U.S. GAAP and IFRS with respect to the treatment of goodwill. Because of this, it is likely that additional guidance will be forthcoming in the continuing evoK lution of accounting for goodwill. David A. Rees, PhD, CPA, is a professor of accounting at Southern Utah University, Cedar City. Troy D. Janes, PhD, CPA, is an assistant professor of accounting at Rutgers, The State University of New Jersey in Camden.

A Comparison
Two sets of accounting standards presently govern most financial reporting in the world: U.S. GAAP and IFRS, which are issued by the IASB. Because FASB and the IASB are working to converge their respective standards, with a view to possible future changes in the accounting for goodwill, it is of interest to compare the current accounting for goodwill required by the two accounting standardssetting bodies. As with U.S. GAAP, IFRS requires that goodwill can only be recognized in a business combination as measured and accounted for under the acquisition method. Furthermore, both standards-setting bodies require that goodwill be retained on the books of most companies without amortization, unless goodwill is impaired. Both sets of standards require that goodwill be tested for impairment at least annually. But under IAS 36, Impairment of Assets, goodwill impairment is conducted at the level of the cash-generating unit (CGU) or group of CGUs, instead of at the level of a reporting unit. Also, rather than U.S. GAAPs two-step impairment test, IAS 36 requires a one-step test, where the carrying amount of a CGU is compared to its recoverable amount. When the recoverable amount is less than the carrying amount, the excess is recorded as a loss, with goodwill being written down first. If goodwill is written

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C C O U N T I N G

& A U D I T international accounting

I N G

Loss Contingencies Face Controversy in Convergence

Amendments to SFAS 5 and IAS 37 Are Rethought Amid Criticism
By Anthony D. Holder and Khondkar E. Karim
s part of their short-term convergence project, FASB and the International Accounting Standards Board (IASB) are currently reviewing their accounting for loss contingencies. Statement of Financial Accounting Standards (SFAS) 5, Accounting for Contingencies, acts as the primary accounting guidance for the accrual or disclosure of loss contingencies. Similarly, International Accounting Standard (IAS) 37, Provisions, Contingent Liabilities and Contingent Assets, prescribes the recognition, measurement, and disclosure requirements for such items. Few convergence topics have generated as much controversy or discussion as this one. This article discusses the viewpoints of both standards-setting bodies, summarizes respondents reactions, articulates the controversies, and illustrates the practical implications of these findings. ed with loss contingencies. The proposed amendments will enhance the current qualitative disclosures by requiring disclosure of publicly available quantitative information (such as the claim amount for assertby Rosemond Desir, Kirsten Fanning, and Ray Pfeiffer (Are Revisions to SFAS No. 5 Needed? Accounting Horizons, vol. 24, no. 4, pp. 525545, December 2010). This research project was undertaken while one

The First Exposure Drafts

In June 2005 and June 2008, the IASB and FASB, respectively, published exposure drafts to expand disclosures about certain loss contingencies in the scopes of IAS 37 and SFAS 5. These projects were undertaken jointly by FASB and the IASB to help reduce the differences in accounting for contingent liabilities between International Financial Reporting Standards (IFRS) and U.S. GAAP. According to FASB, the proposed changes in the first exposure draft (ED 1) result from the perception among investors and other users of financial information that disclosures about loss contingencies are inadequate, primarily because existing FASB guidance does not achieve its stated purpose of providing sufficient information to assist users of financial statements in assessing the likelihood, timing, and amount of future cash flows associat-

ed litigation contingencies), other relevant nonprivileged information, and, in some cases, information about possible recoveries from insurance and other sources. Likewise, according to the IASB, the proposed amendments to IAS 37 (ED 1) will enhance the current qualitative disclosures by requiring additional disclosures. For example, in the case of litigation contingencies, the new rules will require disclosure of the parties contentions and the ways that users can obtain additional information about the litigation.

Related Research
There are relatively few research papers in this area. One notable exception is a study

of the authors was a FASB research fellow, and the results of the study were given to FASB staff prior to the issuance of a second exposure draft in 2010. According to Desir et al., this situation is novel because it is one of the few instances where academic research contributes to policy making ex ante. This is more desirable because it enhances the likelihood that new guidance is actually warranted based on the data and that such new guidance achieves its intended purpose of improving the information available to financial statement users. At FASBs request, the authors looked at whether there was any validity in constituents assertions that SFAS 5 led to inadequate disclosures.
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The study examined a sample of litigation-related losses and documented characteristics of the disclosures that firms made prior to reporting the unfavorable outcome. The authors interpreted their results as indicating a surprisingly large incidence of nondisclosure of contingent losses, which they were unable to explain. In some cases, the authors found that even when there was disclosure, there was a relatively high incidence of companies not providing estimates of expected losses; however, this result was attributed to the permitted exception for cases where companies are unable to estimate the magnitude of expected losses. Alternatively, the authors did find several cases where companies disclosed items that are not yet required, but will be if the proposed changes in the exposure draft are accepted. The latter result was interpreted as suggesting that this information is being provided at users request. On the other side of the coin, there is a quite a bit of anecdotal evidence suggesting that companies will be severely affected by the proposed changes. For example, a 2010 Financial Times article noted that the proposed changes have led to a backlash from 140 of the biggest U.S. businesses, including AT&T, Bank of America, Citigroup, Coca-Cola, Ford Motor, General Electric, Google, HewlettPackard, Intel, and McDonalds (Jean Eaglesham, U.S. Groups Warn on Lawsuit Proposals, www.ft.com/cms/s/0/ 2f720eea-c410-11df-b827-00144 feab49a.html#axzz1JQNXu8QG). Many affected companies are concerned that the proposals could trigger litigation against businesses that make inaccurate estimates of future losses. These companies are also concerned that the proposed changes will stimulate class-action lawsuits and make shareholder-friendly settlements more challenging. The article claims that the only folks who benefit from this are people on the plaintiffs bar, who would love more information about what companies deem the value of litigation may be, and it notes that the companies fear that the proposed changes would open up a new front in the ongoing war between U.S. corporations and class-action attorneys, who specialize in lawsuits that are often settled for a tiny proportion of the initial claim. In fact, SFAS 5 is often referred to as a treaty between the accounting and legal
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professions (M. Barrett, Opportunities for Obtaining and Using Litigation Reserves and Disclosures, Ohio State Law Journal, vol. 63, no. 5, pp. 10171106, 2002). But in June 2008, FASB effectively announced its reconsideration of the treaty by issuing ED 1, the proposed Accounting Standards Update (ASU) 450, Contingencies: Disclosure of Certain Loss Contingencies, which recommended changes to SFAS 5. On the other hand, much of the impetus for the proposed changes underlying IAS 37 is driven by the SECs proposed road map, which sug-

Convergence of Global Accounting Standards, October 29, 2002). Consequently, it is somewhat interesting that the changes in the proposed SFAS 5 ED 1 are similar, but not identical, to those proposed for the IAS 37 ED 1, which seems instead to work against the stated convergence agenda.

Comment Letters
The IASB and FASB received numerous comment letters on the proposal to converge the guidance in IAS 37 with SFAS 5. Respondents included preparers, accounting firms, several accounting bodies, and some individuals. On July 20, 2010, FASB issued a second exposure draft (ED 2) to expand disclosures about certain loss contingencies, primarily because of highly critical feedback in the original comment letters. For this article, the authors obtained the IASBs ED 1 and FASBs ED 1 comment letters directly from the boards respective websites. For the analysis of the formal direct participation of constituents in FASBs and the IASBs due processes, the authors examined 125 comment letters written in response to FASBs original ED 1 and 80 comment letters written in response to the IASBs ED 1, dating from June 2005 to August 2008. FASB. According to the original comment letters, the proposed changes will have a generally negative impact on companies and will not improve the quality of financial reporting. Specifically, the changes will I lead to less accurate and less useful information for investors, I threaten the attorney-client privilege and the attorney work-product doctrine, and I unnecessarily provide damaging information to potential claimants and force corporate defendants to disclose privileged information to plaintiffs. Many commentators also argued that the proposed disclosures will require companies to make public their internal litigation strategies to the very entities involved in the lawsuits against them. Furthermore, the changes will increase the compliance effort necessary to create the expanded disclosures, and they will encourage plaintiffs to file claims with extraordinary demands in order to force companies to settle lawsuits earlier to elim-

Many affected companies are concerned that the proposals could trigger litigation against businesses that make inaccurate estimates of future losses.

gests that FASB and the IASB continue to work toward the convergence of standards through 2011 (Katie Rahr, Khondkar E. Karim, and Robert W. Rutledge, Transitioning to IFRS: What Should CPAs and Accounting Firms Be Doing? The CPA Journal, pp. 69, March 2010). The Financial Accounting Standards Advisory Council (FASAC) defines convergence as follows: [The IASB and FASB] rejected the dictionary definition of convergence, moving toward union or uniformity, as an end in itself, agreeing instead to focus on convergence as described in the 2002 Norwalk Agreementthe development of high-quality compatible accounting standards that could be used for both domestic and cross-border financial reporting (FASB, Memorandum of Understanding: The Norwalk Agreement, 2002, www.fasb.org/ news/memorandum.pdf; FASB, FASB and IASB Agree to Work Together Toward

35

inate disclosure. Thus, many respondents believe that financial statement readers will not be better served by the enhanced disclosure rules. Other respondents, however, noted that the changes proposed by ED1 represent an important step in providing investors with improved disclosures. These letters suggest that the current guidance for the disclosure of loss contingencies does indeed fail to provide adequate information to assist users of financial statements in assessing the likelihood, timing, and amount of future cash flows associated with loss contingencies. According to this group of constituents, FASB is accurate in its assessment that the existing SFAS 5 has failed to produce this adequate information to assist users of financial statements.

IASB. In general, most respondents disagreed with the proposals and suggested that the IASB has not made a sufficiently compelling case for the changes arising from its consideration of contingencies. The consensus viewpoint expressed by this group is that there are insufficient flaws in the current IAS 37 to warrant changes; therefore, they raised questions about whether the amendments will actually improve the relevance and consistency of financial reporting. Furthermore, the proposed changes will fundamentally change the accounting concepts applied to the recognition and measurement of all nonfinancial liabilities. Although some in this group welcomed the IASBs decision to reconsider the concepts underpinning the recognition and measurement of nonfi-

nancial liabilities, many of these same respondents suggested that changing IAS 37 at this stage is premature. An alternative argument expressed by several writers was that making these changes to IAS 37 before amending the Conceptual Framework is inadvisable, because the changes may ultimately impair the authority of the framework. This group of respondents encouraged the board to use the response to the ED 1 in a similar fashion as FASB, as input into the Conceptual Framework Project. Yet many note that FASB has so far used the concept of a stand-ready obligation only in limited cases. Respondents, therefore, commented that one unintended consequence of the amendments may be to create major additional differences

EXHIBIT 1 Timeline of Proposed Changes to Accounting for Loss Contingencies

FASB Timeline March 1975 June 2008 August 2008/ December 2008 July 2010 August 2010

SFAS 5 Issued

ED 1 Issued

ED 1 Comment Letter Deadline/ Effective Date

ED 2 Issued

ED 2 Comment Letter Deadline/ Effective Date

IASB Timeline September 1998 June 2005 October 2005/ January 2007
ED 1 Comment Letter Deadline/ Effective Date

January 2010

April 2010
ED 2 Comment Letter Deadline/ Effective Date

IAS 37 Issued

ED 1 Issued

ED 2 Issued

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between U.S. GAAP and the short-term convergence project. Finally, a pervasive theme expressed by some respondents was that the IASB should continue its joint work with FASB.

The Second Exposure Drafts

On July 20, 2010, FASB released a second exposure draft, Accounting Standards Update: Contingencies (Topic 450): Disclosures of Certain Loss Contingencies (ED 2) that reflected certain changes to its proposal on accounting for contingencies after considering the comments received on ED 1. Like ED 1, ED 2 also revolves around the enhanced disclosures on litigation contingencies. Largely because of the critical feedback received in the original comment letters for ED 1 (litigation contingency disclosures in particular), FASB conducted additional outreach including field tests and a public roundtablebefore issuing ED 2. In January 2010, the IASB also published a second exposure draft that modified its proposed guidance on accounting for contingencies. (See Exhibit 1 for a timeline of FASB and IASB exposure drafts.) As with FASBs ED 2, the IASBs ED 2 also addressed the perceived shortcomings of ED 1. In general, IASB respondents expressed frustration with the inherent ambiguity in the language used in ED 1. For example, respondents were confused about terms such as settle and transfer: What does the term settle mean? Does it mean cancel or fulfill? What if the amount to settle the obligation differs from the transfer amount? At which of the two amounts should the liability be measured? What if the entity is unable to transfer a liability to a third party? Should an entity be expected to measure a liability at an amount that it may never have to actually pay?

the entitys financial position, cash flows, or results of operations. IAS 37, on the other hand, does not require disclosures for remote loss contingencies, regardless of the expected timing of resolution or potential severity of the contingency. FASB also noted that the IASB is expected to evaluate the disclosure requirements in this proposed guidance when it reconsiders the IAS 37 disclosure requirements. One of the IASBs primary reasons for issuing the proposed amendments to IAS 37 is its short-term convergence project. The objective of this project, undertaken jointly with FASB, is to reduce the relatively minor differences between IFRS and U.S. GAAP that can be resolved in a fairly short period of time. The IASB further notes that one aspect of the joint short-term convergence project requires that the two boards consider each others recent standards. Thus, it is interesting that the boards proposed changes appear to be similar, but not identical, to each other.

Exhibit 2 offers a comparison of the exposure drafts.

Current Status and Controversies

The SFAS 5 ED 1 proposal resulted in significant concern and commentary: More than 240 comment letters were received, and FASB held two roundtables to elicit further feedback from companies, auditors, and attorneys. The July 2010 proposal, ED 2, is the culmination of these discussions. But the revised amendments still raise significant concerns among respondents and other interested observers, including the potential required disclosure of key elements of a companys litigation strategy, the possible waiver of attorney-client privilege and attorney work-product protection, and the creation of a potential source of additional litigation. In addition, the new disclosures could embolden plaintiffs to continue what would otherwise be problematic litigation and potentially increase the amounts paid in settlement.

Rationale for Accounting Changes: FASB vs. IASB

According to FASB, the proposed changes to SFAS 5 would require disclosures about a broader population of contingencies than those required by IAS 37. Specifically, the proposed changes would require disclosures about loss contingencies, regardless of the likelihood of loss, if the contingencies are expected to be resolved in the near term and if the contingencies could have a severe impact on
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Some commentators also note that, because the standards for judging a loss contingency to be either probable or remote are so high, most loss contingencies would fall into the category of reasonably possible; however, it is rare for companies to make an estimate of loss contingencies deemed reasonably possible because of the inherent uncertainties in litigation. Furthermore, legal counsel generally refrains from giving an estimate of loss or range of probable loss when responding

to auditors requests for information, because the American Bar Associations (ABA) Statement of Policy Regarding Lawyers Responses to Auditors Request for Information cautions lawyers against making estimates where the likelihood of inaccuracy is other than slight. Constituents also assert that the proposed changes may conflict with the SECs litigation disclosure standards under Item 103 of Regulation S-K. Item 103 requires a

brief description of any material pending legal proceedings, other than ordinary routine litigation incidental to the business, but it does not require disclosure of any proceeding that involves primarily a claim for damages if the amount involved, exclusive of interest and costs, does not exceed 10 percent of the current assets of the company. Some respondents believe that the relative burden and additional costs placed on

EXHIBIT 2 Comparison of Original Guidance with Proposed Amendments

Standard Original Guidance SFAS 5
I Loss contingencies that are probable to occur require the quantitative accrual of a liability in the financial statements. I All other contingent losses involving at least a reasonable possibility that a loss may have been incurred must be disclosed in a note to the financial statements that sets forth the nature of the loss contingency and the range of probable loss, if it is estimable. I If the range of probable loss cannot be estimated, it does not have to be disclosed. Loss contingencies that are deemed remote do not have to be disclosed at all.

ED 1
I The ED 1 amendments would replace and enhance the disclosure requirements in SFAS 5 for loss contingencies that are recognized as liabilities in a financial statement and for certain unrecognized loss contingencies that meet the definitional criteria. I Among the loss contingencies included in SFAS 5 are potential losses from pending and threatened litigation, claims, and assessments. I The amendments would also apply to loss contingencies recognized in a business combination accounted for under SFAS 141(R), Business Combinations.

ED 2
I The amendments would include more robust qualitative disclosures in situations in which quantitative disclosures are limitedfor example, because of the inherent uncertainties about the final resolution of litigation contingencies. I ED 2 requires that entities ignore the possibility of recoveries from insurance or other indemnification arrangements. I It eliminates the requirement to disclose the entitys estimate of its maximum exposure to loss. I It requires that quantitative disclosures be based on nonprivileged or publicly available quantitative information I ED 2 does not provide a prejudicial exemption. I ED 2 does not require disclosure of settlement offers.

Standard Original Guidance IAS 37

I IAS 37 requires that a provision be recognized only if a present obligation (legal or constructive) has arisen as a result of a past event (obligating event), payment is probable (more likely than not), and the amount can be estimated reliably. A constructive obligation arises if past practice creates a valid expectation on the part of a third party. A possible obligation (contingent liability) is disclosed but not accrued; however, disclosure is not required if payment is remote.

ED 1
I The proposed amendment would eliminate the terms contingent asset and contingent liability. It would also reconsider the application of the probability recognition criterion.

ED 2
I The IASB published ED 2 in response to questions and issues raised by respondents to ED 1. Consequently, ED 2 provides guidance on the following questions: I What does the term settle mean? To cancel or fulfill? I What if the amount to settle an obligation differs from the amount to transfer it? At which amount should the liability be measured? What if the entity could not transfer the liability to a third party? Should the entity measure the liability at an amount that it might never pay in practice? I In general, the other proposed changes in ED 2 were semantic or relatively minor.

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small businesses in complying with the proposed changes is more onerous than those placed on larger companies. This charge stems from the fact that the costs to comply are essentially fixed; when compared to companies revenue base or available liquidity, this will result in a proportionally higher cost to comply for smaller companies than for larger corporations. This may place small companies at a distinct competitive disadvantage. Representatives of small companies also note that on February 4, 2008, the SEC amended its disclosure and reporting requirements to expand the number of companies that qualify for its scaled disclosure requirements. Under these amendments, smaller reporting companies were given relief from the extent of disclosure that is required in certain circumstances. According to the SEC, these recommendations were designed to update and improve federal securities regulations that significantly affect smaller companies and their investors in todays capital markets. In the SECs words: It is expected that the amendments will promote capital formation for smaller reporting companies and improve their ability to compete with larger companies for capital. For example, we believe capital formation will be improved by providing flexibility to more smaller reporting companies to tailor their disclosure to their investors' needs. In addition, the cost to raise capital may be reduced to the extent compliance costs, but not benefits, are reduced as a result of the scaled disclosure requirements. If smaller reporting companies allocate the capital they raise and save as a result of our scaled disclosure requirements to business development in an effective manner, these companies will be more competitive. More companies will be able to take advantage of more scaled disclosure item requirements, such as those contained currently in Items 310 and 402 of Regulation S-B. Smaller reporting companies that avail themselves of the scaled disclosure will provide tailored disclosure that may better meet the needs of their investors. (SEC Release 33-8876; www.sec.gov/ rules/final/2007/33-8876.pdf) Finally, FASBs Private Company Financial Reporting Committee (PCFRC) has deferred recommendations to the
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amendment to SFAS 5, expressing concerns that the additional disclosure requirements mandated by the proposed amendments could provide opposing counsel with a road map to be used in litigation.

Practical Implications
As suggested by many comment letters, the motivations for the proposed EDs are not clearly articulated. A stated aim of both FASB and the IASB is to respond to user demands for more explicit disclosure of the loss contingency risks that companies face. It appears, however, that the inherent ambiguity in the proposed changes will necessitate a significant amount of additional resources to compile, analyze, report, and audit the additional required information. For example, most dissenting commentators suggest that while the EDs include specific disclosure requirements that may result in the dissemination of more data, more information may not necessarily be better. In other words, the new data may provide little additional meaningful information for reasoned decision making. Inaccuracies in early estimates potentially expose companies to significant associated liability. The litany of information called for in the new ED requirements compels the disclosure of the fundamental elements of a reporting companys litigation strategy and has the potential to distort the outcome of the underlying proceedings by significantly and unfairly prejudicing the reporting company's litigation or settlement positions by providing a road map for opposing counsel. This potential to distort is opposed to the notion that accounting information should be free from bias. In the authors opinion, it is also possible that the proposed changes may adversely affect certain industries more than others. For example, consider the healthcare industry, where the requirement to disclose information about a contingency if there is at least a reasonable possibility (i.e., more than remote possibility) that a loss may have been incurred would place an inordinate burden on the industry due to the sheer volume of claims or potential claims. The added effort to review each claim independently to ascertain appropriate disclosure will not be costeffective. The ability to effectively audit

this information might be impaired due to the very subjective nature of certain loss contingencies. In addition, the sheer volume of the information that will be required to be reviewed and audited will result in higher fees from both attorneys and auditors. Attorneys and other experts may be unable or unwilling to provide appropriate auditable evidence. Moreover, attorneys responses to auditor inquiries could result in unintended waivers of the attorney-client privilege. As noted above, as FASB and the IASB progress toward convergence, they will, where feasible and cost-effective, value financial reporting transparency. Well-crafted transparency should increase the usefulness of financial information in a users decision-making processes. It is fair to say that four of the practical implications of the research findings are as follows: I The entire convergence project may be more difficult and lengthier due to the observed strong objections of preparers, particularly due to the more litigious U.S. climate, as evidenced here concerning loss contingency disclosure. I The IASB must devote sufficient resources to effectively deal with this different U.S. climate. I FASB must also factor this effect into its efforts on convergence. I If these EDs are evidence of short-term convergence projects, then the current timeframe for convergence may be unrealistic. In addition, while loss contingency disclosures are particularly controversial, the two standards-setting entities need to remain mindful that the ultimate justification of external financial reporting is its ability to aid various user groups in making informed decisions concerning the allocation of scarce economic resources. With respect to the accounting profession, reporting requirements should also pass a K cost-benefit evaluation. Anthony D. Holder, PhD, is an assistant professor of accountancy at the Weatherhead School of Management at Case Western Reserve University, Cleveland, Ohio. Khondkar E. Karim, PhD, CPA, is a professor of accounting at the Manning School of Business at the University of Massachusetts Lowell.

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A X A T I O N

tax policy

Prospects for U.S. Corporate Tax Reform

Deferral Clouds the Picture
By Andrew D. Gross and Michael S. Schadewald
he last major overhaul of the U.S. corporate tax system was the Tax Reform Act of 1986, which reduced the top corporate tax rate from 46% to 34%. Since then, the tax rate has remained relatively unchanged. In sharp contrast, the corporate tax rates of other developed nations have declined substantially. Given the mobility of capital in a globalized economy, a competitive U.S. corporate tax rate is important in attracting foreign investment and encouraging U.S. companies to invest domestically. Bringing U.S. corporate tax rates in line with those of its major trading partners represents a major policy challenge for Congress. According to the Organization for Economic Cooperation and Development (OECD), the U.S. corporate income tax rate was 38.7% in 1990, including both the 34% federal rate plus an average state rate of 4.7% (after adjusting for the federal tax benefit). In contrast, the average corporate income tax rate of the other OECD countries in 1990 was 41.2%. For example, the corporate tax rate was 54.5% in Germany, 42% in France, and 41.5% in Canada (www.oecd.org/ctp/taxdatabase, Table II.1). In 2011, the U.S. tax rate remained relatively unchanged at 39.2% (35% federal plus 4.2% state), whereas the average corporate tax rate of the other OECD countries had dropped to 25.5%. For example, in 2011, the corporate tax rate was only 30.2% in Germany, 34.4% in France, and 27.6% in Canada. (See Exhibit 1.) ing revenue loss is offset by accompanying revenue-raising provisions. Thus, some U.S. lawmakers have called for a revenue-neutral package of reforms that both lowers the corporate tax rate and broadens the tax Seek Level Playing Field, Wall Street Journal, January 26, 2011). The prime targets for funding a corporate rate reduction are business tax deductions and credits, many of which favor cer-

Fiscal Barriers to Lowering the Tax Rate

A major obstacle to lowering the U.S. corporate tax rate is the massive federal budget deficit, which makes a significant tax rate reduction impractical unless the result-

base. In his January 2011 State of the Union speech, President Obama noted that although a parade of lobbyists has rigged the tax code to benefit particular companies and industries all the rest are hit with one of the highest corporate tax rates in the world. To address this problem, he recommended: Get rid of the loopholes. Level the playing field. And use the savings to lower the corporate tax rate for the first time in 25 yearswithout adding to our deficit. Likewise, Treasury Secretary Timothy Geithner has emphasized the importance of eliminating special deductions and credits in order to offset the revenue losses associated with a rate reduction (Tax Redo to

tain industries over others. Examples include accelerated depreciation, the domestic production activities deduction, and the research credit. Due to such provisions, many U.S. corporations currently pay effective tax rates much lower than the federal statutory rate of 35% (U.S. Business Has High Tax Rates but Pays Less, New York Times, May 2, 2011). One problem with a corporate tax reform package that consists of both tax rate reductions and the elimination of selected deductions and credits is that it would have the net effect of actually increasing the tax burden of some U.S. corporations that currently have relatively low effective tax
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rates. For example, depending upon the specific details, it is possible that many retailers might enjoy a net tax decrease, whereas many manufacturers might realize a net tax increase. The existence of both winners and losers makes it difficult to get broad business support for any such revenue-neutral reforms (Winners and Losers in Corporate Tax Reform, Tax Notes, February 14, 2011).

What About Deferral?

Further complicating any discussion of U.S. corporate tax reform is what changes, if any, should be made to the long-standing international tax policy known as deferral. Under deferral, U.S. multinational corporations generally pay no U.S. tax on the income they earn abroad through their foreign subsidiaries. Instead, the payment of any U.S. tax due on foreign profits is deferred until the earnings are repatriated to the U.S. parent company through a dividend distribution. Historically, the policy rationale for deferral is that it allows U.S. corporations to compete in low-tax foreign countries at a tax parity with their local competitors (Approaches to Improve the Competitiveness of the U.S. Business Tax System for the 21st Century, U.S. Department of the Treasury, December 20, 2007). Assuming foreign profits are reinvested abroad, deferral can provide U.S. multinationals with results comparable to a territorial tax system. Under a territorial system, a country taxes only those profits derived from sources within its borders. At present, more than 80% of OECD countries have territorial tax systems (The Importance of Tax Deferral and a Lower Corporate Tax Rate, Tax Foundation, Special Report 174, February 2010). Because deferral is consistent with how most countries tax multinational corporations, it is arguably not a special corporate tax break that should be eliminated to fund a reduction in the corporate tax rate. In evaluating the policy options for taxing U.S. multinationals, however, the relevant factors are not limited to the statutory tax rate and whether a territorial or a worldwide system that permits deferral is employed. Another key factor is the degree to which the U.S. rules governing transfer pricing, outbound transfers of intangible property, and controlled foreign corporations allow U.S. multinationals to shift income to
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low-tax foreign jurisdictions. In other words, the tax benefits of deferral are not limited to the actual offshoring of assets and activities to low-tax foreign jurisdictions. Rather, deferral also provides U.S. multinationals with the opportunity to book a disproportionate amount of their worldwide income in the foreign jurisdictions in which they do business (G.E.s Strategies Let It Avoid Taxes Altogether, New York Times, March 24, 2011). For example, by having a tax haven subsidiary share the development costs of a new product in exchange for the foreign rights to that product, a properly structured cost-sharing agreement can shift a substantial amount of income to that foreign subsidiary. In sum, it is the combination of deferral and the ability to book an outsized share of profits in low-tax foreign jurisdictions such as Ireland, Switzerland, or Bermuda that results in lost U.S. tax revenues and creates a potential fiscal barrier to reducing the corporate tax rate. In fact, one commentator has argued that the current system allows U.S. multinationals to achieve a lower worldwide effective tax rate than a territorial system that includes a lower statutory rate on U.S. profits but stronger safeguards to prevent profit shifting (Stateless Income Is Key to International Reform, Tax Notes, July 4, 2011).

Singapore has a corporate tax rate of only 17%. Due primarily to these benefits of deferral, Microsoft reported an effective tax rate (provision for income taxes income before income taxes) of only 25% for 2010. Another example is Google, which has used an income-shifting strategy known as a Dutch sandwich. This strategy allows Google to shift the taxation of its foreign profits through Ireland and the Netherlands to Bermuda, which does not have a corporate income tax (Googles 2.4% Rate Shows How $60 Billion Lost to Tax Loopholes, Bloomberg News, October 21, 2010). In its annual report for 2010, Google reported that $5.85 billion of its

Deferral also provides U.S. multinationals with the opportunity to book a disproportionate amount of their worldwide income in the foreign jurisdictions in which they do business.
$10.8 billion of pretax income was derived from the companys foreign operations, and that substantially all of the income from foreign operations was earned by an Irish subsidiary. As a consequence, Google reported an effective tax rate of only 21.2% for 2010.

How U.S. Companies Take Advantage of Deferral

The tax benefits of deferral tend to be greatest for U.S. technology companies, pharmaceutical companies, and high-value trademark companies (e.g., Coca-Cola) that can manufacture their products and place their intangible assets in low-tax foreign jurisdictions (Foreign Tax Profiles of Top 50 U.S. Companies, Tax Notes International, July 25, 2011). For example, Ireland has a corporate tax rate of only 12.5%; thus, it is not surprising that Microsoft licenses its software in Europe through an Irish subsidiary, a structure that helps Microsoft shield its foreign profits not only from U.S. taxation but also from the higher corporate tax rates in other European countries (Irish Unit Lets Microsoft Cut Taxes in U.S., Europe, Wall Street Journal, November 7, 2005). In its 2010 annual report, Microsoft identified only five subsidiaries incorporated outside the United States, including three in Ireland and one each in Singapore and Puerto Rico.

Largest U.S. Technology Companies

Technology companies are prime examples of U.S. corporations that report high foreign profits and low effective tax rates. Based on IndustryWeeks 2010 listing, the largest publicly held U.S. manufacturers of computers and other electronic products (by annual revenues) are Apple, Dell, Hewlett-Packard, IBM, and Microsoft. The foreign share of pretax income is substantial for all five corporations. Thus,
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EXHIBIT 1 Taxation of Corporate and Capital Income (2011) Table II.1. Corporate Income Tax Rate1
Adjusted central government corporate income tax rate 3 30.0 25.0 34.0 16.5 20.0 19.0 25.0 21.0 26.0 34.4 15.825 20.0 19.0 20.0 12.5 24.0 27.5 28.0 22.0 22.1 30.0 25.0 28.0 28.0 19.0 25.0 19.0 20.0 30.0 26.3 6.7 20.0 26.0 32.7 6.4 14.5 1.5 11.6 2.2 6.8 0.0 14.4 11.1 Subcentral government corporate income tax rate 4 Combined corporate income tax rate 5 30.0 25.0 34.0 27.6 20.0 19.0 25.0 21.0 26.0 34.4 30.2 20.0 19.0 20.0 12.5 24.0 27.5 39.5 24.2 28.8 30.0 25.0 28.0 28.0 19.0 26.5 19.0 20.0 30.0 26.3 21.2 20.0 26.0 39.2 Y N N N Y Y N Y N Y Y N Y Y N Y Y Y Y Y N Y N Y N

Country Australia* Austria Belgium* Canada Chile* Czech Republic Denmark Estonia* Finland France* Germany* Greece Hungary* Iceland Ireland Israel* Italy* Japan Korea Luxembourg* Mexico Netherlands* New Zealand* Norway Poland* Portugal* Slovak Republic Slovenia Spain Sweden Switzerland* Turkey United Kingdom* United States*

Central government corporate income tax rate 2 30.0 25.0 33.99 (33.0) 16.5 20.0 19.0 25.0 21.0 26.0 34.4 15.825 (15.0) 20.0 19.0 20.0 12.5 24.0 27.5 30.0 22.0 22.05 (21.0) 30.0 25.0 28.0 28.0 19.0 25.0 19.0 20.0 30.0 26.3 8.5 20.0 26.0 35.0

Targeted corporate tax rates 6 Y N Y Y Y Y N

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EXHIBIT 1 Taxation of Corporate and Capital Income (2011) Table II.1. Corporate Income Tax Rate1
Explanatory notes about the content of the table 1. This table shows basic (nontargeted) central, subcentral, and combined (statutory) corporate income tax rates. Where a progressive (as opposed to flat) rate structure applies, the top marginal rate is shown. 2. This column shows the basic central government statutory (flat or top marginal) corporate income tax rate, measured gross of a deduction (if any) for subcentral tax. Where surtax applies, the statutory corporate rate exclusive of surtax is shown in round brackets ( ). 3. This column shows the basic central government statutory corporate income tax rate (inclusive of surtax [if any]), adjusted (if applicable) to show the net rate where the central government provides a deduction in respect of subcentral income tax. 4. This column shows the basic subcentral (combined state/regional and local) statutory corporate income tax rate, inclusive of subcentral surtax (if any). The rate should be the representative rate reported in Table II.3. Where a subcentral surtax applies, the statutory subcentral corporate rate exclusive of surtax is shown in round brackets ( ). 5. This column shows the basic combined central and subcentral (statutory) corporate income tax rate given by the adjusted central government rate plus the subcentral rate. 6. This column indicates whether targeted (nonbasic) corporate tax rates exist (e.g., with targeting through a special statutory corporate tax rate applied to qualifying income, or through a special deduction determined as a percentage of qualifying income). Where a Y is shown, more information can be found in Table II.2. * Country-specific footnotes: Australia: Has a noncalendar tax year; the rates shown are those in effect as of July 1. Belgium: The effective CIT rate can be substantially reduced by a notional allowance for corporate equity (ACE). (E.g., the effective tax rate is only half the nominal tax rate when the return on equity before tax is twice the notional interest rate [3.425% in 2011].) See explanatory notes for more details. Chile: The corporate income tax rate will be temporarily increased to 20% and 18.5% for profits earned in 2011 and 2012 respectively. It is one of the measures contained in Law 20.455, which was enacted to raise finance for the reconstruction of the country hit by an earthquake in February 2010. Estonia: From January 1, 2000, the corporate income tax is levied on distributed profits. France: The rates include a surcharge, but do not include the local business tax (Contribution conomique territoriale, a new tax replacing the former Taxe professionnelle from January 1, 2011) or the turnover based solidarity tax (Contribution de Solidarit). More information on the surcharge is included as a comment. Germany: The rates include the regional trade tax (Gewerbesteuer) and the surcharge. Hungary: The rates do not include the turnover-based local business tax, the innovation tax, the financial institutions surtaxes, the energy suppliers surtax, and the crisis taxes. Israel: Within the VAT law, financial institutions pay taxes on the combination of their wages and salaries and their profits. These amounts are deductible from profits in the assessment of corporate income tax. Italy: These rates do not include the regional business tax (Imposta Regionale sulle Attivit Produttive; IRAP). Luxembourg: The contribution to the unemployment fund increased by 1% up to 5% (up from 4% in 2010). Netherlands: Applies to taxable income over EUR 200,000. New Zealand: Has a noncalendar tax year; the rates shown are those in effect as of April 1, 2011. Poland: There is no subcental government tax; however, local authorities (of each level) participate in tax revenue at a given percentage for each level of local authority. Portugal: Since 2009, two general tax rates are applied at a Central Government Level. A general tax rate of 12.5% will be applied for the first 12,500 of taxable income and a 25% tax rate will be applied for the remaining amount of taxable income (when the total taxable income exceeds 12,500). Switzerland: Church taxes, which cannot be avoided by enterprises, are included. United Kingdom: Has a noncalendar tax year; the rates shown are those in effect as of April 5, 2011. United States: The subcentral rate is a weighted average state corporate marginal income tax rate. Source: OECD tax database, Table II.1, www.oecd.org/document/60/0,3746,en_2649_34533_1942460_1_1_1_1,00.html#C_CorporateCapital Reproduced with permission.

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(Continued from page 41)

deferral plays a major role in lowering their effective tax rates. For the five-year period from 2006 to 2010, the average foreign share of pretax income was 59% for Apple, 82% for Dell, 70% for HewlettPackard, 49% for IBM, and 51% for Microsoft. Across the five companies, the average foreign share of pretax income was 50% in 2006, 48% in 2007, 55% in 2008, 62% in 2009, and 63% in 2010. For the five-year period from 2006 to 2010, the average reported effective tax rate was 29% for Apple, 24% for Dell, 19% for Hewlett-Packard, 27% for IBM, and 27% for Microsoft. Across the five companies, the average reported effective tax rate was 25% in 2006; 26% in 2007, 2008, and 2009; and 23% in 2010. These low effective tax rates are primar-

ily due to the benefits of deferral. In their reconciliations of the effective tax rate to the federal statutory rate of 35%, each of the companies listed foreign earnings taxed at lower rates as one of the reconciling items. For the five-year period 2006 to 2010, the average effect of lower foreign tax rates was 7.6% for Apple,12.5% for Dell, 14.5% for Hewlett-Packard, 7.6% for IBM, and 7.6% for Microsoft. Across the five corporations, the average effect of lower foreign tax rates was 9.4% in 2006, 8.5% in 2007, 9.8% in 2008, 8.7% in 2009, and 13.3% in 2010. Exhibit 2 summarizes the impact of deferral on the five largest publicly held U.S. technology corporations for fiscal year 2010. When evaluating the effective tax rates reported in the companys financial state-

ments, it is important to remember that corporations do not always assume that all of their foreign earnings are indefinitely reinvested abroad, in which case a deferred tax liability is booked in the current year, even though no U.S. tax is paid until those foreign earnings are actually repatriated (ASC 740-30-25). For example, in recent years, Apple has booked a U.S. tax expense on a portion of the unremitted earnings of its foreign subsidiaries, which masks the actual current year cash flow benefit of lower foreign tax rates (Apples High Effective Tax Rate Obscures Foreign Tax Benefits, Tax Notes, Aug. 1, 2011).

Largest U.S. Drug Companies

Another industry whose companies report high foreign profits and low effective tax rates is the pharmaceutical industry. Based on IndustryWeeks 2010 listing, the largest publicly held U.S. pharmaceutical companies (by annual revenues) are Abbott Laboratories, Eli Lilly, Johnson & Johnson, Merck, and Pfizer. As with the largest U.S. technology companies, the foreign share of pretax income is substantial for all five of the largest drug companies. For the five-year period from 2006 to 2010, the average foreign share of pretax income was 102% for Abbott Laboratories, 52% for Eli Lilly, 57% for Johnson & Johnson, 60% for Merck, and 110% for Pfizer. Across the five corporations, the average foreign share of pretax income was 96% in 2006, 71% in 2007, 66% in 2008, and 74% in both 2009 and 2010. For the five-year period from 2006 to 2010, the average reported effective tax rate was 20% for Abbott Laboratories, 6% for Eli Lilly, 22% for Johnson & Johnson, 16% for Merck, and 15% for Pfizer. Across the five corporations, the average reported effective tax rate was 22% in 2006, 11% in 2007, 4% in 2008, 19% in 2009, and 23% in 2010. These low effective tax rates are primarily due to the benefits of deferral. For the fiveyear period from 2006 to 2010, the average effect of lower foreign tax rates was 16.7% for Abbott Laboratories, 18.8% for Eli Lilly, 12.8% for Johnson & Johnson, 47.3% for Merck, and 12.9% for Pfizer. Across the five companies, the average effect of lower foreign tax rates was 16.2% in 2006, 26.9% in 2007, 22.3% in 2008, 11.9% in 2009, and 31.1% in 2010.
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EXHIBIT 2 Largest U.S. Technology Corporations, 2010

Effective tax rate Apple Dell Hewlett-Packard IBM Microsoft 24.4% 21.3% 20.2% 25.0% 25.0% Effect of lower foreign tax rates 11.5% 14.7% 18.3% 10.0% 12.1% Foreign share of worldwide income 70% 84% 63% 54% 62%

Source: Fiscal year 2010 annual reports

EXHIBIT 3 Largest U.S. Pharmaceutical Corporations, 2010

Effective tax rate Abbott Laboratories Eli Lilly Johnson & Johnson Merck Pfizer 19.0% 22.3% 21.3% 40.6% 11.9% Effect of lower foreign tax rates 19.4% 12.6% 12.6% 113.6% 2.5% Foreign share of worldwide income 105% 45% 62% 30% 126%

Source: Fiscal year 2010 annual reports Note: In 2010, Pfizer reported a significant tax settlement and Merck reported significant purchase accounting adjustments, including impairment charges, restructuring charges, and a liability reserve.

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Exhibit 3 summarizes the impact of deferral on the five largest publicly held U.S. pharmaceutical corporations for fiscal year 2010.

Constraints on Reform
Given the fiscal constraints created by massive federal budget deficits, a major policy challenge for U.S. lawmakers is bringing the U.S. corporate tax rate more in line with the lower tax rates imposed by other OECD nations. A key issue in any corporate tax reform is whether to modify the policy of deferral as a means of rais-

eral revenue-raising restrictions on deferral, including taxing the excess returns associated with transferring intangible assets offshore, which would raise $20.8 billion in tax revenues over 10 years. Given the low effective tax rates currently enjoyed by many U.S. multinational corporations, it may be politically feasible to include such changes in a revenue-neutral package of reforms that

would lower the statutory corporate tax rate and broaden the tax base. Andrew D. Gross, PhD, CPA, is an assistant professor of accounting, and Michael S. Schadewald, PhD, CPA, is an associate professor of accounting, both at the Lubar School of Business, University of WisconsinMilwaukee.

Corporations do not always assume that all of their foreign earnings are indefinitely reinvested abroad, in which case a deferred tax liability is booked in the current year, even though no U.S. tax is paid until those foreign earnings are actually repatriated.
ing the additional tax revenues needed to fund a reduction in the corporate tax rate. Because a territorial system is the international norm, it is probably not politically feasible to enact a worldwide system that currently taxes all of a U.S. multinationals foreign profits. Such an approach would raise concerns about the ability of U.S. corporations to compete in foreign markets, even if it were accompanied by a significantly lower corporate tax rate. On the other hand, imposing additional restrictions on deferralsuch as tougher transfer pricing rules or stronger safeguards on outbound transfers of intangibles could raise some of the tax revenues needed to fund a reduction in the corporate tax rate. For example, in its fiscal year 2012 budget, the Obama administration proposed sevJANUARY 2012 / THE CPA JOURNAL

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F I N A N C E business valuation

Sale of Private Company Stock to Employees and Other Parties

By Robert F. Reilly

A
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ccountants often assist closely held corporations (and their owners) with the planning, negotiation, and execution of the sale of company stock. CPAs often assist a closely held company with the taxation, structuring, financial planning, valuation, and other aspects of the stock sale transaction. The owners of a closely held company may sell their stock to obtain liquidity, diversify their wealth, manage their estates, start an ownership transition plan, reward and retain key employees, motivate strategic partners, and fulfill other purposes. Some closely held corporation owners elect to sell private company stock to their employees through an employee stock owner-

ship plan (ESOP). Some owners elect to sell private company stock directly to employees, to vendors and suppliers, to private equity investors, to financing sources, and to other strategic partners. In such cases, CPAs may assist closely held business owners with an ESOP feasibility analysis, with advice on related taxation and financial accounting considerations, with stock valuation analyses, and with the negotiation of the stock purchase financing. Accordingly, accountants should be generally familiar with the basics of private company valuation and private company stock sale transactions. As a private companys most trusted advisor, a CPA may work with the companys legal counsel and valuation analyst
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to structure stock sales that benefit the company, the selling stockholders, and the employees and other buyers. First, the discussion below summarizes the generally accepted valuation approaches with regard to private company securities. These valuation approaches apply to sales of private company stock to an ESOP or to any other investor. In particular, this discussion considers the valuation factors related to the level of value, the stock rights and privileges, and the level at which funds are transferred from the private company to the ESOP. These factors affect the value of all private company stock sold or transferred to all parties (including the ESOP). Second, the discussion below summarizes the valuation considerations in an analysis of private company stock sales to an ESOP, as opposed to other parties. This discussion focuses on the many reasons why two company stock sales that occur on the same day may transact at two different prices. Such an occurrence can be both fair to the ESOP and in compliance with legal and regulatory requirements. Such price differences may be due to differences in the private company securities (e.g., voting stock versus non-voting stock) or differences in the size of the block of closely held corporation stock. It may also be reasonable that two identical blocks of stock could be sold on the same day at two different pricesfor example, one block sold to the ESOP and one block sold to a key employee. This discussion explains some of the reasons for such a pricing difference.

are specific rules of thumb or unique shortcut formulas that are only applicable to companies in the subject industry. These rules or formulas often relate to a pricing multiple that is applied to a company-specific metric. For example, industry-specific formulas may include the following: I multiple annual revenue I multiple annual earnings before interest, taxes, depreciation, and amortization (EBITDA) I multiple number of customers. When one examines these so-called industry rules of thumb, they may be categorized into the following three generally accepted valuation approaches: I Income approach I Market approach I Asset approach.

Income Approach
The income approach is based on the principle that the value of the stock is the present value of the future income expected to be earned by the company owners. There are many different ways to measure income for valuation purposes, including the following: I Net operating income I EBITDA I Earnings before interest and taxes (EBIT) I Pretax net income I After-tax net income I Net cash flow. Each of these measures of private company income may be applicable to the valuation, as long as the discount rate or capitalization rate corresponds to the selected benefit stream. A discount rate (also called a present value discount rate) is the required rate of return on an investment in the private company. Although there are several generally accepted models that valuation analysts use to estimate the discount rate, these models all incorporate some measure of market-derived rate of return, and some adjustment for the associated risk. A capitalization rate is typically calculated as the discount rate minus the expected long-term growth rate in a particular income measure. Assume, for example, that a valuation analyst selects net cash flow as the income measure to value Alpha Private Company. The analyst concludes that 14% is the appropriate market-derived discount rate to apply to net cash flow and projects

Valuation in Private Company Stock Sales to an ESOP

In addition to the generally accepted considerations that apply to any business valuation, there are three considerations that may make the valuation of the private company shares to be sold to an ESOP different from an otherwise identical block of stock: I Level of value to apply in the valuation I Contractual rights and privileges related to the ESOP I Financing of the ESOP purchase of the private stock.

Valuation Approaches and Methods

There are three generally accepted approaches to the valuation of a private company. Many closely held corporation owners may tell their accountant that there
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that Alphas net cash flow will increase at the rate of 4% per year. In this case, the analyst would conclude a 10% direct capitalization rate (i.e., 14% discount rate 4% growth rate = 10% capitalization rate). The two common valuation methods utilizing the income approach are as follows: I Yield capitalization method I Direct capitalization method. A valuation analyst will use the yield capitalization method when a private companys income (however defined) is expected to change at a non-consistent rate in the future. This method requires a discrete projection of annual income for many years into the future (typically until the expected long-term growth rate stabilizes). An analyst calculates business value as the present value of the projected future cash flow, using the present value discount rate described above. This is also called the discounted cash flow method, even when cash flow is not selected as the measure of the private company income. A valuation analyst will use the direct capitalization method when a private companys income (however defined) is expected to change at a constant rate in the future. This method requires a one-year estimate of normalized income for the company. An analyst calculates business value by dividing the one-year income estimate by the direct capitalization rate. If the expected net cash flow for Alpha Private Company is $100, then, based on the aforementioned 10% direct capitalization rate, Alphas business value would be $1,000 (i.e., $100 cash flow 10% direct capitalization rate). To see how different measures of income can be used in the valuation, assume that Alphas estimated next period pre-tax income is $1,200. Based on a 33% income tax rate, Alphas estimated next period after-tax income is $800. Assume the analyst applies the cost of capital models to conclude an after-tax net income (and not net cash flow) capitalization rate of 8%. Applying this net incomebased 8% direct capitalization rate to the $800 after-tax income estimate indicates that Alphas business value would still be $1,000 (i.e., $800 after-tax income 8% capitalization rate). Next, assume the analyst adjusts the 8% after-tax income capitalization rate for income taxes. The adjustment formula is as follows: the after-tax rate of

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8% (1 tax rate) = the pretax rate. The corresponding pretax income capitalization rate is as follows: 8% (1 33%) = 12%. If the analyst applies the 12% pretax income capitalization rate to the $120 pretax income estimate, Alphas business value would still be $1,000 (i.e., $120 pretax income 12% capitalization rate). These last two calculations also answer a common income approach question: Should a valuation be performed on a pretax basis or after-tax basis? As these calculations indicate, the answer is: It doesnt matter. As long as the income measure and the discount/capitalization rates are adjusted by the same income tax rate, either income approach should reach the same business value.

Market Approach
The market approach is based on the principle that a private company can be valued by referring to pricing guidance extracted from what investors paid in arms-length transactions for comparative investments. The following are common market approach valuation methods: I Guideline publicly traded company method (GPTCM) I Guideline merger and acquisition transactions method (GMATM) I Back-solve method. In each of these methods, analysts identify and analyze market data regarding arms-length transactions. Using these data, analysts extract pricing multiples to apply to a private company. These pricing multiples often include the following: I Price to revenue multiple I Price to book value multiple I Price to EBITDA multiple I Price to EBIT multiple I Price to pretax income multiple I Price to after-tax multiple I Price to cash flow multiple. An analyst may apply more than one pricing multiple in a market approach analysis, and examine more than one time period. For example, an analyst may derive pricing multiples to apply to the private company financial fundamentals for these different time periods: I Latest (trailing) 12 months actual results I Next 12 months projected results I Three-year average actual results I Five-year average actual results.

For both the GPTCM and GMATM analyses, an analyst first attempts to identify companies that are directly comparable to the private company. Such comparable companies are often about the same size, operate in the same industry or profession, compete with each other, have the same sources of supply, or have the same types of customers. Once an analyst can identify such comparable companies, the market approach analysis is relatively easy. Of course, an analyst will have to adjust the financial statements of both the comparable public companies and the private company for non-operating items, non-recurring items, differences in accounting principles, and other so-called normalization adjustments. An analyst can often apply the derived mean or median pricing multiples to the private companys financial fundamentals. Analysts will typically synthesize (or weight) the various value indications into one market approach estimate. It is rare, however, for a valuation analyst to identify comparable public companies for most private companies. Compared to most publicly traded or recently acquired companies, the typical private company is much smaller, operates regionally, and operates in a specialized segment of an industry; therefore, valuation analysts generally select and rely on guideline companies. Guideline companies are similar to the private company from an investment risk and expected investment return perspective. Guideline companies fit into the same investment portfolio of companies as private companies; that is, investors would expect the same rate and variability of returns for all of these companies. But guideline companies do not necessarily look like the subject company. Guideline public company pricing multiples are more difficult for a valuation analyst to apply. It is not reasonable to assume that mean or median pricing multiples would automatically apply to the private company, because the selected companies are not directly comparable. Nevertheless, an analyst can compare a private company to guideline companies in terms of factors such as relative growth rates, relative profit margins, and relative returns on investment. From these comparative analyses, an analyst can extract pricing multiples to apply to the private companys financial fundamentals.

The GPTCM is based on an analysts considerations of guideline public companies that trade on national and regional stock exchanges. Those trading prices and pricing multiples are typically based on relatively small trades (i.e., a few thousand shares per trade) of very liquid securities. The GMATM is based on an analysts assessment of recent mergers and acquisitions of entire companies in the private companys industry. These transactional prices and pricing multiples are typically based on what a strategic buyer is willing to pay to obtain operational control of an overall business enterprise. The back-solve method looks at historical sales of stock in the subject company; in other words, an analyst investigates actual arms-length sales of company stock and develops pricing multiples from those transactions. Such transactions typically represent sales of small blocks of stock in very illiquid (private company) securities. Based on the pricing multiples indicated by recent sale transactions, the analyst back-solves the value of the company overall business using the techniques described above. As indicated above, different market approach valuation methods could all reach different levels of value. The related adjustments are summarized in Levels of Value below.

Asset Approach
The asset approach (also called the asset-based approach) is founded on the principle that a private companys equity value is equal to the value of the closely held corporations assets, less the value of the closely held corporations liabilities. The asset approach is used less frequently than the income approach or the market approach in the valuation of closely held corporation securities for the following reasons: I It is more time consuming and, therefore, more expensive to perform. I Many valuation analysts do not have the experience or expertise required to value individual assets and liabilities. I Many valuation analysts are simply uninformed or misinformed regarding the application of this valuation approach. The asset approach is, however, particularly applicable in the following circumstances: I The company is either capital asset intensive or intangible asset intensive.
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I The company is either relatively new or has experienced a recent period of negative operating results. I A buyer or stock acquisition financing source wants to know the debt collateral value of the company assets. I A buyer or financing source wants to know the post-financing solvency of the company. I A third party wants to know what the post-transaction company fair value balance sheet will look like if the stock purchase results in a change of control. I A buyer wants to know why it is being asked to pay a multiple of earnings or a multiple of book value for the private company; in other words, what operating assets are the investors buying in the stock purchase transaction? In order to perform an asset approach valuation, an analyst has to identify and value the following categories of assets and liabilities: I Net working capital (e.g., accounts receivable and inventory) I Tangible personal property (e.g., machinery and equipment) I Real estate (e.g., land and buildings) I Identifiable intangible assets (e.g., patents, copyrights, trademarks, licenses and permits, computer software, customer relationships) I Intangible value in the form of goodwill I Contingent liabilities I Recorded liabilities. The following are some caveats to correct the misconceptions that many valuation analystsand many CPAshold about the asset approach: I It does not conclude a liquidation value in the company; rather, all of the tangible and intangible assets are valued on a continued use/going concern basis, so the concluded business value is a going concern value. I It does not consider tangible assets only; rather, in most successful companies, most of the business value relates to identified intangible asset value and to goodwill. I It does not rely on speculative values for intangible assets; rather, these values are exactly the same as those that would be recorded on audited GAAP financial statements as the result of a purchase price allocation. I It does not result in the net book value conclusion as reported in the companys balance sheet; rather, a prefair value balance

sheet and a postfair value balance bear little relationship to each other. I The most common asset approach valuation methods include the asset accumulation method and the adjusted net asset value method. The typical asset approach valuation formula is summarized as follows: working capital value + tangible assets value + intangible assets value = total assets value recorded liabilities value contingent liabilities value = private company equity value In addition to valuing a companys intangible assets, an analyst also has to identify and quantify any offbalance sheet contingent liabilities. Such liabilities include lawsuits, environmental concerns, and similar items. Typically, the asset approach will indicate a companys total equity value on a marketable, controlling interest level of value. At this stage of a private stock valuation, an analyst will typically adjust all of the indicators to be on the same level of value. Then, the analyst will synthesize (i.e., weight) the income, market, and (if performed) asset approach value indicators in order to reach one final value conclusion for the private company. This weighting is based on the analysts assessment of the quantity and quality of available data, the applicability of each approach to the company, and the range and reasonableness of the various value indicators. To simplify the discussion, assume that an analyst has concluded the companys total equity value. In practice, there is typically an intermediate procedure in which the analyst first concludes the companys invested capital value. From this invested capital, the analyst subtracts the companys long-term interest bearing debt, to reach the total equity value. From this total equity value amount, the analyst subtracts the value of any company preferred stock to conclude a preliminary common equity value. The analyst adjusts the total common equity value for the proceeds from any in-the-money stock options. The analyst then concludes the final total equity value (and the number of outstanding company shares, including exercised in-the-money options). This procedure is typically called a waterfall analysis.

Levels of Value
The term level of value refers to two investment criteria regarding private company stock: I Marketable versus nonmarketablethis criterion indicates how easy it is for the shareholder to sell stock and convert that investment into cash. I Control versus lack of controlthis criterion indicates how much control the shareholder has over the companys business operations and strategic direction. Many valuation analysts (and many CPAs) believe that there are only three separate and independent levels of value: I Marketable, controlling ownership interest (e.g., one shareholder owns 100% of the closely held corporation) I Marketable, noncontrolling ownership interest (e.g., as if the closely held corporation stock was publicly traded on a stock exchange) I Nonmarketable, noncontrolling ownership interest (e.g., stockholder shareholder owns a small block of stock in the closely held corporation) In truth, the above-listed levels of value represent a gross oversimplification. For all companies, these two investment criteria each exist on a continuum. Exhibit 1 more accurately reflects the level of value considerations that an investment analyst should assess with regard to company stock: Where the subject block of stock falls in this X axis and Y axis continuum is a function of the following factors: I The absolute size of the block of stock I The relative size of the block of stock (compared to other stockholders) I The relative voting rights and policies of the private company I The state in which the private company is incorporated I The absolute number of directors on the board and the rotation of board elections I The potential for a corporate liquidity event (e.g., an initial public offering, stock tender offer) I The ability of a plan participant to put shares back into the company I The contractual rights of the block of stock (e.g., come-along rights, tag-along rights, rights of first refusal, registration rights) I The history of private transactions in the company stock

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I The age, investment, retirement, or estate plans of the private companys other major shareholders. As mentioned above, a valuation analyst will adjust all of the value indicators so as to be in the same level of value. Then, the valuation analyst will adjust that level of value to be consistent with describes description of the actual marketability and control attributes of the transaction block of private stock.

Contractual Rights and Privileges

In addition to their effect on a stocks marketability and control attributes, some contractual rights and privileges can separately (and materially) impact the value of private stock. Valuation analysts should ensure that the value increment associated with contractual rights is not double-counted (i.e., both considered as a marketability/control attribute and then again as a contractual attribute). But an analyst should also ensure that the full value increment related to these contractual attributes be considered in the stock valuation. It is noteworthy that this value increment should be considered even if the ESOP block of stock is unique in enjoying that attribute. For example, there is still a value increment associated with dividend prefer-

ences or liquidation preferences, even if both the ESOP-owned stock and the key executiveowned stock both enjoy those preferences. The following are some of the common contractual rights and privileges that a valuation analyst may consider: I Dividend and liquidation preferences I Mandatory redemption rights I Preemptive rights I Conversion and participation rights I Antidilution rights I Registration rights I Voting rights I Protective provisions and veto rights I Board participation rights I Drag-along rights I Right to participate in future equity offerings I Right of first refusal in future equity offerings I Management rights I Access to information rights I Tag-along rights. Each of the above contractual rights may relate to a particular class of private company equity. More commonly, these particular rights and privileges may only relate, by contract, to a particular block of stock. For example, a block of private stock may be the

stock sold to the ESOP, the stock granted to identified senior executives, or the stock retained by certain members of the company founding family. Each of these contractual rights and privileges has an economic value that should be considered in the allocation of the private companys overall value to that particular block of stock.

Financing an ESOP Stock Purchase

Commonly, an ESOP purchase of closely held corporation stock is financed by debt capital. This statement is true whether the ESOP purchases a noncontrolling block of stock or the ESOP purchases 100% of the closely held corporations stock. There are various structures through which an ESOP trust can finance the stock purchase. The following are common financing structures: I The ESOP borrows funds directly from a financial institution, in an outside loan. I The company borrows the funds from the financial institution, and the ESOP borrows the funds from the company through a minor loan structure. I The ESOP borrows some or all of the financing from the stock sellers through a seller-financed transaction. The structure of the stock acquisition financing (including debt term, interest rate, and prepayment options) is important to the ESOP. The structure of the stock purchase financing is not that important to the valuation (i.e., pricing) of the common stockbut the structure of the stock purchase financing may be important to the stock valuation. This issue hinges on who will repay the stock acquisition loan: 1) the company (directly or indirectly) or 2) the ESOP (as a company shareholder). A more technical way to phrase this question is: What is the source of cash used by the ESOP to pay the stock acquisition loan? Is it: 1) employer contributions from the private company or 2) profit distributions from the private company? In both cases, the cash transfers from the company to the ESOPand then from the ESOP to the bank, to repay the acquisition loan. The answer to the question may affect the valuation of the stock. This is because ESOP contributions are accounted for as an operating expense of the company, just like any other retirement plan contributions would be. The company records that expense, which (like any other expense) reduces the profitability of the company. All other things
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EXHIBIT 1 Private Company Common Stock Levels of Value

Absolute control

Ownership Control No control at all No liquidity at all Perfect liquidity

Investment Marketability

50

(such as discount rates and capitalization rates) being equal, a company with lower profits will have a lower stock value. In contrast, ESOP distributions are not accounted for as an operating expense, just like any other profit distribution or dividend to shareholders. Distributions are the payment of net profits to the company stockholders. Unlike contributions, distributions do not represent an employer expense that reduces company profits; that is, the payment of distributions does not affect a closely held corporations reported profitability. All other things (such as discount rates and capitalization rates) being equal, a companys profit distribution does not affect the subject stock value. If an ESOP receives closely held company distributions and then repays the stock acquisition loan to the bank, this loan payment is just like any third-party investor who buys the common stock of a publicly traded company on margin. When the investor pays back the stockbroker from the corporations quarterly dividend payments, that margin loan repayment does not reduce the value of the companys stock.

After the ESOP formation and the stock purchase, however, the structure for the stock acquisition loan could affect the stock valuation. Assume that both the Beta ESOP and the Gamma ESOP need to service $5 million of annual debt service on the stock acquisition loan. Beta transfers the cash as an ESOP contribution (i.e., an expense). If Beta were a C corporation, such a cash trans-

fer would make a great deal of sense, because the $5 million contribution would be a tax-deductible expense for federal income tax purposes (assuming Beta meets the payroll-related deduction limitations). Because Beta and Gamma are both S corporations, there is less value to the ESOP contribution tax deduction. In contrast to Beta, Gamma elects to not recog-

Example
To illustrate the effect of how a closely held corporation transfers funds to an ESOP, consider two identical companies. Beta ESOP Company transfers cash to the ESOP through contributions. Gamma ESOP Company transfers cash to the ESOP through distributions. Both ESOPs borrowed the same amount in a stock acquisition loan, and both ESOPs make the same annual principal and interest payments to the bank to repay those loans. The current-year summary financial statements for both private companies are presented in Exhibit 2. In both cases, assume that the private company stock is owned 80% by an ESOP and 20% by senior management. In addition, to simplify the example, assume that each company is an S corporation for federal income tax purposes. Both Beta and Gamma would have reported identical income statements prior to the purchase of the private company stock by the ESOP. For that reason, in both cases, the ESOP would pay the same priceand recognize the same fair market valuein the initial purchase of the private companys securities.
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nize the cash transfer as an ESOP contribution expense. This recognition increases Gammas pretax income. Because the Gamma ESOP owns 80% of the private company stock, it will receive 80% of all shareholder distributions. Assuming all income is distributed, the ESOP would receive 80% of the shareholder distributions (i.e., more than enough cash to service the stock acquisition debt). The nonESOP shareholders (i.e., key management) would receive the remaining 20% of the profit distributions. Unlike the Beta ESOP contributions, the Gamma profit distributions do not reduce the companys income. In addition, the Gamma ESOP distributions are not an economic burden on the non-ESOP shareholders. Each Gamma shareholder receives a proportionate profit distribution. That Gamma shareholder can use that profit distribution to pay stock purchase debt (as the ESOP will) or not. In contrast, the Beta $5 million ESOP contribution will cost the non-ESOP shareholders $1 million, because the companys income will be reduced by this amount and non-ESOP executives own 20% of the Beta income.

Stock Valuation and Debt

How an ESOP repays a stock acquisition loancontributions or distributions also impacts the effect of that debt on the stock valuation. Valuation analysts sometimes value closely held corporation stock using the direct equity method; that is, they value the common stock directly without reference to the companys total enterprise value. More frequently, valuation analysts value closely held corporation stock using the invested capital methodthey

value the corporations total enterprise (also called total invested capital), then subtract the companys long-term debt, and finally subtract any preferred stock in order to reach a residual value for the companys common stock. As mentioned above, this residual valuation procedure is often called the waterfall procedure. An ESOP sponsor company has two categories of long-term debt on its balance sheets. First, notes payable and bonds payable are recorded as long-term debt. These liabilities represent funds borrowed by the private company that are used by the company and that the company is committed to pay back. Second, under U.S. GAAP, a company must also record the ESOP stock acquisition debt as long-term debt on its balance sheet. This requirement applies even when the ESOP borrowed the funds directly from a third-party lender. This requirement stems from the fact that a company invariably guarantees the ESOPs debt; that is, if the ESOP does not pay off the stock purchase loan, a bank will look to the company to make good on the loan. A valuation analyst will always subtract the sponsors (non-ESOP) long-term debt in order to conclude the stocks value. And a valuation analyst will typically subtract the ESOP debt recorded on the companys balance sheet in order to conclude the stock value. This is because most companies make contributions to an ESOP, and the ESOP pays off debt from these contributions. As explained above, ESOP contributions: 1) result in an operating expense to the private company, 2) reduce the company stock value, and 3) are shared proportionately by all of the companys shareholders (through their per-

centage ownership of company stock). Typically, all C corporations, and many S corporations, use contributions to fund an ESOPs debt service payments. Therefore, stock value is affected by both how a private company distributes funds to an ESOP for debt service purposes and how an ESOP receives debt service funds from the private company (relative to the other company shareholders).

Transactional Scenarios
There are numerous scenarios in which a stock sale to both an ESOP and another buyer can occur simultaneously. For purposes of this discussion, such a transaction would occur when an ESOP (through its trustee) participates in a stock purchase/sale transaction at about the same time that a nonESOP party also participates in a stock purchase/sale transaction. In such scenarios, it is not uncommon for the two stock transactions to take place at two different prices. The discussion below summarizes the valuation considerations related to the following types of stock transaction scenarios: I An initial ESOP formation, when an ESOP purchases company shares and special employees also purchase company shares I A secondary ESOP stock purchase, when both the ESOP and special employees purchase additional blocks of company shares I A transaction in which the ESOP does not buy shares; only special employees buy shares I The sale of shares only to a capital provider, such as a venture capital investor, a private equity investor, or a merchant bank investor I The sale of stock only to a company strategic partner, such as a key customer

EXHIBIT 2 Current Year Summary Income Statement

Beta Company Earnings before interest and taxes and ESOP contributions ESOP contributions Earnings before interest and taxes Interest on (non-ESOP) long-term debt Pretax income Distribution to the ESOP (based on 80% equity ownership) $10,000,000 5,000,000 5,000,000 3,000,000 $ 2,000,000 Gamma Company $10,000,000 10,000,000 3,000,000 $ 7,000,000 $ 5,600,000

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or supplier, an intellectual property licensor or licensee I A company repurchase of its own stock from a non-ESOP party I The sale or other transfer of stock that does not involve either the ESOP or the company; for example, non-ESOP shareholder gift, estate, charitable contribution, or marital estate transfers I Other contractual agreements between the company and special employees that do not include stock transfers; for example, employment, noncompete, consultancy, board membership, intellectual property license, and other agreements. In these above-listed scenarios, a valuation analyst will likely have one set of valuation considerations for transactions involving an ESOP and a slightly different set of valuation considerations for transactions involving a non-ESOP party. For purposes of this discussion, the term special employees will be considered synonymous with the term key employees. These are employees that the company wants to retain and are difficult to replace. In addition to senior management, this category could include skilled engineers, scientists, salesmen, production specialists, or quality specialists. What makes this class of employees special is that management may grant these employees options, warrants, or rights with regard to the company stock. As CPAs are aware, ERISA provides that an ESOP may acquire employer stock if such acquisition, sale or lease is for adequate consideration. With regard to pricing closely held corporation stock, ERISA defines adequate consideration as the fair market value of the asset determined in good faith by the trustee or named fiduciary. These ERISA definitions mean that an ESOP may pay no more than a fair market value price for private stock. An ESOP can, however, pay less than fair market value, if for example the trustee negotiates a favorable deal with the company or selling stockholders. Sellers may often unilaterally offer a below-market price to the ESOP as a form of gratitude to company employees or as a reward for years of loyal service. This is simply one explanation for why an ESOP may pay a different (in this case, lower) price for the stock than other shareholders.
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There are also situations where a private company or selling shareholders may sell stock to non-ESOP shareholders for a belowmarket price. Such a situation often occurs when a company wants to attract, retain, or reward special employees. In a leveraged stock purchase transaction, the financing terms should be at least as favorable to an ESOP as they are to other deal participants. Just

because a private company allows special employees to purchase stock at a favorable price, however, does not mean that the sale transaction is unfair to the ESOP.

Factors that Affect Valuation Considerations

There are a variety of reasons why a CPA might apply different considerations

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to an ESOP stock purchase transaction, as compared to a non-ESOP stock purchase transaction. Twelve of these reasons are summarized below. First, a company may perceive an ESOP stockholder and non-ESOP stockholder differently. To a closely held company, the ESOP is a relatively permanent company owner. Certainly, the ESOP is a longterm investor that will provide part of the permanent capital structure. In contrast, special employees, strategic partners, and certain capital providers are generally not long-term investors. The company wants to retain these parties, of course, and compensate them for their services. From the companys perspective, an ESOP stockholder and non-ESOP stockholder have different investment time horizons and different investment objectives. Second, from a stockholder perspective, the ESOP and the non-ESOP party may perceive the company differently. ESOP participants own the company. The ESOP provides retirement benefits to the plan participants, of course, but plan participants often seek long-term capital appreciation rather than short-term income. NonESOP stockholders typically have a much more finite investment perspective. They typically plan for a specific exit event after five years (or some similar time period). Non-ESOP stockholders want to be compensated for the services they provide (e.g., executive talent, capital, intellectual property) during the period they provide that servicethen they want liquidity. Again, from the stockholder perspective, an ESOP stockholder and non-ESOP stockholder have different investment time horizons and different investment objectives. Third, ESOP and non-ESOP stockholders may be buying different classes of securities. Of course, the type of security will affect the valuation. For example, an ESOP might purchase common stock and nonESOP stockholders might purchase preferred stock. In such a case, special employees, remaining family stockholders, or capital sources may want to be (relatively) assured of periodic dividend distributions. In some instances, an ESOP may purchase the preferred stock. This procedure sometimes happens when a company runs into contribution tax deduction limitations based on employee payroll levels. In that case, the preferred stock is intend-

ed to provide more cash for the ESOP than the company would be able pay through annual plan contributions. Accordingly, the type of security will affect the valuation. Fourth, the form of ownership may affect the value of the stock. An ESOP will typically purchase stock in fee-simple interest, meaning that title to the stock is transferred from the company (or selling stockholder) to the ESOP, subject to any lien that the bank may have related to the stock acquisition loan. In contrast, a nonESOP stockholder may receive only a fractional ownership interest in the stock. For example, a special employee may not actually receive ownership of the stock, but rather receive an option, warrant, grant, or related right. An employee or other nonESOP stockholders rights may vest over time. This vesting may be a function of the term of employment, stock ownership, debt financing provided, or some other relationship with the closely held company. Therefore, unlike for an ESOP, such stock ownership rights may be forfeited if the contractual relationship with the company lapses. Fifth, a securitys rights and privileges directly affect the stock value. This occurs when an ESOP and non-ESOP stockholder both acquire stock (perhaps of the same class) with different sets of rights and privileges. A valuation analyst will take these different rights into consideration in the relative valuations. For example, an ESOP and non-ESOP stockholder could each own stock with differing rights related to: I Voting versus nonvoting I Dividend and profit participation I Liquidation preferences and participation I Control of the board of directors or certain management decisions I Registration, transferability, or other liquidity opportunities I Rights of first refusal and preemptive rights. Sixth, the expected term of the stock could affect the value of stock purchased by an ESOP compared to a non-ESOP stockholder. The common stock typically purchased by an ESOP is usually perpetual term stock, meaning that there is no plan for the ESOP trust to redeem the stock (other than the ERISA-required plan participant retirement put option). Stock sold to a non-ESOP stockholder is typically

issued with an expected finite term, such as 5 or 10 years. After that term, the company may be able to call the stock, or the investor may be able to put the entire block of stock back to the company. Seventh, the liquidity of any security typically affects that security valuation. As mentioned above, ESOP participants enjoy an ERISA-required put option. That is, a plan participant of a certain retirement-related age can put the employer shares in her account back to either the ESOP or the private company (depending on the plan terms). Over a specified pay-out period, the company must buy back the shares at a market price based on the valuation analysts conclusion. Thus, the shares in the plan participants accounts have a certain degree of liquidity. Unless there are contractual or other agreements in place, a nonESOP shareholder may not have this liquidity expectation. Eighth, share vesting and allocation periods may be different for an ESOP stockholder compared to a non-ESOP stockholder. An ESOP participant will expect purchased shares to be allocated to his account as the stock acquisition loan is paid by the ESOP, and contributions and distributions are made by the company to the ESOP. As mentioned above, a non-ESOP stockholder may experience a much different vesting (and, effectively, allocation) period. For a non-ESOP stockholder, the employers shares may be transferred as the employee provides management, noncompetition, joint venture, financing, or other services. Ninth, the expectation of a liquidity event is different for an ESOP compared to a non-ESOP investor. ESOP investors may give very little consideration to a liquidity event in their stock purchase decision, following a buy-and-hold strategy. ESOP participants generally view themselves as the permanent owners of the company. Typically, their only liquidity consideration is a company-wide liquidity event; such a liquidity event would include an initial public offering (IPO) or the overall acquisition of the company. In contrast, a non-ESOP investor typically plans for a specific, shortterm liquidity event that is typically a contractual event and not a control event. In other words, a non-ESOP investor may expect to sell the stock back to the company under the terms of an employment, noncompete, intellectual property license, debt
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indenture, or other contract. In contrast, an ESOP generally expects to be able to (at least) influence when a closely held company has an IPO or a merger and acquision (M&A) transaction occurs. Tenth, there may be a difference in the information disclosure rights available to an ESOP compared to a non-ESOP investor. The ESOP trustee receives the company stock independent valuation report each year. That stock valuation includes: historical and current company financial statements; a current company, industry, and strategic analysis; and projections of future results of operations. The ESOP trustee receives a fair amount of company financial and operational information. Most closely held companies are not very forthcoming with such company-specific information. In contrast, unless they have specific contractual rights, nonESOP stockholders do not have access to the same information. Even special employees (other than a CEO and CFO) may not have as much access to company-specific information as the ESOP trustee does. A companys financing sources might have contractual access to the financial statements, but they might not have access to the stock valuation reports. Eleventh, ESOP stockholders and nonESOP stockholders enjoy different levels of shareholder protection. The ESOP and the plan participants are protected by ERISA. The annual stock valuation must comply with ERISA, and is subject to contrarian review by the IRS and the U.S. Department of Labor. In contrast, a nonESOP stockholder is not subject to ERISA protection, but rather only applicable state securities statutes. A non-ESOP stockholder has no assurance that it can purchase the stock for no more than fair market value and sell the stock for no less than fair market value. A non-ESOP stockholder may only be able to negotiate the best price it can to buy or sell the stock, which might be higher or lower than fair market value. Finally, the most significant difference between an ESOP and non-ESOP stockholder may be the level of value issue. As described above, level of value relates to the following two investment criteria: I Marketable versus nonmarketable interests I Controlling versus noncontrolling interests. Stock owned by an ESOP may represent a different level of value than stock
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owned by a non-ESOP investor. In fact, this is often the case, because two different shareholders cannot both own a controlling interest in a company. If the ESOP owns a controlling interest, then the nonESOP does not, and vice versa. In addition, many ESOPs have contractual rights that allow the plan to acquire ownership control over a period of time. For example, the contract may allow an ESOP to continue to buy blocks of stock each year until it either owns control of the company or owns 100% of the company. In such a case, an ESOP is often treated as a controlling ownerand the employer stock purchase/sale transaction is often treated as a control-level transactionfor stock valuation purposes. In addition, as described above, there are numerous factors (contractual, regulatory, and otherwise) that affect the marketability of ESOP-owned stock compared to nonESOP owned stock. A valuation analyst will consider all of these factors when assessing where each block of company stock falls on the marketability continuum.

Paying Attention to the Differences

CPAs understand that different fair market value estimates may be appropriate for different blocks of private company stock. Likewise, there may be different value estimates depending upon whether the same block of stock is owned by an ESOP or a non-ESOP investor. There are generally accepted valuation approaches and methods related to the valuation of a closely held company. And there are generally accepted considerations related to the valuation of ESOP-owned and nonESOP owned stock in a closely held company. These considerations are different because: I An ESOP and a non-ESOP stockholder have different investment objectives and different investment time horizons. I ESOP and non-ESOPowned securities may enjoy different rights and privileges (including ERISA-related rights). I An ESOP and a non-ESOP stockholder may own company stock at two different levels of value. I ESOP and non-ESOPowned stock may be paid for from two fundamentally different levels of company cash flow employer contributions that reduce the companys income and value versus prof-

it distributions that do not reduce the companys income and value. This last difference is particularly important for S corporations. There is usually little income tax advantage for S corporations to make plan contributions, as opposed to shareholder profit distributions. Nevertheless, the stock valuation impact of this decision can be material. If an ESOP stock acquisition loan is repaid from company contributions, then all company shareholders share in the cost of the ESOP stock purchase. In contrast, if an ESOP stock acquisition loan is repaid from company profit distributions, then only the ESOP pays for the cost of the ESOP stock purchase. In this situation, non-ESOP stockholders do not subsidize the cost of the ESOP stock purchase through reduced (after plan contribution expense) company profits and reduced (due to lower profits) company stock values. There are also several specific differences between ESOP-owned stock and nonESOP owned stock. Many of those differences are summarized above. A valuation analyst should consider each of them in the analysis of the private stock to an ESOP versus another party. There are many different scenarios where a private company might sell or otherwise transfer stock to an ESOP at a different price than to a non-ESOP investor. In many of these scenarios, a private company (or the selling shareholders) will sell stock to an ESOP, which will serve as a long-term owner of the companys permanent capital base. In contrast, a private company might sell stock to other parties for different reasons, such as to attract, retain, or compensate key employees, suppliers, joint ventures, or financing sources. The relationship between these parties and a closely held company is fundamentally different than the relationship between an ESOP and the company. And the investment criteria of these parties may be fundamentally different than an ESOPs investment criteria. A CPA should consider these differences when analyzing the fair market value of the stock to an ESOP, compared to the investment value of the stock to a K nonESOP stockholder. Robert F. Reilly is managing director of Willamette Management Associates (www.willamette.com), Chicago, Ill.

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A N A G E M E N T

cpa consultant

What CPAs Need to Know About Quality Control Assurance Systems

By Jacqueline A. Burke and Ralph S. Polimeni
he word quality, meaning superiority or excellence, has long been used by organizations to describe their product or service. According to The Complete CFO Handbook (Frank J. Fabozzi, Pamela Peterson Drake, and Ralph S. Polimeni, Wiley, 2008), product or service quality consists of three elements: quality of design, quality of conformance to design, and quality of performance. Quality of design refers to the products adherence to appropriate specifications, such as required product life, fatigue resistance, customer service expectations, and government-mandated safety requirements. Quality of conformance is the extent to which products manufactured and services provided adhere to quality design specifications. Quality of performance is affected by both the quality of design and conformance to design, which together determine the overall quality of the product or service. The purpose of this article is to inform (or refresh) CPAs about a quality control assurance system so that they can be in the position to alert businesses, should the need arise, to consult with an expert. Fabozzi, Peterson Drake, and Polimeni (2008) define a quality control assurance system as a continuous system of feedback necessary for decision making to assure optimum product quality (p. 762). Having a basic understanding of quality control assurance systems will also enable CPAs to discuss basic issues with a quality control specialist and management. A quality control assurance system can also be viewed as part of an organizations internal control system. A major objective of internal controls is to establish procedures to protect an organizations assets. An ineffective quality control assurance

system directly impacts the organizations assets. Excessive rework costs and spoiled units lead to higher costs and inefficient use of an organizations resources. An internal audit should incorporate a peri-

employee training costs, frequent equipment recalibration and servicing costs, and employee quality incentive programs costs. I Failure costscosts to correct a defective product, including rework costs, war-

odic review of an organizations quality control assurance system to enhance that part of its internal control system.

Quality Obstacles
Some of the roadblocks to the achievement of product quality are described below. One issue is quality costs, which can be viewed as two separate conflicting costs: I Prevention/appraisal costscosts incurred by an organization to prevent defects, examples of which include

ranty repair costs, packing and shipping costs, and product liability costs. Both prevention/appraisal costs and failure costs often work in inverse fashion. (That is, an increase in spending on prevention/appraisal costs should yield fewer defects, resulting in lower failure costs. The opposite is also true; spending less on prevention/appraisal costs should result in more product defect costs.) As a result, many companies dont strive for zero defects but instead seek to find the best spending level for both cost groups,
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thereby minimizing total quality costs (prevention/appraisal costs plus failure costs). Because zero defects is not the target in this practice, product quality will suffer. Product quality can also suffer when an organization lowers production costs to increase profits and lower its prices to compete against increasing competition. Its the nature of manufacturing companies to seek ways to reduce costs during the production process without sacrificing quality. Cost reduction is acceptable and desirable if it does not compromise quality and, most importantly, safety. Quality problems are not only related to efforts to reduce costs, but can also occur as a result of design and conformance to design problems. Design relates to the technical requirements of a product (e.g., the gauge of steel to be used in a product), whereas conformance relates to adherence to a design (e.g., use of the correct gauge of steel in the manufacturing of the product). An excessively quick increase in production can lead to quality problems. For instance, assembly workers might work too quickly to reach unrealistic production output goals, resulting in poorly assembled products. To overcome these quality obstacles, organizations need to provide a greater focus on controlling product quality. Many organizations, at least on paper, subscribe to what is known as total quality management (TQM), which means that an organization takes a company-wide approach to achieve the highest level of customer satisfaction with its product. What is necessary for an organization to achieve TQM? Todays efforts to attain product quality have evolved into a quality control assurance system that engages all levels of an organization. The responsibility for maintaining an organizations product quality is no longer limited to the quality control department. An effective, company-wide quality control assurance system is critical to reducing product defects.

eral, wide-ranging statement of scope, philosophy, and strategy that provides a general sense of identity for the organization. In addition to a company-wide mission statement, a company should have a quality mission statement. The quality mission statement should state the organizations quality philosophy (i.e., values) regarding the role and importance that a company places on the achievement of

product quality. Some organizations create a separate quality mission statement for their company, while other companies integrate its quality mission statement into the organizations overall company-wide mission statement. All levels of management should be involved in the creation of a quality mission statement, and employees should also be consulted to create an organizational buy-in.

EXHIBIT 1 Quality Control Assurance System

Quality Mission Statement Component 1

Implement Improvements Component 5

Quality Goals and Objectives Component 2

Quality Control Department Component 4

Map Quality Goals and Objectives Component 3

Quality Control Assurance System

EXHIBIT 2 Greene Corporation Divisions and Product Lines

Power Tool Division Gas engine lawnmowers Gas engine chainsaws Hand Tool Division Hand clippers Rakes Shovels Wheelbarrows

Exhibit 1 represents key components in the design and implementation of a quality control assurance system. As can be observed, the process is a continuous loop of ongoing efforts to improve product quality. Component 1: quality mission statement. An organizations company-wide mission statement is normally a very gen-

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The quality mission statement could be organization-wide, that is, applicable to all divisions. Alternatively, some organizations prefer to have each division develop its own, more specific, quality mission statement. A case study will be presented for a medium-size garden tool manufacturer named Greene Corporation. Greene Corporation has two divisionspower tools and hand tools. Exhibit 2 lists their divisions and product lines. Exhibit 3 shows the company-wide mission statement, and Exhibit 4 shows the quality mission statements created by each division of Greene Corporation. Greene Corporation chose different quality mission statements for its two divisions because defective power tools could result in more customer safety problems than hand tools. Once the quality mission statement is

developed and approved by the organization, the company can then develop its plan to achieve the mission. Component 2: quality goals and objectives. Quality goals and objectives should be developed to achieve the organizations quality mission. The quality goals state the results the organization expects to achieve and are often a more detailed version of its general quality mission statement, while the quality objectives indicate what needs to be done to demonstrate the accomplishment of the quality goals. Each quality goal would typically have several quality objectives to accomplish that goal. Although the number of quality goals and related objectives is up to the organization, at least one quality goal and related objective should be developed for each quality mission statement.

EXHIBIT 3 Greene Corporation Company-wide Mission Statement

The mission of Greene Corporation is to develop, market, and manufacture power and hand garden tools for homeowners while effectively utilizing our resources. We specialize in garden tools, which is our only business. Our strategy is to be a leader in the development and design of products that conform to our customer needs. Our philosophy is to manufacture the best tools possible at competitive prices, and to consistently seek ways to provide improved value to our customers. The mission will be conducted in an ethical manner in all aspects and activities of the company.

EXHIBIT 4 Greene Corporation

Power Tool Division Quality Mission Statement The quality mission of the Greene Corporation Power Tool Division is to ensure that our products and technical support service provided to our customers are of the highest level of quality achievable and shall provide the customer with a safe and reliable product. Hand Tool Division Quality Mission Statement The quality mission of the Greene Corporation Hand Tool Division is to provide customers with the highest product quality and customer service possible in conformance with customer expectations and cost constraints.

Once again, all levels of management, with employee input, should be involved in the establishment of quality goals. Many organizations have multiple product lines and may have different quality goals for each product line. For example, products that can impact consumer safety (automobile braking systems) should have higher quality goals than those that dont (automobile sound systems). Quality goals for the department responsible for the automobile braking system hopefully will have a zero defects goal, while the automobile sound system department might strive for a maximum 2% failure rate. As previously discussed in the quality obstacles section, while every organization would like to strive for zero defects in the production process, this quality goal is not always costeffective. Once quality goals are developed, quality objectives need to be created and matched to a quality goal. Exhibit 5 is an example of the quality goals and their related objectives for the two divisions of Greene Corporation. As shown in Exhibit 5, some organizations will have their divisions develop individual quality mission statements, goals, and objectives. If this is the case, it is very important that organizations ascertain that the correct quality goals and objectives have been mapped (i.e., traced) to the appropriate individual production processes or departments. Component 3: map quality goals and objectives. Mapping is important in organizations that manufacture multiple products and have assigned different quality goals and objectives for each division or product line. The mapping process will help determine if quality goals, and their corresponding quality objectives, are effectively communicated and implemented in the appropriate departments. Continuing our example of Greene Corporation, Exhibit 6 presents each division with its various departments and acceptable level of defects based on their quality mission statements, goals, and objectives. Note that in Exhibit 6, the Power Tool Division expects zero defects for departments 1 and 3, which is in line with its Quality Goal 1, Employees will strive to produce a quality product with no operating defects, whereas the hand tool division accepts a 2%
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defect rate for departments 1 and 3, which is appropriate for its quality goal 1, Employees will strive to produce the best quality product possible within cost constraint limitations. In the Greene Corporation example, it was assumed that each department in the organization was dedicated to producing a particular part of a product. For example, department 1 of the power tool division produces gas engines for its lawnmowers and chainsaws. This structure enables the department to strive for one specific level of acceptable defects. In a very small manufacturing company, with limited resources, several different types of production processes, with different quality goals, may have to coexist within the same department. In cases like this, it would be necessary to inform the department employees of the different quality goals. For example, assume instead that Greene Corporation is a very small manufacturing company with no divisions, and that both its gas engines and cutting and forming processes are performed in one department. The employees of that department would be informed that when they produce gas engines, they need to strive for zero defects, whereas it is acceptable to achieve a 2% defect rate when cutting and forming hand tools. Component 4: quality control department. An effective and efficient quality control department is the heart of a quality control assurance system. An organizations quality control (assurance) department normally serves in an audit capacity and is responsible for the quality of a product and service from inception (purchase of raw materials) to completion (shipment of finished products). Some of the primary functions of a quality control department are the following: I Inspect and remove defective items from the production process. The defective items (from raw materials, work-in-process, and finished goods inventories) are either reworked (fixed to meet quality standards), scrapped, or discarded. I Continually review production specifications, methods, and procedures. I Review production documents and records for completeness and accuracy. I Examine processes for enhancing production specifications, methods, and procedures.
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I Review quality control manuals for accuracy and completeness. I Ensure that the latest manuals are available to quality control employees and are being used at all times. I Provide control quality reports to all levels of management. A dysfunctional quality control department is a serious problem and could severely impact the organizations efforts to achieve a quality product. Because of this, internal auditors often perform operational audits of a quality control assurance system, with particular emphasis on the operations of the quality control department. In the Greene Corporation case, the quality control department would be kept in the loop and consulted regarding any changes to each divisions quality mission statements, goals, and objectives. This is important because the quality control department needs to know where to focus its attention. For example, departments 1 and 3 of the power tool division would receive a high priority regarding product inspection because one of the quality objectives listed under quality goal 1 states that all products coming off the assembly line are tested for conformance to design specifications. Component 5: implement improvements. Implementing improvements to enhance product quality is the final component in a quality control assurance system. The expression closing the loop can be used to define this component. The entire quality control assurance system is considered a loop because quality control is a continuous process. The quality control department should work with various department heads to analyze quality variances and advise them, where appropriate, on corrective measures. Management has to be open to implementing suggestive corrective changes to the production system to enhance product quality. The quality control department should follow up to ensure that suggestions were implemented and resulted in an improvement to the production process and product quality. For example, if it is discovered in department 1 (gas engines) of Greene Corporations power tool division that some line production workers were not properly trained, then a process should be set in place to follow up on this deficiency until it is corrected.

Other Quality Control Considerations

Two other areas that CPAs should be aware of relating to quality control are outsourcing and the Six Sigma concept. Outsourcing. Many organizations have been outsourcing a part or all of their production processes. Outsourcing production, especially when done overseas (i.e., offshoring), makes it more difficult to maintain product quality. It is important that organizations set quality standards for the service provider (i.e., company the services are being outsourced to) and set up a system to oversee that the agreed-upon standards are consistently being followed. One way to do this is by requiring service

An effective and efficient quality control department is the heart of a quality control assurance system.
providers to be certified (i.e., accredited) for compliance with International Organization for Standardization (ISO) 9001. The ISO, a nonprofit organization, is the worlds leading creator of international quality standards. According to the British Standards Institute (BSI), ISO 9001 establishes a series of standardized requirements for a quality management system, regardless of the size of the user organization, what it does, or whether it is a private or public company (www.bsiamerica. com/en-us/Assessment-and-Certificationservices/Management-systems/Standardsand-schemes/ISO-9001/). In order to obtain ISO 9001 certification, an organization must be audited and certified by an independent certification body. In the January 2010 issue of The CPA Journal, in Is Outsourced Data Secure? Renu Desai and Robert W. McGee explain that ISO develops, maintains, and publishes the ISO standards. However, the ISO does not actually audit or assess quality management systems to ensure that they are in conformity with the requirements of the standards. Therefore,

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the ISO does not issue ISO 9001 certification. Companies that seek ISO 9001 certification must do so through an independent certification body. For example, the BSI provides this certification both in the United States and other countries. Requesting that your service provider is

ISO 9001certified is a way to minimize some of the risks of outsourcing. Therefore, organizations concerned about the quality of their products when outsourcing should try to limit themselves to service providers that are ISO 9001 certified.

It is important to note that ISO 9001 certification does not guarantee that a product is of high quality. A company can be ISO 9001certified and still produce an inferior product. However, it does send a message to constituents that an ISO 9001certified company strives to achieve

EXHIBIT 5 Quality Goals and Related Objectives

Power Tool Division Quality Goal 1: Employees will strive to produce a quality product with no operating defects. Objectives to achieve Quality Goal 1: Demonstrate that I procedures are in place to train and test employees in product assembly techniques, I assembly equipment adheres to a strict maintenance schedule, I all products coming off the assembly line are tested for conformance to design specifications, I products are not returned by customers because of quality defects, I a zero product recall rate has been achieved, and Quality Goal 2: The technical support staff will strive to provide customers with fast, courteous, accurate, and friendly assistance. Objectives to achieve Quality Goal 2: Demonstrate that I technical staff employees receive periodic updating and testing on existing product specifications; I technical staff employees receive briefings, in a timely manner, on product problems and updates on new product lines; I phone conversations with customers are monitored to assure fast, courteous, accurate, and friendly assistance; and I technical staff employees consistently receive excellent evaluations on customer surveys. Hand Tool Division Quality Goal 1: Employees will strive to produce the best quality product possible within cost constraint limitations. Objectives to achieve Quality Goal 1: Demonstrate that I analyses are periodically performed to improve production quality, efficiency, and reduce costs; I sample testing is performed on products coming off the assembly line to determine conformance to design specifications; I on-the-job training is provided for new employees; and I at least a 95% customer product quality satisfaction rate is achieved. Quality Goal 2: The customer service staff will strive to provide customers with fast, courteous, accurate, and friendly assistance. Objectives to achieve Quality Goal 2: Demonstrate that I phone conversations with customers are monitored to assure fast, courteous, accurate, and friendly assistance; and I customer service employees consistently receive excellent evaluations on customer surveys.

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certain best practices in achieving and maintaining a quality management system. Six Sigma. This was originally developed by Motorola USA in the 1980s and is a quality control management strategy. The name Six Sigma came from the statistical modeling process that is used to evaluate the production process. Basically, Six Sigma attempts to minimize the unevenness in a manufacturing process by identifying and removing the causes of defects. A sigma rating indicates the percentage of defect-free products it creates. A Six Sigma process is one in which 99.99966% (3.4 defects per million) of the products manufactured are statistically expected to be free of defects. In In Pursuit of Implementation Patterns: the Context of Lean and Six Sigma (International Journal of Production Research, December 2008), authors R. Shah, A. Chandrasekaran, and K. Linderman note that although some view Six Sigma as simply a set of statistical techniques, it is often viewed and implemented as a company-wide approach to quality control. A Six Sigma strategy emphasizes the attainment of quantifiable financial targets. Although originally used in the manufacturing industry, Six Sigma is now used in the service industry, including the financial sector (Shaun Aghili, A Six Sigma Approach to Internal Audits, Strategic Finance, February 2009). Aghili further explains that Six Sigma methodology has evolved over time and, as a result, has allowed organizations to combine effective quality control with financial efficiency by helping management identify various non-value-added processes that can be eliminated, thereby improving the companys bottom line. Thats a concept that should be especially appealing to most organizations during the current weak economic times. Aghili notes that individuals can become certified according to their levels of expertise in Six Sigma. These Six Sigma specialists are classified according to different belt levels, or, in other words, different levels of expertise (i.e., master black belts, black belts, green belts, and white belts). Over the years, many industries have adopted the concepts of Six Sigma. While some view it as a fad, many companies still use this method or some similar version. Therefore, it would be useful for CPAs to
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be aware of Six Sigma when working with quality control assurance systems.

Service Organizations
Many of the concepts discussed above also apply to service organizations. The quality control assurance system is very similar for a manufacturing and service organization. The key difference is that a service organization will focus on the quality of services delivered instead of the qual-

satisfied with the quality of customer service). In order to assess the attainment of its goals and objectives, the quality control department can provide customers with the opportunity to take an automated phone customer satisfaction survey at the end of each phone call or repair service. Any suggestions for improvement should be evaluated and implemented when deemed appropriate.

The CPAs Role

An organization can take years to develop a reputation for providing quality products and services, yet the reputation can sadly be destroyed overnight.
ity of products produced. For example, a quality control assurance system for a program transmission signal provider for televisions (i.e., cable, satellite dish) should develop a mission statement and set goals and objectives for customer service and the quality of the organizations transmission signals. For instance, a goal for the customer service department might be to obtain a high level of customer satisfaction in customer service. The related objective might be to achieve a 95% approval rating from customers (i.e., 95% of customers are

An organization can take years to develop a reputation for providing quality products and services, yet the reputation can sadly be destroyed overnight as the result of an ineffective quality control assurance system. The achievement and maintenance of a quality product or service should be the aim of everyone in an organization. To help an organization achieve this, CPAs should be cognizant of and engaged in the quality control assurance system and refer to a specialist if necessary. To be effective in this capacity, CPAs do not need to be expert in quality control assurance systems, but should at least be knowledgeable regarding the various components of the process. By having this basic understanding of quality control assurance systems, CPAs can add value K to their services. Jacqueline A. Burke, PhD, CPA, is an associate professor of accounting and Ralph S. Polimeni, PhD, CPA, is a professor of accounting and the Chaykin Endowed Chair in Accounting, both at the Frank G. Zarb School of Business, Hofstra University, Hempstead, N.Y.

EXHIBIT 6 Greene Corporation Division/Departments and Acceptable Defect Levels

Power Tool Division Department 1 - Gas engines 2 - Painting 3 - Assembly 4 - Packaging Acceptable Defects 0% 2% 0% 3% Hand Tool Division Department 1 - Cutting & forming 2 - Painting 3 - Assembly 4 - Packaging Acceptable Defects 2% 3% 2% 3%

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fraud

CEOs, CFOs, and Accounting Fraud

Implications of Recent Research
By Douglas M. Boyle, Brian W. Carpenter, and Dana R. Hermanson

ccounting fraud, or fraudulent financial reporting, has been an ongoing concern for U.S. investors for several decades, with periodic waves of accounting fraud cases leading to substantial investor losses and overall reductions in investor confidence. Research has documented the devastating effects of accounting fraud cases. For example, Jonathan M. Karpoff, D. Scott Lee, and Gerald Martin (The Cost to Firms of Cooking the Books, Journal of Financial and Quantitative Analysis, 2008) found that firms committing fraud are severely punished by the market: For each dollar that a firm misleadingly inflates its market value, on average, it loses this dollar when its misconduct is revealed, plus an additional $3.08. In addition, a recent Committee of Sponsoring Organizations of the Treadway Commission (COSO)sponsored study, Fraudulent Financial Reporting: 19982007, found that fraud firms were much more likely than similar no-fraud firms to declare bankruptcy, be involuntarily delisted, or have material asset sales in the wake of the fraud. Thus, the consequences to investors of accounting fraud often are quite severe. Recent research provides important new insights into the role of CEOs and CFOs in accounting fraud. In this article, the authors discuss these findings and offer a number of implications for directors, audit committee members, and auditors seeking to prevent or detect accounting fraud. The authors conclude by highlighting some useful antifraud resources.

Recent Research Findings

The Exhibit presents information on six recent studies that examined issues related to

CEOs, CFOs, and accounting fraud. The first two studies documented that accounting fraud is largely driven by the CEO and CFO (top management). The first study, Fraudulent Financial Reporting: 19982007, examined 347 alleged accounting fraud cases investigated by the SEC. The study revealed that financial statement fraud cases often involve the top executives, with the CEO or CFO implicated in 89% of the cases. CEOs were implicated in 72% of the cases, and CFOs in 65%. While lower level personnel often are coerced into carrying out the mechanics of the fraud scheme, the percentages for CEO and CFO involvement are far

higher than for any other type of employee in the company (all less than 40%). In a prior COSO-sponsored study, Fraudulent Financial Reporting: 19871997, the CEO or CFO were named in 83% of the cases; therefore, CEO/CFO involvement continues to be found in the vast majority of fraudulent financial reporting cases, and this appears to be increasing. Given the significant expenditures of time and money devoted to reducing fraud in recent years, such results suggest that fraud prevention and detection efforts may be performed in a more effective and efficient manner with a more targeted focus on the CEO/CFO.
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The second study, Report to the Nations: 2010 Global Fraud Study, was based on a global survey administered by the Association of Certified Fraud Examiners (ACFE) and found a similar result. The study analyzed more than 1,800 fraud cases (primarily occupational fraud) that were investigated by certified fraud examiners. Nearly 14% of the frauds involving executives or upper management were fraudulent financial reporting cases, while less than 5% of the total cases involved fraudulent financial reporting. Thus, fraudulent financial reporting cases were concentrated among executive and upper-management perpetrators. Based on these two studies, it is clear that accounting fraud typically involves CEOs and CFOs, who may coerce lower level employees to participate as well. What is not clear, however, is why some CEOs and CFOs participate in accounting fraud. The third study, by Mei Feng, Weili Ge, Shuqing Luo, and Terry Shevlin, offers new insights into this issue (Why Do CFOs Become Involved in Material Accounting Manipulations? Journal of Accounting and Economics, 2011). First, the authors found that CEO involvement in accounting manipulation appears to be driven by CEOs compensation incentives and facilitated by their power. In other words, the CEO is involved for personal gain through equity compensation, and the CEOs power (e.g., serving as board chair, being the company founder, or having higher pay relative to other executives) is useful in perpetrating the fraud. For CFOs, the results are much different. CFOs of companies accused of manipulating their results do not have equity compensation incentives that are different from CFOs serving clean firms. Thus, CFOs do not appear to be participating in accounting schemes for direct personal gain through equity pay. Rather, the authors conclude that CFOs are involved in material accounting manipulations because they succumb to pressure from CEOs. While Feng et al. and others have found evidence that CEO equity incentives are associated with accounting manipulations, it is important to note that the evidence on this issue is mixed, with various studies in the past decade providing inconsistent results. One recent example of a study reaching a different conclusion than Feng
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et al. is the fourth study in the Exhibit, by Chris S. Armstrong, Alan D. Jagolinzer, and David F. Larcker. Those authors used a very advanced matching process (ensuring that their sample matched each fraud company with a similar clean company) and found no evidence of a link between accounting fraud and CEO equity incentives. In fact, there was some evidence that accounting fraud is less likely as CEO equity incentives increase. Thus, recent research lacks consensus regarding the relationship between CEO equity incentives and accounting fraud. The fifth study in the Exhibit, by Joel H. Amernic and Russell J. Craig, developed a theoretical argument related to CEO narcissism and accounting fraud. The authors stated: Our central thesis is that accounting has unique and distinctive features which plausibly encourage ego-boosting behaviour by certain, more extreme, narcissistic CEOs. Narcissists possess an exaggerated sense of self-importance, a pre-occupation with being the centre of attention, a lack of compassion for others, a high degree of sensitivity to criticism, and high levels of envy and arrogance. It is important for auditors, analysts, regulators and other corporate stakeholders to generally monitor the language of CEOs for narcissisticlike signsincluding such signs provided by financial accounting language and measures. This importance is stressed by Amernic and Craig (2007, p. 27) who contend that CEOs possessing extreme narcissistic-like tendencies are more prone to play loose with the companys reported financial position, to shun remediation strategies and to live in a fantasy world of delusion about the companys financial strength. (Accounting as a Facilitator of Extreme Narcissism, Journal of Business Ethics, 2010, p. 80) The authors provide a rich discussion of how CEO narcissism can lead down a path to materially manipulating the financial statements to fit the CEOs inflated view of himself and the companys performance. Finally, Jeffrey R. Cohen, Ganesh Krishnamoorthy, and Arnold Wright interviewed 30 Big Four audit partners and managers on a range of corporate governance issues (Corporate Governance in

the Post-Sarbanes-Oxley Period: Auditors Experiences, Contemporary Accounting Research, 2010). This included two issues that relate to the present discussion: Who really hires the auditor, and have the Sarbanes-Oxley Act of 2002 (SOX) section 302 certifications by CEOs and CFOs affected the integrity of financial reporting? The authors find that auditors believe, even in the post-SOX period where the audit committee legally hires the audit firm, that the CEO and CFO still largely drive the auditor selection process. (In fact, one interviewee asserted that CEOs are even more interested in auditor selection now than pre-SOX.) Clearly, heavy involvement by management in the auditor selection process has the potential to undermine auditor objectivity. With respect to the SOX section 302 certifications by CEOs and CFOs (where management personally certifies the financial statements), most auditors interviewed believe that such certifications have helped to improve the integrity of financial reporting post-SOX. It appears that CEOs and CFOs may feel more personal accountability due to the section 302 certifications. Based on these six studies, the following major themes emerge: I Accounting fraud is largely driven by CEOs/CFOs, who may coerce lower level personnel to participate as well. I CEOs may engage in accounting fraud related to equity incentives (although the evidence is mixed), power, and narcissism. I CFOs appear to engage in accounting fraud due to pressure exerted by CEOs, rather than due to their own equity incentives. I In many companies, CEOs and CFOs still appear to drive the auditor selection process, but section 302 certifications by CEOs and CFOs are perceived to have improved the integrity of financial reporting post-SOX.

Implications for CPAs

These themes have a number of implications for those focused on preventing or detecting accounting fraud, especially the board/audit committee and external auditor, who oversees the CEO/CFO and tests the financial statements, respectively. First, it is important for the board, audit committee, and external auditor to understand the CEOs personality and level of power within the organization. CEOs with

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EXHIBIT Selected Recent Research Related to CEOs, CFOs, and Accounting Fraud
Study Beasley, Carcello, Hermanson, and Neal, Fraudulent Financial Reporting: 19982007, COSO (2010) Association of Certified Fraud Examiners, Report to the Nations: 2010 Global Fraud Study Feng, Ge, Luo, and Shevlin, Why Do CFOs Become Involvedin Material Accounting Manipulations? Journal of Accounting and Economics (2011) Scope 347 SEC fraud-related enforcement cases from 1/1/98 to 12/31/07 Selected Findings (Excerpts in Quotes) In 72 percent of the cases, the AAERs named the CEO, and in 65 percent the AAERs named the CFO as being associated with the fraud. When considered together, in 89 percent of the cases, the AAERs named the CEO and/or CFO as being associated with the financial statement fraud. In COSOs 1999 study, the CEO and/or CFO were named in 83 percent of the cases. Financial statement fraud schemes were also much more common among executives and upper management. Financial statement fraud cases accounted for 13.8% of the 224 executive/upper management cases, versus only 4.8% of the total cases in the study. We find that while CFOs bear substantial legal costs when involved in accounting manipulations, these CFOs have similar equity incentives to the CFOs of matched non-manipulation firms. In contrast, CEOs of manipulation firms have higher equity incentives and more power than CEOs of matched firms. Taken together, our findings are consistent with the explanation that CFOs are involved in material accounting manipulations because they succumb to pressure from CEOs, rather than because they seek immediate personal financial benefit from their equity incentives. This study examines whether Chief Executive Officer equity-based holdings and compensation provide incentives to manipulate accounting reports. While several prior studies have examined this important question, the empirical evidence is mixed and the existence of a link between CEO equity incentives and accounting irregularities remains an open question . . . In contrast to most prior research, we do not find evidence of a positive association between CEO equity incentives and accounting irregularities after matching CEOs on the observable characteristics of their contracting environments. Instead, we find some evidence that accounting irregularities occur less frequently at firms where CEOs have relatively higher levels of equity incentives. We argue that the special features possessed by financial accounting facilitate extreme narcissism in susceptible CEOs. In particular, we propose that extremely narcissistic CEOs are key players in a recurring discourse cycle facilitated by financial accounting language and measures. Such CEOs project themselves as the corporation they lead, construct a narrative about the corporation and themselves using financial accounting measures, and then reflect on how their accounting-constructed performance is perceived by stakeholders. We do not present empirical evidence about whether the use of accounting language and measures leads to unethical behaviour by extreme narcissistic CEOs . . . Rather, we focus on developing alertness to the potential for accounting, when engaged by an extremely narcissistic CEO, to be a precursor or implement of unethical behaviour. Auditors were asked to share their experiences on who actually has the most influence in the appointment and dismissal of auditors in a public company . . . the mean percentage of actual influence assigned to the management [CEO, CFO] was 53 percent while that assigned to the audit committee was 41 percent One key element of SOX is the certification of the financial statements by top management (Section 302) In this study, approximately 68 percent of the respondents indicated that the requirement has had a positive impact on the integrity of the financial reports.

1,843 fraud cases reported by certified fraud examiners in a survey; the respondents were from more than 100 countries SEC enforcement cases involving material accounting manipulations from mid-1982 to mid-2005 and a control sample

Armstrong, Jagolinzer, and Larcker, Chief Executive Officer Equity Incentives and Accounting Irregularities, Journal of Accounting Research (2010)

Firms with restatements, accounting-related lawsuits, or SEC enforcement actions from 2001 to 2005

Amernic and Craig, Accounting as a Facilitator of Extreme Narcissism, Journal of Business Ethics (2010)

Theoretical argument

Cohen, Krishnamoorthy, and Wright, Corporate Governance in the PostSarbanes-Oxley Period: Auditors Experiences, Contemporary Accounting Research (2010)

Interviews of 30 Big Four audit partners and managers

AAERs=Accounting and Auditing Enforcement Releases; COSO=Committee of Sponsoring Organizations of the Treadway Commission

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tendencies toward narcissism, especially when combined with a great deal of power, may be particularly inclined to misstate the financial results or coerce others to do so. In addition, while research evidence is mixed, it is important to consider the potential for CEO equity incentives to create strong pressure to meet targets, perhaps through manipulation of the results. Second, the CFOs ability to withstand pressure from the CEO is critical. Research suggests that CEO pressure is key to CFO involvement in accounting manipulations. Therefore, it is important for the board, audit committee, and external auditor to monitor how the CFO responds to pressuredoes the CFO always stand her ground, or does the CFO often cave in to the CEOs suggestions on accounting issues? Third, the CEOs and CFOs role in the auditor selection process should be monitored. If management dominates this process, leaving the audit committee in a ceremonial role, it may be more difficult for the auditor to be as objective as possible. If auditor objectivity is reduced, it may be easier for management to successfully manipulate the results. The audit committee and auditor both need to monitor managements role in the auditor selection process and to take their concerns to the board if management appears to be too involved in this process. Finally, how do the CEO and CFO approach their section 302 certifications? Is there a meaningful and robust effort to gain complete comfort with the financial results, or is the certification viewed as a check the box requirement? Both the audit committee and the auditor can attempt to monitor this process.

Additional Resources
The authors encourage interested readers to consult some additional resources that may be helpful in addressing the accounting fraud problem. First, Jack Dorminey, Arron Scott Fleming, Mary-Jo Kranacher, and Richard A. Riley (Beyond the Fraud Triangle, The CPA Journal, July 2010) discuss several existing models of fraud, including the fraud triangle, fraud scale, and fraud diamond, each of which offers unique advantages. The authors encourage interested readers to consider a variety of models and tools available in the fraud area. For
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example, in addition to the traditional focus on incentive, opportunity, and rationalization as ingredients of fraud, the fraud diamond adds a fourth component, capability. Capability addresses the unique personal characteristics often needed to exploit a fraud opportunity, such as intelligence, confidence/ego, coercion skills, effective lying, and immunity to stress. (See David T. Wolfe and Dana R. Hermanson, The Fraud Diamond: Considering the Four Elements of Fraud, The CPA Journal, December 2004.) While many of these traits are desirable in executives, those authors caution CPAs and others to be alert to the risks created by these traits. Boards, audit committees, and auditors are encouraged to consider the capability of top management, including the potential for top management to coerce lower level employees into participating in a fraud. It is important to attempt to assess the level of pressure faced by lower level employees and for lower level employees to have a secure method of communicating their concerns to the board and audit committee (e.g., when inappropriate pressure is being exerted by top management). Second, the 2008 study, Managing the Business Risk of Fraud: A Practical Guide, sponsored by the Institute of Internal Auditors, the ACFE, and the AICPA, provides a very rich discussion of antifraud measures. The study develops and discusses five key principles involved in the fight against fraud: Principle 1: As part of an organizations governance structure, a fraud risk management program should be in place, including a written policy (or policies) to convey the expectations of the board of directors and senior management regarding managing fraud risk. Principle 2: Fraud risk exposure should be assessed periodically by the organization to identify specific potential schemes and events that the organization needs to mitigate. Principle 3: Prevention techniques to avoid potential key fraud risk events should be established, where feasible, to mitigate possible impacts on the organization. Principle 4: Detection techniques should be established to uncover fraud events when preventive measures fail or unmitigated risks are realized.

Principle 5: A reporting process should be in place to solicit input on potential fraud, and a coordinated approach to investigation and corrective action should be used to help ensure potential fraud is addressed appropriately and in a timely manner. Finally, in 2010, the Center for Audit Quality (CAQ) published Deterring and Detecting Financial Reporting Fraud, aimed squarely at the accounting fraud problem. The report states: While there is no silver bullet, the CAQ discussion participants consistently identified three themes: I A strong, highly ethical tone at the top that permeates the corporate culture (an effective fraud risk management program is a key component of the tone at the top) I Skepticism, a questioning mindset that strengthens professional objectivity, on the part of all participants in the financial reporting supply chain I Strong communication among supply chain participants. Thus, the CAQ report focuses on tone at the top, skepticism, and communication as the foundational elements of efforts to mitigate the accounting fraud problem. The CAQ report includes a number of insights in each of these areas. With respect to tone, the authors believe that the board and audit committee need to take a lead role in establishing and monitoring the tone at the top, for these parties are directly responsible for overseeing top management. If top management does not share or act consistent with the boards and audit committees desired tone, then top management likely needs to be replaced. Recent research offers new insights into the role of CEOs and CFOs in accounting fraud. In the final analysis, the accounting fraud problem will never disappear, but numerous resources may be helpful to those seeking to mitigate this problem, especially board members, audit K committee members, and auditors. Douglas M. Boyle, CPA, CMA, is an assistant professor of accounting, and Brian W. Carpenter, PhD, is a professor of accounting, both at the University of Scranton, Scranton, Pa. Dana R. Hermanson, PhD, is a professor at Kennesaw State University, Kennesaw, Ga.

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the cpa & the computer

Auditing in the Cloud: Challenges and Opportunities

By Christina A. Nicolaou, Andreas I. Nicolaou, and George D. Nicolaou
ecent advances in data storage, communication, and information processing technologies have enabled many companies to utilize business processes that are being supported by IT-enabled applications. This is even truer with the widespread use of enterprise resource planning (ERP) systems, such SAP and Oracle, which have now become part of the standard vocabulary of almost every controller, operating officer, and auditor. With such widespread use of IT in business organizations, typical business applications of the past can now be handled by emergent and more sophisticated technology solutions. Many companies now see a tremendous increase in their capital budgets for IT, which always raises questions on the return of these investments and to what extent emerging and innovative solutions can free up much-needed capital resources. While computing applications can be outsourced to external service providers, there are always risks when relying on an external vendor in handling a companys own critical applications, notwithstanding the high cost of such an endeavor. Important applications of a business, including database storage and processing of business events relating to a companys basic revenue, expenditure, and production processes, should be protected by adequate controls and policies that govern data storage, dissemination, and processing. Because these policies and controls define a companys internal control environment, which has an impact on the reliability of reporting in annual reports or other statements, audit standards require external financial statement auditors to perform a review and assessment of such controls that a company adopts. For these reasons, decisions that relate to the adoption and use of underlying technologies that dictate a companys data storage, processing, and data sharing policies place significant constraints on the planning, execuin auditing a companys cloud-based systems. Computing on the cloud involves the provision of IT services through the Internet using a shared infrastructure. This allows convenient and on-demand net-

tion, and skill set required to properly carry out an external financial statement audit or other types of special audit engagements. With modern technologies becoming more widespread but at the same time more complex, it is thus important for auditors to understand not only the nature and potential benefits of new technologies, but also the risks they present and the impact they may have on the performance of the audit. This article reviews the emerging technology of cloud computing in a nontechnical manner and examines issues that arise

work access to shared computing resources, including business software applications and their development, database storage and processing, communication technologies, and the use of enterprise systems. Since cloud computing applications can be shared and used on demand, they enable companies to reduce the costs of data storage and processing, in addition to relieving them of the need for large capital expenditures. While all of the above present unique opportunities for cloud computing users, the use of such emergent technology also
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brings a number of significant risks that have very important implications for the effectiveness of internal controls and may significantly impact the nature of an external auditors work. Knowledge of these risks is critical for auditors to properly audit a cloud computing installation or rely on another auditors report on the effectiveness of controls adopted by a cloud computing provider. It is important for auditors to understand this technology and take precautions in ensuring audit work under these conditions is still of a high quality.

What Is Cloud Computing?

In the past few years, everyone using an e-mail account such as Yahoo or Gmail has in fact used cloud computing. It is locationindependent, web-based computing, utilizing shared virtual servers, on an as-needed basis. Users pay for usage, and thus the cloudcomputing model provides for elasticity in services and expandability in use. Recent estimates claim that a traditional stand-alone IT system rarely uses more than 20%, and as little as 5%, of its processing capabilities at any particular time (Armburst et al., Above the Clouds: A Berkeley View of Cloud Computing, Technical Report No.UCB/ EEXS-2009-28, 2009). Since the 1960s, forethinkers of computing models have predicted that, at some point, computing may be organized as a public utility, next to electricity, gas, water, and phone service (Gary Anthes, Security in the Cloud, Communications of the ACM, November 2010). For instance, when entities have a need for electricity, they pay as they go. This allows unlimited access to a seemingly unlimited amount of the utility, while only paying for what is being used. Cloud computing allows service providers to share their computing resources with many subscribers, improving utilization rates and reducing costs. Some experts predict that as much as 90% of the worlds computing and data storage will be done via the cloud in five to 10 years, while cloud computing applications are predicted to experience a five-fold growth in the next five years (Anita Hawser, Cloud Control: Businesses Looking for Cost-effective Data and IT Infrastructure Solutions Are Increasingly Finding the Answer Is in the Cloud, Global Finance, December 2009). Today, cloud computing offers three different service models, including the following (S. Marston, Z. Li, S. Bandyopadhyay,
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J. Zhang, and A. Ghalsasi, Cloud Computing: The Business Perspective, Decision Support Systems, 2011): I Software as a service (SaaS), which focuses on providing software applications to users via web-based interfaces (e.g., personal applications such as Gmail and enterprise applications such as the Salesforce.com sales management application), so users consume shared applications on the cloud and do not need to install and run applications on local computers. I Platform as a service (PaaS), where users deploy applications they created or acquired on a providers cloud infrastructure, using the providers underlying data center, network, operating systems, and database management systems. Users have control over their data and applications but are relieved of the need to host the underlying platform. Some examples of PaaS include Googles App Engine and Amazons Elastic Compute Cloud (EC2) platform. I Infrastructure as a service (IaaS), which focuses on providing co-location storage facilities and networks, such as shared commercial hot sites for disaster recovery. Users have control over their data and applications as well as operating and database management systems. An example of IaaS includes Amazons S3 storage service. The Exhibit presents the important distinctions in user control over the three different implementation modes, or service models, of cloud computing. Obviously, each of these service models requires a varied level of in-house expertise by users. The benefits and risks of cloud computing, nevertheless, can vary according to the service model adopted, the riskier one being that which requires the least amount of in-house expertise (SaaS). While users may often be lured into the potential benefits of not having to invest in a large in-house computing infrastructure, they need to recognize that they in fact relegate critical control for building or hosting critical IT applications and infrastructure to the cloud computing service provider. The audit of information that is based on these systems, therefore, needs to consider these risks.

entrusts the confidentiality and integrity of its data to a cloud service provider. If unauthorized users access information, an organizations information could be compromised. In addition, all data transfers to cloud storage should be encrypted, minimizing the risk of data breach during transmission. A provider should also adopt adequate policies for key management to encrypt data both during transmission as well as during storage. Beyond user authentication and data breach issues, cloud providers should ensure the privacy of an individual companys data, because a service provider has complete access over a companys confidential data that are stored

Cloud computing allows service providers to share their computing resources with many subscribers, improving utilization rates and reducing costs.
on the cloud. Providers should also adopt policies for the strict maintenance of audit trails, because it is not difficult for application developers to write code that allows skimming of financial data without leaving an audit trail (Dustin Owens, Securing Elasticity in the Cloud, Communications of the ACM, June 2009. In the cloud, different companies, sometimes competitors, share the same infrastructure to store their data. This requires that a provider adopt proper customer segregation policies so that only authorized users are allowed to access data. If a companys data and systems are breached, this means that the confidentiality and integrity of the data and systems of other companies that share the same infrastructure could also be at risk. In a SaaS environment, for example, a provider should segregate databases con-

Security Risks
Cloud computing raises privacy and confidentiality concerns because, under any of the above service models, a company

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taining data of different companies, while such controls should be tested periodically to ensure compliance. As user companies increasingly depend on cloud vendors, it is crucial that there be adequate standardization in cloud computing storage and applications. Cloudcomputing standards are still evolving, however. If a provider ceases operations, for instance, it would become very expensive for a company to transfer all its data to another provider. Due to these risks, a company adopting cloud computing should review service-level agreements (SLA) in detail in order to ensure the following are specified in advance and agreed upon with a provider: I Performance measurement, including requirements for availability of service (expected uptime), speed of transaction response, and issue resolution times are critical issues, because availability of service might also involve data losses and disruption in data transfers. For instance, one major outage of Amazons web service in September 2007, due to issues with its EC2 servers, resulted in significant downtime and as a consequence caused data losses for some of its users. This incident was among the factors prompting Amazon to adopt an SLA for its S3 storage. At this time, Amazon only offers 99.9% (not 100%) service-level guarantee on its S3 data storage and 99.95% guarantee on its EC2 servers. I SLAs for security, as mentioned above, should specify requirements for controls to protect the confidentiality, integrity, and availability of a companys data stored on the cloud. This may include a requirement to follow specific control frameworks

and a requirement for third-party assessments (audits). The next section discusses more recent developments in professional guidance for such assessments. Also, requirements should be laid out for how data should be stored and encrypted (including details of encryption algorithm complexity), who has access to data, policies for disaster recovery, and data retention and destruction. I SLAs should include right-to-audit clauses that specify what a customer company is allowed to audit and when. This may also include a right to review independent assessments, such as those performed in the context of an audit of outsourcing functions to an independent provider. In the United States, until recently, such audits were done under the umbrella of Statement on Auditing Standards (SAS) 70; however, recent developments in professional guidance have expanded the range of options available for such audits. Beyond the existence of adequate policies specified in SLAs, in cloud computing there is always the risk of vendor lock-in. This means that users may not be able to extract or transfer their data or programs from one site when they want to change to a new provider or quit using the service in the future. Another potential problem is that once the users are locked in to their data or systems, they will not have much chance to bargain on the price if cloud computing providers, who control their data, decide to increase service fees. Furthermore, in the case of a provider shutdown, data may be lost. For example, Linkup, an online storage service, was shut down in 2008 because it lost almost

half of its customer data (Armbrust et al. 2010). Linkup was using the online storage service Nirvanix, and data for its 20,000 customers were stored in that system. After the service was disrupted, Linkups 20,000 users had to try other storage providers. Beyond this, in cases where providers are being acquired, users should have controls in place to ensure security of their data. For example, Navajo Systems, a data encryption company, was recently acquired by Saleforce.com, which raises issues of who has access to keys once such changeover occurs (F. Y. Rashid, Salesforce.com Acquires SaaS Encryption Provider Navajo Systems, eWeek.com, August 26, 2011). Another area of risk is the use of insecure application programming interfaces (API) used between applications for interoperability. For example, while a user is logging into a banking or tax program hosted in the cloud, tokens are created that pass login information between applications using APIs. If these are unsecured, then sensitive data could be compromised. Furthermore, account, service, and traffic hijacking could be present in clouds, where such threats may include man-in-the-middle attacks, phishing and spam campaigns, and denial-of-service attacks (Armbrust et al. 2009; M. S. Mimoso, Cloud Security Alliance Releases Top Cloud Computing Security Threats, SearchSecurity.com, March 2010). In sum, while many companies are eager to use cloud computing to reduce capital costs, thereby eliminating the need for a complex computer infrastructure and enlarging computing power and capacity, they should not ignore potential risks involved with the adoption of cloud computing.

EXHIBIT Cloud Computing Service Models and Resource Control

SaaS Data Applications (e.g., ERP systems) System software (operating systems; database management systems; middleware) Computing networks/servers Physical data center User control Provider control Provider control Provider control Provider control PaaS User control User control Provider control Provider control Provider control IaaS User control User control User control Provider control Provider control

ERP=enterprise resource planning; SaaS=Software as a service; PaaS=Platform as a service; IaaS=Infrastructure as a service

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Influence of Cloud Computing on Audits

The emergence of cloud computing has had a significant impact on the accounting profession, because there are many security risks that still cannot be addressed by known measures for proper control and audit in these environments. Outsourcing IT functions to cloud providers creates difficulties for auditors who are trying to assess the controls of a client company. As discussed above, having the permission and right to audit the cloud at any time may present a major technical obstacle for external auditors, as auditors may not be permitted to access systems and data on the cloud (M. D. Ryan, Cloud Computing Privacy Concerns on Our Doorstep, Communications of the ACM, January 2011). Auditors are not likely to be granted such all-inclusive access on the cloud because of the potential disruption to service and the plausible compromise to the security of other companies data that are maintained on the same cloud infrastructure. In a cloud environment, it is often unknown where data are being stored (i.e., their physical location), which complicates issues of legal jurisdiction over data protection and confidentiality. Making matters worse for auditors is that professional organizations, such as the AICPA, the Canadian Institute of Chartered Accountants (CICA), and the Information Systems Audit and Control Association (ISACA), still have not defined cloud audit requirements, although progress is being made in this area (AICPA, Service Organization Control Reports: Managing Risks by Obtaining a Service Auditors Report, 2010; M. Datardina and Y. Audette, Cloud Computing: A Primer, CICA, 2011; ISACA, IT Control Objectives for Cloud Computing: Controls and Assurance in the Cloud, 2011). Even before cloud computing, the AICPA specified the required elements when auditing service organizations or vendors who outsourced aspects of a client companys operations. SAS 70 provides a standard by which service organizations can demonstrate the effectiveness of their internal controls without having every client company perform an audit on their operations. Under SAS 70, a certified independent service auditor performs an audit and issues a report that may be shared with the audit teams of the service organizations clients. While these reports provide evidence over any aspects
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of financial processing and reporting that have been outsourced, service providers have recently inappropriately touted such reports as catch-all certifications of proper governance, security, or privacy in their organizations (D. Schroeder, SAS 70 Is Dead: Hello Better Cloud Governance? Information Week, July 5, 2011). A more inclusive Statement on Standards for Attestation Engagements (SSAE) 16 has been issued, effective as of June 15, 2011. Its purpose is to replace the aging SAS 70 report standard by updating the U.S. Service Organization reporting standard and to keep pace with the more globally accepted international accounting standards, especially the ISO reporting standard ISAE 3402, issued by the International Auditing and Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC). Thus, SSAE 16, now known as an attest standard, is attempting to assist service auditors in providing a more indepth range of options in their reporting, including the following: I A requirement for management attestation. Because SSAE 16 is an attestnot an auditstandard, management is required to describe the companys service delivery system, controls, and control objectives instead of just having the auditor giving their opinion about the controls of a company (Curt Finch, From SAS 70 to SSAE 16: How to Keep Your Cloud Service on Track, Inc., July 28 2011). This attestation now holds management directly accountable. I Verification that appropriate criteria are used for system evaluation. Under SSAE 16, depending on the type of service provided, management now must use suitable criteria from a widely recognized standard (such as the Trust Services Framework) with appropriate criteria used when assessing the companys service delivery system. With the new SSAE 16 standard, a broader framework for Service Organizations Control (SOC) reports was also announced. There are now three different types of SOC reports that allow cloud service providers to offer their customers different levels of risk management assurance. A cloud provider can engage an independent auditor to perform a SOC 1 report and provide assurance to clients regarding the controls fol-

lowed by the provider that may affect the clients financial reporting processes and systemsthis report was previously issued as part of a SAS 70 audit. Nevertheless, such a report is not cloud-computing specific. As a result, while this new standard will assist in assessing the controls of cloud providers, it does not mean that cloud vendors will necessarily become certified upon being evaluated using SSAE 16 (J.M. Sherinsky, Replacing SAS 70, Journal of Accountancy, August 2010). In the absence of more specific guidance, however, it can still meet the needs of user entities management and their auditors, as they evaluate the effect of controls at the service organization on the user entities financial statement assertions. The AICPA and CICA previously developed Trust Services criteria (for WebTrust and SysTrust engagements). These were intended to provide independent assurance that an entitys controls met one or more of these principles and criteria, including an assessment of an entitys security, confidentiality, privacy, processing integrity, and system availability. These same principles and criteria are now incorporated into the SOC 2 and SOC 3 reports. In general, SOC 3 reports are for broad use and public consumption, while SOC 2 reports are meant to provide more detail on the processing and controls at a cloud computing service providers installation and inform customers of the service auditors findings in testing such controls. Yet, these assurance services are still general-use, and not specific to cloud-computing environments or service providers. With user pressure on auditors to provide some assurance in advanced technology environments, such as cloud computing providers, the guidelines for a SOC 2 standard were developed in line with the Trust Services Framework; an auditor performing a SOC 2 engagement would thus provide assurance over a service providers controls relevant to security, availability, processing integrity, confidentiality, and privacy of data and systems (A. Defelice, Cloud computing: What Accountants Need to Know, Journal of Accountancy, October 2010). A SOC 2 report structure is similar to a SOC 1 report in that the management of a service organization provides detailed assertions regarding the information systems and management prac-

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tices used to deliver services. This report is intended for users who need to have a thorough understanding of the service organization and its internal controls, and can form an important part of the users oversight of the cloud service organization, vendor management, internal corporate governance, and risk management. With these potential assurance engagements, financial statement auditors of user companies could possibly rely on a SOC report to supply third-party expert assurance over the reliability of internal controls of client organizations and their operations outsourced to cloud providers. Audit plans, most importantly, should reflect the level of responsibility of the client company in the case of cloud computing providers. It is necessary for external financial statement auditors to clearly delineate where the responsibility of the service provider ends and where the one for the client begins. This will determine what level of SOC report should be sought to provide the necessary assurance for audit purposes. For example, Saleforce.com, a major cloud computing provider (in a SaaS model), provides access to its Trust Services (SysTrust or SOC 3) report, in which independent accountants provide an opinion regarding the companys assertions on system security, availability, and confidentiality. Other providers, such as Amazon Web Services and Google Apps, publish the control objectives that were met in their successful completion of a SAS 70 Type II audit (assurance throughout a specified period). Recent service disruption incidents at Amazon Web Services, however, show that even with a SAS 70 report in place, there is no assurance of the vendors risk management policies and operations independent of their impact on financial reporting. Independent accountants and financial statement auditors are therefore poised to be key players in providing detailed assurance over the controls and risk management policies adopted by cloud service providers. This should aid in the further deployment of the technology and realization of its benefits, while reducing negative impacts due to security concerns.

speak with near certainty about the numerous benefits that are offered to businesses by going to the cloud. Certainly, such benefits as the scalability of services can result in a reduced cost for IT services and significantly reduce the need for large investments in IT infrastructure. Furthermore, the on-demand nature of cloud computing enables companies to be quicker to market with their product while having unlimited availability to the various IT services offered in the cloud.

The control and audit issues that arise for companies in the cloud are major concerns for cloud service organizations and user companies, as well as external financial statement auditors.
While there are numerous benefits that will drive widespread adoption of the technology, security and privacy risks in the cloud are major concerns that still prevent many companies from adopting the technology. It is currently unknown how providers will be able to protect data from theft and manipulation; therefore, organizations are only willing to place noncritical applications and general data in the cloud. Also, the loss of control over data in the cloud is threatening to companies because they are worried about data loss and recovery of their information following a disaster. Beyond such issues of data loss and data control, many user companies are also faced with additional risks. Because many clients of cloud computing service providers may not possess the inhouse expertise to maintain their own database management systems, deal with operating system issues, or keep up with

critical software application updates, they relegate critical control to a cloud service provider. The types of security measures and controls deployed by the cloud service provider, therefore, could have a significant impact on the reliability of reports and data produced by user companies and the reporting of their financial results. The control and audit issues that arise for companies in the cloud are major concerns for cloud service organizations and user companies, as well as external financial statement auditors of user companies. Audit standards have not yet developed to the point where there is clear-cut guidance to external auditors regarding how and what to test in a clients operations when these depend on a cloud service provider. The SOC standards only provide general guidance regarding the reliance of an external auditor on the attestation service provided by another independent accountant regarding a cloud providers assertions on selected aspects of their systems and operations. External financial statement auditors should assess the service level agreement between a company and its cloud provider in order to determine the extent of testing they can conduct in-house, versus the level and type of reliance they will need to receive from a third-party assurance provider. This assessment should at least help mitigate some of the audit risks when the client utilizes the services of a cloud computing provider. As these services become more complex, however, and companies rely at a maximum on the level of security and controls implemented by a cloud service provider, external auditors may need to develop in-house skills in auditing these systems and the organizational controls that surround their development and continued operation. With so many companies adopting this emerging technology, auditing in or through the cloud will be ingrained in the vocabulary of every auditor not-too-far in K the future. Christina A. Nicolaou, MAcc, is an accounting and audit professional with KPMG, in Limassol, Cyprus. Andreas I. Nicolaou, PhD, is the Owens-Illinois Professor of Business Administration at Bowling Green State University, Bowling Green, Ohio. George D. Nicolaou is a director with KPMG, in Limassol, Cyprus.
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Risks Versus Benefits

Much of the research and media attention on cloud computing has focused solely on the positive aspects of the technology, which

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T E C H N O L O G Y what to bookmark

Website of the Month: Nonprofit Finance Fund

By Susan B. Anders
he Nonprofit Finance Fund (NFF) is a community development institution with a 30-year history of providing financial resources and management advice to nonprofit organizations. NFF, whose motto is where money meets mission, uses its financial knowledge to offer loans and grants, consulting, and group education for free or at low cost. CPAs who advise nonprofit organizations, serve on boards of directors, or volunteer their expertise and services can find some excellent information and tools on the organizations website, www.nonprofit financefund.org. It offers access to free online resources such as articles, case studies, surveys, worksheets and checklists, web chats, and webinars. The home and main pages rely on a common main menu sidebar that lists the websites major categories: services, initiatives, resources and articles, NFF news, events, FAQ, and the NFFs four regional offices. The menu links to the main pages offer a secondary index of category-specific topics and materials. The homepage highlights some of the sites resources, such as news articles, recorded presentations, a link to annual survey results, and topics of recent blog posts. The NFF website makes it very easy to access the organizations contact information; email addresses and telephone numbers for its eight offices are included at the bottom of every webpage. As an example of the high quality and on-point financial guidance provided on the NFF website, the following is a quote from the websites Guide to Navigating Changing Times: The recession reveals the precarious state of a sector that is continually asked to do more with less. This crisis presents funders and government with an

opportunity to substantively change practices that perpetuate inefficiency and stymie innovation and growth. ... This recession is forcing the issue of how to better invest in what works for the benefit of society.

Publications
NFF conducts an annual survey of nonprofit managers and makes the results freely

available in a variety of formats, such as executive summary brochures, slideshow presentations of the general findings, detailed respondent comments, and spreadsheet summaries of the data. The 2011 survey revealed that the economic recovery has been slow for the nonprofit sector and constrained resources have made it difficult to meet ever-increasing demands for services. More than half of respondents did not believe their
JANUARY 2012 / THE CPA JOURNAL

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organizations could meet demand in 2011. Even more concerning is the 63% of lifeline nonprofits that expected to be unable to meet demand. Half of all survey participants indicated that the type of support they most needed was unrestricted general operating funding. The aforementioned Guide to Navigating Changing Times presents frequently asked questions and answers, which often contain links to additional resources. The same materials are available throughout the website, but the guide saves users time by identifying items from sections of the website that CPAs might not normally investigate. For example, the question, What is the impact of recession on the nonprofit sector? provides summaries of the annual surveys mentioned above. Another question, What should my nonprofit consider doing during this financial crisis? offers links to a self-assessment worksheet and questions to assess and address risk. Finally, How should my nonprofit handle a facility project during the recession? includes a link to an NFF webpage on the New Markets Tax Credit program. The websites research and guides section contains case studies, planning guides, studies and reports, survey results, tips, videos, webinars, and worksheets. Many of these resources would be quite useful for CPAs working with non-accountants at nonprofit organizations. Case studies include Appreciating Depreciation: Thinking Strategically About Fixed Assets, which addresses the need to fund regular maintenance and renovation, items that are often not provided for by capital campaign donations. Case for Capital: Financial Reporting Done Right, is a four-page PDF planning guide that presents a U.S. GAAP-compliant approach to increasing transparency in reporting capital management by segregating capital from revenue. Why Do Balance Sheets Matter? is a six-page reprinted article that explains the balance sheet in nontechnical language, including a sample financial statement. Preparing Your Organization to Apply for a Loan is a 60-minute webinar with a lengthy question-and-answer session that is also available as a downloadable slideshow. The tips section of the page contains Top Ten Financial Essentials for
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Nonprofits and Funders, available as a PDF. These tips for funders include realizing that nonprofit is a tax status, not a business plan, and understanding that nonprofits must balance mission, capacity, and finance to be effective. Examples of additional tips for nonprofits are insisting on

ital funding. Social Currency offers connections to other blogs, such as Next Billion and Philanthropy 2173. Many entries include links to other resources, as well as a list of keyword links to connect to related posts. For example, a September entry, Impact Investing: Transforming

Examples of additional tips for nonprofits are insisting on clear, reliable, routine, management-friendly financial information, as well as telling the program story in financial terms and the financial story in program terms.

clear, reliable, routine, management-friendly financial information, as well as telling the program story in financial terms and the financial story in program terms. The webpage also offers worksheets, including two-page financial self-assessment surveys that feature checklists of questions regarding revenues, expenses, profitability, the balance sheet, liquidity, and financial planning. The Guide to Navigating Changing Times also offers two worksheets. Questions to Consider in a Financial Crisis is a one-page PDF that serves as a simple self-assessment tool for developing a financial portrait that can be shared with funders and supporters. The assessment covers revenue reliability and changes in revenue streams, cost-cutting measures, effects of operating results on the balance sheet, effects of changes in the balance sheet on liquidity, and flexible budgeting. Tips for Nonprofits in Navigating the Financial Crisis, another one-page PDF, offers a financial planning approach for assessing risk and then addressing it. The guidance is provided in the form of well-defined action steps.

Other Resources
The NFFs interesting blog, Social Currency, has recent posts on deficit management, traits needed to make successful financial changes, and flexible cap-

How We Make Money While Making a Difference, contains a link to a recent 40page issue of Innovations, a quarterly entrepreneurial journal. The blog also offers a search feature and access to the past years archives. Web chats are series of online discussions and question-and-answer sessions with experts in a variety of nonprofit financial fields. The Summer 2011 series addressed adjusting to the new normal; the Fall 2010 series explored new strategies in nonprofit finance. Attendance is free to all users, and transcripts of the chats are available after the event ends. The other resources webpage includes links to about two dozen external websites, including the Center for Effective Philanthropy, the Council on Foundations, and the Urban Institute. The Guide to Navigating Changing Times also contains handy links to outside websites, such as the 12 branches of the Federal Reserve Bank and the Foundation Center. The regional office webpages provide information on regional services and upcomK ing events. Susan B. Anders, PhD, CPA, is a professor of accounting at St. Bonaventure University, St. Bonaventure, N.Y.

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CLASSIFIED
PROFESSIONAL OPPORTUNITIES
NASSAU COUNTY / NEW YORK CITY CPA FIRM Established firm with offices in NYC and Long Island, which has successfully completed transactions in the past, seeks to acquire or merge with either a young CPA with some practice of his own or a retirement-minded practitioner and/or firm. Call partner at 516.328.3800 or 212.576.1829.

M A R K E T P L A C E
Rotenberg Meril, Bergen Countys largest independent accounting firm, wants to expand its New York City practice and is seeking merger/acquisition opportunities in Manhattan. Ideally, we would be interested in a high quality audit and tax practice, including clients in the financial services sector, such as broker dealers, private equity and hedge funds. An SEC audit practice would be a plus. Contact Larry Meril at lmeril@rmsbg.com, 201-487-8383, to further discuss the possibilities. Merger Opportunity Very successful midtown practice (volume over $3M) with attractive offices and two partners seeks to build it to a nice midsize firm. If you seek merger into a highly profitable upbeat environment and have a volume of $500K-5M, please contact us now to discuss the opportunity. Write confidentially to nyccpamerger@yahoo.com.

PROFESSIONAL OPPORTUNITY l SPACE FOR RENT l SITUATIONS WANTED l FINANCIAL ACCOUNTING & AUDITING l PRACTICE WANTED l PRACTICE SALES l HOME OFFICE FOR SALE l BUSINESS SERVICES l TAX CONSULTANCY PEER REVIEW l PROFESSIONAL CONDUCT EXPERT l EXPERIENCED TAX PROFESSIONALS WANTED l POSITIONS AVAILABLE l EDUCATION

NYC Retirement minded practitioner needs tax CPA. Will train and transition. Flexible time acceptable. Italian Language Helpful. Principals Only Rapstore@aol.com. SEEKING SOLE PRACTITIONER FOR MERGER with a book of business in lower Westchester County. Have space and will grow together. BACFIRM@GMAIL.COM.

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Goldstein Lieberman & Company LLC one of the regions fastest growing CPA firms wants to expand its practice and is seeking merger/ acquisition opportunities in the Northern NJ, and the entire Hudson Valley Region including Westchester. We are looking for firms ranging in size from $300,000 - $5,000,000. To confidentially discuss how our firms may benefit from one another, please contact Phillip Goldstein, CPA at philg@glcpas.com or (800) 839-5767. CPA Firm Seeks to purchase small write-up practice in Metro NY area. E-mail: sbdcpa@ymail.com.

34th Street/Penn Station Area. Windowed office available in newly renovated CPA suite. Full service building; City views, many amenities. Call Len at 212-868-2511. CPA FIRM LOCATED IN LOWER WESTCHESTER has attractive windowed office space available for occupancy. Conveniently located. Association with retirement-minded or Sole practitioner possible. Accountingfirm17@gmail.com.

NEED TO INCORPORATE? Complete Incorporation Package Includes: PreparationState Filing Fees Corporate Kit via UPS Registered Agent Services Available NEED TO DISSOLVE or REINSTATE or AMEND? Qualified Staff to Help Accomplish Your Corporate or LLC Goals! All 50 States. Simply Call. INTERSTATE DOCUMENT FILINGS INC. Toll Free 800-842-9990

SITUATIONS WANTED
Melville, Long Island CPA firm seeking to acquire practice of retirement minded professional whose practice includes tax, compilations and reviews, and bookkeeping services. Contact steve@stevenrosecpa.com or (631) 393-6430. New York City Metro Technical Accounting/Auditing Pro seeks issues-oriented and financial statements completion-type work, such as draft footnotes and statement format, on a project or other basis at a reasonable professional rate for CPAs in need of this type of temporary help. Also available for audit, reviews or compilations workpaper or report review. Can serve in SOX/PCAOB concurring partner review function or independent monitoring function under new Engagement Quality Review (EQR) in years between smaller firm AICPA Peer Reviews. Call 516-249-2882. OVERTAXED & OVERWORKED? Let SL Tax Consulting, LLC assist with compliance, review, research, planning and audits. Expertise in Federal and multi-state corporate income, franchise, sales, use and other business taxes. Owned by a CPA with over 30 years of tax experience. Reasonable professional rates. SL Tax Consulting, LLC Contact: SLTax@optimum.net or (908) 692-6700.

margenjid@yahoo.com

Do you need to find BALANCE?

Psychotherapy for the Professional Private and Confidential Depression * Anxiety Relationship Conflict * Substance Abuse

SPACE FOR RENT

OFFICE SPACE AVAILABLE THROUGHOUT MANHATTAN 300 square feet to 15,000 square feet. Elliot Forest, Licensed Real Estate Broker, 212-447-5400. AAA PROFESSIONAL OFFICES FOR RENT. NASSAU COUNTY. 1-, 2-, 3-room suites facing Hempstead Tpke. FREE UTILITIES. FREE FRONT PARKING. 516-735-6681.

2129796445
Charles Cucchiara, L.C.S.W.
80 East 11th Street, Suite 312 New York, NY 10003

BUSINESS OPPORTUNITIES
Nassau County peer reviewed sole practitioner with Masters in Taxation has available time to assist overburdened practitioner. Open to merger, buyout or other arrangements. bcpa11@yahoo.com. Westchester CPA firm seeks to acquire accounts and/or practice. Retirement minded, sole practitioners, and small firms welcome. High retention and client satisfaction rates. Please call Larry Honigman at (914) 762-0230, or e-mail Larry@dhcpas.biz.

Midtown CPA firm has large, furnished, windowed office. Internet and services also available. Contact David Mond at dmond@akmcpa.com or 212.382.0404.

Melville Long Island on Rte 110

Two windowed offices in a CPA Suite; Full service building with amenities including use of a conference room. Cubicles also available. Contact Lenny at 212-736-1711 or Bradley@smallbergsorkin.com. ESTABLISHED WALL ST. CPA Looking for the right CPA to share/merge info@goldfinecpa.com 212-714-6655

TAX CONSULTANCY
INNOVATIVE STRATEGIES
for sales and use tax compliance, audits, refunds, appeals, and bankruptcy. Extensive multistate experience.

BUSINESS SERVICES
Steve Strickler, CFP specializing in helping CPAs buy or start a practice. Consulting for Financing, Marketing and Practice Valuation. 410-988-2924.

12.965sf on W. 34th St. 19 offices, 2 conference rooms, lots of extras, rent negotiable. Elliot @ 212-447-5400.

Jeffrey J. Coren, CPA

212-594-6970

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SALES TAX, AUDITS, APPEALS, & CONSULTATIONS. Experience: Many years with New York State Sales Tax Bureau as auditor and auditor supervisor. Jack Herskovits. 718-436-7900. SALES TAX, ISAAC STERNHEIM & CO. Sales tax consultants, audits, appeals, & consultations. Principals with many years of experience as Sales Tax Bureau audit supervisors. (718) 436-7900. SALES TAX PROBLEMS? More than 25 years of handling NYS audits and appeals. CPAs, attorney, and former NYS Sales Tax Auditor on staff. All businesses, including service stations, pizzerias, restaurants. Free initial consultation. Rothbard & Sinchuk LLP 516-454-0800, x204

Buxbaum Sales Tax Consultants

www.nysalestax.com (845) 352-2211 (212) 730-0086 A Leading Authority in Sales & Use Tax For the State of New York Sales Tax Audits Resolution with Client Satisfaction Tax Appeals Representation Results at the NYS Division of Tax Appeals Collection Matters Resolving Old Debts & New Liabilities Refund Opportunities Recovering Sales & Use Tax Overpayments More than 40 years of successful results! See our published decisions

PEER REVIEW SERVICES

PREPARE FOR PEER REVIEW Yehuda@bunkercpa.com 718-438-4858 Yehuda Bunker, CPA 30 years not for profit accounting. CPE courses in auditing available. PEER REVIEW SPECIALIZING IN EMPLOYEE BENEFIT PLANS CIRA, BROKER DEALERS INSPECTIONS & REVIEW SERVICES JOHN M SACCO, CPA JMSaccocpa@SAccoManfre.com 914-253-8757 SACCO MANFRE CPA PLLC Midtown CPA firm seeks merger or purchase of practice. We have the space, finances, staff and experience to ease a transition and to provide for very high retention and satisfaction of your existing client base. Complete confidentiality. E-mail: lkatz@akmcpa.com.

PRACTICE WANTED

FINANCIAL ACCOUNTING & AUDITING

Accounting Manager, Suwanee, GA: Bachelor's degree in Accounting plus 5 yrs. exp. in accounting and financial mgmt. reqd. Resume to Evan Song Enterprises, Inc., 1199 Station Center Blvd., Suwanee, GA 30024. CPA, Birmingham, AL: Master's degree in Accountancy plus CPA license and 1 yr. exp. (or Bachelor's + 5 yrs. exp.) as financial analyst or financial manager. Resume to Rodl Warren Averett, LLC, 2500 Acton Rd., Birmingham, AL 35243.

SALES TAX PROBLEMS?

Are you being audited? Free Evaluation Former Head of NY Sales Tax Division Audits Appeals Refund Claims * Reasonable fees * (212) 563-0007 (800) 750-4702 E-mail: lr.cole@verizon.net LRC Group Inc. Lawrence Cole, CPA Nick Hartman

Peer Review Services HIGH QUALITY / PRACTICAL APPROACH Peer reviews since 1990. Review teams with recognized experts in the profession. David C. Pitcher, CPA / Gregory A. Miller, CPA DAVIE KAPLAN, CPA, P.C. 585-454-4161 www.daviekaplan.com.

Peer Review If you need help, the first step is Nowicki and Company, LLP 716-681-6367 ray@nowickico.com

MARKETING SERVICES
FREE brochure How to Establish Your Fees. Practical tips for accountants who want to improve their fee structure. Call Mostad & Christensen at (800) 654-1654 or go to: www.mostad.com/kc/ss.

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PROFESSIONAL CONDUCT EXPERT

PROFESSIONAL CONDUCT EXPERT Former Director Professional Discipline, 25 Years Experience, Licensure, Discipline, Restoration, Professional Advertising, Transfer of Practice; AICPA and NYSSCPA Proceedings, Professional Business Practice. Also available in Westchester County ROBERT S. ASHER, ESQ. 295 Madison Avenue, New York, NY 10017 (212) 697-2950

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Rates & Word Count: Basic Rate: $4.00 per word; $56 minimum charge14 words. Classified Display & Color Rates: 2 1/4 x 1 col. inch = $165.00 net *Special Option: Logo in color = $45.00 net Closing Date: All ads must be received no later than the first Monday of the month preceding the issue date. Payment: All ads are prepaid. Payment by check or credit card must be received by the 1st of the month preceding the issue date. All checks should be mailed to: NYSSCPA P.O. Box 10489 Uniondale, NY 11555-0489 Ad copy should be e-mailed as a Word attachment: mdeise@executivepublishing.com katieg@executivepublishing.com (do not send ad copy to P.O. Box). Please note on the ad copy which issue(s) you would like the ad to run in and the check number which was sent in payment. For further information, please call Sales Desk at 410-893-8003, fax: 1-410-893-8004, or E-mail: mdeise@executivepublishing.com katieg@executivepublishing.com

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Ad Index & FAXFORMATION Service. Heres the quickest and easiest way to receive information from the advertisers in this issue of The CPA Journal. Simply circle the name of the company/product you are interested in and fax this page or a copy to us at: FAX # 800-605-4392.

Ad Index & Website Connections

AD INDEX Page# INTERNET ADDRESS Find our advertisers on the Web. AD INDEX Page# INTERNET ADDRESS Find our advertisers on the Web.

ADP Small Business Services PNC Bank HP Audimation Services, Inc.

C2 www.accountant.adp.com 01 29 37 www.pnc.com/cfo www.hp.com/go/voyager www.audimation.com

Transition Advisors, LLC Pearl Insurance Sterling National Bank

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www.transitionadvisors.com

C3 www.nysscpainsurance.com C4 www.snb.com

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JANUARY 2012 / THE CPA JOURNAL

C O N O M I C

& M A R K E monthly update

A T A

Fort Capitals Selected Statistics

U.S. Equity Indexes S&P 500 Dow Jones Industrials Nasdaq Composite NYSE Composite Wilshire 5000 Dow Jones Transports Dow Jones Utilities 11/30/11 1,247 12,046 2,620 7,485 13,039 4,946 449 YTD Return -0.80% 4.00% -1.20% -6.00% -1.90% -3.10% 10.80% Fort Capital's Proprietary Market Risk Barometer Market Valuation Monetary Environment Investor Psychology Internal Market Technicals Overall Short-Term Outlook Overall Long-Term Outlook 4.45 6.03 Bullish 10 9 8 7 Neutral 6 5 4 5 6 5 5 Bearish 3 2 1

As of 10/31/11

Selected Interest Rates Fed Funds Rate 3-Month Libor Prime Rate 15-Year Mortgage 30-Year Mortgage 1-Year ARM 3-Month Treasury Bill 5-Year Treasury Note 10-Year Treasury Bond 10-Year Inflation Indexed Treas.

11/30/11 0.08% 0.53% 3.25% 3.38% 4.02% 2.78% 0.01% 0.96% 2.07% 0.03%

10/31/11 0.08% 0.43% 3.25% 3.42% 4.13% 2.95% 0.02% 0.97% 2.11% 0.08%

Equity Market Statistics Dow Jones Industrials Dividend Yield Price-to-Earnings Ratio (12 Mth Trailing) Price-to-Book Value S&P 500 Index Earnings Yield Dividend Yield Price/Earnings (12 Mth Trailing as Rpt) Price/Earnings (2011 EPS Est as Rpt)

10/31/11 2.71% 15.34 2.53 7.56% 2.18% 13.23 12.85

09/30/11 2.94% 11.79 2.35 8.04% 2.31% 12.45 11.54

Key Economic Statistics National Producer Price Index (monthly chg) Consumer Price Index (monthly chg) Unemployment Rate ISM Manufacturing Index ISM Services Index Change in Non-Farm Payroll Emp. New York State Consumer Price Index - NY, NJ, CT Unemployment Rate NYS Index of Coincident Indicators

Most Recent

Prior Month
9.60%

Chart of the Month

Unemployment Rate
9.40% 9.20% 9.00% 8.80% 8.60% 8.40% 8.20% 8.00%

-0.30% -0.10% 8.60% 52.70 52.00 120,000

0.80% 0.30% 9.00% 50.80 52.90 80,000

7.90% -1.70%

8.00% -0.20%

Commentary on Significant Economic Data This Month The unemployment rate declined from 9.0% in October 2011 to 8.6% in November, falling to a rate not seen in two and a half years, since March 2009. The decline in the unemployment rate came from both an increase in jobs as well as a contraction of 315,000 in the labor force. It is likely that many of the long-term unemployed are simply dropping out of the labor force as their unemployment insurance benefits expire. The government continued to drag down payrolls, as there were 20,000 job cuts in the public sector, while private payrolls rose by 140,000, a smaller increase than the previous month.
The information herein was obtained from various sources believed to be accurate; however, Fort Capital does not guarantee its accuracy or completeness. This report was prepared for general information purposes only. Neither the information nor any opinion expressed constitutes an offer to buy or sell any securities, options, or futures contracts. Fort Capitals Proprietary Market Risk Barometer is a summary of 30 indicators and is copyrighted by Fort Capital LLC. For further information, visit www.forte-captial.com, send a message to info@forte-capital.com, or call 866-586-8100.

De c

Source: Federal Reserve

Fe b

Ja n

-0.20%

0.20%

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20 11 M ar 20 11 Ap r2 01 1 M ay 20 11 Ju n 20 11 Ju l2 01 1 Au g 20 11 Se p 20 11 Oc t2 01 1 No v2 01 1

20 10

20 11

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E D I T O R I A L a message from the editor-in-chief

Tax Reform
Reflecting Our Values

hroughout the history of taxation in the United States, taxes have been used to encourage or discourage certain types of behavior. For example, personal deductions for real estate taxes and mortgage interest on primary and secondary residences have encouraged home ownership, while high excise taxes on tobacco products, heating oil, and gasoline have attempted to curtail their use. Of late, there has been much discussion among our legislators and those in the media about the need for tax reform, to reduce complexity and to enhance the systems overall fairness. But there are differing opinions on how to define the concept of equity and what direction reform should takegenerally along partisan lines. Historically, equality and progressivity have been cornerstones of the U.S. tax structurea progressive tax structure applies a higher marginal rate to higher income earnersbut over the past few decades, our federal tax system seems to be moving away from these goals. For example, the alternative minimum tax (AMT) has been steadily affecting more and more middle class taxpayers because it has not been adjusted for inflation since 1969 when it was first enacted. And the Social Security payroll tax applies only up to a cap (106,800 for 2011); taxpayers with incomes above this cap do not pay any more in taxes as their income rises.

challenged or long-term unemployed. Our tax code has a history of providing incentives to achieve desired social and economic goals. Lets use it to help create more job opportunities for all workers. Such a program could potentially pay for itself because of the added income tax revenue that would be collected from a larger workforce.

Growing the Economy

As part of last Decembers Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act, Congress enacted a one-year tax holiday that reduced the Social Security withholding rate by two percentage points for employeesfrom 6.2% to 4.2%. Its cost was approximately $120 billion and it expired as of December 31, 2011. By most economists assessments, the extension of this tax cut is essential to the health of our economy. But how do we pay for it without running up an even larger debt? At the time The CPA Journal went to press, the U.S. Senate had agreed to a two-month extension but House Republicans had publicly opposed the bill. There were reports in the media that Democrats proposed to fund this plan by raising taxes on taxpayers earning more than $1 million annually. But instead the proposal pays for the tax cut extension with new fees on Fannie Mae and Freddie Mac, the mortgage lending giants. These fees will, no doubt, be passed on to home buyers, and will further exacerbate problems in the housing market.

Policy Development and Research, Housing data for the third quarter of 2011 indicate that the recovery in the housing market continues to remain fragile (U.S. Housing Market Conditions, November 2011). For most Americans, their home is their largest single investment. Unless we can establish tax policies that will help our housing sector bounce back from its economic ailments, prospects for an economic recovery will likely remain elusive.

Timeless Advice
A message that President Roosevelt wrote to Congress on June 19, 1935advocating an inheritance tax in addition to an estate taxcontinues to have relevance today. In the message he said: Our revenue laws have operated in many ways to the unfair advantage of the few, and they have done little to prevent an unjust concentration of wealth and economic power. Therefore, in spite of the great importance in our national life of the efforts and ingenuity of unusual individuals, the people in the mass have inevitably helped to make large fortunes possible. Whether it is wealth achieved through the cooperation of the entire community or riches gained by speculationin either case, the ownership of such wealth or riches represents a great public interest and a great ability to pay. As always, I welcome your comments. K Mary-Jo Kranacher, MBA, CPA/CFF, CFE Editor-in-Chief ACFE Endowed Professor of Fraud Examination, York College, The City University of New York (CUNY) mkranacher@nysscpa.org
JANUARY 2012 / THE CPA JOURNAL

Reducing Unemployment
Many argue that we cant raise taxes on the wealthy because they are the job creators. But where are the jobs? Unemployment and housing foreclosures are the desperate reality for many in our society. Providing tax credits for a business that incrementally increases its workforce could encourage businesses to hire more employees; historically, these tax credits were restricted to hires from certain groups, such as veterans, the physically

Shore Up Housing
According to the U.S. Department of Housing and Urban Developments Office of

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